chapter 02 financial reporting and analysis ppt

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McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc !ll rights reser"e#

FinancialStatement

Analysis

K R Subramanyam

John J Wild



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2CHAPTER

Financial Reportingand Analysis



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Statutory Financial Reports



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GAAP

Types of Accounting rules and guidelines

o Statements of Financial Accounting Standardso

APB Opinions.o Accounting Research Bulletins (ARB.o A!"PA pronouncements. #he A!"PA issues guidelines

for certain topics $et to %e addressed %$ the FASB in itsStatements of Position (SOP or for those in&ol&ingindustr$-specific matters in its !ndustr$ Audit and

Accounting 'uidelines.o !#F Bulletins. !#F Bulletins are issued %$ the FASB)s

merging !ssues #as* Force.o !ndustr$ practices.



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Environmental Factors



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Securities and Exchange Commission (SEC

o !ndependent" #uasi$%udicial government agency

o Administer securities regulations & disclosures

o Can modify & set GAAP" if necessary

o Rarely directly challenges FAS'

o a%or player in glo)al accounting



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!nternational Financial ReportingStandards (!FRS



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anagers of Companies

o Primary responsi)ility for fair & accurate

reportso Applies accounting to reflect )usiness

activitieso

anagerial discretion is necessary inaccountingo a%or lo))yist on GAAP



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Auditingo S" re0uires Audit Report

o Audit opinion can %e1o clean (fairl$ presentedo 0ualified (ecept foro

disclaimer (no opiniono "hec* Auditor 0ualit$ independence

Auditors



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Corporate Governance

o Board of directors o&ersighto Audit committee of the %oard

o o&ersee accounting processo

o&ersee internal controlo o&ersee internal6eternal audit

o !nternal Auditor



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!nternal *sers External *sers



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Alternative information sources

+oluntary ,isclosure

Economic" !ndustry & Company -e.so !mpacts current future financial condition and performance

!nformation !ntermediarieso !ndustr$ de&oted to collecting7 processing7 interpreting

disseminating compan$ information

o !ncludes anal$sts7 ad&isers7 de%t raters7 %u$- and sell-side anal$sts7 and forecasters

o

8a9or determinant of 'AAP

8oti&ation - :egal lia%ilit$7 pectations Ad9ustment7 Signaling78anaging epectations

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,esira)le /ualities of Accounting!nformation

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Financial Accounting

o 0istorical Cost - fair o%9ecti&e &alues from arm)s-length%argaining

o Accrual Accounting - recogni;e re&enues <hen earned7epenses <hen incurred

o ateriality - threshold <hen information impacts decision

ma*ingo Conservatism - reporting or disclosing the least optimistic

information a%out uncertain e&ents and transactions

!mportant Accounting Principles

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Relevance of Accounting !nformation

Relation )et.een Accounting -um)ers and Stoc1 Prices

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o Timeliness - periodic disclosure7 not real-time%asis

o Fre#uency - 0uarterl$ and annuall$

o For.ard 2oo1ing - limited prospecti&einformation

2imitations of Accounting !nformation

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Accruals$The Cornerstone

o sta%lish compan$ and in&est =55 e0uit$o Purchase plain #-shirts for =+ eacho Fied screen cost of =55o >aria%le print cost of =5.+ per #-shirt

o Sold 2+ #-shirts at =5 each for casho Sold 2+ #-shirts at =5 each on credit

!llustration $ Case Facts

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Receipts Assets

T$Shirt sales 3456 Cash 3475

Payments

T$Shirt purchases 3566 Equity

Screen purchase 866 'eginning E#uity 3766

Printing charges 75 2ess net cash outflo. (945

Total payments 3(:75 Total e#uity 3475

-et cash outflo. 3(945

Accruals$ The Cornerstone

Case !llustration ; Cash Accounting

Statement of Cash Flo.s 'alance Sheet (Cash )asis

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Revenues AssetsT$Shirt sales 3566<66 Cash 3475<66

T$Shirt inventory ==7<56

Expenses Receiva)les 456<66

T$Shirts costs 3456<66 Total assets 3>:4<56

Screen depreciation 56<66Printing charges =7<56 Equity

Total expenses (==7<56 'eginning e#uity 3766<66

Add net income 8:4<56

-et income 38:4<56 Total e#uity 3>:4<56

Accruals-#he "ornerstone

Case !llustration ; Accrual Accounting

'alance Sheet (Accrual )asis!ncome Statement

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Re&enue Recognition ? recogni;e re&enues <hen

( arned

(2 Reali;ed or Reali;a%le

pense 8atching ? match <ith corresponding re&enues

- Product costs

- Period costs


Foundations of Accrual Accounting

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Relation )et.een Cash Flo.s and Accruals

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Short$Term and 2ong$Term Accruals

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Accruals and Cash Flo.s $ yths

o yth? Since compan$ &alue depends on future cash

flo<s7 onl$ current cash flo<s are rele&ant for&aluation.

o yth? All cash flo<s are &alue rele&ant.o yth? All accrual accounting ad9ustments are &alue

irrele&ant.o yth? "ash flo<s cannot %e manipulated.o yth? All income is manipulated.o yth? !t is impossi%le to consistentl$ manage

income up<ard in the long run.

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Accruals and Cash Flo.s $ Truths

o Truth? Accrual accounting (income) is more

rele&ant than cash flo<.o Truth? "ash flo<s are more relia%le than

accruals.o Truth? Accrual accounting num%ers are su%9ect

to accounting distortions.o Truth? "ompan$ &alue can %e determined %$

using accrual accounting num%ers.

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Economic concepts of income

Economic incomeo 8easures changes in Shareholders <ealth.o "ash flo<s @ Present &alue of epected future cash flo<s.o seful <hen the o%9ecti&e of anal$sis is determining the eact

return to the shareholder for the period.o :ess useful for forecasting future earnings potential.

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Accounting concept of income

o Based on the concept of accrual accountingo 8ain purpose is income measuremento

#<o main processes ?o Re&enue recognitiono pense matching

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Accounting +s Economic income

Reasons for differenceo Alternati&e income conceptso

istorical costo #ransaction %asiso "onser&atismo arnings management

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Fair value accounting

Asset and lia%ilit$ &alues are determined on the%asis of their fair &alues (t$picall$ mar*et priceson the measurement date (i.e.7 approimatel$the date of the financial statements.

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0istorical cost +s Fair value

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Advantages & ,isadvantages

Advantageso Reflects current information.o "onsistent measurement criteria.

o "ompara%ilit$o Co conser&ati&e %iaso 8ore useful for e0uit$ anal$sis

,isadvantageso :o<er o%9ecti&it$o Suscepti%ilit$ to manipulation. se of :e&el 3 inputs.o :ac* of conser&atism.

o cessi&e income &olatilit$.

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!mplications for Analysis

o Focus on the %alance sheet.

o Restating income.

o Anal$;ing use of inputs.o Anal$;ing financial lia%ilities.

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Accounting Analysis

,emand for Accounting Analysis

o Ad9ust for accounting distortions so financial

reports %etter reflect economic realit$

o Ad9ust general-purpose financial statements tomeet specific analysis objectives of a particular

user

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Accounting Analysis

Sources of Accounting Distortions

o Accounting Standards ? attri%uted to

political process of standard-setting7

2 accounting principles and assumptions7 and3 conser&atism

o Estimation Errors ? attri%uted to estimation errors inherent in accrualaccounting

o Relia)ility vs Relevance ? attri%uted to o&er-emphasis on relia%ilit$ atthe loss of rele&ance

o Earnings anagement ? attri%uted to <indo<-dressing of financialstatements %$ managers to achie&e personal %enefits

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Accounting Analysis

Analysis @)%ectives

o Comparatives Analysis ? demand for financial comparisonsacross companies and6or across time

o !ncome easurement - demand for ( e0uit$ <ealthchanges and (2 measure of

earning po<er. #hese correspond to t<o alternati&eincome concepts

( conomic !ncome (or

empiricall$7 economic profit (2 Permanent !ncome (or

empiricall$7 sustainable profit

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Accounting Analysis

Earnings anagement ; Fre#uent Source of ,istortion

Earning anagement strategies?o

!ncreasing !ncome ? managers ad9ust accruals to increasereported incomeo 'ig 'ath ? managers record huge <rite-offs in one period to

relie&e other periods of epenseso !ncome Smoothing ? managers decrease or increase reported

income to reduce its &olatilit$

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Accounting Analysis

Earnings anagement ; otivations

o Contracting !ncentives - managers ad9ust num%ers used in

contracts that affect their <ealth (e.g.7 compensation contractso Stoc1 Prices ? managers ad9ust num%ers to influence stoc*

prices for personal %enefits (e.g.7 mergers7 option or stoc*offering

o @ther Reasons - managers ad9ust num%ers to impact

la%or demands7

2 management changes7 and

3 societal &ie<s

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Accounting Analysis

Earnings anagement ; echanics

o !ncoming Shifting? Accelerate or dela$ recognition of re&enues or epenses toshift income from one period to another

o Classificatory Earnings anagement?

Selecti&el$ classif$ re&enues arnings and epenses incertain parts 8anagement of the income statement to affectanal$sis inferences regarding the recurring nature of theseitems

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Accounting Analysis

Process of Accounting Analysis

Accounting anal$sis in&ol&es se&eral inter-related processes andtas*s that can %e grouped into t<o %road areas1

o Evaluating Earning /uality? Steps !dentif$ and assess *e$ accounting policies

2 &aluate etent of accounting flei%ilit$

3 Determine the reporting strateg$

4 !dentif$ and assess red flags

o Ad%usting Financial Statements?

!dentif$7 measure7 and ma*e necessar$ ad9ustments to financialstatements to %etter ser&e one)s anal$sis o%9ecti&esE

Chapters =$: focus on ad%usting (recasting the statements

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Auditing And Financial Statement Analysis

chapter 02 financial reporting and analysis ppt

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