Financial Statements: An Overview PDF

Chapter 1\ Financial Statements: An Overview Map or Maze - A map helps its user reach a desired destination through clarity of representation. - A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired...

Chapter 1\ Financial Statements: An Overview Map or Maze - A map helps its user reach a desired destination through clarity of representation. - A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal. - Financial statements have the potential for being both map and maze. - Form the basis for understanding the financial position of a firm - Allow users to assess historical and prospective financial performance - Present clear representations of a firm's financial health Financial Statements as a Maze - Overwhelming amount of information - Unreliable auditing - Complex policies and reporting requirements - Considerable discretion given to management - Key information hidden or omitted The main objectives of this book are to - ensure that financial statements serve as a map, not a maze, - demonstrate how to read and evaluate financial statements, - provide the tools and techniques needed to complete a comprehensive financial statement analysis, and - encourage intelligent decision making. Usefulness of Information - Financial position - Success of operations - Policies and strategies of management - Insight into future performance Volume of Information - Financial statements - Notes to the financial statements - Auditor's report - Five-year summary of key financial data - High and low stock prices - Management's discussion and analysis of operations - Other material - Generally accepted accounting principles (GAAP) - Securities and Exchange Commission (SEC) - Financial Accounting Standards Board (FASB) - International Accounting Standards Board (IASB) Figure 1.1 FASB/SEC Relationship Global Economy - Need for international accounting standards - Lack of SEC recommendation to adopt IFRS standards in the U.S. - Text focuses on U.S. GAAP, however the analysis process illustrated can be applied to reports based on IFRS. Where to Find a Company's Financial Statements - Form 10-K - Filed annually with the SEC - Same order for all filing companies - Electronic Data Gathering, Analysis, and Retrieval (EDGAR) Where to Find a Company's Financial Statements - Annual report - Financial statements - Public relations material - Sent to shareholders and prospective investors - Corporate website The Financial Statements - Balance sheet (or statement of financial position) - Income statement (or earnings statement) - Statement of stockholders' equity - Statement of cash flows Notes to the Financial Statements - Integral part of the statements - Summary of the firm's accounting policies - Details about particular accounts - Other supplementary information Auditor's Report - Attests to the fairness of the presentation of financial statements - Sarbanes-Oxley (SOX) Act of 2002 - Internal auditors and external auditors Auditor's Report - Types of reports - Unqualified reports - Qualified reports - Adverse opinion - Disclaimer of opinion - Unqualified opinion with explanatory language Financial Reporting Reforms - SOX Title I -- Public Company Accounting Oversight Board (PCAOB) - SOX Title II -- prohibits non-audit services during an external audit - SOX Titles III and IV -- corporate responsibility - SOX Title IX -- harsh penalties for violations Management Discussion and Analysis - Sometimes labeled "Financial Review" - Coverage of trends, events, and/or uncertainties in liquidity, capital resources, and results of operations Five-year Summary of Selected Financial Data and Market Data - Net sales or operating revenues - Income or loss from continuing operations - Total assets - Long-term obligations and redeemable preferred stock - Cash dividends per common share - Two years of high and low common stock price by quarter Pandora (a.k.a. "PR Fluff") - Colored photographs - Charts - Shareholders' letter from the CEO - Other items to make the report attractive - Often informative but sometimes misleading Proxy Statement - Used to solicit shareholder votes - Important in assessing who manages the firm, how management is paid, and conflict of interest issues Missing and Hard-to-Find Information - Employee relations with management - Morale and efficiency of employees - Reputation of the firm with customers - Firm's prestige in the community - Effectiveness of management Missing and Hard-to-Find Information - Provisions for management succession - Potential exposure to regulation changes - Publicity in the media - Companies operating in several lines of unrelated business Characteristics, Assumptions, Principles, and Basis of Accounting - Materiality - Comparability - Consistency - The Going Concern Assumption The Time Period Assumption Characteristics, Assumptions, Principles, and Basis of Accounting - The Monetary Unit Assumption - The Revenue Recognition Principle - The Matching Principle - The Accrual Basis of Accounting - The Cash Basis of Accounting Complexities and the Quality of Financial Reporting Accounting Choices - Management discretion in application of reporting regulations - Differing accounting methods impact comparability of companies - Financial data appropriated to particular time periods Timing of Revenue and Expense Recognition - Accrual basis of accounting - Recognizes revenues when earned - Recognizes expenses when incurred - Recognizes revenues and expenses independent of cash inflows and outflows - Involves judgments by management on timing Discretionary Items - Equipment repair and maintenance - Marketing and advertising - Research and development - Capital expansion - Replacement of plant assets - Development of new product lines - Disposal of an operating division Discretionary Items - Management choices have an immediate and long-term impact on profitability (perhaps not in the same direction). - Financial analyst should scrutinize management's policies regarding discretionary items. CASE STUDY №1 1. Revenues -- income statement 2. Detailed information about the term, cost and maturity of debt -- Notes to the financial statements 3. Changes to the company\'s equity accounts.-statement of stockholders' equity 4\. An unqualified opinion -- Auditor's report 5\. Assets -- balance sheets 6\. Attestation to the fairness of financial statements. -- auditor's report 7\. Discussion of the company\'s liquidity -- management discussion and analysis 8\. Cash inflows from investing activities -- statements of cash flow 9\. A breakdown of sales increases into price and volume components - management discussion and analysis 10\. Summary of significant accounting policies -- notes to the financial statements Class work 1 Chapter 1 True-False 1\. A firm's annual report contains only two pieces of information: the financial statements and the notes to the financial statements. FALSE 2\. The SEC regulates U.S. companies that issue securities to the public and requires the issuance of a prospectus for any new security offering. TRUE 3\. The FASB has congressional authority to set accounting policies. FALSE 4\. The European Union began requiring publicly traded companies to use U.S. GAAP in 2005.FALSE 5\. External auditors are required to audit the internal control assessment of the company as well as the financial statements. TRUE 6\. Congress passed the Sarbanes-Oxley Act of 2002 in hopes of ending future accounting scandals and renewing investor confidence in the marketplace. TRUE 7\. The Management Discussion and Analysis is of potential interest to the analyst because it contains information that cannot be found in the financial data. TRUE 8\. Information that is significant enough to make a difference in a decision is considered to be immaterial. FALSE 9\. The time period assumption assumes a two year time frame with interim reporting occurring daily and weekly. FALSE 10\. GAAP-based financial statements are prepared according to the accrual basis of accounting. TRUE Fill in the Blank 1\. The SEC requiresall public companies to file a Form 10-K report annually. 2\. A corporate annual report contains AUDITED financial statements. 3\. MANAGEMENT is responsible for the preparation of the financial statements, including the notes, and the EXTERNAL AUDITOR attests to the fairness of the presentation. 4\. The SARBONES-OXLEY ACT was passed in 2002 and was one of the most sweeping corporate reforms since the Securities Act of 1934. 5\. The PROXY STATEMENT is a document used to solicit shareholder votes. 6\. The MONETARY UNIT ASSUMPTION Assumption is the assumed unit of measurement when preparing financial statements. 7\. The cash basis of accounting recognizes REVENUE when cash is received and recognizes EXPENSES when cash is paid. 8\. The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality, the higher the QUALITY OF THE financial statements and reported earnings. 9\. One of the generally accepted accounting principles that provide the foundation for preparing financial statements is the REVENUE RECOGNITION principle. 10\. Management exercises control over the budget level and timing of CAPITAL expenditures. **Multiple Choice** 1\. What information would not be found in a firm's annual report? a\. Notes to the financial statements. **b. Financial Reporting Rulings.** c\. Auditor's report. d\. High and low stock prices. 2\. Which agency requires the filing of Form 10-Ks, Form 10-Qs and Form 8-Ks? a\. FASB. b\. IASB. 3\. Which of the following statements is true? **a. Foreign firms registered with the SEC may file reports based on IFRS.** b\. U.S. firms registered with the SEC may file reports based on IFRS. 4\. Which financial statement presents the results of operations? a\. Balance sheet. b\. Statement of financial position. 5\. Which financial statement shows the assets, liabilities and stockholders' equity of the firm on a particular date? a\. Statement of stockholders' equity. b\. Statement of cash flows. 6\. Which financial statement provides information about operating, financing and investing activities? a\. Statement of financial position. **b. Statement of cash flows.** 7\. What information can be found on a statement of stockholders' equity? a\. A reconciliation of the cash account and the retained earnings account. 8\. What basic financial statements can be found in a corporate annual report? 9\. What is an unqualified audit report? a\. A report stating that the auditors are not qualified to report on a firm. b\. A report that states the financial statements are in violation of GAAP. c\. A report that states that departures from GAAP exist in the firm's financial statements. **d. A report that states the financial statements are presented fairly, in all material respects, and are in conformity with GAAP.** 10\. What is a qualified report? **a. A report stating that the auditors are not qualified to report on a firm.** b\. A report that states the financial statements are in violation of GAAP. c\. A report that states that departures from GAAP exist in the firm's financial statements. d\. A report that states the financial statements are presented fairly, in all material respects, and are in conformity with GAAP. 11\. What organization has the authority to register, inspect, and discipline auditors of all publicly owned companies? 12\. According to Section 302 of the Sarbanes-Oxley Act, who must certify the accuracy of the financial statements of a public company? a\. Public Company Accounting Oversight Board. 13\. All of the following items should be discussed in the management discussion and analysis except for: a\. Anticipated changes in the mix and cost of financing resources. **b. The market value of all assets.** c\. The internal and external sources of liquidity. d\. Unusual or infrequent transactions that affect income from continuing operations. 14\. Which of the following is an internal source of liquidity? a\. Borrowing. b\. Sales of stock. c\. Gifts and donations. **d. Sales of products or services.** 15\. Which of the following is an external source of liquidity? a\. Sales of services. b\. Repurchase of stock. **c. Borrowing.** d\. Sales of products. 16\. Which of the following is not a condition that must be met for an item to be recorded as revenue? 17\. How are revenues and expenses recognized under the accrual basis of accounting? 18\. In what industry would it be expected that companies would spend a significant amount on research and development activities? **a. Pharmaceutical.** b\. Clothes retailer. c\. Groceries. d\. Wholesale distributor of computer parts. 19\. Which of the following items is a discretionary expenditure? a\. Union wages. b\. Factory building to produce inventory. **c. Advertising.** d\. Taxes. 20\. Which of the following statements is false with regard to quality of financial reporting? a\. Financial statements should reflect an accurate picture of a company's financial condition and performance. **b. It is unlikely that management can manipulate the bottom line due to the regulations in place to enforce GAAP.** c\. Financial information should be useful both to assess the past and predict the future. d\. The closer that the picture presented through the financial data is to reality, the higher the quality of financial reporting. 1. **Mazes in Financial Statement Data**\ Financial statement data is often hindered by complexities, making it difficult to understand and extract valuable insights. These interferences, akin to a maze, arise from various sources such as the use of different accounting methods, complex financial instruments, and numerous assumptions. For instance, inconsistent revenue recognition practices, off-balance-sheet financing, and estimations related to asset valuation can cloud the true financial picture. These issues create barriers for stakeholders, such as investors and analysts, who must navigate through these complexities to understand the true financial health of an organization. Transparent reporting and simplified disclosure practices are essential to reduce these \"mazelike\" interferences. 2. **FASB and SEC Relationship**\ The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have a complementary relationship in the U.S. financial reporting system. The SEC, a government agency, oversees the securities industry and enforces regulations to ensure accurate and transparent reporting for investors. The FASB, a private non-profit organization, sets the accounting standards (Generally Accepted Accounting Principles or GAAP) that companies must follow in preparing financial statements. While the SEC has the authority to establish accounting rules, it often delegates this responsibility to the FASB, ensuring consistent and transparent financial reporting practices. 3. **Importance of Notes in Financial Statements**\ The notes to financial statements are crucial because they provide additional context and detailed explanations of the numbers presented in the financial statements. They offer clarity on accounting policies, potential risks, and assumptions used in preparing the statements. Without the notes, users may misunderstand or overlook important aspects, such as off-balance-sheet items, contingent liabilities, and related-party transactions. These disclosures help stakeholders make more informed decisions, providing a deeper understanding of the company's financial position and performance. 4. **Impact of the Sarbanes-Oxley Act on Internal Auditing**\ The Sarbanes-Oxley Act (SOX) of 2002 had a profound impact on internal auditing by instituting stricter regulations to ensure the accuracy and reliability of financial reporting. It required companies to implement stronger internal controls, establish auditing committees, and ensure greater oversight of financial processes. SOX also mandated that executives personally certify the accuracy of financial statements, placing more responsibility on internal auditors. This increased focus on accountability and transparency led to enhanced internal audit functions, strengthening the overall financial reporting process and reducing the risk of fraud. 5. **Internal and External Sources of Liquidity**\ Liquidity refers to a firm\'s ability to meet short-term financial obligations. Internal sources of liquidity include cash generated from operations, accounts receivable, and inventory that can be quickly converted to cash. External sources include loans, credit lines, or issuing new equity. A material deficiency in liquidity occurs when a company cannot meet its obligations as they become due, potentially leading to financial distress. If a firm has a material deficiency in liquidity, it should disclose this in the management discussion and analysis section of its report, outlining the reasons for the deficiency, any steps taken to address it, and the potential impact on its operations and financial health. 6. **Missing or Hard-to-Find Information in Financial Statements**\ Financial statements may not always provide a complete picture of a company's financial condition. Information that is difficult to find or missing may include non-financial data such as customer satisfaction, employee turnover, or environmental risks. Additionally, estimates and judgments related to future events, like impairment of assets or contingent liabilities, may not be fully disclosed or may be difficult to interpret. Off-balance-sheet items, such as operating leases or special purpose entities, may also be omitted or inadequately explained, making it challenging to assess the true financial health of a firm. 7. **Importance of Comparability and Consistency in Financial Reporting**\ Comparability and consistency are essential for ensuring that financial statements provide useful, meaningful, and comparable information over time and across different entities. Comparability allows users to assess the relative performance of companies within the same industry, while consistency ensures that the same accounting methods are applied across periods. This reduces confusion and allows stakeholders to make more accurate assessments and comparisons. Without these characteristics, it would be difficult for investors and analysts to make informed decisions or accurately evaluate a company's financial standing. 8. **Two Key Principles of Accrual Basis Accounting**\ The accrual basis of accounting is grounded in two key principles: the revenue recognition principle and the matching principle. The revenue recognition principle dictates that revenue should be recognized when it is earned, regardless of when payment is received. This ensures that financial statements reflect the actual performance of a company. The matching principle requires that expenses be recognized in the same period as the related revenue, ensuring that the costs associated with generating revenue are properly accounted for. Together, these principles ensure that financial statements provide an accurate and timely depiction of a company's financial performance.