Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-2 Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-3 Chapter 1: Financial Statements An Overview maze (māz), n. 1. An intricate, usually confusing network of passages, some blind and some leading to a goal. 2. Anything made up of many confused or conflicting elements. 3. A mental state of confusion or perplexity.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-4 Map or Maze A map helps its user reach a desired destination through clarity of representation.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-5 Map or Maze A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-6 Auditor’s Report Statement of Cash Flows MD&A Statement of Shareholders’ Equity Balance Sheet Notes Income Statement Map or Maze A maze of information

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-7 Map or Maze Business financial statements have the potential for being map and maze.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-8 Financial Statements as a Map Form the basis for understanding the financial position of a firm Allow users to assess historical and prospective financial performance Present clear representations of firm’s financial health, leading to informed business decisions

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-9 Financial Statements as a Maze Overwhelming amount of information Unreliable auditing Constantly changing and complex policies and reporting requirements Considerable discretion given to management, influencing content and presentation Key information hidden or omitted

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-10 Main Objectives of This Book Ensure that financial statements serve as a map, not a maze Demonstrate how to read and evaluate business financial statements Provide the tools and techniques needed to complete a comprehensive financial statement analysis Encourage intelligent decision making

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-11 Usefulness Financial position of the company Financial position of the company Success of operations Success of operations Policies and strategies of management Policies and strategies of management Insight into future performance Insight into future performance Financial statements and accompanying notes contain a wealth of information.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-12 Usefulness Financial statement users should be able to find and interpret information to answer questions about a company. Financial statements and other data generated by corporate financial reporting can help users develop answers to the following questions (and many others).

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-13 Usefulness Questions One Might Ask Would an investment generate attractive returns? What is the degree of risk inherent in the investment? Should existing investing holdings be liquidated? Will cash flows be sufficient to service interest and principal payments on debt?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-14 Usefulness Questions One Might Ask Does the company provide a good opportunity for employment, advancement, and employee benefits? How well does this company compete in its operating environment? Is this firm a good prospect as a customer?

(C) 2007 Prentice Hall, Inc.1-15 Volume of Information: The Annual Report 1. Introduction (period covered; board of directors; major shareholders; business industry) 2. Activities 1.Investments 2.Production and Sale of Goods and Services 3.Financial Structure and risks 4.Corporate Governance Report 5.Assessment of Financial Performance

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-16 Volume of Information Financial Statements Prepared according to generally accepted accounting principles (GAAP) or IFRS Intended to present financial information that is understandable and relevant and reliable for decision- making

(C) 2007 Prentice Hall, Inc.1-17 GAAP  Global: Two major accounting standards:  IFRS (IASB)  US GAAP (FASB)  TURKEY  TAS (TMSK)  Capital Markets Board Standards

(C) 2007 Prentice Hall, Inc.1-18 Development of International Accounting Standards  International Financial Reporting Standards (IFRS-IASB)  14 member committee of auditors, accountants, academics and financial statement users  Developed International Accounting Standards (IAS) to help investors cope with financial analysis in global capital markets  Currently in use by European Union, Australia, South Africa …

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-19 Volume of Information Globalization IASB was created in 1973 with the goal of adopting uniform international accounting standards. Consistency in financial statements would benefit investors and creditors. Companies could list securities in any market with one set of statements.

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(C) 2007 Prentice Hall, Inc.1-21 Where to Find a Company’s Financial Statements:  Istanbul Stock Exchange web site  Annual report  Website of the company

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-22 The Financial Statements Balance Sheet Balance Sheet Income Statement or Earnings Statement Income Statement or Earnings Statement Statement of Stockholders’ Equity Statement of Stockholders’ Equity Statement of Cash Flows Statement of Cash Flows Annual reports contain four basic financial statements.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-23 Notes to the Financial Statements An integral part of the statements Provide a summary of the firm’s accounting policies Explain any changes in accounting policies

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-24 Notes to the Financial Statements Present detail about particular accounts Inventory Inventory Property, plant, and equipment Property, plant, and equipment Investments Investments Long-term debt Long-term debt Equity accounts Equity accounts

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-25 Notes to the Financial Statements Include other information Major acquisitions or divestitures Major acquisitions or divestitures Officer and employee retirement, pension, and stock option plans Officer and employee retirement, pension, and stock option plans Leasing arrangements Leasing arrangements Term, cost, and maturity of debt Term, cost, and maturity of debt

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-26 Notes to the Financial Statements Include other information Pending legal proceedings Pending legal proceedings Income taxes Income taxes Contingencies and commitments Contingencies and commitments Quarterly results of operations Quarterly results of operations Operating segments Operating segments

(C) 2007 Prentice Hall, Inc.1-27 Auditor’s Report  Unqualified  Qualified  Adverse opinion  Disclaimer of opinion

(C) 2007 Prentice Hall, Inc.1-28 Auditor’s Report (cont.)  Unqualified (what you want!)  Statements present information in conformity with GAAP

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(C) 2007 Prentice Hall, Inc.1-30 Auditor’s Report (cont.)

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(C) 2007 Prentice Hall, Inc.1-32 Auditor’s Report (cont.) Auditor’s Report (cont.)  Adverse opinion (not what you want!)  Financial statements have not been presented fairly in accordance with GAAP

(C) 2007 Prentice Hall, Inc.1-33 Auditor’s Report (cont.)  Disclaimer of opinion is issued when  auditor can’t evaluate the fairness of the statements and expresses no opinion  there is material scope limitation of the audit

(C) 2007 Prentice Hall, Inc.1-34 Auditor’s Report (cont.)  Unqualified opinion with explanatory language is warranted when there is  a consistency departure due to a change in accounting principle  uncertainty caused by future events such as contract disputes and lawsuits  an event (or events) that the auditor wishes to describe because they may present business risk and/or going- concern problems

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Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-36 Management Discussion and Analysis (MD&A) Sometimes labeled “Financial Review” Contains information that cannot be found in the financial data Includes coverage of favorable or unfavorable trends and significant events or uncertainties in particular areas

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-37 Companies do a good job of describing historical events. Very few firms provide accurate and meaningful forecasts. Explanations about why changes have occurred in profitability and liquidity are helpful. MD&A Usefulness

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-38 Pandora (A.K.A. “PR Fluff”) Colored photographs Colored photographs Charts Charts Shareholders’ letter from the CEO Shareholders’ letter from the CEO Other items to make the report attractive Other items to make the report attractive Getting to what is needed through the “PR fluff” can be a challenge.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-39 Missing and Hard-to-Find Information Employee relations with management Employee relations with management Morale and efficiency of employees Morale and efficiency of employees Reputation of the firm Reputation of the firm Firm’s prestige in the community Firm’s prestige in the community Effectiveness of management Effectiveness of management Provisions for management succession Provisions for management succession Potential exposure to regulation changes Potential exposure to regulation changes

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-40 Missing and Hard-to-Find Information Affects public perception of firm Affects public perception of firm Can impact financial performance Can impact financial performance Publicity in the Media Breakdown of financial data is found in notes to financial statements Breakdown of financial data is found in notes to financial statements Companies Operating in Several Lines of Unrelated Business

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-41 Complexities GAAP Provide some measure of uniformity Allow management considerable discretion in applying regulations Use of the accrual rather than the cash basis of accounting

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-42 Complexities Accounting Choices Accounting choices and estimates impact financial statement numbers. Quality of financial reporting is impacted if accounting choice does not reflect economic reality. Financial data must be appropriated to particular time periods even though a firm’s life is continuous.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-43 The Future of Financial Statements FASB tends to develop detailed rules. IASB uses broader principles. FASB and IASB are working together to develop one set of standards. Significant changes being worked on include lease accounting, classification of financial instruments, inventory accounting, and revenue recognition.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-44 The Future of Financial Statements Proposal for statements to show subtotals for five general categories Business Business Discontinued operations Discontinued operations Financing Financing Income taxes Income taxes Equity Equity

(C) 2007 Prentice Hall, Inc.1-45 Why Analysts do Analysis?  Evaluating an equity investment to include in a portfolio,  Evaluating mergers and acquisitions,  Evaluating a subsidiary or a segment,  Venture capital decisions,  Determining the creditworthiness of a company that has made a loan request,  Assigning a debt rating,  Valuing a security

(C) 2007 Prentice Hall, Inc.1-46 To Arrive in a Conclusion!!!  They evaluate past financial performance  To predict future financial performance

(C) 2007 Prentice Hall, Inc.1-47 Questions one might ask  Would the investment generate enough returns?  What is the degree of risk?  Will cash flows be adequate to service interest and principle?

(C) 2007 Prentice Hall, Inc.1-48 FINANCIAL STATEMENT ANALYSIS FRAMEWORK 1. Articulate the purpose and the context of the analysis 2. Collect Data  Economy; industry; company; comparable peer company  Financial statements; other financial data  Discussion with management; suppliers; customers;  Company site visit 3. Process data (read the data; prepare common size F/S; calculate ratios) 4. Analyze and interprete data, 5. Develop and communicate conclusions and recommendations

FSA = Business Analysis  Areas of analysis  Plans  Financing  Investing  Operating  Tools of Analysis  Comparative financial statements  Common size financial statement analysis  Ratio analysis  Cash flow analysis  valuation Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall1-49

(C) 2007 Prentice Hall, Inc.1-50 Complexities-1  Accounting choices and estimates and management judgment- accrual basis of accounting  Complex merger&acquisition transactions  Goodwill  Consolidation  Use and accounting for financial instruments such as derivatives  Foreign Operations

(C) 2007 Prentice Hall, Inc.1-51 Complexities-2  Complexity of GAAP (i.e. IFRS)  Frequent change in GAAP

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-52 Quality of Financial Reporting Financial statements should reflect an accurate picture of a company’s financial condition and performance reflect an accurate picture of a company’s financial condition and performance be useful to assess the past and predict the future be useful to assess the past and predict the future The closer the picture to financial reality, the higher the quality of the financial statements.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-53 Quality of Financial Reporting Discretionary Items Budget level and timing of expenditures Budget level and timing of expenditures Marketing and advertising Marketing and advertising Research and development Research and development Capital expansion Capital expansion Replacement of plant assets Replacement of plant assets Development of new product lines Development of new product lines Disposal of an operating division Disposal of an operating division