Financial Analysis and Reporting PDF

Financial analysis and reporting Dr. Ma. Teresa B. Ballados Overview of Financial Statement Analysis and Reporting 1.Business Analysis 2. Financial Statements - Basis for Analysis 3. Financial Statement Analysis 4. Reporting Environment Course Outcomes (CO) CO1. Discuss the...

Financial analysis and reporting Dr. Ma. Teresa B. Ballados Overview of Financial Statement Analysis and Reporting 1.Business Analysis 2. Financial Statements - Basis for Analysis 3. Financial Statement Analysis 4. Reporting Environment Course Outcomes (CO) CO1. Discuss the purpose of financial analysis and reporting to assess business performance and financial health of an organization in order to forecast future business activities and value of a firm. CO 2. Apply financial statement analysis tools and techniques to generate financial data. Engage Engage Activity  Read and analyze the case titled, “Something to Smile About?”  Afterwhich share your reactions and insights about the case. Overview of Financial Statement Analysis  Business Analysis  Financial statement analysis is an integral and important part of the broader field of business analysis.  Business analysis is the process of evaluating a company’s economic prospects and risks. This includes analyzing a company’s business environment, its strategies, and its financial position and performance.  Business analysis is useful in a wide range of business decisions, such as whether to invest in equity or in debt securities, whether to extend credit through short- or long-term loans, how to value a business in an initial public offering (IPO), and how to evaluate restructurings including mergers, acquisitions, and divestitures.  The Initial Public Offering IPO Process is where a previously unlisted company sells new or existing securities and offers them to the public for the first time.  Business Analysis  Financial statement analysis is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis.  Financial statement analysis reduces reliance on hunches, guesses, and intuition for business decisions. It decreases the uncertainty of business analysis. It does not lessen the need for expert judgment but, instead, provides a systematic and effective basis for business analysis.  Business Analysis  Business analysis is the evaluation of a company’s prospects and risks for the purpose of making business decisions. These business decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit testing, compensation negotiations, and countless other decisions.  Business analysis aids in making informed decisions by helping structure the decision task through an evaluation of a company’s business environment, its strategies, and its financial position and performance.  Business Analysis  Aninitial step in business analysis is to evaluate a company’s business environment and strategies.  Business analysis is applied in many forms and is an important part of the decisions of security analysts, investment advisors, fund managers, investment bankers, credit raters, corporate bankers, and individual investors. This section considers major types of business analysis. Business Analysis  Colgate’s brand leadership together with its international diversification and sensible business strategies have enabled it to become one of the most successful consumer products companies in the world Types of Business Analysis  1. Credit Analysis Creditors lend funds to a company in return for a promise of repayment with interest. This type of financing is temporary since creditors expect repayment of their funds with interest. Creditors lend funds in many forms and for a variety of purposes. Trade (or operating) creditors deliver goods or services to a company and expect payment within a reasonable period, often determined by industry norms. Most trade credit is short term, ranging from 30 to 60 days, with cash discounts often granted for early payment. Trade creditors do not usually receive (explicit) interest for an extension of credit. Instead, trade creditors earn a return from the profit margins on the business transacted. Types Business Analysis  1. Credit Analysis Nontrade creditors (or debtholders) provide financing to a company in return for a promise, usually in writing, of repayment with interest (explicit or implicit) on specific future dates. This type of financing can be either short or long term and arises in a variety of transactions. Types Business Analysis  1. Credit Analysis The creditors bear the risk of default. This means a creditor’s interest and principal are jeopardized when a borrower encounters financial difficulties. This asymmetric relation of a creditor’s risk and return has a major impact on the creditor’s perspective, including the manner and objectives of credit analysis. Types Business Analysis  1. Credit Analysis Credit analysis is the evaluation of the creditworthiness of a company. Creditworthiness is the ability of a company to honor its credit obligations. Stated differently, it is the ability of a company to pay its bills. Accordingly, the main focus of credit analysis is on risk, not profitability. Variability in profits, especially the sensitivity of profits to downturns in business, is more important than profit levels. Profit levels are important only to the extent they reflect the margin of safety for a company in meeting its obligations. Credit analysis focuses on downside risk instead of upside potential. This includes analysis of both liquidity and solvency. Types Business Analysis  1. Credit Analysis Liquidity is a company’s ability to raise cash in the short term to meet its obligations. Liquidity depends on a company’s cash flows and the makeup of its current assets and current liabilities. Solvency is a company’s longrun viability and ability to pay long-term obligations. It depends on both a company’s long-term profitability and its capital (financing) structure. Types Business Analysis  2. Equity Analysis  Equity investors provide funds to a company in return for the risks and rewards of ownership.  Equity investors are major providers of company financing. Equity financing, also called equity or share capital, offers a cushion or safeguard for all other forms of financing that are senior to it. This means equity investors are entitled to the distributions of a company’s assets only after the claims of all other senior claimants are met, including interest and preferred dividends. As a result, equity investors are said to hold a residual interest. This implies equity investors are the first to absorb losses when a company liquidates, although their losses are usually limited to the amount invested Types Business Analysis  2. Equity Analysis However, when a company prospers, equity investors share in the gains with unlimited upside potential. Thus, unlike credit analysis, equity analysis is symmetric in that it must assess both downside risks and upside potential. Because equity investors are affected by all aspects of a company’s financial condition and performance, their analysis needs are among the most demanding and comprehensive of all users. Individuals who apply active investment strategies primarily use technical analysis, fundamental analysis, or a combination. Types Business Analysis  2. Equity Analysis  Technical analysis, or charting, searches for patterns in the price or volume history of a stock to predict future price movements.  Fundamental analysis, which is more widely accepted and applied, is the process of determining the value of a company by analyzing and interpreting key factors for the economy, the industry, and the company. A main part of fundamental analysis is evaluation of a company’s financial position and performance.  To determine intrinsic value, an analyst must forecast a company’s earnings or cash flows and determine its risk  Financial Statements-Basis for Financial Analysis  Financial statements and related disclosures inform us about the four major activities of the company: planning, financing, investing, and operating. It is important to understand each of these major business activities before we can effectively analyze a company’s financial statements.  Financial Statements-Basis for Financial  Planning Activities Analysis A company exists to implement specific goals and objectives. For example, Colgate aspires to remain a powerful force in oral, personal, and home care products. A company’s goals and objectives are captured in a business plan that describes the company’s purpose, strategy, and tactics for its activities. A business plan assists managers in focusing their efforts and identifying expected opportunities and obstacles. Insight into the business plan considerably aids our analysis of a company’s current and future prospects and is part of the analysis of business environment and strategy. We look for information on company objectives and tactics, market demands, competitive analysis, sales strategies (pricing, promotion, distribution), management performance, and financial projections. Information of this type, in varying forms, is often revealed in financial statements. It is also available through less formal means such as press releases, industry publications, analysts’ newsletters, and the financial press  Financial Statements-Basis for Financial Analysis  Financial statement analysis helps us estimate the degree of risk, and yields more informed and better decisions. While information taken from financial statements does not provide irrefutable answers, it does help us to gauge the soundness of a company’s business opportunities and strategies and to better understand its financing, investing, and operating activities.  Financial Statements-Basis for Financial Analysis  Financing Activities  A company requires financing to carry out its business plan. Example: Colgate needs financing for purchasing raw materials for production, paying its employees, implementing marketing campaigns, and research and development.  Financing activities refer to methods that companies use to raise the money to pay for these needs. Because of their magnitude and their potential for determining the success or failure of a venture, companies take care in acquiring and managing financial resources.  Financial Statements-Basis for Financial  Analysis Financing Activities  There are two main sources of external financing—equity investors (also called owners or shareholders) and creditors (lenders).  Decisions concerning the composition of financing activities depend on conditions existing in financial markets.  Financial markets are potential sources of financing. In looking to financial markets, a company considers several issues, including the amount of financing necessary, sources of financing (owners or creditors), timing of repayment, and structure of financing agreements. Decisions on these issues determine a company’s organizational structure, affect its growth, influence its exposure to risk, and determine the power of outsiders in business decisions.  Financial Statements-Basis for Financial  Analysis Financing Activities  Investors provide financing in a desire for a return on their investment, after considering both expected return and risk.  Return is the equity investor’s share of company earnings in the form of either earnings distribution or earnings reinvestment.  Earnings distribution is the payment of dividends to shareholders.  Dividends can be paid directly in the form of cash or stock dividend, or indirectly through stock repurchase.  Dividend payout refers to the proportion of earnings distributed. It is often expressed as a ratio or a percentage of net earnings.  Financial Statements-Basis for Financial Analysis  Financing Activities  Earnings reinvestment (or earnings retention) refers to retaining earnings within the company for use in its business; this is also called internal financing. Earnings reinvestment is often measured by a retention ratio.  The earnings retention ratio, reflecting the proportion of earnings retained, is defined as one less the dividend payout ratio.  Financial Statements-Basis for Financial  Analysis Financing Activities  Equity financing can be in cash or any asset or service contributed to a company in exchange for equity shares. Private offerings of shares usually involve selling shares to one or more individuals or organizations.  Public offerings involve selling shares to the public. There are significant costs with public offerings of shares, including government regulatory filings, stock exchange listing requirements, and brokerage fees to selling agents. The main benefit of public offerings of shares is the potential to raise substantial funds for business activities.  Financial Statements-Basis for Financial  Analysis Financing Activities  Companies also obtain financing from creditors. Creditors are of two types: (1) debt creditors, who directly lend money to the company, and (2) operating creditors, to whom the company owes money as part of its operations. Debt financing often occurs through loans or through issuance of securities such as bonds. Debt financers include organizations like banks, savings and loans, and other financial or nonfinancial institutions. Operating creditors include suppliers, employees, the government, and any other entity to whom the company owes money. Engage Explore Activity  Financial Statements-Basis for Financial  Analysis Investing Activities Investing activities refer to a company’s acquisition and maintenance of investments for purposes of selling products and providing services, and for the purpose of investing excess cash. Operating assets include investments in land, buildings, equipment, legal rights (patents, licenses, copyrights), inventories, human capital (managers and employees), information systems, and similar assets are for the purpose of conducting the company’s business operations. Companies often temporarily or permanently invest excess cash in securities such as other companies’ equity stock, corporate and government bonds, and money market funds. Such assets are called financial assets.  Financial Statements-Basis for Financial Analysis  Investing Activities Investing decisions involve several factors such as type of investment necessary (including technological and labor intensity), amount required, acquisition timing, asset location, and contractual agreement (purchase, rent, and lease).  Financial Statements-Basis for Financial Analysis  Operating Activities Operating activities represent the “carrying out” of the business plan given its financing and investing activities. Operating activities involve at least five possible components: research and development, procurement, production, marketing, and administration. A proper mix of the components of operating activities depends on the type of business, its plans, and its input and output markets  Financial Statements-Basis for Financial Analysis  Operating Activities Operating activities are a company’s primary source of earnings. Earnings reflect a company’s success in buying from input markets and selling in output markets. How well a company does in devising business plans and strategies, and deciding the mix of operating activities, determines its success or failure.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Balance Sheet The accounting equation (also called the balance sheet identity) is the basis of the accounting system: Assets= Liabilities + Equity. Assets relates to the resources controlled by a company, or assets. These resources are investments that are expected to generate future earnings through operating activities. To engage in operating activities, a company needs financing to fund them. Liabilities are funding from creditors and represent obligations of a company or, alternatively, claims of creditors on assets.  Financial Statements-Basis for Financial Analysis  Financial Statements Reflect Business Activities  Balance Sheet Equity (or shareholders’ equity) is the total of (1) funding invested or contributed by owners (contributed capital) and (2) accumulated earnings in excess of distributions to owners (retained earnings) since inception of the company  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Balance Sheet  Assets and liabilities are separated into current and noncurrent amounts.  Current assets are expected to be converted to cash or used in operations within one year or the operating cycle, whichever is longer.  Current liabilities are obligations the company is expected to settle within one year or the operating cycle, whichever is longer. The difference between current assets and current liabilities is called working capital.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Balance Sheet  Assets and liabilities are separated into current and noncurrent amounts.  Current assets are expected to be converted to cash or used in operations within one year or the operating cycle, whichever is longer.  Current liabilities are obligations the company is expected to settle within one year or the operating cycle, whichever is longer. The difference between current assets and current liabilities is called working capital.  Financial Statements-Basis for Financial Analysis  Financial Statements Reflect Business Activities  Balance Sheet  It is revealing to rewrite the accounting equation in terms of business activities, namely, investing and financing activities: Total investing =Total financing; or alternatively, Total investing = Creditor financing + Owner financing  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Income Statement  An income statement measures a company’s financial performance over a period of time, typically a year or a quarter. It is a financial representation of the operating activities of a company during the period. Typically, the bottom line is net income, which purports to measure the amount that the company earned during the period. The line items of the income statement provide details of revenues, expenses, gains, and losses in a bid to explain how a company earned its net income.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Income Statement  In addition to signaling earning power, income is also supposed to measure the net change in shareholder’s equity during a period from nonowner sources—that is, before considering distributions to and contributions from equity holders. The measure of income that serves this role is called comprehensive income and is reported by most companies (including Colgate) in its statement of shareholders’ equity. Income statements often include several other interim measures of income.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Income Statement  Income from continuing operations represents earnings from continuing operations before the provision for income tax.  Operating earnings does not have a fixed definition, but refers to the difference between sales revenues and all operating expenses.  Gross profit (or gross margin) is the difference between sales and cost of goods sold, and measures the ability of a company to cover its product costs.  Earnings are determined using the accrual basis of accounting. Under accrual accounting, revenues are recognized when a company sells goods or renders services, regardless of when it receives cash.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Statement of Changes in Shareholders’ Equity  The statements of retained earnings, comprehensive income, and changes in capital accounts are often called the statements of changes in shareholders’ equity.  This statement is useful in identifying reasons for changes in equity holders’ claims on the assets of a company.  Comprehensive income includes certain adjustments that are collectively called other comprehensive income.  The other comprehensive income is accumulated over time and shown on the balance sheet as a separate part of shareholder’s equity called accumulated other comprehensive income.  Financial Statements-Basis for Financial Analysis  Financial Statements Reflect Business Activities  Statement of Cash Flows  The statement of cash flows reports cash inflows and outflows separately for a company’s operating, investing, and financing activities over a period of time.  The cash flows depict a highly profitable company that is investing for future growth but still managing to use a significant amount of cash for reducing its capital base.  Financial Statements-Basis for Financial  Analysis Financial Statements Reflect Business Activities  Notes to Financial Statements  Explanatory notes that accompany financial reports play an integral part in financial statement analysis. Notes are a means of communicating additional information regarding items included or excluded from the body of the statements. The technical nature of notes creates a need for a certain level of accounting knowledge on the part of financial statement analysts. Explanatory notes include information on  (1) accounting principles and methods employed,  (2) detailed disclosures regarding individual financial statement items,  (3) commitments and contingencies,  (4) business combinations,  (5) transactions with related parties,  (6) stock option plans,  (7) legal proceedings, and  (8) significant customers. Engage Explore Activity  Financial Statement Analysis  Financialstatement analysis is an important and integral part of business analysis. The goal of business analysis is to improve business decisions by evaluating available information about a company’s financial situation, its management, its plans and strategies, and its business environment.  Financial Statement Analysis  Financial analysis is the use of financial statements to analyze a company’s financial position and performance, and to assess future financial performance.  Several questions can help focus financial analysis. One set of questions is future oriented. For example, does a company have the resources to succeed and grow? Does it have resources to invest in new projects? What are its sources of profitability? What is the company’s future earning power? A second set involves questions that assess a company’s track record and its ability to deliver on expected financial performance.  For example, how strong is the company’s financial position? How profitable is the company? Did earnings meet analyst forecasts? This includes an analysis of why a company might have fallen short of (or exceeded) expectations.  Financial Statement Analysis  Financial analysis consists of three broad areas— profitability analysis, risk analysis, and analysis of sources and uses of funds.  Profitability analysis is the evaluation of a company’s return on investment. It focuses on a company’s sources and levels of profits and involves identifying and measuring the impact of various profitability drivers. It also includes evaluation of the two major sources of profitability—margins (the portion of sales not offset by costs) and turnover (capital utilization).  Profitability analysis also focuses on reasons for changes in profitability and the sustainability of earnings.  Financial Statement Analysis  Riskanalysis is the evaluation of a company’s ability to meet its commitments.  Risk analysis involves assessing the solvency and liquidity of a company along with its earnings variability. Because risk is of foremost concern to creditors, risk analysis is often discussed in the context of credit analysis.  Financial Statement Analysis  Five important sets of tools for financial analysis:  1. Comparative financial statement analysis  2. Common-size financial statement analysis  3. Ratio analysis  4. Cash flow analysis  5. Valuation  Financial Statement Analysis 1. Comparative Financial Statement Analysis  Individuals conduct comparative financial statement analysis by reviewing consecutive balance sheets, income statements, or statements of cash flows from period to period. This usually involves a review of changes in individual account balances on a year-to-year or multiyear basis. The most important information often revealed from comparative financial statement analysis is trend. A comparison of statements over several periods can reveal the direction, speed, and extent of a trend. Comparative analysis also compares trends in related items.  Financial Statement Analysis Comparative Financial Statement Analysis  Comparative financial statement analysis also is referred to as horizontal analysis given the left-right (or right-left) analysis of account balances as we review comparative statements.  Two techniques of comparative analysis are especially popular: year-to-year change analysis and index- number trend analysis.  Financial Statement Analysis Comparative Financial Statement Analysis Year-to-Year Change Analysis. Comparing financial statements over relatively short time periods—two to three years—is usually performed with analysis of year- to-year changes in individual accounts. A year-to-year change analysis for short time periods is manageable and understandable. It has the advantage of presenting changes in absolute peso/dollar amounts as well as in percentages.  Financial Statement Analysis Comparative Financial Statement Analysis Year-to-Year Change Analysis. Computation of year-to-year changes is straightforward. Still, a few rules should be noted. When a negative amount appears in the base and a positive amount in the next period (or vice versa), we cannot compute a meaningful percentage change. Also, when there is no amount for the base period, no percentage change is computable. Similarly, when the base period amount is small, a percentage change can be computed but the number must be interpreted with caution.  Financial Statement Analysis Comparative Financial Statement Analysis Year-to-Year Change Analysis.  Financial Statement Analysis Comparative Financial Statement Analysis Index-Number Trend Analysis. A useful tool for long-term trend comparisons is index- number trend analysis. Analyzing data using index- number trend analysis requires choosing a base period, for all items, with a preselected index number usually set to 100. Because the base period is a frame of reference for all comparisons, it is best to choose a normal year with regard to business conditions  Financial Statement Analysis The change in cash balance between Year 1 and Year 2 for this illustration is 50% (150% - 100%), and is easily inferred from the index numbers. However, the change from Year 2 to Year 3 is not 75% (150% - 75%), as a direct comparison might suggest. This involves computing the Year 2 to Year 3 change by reference to the Year 2 balance. The percentage change is, however, computable using index numbers only. For example, in computing this change, we take 75%/150% = 0.50, or a change of 50%.  Financial Statement Analysis 2. Common-Size Financial Statement Analysis  The sum of individual accounts within groups is 100%, this analysis is said to yield common-size financial statements.  This procedure also is called given the up-down (or down-up) evaluation of accounts in common-size statements.  Common-size financial statement analysis is useful in understanding the internal makeup of financial statements. For example, in analyzing a balance sheet, a common-size analysis stresses two factors: 1. Sources of financing—including the distribution of financing across current liabilities, noncurrent liabilities, and equity. 2. Composition of assets—including amounts for individual current and noncurrent assets.  Financial Statement Analysis Common-size analysis of a balance sheet is often extended to examine the accounts that make up specific subgroups. Temporal (time) comparisons of a company’s common-size statements are useful in revealing any proportionate changes in accounts within groups of assets, liabilities, expenses, and other categories Common-size statements are especially useful for intercompany comparisons because financial statements of different companies are recast in common-size format. Comparisons of a company’s common-size statements with those of competitors, or with industry averages, can highlight differences in account makeup and distribution.  Financial Statement Analysis 3. Ratio Analysis Ratio analysis is among the most popular and widely used tools of financial analysis. Yet its role is often misunderstood and, consequently, its importance often overrated. Analysis of a ratio can reveal important relations and bases of comparison in uncovering conditions and trends difficult to detect by inspecting the individual components that make up the ratio. Factors Affecting Ratios. Beyond the internal operating activities that affect a company’s ratios, we must be aware of the effects of economic events, industry factors, management policies, and accounting methods.  Financial Statement Analysis  Ratios must be interpreted with care because factors affecting the numerator can correlate with those affecting the denominator. For instance, companies can improve the ratio of operating expenses to sales by reducing costs that stimulate sales (such as advertising). However, reducing these types of costs is likely to yield long-term declines in sales or market share.  Ratios are usefully interpreted in comparison with (1) prior ratios, (2) predetermined standards, and (3) ratios of competitors.  Finally, the variability of a ratio across time is often as important as its trend.  Financial Statement Analysis Ratio analysis as applied to three important areas of financial statement analysis: 1. Credit (Risk) Analysis a. Liquidity. To evaluate the ability to meet short-term obligations. b. Capital structure and solvency. To assess the ability to meet long-term obligations. 2. Profitability Analysis a.Return on investment. To assess financial rewards to the suppliers of equity and debt financing. b. Operating performance. To evaluate profit margins from operating activities. c. Asset utilization. To assess effectiveness and intensity of assets in generating sales, also called turnover. 3. Valuation a. To estimate the intrinsic value of a company (stock).  Financial Statement Analysis 4. Cash Flow Analysis Cash flow analysis is primarily used as a tool to evaluate the sources and uses of funds. Cash flow analysis provides insights into how a company is obtaining its financing and deploying its resources. It also is used in cash flow forecasting and as part of liquidity analysis Cash Flow Analysis Cash Flow Analysis  Financial Statement Analysis 5. Valuation Models Valuation is an important outcome of many types of business and financial statement analysis. Valuation normally refers to estimating the intrinsic value of a company or its stock. The basis of valuation is present value theory. This theory states the value of a debt or equity security (or for that matter, any asset) is equal to the sum of all expected future payoffs from the security that are discounted to the present at an appropriate discount rate. Present value theory uses the concept of time value of money—it simply states an entity prefers present consumption more than future consumption. Accordingly, to value a security an investor needs two pieces of information: (1) expected future payoffs over the life of the security and (2) a discount rate. The discount rate in the case of a bond is the prevailing interest rate (or more precisely, the yield to maturity), while in the case of a stock it is the riskadjusted cost of capital (also called the expected rate of return).  Financial Statement Analysis Debt Valuation The value of a security is equal to the present value of its future payoffs discounted at an appropriate rate. The future payoffs from a debt security are its interest and principal payments. A bond contract precisely specifies its future payoffs along with the investment horizon. The value of a bond at time t, or Bt , is computed using the following formula: where It n is the interest payment in period t n, F is the principal payment (usually the debt’s face value), and r is the investor’s required interest rate, or yield to maturity  Financial Statement Analysis Equity Valuation  The basis of equity valuation, like debt valuation, is the present value of future payoffs discounted at an appropriate rate. . With equity, the investor has no claim on predetermined payoffs. Instead, the equity investor looks for two main (uncertain) payoffs—dividend payments and capital appreciation.  Financial Statement Analysis  Capitalappreciation denotes change in equity value, which in turn is determined by future dividends, so we can simplify this task to state that the value of an equity security at time t, or Vt , equals the sum of the present values of all future expected dividends: where Dt n is the dividend in period t n, and k is the cost of capital. This model is called the dividend discount model. Financial Statement Analysis Engage Elaborate Activity Using the 2019, 2020, and 2021 financial statements of Colgate-Palmolive Company, prepare the following: 1. Comparative financial statement analysis 2. Common-size financial statement analysis 3. Ratio analysis Market Price per share is $150 Dividends Payout ratio is 50% Retention Ratio is 50% Cash Dividends ratio is 60%  Reporting Environment  Statutory financial reports—primarily the financial statements—are the most important product of the financial reporting environment. Information in financial statements is judged relative to: (1) the information needs of financial statement users and (2) alternative sources of information such as economic and industry data, analyst reports, and voluntary disclosures by managers.  The primary factors are accounting rules (GAAP), manager motivations, monitoring and enforcement mechanisms, regulators, industry practices, and other information sources.  Reporting Environment  Earnings Announcements  Annual and quarterly financial statements are made available to the public only after the financial statements are prepared and audited.  Yet companies almost always release key summary information to the public earlier through an earnings announcement.  Earnings announcements provide key summary information about company position and performance for both quarterly and annual periods.  The detailed information in financial statements can be analyzed to provide insights about a company’s performance and future prospects that are not available from summary information in earnings announcements.  Reporting Environment Generally Accepted Accounting Principles (GAAP)  Financial statements are prepared in accordance with GAAP, which are the rules and guidelines of financial accounting.  These rules determine measurement and recognition policies such as how assets are measured, when liabilities are incurred, when revenues and gains are recognized, and when expenses and losses are incurred.  They also dictate what information must be provided in the notes. Knowledge of these accounting principles is essential for effective financial statement analysis.  Reporting Environment Managers  Primary responsibility for fair and accurate financial reporting rests with managers. Managers have ultimate control over the integrity of the accounting system and the financial records that make up financial statements.  Judgment in financial accounting involves managerial discretion. Ideally, this discretion improves the economic content of accounting numbers by allowing managers to exercise their skilled judgment and to communicate their private information through their accounting choices and estimates.  Reporting Environment Monitoring and Enforcement  Mechanisms Monitoring and enforcement mechanisms ensure the reliability and integrity of financial reports. Some of these, such as the SEC and mechanisms, such as auditing, evolve over time.  Externalauditing is an important mechanism to help ensure the quality and reliability of financial statements. All public companies’ financial statements must be audited by an independent certified public accountant (CPA).