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• Financial statements are useful for decision-making, can be used to describe organizations that govern accounting rule-making, describe the components of a form 10-k, has complex accounting rules, and can used to understand managements impact on the quality of financial reporting

Map of Maze:

• Financial statements are a map used to understand a firms financial position to asses its prospective financial performance
• Financial statements present clear representations of a firms financial health
• The complexity of accounting policies for preparing financial statements could lead to information confusion and variations in quality of information presented.
• Rules are constantly evolving and changing causing confusion
• Management discretion in a number of areas influences financial statement content influencing evaluation
• Financial statements information can answere questions about investments, risks, and company opportunites.

Usefulness

• The purpose of the financial statement is to find information to answer the following questions about the company:
• Can investments generate attractive returns?
• What is the risk of the investment?
• Should the existing investment holding be liquidated?
• Will cash flows be sufficient to service any borrowing needs?
• Does the company provide opportunites for employees?
• How well does the company compete?
• Is this firm a good prospect for customers?
• The Securities and Exchange Commission (SEC) requires large, publicly held companies to file an annual report
• This information is used by shareholders, the general public, regulators, analysts, and researchers.
• Annual reports and 10-K reports contain the same information like financial statements, notes, and required data.
• The information in financial statements help interested parties evaluate position, success, strategies, and future performance.

Volume of Information

• Annual reports contain a great quantity of information including, statements, notes, auditors report, managements discussion, and other material.
• Financial statements are prepared in accordance with generally accepted accounting principles (GAAP)
• Information should be understandable, relevant, and reliable for decision making
• Two authorities are responsible for establishing GAAP in the US which are the SEC (public) and the FASB (private)
• Required SEC filings include the 10-k (annual), 10-Q (quarterly), and 8-K (circumstantial)

FASB Goals and SEC relationship

• Three goals of the FASB:
• Simplify user access by codifying in one source all authoritative GAAP in the US
• Ensure that the codified content accurately represents authoritative US GAAP
• Create a codification research system that is up to date for the released results of standard-setting activity
• The SEC has congressional authority, making rule delegated to the FASB
• The SEC steps in when specific circumstances warrant penalties, like in accounting fraud.

Global Economy and Financial Statements:

• Business globalization has created the need for uniform accounting rules.
• The International Accounting Standards Board (IASB) is responsible for establishing accounting standards and promoting worldwide acceptance of those standards.
• The IASB established the International financial reporting standards (IFRS)
• The SEC has supported global accounting standards in principle but requires US companies to follow GAAP
• A 10-K needs to be filed annually with the SEC for all publicly traded companies in the US
• All companies follow the organization of statements (i.e., the same order)
• An annual report is required to be provided to shareholders prior to a firm's annual shareholder meeting
• Annual reports contain financial statements and public relations material
• A corporate website includes additional information such as colorful pictures showing customers

The Financial Statements

• An annual report contains four basic financial statements:
• Balance sheet (or statement of financial position) - shows the financial position of the firm, its assets, liabilities and equity at a specific date
• Income statement (or earnings statement) - presents the results of operations, like revenues, expenses, and profit or loss for the accounting period
• Statement of comprehensive income – presents the changes in equity of a company from all sources
• Statement of stockholders' equity reconciles the beginning and ending balances of all accounts that appear in the stockholders' equity section of the balance sheet
• The statement of cash flows provides information about inflow and outflow activities.

Notes on Financial Statements and Auditors report

• Notes are immediately included following the four financial statements and are an integral part of the statements.
• Notes provide a summary of the firm's accounting policies, details about particular accounts and other supplementary information
• Management is responsible for preparation of the financial statements and the notes
• An auditor's report attests to the fairness of the presentation of the financial statements
• The Sarbanes-Oxley Act Section 404, requires an internal control report that includes a statement regarding the effectiveness of internal controls and the disclosure of any material weaknesses

Internal Controls and Audit Reports

• Internal controls are policies and practices a company uses to protect the integrity of its assets and financial and accounting information, promoting accountability and preventing fraud
• Audit reports can be:
• Unqualified - statements are fairly presented with GAAP
• Qualified - opinion rendered when the statements are fairly presented “except for” certain items
• Adverse – statements have not been fairly presented with GAAP
• Disclaimer - the independent auditor could not evaluate the fairness of the financial statements and, as a result, expresses no opinion on them
• Unqualified with explanatory language - states that the financial statements have been presented fairly in accordance with GAAP, but there are items the auditors explain.
• The auditors report was moved to the first part of the report in 2019

Financial Reporting Reforms and Mandates:

• Prior to SOX, auditors followed a self-regulatory model
• SOX Title I established the Public Company Accounting Oversight Board (PCAOB), which registers, inspects, and disciplines auditors
• The PCAOB can write auditing rules and set quality control and ethics standards
• SOX Title II addresses areas of auditor independence like prohibiting certain non-audit services
• They also require the rotation of the primary audit partners every five years
• SOX Title III and IV focus on corporate responsibility
• Section 302 mandates that the CEO and CFO of a publicly owned company certify to the accuracy of the financial statements.
• SOX Title IX attaches harsher penalties for violations

More on SOX:

• Section 906 addresses criminal penalties for certifying a misleading or fraudulent financial report
• Sections 302 and 906 work together with section 404 to encourage CFO's and CEO's to take responsibility for strong internal controls to prevent accounting fraud
• The Management Discussion and Analysis (MD&A) contains data not found in the financial data
• MD&A includes coverage of trends and significant events or uncertainties in liquidity, capital resources, the results of operations.
• 2020 Admendments added a new item to clarify the purpose of MD&A disclosures
• 2020 Amendments required disclosure of critical accounting estimates
• Discretionary items include revenues and expenses under that control of management with respect to budget levels and timing.

Disclosure and Financial Statement Principals:

• "Other information" like color photos and charts is included on the website, it may be misleading.
• Proxy statements are used to solicit shareholders votes
• Some financial facts annd data are not available in the financial statements
• Materiality data must be significant enough to make a difference in decision making
• Comparability allows users to compare the financial information of an entity to other entities as well as compare financial information of that entity to itself from one time period to another
• The consistency is shown when the same accounting methods are used from one time period to another
• The going concern assumption states that businesses will operate indefinitely
• Time period assumption indicates a specified time period that business firms use to report financial information
• Monetary unit assumption is the assumed unit of measurement when preparing financial statements
• The revenue recognition principle consists of four conditions that must be met to record revenue:
• The revenues must be earned
• The amount of revenue must be measurable
• The cost of generating the revenues can be determined
• The revenue must be realizable
• The five step framework is that a contract is identified, with the obligation defined along with price and its allocation. The revenue is recognized when the obligation is satisfied.
• The Matching Principle requires revenues and expenses to be properly matched in the same time period.

Accounting and complex finance terms

• Accrual basis of accounting is the GAAP basis which is reported on both revenue recognition and matching principles.
• Revenue is recognized when a sale is made not when cash is received
• Expense is recognized when a sale is made and not when cash is receieved
• Cash basis accounting recognizes all cash movement
• GAAP provides a measure of uniformity but also allows corporate management considerable discretion in applying the regulations
• Regulations can impact firms financial condition and its performance.

Impacts on financial statements

• Differing accounting methods impact comparability of companies
• Quality of financial reporting can be impacted if the accounting choice does not reflect economic reality
• Financial statements are prepared on certain dates at the end of accounting periods, but a firms life is continuous. Financial data must be appropriated to particular time periods.
• The GAAP principle is the bases for preparing financial statements is the matching principle
• Expenses are matched with the generation of revenues to determine net income for an accounting period
• The accrual basis of accounting recognizes revenues when earned, and expenses when incurred, independent of cash inflows and outflows.
• This involves judgements by management on timing and the more conservative the higher the the quality of earnings.
• Management choices have an immediate and long-term impact on profitability
• Financial analyst should scrutinize management's policies regarding discretionary items