UNDERSTANDING

FINANCIAL STATEMENTS

Accounting Environment
and Financial Statements

Why use
financial
statements
?

Financial statements allow users to assess:

financial position of the company

success of its operations
policies and strategies of management
insight into future performance

Financial statements are

historical, but they can help see
into the future

Users of
accounting
informationstakeholders
Internal usersthose who make decisions directly affecting the
internal operations of the enterprise.

Board of directors
Compensation plans, hiring and termination decisions.
Dividend payment decisions.
Investment in new PPE decisions.
Management
Operating, financing, and investing
decisions.
Reporting decisions.
Employees
Employment/compensation decisions.

External
stakeholders
Investors and potential investors (stockholders)
Creditors and potential creditors (banks,
bondholders)
Suppliers
Customers
Unions
Community
Governmental agencies
Other interested parties (e.g., financial analysts)

Questions of
External FS
Users

Would an investment generate attractive returns?

What is the degree of risk inherent in the investment?
Should existing investing holdings be liquidated?
Will cash flows be sufficient to pay dividends?
Will cash flows be sufficient to service interest
and principal payments on debt?
How well does this company compete in its operating environment?
Is this firm a good prospect as a customer?

Financial
reporting:
reporting
to external
users
Management incentives
Management has a natural self-bias.
Accounting standards and other safeguards
ensure that accounting information is neutral
and objective.
Uniform presentation

External Audit

Required of publicly traded companies

External auditors hired by the companys Audit
Committee (which is a committee of the stockholders
board of directors)
The external auditors issue an opinion

Unqualified fairly stated in accordance

with GAAP
Qualified fairly stated except for
Adverse NOT fairly stated (very bad)
Disclaimer NO OPINION is given (also very bad)

GAAP

Accounting rules have been issued in order to ensure

that financial information is relevant, reliable and
understandable by users.
GAAP provide comparability.
Zimbabwe Stock Exchange

Regulates companies traded publicly in Zimbabwe

ZSE has the authority to set accounting policies.

Public
Company
Accounting
Oversight
Board

Created by Congress in 2002 by Sarbanes-Oxley Act

Created as a response to the accounting scandals in
2001/2002 (incl.Enron, WorldCom, Tyco, Qwest,
Haliburton)
Board will be overseen by the SEC
5 members of which no more than
2 members can be CPAs
shareholders
Has responsibility for setting future accounting
principles,
i.e. reviewing/revising current accounting principles
(incl. revenue recognition issues and stock options).

Ive got
the goods

Corporate
Thieves

SarbanesOxley Act

Should have paid more

attention in acctg 205

The Bill now requires the CEO and CFO to certify the
results of their company or face legal ramifications.
Annual Report must include an internal control report
(404):
(1) stating the responsibility of management for
Company Z CFO
establishing and maintaining an adequate internal
control structure and procedures for financial reporting;
and
(2) contain an assessment, as of the end of the year, of
the effectiveness on the IC structure and financial
reporting procedures
(3) The IC report must be attested to by the auditor

SarbanesOxley Act

The Bill requires significant changes to audit

committees
Each member shall be an independent
member
of the board of directors
Each audit committee must have a financial expert

EXPERT

SarbanesOxley Act
I can do your audit, your bookkeeping, be your
internal auditor, provide you investment banking
services, IS consulting, your taxes and so forth
and so forth

made it illegal for audit firms to provide nine

types of consulting services, incl.
bookkeeping, financial IS consulting, internal
audits, appraisal, actuarial, human resources,
investment banking, and legal services
set mandatory five-year audit lead partner
and reviewing partner rotation (not rotation of
audit firm at this time)

SarbanesOxley Act

an auditor on a particular companys

audit cannot accept employment with
that company for 1 year after an audit.

Public Co. Accounting Oversight Board

will establish auditing, ethics, and
independence standards and conduct
disciplinary investigations, and register
audit firms.

You need a new CFO?

Sounds Great! I can start
next week but first I need
to finish your unqualified
audit report

Wonderful! Golf at the club on

Saturday?

International
Accounting
Standards
International differences in GAAP.
Divergent national accounting practices
around the world can have a significant
impact on reported financial statements.
Companies should be able to make their
financial statements understandable to
users all over the world.
A trend is toward increasing
harmonization, so differences will
diminish over time.

International
Accounting
Standards
International Accounting Standards
Committee (IASC)
Formed to develop worldwide
accounting standards to aid foreign
companies and U.S. companies in
their business transactions.

SEC does not recognize IASC

standards as sufficient for listing on
U.S. stock exchanges.

Annual Report

financial statements:
Statement of financial position, statement of profit
or loss, Statement of changes in equity,
Statement of Cash Flows
notes to the financial statements
auditors report
5-year summary of key financial data
high and low stock selling prices
management discussion & analysis of operations

Notes to
Financial
Statements

Are an integral part of the statements

Provide summary of accounting policies
Present detail about particular accounts
(e.g. inventory, investments, long-term
debt)
Include other information (e.g. leasing
arrangements, pending legal
proceedings, income taxes)

Other
Required
Information

5 year summary of
selected financial data
Market data (high and
low stock sale prices) for
past two years
Management Discussion
& Analysis (MD&A)

MD & A

1.Internal/external sources of liquidity

2. Any material deficiencies in liquidity and
how they will be remedied
3. Commitments for capital expenditures/sources
of funding
4. Anticipated changes in mix and cost of financing
resources
5. Unusual/infrequent transactions which affect income from
continuing operations
6. Events causing material changes in cost/revenue relationships
(e.g. future price increase)
7. Breakdown of sales increases in price & volume components

Sources of
Confusion

Earnings per share

Consolidation of parent and subsidiaries
Reporting leases
Reporting pensions
Translation of foreign operations
Off-balance sheet financing
Accounting for derivatives
Comprehensive income reporting
Two sets of books - financial vs. tax reporting

Quality of
Financial
Reporting

Management has considerable

discretion within GAAP
Potential exists to manipulate
the profit/loss reported
The closer the financial data
presented represent financial
reality, the higher the quality of
the financial statements and
reported earnings

Ways to
Affect
Quality

Accounting policies and estimates choices and

changes
GAAP provide some measure but they allow considerable
discretion.
Depreciation of fixed assets is a good example:
(1) choice of method - S/L, RBM
2) different estimates possible- useful lives and
residual value
Timing of revenues and expenses
Non-recurring and non-operating items