1. Chapter 1 Financial Statements: An Overview

2. Map or Maze
A map helps its user reach a desired destination through clarity of representation.
A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.
Financial statements have the potential for being both map and maze.
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3. 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 a firm’s financial health
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4. Financial Statements as a Maze
Overwhelming amount of information
Unreliable auditing
Complex policies and reporting requirements
Considerable discretion given to management
Key information hidden or omitted
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5. Map or Maze The main objectives of this book are to
ensure that financial statements serve as a map, not a maze,
demonstrate how to read and evaluate financial statements,
provide the tools and techniques needed to complete a comprehensive financial statement analysis, and
encourage intelligent decision making.
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6. Map or Maze Usefulness of Information Financial position
Success of operations
Policies and strategies of management
Insight into future performance
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7. Map or Maze Volume of Information Financial statements
Notes to the financial statements
Auditor’s report
Five-year summary of key financial data
High and low stock prices
Management’s discussion and analysis of operations
Other material
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8. Map or Maze Volume of Information
Generally accepted accounting principles (GAAP)
Securities and Exchange Commission (SEC)
Financial Accounting Standards Board (FASB)
International Accounting Standards Board (IASB)
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9. Map or Maze
Figure 1.1 FASB/SEC Relationship FIGURE 1.1 FASB/SEC Relationship
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10. Map or Maze Global Economy Need for international accounting standards
Lack of SEC recommendation to adopt IFRS standards in the U.S.
Text focuses on U.S. GAAP, however the analysis process illustrated can be applied to reports based on IFRS.
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11. Map or Maze Where to Find a Company’s Financial Statements Form 10-K
Filed annually with the SEC
Same order for all filing companies
Electronic Data Gathering, Analysis, and Retrieval (EDGAR)
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12. Map or Maze Where to Find a Company’s Financial Statements
Annual report
Financial statements
Public relations material
Sent to shareholders and prospective investors
Corporate website
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13. Map or Maze The Financial Statements
Balance sheet (or statement of financial position)
Income statement (or earnings statement)
Statement of stockholders’ equity
Statement of cash flows
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14. Map or Maze Notes to the Financial Statements
Integral part of the statements
Summary of the firm’s accounting policies
Details about particular accounts
Other supplementary information
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15. Map or Maze Auditor’s Report
Attests to the fairness of the presentation of financial statements
Sarbanes-Oxley (SOX) Act of 2002
Internal auditors and external auditors
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16. Map or Maze Auditor’s Report Types of reports Unqualified reports
Adverse opinion
Disclaimer of opinion
Unqualified opinion with explanatory language
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17. Map or Maze Financial Reporting Reforms
SOX Title I – Public Company Accounting Oversight Board (PCAOB)
SOX Title II – prohibits non-audit services during an external audit
SOX Titles III and IV – corporate responsibility
SOX Title IX – harsh penalties for violations
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18. Map or Maze Management Discussion and Analysis
Sometimes labeled “Financial Review”
Coverage of trends, events, and/or uncertainties in liquidity, capital resources, and results of operations
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19. Map or Maze
Five-year Summary of Selected Financial Data and Market Data
Net sales or operating revenues
Income or loss from continuing operations
Total assets
Long-term obligations and redeemable preferred stock
Cash dividends per common share
Two years of high and low common stock price by quarter
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20. Map or Maze Pandora (a.k.a. “PR Fluff”) Colored photographs Charts
Shareholders’ letter from the CEO
Other items to make the report attractive
Often informative but sometimes misleading
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21. Map or Maze Proxy Statement Used to solicit shareholder votes
Important in assessing who manages the firm, how management is paid, and conflict of interest issues
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22. Map or Maze Missing and Hard-to-Find Information
Employee relations with management
Morale and efficiency of employees
Reputation of the firm with customers
Firm’s prestige in the community
Effectiveness of management
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23. Map or Maze Missing and Hard-to-Find Information
Provisions for management succession
Potential exposure to regulation changes
Publicity in the media
Companies operating in several lines of unrelated business
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24. Map or Maze
Characteristics, Assumptions, Principles, and Basis of Accounting
Materiality
Comparability
Consistency
The Going Concern Assumption
The Time Period Assumption
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25. Map or Maze
Characteristics, Assumptions, Principles, and Basis of Accounting
The Monetary Unit Assumption
The Revenue Recognition Principle
The Matching Principle
The Accrual Basis of Accounting
The Cash Basis of Accounting
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26. Complexities and the Quality of Financial Reporting
Accounting Choices
Management discretion in application of reporting regulations
Differing accounting methods impact comparability of companies
Financial data appropriated to particular time periods
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27. Complexities and the Quality of Financial Reporting
Timing of Revenue and Expense Recognition
Accrual basis of accounting
Recognizes revenues when earned
Recognizes expenses when incurred
Recognizes revenues and expenses independent of cash inflows and outflows
Involves judgments by management on timing
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28. Complexities and the Quality of Financial Reporting
Discretionary Items
Equipment repair and maintenance
Marketing and advertising
Research and development
Capital expansion
Replacement of plant assets
Development of new product lines
Disposal of an operating division
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29. Complexities and the Quality of Financial Reporting
Discretionary Items
Management choices have an immediate and long-term impact on profitability (perhaps not in the same direction).
Financial analyst should scrutinize management’s policies regarding discretionary items.
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30. The Journey Through the Maze Continues
Chapter 2 – The Balance Sheet Chapter 3 – Income Statement and Statement of Stockholders’ Equity Chapter 4 – Statement of Cash Flows Chapter 5 – The Analysis of Financial Statements
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31. 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.
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