Financial Reporting
and Analysis
2
CHAPTER
Financial Reporting
Environment
Regulators
Alternative Information
Sources
Industry
Practices
Economy and Industry
Information
FASB
GAAP
Managers
Voluntary
Disclosure
AICPA
Analysts
Statutory Financial Reports
(Financial Statements)
SEC
Corporate
Governance
Litigation
Auditors
Enforcement and Monitoring Mechanisms
Investors
and
Creditors
Other
Users
Users
Form 10-K
(Annual Report)
10-Q
(Quarterly Report)
20-F
(Registration Statement/
Annual Report [Foreign])
8-K
(Current Report)
Statutory Financial Reports
14-A
(Proxy Statement/
Prospectus)
Other
SEC Filings
Earnings Announcements
 Key summary measures (pre-audit)
 Often one to six week lag
 Informative to market
 Lacks supporting financial details
Environmental Factors
GAAP
Generally Accepted Accounting Principles
Level I
(Most authoritative)
Level II
Level III
Level IV
(Least authoritative)
FASB
Standards and
Interpretations
FASB
Technical
Bulletins
APB
Opinions
AICPA
Industry Audit &
Accounting Guidelines
FASB
Emerging Issues Task Force
FASB
Implementation
Guides
AICPA(CAP)
Accounting
Research Bulletins
AICPA
Interpretations
AICPA
Statement of
Position
AICPA
Practice Bulletins
Recognized and
Widely Used Industry
Practices
Environmental Factors
Unions
Securities and
Exchange
Commission
AICPA
Investors
Lenders
Politicians
Accountants
Others
Provide input to
Financial Accounting Standards Board
Help set
Generally Accepted Accounting Principles
Environmental Factors
Securities and Exchange Commission (SEC)
 Independent, quasi-judicial government agency
 Administer securities regulations & disclosures
 Can modify & set GAAP, if necessary
 Rarely directly challenges FASB
 Major player in global accounting
Environmental Factors
International Accounting Standards (IAS)
 Set by International Accounting
Standards Board
 Not currently accepted in U.S.
 SEC under pressure to accept IAS
Environmental Factors
Managers of Companies
 Main
for fair &Accounting
accurate reports
 Setresponsibility
by International
 Applies
accounting
to reflect business
Standards
Board
activities
 Not currently
accepted
in in
U.S.
 Managerial
discretion
is necessary
accounting
 SEC
underonpressure
to accept
 Major
lobbyist
GAAP
IAS
Environmental Factors
Auditing
 SEC
requires
Audit Report Accounting
 Set
by International
 Audit
opinion can
be:
Standards
Board
- clean (fairly presented)
 Not -currently
accepted
qualified (except
for) in U.S.
Auditors
- disclaimer (no opinion)

SEC
under
pressure
to
accept
 Check Auditor quality & independence
IAS
Environmental Factors
Corporate Governance
 Board
oversightAccounting
 Set of
bydirectors
International
 Audit
committeeBoard
of the board
Standards
- oversee accounting process
Not currently
accepted in U.S.
-oversee
internal control
- oversea internal/external audit

SEC
under
pressure
to
accept
 Internal Auditor
IAS
Environmental Factors
Internal Users
External Users
Managers
Officers
Internal Auditors
Sales Managers
Budget Officers
Controller
Lenders
Shareholders
Governments
Labor Unions
External Auditors
Customers
Environmental Factors
Equity Investors
 Active & Speculative Investors rely on
financial reports
Creditors
 Solvency & Liquidity analysis relies
on financial reports
Environmental Factors
Economic, Industry & Company News
 Impacts current & future financial condition and
performance
Voluntary Disclosure
 Many factors encourage voluntary disclosure by
managers
Information Intermediaries
 Industry devoted to collecting, processing, interpreting
& disseminating company information
 Includes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
 Major determinant of GAAP
Financial Accounting
Objectives
Stewardship
• Safeguard assets
• Increase equity value
• Protect creditors
Accountability &
Performance
Measurement
Historical Emphasis
(but still important)
Information Perspective
• Amount
…of
• Timing
prospective
• Uncertainty
net cash
inflows
Predictability & Decision
Usefulness
Modern Emphasis
Financial Accounting
Hierarchy of Accounting Qualities
Users of accounting
information
Decision makers and their characteristics
Benefits > Costs
Constraints
Materiality
Understandability
User-specific
qualities
Primary qualities
Ingredients of
primary qualities
Decision usefulness
Relevance
Predictive
value
Reliability
Feedback
value
Neutrality
Representational
faithfulness
Timeliness
Secondary qualities
Verifiability
Comparability and
consistency
Financial Accounting
Important Accounting Principles
• Double Entry - duality from accounting equation, A=L+E
• Historical Cost - fair & objective values from arm’s-length
transactions
• Accrual Accounting - recognize revenues when earned,
expenses when incurred
• Full Disclosure - measure and/or disclose material events
and transactions
• Materiality - threshold when information impacts decision
making
• Conservatism - reporting or disclosing
the least optimistic information
about uncertain events and transactions
FASB
Financial Accounting
Relevance of Accounting Numbers
Percent of Stock Price
Explained
Relation between Accounting Numbers and Stock Prices
100%
80%
Book Value
60%
Earnings
40%
Combined
20%
0%
65
70
75
80
Year
85
90
95
Financial Accounting
Limitations of Accounting Numbers
• Timeliness - periodic disclosure, not
•
real-time basis
• Frequency - quarterly and annually
• Forward Looking - limited prospective
information
Accruals--The Cornerstone
Net
Income
=
Operating
Cash Flow
+
Accruals
Accruals--The Cornerstone
Foundations of Accrual Accounting
Revenue Recognition – recognize revenues when
(1) Earned
(2) Realized or Realizable
Expense Matching – match with corresponding revenues
-Product costs
-Period costs
Accruals--The Cornerstone
Relation between Cash Flows and Accruals
Operating cash flow (OCF)
-/+
Cash investment & divestment in operating assets
=
Free cash flow (FCF)
+/-
Financing cash flows (including investment &
divestment in financing assets)
=
Net cash flow (NCF)
Accruals--The Cornerstone
Short-Term and Long-Term Accruals
Short-Term Accruals: Yield current assets and current
liabilities (also called working
capital accruals)
Long-Term Accruals: Yield non-current assets and noncurrent liabilities (arise mainly from
capitalization)
Note: Analysis research suggests short-term accruals
are more useful in company valuation
Accruals--The Cornerstone
Relevance of Cash Flows and Income over a Company’s Life Cycle
+
Financing
cash flow
Inception
Free cash
flow
Operating
cash flow
Income
Growth
Maturity
Investing
cash flow
Decline
Accruals--The Cornerstone
Comparison of Stock Price, Net Income, and Free Cash Flows
Fiscal year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Stock price
4.22
5.33
8.25
13.47 16.28
13.25
11.44
10.19
11.87
19.91
Net income
0.18
0.24
0.28
0.35
0.51
0.58
0.60
0.67
0.78
Free cash flow
0.04
(0.01)
(0.05)
(0.17) (0.48)
(0.50)
(0.19)
(0.21)
0.84
0.60
Stock price
18.94
16.62
15.50
24.50 23.25
19.63
13.63
5.88
11.13
11.00
Net income
2.00
0.81
1.89
2.02
(2.13)
0.64
(1.24) (0.45)
0.51
Free cash flow
1.76
(2.26)
0.20
1.29
2.71
Wal-Mart
0.44
Kmart
2.07
(0.47) (2.15)
0.48
0.61
1.35
Accruals--The Cornerstone
Percent of Price Explained
Relation between Stock Prices and Various Income and Cash
Flow Measures for a Large Sample of Companies
70.00
60.00
57.62
44.36
50.00
40.00
33.02
32.62
30.00
20.00
10.00
1.00
0.00
NIBX
NI
OCF
FCF
NCF
NIBX = Net Income before Extraordinary Items and Discontinued Operations; NI = Net Income;
OCF = Operating Cash Flow; FCF = Free Cash Flows; NCF = Net Cash Flow (Change in Cash).
Accruals--The Cornerstone
Relation between Stock Returns and both Income and Operating
Cash Flows for Different Horizons of a Large Sample of Companies
.
45.00
40.26
Percent of Stock Returns Explained
40.00
35.00
30.00
25.00
OCF
NI
20.00
16.20
15.00
10.88
10.00
3.24
5.00
3.18
0.10
0.00
Quarter
Annual
Time Horizon
Source: Dechow, P
Four-Year
Accruals--The Cornerstone
Accruals and Cash Flows --- Myths
.
• Myth: Since company value depends on future cash flows,
only current cash flows are relevant for valuation.
• Myth: Company value equals discounted future cash flows.
• Myth: All cash flows are value relevant.
• Myth: All accruals accounting adjustments are value
irrelevant.
• Myth: Cash flows cannot be manipulated.
• Myth: All income is manipulated.
• Myth: It is impossible to consistently
•
manage income upwards in long run.
• Myth: Accounting rules are irrelevant
for valuation.
Accruals--The Cornerstone
Accruals and Cash Flows --- Truths
.
• Truth: Accrual accounting (income) is more
relevant than cash flow.
• Truth: Cash flows are more reliable than accruals.
• Truth: Accrual accounting numbers are subject
to accounting distortions.
• Truth: Company value can be
determined by using
accrual accounting
numbers.
Accounting Analysis
Demand for Accounting Analysis
 Adjust for accounting distortions so financial
reports better reflect economic reality
 Adjust general-purpose financial statements
to meet specific analysis objectives of a
particular user
Accounting Analysis
Sources of Accounting Distortions
 Accounting Standards – attributed to (1) political
process of standard-setting, (2) accounting
principles and assumptions, and (3) conservatism
 Estimation Errors – attributed to estimation errors
inherent in accrual accounting
 Reliability vs Relevance – attributed to overemphasis on reliability at the loss of relevance
 Earnings Management – attributed to windowdressing of financial statements by
managers to achieve personal benefits
Accounting Analysis
Sources of Analysis Objectives
 Comparatives Analysis – demand for financial comparisons
across companies and/or across
time
 Income Measurement -- demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income concepts
(1) Economic Income (or
empirically, economic profit)
(2) Permanent Income (or
empirically, sustainable profit)
Chapter 6 discusses these measures in detail
Accounting Analysis
Earnings Management – Frequent Source of Distortion
Three common strategies:
 Increasing Income – managers adjust accruals
to increase reported
income
 Big Bath
– managers record huge
write-offs in one period to
relieve other periods of
expenses
 Income Smoothing– managers decrease or
increase reported income
to reduce its volatility
Accounting Analysis
Earnings Management – Motivations
 Contracting Incentives -- managers adjust numbers
used in contracts that affect their wealth (e.g.,
compensation contracts)
 Stock Prices – managers adjust numbers to influence
stock prices for personal benefits (e.g., mergers, option
or stock offering)
 Government Favors – managers adjust numbers to
affect political actions (e.g., antitrust actions, IRS
pressures, government subsidies)
 Other Reasons -- managers adjust numbers to impact
(1) labor demands, (2) management changes, and (3)
societal views
Accounting Analysis
Earnings Management – Mechanics
 Incoming Shifting – Accelerate or delay
recognition of revenues or
expenses to shift income from
one period to another
 Classificatory
– Selectively classify revenues
and expenses in certain parts
of the income statement to
affect analysis inferences
regarding the recurring nature
of these items
Accounting Analysis
Process of Accounting Analysis
Accounting analysis involves several inter-related processes
and tasks that can be grouped into two broad areas:
Evaluating Earning Quality –
Identify and assess key accounting policies
Evaluate extent of accounting flexibility
Determine the reporting strategy
Identify and assess red flags
Adjusting Financial Statements -Identify, measure, and make necessary adjustments
to financial statements to better serve one’s analysis
objectives; Chapters 3-6 focus on adjusting
(recasting) the statements