UNDERSTANDING FINANCIAL STATEMENTS Accounting Environment and Financial Statements Chapter 1- Part 1

Why use financial statements ? Financial statements allows users to assess: –financial position of the company –success of its operations –policies and strategies of management –insight into future performance Financial statements are “historical,” but they can help see into the future Financial statements allows users to assess: –financial position of the company –success of its operations –policies and strategies of management –insight into future performance Financial statements are “historical,” but they can help see into the future

Users of accounting information- stakeholders Internal users—those who make decisions directly affecting the internal operations of the enterprise. Board of directors Compensation plans, hiring and termination decisions. Dividend payment decisions. Investment in new PPE decisions. Management Operating, financing, and investing decisions. Reporting decisions. Employees Employment/compensation decisions. Internal users—those who make decisions directly affecting the internal operations of the enterprise. Board of directors Compensation plans, hiring and termination decisions. Dividend payment decisions. Investment in new PPE decisions. Management Operating, financing, and investing decisions. Reporting decisions. Employees Employment/compensation decisions.

External “stakeholders” Investors and potential investors (stockholders) Creditors and potential creditors (banks, bondholders) Suppliers Customers Unions Community Governmental agencies (SEC, IRS) Other interested parties (e.g., financial analysts) Investors and potential investors (stockholders) Creditors and potential creditors (banks, bondholders) Suppliers Customers Unions Community Governmental agencies (SEC, IRS) Other interested parties (e.g., financial analysts)

Questions of External FS Users 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 pay dividends? Will cash flows be sufficient to service interest and principal payments on debt? How well does this company compete in its operating environment? Is this firm a good prospect as a customer? 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 pay dividends? Will cash flows be sufficient to service interest and principal payments on debt? How well does this company compete in its operating environment? Is this firm a good prospect as a customer?

Financial reporting: reporting to external users Management incentives Management has a natural self-bias. Accounting standards and other safeguards ensure that accounting information is neutral and objective. Uniform presentation – Annual report (Balance Sheet, Income Statement, Statement of Retained Earnings, Statement of Cash Flows, Notes to the financial statements, auditor’s opinion, MD&A, other supplemental information) Management incentives Management has a natural self-bias. Accounting standards and other safeguards ensure that accounting information is neutral and objective. Uniform presentation – Annual report (Balance Sheet, Income Statement, Statement of Retained Earnings, Statement of Cash Flows, Notes to the financial statements, auditor’s opinion, MD&A, other supplemental information)

External Audit Required of publicly traded companies External auditors hired by the company’s Audit Committee (which is a committee of the stockholders’ board of directors) The external auditors issue an opinion –Unqualified – “fairly stated” in accordance with GAAP –Qualified – “fairly stated” except for…… –Adverse – “NOT fairly stated” (very bad) –Disclaimer – NO OPINION is given (also very bad) Required of publicly traded companies External auditors hired by the company’s Audit Committee (which is a committee of the stockholders’ board of directors) The external auditors issue an opinion –Unqualified – “fairly stated” in accordance with GAAP –Qualified – “fairly stated” except for…… –Adverse – “NOT fairly stated” (very bad) –Disclaimer – NO OPINION is given (also very bad)

GAAP Acctg rules have been issued in order to insure that financial information is relevant, reliable and understandable by users. GAAP provide comparability. Securities and Exchange Commission –Regulates companies traded publicly in the US –SEC has the Congressional authority to set accounting policies. Prior to 2003, SEC had delegated accounting rule- making to the Financial Accounting Standards Board (FASB). –In 2002, Congress set up the Public Company Accounting Oversight Board. (under the SEC) to be responsible for Financial Accounting Standards. Acctg rules have been issued in order to insure that financial information is relevant, reliable and understandable by users. GAAP provide comparability. Securities and Exchange Commission –Regulates companies traded publicly in the US –SEC has the Congressional authority to set accounting policies. Prior to 2003, SEC had delegated accounting rule- making to the Financial Accounting Standards Board (FASB). –In 2002, Congress set up the Public Company Accounting Oversight Board. (under the SEC) to be responsible for Financial Accounting Standards.

Financial Accounting Standards Board (FASB) Comprised of seven full-time paid members Major function is to study accounting issues and establish accounting standards. Issues statements: –Statements of Financial Accounting Standards – Statements of Financial Accounting Concepts –Interpretations Lengthy deliberation process FASB has no enforcement power Comprised of seven full-time paid members Major function is to study accounting issues and establish accounting standards. Issues statements: –Statements of Financial Accounting Standards – Statements of Financial Accounting Concepts –Interpretations Lengthy deliberation process FASB has no enforcement power I hereby inform you that you are in violation of financial acctg std #162

Public Company Accounting Oversight Board Created by Congress in 2002 by Sarbanes-Oxley Act Created as a response to the accounting scandals in 2001/2002 (incl.Enron, WorldCom, Tyco, Qwest, Haliburton) Board will be overseen by the SEC 5 members of which no more than 2 members can be CPAs Has responsibility for setting future accounting principles, i.e. reviewing/revising current accounting principles (incl. revenue recognition issues and stock options). Created by Congress in 2002 by Sarbanes-Oxley Act Created as a response to the accounting scandals in 2001/2002 (incl.Enron, WorldCom, Tyco, Qwest, Haliburton) Board will be overseen by the SEC 5 members of which no more than 2 members can be CPAs Has responsibility for setting future accounting principles, i.e. reviewing/revising current accounting principles (incl. revenue recognition issues and stock options). I’ve got the goods shareholders Corporate Thieves

Sarbanes- Oxley Act The Bill now requires the CEO and CFO to “certify” the results of their company or face legal ramifications. Annual Report must include an internal control report (404): (1) stating the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the year, of the effectiveness on the IC structure and financial reporting procedures (3) The IC report must be attested to by the auditor The Bill now requires the CEO and CFO to “certify” the results of their company or face legal ramifications. Annual Report must include an internal control report (404): (1) stating the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the year, of the effectiveness on the IC structure and financial reporting procedures (3) The IC report must be attested to by the auditor Should have paid more attention in acctg 205 Company Z CFO

Sarbanes- Oxley Act The Bill requires significant changes to audit committees –Each member shall be an independent member of the board of directors –Each audit committee must have a “financial expert” The Bill requires significant changes to audit committees –Each member shall be an independent member of the board of directors –Each audit committee must have a “financial expert” EXPERT

Sarbanes- Oxley Act made it illegal for audit firms to provide nine types of consulting services, incl. bookkeeping, financial IS consulting, internal audits, appraisal, actuarial, human resources, investment banking, and legal services set mandatory five-year audit lead partner and reviewing partner rotation(not rotation of audit firm at this time) made it illegal for audit firms to provide nine types of consulting services, incl. bookkeeping, financial IS consulting, internal audits, appraisal, actuarial, human resources, investment banking, and legal services set mandatory five-year audit lead partner and reviewing partner rotation(not rotation of audit firm at this time) I can do your audit, your bookkeeping, be your internal auditor, provide you investment banking services, IS consulting, your taxes and so forth and so forth

Sarbanes- Oxley Act an auditor on a particular company’s audit cannot accept employment with that company for 1 year after an audit. Public Co. Accounting Oversight Board will establish auditing, ethics, and independence standards and conduct disciplinary investigations, and register audit firms. an auditor on a particular company’s audit cannot accept employment with that company for 1 year after an audit. Public Co. Accounting Oversight Board will establish auditing, ethics, and independence standards and conduct disciplinary investigations, and register audit firms. You need a new CFO? Sounds Great! I can start next week but first I need to finish your “unqualified” audit report Wonderful! Golf at the club on Saturday?

International Accounting Standards International differences in GAAP. Divergent national accounting practices around the world can have a significant impact on reported financial statements. Companies should be able to make their financial statements understandable to users all over the world. A trend is toward increasing harmonization, so differences will diminish over time. International differences in GAAP. Divergent national accounting practices around the world can have a significant impact on reported financial statements. Companies should be able to make their financial statements understandable to users all over the world. A trend is toward increasing harmonization, so differences will diminish over time.

International Accounting Standards International Accounting Standards Committee (IASC) Formed to develop worldwide accounting standards to aid foreign companies and U.S. companies in their business transactions. SEC does not recognize IASC standards as sufficient for listing on U.S. stock exchanges. International Accounting Standards Committee (IASC) Formed to develop worldwide accounting standards to aid foreign companies and U.S. companies in their business transactions. SEC does not recognize IASC standards as sufficient for listing on U.S. stock exchanges.

Annual Report financial statements: Balance Sheet, Income Statement (Earnings Statement), Statement of Shareholders’ Equity Statement of Cash Flows notes to the financial statements auditor’s report 5-year summary of key financial data high and low stock selling prices management discussion & analysis of operations financial statements: Balance Sheet, Income Statement (Earnings Statement), Statement of Shareholders’ Equity Statement of Cash Flows notes to the financial statements auditor’s report 5-year summary of key financial data high and low stock selling prices management discussion & analysis of operations

Notes to Financial Statements Are an integral part of the statements Provide summary of accounting policies Present detail about particular accounts (e.g. inventory, investments, long-term debt) Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes) Are an integral part of the statements Provide summary of accounting policies Present detail about particular accounts (e.g. inventory, investments, long-term debt) Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes)

Additional Information Contain some supplementary information required by SEC and FASB Examples include: –information on foreign currency translations for firms doing business in/with foreign countries –information by segment for firms with several lines of business Contain some supplementary information required by SEC and FASB Examples include: –information on foreign currency translations for firms doing business in/with foreign countries –information by segment for firms with several lines of business

Other Required Information 5 year summary of selected financial data Market data (high and low stock sale prices) for past two years Management Discussion & Analysis (MD&A) 5 year summary of selected financial data Market data (high and low stock sale prices) for past two years Management Discussion & Analysis (MD&A)

MD & A 1.Internal/external sources of liquidity 2. Any material deficiencies in liquidity and how they will be remedied 3. Commitments for capital expenditures/sources of funding 4. Anticipated changes in mix and cost of financing resources 5.Unusual/infrequent transactions which affect income from continuing operations 6.Events causing material changes in cost/revenue relationships (e.g. future price increase) 7.Breakdown of sales increases in price & volume components 1.Internal/external sources of liquidity 2. Any material deficiencies in liquidity and how they will be remedied 3. Commitments for capital expenditures/sources of funding 4. Anticipated changes in mix and cost of financing resources 5.Unusual/infrequent transactions which affect income from continuing operations 6.Events causing material changes in cost/revenue relationships (e.g. future price increase) 7.Breakdown of sales increases in price & volume components

Sources of “Confusion” Earnings per share Consolidation of parent and subsidiaries Reporting leases Reporting pensions Translation of foreign operations Off-balance sheet financing Accounting for derivatives “Comprehensive” income reporting Two sets of books - financial vs. tax reporting Earnings per share Consolidation of parent and subsidiaries Reporting leases Reporting pensions Translation of foreign operations Off-balance sheet financing Accounting for derivatives “Comprehensive” income reporting Two sets of books - financial vs. tax reporting

Quality of Financial Reporting Management has considerable discretion within GAAP Potential exists to “manipulate” the profit/loss reported The closer the financial data presented represent financial reality, the higher the quality of the financial statements and reported earnings Management has considerable discretion within GAAP Potential exists to “manipulate” the profit/loss reported The closer the financial data presented represent financial reality, the higher the quality of the financial statements and reported earnings

Ways to Affect Quality Accounting policies and estimates choices and changes GAAP provide some measure but they allow considerable discretion. Depreciation of fixed assets is a good example: (1) choice of method - S/L, DDB 2) different estimates possible- useful lives and residual value Timing of revenues and expenses Discretionary items Nonrecurring and nonoperating items Accounting policies and estimates choices and changes GAAP provide some measure but they allow considerable discretion. Depreciation of fixed assets is a good example: (1) choice of method - S/L, DDB 2) different estimates possible- useful lives and residual value Timing of revenues and expenses Discretionary items Nonrecurring and nonoperating items