Analyzing a Company’s Financial Reporting
Lecture 8
What you should expect
Understand the Financial Statements
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What are the financial statements saying?
What are the financial statements not saying?
What are the accounting principles that govern the statements?
How do internal controls work to enhance reporting reliability?
What are the sensitive areas in the financial reports?
How do I recognize a “red flag”?
How does Wall Street view the financial statements?
Develop a Critique for Your Firm’s Financial Statements
Questions to Ask
How Firm Valuation Issues Arise
Diversity in Generally Accepted Accounting Principles (GAAP)
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Examples:
─ Show securities at cost
─ Show securities at market value when below cost
─ Show securities at cost plus interest earned but not yet paid
─ Show securities at approximate market value
Another Example
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Examples:
─ Recognize revenue in the period when products or services are delivered
─ Recognize revenue in the period when product is ready for delivery
─ Recognize revenue in the period when payment is received from customer or client
Why is Accounting for Current Enterprise
Transactions So Difficult?
• The numbers are important but equally
important are the principles and practices that
lie behind them
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Revenue recognition
Accruals
Asset vs. expense
Valuation
Depreciation and amortization
Currrency translation
Why is Accounting for Enterprise Transactions
so Difficult?
• Sophisticated Issues
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Special Purpose Entities
Derivatives
Lease Accounting
Expensing stock options
Restructuring charges
Recognizing debt associated with pension benefits
Information Quality
Not where it needs to be
Appropriateness of financial
Information
Meets Objectives
In Reflecting
Business Performance
41%
For Management Decision Making
26%
For Forward looking Management
Planning and Strategy
16%
The Limitations of GAAP Accounting
The Objective:
Faithfully represent the business and provide information about future cash
flows
The practical Problem:
Measurement is difficult and subject to speculation
“Tell us that you know, but leave the speculation to us”
The Tradeoff:
Relevance versus reliability
The SEC Final Rule on Sarbanes-Oxley
The certification statement regarding fair presentation of financial statements
and other financial information is not limited to a representation that the
financial statements and other financial information have been presented in
accordance with “generally accepted accounting principles” and is not
otherwise limited by reference to generally accepted accounting principles.
We believe that Congress intended this statement to provide assurances that
the financial information disclosed in a report, viewed in its entirely, meets a
standard of overall material accuracy and completeness that is broader than
financial reporting requirements under generally accepted accounting principles
[emphasis added]
U.S. Securites and Exchange Commission, Final Rule: Certification of Disclosure in Companies’ Quarterly and
Annual Reports, Release Nos. 33-8124, 34-46427; File No. S7-21-02, http://www.sec.gov/rules/final/33-8124.html
How Should You Deal with the
Issues?
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Understand GAAP and its limitations
─ Appreciate the relevance-reliability tradeoff
─ Recognize the diversity in accounting applications
─ Recognize the critical accounting policies
─ Recognize unresolved issues in GAAP
─ Recognize where choices can be made
 How does your firm treat depreciation accounting?
Be alert to poor application of GAAP
─ How sensitive are earning to estimates?
─ How would you characterize the revenue recognition-aggressive or
conservative?
─ Does the application of GAAP “faithfully represent” the business?
Market is demanding transparency as well as compliance with GAAP
─ Transparency on performance
─ Transparency on asset and liability position
The Focus for the
Non-Financial Professional
Take the position of the shareholder (owner)
How much did I make this year?
What is my financial position?
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my share of assets?
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my obligations?
How much can I expect to make in the future?
What is my stock worth?
Accounting Essentials for NonFinancial Professionals
1. Navigating the Financial Statements
2. Highlighting Some Key Issues:
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The use of estimates in financial reports
Revenue recognition
Recognizing variable interest entities (SPEs)
Distinguishing liabilities and equity
Accounting for stock based compensation
Navigating the Financial Statements
A. Understand what each statement is saying
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What is recognized and what is not recognized?
What are the accounting principles employed?
How do firms in the same industry differ?
B. Identify the sensitive issues
The financial statements are the lens on the business
The eye on the lens is the eye of the shareholders
The lens can be out of focus
Viewing the Business Through the
Financial Statements
Business Activities:
• Financial Activities
• Investing Activities
• Operating Activities
Financial Activities
Investing Activities
Operating Activities
Raise monies
from investors
Invest in
business assets
Employ assets in
trading to “add value”
Return value to investors
The Financial Reports
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Management Discussion and Analysis
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The Four Financial Statements
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Balance Sheet
Income Statement
Cash Flow Statement
Shareholders’ Equity Statement (required by the SEC, not GAAP)
Footnotes to the Financial Statements
Cash Accounting
2003
CASH
2004
CASH
Report Cash Added
The Cash Flow Statement
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Cash From Operations
Cash investing
=
Net cash from operations
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Net cash paid to investors
- Shareholders
- Debtholders
=
Change in cash
Cash generated by
business
Cash remaining after
distribution to investors
Qualcomm Cash Flows: Bottom Line Summary
(in millions of dollars)
Cash Flow from Operations
1,782
Cash spent on investments
1,029
Net cash from operations
753
Net cash paid to investors:
To shareholders
103
To debtholders
12
Change in cash
115
638
Does Cash Accounting Draw a Sensible
Picture of the Business for the Shareholders?
How much did I make this period?
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Investments add to earnings rather than reduce them
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Earnings are made (or lost) other than by cash
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Sales on credit
Inputs purchased on credit
Services paid for with stock
How Accrual Accounting Works
Focusing the lens to capture the economics of the business
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Recognize revenues when delivery has occurred even if cash has not been
received
Expenses are recognized in the same accounting period as the revenues to
which they relate
Investments are placed on the balances sheet, rather than charged to current
operations
─ Examples:
 Inventory and Property, plant and equipment
Non-cash effects on shareholder value are recognized (the accruals)
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Examples:
 Sales on credit
─ Revenue and accounts receivable
 Wages not paid and pensions
─ Wages expenses and wages payable
─ Pension expense and pension liability
Thinking about Poor Accrual Accounting
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Inappropriate “capitalization”
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Recognizing investments as assets rather than expenses
(R&D and brand building)
─ Recognizing expenses as assets
Here’s the Rub!
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Accrual accounting ideally gives a better picture than cash accounting,
but accrual accounting requires estimates.
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Estimates are really forecasts of the future. They will usually turn out to
be wrong, but they should be an unbiased, best guess.
The Accrual Accounting Picture
2003
The Balance Sheet
2004
The Balance Sheet
Liabilities
Liabilities
Assets
Assets
Equity
Equity
Report Additions to Equity
The Equity Statement
•Net Additions from share issues and payouts
•Additions from the business
The Income Statement
Revenues
-Expenses
Net income
Navigating the Equity Statement
A. Understand What the Statement is Saying
1. Additions from transactions with shareholders
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Share issues (+)
Share repurchases (-)
 Dividends (-)
2. Additions from running the business for the shareholders
B. Identify the Sensitive Issues
Navigating the Income Statement
1. What the Statement is Saying
Revenues
- Expenses
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Cash + revenue accruals
Cash + misclassified + expense
Investments accruals
= Net income =
Misclassification Estimates
2. Sensitive Issues
• Misclassification of investments: the “capitalization” question
• Estimates for revenue and expense accruals
Revenue Recognition: The Realization Principle
Revenues should be recognized when
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The earnings process with respect to the revenue is complete or virtually
complete.
The first criterion means that the entity has substantially accomplished what it must do
to be entitled to the benefits represented by the revenue (usually cash inflow). For most
firms, this criterion is satisfied at the time of delivery (by delivering the merchandise or
service , the firm has preformed at least most of what it is suppose to do to be entitled
to the revenue).
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The amount and timing of cash flows from the revenue are reasonably
determinable.
The second criterion requires that revenue be recognized in the income statement only
if cash has already been collected or the amount and timing of cash to be collected can
be estimated with reasonable precision.
Revenue Recognition: The Realization Principle
Implications:
If the firm sold and delivered a product, it should recognize revenue
even if it did not collect cash, as long as there is reasonable certainly of
collection.
If the firm collected cash but has not delivered the product yet, it should
not recognize revenue.
If the firm delivered the product but cannot determine the sufficient
precision when and how much cash will be collect, it should not recognize
the revenue.
Revenue Recognition: Multiple Deliverables
Qualcomm: Equipment and services
Equipment
delivery
Service period
End of contract
The Key Question: Is revenue recognition aggressive or conservative?
Expense Recognition: The Matching Principle
The matching principle requires that each cost be reported as an expense in the same
period in which the revenues that the cost helped generate are recognized.
To implement the matching principle, management should first apply the realization
principle and decide which revenues to recognize. Then, it should identify all the costs
that helped generate those revenues and report them as an expense in the same
income statement together with the revenues.
Implications:
• Expenditures that generate future revenues are investments
• Costs that generate current revenues are expenses
For examples;
• Inventory cost is recognized when goods are sold (as cost of goods sold)
• Depreciation is recognized over the service life of an asset
• Mismatching : the WorldCom con
The Key Questions:
• Is the capitalization of expenses appropriate?
• Have all costs to generate current expenses been recognized?
Navigating the Balance Sheet
1.
What the statement is saying?
Liabilities
Assets
Equity
Equity = Asset - Liabilities
Asset represent
• Probable future benefits
• Measurable with reasonable reliability
• Resulting from past transaction or events
Liabilities represent
• Probable future sacrifice of economic benefits
• Measurable with reasonable reliability
• Resulting from past transaction or events
2. The Sensitive Issues
• Recognition of assets and liabilities
• Measurements of assets and liabilities
Measurement in the Balance Sheet
Historical Cost Accounting
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Original cost adjusted for accruals to recognize revenues and expenses
─ PPE: historical cost less accumulated depreciation
─ Unearned revenue
─ Accrued expenses
─ Capitalized costs
Fair Value Accounting
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Marking assets to market
─ “Trading” and “available-for-sale” securities
─ Derivatives
Quasi or estimated fair value
─ Receivables
─ Pension liabilities
Conditional fair valuing: impairment
─ Inventory: lower of cost or market
─ PPE
─ Goodwill
Measurement in the Balance Sheet: Qualcomm
Mark-to-Market
Cash and Cash Equivalents
Short-term marketable securities
Long-term marketable securities
Accounting Payable
Quasi Fair Value
Accounts Receivable, net
Financing Receivable, net
$2,045
2,516
611 (out of $811)
195
484
6
Conditional Fair Value applied to the following historical cost items:
Goodwill
347
Inventories
110
PPE
622
Historical Cost but usually Close to Fair Value
Financing Debt
226
All other assets and liabilities are at historical cost, adjusted for accruals
The Balance Sheet: The Key Questions
Recognition:
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Are liabilities missing? If so, is there transparent footnote disclosure?
What are the contingencies?
What are the executory contracts not recognized?
Measurement:
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Are mark-to-market prices from liquid markets?
Are estimated fair values unbiased?
Have impairments been made? Are they unbiased?
Are accruals unbiased?
(Broad) Questions to Ask
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Revenue recognition
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Can the revenue recognition policy be characterized as aggressive or
conservative?
How much of the revenue is due to revenues deferred from the past, net of
revenues currently deferred ? (Are we baking or eating cookies?)
Is the firm recognizing all expenses necessary to generate revenue?
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Are costs appropriately capitalized?
Are accrued expense liabilities appropriately recognized?
(Broad) Questions to Ask
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What will be effect of current estimates on future earnings?
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Restructuring charges?
Impairments and write-downs?
─ Allowances?
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Are fair values reliable?
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Are there transactions that might be interpreted as form over substance?
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Structured finance transactions?
Unconsolidated variable interest entities?
─ Doubtful arrangements to recognize revenue?
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The catch-all question: Do the accounting and the disclosures faithfully
and transparently represent the business activities?