Communicating and Interpreting Accounting Information Chapter 5: Communicating and interpreting accounting information. Chapter 5 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Players in the Accounting Communication Process This graphic identifies the people involved in the accounting communication process. They include regulators, managers, directors, auditors, information intermediaries, and users. Each person or group plays a unique role in the process and is guided by legal and professional standards.

Players in the Accounting Communication Process Management Preparation CEO, CFO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS We will begin this chapter by looking at the players in the accounting communication process. Management is responsible for the preparation of financial statements. The chief executive officer and chief financial officer bear ultimate responsibility for the content of the financial statements. They are guided by members of the accounting staff who followed generally accepted accounting principles. Independent auditors verify the fairness of presentation of the financial statements in accordance with generally accepted accounting standards. Independent auditors are guided by generally accepted auditing standards. An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP.

Players in the Accounting Communication Process Management Preparation CEO, CFO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Information intermediaries such as financial analysts make predictions concerning the company’s future earnings and stock prices as a result of past financial information. Financial analysts make predictions concerning companies’ future earnings and stock prices.

Players in the Accounting Communication Process Management Preparation CEO, CFO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Here are some web sites that contain extensive financial information about publicly listed companies. Web Info Services: www.sec.gov; www.compustat.com; www.finance.yahoo.com; www.bloomberg.com; www.hoovers.com; www.factiva.com

Annual Reports For privately held companies, annual reports are simple documents that include: Four basic financial statements. Related notes (footnotes). Report of independent accountants (auditor’s opinion) if the statements are audited. Privately held companies whose reports are not distributed to the general public are required to issue the four basic financial statements, related notes to financial statements, and if the statements are audited, the auditor’s report. The annual reports of public companies are significantly more elaborate, both because of additional SEC reporting requirements and because many companies use their annual reports as public relations tools.

Annual Reports For public companies, annual reports are elaborate due to SEC reporting requirements: Nonfinancial Section Includes a letter to the stockholders, a description of management’s philosophy, products, successes, etc. Financial Section SEC sets minimum disclosure standards for the financial section for public companies. Due to elaborate reporting requirements of the Securities and Exchange Commission, publicly held companies issue an annual report that can be divided into two major sections. The first section deals with nonfinancial matters and the second section deals with the financials. The nonfinancial section contains a letter to the stockholders, usually from the CEO, a description of management’s philosophy, products produced and sold, and any major successes or failures the company has experienced in the past year. Beautiful photographs of products, facilities, and personnel are often included. The financial section includes the core of the report. The SEC sets minimum disclosure standards for the financial section of the annual report for public companies.

Annual Reports to Shareholders Summarized financial data for 5- or 10-years. Management Discussion and Analysis (MD&A). The four basic financial statements. Notes (footnotes). Independent Accountant’s Report and the Management Certification. Recent stock price information. Summaries of the unaudited quarterly financial data. Lists of directors and officers of the company and relevant addresses. Here is a list of the major categories of information that you will find in the typical annual report of a publicly held company. Towards the end of the report there is a summary of financial data for five or ten years. Management is required to communicate to the reader certain financial and nonfinancial information. This is referred to as management discussion and analysis. All annual reports contain the four basic financial statements and related notes to those financial statements, and the report of the independent accountant, and the management certification. In addition, many annual reports contain information about the recent stock price for each quarter of the year. Also, we may find summaries of unaudited quarterly financial information, a listing of the company’s directors and officers, and relevant addresses and telephone numbers for contacting the company.

Quarterly Reports to Shareholders Usually begin with short letter to stockholders Condensed unaudited income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Publicly held companies usually produce quarterly reports. The typical quarterly report frequently begins with a short letter to the stockholders from either the CEO or the CFO. The quarterly report contains a condensed unaudited income statement and balance sheet for the quarter. In some quarterly reports, we can expect to find a statement of cash flows and the statement of stockholders’ equity, but these are often omitted. Additionally, some notes to the financial statements may be omitted.

SEC Reports – 10-K, 10-Q, 8-K Form 10-K Annual Report Due within 90 days of the fiscal year-end. Contains audited financial statements. Form 10-Q Quarterly Report Due within 45 days of the end of the quarter. Financial statements can be unaudited. Companies are required to prepare reports for the Securities and Exchange Commission. One of the most common reports is known as form 10-K, or the annual report. The form is due within 90 days of the end of the company’s fiscal year and it must contain audited financial statements. The form 10-Q is a quarterly report. It is due within 45 days of the end of each quarter and contains financial statements that are usually unaudited. Form 8-K is a current events report. It is due within 15 days of the occurrence of a major reportable event. Any financial statements that are included in the form can be unaudited. Form 8-K Current Report Due within 4 days of the major event date.

Return on Assets (ROA) Analysis = Net Income* Average Total Assets1 ROA measures how much the firm earned for each dollar of investment. In its broadest measure, return on assets is calculated by dividing net income by average total assets. Remember that average total assets is the beginning asset balance plus the ending asset balance divided by two. ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy. Firms with higher ROA are doing a better job of selecting and managing investments, all other things equal. Since it is independent of the source of financing (debt vs. equity), it can be used to evaluate performance at any level within the organization. It is often computed on a division-by-division or product line basis and used to evaluate division or product line managers’ relative performance. Like all ratios, the key to interpreting change is to dig deeper to understand the reason for each change. Inspection of the income statement reveals that the only reason for the increase in ROA between 2007 and 2008 was an increase in “Other income” from investing activities which cannot be repeated in future periods. Unless consumer discretionary spending increases, it will be very difficult for Callaway to continue to improve its ROA. *(In complex calculations, interest expense (net of tax) and minority interest are added back to net income. 1(beginning total assets + ending total assets) ÷ 2

ROA Profit Driver Analysis Net Profit Margin Asset Turnover = × Net Income Average Total Assets Net Sales × = 1. Net profit margin is Net Income divided by Net Sales. It measures how much of every sales dollar is profit. It can be increased by a. Increasing sales volume. b. Increasing sales price. c. Decreasing cost of goods sold and operating expenses. 2. Asset turnover is Net Sales divided by Average Total Assets. It measures how many sales dollars the company generates with each dollar of assets. It can be increased by a. Collecting accounts receivable more quickly. b. Centralizing distribution to reduce inventory kept on hand. c. Consolidating production facilities in fewer factories to reduce the amount of assets necessary to generate each dollar of sales.

Differences in Accounting Methods Financial accounting standards and disclosure requirements are adopted by national regulatory agencies. Many countries, including the members of the European Union, have adopted international financial reporting standards (IFRS) issued by the International Accounting Standards Board (IASB). IFRS are similar to U.S. GAAP, but there are several important differences. Here is a chart showing some of the key similarity and differences between U. S. GAAP and IFRS rules.

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