Chapter 1: Financial

Statements
An Overview
maze (mz), n. 1. An intricate,
usually confusing network of
passages, some blind and
some leading to a goal. 2.
Anything made up of many
confused or conflicting
elements. 3. A mental state of
confusion or perplexity.
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Map or Maze

A map helps its user reach a

desired destination through
clarity of
representation.

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Map or Maze
A maze 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
A maze of information
Auditors Report MD&A

Income Statement
Notes

Statement of Cash Flows

Statement of Shareholders Equity

Balance Sheet

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Map or Maze
Business financial statements have
the potential for being map and
maze.

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Financial Statements as a
Map
Form the basis for understanding
the financial position of a firm
Allow users to assess historical and
prospective financial performance
Present clear representations of
firms financial health, leading to
informed business decisions

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Financial Statements as a
Maze
Overwhelming amount of information
Unreliable auditing
Constantly changing and complex
policies and reporting requirements
Considerable discretion given to
management, influencing content
and presentation
Key information hidden or omitted
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EBF3093 Main Objectives
Ensure that financial statements serve
as a map, not a maze
Demonstrate how to read and evaluate
business financial statements
Provide the tools and techniques
needed to complete a comprehensive
financial statement analysis
Encourage intelligent decision making

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Usefulness
Financial statements and
accompanying notes contain a wealth
of information.
Financial position of the company
Success of operations
Policies and strategies of
management
Insight into future performance
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Usefulness
Financial statement users should be
able to find and interpret
information to answer questions
about a company.
Financial statements and other data
generated by corporate financial
reporting can help users develop
answers to the following questions
(and many others).
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Usefulness
Questions One Might Ask
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 service
interest and principal payments on
debt?
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Usefulness
Questions One Might Ask
Does the company provide a good
opportunity for employment,
advancement, and employee
benefits?
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
Annual Reports
Annual reports contain a great
quantity of information.
Financial statements
Notes to the financial statements
Auditors report
Five-year summary of key
financial data
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Volume of Information
Annual Reports
High and low stock prices
Managements discussion and
analysis of operations
Material included at the
imagination and discretion of
management

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Volume of Information
Financial Statements
Prepared according to generally
accepted accounting principles
(GAAP)
Intended to present financial
information that is
understandable and relevant and
reliable for decision-making

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Volume of Information
Generally Accepted Accounting
Principles
Two authorities primarily responsible
for establishing GAAP in the United
States
Securities and Exchange Commission
(SEC), a public-sector organization
Financial Accounting Standards
Board (FASB), a private-sector
organization

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Volume of Information
Securities and Exchange
Commission
Regulates US companies that issue
securities to the public
Requires regular filing of
Annual reports (10-K)
Quarterly reports (10-Q)
8-K reports in particular
circumstances

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Volume of Information
Securities and Exchange
Commission
Has congressional authority to set
accounting policies
Has issued rulings called Accounting
Series Releases (ASRs) and
Financial Reporting Rulings (FRRs)
For the most part, rule making has
been delegated to the FASB.

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Volume of Information
Financial Accounting Standards
Board
Issues Statements of Financial
Accounting Standards (SFASs)
and interpretations

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Volume of Information
The SEC and the FASB
Work closely together in the
development of accounting policy
SEC has played a largely supportive
role.
Corporate scandals have brought the
challenges and pressures the FASB
faces to the forefront.

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Volume of Information
The SEC and the FASB

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Volume of Information
The SEC and the FASB
SEC and the FASB continue to
examine potential rule changes
and new rules.
Changes will most likely evolve
through joint projects between U.S.
rule-making bodies and the
International Accounting Standards
Board (IASB).
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Volume of Information
Globalization
IASB was created in 1973 with the goal
of adopting uniform international
accounting standards.
Consistency in financial statements
would benefit investors and creditors.
Companies could list securities in any
market with one set of statements.

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Where to Find a
Companys Financial
Statements
Form 10-K
Filed annually with the SEC
Contains uniform content
Same order for all filing companies
Can be accessed through the
Electronic Data Gathering, Analysis,
and Retrieval (EDGAR) database at
www.sec.gov
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Where to Find a
Companys Financial
Statements
Annual report
Financial statements
Other public relations material
Sent to shareholders and prospective
investors
Corporate Web site

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The Financial Statements
Annual reports contain four basic
financial statements.
Balance Sheet
Income Statement or Earnings
Statement
Statement of Stockholders Equity
Statement of Cash Flows
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The Financial Statements
The Balance Sheet
Also called the statement of
financial position
Shows the financial position of the
firm on a particular date
Assets
Liabilities
Stockholders equity

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The Financial Statements
The Income Statement
Also called the earnings statement
Presents the results of operations
for the accounting period
Revenues
Expenses
Net profit or loss
Net profit or loss per share

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The Financial Statements
The Statement of Stockholders
Equity
Reconciles the beginning and ending
balances of all accounts that appear
in the stockholders equity section
of the balance sheet
Some firms prepare a statement of
retained earnings which reconciles
the beginning and ending balances
of the retained earnings account.

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The Financial Statements
The Statement of Cash Flows
Provides information about the
cash inflows and outflows during an
accounting period
Operating activities
Financing activities
Investing activities

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Notes to the Financial
Statements
An integral part of the statements
Provide a summary of the firms
accounting policies
Explain any changes in accounting
policies

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Notes to the Financial
Statements
Present detail about particular
accounts
Inventory
Property, plant, and equipment
Investments
Long-term debt
Equity accounts

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Notes to the Financial
Statements
Include other information
Major acquisitions or divestitures
Officer and employee retirement,
pension, and stock option plans
Leasing arrangements
Term, cost, and maturity of debt

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Notes to the Financial
Statements
Include other information
Pending legal proceedings
Income taxes
Contingencies and commitments
Quarterly results of operations
Operating segments

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Notes to the Financial
Statements
Supplementary information required
by SEC and FASB
Reserves for companies operating in
extractive industries
Effect of foreign currency translations
Financial information for each
reportable segment of a firm with
several lines of business

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Auditors Report
Report of an independent or external
auditor
Attests to the fairness of the
presentation of financial
statements
Sarbanes-Oxley (SOX) Act of 2002
Internal control report
Managements assessment of
internal control structures
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Auditors Report
Impact of SOX on Internal
Auditing
Need for internal auditors to assess
effectiveness of internal controls
and to disclose weaknesses in a
firms internal controls system
Strengthened internal controls
Enhanced value of internal audit
function

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Auditors Report
Unqualified reports
Statements present information in
conformity with GAAP.
Qualified reports
In our opinion, except for the
(nature of the departure explained),
the financial statements present
fairly
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Auditors Report
Adverse opinion
Financial statements have not been
presented fairly in accordance with
GAAP.
Disclaimer of opinion
Auditor cannot evaluate the fairness of
the statements and expresses no
opinion.
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Auditors Report
Unqualified opinion with explanatory
language
Additional explanatory paragraphs
Occurs under many circumstances
Change in accounting principle
Uncertainty caused by future events
Events that may present business risk
and/or going-concern problems
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Sarbanes-Oxley Act of
2002
Passed by Congress in hopes of
ending future accounting
scandals and renewing investor
confidence in the marketplace
Established the Public Company
Accounting Oversight Board
(PCAOB)

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Sarbanes-Oxley Act of
2002
The PCAOB
Private, non-profit organization
Registers, inspects, and disciplines
auditors
Writes auditing rules
Sets quality control and ethics
standards
SEC has oversight of the board.
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Sarbanes-Oxley Act of 2002
Title II
Prohibits nonaudit services during an
external audit
Bookkeeping
Design and implementation of financial
information systems
Valuation, appraisal, actuarial, internal
audit, broker, dealer, or investment
banking services
Management or human resources
functions
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Sarbanes-Oxley Act of 2002
Titles III, IV, and IX
Corporate responsibility
Harsher penalties for violations
CEO and CFO must certify accuracy
of financial statements.
Officers who certify inaccurate
reports could face up to
$1,000,000 in fines and/or a jail
sentence of up to 10 years.
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Management Discussion
and Analysis (MD&A)
Sometimes labeled Financial
Review
Contains information that cannot be
found in the financial data
Includes coverage of favorable or
unfavorable trends and significant
events or uncertainties in
particular areas
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MD&A
Elements of discussion
Internal and external sources of
liquidity
Any material deficiencies in liquidity
and how they will be remedied
Commitments for capital expenditures,
the purpose of such commitments,
and expected sources of funding
Anticipated changes in the mix and
cost of financing resources
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MD&A
Elements of discussion
Unusual or infrequent transactions
that affect income from
continuing operations
Events causing material changes in
cost/revenue relationships (e.g.
future price increase)
Breakdown of sales increases into
price & volume components
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MD&A
Usefulness
Companies do a good job of
describing historical events.
Very few firms provide accurate
and meaningful forecasts.
Explanations about why changes
have occurred in profitability and
liquidity are helpful.

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Five-Year Summary of
Selected Financial Data and
Market Data
Net sales or operating revenues
Income or loss from continuing
operations per common share
Total assets
Long-term obligations and
redeemable preferred stock
Cash dividends per common share
Two years of high and low common
stock prices by quarter
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Pandora (A.K.A. PR
Fluff)
Colored photographs
Charts
Shareholders letter from the CEO
Other items to make the report
attractive
Getting to what is needed through
the PR fluff can be a challenge.
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Proxy Statement
Used to solicit shareholder votes
Important in assessing who
manages the firm, how
management is paid, and
potential conflict-of-interest
issues

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Proxy Statement
Contents
Voting procedures and information
Background of nominated directors
Director and executive compensation
Proposed changes in compensation
plans
Audit committee report
Breakdown of audit and non-audit
fees
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Missing and Hard-to-Find
Information
Employee relations with management
Morale and efficiency of employees
Reputation of the firm
Firms prestige in the community
Effectiveness of management
Provisions for management succession
Potential exposure to regulation
changes

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Missing and Hard-to-Find
Information
These qualities impact the firms
operating success both directly
and indirectly but are difficult to
quantify.

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Missing and Hard-to-Find
Information
Publicity in the Media
Affects public perception of firm
Can impact financial performance

Companies Operating in Several

Lines of Unrelated Business
Breakdown of financial data is
found in notes to financial
statements
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Complexities
GAAP
Provide some measure of
uniformity
Allow management considerable
discretion in applying regulations
Use of the accrual rather than the
cash basis of accounting

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Complexities
Accounting Choices
Accounting choices and estimates
impact financial statement numbers.
Quality of financial reporting is
impacted if accounting choice does
not reflect economic reality.
Financial data must be appropriated to
particular time periods even though
a firms life is continuous.
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The Future of Financial
Statements
FASB tends to develop detailed rules.
IASB uses broader principles.
FASB and IASB are working together
to develop one set of standards.
Significant changes being worked on
include lease accounting,
classification of financial
instruments, inventory accounting,
and revenue recognition.
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The Future of Financial
Statements
Proposal for statements to show
subtotals for five general categories
Business
Discontinued operations
Financing
Income taxes
Equity

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Quality of Financial
Reporting
Financial statements should
reflect an accurate picture of a
companys financial condition and
performance
be useful to assess the past and
predict the future
The closer the picture to financial
reality, the higher the quality of
the financial statements.
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Quality of Financial
Reporting
Timing of Revenue and Expense
The Matching
Recognition
Principle
Expenses are matched with the
generation of revenues to determine
net income.
Matching process involves judgments by
management regarding the timing of
expense and revenue recognition.
The more conservative the approach, the
higher the quality of earnings.
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Quality of Financial
Reporting
Discretionary Items
Budget level and timing of expenditures
Budget level and timing of expenditures
Marketing and advertising
Research and development
Capital expansion
Replacement of plant assets
Development of new product lines
Disposal of an operating division

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Quality of Financial
Reporting
Discretionary Items
The financial analyst should carefully
scrutinize managements policies
with respect to discretionary items.
Such analysis can provide insight into
strengths and weaknesses of a
company and contribute to an
assessment of its ability to perform
successfully in the future.
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The Journey Through the
Maze Continues
The Balance Sheet
Income Statement and Statement
of Stockholders Equity
Statement of Cash Flows
A Guide to Earnings and Financial
Reporting Quality
The Analysis of Financial
Statements
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