Accounting I: Financial Statements

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Jan. 3, 2012

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Donald W. Reynolds National Center

For Business Journalism

At Arizona State University

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James K. Gentry, Ph.D. Clyde M. Reed Teaching Professor School of Journalism and Mass Communications University of Kansas jgentry@ku.edu

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Types of Companies Public Private

Financial statements conforming to public company statements

Non-profits

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Important Terms Unaudited Audited Accountants Certified Public Accountants (CPAs) GAAP, FASB, AICPA, PCAOB

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Assessing a Company Context Trends Rules Outsiders Insiders

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Annual Report (or 10-K) Auditor’s report: Clean, qualified? MD&A or Management’s Discussion

and Analysis Financial statements and footnotes Management’s letter if annual report

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MD&A Must read it Often a source of good information and

insights Densely written Explains financial information SEC says it wants greater transparency

Auditor’s Report Independent auditor’s opinion on whether

financial statements are presented fairly in all material respects, in accordance with GAAP: We looked at these statements They’re management’s responsibility; we’re just

here to express our opinion We followed the rules in our audits and here’s

what an audit involves In our opinion, the statements fairly present the

company’s position

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Auditor’s Report by Category Clean or Unqualified Qualified Disclaimer Adverse

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New Auditor’s Report Combines traditional report with

“internal controls” requirement of Sarbanes-Oxley Act

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Goal of Accounting Record, classify and report financial

transactions. To provide managers across the organization with information that facilitates: Control of activities and expenditure Refinement of operational plans Accountability Reporting on project outcomes Writing of bids for new funds

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Goal of Finance Maximize shareholder wealth as

reflected in market price of the stock Achieving this goal requires financial

manager to focus on economic profit, not accounting profit

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Financial Decisions Long-term investment decisions

Capital budgeting Long-term financing decisions

Capital structure Working capital management decisions

Net working capital

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Financial Decisions Investing decisions: Types of assets

firm wants to hold. Financing decisions: Acquisition of

funds needed to support long-term investments.

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Generally Accepted Accounting Principles Guidelines based on theory and

practice Evolved over time Procedures, concepts and standards

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GAAP: Assumptions Periodicity Going concern Economic entity Monetary unit

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GAAP: Principles Full disclosure Matching Historical cost Revenue realization Consistency

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GAAP: Underlying Considerations Materiality Industry practices Conservatism

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Specialized Industry GAAP Banking and thrift industries Benefit plans, including pension funds Broadcasting industry Cable television industry Computer software Finance companies Investment companies

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Cash or Operating Cycle Cash Purchase inventory Produce product Sell product Cash

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Cash or Operating Cycle (cont.) “Cash”

Cash Receivables Debt

Inventory Raw materials Work in progress Finished goods

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Cash or Operating Cycle (cont.) Sell product

Accounts receivable Cash

Cash Collect receivables as cash

Pay off payables Start over

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Accrual Method Records revenues as soon as the “sale”

occurs Records expenses as soon as the bill is

received IE, transactions enter the financial

records when they occur, not when cash changes hands

Accrual method, therefore, shows “scores,” not real spendable dollars

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About These Numbers: They’re Squishy Goods will not necessarily be paid for Goods are not necessarily going to be

kept Inventory might be out of date, obsolete

or unsellable Status of some inventory may be

uncertain Intangible assets are estimates

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About These Numbers: They’re Squishy (cont.) Machinery or other fixed assets might be

obsolete or falling apart long before the so-called useful life is up

Goodwill Accounting conventions Timing issues Bottom line: In many ways, statements

are a collection of estimates.

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Because They’re Squishy You need to know the rules and

assumptions used to create the numbers

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Income Statement or ... Statement of earnings Statement of operations Statement of income and

comprehensive income

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Income Statement Covers a period of time, typically a year

or quarter Reports income from ongoing activities Reports income from activities beyond

management’s control (comprehensive income)

Involves estimates

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Basic Income Statement Sales or revenues Expenses Taxes Net income or profit

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Income Statement Sales or revenues Cost of goods sold Gross profit Operating expenses

Sales, general and administrative Depreciation, amortization

Operating profit Other income/expenses Interest Income taxes Net income or profit

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Cost of Goods Sold Expenses incurred in the cost of

manufacturing or creating or acquiring the product the company sells.

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Cost of Goods Sold Manufacturer: What the company pays

for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.

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Cost of Goods Sold Retailer: What the company pays

suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.

Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.

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SGA Includes office expenses, accounting,

shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.

Often includes depreciation and amortization.

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Other Income/Expenses Discontinued items Unusual/extraordinary items Changes in accounting principle Impairment charge Sale of investment Minority interest

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Thinking Inside the Box Revenues Minus cost of goods sold Equals gross profit Minus operating expenses Equals operating profit Minus or plus other expenses/income Minus or plus interest expenses/income Minus income taxes Net income

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Inside the Box Earnings Sales or revenues Cost of goods sold Gross profit Operating expenses

Sales, general and administrative Depreciation, amortization

Operating profit

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‘One-Time’ Gains That Reoccur Don’t be fooled by extraordinary items

that make the net income look better than it really is

Extraordinary items should be both unusual in nature and infrequent in occurrence

Examples: Writedowns, restructurings, etc.

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Earnings Per Share Basic earnings per share

(Bloomberg) Diluted earnings per share (Wall

Street Journal, fully diluted)

Calculating EPS Basic: Net income for period divided by

weighted average number shares outstanding.

Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.

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Pro Forma Results Expenses against earnings are not

standardized across an industry Selectively defined earnings SEC’s Regulation G (1/03) states that

non-GAAP numbers used in an earnings release must be accompanied by, and reconciled with, the “most directly comparable GAAP number”

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Pro Forma Results

Recommendation: GAAP results should precede pro forma results in earnings releases

Headlines should show GAAP earnings Pro forma has value for many companies Common pro forma: EBITDA “As a matter of form”

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Balance Sheet It balances Assets = Liabilities + Shareholders’

Equity

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Assets Current assets

Cash and cash equivalents Accounts receivable Inventories Prepaids

Investments and other assets

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Assets Property, plant and equipment, net

Land and improvement Buildings and improvements Equipment Less accumulated depreciation

Goodwill and other intangibles

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Goodwill Difference between what a firm pays to buy

another company and the book value (total assets minus total liabilities) of that company.

Has been written off over time, typically 40 years

No longer amortize Other intangible assets will continue to be

amortized over useful lives

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Impairment Instead of writing off over time, now use

“impairment testing” The impairment is expensed on the

income statement

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Liabilities Current liabilities

Accounts payable Accrued liabilities Income taxes Current maturity of long-term debt

Noncurrent liabilities Long-term debt Deferred income taxes

Commitments and contingencies

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Shareholders’ Equity Capital stock

Preferred stock Common stock

Additional paid-in capital Retained earnings Treasury stock

Total shareholders’ equity Total L + OE

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Statement of Cash Flows Record of cash provided by cash

sources and of cash consumed by cash uses.

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Cash Flows (cont.) Information about use of cash Information about investing and financing Ability to continue as a going concern Ability to generate future positive cash

flows Ability to meet obligations and pay

dividends

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Cash Flows From operations From investing From financing

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Flexibility Companies have some flexibility in

categories for entries. Total change in cash, however, will not

change. Overwhelming majority of all accounting

standards deal with balance sheet and income statement, not cash flows statement.

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Free Cash Flow Powerful tool for making a company

successful Powerful indicator for investors Cash that is left over after productive

capacity is maintained or expanded Permits expansion, paying down debt,

buying back shares, etc.

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Free Cash Flow (cont.) Several ways to calculate it Companies create their own models Gross way to do it:

Cash from operating activities Minus capital expenditures Equals free cash flow

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American Standard Model

Cash from operating activities Minus capital expenditures Plus proceeds from disposal of property Plus proceeds from sale and

leasebacks Equals free cash flow

Free Cash Models ‘Gross’ method American Standard method VF method

Cash from operating minus cash from investing

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Looking at the Numbers Note changes in amounts year to year, especially

revenues and expenses Note numbers that are significantly larger or smaller

than the previous period Look at trend line for sales/revenues, operating

income and net income. Calculate percentage change for each.

Look at cash flow. Look at free cash flow Tie the numbers to the footnotes.

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Techniques Calculate percentage change Trend analysis Common size analysis Ratio analysis

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Sarbanes-Oxley Act of 2002 Response to abuses with Enron and

WorldCom as catalysts New responsibilities and resources for

SEC Created PCAOB Major emphasis on “internal controls” More disclosure for public companies

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Sarbanes-Oxley Act Analysts must disclose potential conflicts of

interest Limited types of services accounting firms

can provide to public company clients CEO, CFO attest to accuracy, completeness,

fairness of financial statements Rigorous penalties for fraud, other misdeeds

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Public Company Accounting Oversight Board Created by SOX to oversee accounting Began operating in 2003 SEC appoints members to five-year terms Five full-time members including a chairman Two must be or have been CPAs All members must be “financially literate” In 2008, Supreme Court upheld PCAOB but

said SEC couldn’t remove board members

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PCAOB’s Duties Set rules on “auditing, quality control,

ethics, independence, and other standards…”

Conduct “inspections” of accounting firms

Conduct “investigations and disciplinary proceedings”

Enforce compliance with SOX

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Section 404: Internal Controls “Management Assessment of Internal

Controls” Each 10-K must contain an “internal control

report” that: States management is responsible for

internal control structure and procedures Contains an assessment on effectiveness of

internal control structure and procedures

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Management on the Spot Section 404 means that management must

evaluate and test internal controls over financial reporting, including anti-fraud programs, annually.

Management certifies that it does (or doesn’t) have adequate internal controls in place.

Independent auditor attests to adequacy of controls.

Management will be forced to answer for fraudulent activities, misconduct, etc.

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Private Company Impact Banks, insurers requiring companies to

embrace SOX. Now most private firms have audited financial

statements If private company owners want to sell to

public company, must be in compliance Private equity funds more willing to invest in

companies in compliance Best outside directors easier to attract Adding ethics codes, independent directors

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Non-Profit Impact Audit committees, independent members CEO, CFO attest to accuracy, completeness,

fairness of financial statements Financial statements more accessible Codes of ethics Rules governing transactions with “insiders”