INRODUCTION TO FINANCIAL STATEMENT ANALYSIS

Chapter 1

CHAPTER 1 OBJECTIVES
Understand

the decision emphasis of financial statement analysis and why a comprehensive approach is needed to meet this objective. Indicate who uses financial statements and how they use them to make decisions.

CHAPTER 1 OBJECTIVES (CONT.)

Show the importance of generally accepted accounting principles (GAAP) to analysis, which organizations determine GAAP, why GAAP differs among countries, and the benefits of harmonizing GAAP. Determine the various concepts of capital maintenance and attributes of asset measurement.

CHAPTER 1 OBJECTIVES (CONT.)

Articulate the benefits and limitations of the nominal dollar capital maintenance concept and historical cost valuation in financial reporting and analysis. Explain how inconsistent terminology, data volume, transaction complexity, information variability, and financial statement limitations can affect financial statement analysis.

OVERALL PERSPECTIVE
Analysisseparation

of something into its parts to study its nature, proportion, function, and interrelationship Analytical processprovides insights about how the entirety operates, where it came from, and where it is going

OVERALL PERSPECTIVE (CONT.)

Financial

statement analysis

Art and science of examining corporate financial statements Financial statementscorporate monetary disclosures

OVERALL PERSPECTIVE (CONT.)

Objective

of this book: Students will

Learn how to analyze financial statements Critically evaluate corporate disclosures and related information

COMPREHENSIVE ANALYSIS

Business environmentan analyst must understand the context in which a company does business Components of business environment

Overall economy Legal environment Political climate Cultural context

COMPREHENSIVE ANALYSIS (CONT.)

Data

sources

amount and variety of information sources needed to conduct analysis

Qualities

of data sources

Timing-current versus historical Potential bias-objective versus subjective Type-quantitative versus qualitative

CATEGORIES OF ANALYSTS

Equity investorsowners who seek to maximize return on investment, subject to a given risk level Credit granterslenders who seek payment of principal and interest in a timely manner Corporate managersowners agents who seek information to plan and control their entitys operations

CATEGORIES OF ANALYSTS (CONT.)

Merger and acquisitions specialists professionals who, for a fee, realign corporations to maximize shareholder value Internal and external auditorsindependent evaluators who attest to the fairness of managerial representations (external auditors) and corporate employees who seek to improve business operations (internal auditors)

CATEGORIES OF ANALYSTS (CONT.)

Regulatorsrepresentatives

of government entities who judge an entitys compliance with existing laws and regulatory requirements Corporate employeesindividuals, or their collective bargaining agents, who seek to maximize compensation for their services

REPORTING STANDARDS
Authoritative

pronouncements that when taken together with accepted financial reporting conventions compose generally accepted accounting principles (GAAP)

REPORTING STANDARDS (CONT.)

Collaborative

partnership

Securities and Exchange Commission (SEC) quasi-governmental agency that has the legal authority to set reporting standards Financial Accounting Standards Board (FASB)private U.S. standard setting body that determines most authoritative pronouncements

REPORTING STANDARDS (CONT.)

Financial

reporting standards consist of

Corporate financial statements Notes to the financial statements Supplemental financial statement disclosures

REPORTING STANDARDS (CONT.)

International dimension Countries determine national generally accepted accounting principles Differences in business formation, development, and activity produce various national standards GAAP is classified into models, such as the Anglo American and European Models of accounting or financial reporting

REPORTING STANDARDS (CONT.)

International Accounting Standards Committee (IASC)collaborative effort by the accounting bodies of many nations to reduce financial reporting alternatives and harmonize accounting standards; lacks enforcement power of national bodies, such as the FASB

DISCLOSURE CHALLENGES
Desirable

qualitative characteristics of financial reporting

Relevant information matters to analysts by helping them predict the future Reliable information can be verified and is unbiased

DISCLOSURE CHALLENGES (CONT.)

Capital

maintenance selection

Amount of investment that must be recovered through revenues before income is earned; alternative concepts exist that result in different degrees of relevance and reliability in the financial statements

DISCLOSURE CHALLENGES (CONT.)

Nominal

dollar concept of capital maintenancerecognizes income after recovering the number of dollars invested in the asset sold; ignores overall inflation rate or price changes for specific goods; underlies the current system of financial reporting in the U.S. and most countries

DISCLOSURE CHALLENGES (CONT.)

General

purchasing power concept of capital maintenanceincome results when an entity recovers more revenues than the general purchasing power equivalent of its investment; not GAAP

DISCLOSURE CHALLENGES (CONT.)

Physical

capital concept of capital maintenanceincome results when an entity recovers more revenues than the current cost of its investment; not GAAP

DISCLOSURE CHALLENGES (CONT.)

Historical

costprinciple that governs asset measurement; used with the nominal dollar concept of capital maintenance to compose financial reporting system

DISCLOSURE CHALLENGES (CONT.)

Information

complexitiesobstacles that hinder financial statement disclosures and analysis

Inconsistent terminology and financial statement formats vary among companies and over time Numerous information sources provide substantive amounts of data

DISCLOSURE CHALLENGES (CONT.)

Information

complexities (cont.)

Transaction complexities reflect the increasingly complicated ways in which business is conducted Data sources vary greatly with respect to their relevance and reliability Financial statements report only selected events in constant monetary units and on the basis of historical cost