Topic 1: Financial Statements: An Overview

Topic 1: Financial Statements: An Overview
I. Why Financial Analysis?
II. Sources of Information
III. Veil
IV. Quality of Financial Reporting
I. Why Financial Analysis?
Would you as a loan officer loan $100 million to Flagstaff Medical Center?
Would you as an investor buy Phoenix Sun at $200 million?
Would you as a recent college graduate accept a job offer with Northland Beverage Co.?
Would you as the CEO of Outback Steakhouse Inc. give a green light to the opening of
30 new restaurants next year?
Financial analysis helps us better understand the financial position of a firm and answer
the above questions. That is, investors, creditors, managers, and stakeholders can make
better economic decisions through analyzing financial statements.
Financial statements are prepared according to GAAP (generally accepted accounting
The SEC (Securities and Exchange Commission) and the FASB (Financial Accounting
Standards Board) are responsible for establishing GAAP.
II. Sources of Information
You can retrieve corporate financial statements from the SEC at Frequently, you can also do
an internet search and download them from companies’ websites (I like it this way), say
All publicly held companies must file a Form 10-K annually with the SEC (along with
other forms). The due date for this filing is 3 months following the end of the fiscal year.
This filing usually has the following items:
1. Business of company.
2. Properties.
3. Legal proceeding.
4. Management discussion and analysis
5. Financial statements and footnotes.
6. Changes or disagreements with auditors.
7. Executive compensation.
8. Certain relationships and related transactions.
These firms also need to file a less extensive document, 10-Q, with the SEC quarterly.
Notes (10K)
An important integral part of the financial statements is footnotes (notes). The notes
usually include information about:
1. A summary of the firm’s accounting policies.
2. Whether there is a change in these policies during the reporting period.
3. Details about particular accounts, such as inventories, property, plant, and equipment,
investments, and long-term debts.
4. Major acquisitions or divestitures.
5. Employee retirement, pension, and stock option plans.
6. Leasing arrangements.
7. The term, cost, and maturity of debt.
8. Pending legal proceedings.
9. Income taxes.
10. Commitments.
11. And more.
The following exhibit is the first page of the first note from Coca Cola’s 2005 10-K (there
is a total of 19 notes).
COCA COLA CO filed this 10-K on Mar 04, 2005
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The Coca-Cola Company and Subsidiaries
The Coca-Cola Company is predominantly a manufacturer, distributor and
marketer of nonalcoholic beverage concentrates and syrups. In these notes, the
terms "Company," "we," "us" or "our" mean The Coca-Cola Company and all
subsidiaries included in the consolidated financial statements. Operating in more
than 200 countries worldwide, we primarily sell our concentrates and syrups, as well
as some finished beverages, to bottling and canning operations, distributors,
fountain wholesalers and fountain retailers. We also market and distribute juices and
juice drinks, sports drinks, water products, teas, coffees and other beverage
products. Additionally, we have ownership interests in numerous bottling and
canning operations. Significant markets for our products exist in all the world's
geographic regions.
Basis of Presentation and Consolidation
Our consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States. Our Company
consolidates all entities that we control by ownership of a majority voting interest as
well as variable interest entities for which our Company is the primary beneficiary.
Refer to the heading "Variable Interest Entities" for a discussion of variable interest
We use the equity method to account for our investments for which we have
the ability to exercise significant influence over operating and financial policies.
Consolidated net income includes our Company's share of the net earnings of these
companies. The difference between consolidation and the equity method impacts
certain financial ratios because of the presentation of the detailed line items reported
in the financial statements.
We use the cost method to account for our investments in companies that we
do not control and for which we do not have the ability to exercise significant
influence over operating and financial policies. In accordance with the cost method,
these investments are recorded at cost or fair value, as appropriate.
We eliminate from our financial results all significant intercompany
transactions, including the intercompany transactions with variable interest entities
and the intercompany portion of transactions with equity method investees.
Certain amounts in the prior years' consolidated financial statements have been
reclassified to conform to the current-year presentation.
Variable Interest Entities
In December 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46 (revised December 2003), "Consolidation of Variable
Interest Entities" ("Interpretation 46" or "FIN 46"). Application of this interpretation
was required in our consolidated financial statements for the year ended
December 31, 2003 for interests in variable interest entities that were considered to
be special-purpose entities. Our Company determined that we did not have any
arrangements or relationships with special- purpose entities. Application of
Interpretation 46 for all other types of variable interest entities was required for our
Company effective March 31, 2004
Source: Coca Cola 2005 10-K
Management Discussion and Analysis
In this section, information is provided by the firm about:
1. The mix of price relative to volume increases (decreases) for products sold or services
2. Firm’s liquidity.
3. Firm’s capital sources and how new investments will be financed.
4. Firm’s operations.
5. Favorable and unfavorable business trends.
6. Significant events and uncertainties.
Auditor’s Report (10K)
When the financial statement presentation is fair, the “independent” auditor issues an
“unqualified” (read “good”) report that states the financial statements present fairly in
conformity with GAAP. The following is an example of an unqualified report.
COCA COLA CO filed this 10-K on Mar 04, 2005
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Report of Independent Registered Public Accounting Firm
Board of Directors and Shareowners
The Coca-Cola Company
We have audited the accompanying consolidated balance sheets of The CocaCola Company and subsidiaries as of December 31, 2004 and 2003, and the related
consolidated statements of income, shareowners' equity, and cash flows for each of
the three years in the period ended December 31, 2004. Our audits also included the
financial statement schedule listed in the Index at Item 15(a). These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and schedule
based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of The Coca-Cola Company and
subsidiaries at December 31, 2004 and 2003, and the consolidated results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole, presents
fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in 2004 the
Company adopted the provisions of FASB Interpretation No. 46 (revised December
2003) regarding the consolidation of variable interest entities. As discussed in
Notes 1 and 4 to the consolidated financial statements, in 2002 the Company
changed its method of accounting for goodwill and other intangible assets.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of The Coca-Cola
Company and subsidiaries' internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated February 25, 2005, expressed an unqualified
opinion thereon.
Atlanta, Georgia
February 25, 2005
Source: Coca Cola 2005 10-K
When the auditor has concerns about the fairness of the presentation, the auditor issues a
“qualified” report, such as “In our opinion, except for the (nature of the concerns), the
financial statements present fairly …..” Yap, something smells fishy.
Proxy Statement
When a firm solicits shareholder votes, the firm needs to file proxy filing (14A) with the
SEC. This source of information is useful in assessing how management is paid and
potential conflict-of-interest issues with auditors. This statement includes:
1. Voting procedure and information.
2. Background information about the company’s nominated directors.
3. Director compensation.
4. Executive compensation.
5. A breakdown of audit and non-audit fees paid to the auditor.
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The following section is retrieved from WorldCom’s 2002 14A filing. WorldCom has a
new name: MCI.
We have entered into certain loan and guaranty arrangements involving
Mr. Ebbers [Note: CEO], principally relating to certain obligations to financial
institutions secured by Mr. Ebbers' stock in WorldCom. We initially established
these arrangements in 2000, and have agreed to certain modifications since
January 1, 2001, as described below.
We agreed to guarantee $150 million principal amount of indebtedness owed by
Mr. Ebbers to Bank of America, N.A., or Bank of America, as well as certain
additional payments and related costs. The additional payments included, among
other things, amounts payable to Bank of America by Mr. Ebbers or certain
companies controlled by him relating to an approximately $45.6 million letter of
credit secured by a portion of Mr. Ebbers' stock and used to support financing
to an unrelated third party; specified amounts, including margin debt, that
became payable following stock price declines; and amounts subject to a margin
call with respect to certain margin debt.
The scheduled maturity of the Bank of America margin debt was extended in
January 2002 for a period of up to two years. However, following declines in the
closing price of the WorldCom group stock through early February 2002, we made
aggregate payments of approximately $198.7 million to repay all of the
outstanding debt covered by our guaranty and deposited with Bank of America
approximately $35 million to collateralize the letter of credit, which is
scheduled to expire on February 15, 2003, subject to renewal, extension or
substitution. Our payments, together with any amounts paid or costs incurred by
us in connection with the letter of credit, plus accrued interest at a floating
rate equal to that under one of our credit facilities, is payable by Mr. Ebbers
to us, as modified in April 2002, within 90 days after demand, or within
180 days after demand if subsequent to his death or incapacity. The amount of
such interest accrued through March 31, 2002, is approximately $1.25 million and
the interest rate as of that date was 2.21% per annum.
In addition to the guaranty arrangements, during 2000 we agreed to loan up
to $100 million to Mr. Ebbers. Since January 1, 2001, we have agreed to loan him
up to an additional $65 million, for a total maximum principal amount of
$165 million. These loans bear interest at floating rates equal to that under
certain of our credit facilities and, as modified in April 2002, are payable
within 90 days after demand, or within 180 days after demand if subsequent to
Mr. Ebbers' death or incapacity. As of April 19, 2002, the aggregate principal
amount of indebtedness owed by Mr. Ebbers to us under these loans was
approximately $160.8 million. Accrued interest on these loans is approximately
$5.75 million through March 31, 2002, at interest rates ranging from 2.18% to
2.19% per annum as of that date.
Source: WorldCom 2002 14A
Dude, this is not cool, right? Why?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------SEC Votes to Propose Changes to Disclosure Requirements
Concerning Executive Compensation and Related Matters
Washington, D.C., Jan. 17, 2006 — The Securities and Exchange Commission today
voted to publish for comment proposed rules that would amend disclosure
requirements for executive and director compensation, related party transactions,
director independence and other corporate governance matters, and security
ownership of officers and directors. The proposed rules would affect disclosure in
proxy statements, annual reports and registration statements. The proposals would
require most of this disclosure to be provided in plain English. The proposals also
would modify the current reporting requirements of Form 8-K regarding
compensation arrangements.
1. Executive and Director Compensation
The proposals would refine the currently required tabular disclosure and combine it
with improved narrative disclosure to elicit clearer and more complete disclosure of
compensation of the principal executive officer, principal financial officer, the three
other highest paid executive officers and the directors.
New company disclosure in the form of a Compensation Discussion and Analysis
would address the objectives and implementation of executive compensation
programs - focusing on the most important factors underlying each company's
compensation policies and decisions.
Following this new section, executive compensation disclosure would be organized
into three broad categories: compensation over the last three years; holdings of
outstanding equity-related interests received as compensation that are the source of
future gains; and Retirement plans and other post-employment payments and
A reorganized Summary Compensation Table would be the principal vehicle
for showing three-year compensation and would include additional
o A new column would report total compensation.
o A dollar value will be shown for all stock-based awards, including stock
and stock options, measured at grant date fair value, computed
pursuant to Financial Accounting Standards Board's Statement of
Financial Accounting Standards No. 123 (revised 2004), Share-Based
Payment, to provide a more complete picture of compensation and
facilitate reporting total compensation.
o The "All Other Compensation" column would include the aggregate
increase in actuarial value of pension plans accrued during the year
and all earnings on deferred compensation that is not tax-qualified.
o The threshold for disclosing perquisites would be reduced to $10,000
and interpretive guidance is provided for determining what is a
o Two supplemental tables would report Grants of Performance-Based
Awards and Grants of All Other Equity Awards.
Disclosure regarding outstanding equity interests would include
the Outstanding Equity Awards at Fiscal Year-End Table, which would
show outstanding awards representing potential amounts that may be
received in the future; and
o the Option Exercises and Stock Vested Table, which would show
amounts realized on equity compensation during the last year.
Retirement plan and post-employment disclosure would include
o the Retirement Plan Potential Annual Payments and Benefits Table,
which would disclose annual benefits payable to each named executive
o the Nonqualified Defined Contribution and Other Deferred
Compensation Plans Table, which would disclose year-end balance,
and executive contributions, company contributions, earnings and
withdrawals for the year; and
o disclosure of payments and benefits (including perquisites) payable on
termination or change in control, including quantification of these
potential payments and benefits.
A Director Compensation Table, similar to the Summary Compensation Table, and
related narrative would disclose director compensation for the last year.
2. Related Person Transactions, Director Independence and Other
Corporate Governance Matters
The proposals would update, clarify, and slightly expand the disclosure provisions
regarding related person transactions. Principal changes would include a disclosure
requirement regarding policies and procedures for approving related party
transactions, a slight expansion of the categories of related persons and a change in
the threshold for disclosure from $60,000 to $120,000. The requirement to disclose
these transactions would also be made more principles-based, and would require
disclosure if the company is a participant in a transaction in which a related person
has a direct or indirect material interest.
A proposed new item (Item 407 of Regulations S-K and S-B) would require
disclosure of whether each director and director nominee is independent;
a description of any relationships not otherwise disclosed that were
considered when determining whether each director and director nominee is
independent; and
disclosure of any audit, nominating and compensation committee members
who are not independent.
Proposed Item 407 also would consolidate corporate governance related disclosure
requirements currently set forth in a number of places in the proxy rules and
Regulations S-K or S-B. This would include disclosure regarding board meetings and
committees, and specific disclosure about nominating and audit committees.
Proposed Item 407 would also require similar disclosure regarding compensation
committees and a narrative description of their procedures for determining executive
and director compensation.
3. Security Ownership of Officers and Directors
The proposals would require disclosure of the number of shares pledged by
4. Form 8-K
The proposals would modify the disclosure requirements in Form 8-K to capture
some employment arrangements and material amendments thereto only for named
executive officers. The proposals would also consolidate all Form 8-K disclosure
regarding employment arrangements under a single item.
5. Plain English Disclosure
The proposals would require companies to prepare most of this information using
plain English principles in organization, language and design.
Comments on the proposed rules should be received by the Commission within 60
days of publication in the Federal Register.
One-Stop Online Source
Yahoo at
III. Veil
Financial statements are, at best, an approximation of business reality because of (1)
selective reporting of business events, and (2) alternative accounting methods and
GAAP allows for considerable discretion in the preparation of financial statements.
Here, I just raise three examples (too many to list):
1. Accounting income is measured using the accrual concept. Cash inflows are
recognized as income in the “appropriate” accounting periods, that is as goods and
services are provided, rather than as cash is collected. Within this framework, managers
and accountants can be “creative.”
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The SEC vs. Xerox case shows that the line between being creative and being illegal is
quite thin.
Civil Action No.
02-272789 (DLC)
The Securities and Exchange Commission ("the Commission") alleges for its
Complaint as follows:
1. From at least 1997 through 2000, Xerox Corporation ("Xerox") defrauded
investors. In a scheme directed and approved by its senior management, Xerox
disguised its true operating performance by using undisclosed accounting maneuvers
-- most of which were improper -- that accelerated the recognition of equipment
revenue by over $3 billion and increased earnings by approximately $1.5 billion.
5. The most significant and pervasive of these accounting actions were used to pull
forward and recognize immediately revenues from leases of Xerox equipment that,
under Xerox's historical accounting practices, would have been recognized in future
years. As a result, Xerox portrayed its business and growth as far more robust in
1997-99 than it in fact was. Moreover, by accelerating future revenues and profits
into the present, Xerox made the prospect of achieving future expectations even
more difficult and increased the company's vulnerability to future business
downturns. As it happened, underlying sales and business conditions worsened in
1999 and later periods, and Xerox's prior-year accounting actions began to
negatively affect its reported results. Xerox could no longer rely in lean times on
deferred financing and service revenue from its leases because some of that revenue
already had been recognized as income to make the company's financial statements
more robust in earlier years.
Source: SEC
Xerox paid a $10 million fine to settle the SEC probe:
Securities and Exchange Commission
Washington, D.C.
Litigation Release No. 17465 / April 11, 2002
Accounting and Auditing Enforcement Release No. 1542 / April 11, 2002
Securities and Exchange Commission v. Xerox Corporation, Civil Action No.
02-CV-2780 (DLC) (S.D.N.Y.) (April 11, 2002)
Without admitting or denying the allegations of the complaint, Xerox consented to
the entry of a Final Judgment that permanently enjoins the company from violating
the antifraud, reporting and recordkeeping provisions of the federal securities laws,
specifically Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a),
13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (“Exchange
Act”) and Rules 10b-5, 13a-1, 13a-13, 12b-20 and 13b2-1 promulgated thereunder.
In addition, Xerox agreed to pay a $10 million civil penalty and to restate its financial
results for the years 1997 through 2000. Xerox also agreed to have its board of
directors appoint a committee composed entirely of outside directors to review the
company’s material internal accounting controls and policies.
Source: SEC
What did you learn from this case?
-----------------------------------------------------------------------------------------------------------2. There are three major categories of depreciation methods: straight-line, accelerated,
and unit-of-production. Different methods for calculating depreciation lead to different
values of net income. The choice of depreciation method also has an impact on the
presentation of balance sheet.
Suppose that a firm purchase a $30,000 truck that is estimated to have a 5-year useful life
and $0 salvage value.
The depreciation amount for the first year under the straight-line method is:
Depreciation base (cost less salvage value)/depreciation period = ($30,000-$0)/5 =
The depreciation amount for the same accounting period under one particular accelerated
method (there are a variety of accelerated methods):
Cost less accumulated depreciation * twice the straight line rate = $30,000 * (2 * .2) =
So, the effects of depreciation methods on income statement and balance sheet are:
Income Statement
Depreciation Expense
Balance Sheet
Fixed Assets
Less Accumulated Depreciation
Net Fixed Assets
3. Many of the expenses made by a firm are discretionary in nature. A firm can
effectively improve one particular accounting period’s earnings by allocating some
expenses to other accounting periods (example: postponing the repair and maintenance of
facilities and equipment).
IV. Quality of Financial Reporting
In general, one assesses the quality of financial reporting by asking the following
1. Are reported earnings repeatable? Are reported earnings influenced by one-time
2. Are reported earnings driven by operating events or by financing decisions (a.k.a.
fancy tricks)?
3. Is the management reasonably conservative in making accounting judgments?
Generally speaking, the more conservative the management is (conservatism usually
means the use of less favorable accounting treatments), the higher the quality.
4. Is the management straightforward in disclosing accounting information?
5. Does the firm have a sound monitoring mechanism? Does the firm hire an
“independent” and “reputable” auditor? Is the board reasonably independent?
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