1. 1 Additional Aspects of Financial Reporting and Financial Analysis C hapter 5 An electronic presentation by Douglas Cloud Pepperdine University An electronic presentation by Douglas Cloud Pepperdine University

2. 2 1.Describe an auditor’s report. 2.Explain the disclosure in management’s discussion and analysis. 3.Understand the meaning of an operating segment. 4.Describe the disclosure in a segment report. 5.Explain interim reporting. ObjectivesObjectives ContinuedContinued

3. 3 6.Prepare an interim report. 7.Understand intracompany and intercompany comparisons (Appendix). 8.Prepare horizontal and vertical percentage analyses (Appendix). 9.Perform ratio analysis (Appendix). Objectives

4. 4 Market Efficiency The prices of securities traded in the capital market fully reflect all publicly available information. Evidence from research on an efficient market hypothesis tends to show-- These prices are adjusted almost immediately based on new information and in an unbiased manner.

5. 5 Auditor’s Report (Opinion) 1.The auditor is independent. 2.The audit was performed on specified financial statements. 3.The financial statements are the responsibility of the company’s management; the opinion is the responsibility of the auditors. 4.The audit was conducted according to generally accepted auditing standards. ContinuedContinued An auditor’s standard report includes these statements...

6. 6 Auditor’s Report (Opinion) 5.The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements. 6.The audit included examination, assessment, and evaluation stages. 7.The audit provides a reasonable basis for an opinion. 8.An opinion is expressed concerning the fair presentation.

7. 7 Auditor’s Report (Opinion) The first (introductory) paragraph lists the financial statements that were audited, declares that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The second (scope) paragraph describes what the auditor has done. The third (opinion) paragraph gives the auditor’s opinion. An unqualified opinion contains three paragraphs.

8. 8 1.An unqualified opinion is not a “clean bill of health.” 2.An unqualified opinion provides no assurance of the future success of the company. 3.An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements. Auditor’s Report (Opinion) There are three things that the audit report does not say.

9. 9 Management’s Discussion and Analysis (MD&A) The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. The MD&A provides information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial condition and changes in financial condition. Where knowledge of segment information is useful to understanding a company’s business, the discussion is to focus on each relevant, reportable operating segment, as well as on the whole company.

10. 10 Liquidity Capital Resources Results of Operations General Information Major discussion issues that may involve intracompany and intercompany comparisons. Management’s Discussion and Analysis (MD&A)

11. 11 Segment Reporting 1.that engages in business activities to earn revenues and incur expenses, 2.whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and 3.for which financial information is available. An operating segment is a component of a company--

12. 12 Segment Reporting An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 1.Revenue Test. Its reported revenues are 10% or more of the combined revenues of all the company’s reported operating segments.

13. 13 Segment Reporting An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 2.Profit Test. The absolute amount of its profit (loss) is 10% or more of the combined reported profits of all operating segments that did not report a loss.

14. 14 Segment Reporting An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 3.Asset Test. Its segment assets are 10% or more of the combined assets of all operating segments.

15. 15 TEAL COMPANY Operating Segment Financial Results for Year Ended December 31, 2004 Reportable Operating Segments All Other Total A B C Segments Results Segment revenues$ 300$2,530$ 370$ 600$ 3,800 Segment operating profit (pretax)$ 70$ 495$ 105$ 140$ 810 General corporate expenses(100) Corporate interest expense (80) Pretax income from cont’g operations$ 630 Segment assets at 12/31/2004$1,800$9,400$2,000$2,800$16,000 Gen. corp. assets 3,000 Total assets 12/31/2004$19,000

16. 16 Interim Income Taxes 1.Estimated Annual Income: First quarter$ 20,000actual income Second quarter26,000actual income Third quarter25,000estimated income Fourth quarter 29,000estimated income $100,000estimated annual income ContinuedContinued

17. 17 Interim Income Taxes 2. Estimated Effective Income Tax Rate: 15% x $20,000 = $ 3,000 30% x ($100,000 – $20,000) = 24,000 Estimated total tax = $27,000 27% Effective tax rate = $27,000 Estimated income tax $100,000 Estimated IncomeContinuedContinued

18. 18 Interim Income Taxes 3. Estimated Income Tax for First Six Months: $46,000 x 27% = $12,420 estimated income tax on first six months’ income 4. Estimated Income Tax for Second Quarter: $12,420 estimated income tax on first six months of income (5,220)estimated income tax on first-quarter income $ 7,200 estimated income tax on second-quarter income

19. 19 Preparation of Disclosure of Summarized Interim Financial Data When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum.

20. 20 Sales or gross revenues, income taxes, extraordinary items (net of tax), the cumulative effect of a change in accounting principle, and net income Earnings per share for each period presented Seasonal revenues, costs, and expenses Significant changes in estimates of income taxes. Contingent items Changes in accounting principles or estimates Significant changes in financial position Preparation of Disclosure of Summarized Interim Financial Data

21. 21 Two SEC forms that are important to accountants are-- Form 10-K Form 10-Q SEC Reports

22. 22 SEC Reports Form 10-K is the most common SEC annual report form and is required to be filed with the SEC within 90 days of a company’s fiscal year-end.

23. 23 SEC Reports Form 10-Q is used to report a company’s quarterly financial information to the SEC and is required to be filed within 45 days of the end of the company’s first three fiscal quarters.

24. 24 Financial Analysis Comparison Financial Analysis Comparisons Intracompany Intercompany Percentage Analyses Horizontal Vertical Ratio

25. 25 Under international standards, reportable segments include both business segments and geographical segments, with a business segment providing goods or services and being different from other business segments as to risks and returns. International Accounting Differences

26. 26 International Accounting Differences International standards differ from U.S. standards in that they do not allow: (1)The allocation of expenses between interim periods (2)The deferral of manufacturing variances that are expected to be offset in a later interim period (3)The deferral of a temporary market decline in inventory that is expected to be recovered in a later interim period

27. 27 Horizontal Analysis In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars.

28. 28  from 12/31/04 to 12/31/05 Base Year % = Horizontal Analysis Sales$138,000 $130,000 12/31/05 12/31/04 $8,000 $130,000 % = = 6.2% Now, using data from Exhibit 5-5, let’s examines Sales from December 31, 2004 to December 31, 2005.

29. 29  from 12/31/03 to 12/31/04 Base Year % = Horizontal Analysis Gross profit$55,900 $42,000 12/31/04 12/31/03 $13,900 $42,000 % = = 33.1% Again using data from Exhibit 5-5, let’s calculate the change in gross profit from December 31, 2003 to December 31, 2004.

30. 30 Vertical Analysis (Income Statement) In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars.

31. 31 2005 Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130,000 100.0 106.2 Sales, $138,000 Sales, net, $130,000 = 106.2 Vertical Analysis (Income Statement)

32. 32 (6.2)% Sales returns, ($8,000) Sales, net, $130,000 = 106.2 (6.2) Vertical Analysis (Income Statement) 2005 Amount Percent 2005 Amount Percent Sales$138,000 Sales returns (8,000) Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130,000 100.0

33. 33 (57.0)% Cost of goods sold, ($74,100) Sales, net, $130,000 = (6.2) (57.0) Vertical Analysis (Income Statement) Sales, net $130,000 100.0 2005 Amount Percent Sales$138,000 Sales returns (8,000) Cost of goods sold(74,100) Gross profit$ 55,900 106.2

34. 34 43.0% Gross profit, $55,900 Sales, net, $130,000 = 106.2 (6.2) (57.0) 43.0 Vertical Analysis (Income Statement) 2005 Amount Percent Sales$138,000 Sales returns (8,000) Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130,000 100.0

35. 35 Vertical Analysis (Balance Sheet) 2005 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129,200 3.0% Cash, $3,900 Total Assets, $129,200 = 3.0 Total Assets $129,200 100.0

36. 36 Vertical Analysis (Balance Sheet) 2005 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129,200 3.0 Total Assets $129,200 100.0 5.9% Receivables (net), $7,600 Total Assets, $129,200 = 5.9

37. 37 Vertical Analysis (Balance Sheet) Using this approach on the rest of the assets, this section can be completed.

38. 38 Vertical Analysis (Balance Sheet) 2005 Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129,200 3.0 Total Assets $129,200 100.0 5.9 6.9.8 16.6 83.4

39. 39 In calculating vertical analysis amounts for liabilities and stockholders’ equity, all items are divided by “total liabilities and stockholders’ equity.” Vertical Analysis (Balance Sheet) 3.9% Accounts Payable, $5,000 Total L& SE, $129,200 = 2005

40. 40 Ratio Analysis Stockholders’ Profitability Ratios Earnings per share is probably the most frequently cited ratio in a financial analysis. Net Income – Preferred Dividends Average Common Shares Outstanding $11,000$1,200 5,400 = $1.81

41. 41 Ratio Analysis Stockholders’ Profitability Ratios Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. Market Price per Common Share Earnings per Share $14.25 $1.81 = 7.9 times

42. 42 Ratio Analysis Stockholders’ Profitability Ratios Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as compared with the ending market price of the stock. Dividends per Common Share Market Price per Common Share $1.00 $14.25 = 7.0%

43. 43 Ratio Analysis Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. Net Income Net Sales $11,000 $130,000 = 8.5% Company Profitability Ratios

44. 44 Ratio Analysis Return on total assets indicates how efficiently a company uses its economic resources. Net Income + Interest Expense (net of tax) Average Total Assets $11,000 + ($3,000 x 0.7) ($129,200 + $112,000)/2 = 10.9% Company Profitability Ratios

45. 45 Ratio Analysis Return on stockholders’ equity shows the residual returns on the owners’ equity. Company Profitability Ratios Net Income Average Stockholders’ Equity $11,000 ($93,000 + $79,000)/2 = 12.8%

46. 46 Ratio Analysis The current ratio is used to evaluate a company’s short-run liquidity. Liquidity Ratios Current Assets Current Liabilities $21,400 $11,200 = 1.91 times

47. 47 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Liquidity Ratios Quick Assets Current Liabilities $11,500 $11,200 = 1.03 times

48. 48 Ratio Analysis Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period. Activity Ratios Cost of Goods Sold Average Inventory $74,100 ($8,900 + $10,100)/2 = 7.8 times or 47 days 365 7.8

49. 49 Ratio Analysis Receivables turnover indicates how many times receivables are “turned over” or collected each period. Activity Ratios Net Credit Sales Average Net Receivables $130,000 x 0.70 ($7,600 + $8,600)/2 = 11.2 times or 33 days 365 11.2

50. 50 Ratio Analysis The payables turnover ratio measures the number of times accounts payable turns over during the year. Activity Ratios Cost of Goods Sold Average Accounts Payable $74,100 ($5,000 + $6,600)/2 = 12.8 times or 29 days 365 12.8

51. 51 Ratio Analysis The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets $36,200 $129,200 = 28%

52. 52 Ratio Analysis Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings. Stability Ratios Pretax Operating Income Interest Expense $15,700 + $3,000 $3,000 = 6.2 times

53. 53 Ratio Analysis Book value per common share shows the net assets per share of stock. Stability Ratios Common Stockholders’ Equity Outstanding Common Shares $93,000 – ($140 x 150) 5,400 = $13.33 per common share

54. 54 Ratio Analysis Cash flow from operations to sales ratio is used to evaluate the cash generated from sales. Cash Flow Ratios Cash Flow From Operations Sales

55. 55 Ratio Analysis Cash flow from operations to net income ratio enables users to understand how the earnings of net income relates to the cash flow from operations. Cash Flow Ratios Cash Flow From Operations Net Income

56. 56 Ratio Analysis Cash flow from operations per share is expressly prohibited. However, users may wish to compute it for internal use. Cash Flow Ratios Cash Flow From Operations Average Shares of Common Stock Outstanding

57. 57 Ratio Analysis Cash flow from operations divided by the amount of debt maturing next year ratio measures the ability of a company to make principal payments. Cash Flow Ratios Cash Flow From Operations Debt Maturing Next Year

58. 58 C hapter 5 The End

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