Financial Accounting
A Decision-Making Approach, 2nd Edition
King, Lembke, and Smith
*
Prepared by
Dr. Denise English,
Boise State University
John Wiley & Sons, Inc.
CHAPTER
FIFTEEN
USING FINANCIAL
STATEMENT
INFORMATION
After reading Chapter 15, you should be able to:
1. Describe the importance of the Securities and Exchange
Commission for users of financial information and
provide a general overview of SEC reporting
requirements.
2. Explain what is meant by consolidated financial
statements, their advantages and limitations for
decision makers, and the basic approach to preparing
them.
3. Describe current requirements with respect to segment
reporting and how such information can be useful for
decision making.
4. Describe how interim financial reporting may help
decision makers.
CHAPTER
FIFTEEN
USING FINANCIAL
STATEMENT INFORMATION
After reading Chapter 15, you should be able to:
5. Identify the types of notes and supplemental information
expected to be found in financial reports and link this
information to decisions about enterprise activities.
6. Identify, describe, and use financial ratios to evaluate
financial statements and identify specific characteristics
of an enterprise.
7. Explain why understanding personal financial reporting is
important, and how it differs from corporate financial
reporting.
The Securities and
Exchange Commission



The Securities and Exchange Commission (SEC) is a
government agency having primary responsibility for
regulating the financial reporting of companies with publicly
traded securities.
The SEC was established in 1934 to oversee the issuance
and trading of securities by publicly held companies and to
assure full and fair disclosure by those companies.
The SEC was given authority over reporting and disclosure
requirements, but does not regulate a company’s activities.
Nor does it guarantee the results of decisions made by
information users.
Authority and
Impact of the SEC



The SEC has generally taken the position that it would
prefer to see accounting standards established by the
private sector bodies, such as the FASB.
If the private-sector body issues a standard with which the
SEC disagrees, the SEC typically accepts the standard but
requires companies to disclose in notes to the financial
statements what the effects of using the SEC’s preferred
method would be.
A company that files misleading financial statements may
face civil, or criminal penalties levied by the SEC. The SEC
can also stop all trading in a company’s securities, denying
the company access to the capital markets.
SEC Filing and
Reporting Requirements
Public companies are required to file a number of reports with the
SEC, the most common of which are:
Registration statement--must be filed before securities can be issued
and must include audited financial statements from the registrant.
Form 10-K--must be filed annually, cover the last annual accounting
period, and include audited financial statements.
Form 10-Q--must be filed quarterly and covers the most recent threemonth period; it is less detailed than the 10-K, but must include
financial statements which can be unaudited.
Form 8-K--must be filed within fifteen days of the occurrence of an
unscheduled material event, such as bankruptcy, change of auditor, or
the disposal of a major segment of business.
Management’s Discussion
and Analysis



The Management’s Discussion and Analysis (MD&A)
section of the annual report presents management’s
detailed analysis of the company’s position and
operations, along with a line-by-line discussion of
changes in the financial statements.
In addition, it focuses on the company’s liquidity, capital
resources, matters expected to have a significant effect
on the company, and the effects of inflation.
It helps decision makers understand the “why” behind
the numbers.
Level of Financial
Statement Disclosure


A primary issue relating to the usefulness of information
reported in financial statements relates to the type of
reporting that best presents the overall picture of a
company’s activities and position, while at the same time
permits decision makers to grasp the details of the
different aspects of the business enterprise.
The general approach to resolving this issue has been for
the authoritative bodies to require companies to present
consolidated financial statements along with additional
disclosures relating to different business-line and
geographic areas of the business.
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Consolidated Financial Statements




Financial statements that report on the combined financial position
and activities of a parent company and other companies that it
controls (subsidiaries) are called consolidated financial
statements.
The parent and its subsidiaries are legal entities, but the
consolidated entity is not. The consolidated entity has economic
reality, though, and provides a basis for defining the reporting entity.
A parent company has control if it can direct subsidiary policies
and, in effect, use the subsidiary’s assets as its own. A controlling
interest in the subsidiary may occur when a majority, or even a
significant amount (larger than other shareholders) is owned.
The portion of stock owned by others (than the parent company) are
referred to as minority or noncontrolling interests.
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Consolidated Statements
and Decision Making



Consolidated statements are prepared primarily for
those who have a long-run interest in the parent
company, such as owners and long-term creditors.
It would be difficult for a decision maker to analyze each
subsidiary in addition to the parent and make an overall
evaluation without consolidated financial statements.
If only interest in a subsidiary exists, however,
consolidated financial statements will not be as useful.
+
Consolidated Statements
and Decision Making



When examining consolidated financial statements, if
the parent and subsidiary entities are dissimilar,
some difficulty in interpreting financial statements
may occur.
Another limitation of consolidated financial statements
is that not all of the assets reported in the balance
sheet are directly available for the parent’s use.
Under GAAP, consolidated financial statements
must be presented whenever general-purpose
statements are issued to the public.
+
Principles of Consolidated
Financial Statements


Consolidated financial statements for a combined
entity are presented as if the related companies
were actually a single company.
An additional step is taken to remove the effects of
transactions or relationships between the affiliated
companies. The main items that are eliminated are as
follows:
–
–
–
–
Parent’s investment in subsidiary;
Stockholders’ equity of the subsidiary(ies);
Intercompany receivables/payables;
Intercompany sales and profits.
Segment Disclosures


By analyzing a company’s different activities, a
decision maker is in a better position to assess a
company’s future and judge the economic impact of
possible future events.
The FASB has mandated that certain disaggregated
information be included with corporate financial
statements. These additional disclosures provide
information about the following:
–
–
–
a company’s different operating segments;
the different geographic areas in which it operates;
the company’s major customers.
Interim Financial Reporting

Interim financial reports, issued between annual
reports, help meet the need for timely information. All
publicly traded companies are required to file interim
reports quarterly with the SEC.

At a minimum, interim reports must include:
–
–
–
–
–
–
Sales revenue, income tax expense, and net income;
Earnings per share for each period presented;
Disposal of a segment of the business, extraordinary items,
unusual or infrequently occurring items, and accounting changes;
Significant changes in income taxes;
Contingent items;
Significant changes in financial position.
Notes and Other
Financial Statement Information



The notes to the financial statements are provided
by management to supplement the numbers in the
financial statements.
Some forms of disclosure are mandated by GAAP, but
management frequently has some discretion in
deciding whether to include certain details in the body
of the financial statements, or in the notes.
Because notes are designed to explain and expand on
the information included in the body of the financial
statements, they do not replace the information on the
statements.
Summary of Required
Note Disclosures
Exhibit 15-3
(partial)
Accounts Receivable •allowance for doubtful accounts
•accounts pledged or assigned
Inventories
•valuation methods (e.g., lower of cost or market)
•costing methods (e.g., FIFO, LIFO)
•major categories of inventories
•special inventory financing arrangements
Investments
•valuation methods
•alternate valuations (e.g. market value)
Property, Plant,
•depreciation methods
and Equipment
•interest included in cost
•accumulated depreciation
•collateral arrangements for borrowings
Summary of Required
Note Disclosures
Financial Instruments
Long-term Debt
Pensions
Other Postretirement
Benefits (e.g., medical
insurance)
Exhibit 15-3
(partial)
•description, nature, and purpose
•principal amounts and fair values
•gains and losses from changes in fair values
•description of each type or issue of debt
•maturities of debt by year
•special terms or provisions
•description of plans
•amounts of all components used in
computation of employers’ cost and obligation
•description of plans
•amounts of all components used in
computation of employers’ cost and obligation
•estimated effect of change in health care cost
Summary of Required
Note Disclosures
Income Taxes
Stockholders’
Equity
Contingencies
Exhibit 15-3
(partial)
•amounts and classification of deferred taxes
•reconciliation of reported income tax expense with
taxes computed at the statutory rate
•par or stated value of stock
•number of shares authorized, issued, outstanding
•details of employee stock incentive plans
•value of stock options granted
•description of unresolved events that could have a
significant effect on the company in the future
Summary of Significant
Accounting Policies


All companies are required to provide a
summary of significant accounting policies
used to prepare the financial statements.
Other supplemental information often
includes quarterly financial information and
five-year or ten-year financial summaries.
Content of Summary of
Significant Accounting Policies
Exhibit 15-4
(partial)
Consolidation policy--a brief statement of which subsidiaries are
consolidated and, if not all are consolidated, what the basis for exclusion
is. Also, the treatment of intercompany transactions is described.
Cash and Cash Equivalents--a description of what securities are
considered cash equivalents, as well as any policies that might affect the
availability of cash.
Accounts Receivable--an explanation of any receivables that are
special or that have nonroutine collection patterns.
Inventories--a description of inventory valuation methods used (e.g.,
cost, lower of cost or market) and inventory costing methods used
(e.g. LIFO, FIFO). Special inventory valuation practices, such as for
inventory being constructed under long-term contract, are described.
Other Current Assets--a description of content, if significant.
Content of Summary of
Significant Accounting Policies
Exhibit 15-4
(partial)
Investments--a description of investments and how they are valued.
Property, Plant, and Equipment--a brief statement about how fixed
assets are valued and depreciated. Sometimes, the depreciation
periods are disclosed. More detail is usually given in a subsequent note.
Liabilities--valuation and classification descriptions. This item may be
omitted because liabilities are always discussed in detail in a separate
note.
Owner’s Equity--often omitted because policies relating to owners’
equity are fairly standard. Computations for earnings per share may be
described, as might the method of accounting for treasury stock, if any.
Subsequent notes may describe stock options or special owners’ equity
transactions.
Content of Summary of
Significant Accounting Policies
Exhibit 15-4
(partial)
Revenue Recognition--a description of when revenues and other
types of income are recognized.
Specialized Industry Practices--a description of recognition and
measurement policies unique to the industry.
Other Items--an explanation of special accounting treatment accorded
particular transactions or events, such as the adoption of a new
accounting method.
Foreign Currency Translation--a description of the currencies used in
the company’s business and how they are restated to dollars.
Use of Estimates--a caveat explaining that accounting employs
estimates that affect reported amounts and that estimates could differ
from actual amounts.
Content of Summary of
Significant Accounting Policies
Exhibit 15-4
(partial)
Concentrations--when applicable, a description of the company’s
limited number of suppliers, customers, transportation channels, or
similar factors that could adversely affect the company under certain
conditions.
Reclassifications--a description of any amounts that have been
reclassified from prior year financial statements to conform with
current classification.
Financial Analysis

Financial statement analysis often involves
comparing reported information about a
company over different time periods and
between different companies during the same
period of time. Three financial analysis
approaches are:
–
–
–
horizontal analysis
vertical analysis
ratio analysis.
Horizontal Analysis


An analysis of financial statement data over a period of
years is horizontal or trend analysis.
Typically the amounts for the current and one or two
earlier periods are compared to determine both the
dollar amount and percentage change from period to
period.
Net Sales
2001
2000
$25,350 $23,120
Change
Dollar Percent
$2,230
9.65%
Vertical Analysis



An analysis of the individual components of the financial
statements is referred to as vertical analysis.
In vertical analysis, the dollar amounts in the financial
statement are restated as percentages to show their
proportion of the totals.
Statements presented in percentages are referred to as
common-size financial statements.
2001
Net sales
$25,350
Operating expenses 20,070
Net income
5,280
Common
Size
100.0
79.2
20.8
2000
$23,120
17,280
5,840
Common
Size
100.0
74.7
25.3
Ratio Analysis


Liquidity
Solvency
Profitability
Return to investors
Comparisons within financial statements
and across time often are made with the
help of summary measures and ratios as
discussed in previous chapters.
Financial ratios can be analyzed with
respect to liquidity, solvency, profitability,
and return to investors.
Summary of Key Ratios
Exhibit 15-5
(partial)
Net sales revenue
1. Accounts receivable turnover:
Accounts receivable
Net sales revenue
2. Asset turnover:
Total assets
3. Cash flow
per share:
Cash provided by operations - preferred dividends
Number of common shares outstanding
Cash provided by operations
Current maturities of debt
5. Cash flow to total debt: Cash provided by operations
Total debt
Current assets
6. Current ratio:
Current liabilities
4. Cash flow to current maturities of debt:
Summary of Key Ratios
Exhibit 15-5
(partial)
Accounts Receivable
7. Days sales in receivables:
Credit sales / 365 days
Inventory
8. Days sales in inventory:
Cost of goods sold / 365 days
9. Debt to equity:
10. Diluted earnings
per share:
11. Dividend payout:
Long-term debt excluding deferred taxes
Stockholders’ Equity
Net income- preferred dividends
+ adjustment for conversion of securities
Common shares outstanding +
additional shares from potential conversion
Dividends paid
Net income
Summary of Key Ratios
Exhibit 15-5
(partial)
Cash dividend per share
Market price per share
12. Dividend yield:
13. Dividends to operating
cash flow:
Dividends paid
Cash provided by operations
14. Earnings per share:
Net income- preferred dividends
Common shares outstanding
15. Gross margin percentage:
16. Inventory turnover:
Net sales - cost of goods sold
Net sales
Cost of goods sold
Inventory
Summary of Key Ratios
17. Long-term debt to
total assets:
18. Net income margin:
19. Operating cycle:
Long-term debt
Total assets
Net income
Net sales revenue
Accounts receivable +
Inventory
Credit sales/365 days Cost of goods sold/365 days
20. Price-earnings ratio:
21. Quick ratio:
Exhibit 15-5
(partial)
Market price per share of common stock
Earnings per share
Quick assets
Current liabilities
Summary of Key Ratios
Net income
Total assets
22. Return on assets:
23. Return on common
equity:
Net income - preferred dividends
Stockholders’ equity - preferred stock claims
24. Return on total equity:
25. Times interest earned:
26. Times preferred
dividends earned:
Exhibit 15-5
(partial)
Net income
Stockholders’ equity
Operating income
Interest on long-term debt
Net income
Preferred dividends
Liquidity


Liquidity measures provide an indication of an entity’s
position with respect to cash and assets that may be
converted into cash in the relatively near future.
Some liquidity measures are:
–
–
–
–
–
–
–
–
current ratio
quick ratio
accounts receivable turnover
days sales in receivables
inventory turnover
days sales in inventory
operating cycle
cash flow to current maturities of debt
Solvency


Solvency measures help decision makers
evaluate an entity’s ability to meet its
obligations in a timely manner.
Some solvency measures are:
–
–
–
–
Long-term debt to total assets
Debt to equity
Times interest earned
Cash flow to total debt.
Profitability


Profitability measures provide indications of a
company’s operating success.
Some profitability measures are:
–
–
–
–
–
Gross profit (margin) percentage
Net income margin (return on sales)
Return on common equity
Asset turnover
Return on assets.
Return to investors


Return measures focus on more direct
measures of returns to investors.
Some return measures are:
–
–
–
–
–
Earnings per share
Diluted earnings per share
Dividend payout
Dividends to operating cash flow
Cash flow per share.
Personal Financial Reporting


Individuals are often asked to provide personal financial
information when seeking a large loan, or entering a
business venture. Personal financial statements are also
used for purposes such as reviewing the adequacy of
resources accumulated for retirement, analysis of asset
holdings, and estate planning.
Two personal financial statements are generally prepared:
– Statement of financial condition (personal balance
sheet);
– Statement of changes in net worth (personal income
statement).
Personal Financial Reporting


Assets should be reported at their fair values, and liabilities at
the lower of the discounted future cash payments or the current
cash settlement amount on a personal balance sheet. In
addition, an estimated income tax liability must be reported for
the difference between the current fair values of the assets and
liabilities and their tax bases.
Changes in the values of the assets and liabilities are reported
in the personal income statement, as is the change in the
estimated income tax that would have to be paid on the
changes; distinction between realized and unrealized changes
in net worth should also be drawn.
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