McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 5
Financial Reporting and Analysis
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Fred Phillips, Ph.D., CA
Learning Objective 1
Explain the needs of financial
statement users.
5-3
The Needs of Financial
Statement Users
Managers
Directors
Government
Creditors
5-4
Investors
Learning Objective 2
Describe the environment for
financial reporting, including
the Sarbanes-Oxley Act.
5-5
Accounting Fraud
Incentive
(Why?)
The
Fraud
Triangle
Opportunity
(How?)
5-6
Character
(Who?)
Incentive to Commit Fraud
Creating Business
Opportunities
Satisfying Personal
Greed
5-7
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.
5-8
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.
5-9
The Sarbanes-Oxley (SOX) Act
Counteract
Incentives
SOX
Reduce
Opportunities
5-10
Encourage
Good
Character
Learning Objective 3
Prepare a comparative
balance sheet, multistep
income statement, and
statement of stockholders’
equity.
5-11
Financial Reporting in the U.S.
Enhance
financial
statement
format
Fiscal
Year End
Obtain
independent
external
audit
Release
additional
financial
information
Preliminary
Release of
Key Results
Final
Release of
Annual
Report
Independent External Audit
Financial Statement Preparation
March 31,
2008
5-12
May 8,
2008
May 30,
2008
Comparative Financial Statements
ACTIVISION, INC.
Balance Sheet
(in millions of U.S. dollars)
March 31,
2008
Assets
Current Assets
Cash
Short-Term Investments
Accounts Receivables
Inventories
Other Current Assets
Total Current Assets
Property and Equipment, net
Other Noncurrent Assets
Goodwill
Total Assets
Liabilities and Stockholders' Equity
Current Liabilities
Accounts Payable
Accrued and Other Liabilities
Total Current Liabilities
Other Noncurrent Liabilities
Total Liabilities
Stockholders' Equity
Contributed Capital
Retained Earnings
Total Stockholders' Equity
Total Liabilities and Stockholders' Equity
5-13
$
$
$
$
March 31,
2007
1,396 $
53
203
147
180
1,979
55
217
279
2,530 $
384
570
149
91
207
1,401
47
151
195
1,794
130 $
426
556
26
582
136
205
341
41
382
1,175
773
1,948
2,530 $
984
428
1,412
1,794
A comparative
format reveals
changes over
time, such as
Activision’s huge
increase in Cash
and decline in
Short-term
Investments.
Multistep Income Statements
ACTIVISION, INC.
Income Statement
(in millions of U.S. dollars)
Year Ended March 31,
2008
2007
Sales and Service Revenues
$
2,898 $
1,513 $
Expenses
Cost of Sales
1,645
979
Research and Development
270
133
Marketing and Sales
308
196
General and Administrative
195
132
Total Operating Expenses
2,418
1,440
Income from Operations
480
73
Revenue from Investments
51
37
Income before Income Tax Expense
531
110
Income Tax Expense
186
24
Net Income
$
345 $
86 $
5-14
2006
1,468
942
132
283
96
1,453
15
31
46
6
40
Statement of Stockholders’ Equity
ACTIVISION, INC.
Statement of Stockholders' Equity
For the Year Ended March 31, 2008
(in millions of U.S. dollars)
Contributed Retained
Capital
Earnings
Balances at March 31, 2007
$
984 $
428
Net Income
345
Dividends Declared
Issued Shares of Stock
191
Repurchased Shares of Stock
Balances at March 31, 2008
$
1,175 $
773
5-15
Learning Objective 4
Describe other significant aspects
of the financial reporting process,
including external audits and the
distribution of financial
information.
5-16
Independent External Audit
Auditors are Certified Public Accounts who are
independent of the company.
5-17
Unqualified
Audit Opinion
Qualified
Audit Opinion
Financial
statements are
presented in
accordance with
GAAP
Financial
statements fail to
follow GAAP or not
able to complete
needed tests
Preliminary Releases
Most public companies
announce quarterly and
annual earnings through
a press release that is
sent to news agencies.
5-18
Financial Statement Release
Name of Financial Section
Information Presented
1 Summarized financial data key figures covering a period of 5 or 10 years.
2 Management's discussion an honest and detailed analysis of the company's
and analysis (MD&A)
financial condition and operating results; must read for
any serious financial statement user.
3 Management's report on
statements that describe management's responsibility
internal control
for ensuring adequate internal control over financial
reporting and that report on the effectiveness of these
controls during the year.
4 Auditor's report
the auditor's conclusion about whether GAAP was
followed (and, for public companies, whether internal
controls were effective).
5 Comparative financial
a multi-year presentation of the four basic statements.
statements
6 Financial statement notes further informaton abou the financial statements; crucial
to understanding the financial statement data.
7 Recent stock price data
brief summary of highs and lows during the year.
8 Unaudited quarterly data condensed summary of each quarter's results.
9 Directors and officers
a list of who's overseeing and running the company.
5-19
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.
SEC Filing
Description
Form 10-K Annual filing of financial information
Form 10-Q Quarterly filing of financial information
Form 8-K Reports significant business events
5-20
Learning Objective 5
Explain the reasons for, and
financial statement
presentation effects of,
adopting IFRS.
5-21
Globalization and IFRS
International Financial Reporting Standards
(IFRS) are accounting rules established by the
International Accounting Standards Board for
use in over 100 countries around the world.
In 2008, the SEC announced a plan to allow
some U.S. companies to use IFRS in 2009 and
could require mandatory use of IFRS
starting in 2014.
5-22
IFRS Formatting of Financial
Statements
5-23
A side-by-side
comparison of a
balance sheet
prepared using
GAAP and a
statement of
financial position
prepared using
IFRS.
5-24
Learning Objective 6
Compare results to common
benchmarks.
5-25
Comparison to Common
Benchmarks
To help interpret amounts on the financial
statements, it’s useful to have points of
comparison or “benchmarks.”
5-26
Prior Periods
Competitors
Time series analysis
compares a company’s
results for one period to
its own results over a
series of time periods.
Cross-sectional analysis
compares the results of
one company with those
of others in the same
section of the industry.
Time Series Analysis Chart
5-27
Cross-Sectional Analysis
5-28
Learning Objective 7
Calculate and interpret the
debt-to-assets, asset turnover,
and net profit margin ratios.
5-29
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.
(2) Assets
generate
(3) Revenues
Investing
(1) Debt & Equity
Financing
5-30
Financing
Operating
(4) Net Income
Financial Statement Ratios
In addition to making it possible to compare
companies of different sizes, a benefit of ratio
analysis is that it enables comparisons between
companies reporting in different currencies
(dollars vs. euros).
5-31
Financial Statement Ratios
The debt-to-assets ratio provides the percentage of
assets financed by debt. A higher ratio means
greater financial risk.
5-32
Financial Statement Ratios
The asset turnover ratio measures how well assets
are used to generate sales. A higher ratio means
greater efficiency.
5-33
Financial Statement Ratios
The net profit margin ratio measures the ability to
generate sales while controlling expenses. A higher
ratio means better performance.
5-34
How Transactions Affect Ratios
Three-step process:
1. Analyze the transaction to determine its effects on the
accounting equation.
2. Relate the effects in step 1 to the ratio’s components,
to determine whether each component increases,
decreases, or stays the same.
3. Evaluate the combined impact of the effects in step 2
on the overall ratio.
5-35
Chapter 5
Solved Exercises
M5-4, M5-5, M5-9, M5-10, E5-11,
E5-16
M5-4 Preparing and Interpreting a Multistep Income Statement
Nutboy Theater Company reported the following single-step
income statement. Prepare a multistep income statement for the
local theater company. Also, calculate the net profit margin and
compare it to the 8% earned in 2009. In which year did the
company generate more profit from each dollar of sales?
5-37
M5-4 Preparing and Interpreting a Multistep Income Statement
NUTBOY THEATER COMPANY
Income Statement
For the Year Ended December 31, 2010
Revenues:
Ticket Sales
$
Concession Sales
2,500
Total Sales Revenues
52,500
Operating Expenses:
Salaries and Wage Expense
Advertising Expense
Utilities Expense
30,000
8,000
7,000
Total Operating Expenses
45,000
Income from Operations
Other Revenue (Expense):
7,500
Interest Revenue
200
Other Revenue
50
Income before Income Tax Expense
Income Tax Expense
Net Income
50,000
7,750
2,500
$
5,250
Net Profit Margin = Net Income / Total Sales Revenues
= $5,250 / $52,500
= 10%
5-38
M5-5 Preparing a Statement of Stockholders’ Equity
On December 31, 2008, WER Productions reported $100,000 of
contributed capital and $20,000 of retained earnings. During 2009, the
company had the following transactions. Prepare a statement of
stockholders’ equity for the year ended December 31, 2009.
a. Issued stock for $50,000.
b. Declared and paid a cash dividend of $5,000.
c. Reported total revenue of $120,000 and total expenses of
$87,000.
5-39
M5-5 Preparing a Statement of Stockholders’ Equity
WER PRODUCTIONS
Statement of Stockholders’ Equity
For the Year Ended December 31, 2009
Balances at December 31, 2008
Net Income
Dividends Declared
Issued Shares of Stock
Balances at December 31, 2009
5-40
Contributed
Capital
Retained
Earnings
$
$ 20,000
33,000
(5,000)
100,000
50,000
$ 150,000
$ 48,000
M5-9 Determining the Effects of Transactions on Debt-toAssets, Asset Turnover, and Net Profit Margin
Using the transactions in M5-8, complete the following table by
indicating the sign of the effect (+ for increase, - for decrease, NE for
no effect, and CD for cannot determine) of each transaction.
Consider each item independently.
Transaction
a. Issued 10,000 shares of stock for
$90,000 cash.
b. Equipment costing $4,000 was
purchased by issuing a note
payable.
c. Recorded depreciation of $1,000 on
the equipment.
5-41
Debt-to-Assets
Asset Turnover
Net Profit Margin
–
–
NE
+
–
NE
+
+
–
M5-10 Preparing Comparative Financial Statements
Complete the blanks in the following comparative income
statements, statement of stockholders’ equity, and balance sheets.
(a) Income from Operations
(b)Income before Income Tax Expense
(c) 100
5-42
M5-10 Preparing Comparative Financial Statements
(d) 480
(e) 80 (from December 31, 2009, Balance Sheet)
(f) 120
5-43
M5-10 Preparing Comparative Financial Statements
(g) 480
(h) 180
5-44
E5-11 Analyzing and Interpreting Asset Turnover and Net Profit
Margin
RadioShack Corporation has populated the world with stores from
Greece to Canada, and in the United States, an estimated 94 percent
of all Americans live or work within five minutes of the electronics
retailer—not bad for a company that originally started business as
American Hide & Leather Company. The following amounts (in
millions) were reported in RadioShack’s income statement and
balance sheet.
Requirements are listed on the next slide.
5-45
E5-11 Analyzing and Interpreting Asset Turnover and Net Profit
Margin
Required:
1. Compute the asset turnover and net profit margin ratios for 2008 and
2007.
2008
Asset turnover
2007
Asset turnover
5-46
=
=
Sales Revenue
Average Total Assets
=
$4,225
($2,284 + $1,990)/2
=
1.98
Sales Revenue
Average Total Assets
=
$4,252
($1,990 + $2,070)/2
=
2.09
2008
Net profit margin
=
Net Income
Sales Revenue
=
$192
$4,225
= .045 = 4.5%
2007
Net profit margin
=
Net Income
Sales Revenue
=
$237
$4,252
= .056 = 5.6%
E5-11 Analyzing and Interpreting Asset Turnover and Net Profit
Margin
Required:
2. Would analysts be more likely to increase or decrease their
estimates of stock value on the basis of these changes? Explain
what the changes in these two ratios mean.
The asset turnover ratio determines how well assets are
used to generate sales. This analysis indicates that the
company has decreased its efficiency in using assets
to generate sales from 2.09 in 2007 to 1.98 in 2008.
Net profit margin measures a company’s ability to
control expenses while generating sales. This analysis
indicates that the company’s performance is this regard
has declined from 5.6% in 2007 to 4.5% in 2008.
5-47
E5-11 Analyzing and Interpreting Asset Turnover and Net Profit
Margin
Required:
3. Compute the debt-to-assets ratio for 2008 and 2007.
5-48
2008
Debt-to-assets
=
Total Liabilities
Total Assets
=
$1,466
$2,284
= .642 = 64.2%
2007
Debt-to-assets
=
Total Liabilities
Total Assets
=
$1,220
$1,990
= .613 = 61.3%
E5-11 Analyzing and Interpreting Asset Turnover and Net Profit
Margin
Required:
4. Would analysts be more likely to increase or decrease their
estimates of RadioShack’s ability to repay lenders on the basis of
this change? Explain by interpreting what the change in this ratio
means.
The debt-to-assets ratio indicates the percentage of
assets financed by debt as a sign of the company’s
financing risk. This analysis indicates that the
company has increased its debt financing from 61.3%
in 2007 to 64.2% in 2008. Analysts would likely
decrease their estimates of RadioShack’s ability to
repay lenders because the company increased its
relative reliance on debt financing, making the
company more risky.
5-49
E5-16 Finding Financial Statement Information
Indicate whether each of the following would be reported on the
balance sheet (B/S), income statement (I/S), or statement of
stockholders’ equity (SSE).
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
5-50
Insurance costs paid this year, to expire next year.
Insurance costs expired this year.
Insurance costs still owed.
Cost of equipment used up this accounting year.
Equipment book value (carrying value).
Amounts contributed by stockholders during the year.
Cost of supplies unused at the end of the year.
Cost of supplies used during the accounting year.
Amount of unpaid loans at end of year.
Dividends declared and paid during this year.
B/S
I/S
B/S
I/S
B/S
SSE
B/S
I/S
B/S
SSE
E5-16 Finding Financial Statement Information
Indicate whether each of the following would be reported on the
balance sheet (B/S), income statement (I/S), or statement of
stockholders’ equity (SSE).
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
5-51
Insurance costs paid this year, to expire next year.
Insurance costs expired this year.
Insurance costs still owed.
Cost of equipment used up this accounting year.
Equipment book value (carrying value).
Amounts contributed by stockholders during the year.
Cost of supplies unused at the end of the year.
Cost of supplies used during the accounting year.
Amount of unpaid loans at end of year.
Dividends declared and paid during this year.
B/S
I/S
B/S
I/S
B/S
SSE
B/S
I/S
B/S
SSE
End of Chapter 5