1 Additional Aspects of Financial Reporting and Financial Analysis C hapter 5

2 1.Describe an auditor’s report. 2.Explain the disclosure in management’s discussions and analysis. 3.Understand the meaning of an operating segment. 4.Describe the disclosure in a segment report. 5.Explain interim reporting. Objectives

3 6.Prepare an interim report. 7.Understand intracompany and intercompany comparisons. 8.Prepare horizontal and vertical percentage analysis. 9.Perform ratio analysis. Objectives

4 Market Efficiency The prices of securities traded in the capital market fully reflect all publicly available information. Evidence from research on an efficient market hypothesis tends to show-- These prices are adjusted almost immediately based on new information and in an unbiased manner.

5 Auditor’s Report (Opinion)  The auditor is independent.  The audit was performed on specified financial statements.  The financial statements are the responsibility of the company’s management; the opinion is the responsibility of the auditors.  The audit was conducted according to generally accepted auditing standards. An auditor’s standard report includes these statements... ContinuedContinued

6 Auditor’s Report (Opinion)  The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements.  The audit included examination, assessment, and evaluation stages.  The audit provides a reasonable basis for an opinion.  An opinion is expressed concerning the fair presentation.

7 An unqualified opinion contains three paragraphs. Auditor’s Report (Opinion) The first (introductory) paragraph lists the financial statements that were audited, declares that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The second (scope) paragraph describes what the auditor has done. The third (opinion) paragraph gives the auditor’s opinion.

8  An unqualified opinion is not a “clean bill of health.”  An unqualified opinion provides no assurance of the future success of the company.  An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements. Auditor’s Report (Opinion) There are three things that the audit report does not say.

9 Management’s Discussion and Analysis (MD&A) The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. The MD&A provides information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial condition and changes in financial condition. Where knowledge of segment information is useful to understanding a company’s business, the discussion is to focus on each relevant, reportable operating segment, as well as on the whole company.

10 Liquidity Capital Resources Results of Operations General Information Management’s Discussion and Analysis (MD&A) Major discussion issues that may involve intracompany and intercompany comparisons.

11 Segment Reporting  that engages in business activities to earn revenues and incur expenses,  whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and  for which financial information is available. An operating segment is a component of a company--

12 Segment Reporting An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: Revenue Test Profit Test Asset Test

13 TEAL COMPANY Operating Segment Financial Results for Year Ended December 31, 2000 Reportable Operating Segments All Other Total A B C Segments Results Segment revenues$ 300$2,530$ 370$ 600$ 3,800 Segment operating profit (pretax)$ 70$ 495$ 105$ 140$ 810 General corporate expenses(100) Corporate interest expense (80) Pretax income from cont’g operations$ 630 Segment assets at 12/31/2000$1,800$9,400$2,000$2,800$16,000 Gen. corp. assets 3,000 Total assets 12/31/2000$19,000

14 Interim Income Taxes Estimated Annual Income: First quarter$20,000actual income Second quarter26,000actual income Third quarter25,000estimated income Fourth quarter 29,000estimated income $100,000estimated annual income Continued

15 Interim Income Taxes Estimated Effective Income Tax Rate: Continued $ 3, /4 3m 15% x $20,000 = $ 3,000 30% x ($100,000 - $20,000) = 24,000 Estimated total tax = $27,000 27% Effective tax rate = $27,000 Estimated income tax $100,000 Estimated Income

16 Interim Income Taxes Estimated Income Tax for First Six Months: $ 3, /4 3m $46,000 x 27% = $12,420 estimated income tax on first six months’ income Estimated Income Tax for Second Quarter: $ 3, /4 3m $12,420 estimated income tax on first six months of income (5,220)estimated income tax on first-quarter income $7,200 estimated income tax on second-quarter income

17 Preparation of Disclosure of Summarized Interim Financial Data When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum.

18 Preparation of Disclosure of Summarized Interim Financial Data Sales or gross revenues, income taxes, extraordinary items (net of tax), the cumulative effect of a change in accounting principle, and net income. Earnings per share for each period presented. Seasonal revenues, costs, and expenses. Significant changes in estimates of income taxes. Contingent items. Changes in accounting principles or estimates. Significant changes in financial position.

19 SEC Reports Two SEC forms that are important to accountants are-- Form 10-K Form 10-Q

20 SEC Reports Form 10-K is the most common SEC annual report form and is required to be filed with the SEC within 90 days of a company’s fiscal year-end.

21 SEC Reports Form 10-Q is used to report a company’s quarterly financial information to the SEC and is required to be filed within 45 days of the end of the company’s first three fiscal quarters.

22 Financial Analysis Comparison Financial Analysis Comparisons Intracompany Intercompany Percentage Analyses Horizontal Vertical Ratio

23 Horizontal Analysis In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars.

24  from 12/31/00 to 12/31/01 Base Year % = Horizontal Analysis Sales$138,000 $130,000 12/31/01 12/31/00 $8,000 $130,000 % = = 6.2% Now, using the data from Exhibit 5-5, let’s try gross profit from December 31, 1999 to December 31, 2001.

25  from 12/31/99 to 12/31/01 Base Year % = Horizontal Analysis Gross profit$55,900 $42,000 12/31/01 12/31/ 99 $13,900 $42,000 % = = 33.1%

26 Vertical Analysis (Income Statement) In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars.

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, Sales, $138,000 Sales, net, $130,000 = Vertical Analysis (Income Statement)

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (6.2)% Sales returns, ($8,000) Sales, net, $130,000 = (6.2) Vertical Analysis (Income Statement)

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (57.0)% Cost of goods sold, ($74,100) Sales, net, $130,000 = (6.2) (57.0) Vertical Analysis (Income Statement)

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, % Gross profit, $55,900 Sales, net, $130,000 = (6.2) (57.0) 43.0 Vertical Analysis (Income Statement)

31 Vertical Analysis (Balance Sheet) 2001 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, % Cash, $3,900 Total Assets, $129,200 = 3.0 Total Assets $129,

32 Vertical Analysis (Balance Sheet) 2001 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129, % Receivables (net), $7,600 Total Assets, $129,200 = 5.9

33 Vertical Analysis (Balance Sheet) Using this approach on the rest of the assets, this section can be completed.

34 Vertical Analysis (Balance Sheet) 2001 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129,

35 In calculating vertical analysis amounts for liabilities and stockholders’ equity, all items are divided by “total liabilities and stockholders’ equity.” Vertical Analysis (Balance Sheet) 3.9% Accounts Payable, $5,000 Total L& SE, $129,200 =

36 Ratio Analysis Stockholders’ Profitability Ratios Earnings per share is probably the most frequently cited ratio in a financial analysis. Net Income - Preferred Dividends Average Common Shares Outstanding $11,000$1,200 5,400 = $1.81

37 Ratio Analysis Stockholders’ Profitability Ratios Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. Market Price per Common Share Earnings per Share $14.25 $1.81 = 7.9 times

38 Ratio Analysis Stockholders’ Profitability Ratios Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as compared with the ending market price of the stock. Dividends per Common Share Market Price per Common Share $1.00 $14.25 = 7.0%

39 Ratio Analysis Company Profitability Ratios Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. Net Income Net Sales $11,000 $130,000 = 8.5%

40 Ratio Analysis Return on total assets indicates how efficiently a company uses its economic resources. Net Income + Interest Expense (net of tax) Average Total Assets $11,000 + ($3,000 x 0.7) ($129,200 + $112,000)/2 = 10.9% Company Profitability Ratios

41 Ratio Analysis Return on stockholders’ equity shows the residual returns on the owners’ equity. Company Profitability Ratios Net Income Average Stockholders’ Equity $11,000 ($93,000 + $79,000)/2 = 12.8%

42 Ratio Analysis The current ratio is used to evaluate a company’s short-run liquidity. Liquidity Ratios Current Assets Current Liabilities $21,400 $11,200 = 1.91 times

43 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Liquidity Ratios Quick Assets Current Liabilities $11,500 $11,200 = 1.03 times

44 Ratio Analysis Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period. Activity Ratios Cost of Goods Sold Average Inventory $74,100 ($8,900 + $10,100)/2 = 7.8 times or 47 days

45 Ratio Analysis Receivables turnover indicates how many times receivables are “turned over” or collected each period. Activity Ratios Net Credit Sales Average Net Receivables $130,000 x 0.70 ($7,600 + $8,600)/2 = 11.2 times or 33 days

46 Ratio Analysis The payables turnover ratio measures the number of times accounts payable turns over during the year. Activity Ratios Cost of Goods Sold Average Accounts Payable $74,100 ($5,000 + $6,600)/2 = 12.8 times or 29 days

47 Ratio Analysis The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets $36,200 $129,200 = 28%

48 Ratio Analysis Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings. Stability Ratios Pretax Operating Income Interest Expense $15,700 + $3,000 $3,000 = 6.2 times

49 Ratio Analysis Book value per common share shows the net assets per share of stock. Stability Ratios Common Stockholders’ Equity Outstanding Common Shares $93,000 - ($140 x 150) 5,400 = per common share

50 Ratio Analysis Cash flow from operations to sales ratio is used to evaluate the cash generated from sales. Cash Flow Ratios Cash Flow From Operations Sales

51 Ratio Analysis Cash flow from operations to net income ratio enables users to understand how the earnings of net income relates to the cash flow from operations. Cash Flow Ratios Cash Flow From Operations Net Income

52 Ratio Analysis Cash flow from operations per share is expressly prohibited. However, users may wish to compute it for internal use. Cash Flow Ratios Cash Flow From Operations Average Shares of Common Stock Outstanding

53 Ratio Analysis Cash flow from operations divided by the amount of debt maturing next year ratio measures the ability of a company to make principal payments. Cash Flow Ratios Cash Flow From Operations Debt Maturing Next Year

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