Understanding
Financial Statements
Seventh EDITION
Lyn M. Fraser
Aileen Ormiston
Financial Statements
An Overview
Map or Maze
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Chapter 1
1-2
Financial Statements
An Overview
Map or Maze
Statement of Cash Flows
Balance Sheet
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MD&A
Income Statement
Notes
Auditor’s Report
Statement of Shareholders’ Equity
Chapter 1
1-3
Map:
To help its user
reach a desired
destination through
clarity of
representation
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Maze:
On the other hand. . .
Attempts to confuse its user by
purposefully introducing conflicting
elements and complexities that
prevent reaching the desired goal
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Map or Maze
Financial statements are potentially
both MAP and MAZE
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Financial Statements--MAP
Form basis for understanding the financial
position of a firm
Allow users to assess historical and
prospective financial performance
Present picture of firm’s financial health,
leading to informed business decisions
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Financial Statements--MAZE
Contain large amounts of information
Accounting policies and reporting
requirements are complex and
constantly changing
Allow management considerable
discretion
Hide or omit key information
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Our Goal:
To ensure that financial statements
serve as a map, not a maze
The better one can read and understand
the financial statements, the more
useful they are as a MAP to
intelligent decision-making
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Why use financial statements?
Savvy use of financial statements
allows user to assess:
Financial position of the company
Success of its operations
Policies and strategies of management
Insight into future performance
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Questions one might ask:



What is the degree of risk inherent
in the investment?
Would an investment generate
attractive returns?
Should existing investing holdings
be liquidated?
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More questions one might ask


Will cash flows be sufficient to
service interest and principal
payments on debt?
Does company provide a good
opportunity for employment?
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More questions one might ask


Con’t
How well does this company
compete in its operating
environment?
Is this firm a good prospect as a
customer?
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Volume of Information
The Annual Report
Financial statements
Notes to the financial statements
The auditor’s report
Five-year summary of key financial data
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The Annual Report
Continued
High and low stock prices
Management’s discussion and
analysis of operations
Material included at the imagination
and discretion of management
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Financial Statements
Are prepared according to generally
accepted accounting principles
(GAAP)
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GAAP
Two authorities primarily responsible for
establishing GAAP in the United
States are the SEC and the FASB
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SEC
Stands for
Securities and Exchange Commission
Regulates US companies that issue
securities to the public
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SEC
Continued
Requires



Regular filing of annual reports (10-K)
Quarterly reports (10-Q); and
Other reports dependent upon particular
circumstances



Change in auditor
Bankruptcy
Other important events
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SEC
Continued
Has Congressional authority to set
accounting policies, but usually
delegates accounting rule-making to
the FASB
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FASB
Stands for



Financial Accounting Standards Board
Comprised of 7 full-time paid members
Issues Statements of Financial
Accounting Standards (SFAS) and
Interpretations

Lengthy deliberation process
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The FASB Deliberation Process
1. Introduction of topic or project on
the FASB agenda
2. Research and analysis of the problem
3. Issuance of a discussion
memorandum
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The FASB Deliberation Process
4.
5.
6.
7.
Con’t.
Public hearings
Board analysis and evaluation
Issuance of an exposure draft
Period of public comment
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The FASB Deliberation Process
Con’t.
8. Review of public response, revision
9. Issuance of SFAS
10. Amendments and Interpretations,
as needed
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The SEC and FASB
Have worked closely together in the
development of account policy
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The SEC and FASB
Continued
Recent history of corporate failures and
accounting scandals have focused
attention and criticism on regulatory
authorities
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Where to Find a Company’s
Financial Statements:



Form 10-K
Annual report
Website
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The Four Basic
Financial Statements
1. Balance Sheet
2. Income Statement or Earnings
Statement
3. Statement of Shareholders’ Equity
4. Statement of Cash Flows
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Financial Statement Notes:




Are an INTEGRAL part of the statements
Provide summary of accounting policies
Present detail about particular accounts
(e.g. inventory, investments, etc.)
Include other information (e.g. leasing
arrangements, pending legal
proceedings, income taxes, etc.)
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Financial Statement Notes:
Continued
Contain some supplementary
information required by SEC and
FASB
Examples include:


Information on foreign currency
translations for firms doing business
in/with foreign countries
Information by segment for firms with
several lines of business
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Auditor’s Report
Unqualified
Qualified
Adverse opinion
Scope limitation
Disclaimer of opinion
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Auditor’s Report


Continued
Unqualified (what you want!)-statements present information in
conformity with GAAP
Qualified (not what you want)—are
reports other than an unqualified
opinion
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Auditor’s Report


Continued
Adverse opinion states that the
financial statements have not been
presented fairly in accordance with
GAAP
Scope limitation means that the
extent of the audit work has been
limited
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Auditor’s Report
Continued
Disclaimer of opinion:
Keep in mind that auditor is hired
by the firm being audited--always
the possibility of conflict of interest
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Management Discussion
and Analysis (MD&A)


Sometimes labeled “Financial
Review”
Contains information that cannot be
found in the financial data
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(MD&A)
1.
2.
3.
Continued
Internal/external sources of liquidity
Any material deficiencies in liquidity
and how they will be remedied
Commitments for capital
expenditures/sources of funding
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(MD&A)
4.
5.
Continued
Anticipated changes in mix and cost
of financing resources
Unusual/infrequent transactions
which affect income from continuing
operations
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(MD&A)
6.
7.
Continued
Events causing material changes in
cost/revenue relationships (e.g.
future price increase)
Breakdown of sales increases in
price & volume components
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(MD&A)
Continued
Alas, there are problems as well
with the usefulness of the MD&A
section
Companies do a good job of
describing historical events but. . .
Very few provide accurate forecasts
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(MD&A)
Continued
More helpful has been the addition
to the MD&A of explanations about
why changes have occurred in
profitability and liquidity
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Five-Year Summary of Selected
Financial Data and Market Data


Required by SEC
Offers a quick look at some overall
trends
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Five-Year Summary
Continued
Includes:



Net sales or operating revenues
Income or loss from continuing
operations
Income or loss from continuing
operations per common share
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Five-Year Summary



Continued
Total assets
Long-term obligations and
redeemable preferred stock
Cash dividends per common share
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Pandora (A.K.A. “PR Fluff”)
Getting what is needed can be a challenge
Colored photographs
Charts
Shareholders’ letter from the CEO
Website
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Proxy Statement
Used to solicit shareholder votes
Required by the SEC
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Proxy Statement
Continued
Contains


Voting procedures and information
Background information about the
company’s nominated directors
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Proxy Statement



Continued
Director compensation
Executive compensation
Any proposed changes in
compensation plans
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Proxy Statement


Continued
Audit committee report
Breakdown of audit and nonaudit
fees paid to the auditing firm
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Missing and
Hard-to-Find Information
Not available in the financial statements:



Employee relations with
management
Morale/efficiency of employees
Reputation/public perceptions of
firm
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Missing and
Hard-to-Find Information


Continued
Effectiveness of management
team/provisions for succession
Potential exposure to regulatory
changes
IMPACT OPERATING SUCCESS
BUT ARE DIFFICULT TO QUANTIFY
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Missing and
Hard-to-Find Information
Continued
Publicity in the Media



Affects public perception of firm and can
impact financial performance
Proven correlation between financial
returns and reputation
A recent example of adverse publicity is
Bridgestone/Firestone for denying and
covering up the deaths allegedly caused
by their tires
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Missing and
Hard-to-Find Information
Continued


Facts are available, but may be
difficult for an average user to find
Many items must be extracted from
notes, supplementary schedules,
MD&A section in order to interpret
financial statement numbers--the
facts are there, but they are not
self-evident!
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Complexities
A Global Marketplace
International Accounting Standards
Committee (IASC) formed in 1973
with goal of determining
international GAAP
US presently has not accepted the
current international accounting
standards
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Complexities
continued
Mythical Mountain
GAAP provide some measure but they allow
considerable discretion
Accounting choices and estimates affect
amounts on financial statements
Depreciation of fixed assets is a good example
(choice of method, different “good faith”
estimates possible)
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Complexities
continued
Other Discretionary Issues



Although the firm’s life is continuous,
financial data is presented for arbitrary
time periods--year, quarter and the like
Leads to need for more adjustments and
estimates
Statements are prepared on “accrual”
basis
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More Complications




Goodwill and Other Intangible
Assets
Consolidation of parent and
subsidiaries
Reporting leases
Reporting pensions
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More Complications
Continued



Translation of foreign operations
Off-balance sheet financing
Accounting for derivatives
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More Complications
Continued


“Comprehensive” income reporting
Two sets of books (yes, it’s legal!!) financial vs. tax reporting
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Quality of Financial Reporting
Management has considerable discretion
within GAAP
Potential exists to “manipulate” the
profit/loss reported
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Quality of Financial Reporting
Continued
Ideally, financial statements should:


Reflect an accurate picture of a
company’s financial condition and
performance
Information should be useful both
to assess the past and predict the
future
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Quality of Financial Reporting
Continued


The sharper and clearer the picture
presented through the financial data
and the closer that picture is to
financial reality. . .
The higher is the quality of the
financial statements and reported
earnings
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Quality of Financial Reporting
Continued
Examples of opportunities for
management to affect the quality
of financial statements. . . .
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Quality of Financial Reporting
Continued




Accounting Policies, Estimates—
Choices and Changes
Timing of Revenue and Expense
Recognition
Discretionary Items
Nonrecurring and Nonoperating
Items
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Accounting Policies, Estimates—
Choices and Changes
Choices
Management makes choices with respect
to accounting policies
Management makes estimations in the
applications of those policies
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Accounting Policies, Estimates—
Choices and Changes Continued
Changes
Policy or estimate may be changed
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Timing of Revenue and
Expense Recognition
The Matching Principle:
Expenses are matched with the
generation of revenues in order to
determine net income for an
accounting period
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Timing of Revenue and
Expense Recognition Continued
Matching process involves management
judgments regarding the timing of
expense and revenue recognition
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Timing of Revenue and
Expense Recognition Continued
Usually the more conservative the
approach (least favorable to
management) the higher the quality
of earnings
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Discretionary Items
Budget level and timing of expenditures
for many items are discretionary, e.g.
Advertising/marketing
Repairs/maintenance
Research and development
Capital expansion
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Nonrecurring and
Nonoperating Items



Are not part of normal ongoing
business
Earnings figure should reflect future
operating potential
Should be reviewed and possibly
eliminated from earnings
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Nonrecurring and
Nonoperating Items
Continued
Other transactions to consider



Write-downs for the impairment of
assets
Accounting changes
Extraordinary items
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The Journey
Through the Maze Continues
Ch. 2:
Ch. 3:
Ch. 4:
Ch. 5:
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The Balance Sheet
The Income Statement and
Statement of Stockholders’ Equity
Statement of Cash Flows
The Analysis of Financial
Statements
1-72