Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 5 Corporate Financial Reporting and Analysis

5-2 Activision’s Situation This chapter focuses on Activision—a leading maker of videogames for Sony, Nintendo, and Microsoft, to help us understand how users analyze financial statements to get information to use in their decision-making.

5-3 Learning Objective 1 Explain the needs of financial statement users.

5-4 The Needs of Financial Statement Users Managers Managers at all levels within a company use accounting information to run the business. When accounting information is used by managers to make business decisions, it is being used to fulfill a management function.

5-5 The Needs of Financial Statement Users Directors The board of directors ensure that managers make decisions that benefit stockholders. Stockholders Directors Managers Elect Oversee When accounting information is used by directors to oversee management of the business, it is being used in a governance role.

5-6 The Needs of Financial Statement Users Creditors Creditors use accounting information to decide whether to enter into contracts with a company. Loan covenants are terms of a loan agreement which, if broken, entitle the lender to demand immediate repayment or renegotiation of the loan. When accounting information is used by creditors to administer contracts, it is being used in a contracting role.

5-7 The Needs of Financial Statement Users Investors Investors (and their advisors) look to accounting information to help evaluate the financial strength of a business and ultimately to estimate its value. When accounting information is used to assess stock price, it is being used in a valuation role.

5-8 Learning Objective 2 Describe the environment for financial reporting, including the Sarbanes-Oxley Act of 2002.

5-9 The Fraud Triangl e Accounting Fraud Opportunity (How?) Incentive (Why?) Character (Who?)

5-10 Incentive to Commit Fraud Creating Business Opportunities Satisfying Personal Greed

5-11 Opportunity to Commit Fraud Internal controls are the methods that a company uses to protect against theft of assets, to enhance the reliability of accounting information, to promote efficient and effective operations, and to ensure compliance with laws and regulations.

5-12 Character to Rationalize and Conceal Fraud Most fraudsters have a sense of personal entitlement, which outweighs other moral principles, such as fairness, honesty, and concern for others.

5-13 The Sarbanes-Oxley Act of 2002 Counteract Incentives Reduce Opportunities Encourage Good Character

5-14 Learning Objective 3 Prepare a comparative balance sheet, multi-step income statement, and statement of stockholders’ equity.

5-15 The Financial Reporting Process March 31, 2006 May 4, 2006 June 9, 2006 Fiscal Year End Preliminary Release of Key Results Final Release of Annual Report Financial Statement Preparation Independent External Audit Enhance financial statement format Obtain independen t external audit Release additional financial information

5-16 Financial Statement Formatting The financial statements shown in previous chapters provided a good introduction to their basic structure and content, but they were somewhat simplified.

5-17 Comparative Financial Statements Comparative financial statements report numbers for two or more time periods to make it easy for users to compare account balances from one period to the next.

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5-19 Here is Activision’s comparative, multi-step income statement for a three-year period.

5-20 Here is Activision’s Statement of Stockholders’ Equity.

5-21 Learning Objective 4 Describe significant aspects of the financial reporting process.

5-22 Independent External Audit Auditors, who are experts in financial reporting, issue a one-page report that states whether the company’s financial statements appear to have been prepared using GAAP. An unqualified audit opinion indicates that the financial statements are presented in accordance with GAAP. A qualified audit opinion indicates that either the financial statements do not follow GAAP or the auditors were not able to complete the tests needed to determine whether the financial statements follow GAAP.

5-23 Preliminary Releases Most public companies announce quarterly and annual earnings through a press release that is sent to news agencies.

5-24 Financial Statement Release (1)Summarized Financial Data (2)Management’s Discussion and Analysis (MD&A) (3)Management’s Report on Internal Control (4)Auditor’s Report (5)Comparative Financial Statements (6)Financial Statement Notes (7)Recent Stock Price Data (8)Unaudited Quarterly Data (9)Directors and Officers In addition to the financial information, annual reports also include a friendly letter to investors from top executives, glossy pictures of the company’s products, and glowing commentaries about the company’s position in its industry.

5-25 Securities and Exchange Commission (SEC) Filings Public companies are required to electronically file certain reports with the SEC, including Form 10-K, Form 10-Q, and Form 8-K.

5-26 Investor Information Web Sites There are thousands of investor websites that contain information about publicly traded companies. Be careful when using websites, especially in the case of financial ratios since you are rarely told what formulas were used to calculate the ratios.

5-27 Learning Objective 5 Compare results to common benchmarks.

5-28 Comparison to Common Benchmarks Prior Periods Time series analysis compares a company’s results for one period to its own results over a series of time periods. Competitors Cross-sectional analysis compares the results of one company with those of others in the same section of the industry. To help interpret amounts on the financial statements, it’s useful to have points of comparison or “benchmarks.”

5-29 Thousands of U.S. Dollars From this time-series analysis we see that Activision’s financial profile changed between 2005 and During this period they reduced debt, increased stockholders’ equity, and grew significantly in total assets and revenues. Curiously, net income in 2006 was down from 2005.

5-30 From this cross-sectional analysis we see that Activision is in the middle between THQI and ERTS across most of the financial measures. It is hard to overlook the towering bars of ERTS, which suggest that this company dominates play in the industry. Thousands of U.S. Dollars

5-31 Learning Objective 6 Calculate and interpret the debt-to- assets, asset turnover, and net profit margin ratios.

5-32 Financial Statement Ratio Analysis (1) Debt & Equity Financing (2) Assets(3) Revenues (4) Net Income (b) Asset Turnover Invested in generate produce (a) Debt-to-Assets (c) Net Profit Margin A Framework for Financial Statement Ratio Analysis The goal of ratio analysis is to get to the heart of how well each company performed given the resources it had available.

5-33 A Basic Business Model Most businesses can be broken down into 4 elements: (1)Obtain financing from lenders and investors, which is used to invest in assets, (2)Invest in assets, which are used to generate revenues, (3)Generate revenues, which produce net income, (4)Produce net income, which is needed to satisfy lenders and investors. (1) Debt & Equity Financing (2) Assets(3) Revenues (4) Net Income Operating Investing Financing Invested in generate produce

5-34 Debt-to-Assets Ratio Total Liabilities Total Assets = Debt-To-Assets Ratio This ratio provides the percentage of assets financed by debt. A higher ratio means greater financial risk. Debt-to-Assets Ratio $194 $1,420 == 13.7%

5-35 Asset Turnover Ratio Sales Revenue Average Total Assets Asset Turnover = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

5-36 Asset Turnover Ratio Sales Revenue Average Total Assets Asset Turnover = This ratio measures how well assets are used to generate sales. A higher ratio means greater efficiency. = 1.08 $1,468 ($1,420+$1,307)/2 Asset Turnover =

5-37 Net Profit Margin Ratio This ratio measures the ability to generate sales while controlling expenses. A higher ratios means better performance. Net Profit Margin Ratio Net Income Sales Revenue == 2.9% Net Profit Margin Ratio $42 $1,468 =

5-38 Analysis of Videogame Companies Here is a comparison of the ratios for Activision, Electronic Arts, and Take-Two Interactive Software. Let’s compare Activision with Electronic Arts: (1)Activision generated less profit on each dollar of sales, (2)Activision generated greater sales per dollar of assets, and (3)Activision had less debt compared to assets.

5-39 End of Chapter 5