Financial Reporting and Analysis

Examining Financial StatementsFinancial Condition Analysis

May 28, 2011Coe Chapter 8Wang Chapters 7 and 12IntroductionHow do you know you can trust what is reported in an entitys financial statements?Once you know you can trust it, how do you interpret whats there?AuditingFinancial auditsUsed by governing board, management, bond underwriters, bond agencies, unions, interest groups, citizensPerformance auditsHow well the organization is performingAvailable to everyone, but primarily for internal use.Who are the Auditors?Federal GovernmentInspectors generalAppointed by PresidentLocated within agencyOriginally concerned with fraud, but responsibilities expanded to financial auditing in 1994Government Accountability Office (GAO)Legislative BranchConsolidates agencies financial statementsAudits agencies at request of CongressWho are the Auditors?StateState auditors audit state agencies Auditor GeneralFinancial auditsPerformance audits Governor or legislative requestOwn initiativeLocal governmentState requires hiring CPANonprofitsAudits are optional uses CPAMay be required by funding agencyRequired if > $300,000 received from federal funds

Generally Accepted Auditing StandardsGeneral standards the auditors shouldHave adequate technical training and proficiencyMaintain an independent mental attitude toward the assignmentTake professional care when conducting audits and preparing reportsField work standards the auditors shouldAdequately plan the work and properly supervise assistantsProperly study internal accounting controls to determine their reliabilityCollect sufficient evidence to express an opinion regarding the fairness of the financial statements

Generally Accepted Auditing StandardsReporting standards the report shouldInclude a statement as to whether the financial statements are presented in accordance with GAAPInclude a statement whether such principles were adhered to during the audit periodIndicate the financial statements are adequate unless otherwise statedSubmit an opinion on the financial statements or a statement that an opinion could not be expressedGenerally Accepted Governmental Auditing StandardsSecond set of guidelines followed by governmentComptroller GeneralYellow Book GAO publication Government Auditing StandardsAdopts GAAS and extends field work requirementsState and local governments that receive federal grants must follow GAGAS

Audit ReportReasonable assurance as to fairness of financial statementsUse of samplingFinancial statements free of material misstatementsTypes of opinionUnqualified opinion (clean)Qualified opinion certain departures from GAAPDisclaimer serious departures from GAAP auditor cannot offer opinion on part of financial statementsAdverse opinion do not represent financial condition fairlyAuditors ReportOpinion on fair presentation of financial statementsReport on compliance and internal control over financial transactionsReport on compliance and internal control over each major federal award programMust report which internal controls were testedReportable conditions listedMaterial weakness reportable condition that could result in material misstatementAudit FindingsReportable conditions presented including:The condition the internal control weakness or compliance issueThe criterion the basis for determining the weakness or compliance issueThe cause why the weakness occurredThe effect negative impact caused by weakness or compliance issueCAFRGAAP only requires:Basic set of financial statementsFootnote disclosuresRequired supplementary informationGovernment Finance Officers Association encourages the preparation of a CAFR to provide statistical and demographic information to make the statements more useful for analystsCAFR SectionsIntroductory title page, org chart, contentsFinancial SectionAudit reportMD&ABasic financial statementsFund financial statementsFootnotesRequired supplementary informationCombining statement for non major funds and individual fund statementsStatistical sectionOther Financial ReportsPopular Annual Financial Report (PAFR)Simpler version of financial statements for non-technical readersSingle Audit Financial ReportEntities used to be audited by each federal agency from which a grant was receivedSingle Audit Act limits redundancy audits governments and nonprofits that spend $500,000 in federal funds annuallyNonprofit Financial ReportsBasic Financial ReportStatement of Financial Condition - Part IV, Form 990Statement of Activities Part I, Form 990Statement of Functional Expenses Part II, Form 990Statement of Cash Flows Not in 990Notes to Financial StatementsOptions for small nonprofitsCompilationReview compliance letter. Not auditedAgreed-upon procedures examines specific accounting procedures to determine if controls are adequateMembers audit volunteer with accounting background performs a review

Financial Performance MonitoringFinancial monitoring systemOngoing check on the budgetHelps uncover inefficient practices and operationsHelps avoid further deterioration of financial conditionToolsIndicators that assess financial performanceTechniques to detect unacceptable financial performanceTechniques to diagnose causes of underperformance and provide suggestions for performance improvementFinancial IndicatorsFinancial input indicators availability of resources and level of resource consumptionTotal revenues or revenues per capitaTotal revenues by fund do we over rely on a particular revenue source? % of intergovernmental revenue do we over rely on other government support?Total expenditures or expenditures per capitaExpenditures by functionFinancial IndicatorsFinancial process indicators issues in financial operations such as liquidity and borrowing capacityLiquidity enough cash and CE to meet short-term obligations?Current ratio current assets / current liabilitiesShould be 2:1Net Assets or Change in Net Assets (Operating surplus or deficit)Difference between total revenues and total expenses for the yearFund Equity or Fund Operating Surplus (Deficit)Continuing deficits indicate a problem.Borrowing CapacityTotal debt / total assetsRule of thumb should not exceed .5

Financial IndicatorsFinancial results indicators how efficiently financial resources are used and how effectively revenues, earnings, or profits are producedAsset allocation efficiency total asset turnoverTotal revenues / total assets = revenue per $ of assetsFixed asset turnover Total revenues / total fixed assetsHigher ratios are betterIndicators of earning and profitability for business-type operationsReturn on assets change in net assets / total assetsReturn on net assets change in net assets / net assets Detecting Unacceptable PerformanceExamine indicatorsCompare to standards and benchmarksBudgets, state or nationwide averages, similar organizationsIs deviation within acceptable range?Did we expect decreased performance?Find the cause of underperformanceOne time event? Likely not a continuing problem.Systemic? Will have to address.Determine the performance trendLook at the trend over several yearsDetecting Unacceptable PerformanceDevelop a complete picture of performanceExamine other indicators that are associated with the initial indicatorExamine the components of the indicator separately and in more detailUnderstand the cause and take action if warranted:Non-random causes of underperformance:Unpredictable socioeconomic changesPoor planningInefficient or ineffective practices in management of operationsApproaches for Dealing with UnderperformanceModify financial goals, objectives or standards to reflect reality in the planning processModify organizational strategies, procedures, and activities to improve efficiency and effectiveness in management or operationsEliminate invalid or unreliable indicators from the monitoring systemRevise unrealistic performance standardsFinancial Condition AnalysisA thorough evaluation of the financial health of an organization.Ultimate purposeIdentify factors that impact financial conditionProvide recommendations to improve financial conditionFCA stresses importance of socioeconomic and organizational factors in the analysisAnalysis of financial statements has a narrower focusFinancial monitoring conducted more frequently than FCAFinancial Condition AnalysisWhen to perform:Beginning of period when preparing budgetEnd of period when financial report preparedDuring a financial crisis or emergencyPart of organizational strategic planning processWho conducts?Internal management teamOutside consultantsIndependent auditorsFinancial Condition AnalysisLevel of difficulty determined by:Scope of the analysis four financial condition dimensions (Analysis can focus on one or more dimensions):Cash solvency ability to pay current liabilitiesBudget solvency ability to collect sufficient revenues to pay expenditures or expensesLong-run solvency ability to pay off long-term obligationsService solvency ability to support desirable level of servicesAvailability of measures and dataSpecification and testing of how a financial condition is affected by socioeconomic/organizational factorsSpecification called FCA ModelingMeasuring Financial ConditionGood financial measure should satisfy three criteria:Measurement validity must assess a specified element of the dimension under evaluationEx. Revenue/expenditure measure not valid for cash solvency but valid for budgetary solvencyMeasurement reliability elements used in measure should be consistent and objectiveMeasurement affordability affordable to obtainExample Cash Solvency MeasuresAssets available to pay off current liabilities:Cash ratio = Cash & Cash Equivalents + Marketable Securities / Current LiabilitiesHigher ratio is betterQuick ratio = Cash & Cash Equivalents + Marketable Securities + Receivables / Current LiabilitiesHigher ratio is betterLess restrictive than cash ratioExample Budgetary Solvency MeasuresOperating ratio = Total Revenues / Total Expenditures (Expenses)Assesses sufficiency of revenues to cover expensesHigher ratio = higher budgetary solvencyOwn-Source Ratio = Revenues of Own Sources / Total RevenuesOwn source includes taxes, fees, charges considered more stable and controllable than intergovernmental revenuesExample Long-Run Solvency MeasuresNet Asset Ratio = Total Net Assets / Total AssetsMeasures ability to withstand financial emergencies during economic slowdowns, loss of major taxpayers/tax base, and natural disasters.Higher ratio = better long-run solvencyCan exclude capital assets from numerator may not be available to pay long-term debtLong-Term Debt Ratio = Total Long-Term Debt / Total Assets (or Total Revenues)Measures ability to pay off long-term debtHigher ratio = worse long-run solvency

Example Service Solvency MeasuresNet Assets Per Capita = Total Net Assets / PopulationLevel of net assets per residentHigher ratio = better service solvencyLong-Term Debt Per Capita = Total Long-Term Debt / PopulationLevel of long-term debt per residentHigher ratio indicates deterioration of service solvencyMeasuring Socioeconomic/Organizational FactorsSelection CriteriaMeasurement validity, reliability and affordabilityTheoretical cause-effect relationship to show how factor affects financial conditionTheoretical justification of measurementMost important selection criterionExample population data justifiable when in an analysis that uses revenues to measure financial conditionMeasure is better if more controllableSensitive to policies and managerial actionsMeasurement controllabilityExample Socioeconomic/Organizational FactorsSocioeconomicPopulationIncomeProperty valuesEducation levelAgeEmployment rateOrganizational factorsBudget managementCash managementInvestment managementInternal controlsProfessionalism and leadershipWarning TrendsRequires examination of at least three periodsContinuing deterioration in the measure constitutes a warning trendFluctuations in trend may bear investigationRelationships Between FactorsStudying a factors impact on financial positionFactor must be related to financial impactMeasures of associationsCorrelation coefficientDirection positive or negative valueMagnitude relation varies from -1.000 to +1.000; Interpretation0 = no relationship> 0 < .500 weak positive.5 to .699 moderate positive.7 to .999 strong positive1.000 perfect positiveRelationships Between FactorsExact form of relationship must be determinedBreak down the relationship into a useful methodology for projecting the impactPer capitaGrowth ratePercentage relationshipMultiple factors will generally be responsible for the impactRequires more advanced statistical techniques, such as regression