chapter 5 communicating and interpreting accounting information

Chapter 5

Communicating and InterpretingAccounting Information

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

5-2Players in the Accounting

Communication Process

An An unqualifiedunqualified opinion states opinion states that the financial statements are that the financial statements are fair presentations in all material fair presentations in all material

respects in conformity with respects in conformity with GAAP.GAAP.

An An unqualifiedunqualified opinion states opinion states that the financial statements are that the financial statements are fair presentations in all material fair presentations in all material

respects in conformity with respects in conformity with GAAP.GAAP.

Independent AuditorsIndependent AuditorsVerificationVerification

Partners, Managers, StaffPartners, Managers, StaffGuided by GAASGuided by GAAS



ManagementManagementPreparationPreparation

CEO, CFO, Accounting StaffCEO, CFO, Accounting StaffGuided by GAAPGuided by GAAP


CEO, CFO, Accounting StaffCEO, CFO, Accounting StaffGuided by GAAPGuided by GAAP


5-3

Information Information IntermediariesIntermediaries

Analysis and AdviceAnalysis and AdviceFinancial analysis, Financial analysis,

Information servicesInformation services




Financial analysts Financial analysts make predictions make predictions

concerning concerning companies’ future companies’ future earnings and stock earnings and stock

prices.prices.



prices.prices.

Players in the Accounting







CFO, CEO, Accounting StaffCFO, CEO, Accounting StaffGuided by GAAPGuided by GAAP




5-4









prices.prices.



prices.prices.











Web Info Services:Web Info Services:www/sec/govwww/sec/gov

www.compustat.comwww.compustat.comwww.djnr.comwww.djnr.com

www.bloomberg.comwww.bloomberg.comwww.firstcall.comwww.firstcall.comwww.hoover.comwww.hoover.com

Web Info Services:Web Info Services:www/sec/govwww/sec/gov

www.compustat.comwww.compustat.comwww.djnr.comwww.djnr.com

www.bloomberg.comwww.bloomberg.comwww.firstcall.comwww.firstcall.comwww.hoover.comwww.hoover.com


5-5

Government Government RegulatorsRegulatorsVerificationVerification

SEC MembersSEC MembersGuided by SEC regs.Guided by SEC regs.

Government Government RegulatorsRegulatorsVerificationVerification

SEC MembersSEC MembersGuided by SEC regs.Guided by SEC regs.

UsersUsersAnalysis and DecisionAnalysis and Decision

Investors, Lenders, etc.Investors, Lenders, etc.

UsersUsersAnalysis and DecisionAnalysis and Decision

Investors, Lenders, etc.Investors, Lenders, etc. Public companies only


















5-6

Guiding Principles for Communicating Useful Information

Primary Objective of External Financial ReportingPrimary Objective of External Financial Reporting To provide economic information to external users To provide economic information to external users

for decision making.for decision making.



Primary Qualitative CharacteristicsPrimary Qualitative Characteristics

Relevance:Relevance: Timely and Predictive and Feedback ValueTimely and Predictive and Feedback Value

Reliability:Reliability: Accurate, Unbiased, and VerifiableAccurate, Unbiased, and Verifiable




Secondary Qualitative CharacteristicsSecondary Qualitative Characteristics

Comparability:Comparability: Across businessesAcross businesses

Consistency:Consistency: Over timeOver time





5-7

Guiding Principles for Communicating Useful Information

















The full-disclosure principles requires . . .The full-disclosure principles requires . . .

1.1.A complete set of financial statements,A complete set of financial statements,andand

2.2.Notes to the financial statementsNotes to the financial statements

The full-disclosure principles requires . . .The full-disclosure principles requires . . .

1.1.A complete set of financial statements,A complete set of financial statements,andand

2.2.Notes to the financial statementsNotes to the financial statements


5-8

The Disclosure Process

Press ReleasesPress Releases are used to announce are used to announce quarterly and annual earnings as soon quarterly and annual earnings as soon as the verified figures are available.as the verified figures are available.

Press ReleasesPress Releases are used to announce are used to announce quarterly and annual earnings as soon quarterly and annual earnings as soon as the verified figures are available.as the verified figures are available.

Earnings Press Release Excerpt for Gallaway GolfEarnings Press Release Excerpt for Gallaway Golf

Callaway® Golf

CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, 2001. Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of 2000. Net income increased . . . . . .

Earnings Press Release Excerpt for Gallaway GolfEarnings Press Release Excerpt for Gallaway Golf

Callaway® Golf

CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, 2001. Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of 2000. Net income increased . . . . . .


5-9

Annual Reports

For For privatelyprivately held companies, held companies, annual reports are simple annual reports are simple documents that include:documents that include:

1.1. Four basic financial statements.Four basic financial statements.

2.2. Related footnotes.Related footnotes.

3.3. Report of independent Report of independent accountants (auditor’s opinion).accountants (auditor’s opinion).

For For privatelyprivately held companies, held companies, annual reports are simple annual reports are simple documents that include:documents that include:

1.1. Four basic financial statements.Four basic financial statements.

2.2. Related footnotes.Related footnotes.

3.3. Report of independent Report of independent accountants (auditor’s opinion).accountants (auditor’s opinion).


5-10

Annual Reports

For For publicpublic companiescompanies, annual , annual reports are elaborate because of reports are elaborate because of

SEC reporting requirements:SEC reporting requirements:1.1. A Nonfinancial SectionA Nonfinancial Section

A letter to the stockholders, a A letter to the stockholders, a description of management’s description of management’s philosophy, products, successes, etc.philosophy, products, successes, etc.

2.2. A Financial SectionA Financial Section See next slide for a detailed listing . . See next slide for a detailed listing . .

. .

For For publicpublic companiescompanies, annual , annual reports are elaborate because of reports are elaborate because of

SEC reporting requirements:SEC reporting requirements:1.1. A Nonfinancial SectionA Nonfinancial Section

A letter to the stockholders, a A letter to the stockholders, a description of management’s description of management’s philosophy, products, successes, etc.philosophy, products, successes, etc.

2.2. A Financial SectionA Financial Section See next slide for a detailed listing . . See next slide for a detailed listing . .

. .


5-11

Annual Reports - Financial Section

1.1. Summarized financial Summarized financial data for 5- or 10-years.data for 5- or 10-years.

2.2. Management Management Discussion and Discussion and Analysis (Analysis (MD&AMD&A).).

3.3. The four basic financial The four basic financial statements.statements.

4.4. Notes (footnotes).Notes (footnotes).

5.5. Independent Independent Accountant’s Report.Accountant’s Report.

1.1. Summarized financial Summarized financial data for 5- or 10-years.data for 5- or 10-years.

2.2. Management Management Discussion and Discussion and Analysis (Analysis (MD&AMD&A).).

3.3. The four basic financial The four basic financial statements.statements.

4.4. Notes (footnotes).Notes (footnotes).

5.5. Independent Independent Accountant’s Report.Accountant’s Report.

6.6. Recent stock price Recent stock price information.information.

7.7. Summaries of the Summaries of the unaudited quarterly unaudited quarterly financial data.financial data.

8.8. Lists of directors and Lists of directors and officers of the company officers of the company and relevant and relevant addresses.addresses.

6.6. Recent stock price Recent stock price information.information.

7.7. Summaries of the Summaries of the unaudited quarterly unaudited quarterly financial data.financial data.

8.8. Lists of directors and Lists of directors and officers of the company officers of the company and relevant and relevant addresses.addresses.


5-12

Quarterly Reports

Usually begin with short letter to Usually begin with short letter to stockholders,stockholders,

Condensed Condensed unauditedunaudited income income statement and balance sheet for the statement and balance sheet for the quarter.quarter.

Often, cash flow statement and Often, cash flow statement and statement of stockholders’ equity are statement of stockholders’ equity are omittedomitted. Some notes to the financial . Some notes to the financial statements also may be omitted.statements also may be omitted.

Usually begin with short letter to Usually begin with short letter to stockholders,stockholders,

Condensed Condensed unauditedunaudited income income statement and balance sheet for the statement and balance sheet for the quarter.quarter.

Often, cash flow statement and Often, cash flow statement and statement of stockholders’ equity are statement of stockholders’ equity are omittedomitted. Some notes to the financial . Some notes to the financial statements also may be omitted.statements also may be omitted.


5-13

SEC Reports

Form 10-K Annual ReportForm 10-K Annual Report•Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end•Contains audited financial statementsContains audited financial statements

Form 10-K Annual ReportForm 10-K Annual Report•Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end•Contains audited financial statementsContains audited financial statements

Form 10-Q Quarterly ReportForm 10-Q Quarterly Report•Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter•Financial statements can be unauditedFinancial statements can be unaudited

Form 10-Q Quarterly ReportForm 10-Q Quarterly Report•Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter•Financial statements can be unauditedFinancial statements can be unaudited

Form 8-K Current ReportForm 8-K Current Report•Due within 15 days of the major event dateDue within 15 days of the major event date•Financial statements can be unauditedFinancial statements can be unaudited

Form 8-K Current ReportForm 8-K Current Report•Due within 15 days of the major event dateDue within 15 days of the major event date•Financial statements can be unauditedFinancial statements can be unaudited


5-14

Financial Statement Formats

Let’s take aLet’s take acloser lookcloser lookat the assetat the asset

section of thesection of thebalance balance sheet!sheet!


5-15


5-16

Current assets Current assets are assets that are assets that

will be turned into will be turned into cash or expire cash or expire (be used up) (be used up)

within the longer within the longer of one year or the of one year or the operating cycle.operating cycle.

Current assets Current assets are assets that are assets that

will be turned into will be turned into cash or expire cash or expire (be used up) (be used up)

within the longer within the longer of one year or the of one year or the operating cycle.operating cycle.


5-17

Property, plant and Property, plant and equipment includes equipment includes assets with useful assets with useful lives of more than lives of more than one year acquired one year acquired

for use in the for use in the business rather business rather

than for resale. The than for resale. The amount is reported amount is reported net of net of accumulated accumulated

depreciationdepreciation..

Property, plant and Property, plant and equipment includes equipment includes assets with useful assets with useful lives of more than lives of more than one year acquired one year acquired

for use in the for use in the business rather business rather

than for resale. The than for resale. The amount is reported amount is reported net of net of accumulated accumulated

depreciationdepreciation..


5-18

Intangible assets Intangible assets have no physical have no physical existence and a existence and a long life. They long life. They

include patents, include patents, copyrights, copyrights,

trademarks, etc.trademarks, etc.

Intangible assets Intangible assets have no physical have no physical existence and a existence and a long life. They long life. They

include patents, include patents, copyrights, copyrights,

trademarks, etc.trademarks, etc.


5-19

Let’s now look Let’s now look at the liability at the liability section of a section of a classified classified

balance sheet.balance sheet.


5-20


5-21

Current liabilities Current liabilities are obligations are obligations that will be paid that will be paid

with current with current assets, normally assets, normally within one year.within one year.

Current liabilities Current liabilities are obligations are obligations that will be paid that will be paid

with current with current assets, normally assets, normally within one year.within one year.


5-22

Long-term liabilities are debts that have Long-term liabilities are debts that have maturity dates extending beyond one maturity dates extending beyond one

year from the balance sheet date.year from the balance sheet date.

Long-term liabilities are debts that have Long-term liabilities are debts that have maturity dates extending beyond one maturity dates extending beyond one

year from the balance sheet date.year from the balance sheet date.


5-23

Finally, we get to the

stockholders’ equity section of a classified balance sheet.


5-24

Contributed capital is often shown in Contributed capital is often shown in two separate accounts . . .two separate accounts . . .

1.1. Common stockCommon stock

2.2. Paid-in capitalPaid-in capital

Contributed capital is often shown in Contributed capital is often shown in two separate accounts . . .two separate accounts . . .

1.1. Common stockCommon stock

2.2. Paid-in capitalPaid-in capital


5-25

Comprehensive income includes unrealized Comprehensive income includes unrealized gains/losses on security investments, gains/losses on security investments,

minimum pension liability adjustment, and minimum pension liability adjustment, and foreign currency translation adjustments.foreign currency translation adjustments.

Comprehensive income includes unrealized Comprehensive income includes unrealized gains/losses on security investments, gains/losses on security investments,

minimum pension liability adjustment, and minimum pension liability adjustment, and foreign currency translation adjustments.foreign currency translation adjustments.


5-26

Retained earnings is the total Retained earnings is the total earnings of the company less the earnings of the company less the

total dividends declared since total dividends declared since inception of operations.inception of operations.

Retained earnings is the total Retained earnings is the total earnings of the company less the earnings of the company less the

total dividends declared since total dividends declared since inception of operations.inception of operations.


5-27

Companies often purchase shares of its own Companies often purchase shares of its own common stock. This stock is said to be held in the common stock. This stock is said to be held in the

treasury and can be used to satisfy employee treasury and can be used to satisfy employee stock purchase or option plans. Treasury shares stock purchase or option plans. Treasury shares

may also be used in connection with the may also be used in connection with the acquisition of another company.acquisition of another company.

Companies often purchase shares of its own Companies often purchase shares of its own common stock. This stock is said to be held in the common stock. This stock is said to be held in the

treasury and can be used to satisfy employee treasury and can be used to satisfy employee stock purchase or option plans. Treasury shares stock purchase or option plans. Treasury shares

may also be used in connection with the may also be used in connection with the acquisition of another company.acquisition of another company.


5-28

Balance Sheet Ratios andDebt Contracts

When a company borrows money, they often agree to certain restrictions on their activity. Ratios typically part of the borrowing agreement include:

Total Liabilities÷ Stockholders' Equity= Debt-to-Equity Ratio

Total Liabilities÷ Stockholders' Equity= Debt-to-Equity Ratio

Current Assets÷ Current Liabilities= Current Ratio

Current Assets÷ Current Liabilities= Current Ratio


5-29

Classified Income Statement

Income statements may contain five Income statements may contain five sections:sections:

1.1. Continuing operationsContinuing operations

2.2. Discontinued operationsDiscontinued operations

3.3. Extraordinary itemsExtraordinary items

4.4. Cumulative effect of changes in Cumulative effect of changes in accounting methodsaccounting methods

5.5. Earnings per shareEarnings per share

Income statements may contain five Income statements may contain five sections:sections:

1.1. Continuing operationsContinuing operations

2.2. Discontinued operationsDiscontinued operations

3.3. Extraordinary itemsExtraordinary items

4.4. Cumulative effect of changes in Cumulative effect of changes in accounting methodsaccounting methods

5.5. Earnings per shareEarnings per share


5-30


Net sales− Cost of goods sold

Gross profit− Operating expenses

Income from operations± Nonoperating revenues/expenses and gains/losses

Income before income taxes− Income tax expense

Net income

General Format for the Classified Income StatementGeneral Format for the Classified Income Statement

Gross sales minus any Gross sales minus any discounts, returns, and discounts, returns, and

allowances during the period.allowances during the period.

Gross sales minus any Gross sales minus any discounts, returns, and discounts, returns, and

allowances during the period.allowances during the period.


5-31






Net income


Cost of inventory sold.Cost of inventory sold.Cost of inventory sold.Cost of inventory sold.


5-32






Net income


Not related to the company’s primary Not related to the company’s primary operations. Usually includes interest income or operations. Usually includes interest income or

expense and any gains or losses from the expense and any gains or losses from the retirement of equipment.retirement of equipment.

Not related to the company’s primary Not related to the company’s primary operations. Usually includes interest income or operations. Usually includes interest income or

expense and any gains or losses from the expense and any gains or losses from the retirement of equipment.retirement of equipment.


5-33






Net income

General Format for the Classified Income StatementGeneral Format for the Classified Income StatementIn addition, companies may have nonrecurring items. In addition, companies may have nonrecurring items. These nonrecurring items may include:These nonrecurring items may include:

1. 1. Discontinued operations,Discontinued operations,2. 2. Extraordinary items,Extraordinary items,3. 3. Cumulative effect of changes in accounting methods.Cumulative effect of changes in accounting methods.

These items are reported separately because they are These items are reported separately because they are not useful in predicting future income of the company.not useful in predicting future income of the company.

In addition, companies may have nonrecurring items. In addition, companies may have nonrecurring items. These nonrecurring items may include:These nonrecurring items may include:

1. 1. Discontinued operations,Discontinued operations,2. 2. Extraordinary items,Extraordinary items,3. 3. Cumulative effect of changes in accounting methods.Cumulative effect of changes in accounting methods.

These items are reported separately because they are These items are reported separately because they are not useful in predicting future income of the company.not useful in predicting future income of the company.


5-34

Discontinued Operations

Income or loss on Income or loss on segment’s operation for segment’s operation for

the period.the period.

Income or loss on Income or loss on segment’s operation for segment’s operation for

the period.the period.

Gain or loss on Gain or loss on disposal of the disposal of the

segment.segment.

Gain or loss on Gain or loss on disposal of the disposal of the

segment.segment.

Sale or abandonment of a Sale or abandonment of a segmentsegment of a of a business.business.

Sale or abandonment of a Sale or abandonment of a segmentsegment of a of a business.business.

Show net of applicable taxes.Show net of applicable taxes.


5-35

Extraordinary Items

UnusualUnusual InfrequentInfrequent



5-36

Cumulative Effect of Changes in Accounting Methods

The change must be to a The change must be to a preferable preferable methodmethod and must be disclosed in notes and must be disclosed in notes

to financial statements.to financial statements.

The change must be to a The change must be to a preferable preferable methodmethod and must be disclosed in notes and must be disclosed in notes

to financial statements.to financial statements.

GAAP GAAP MethodMethodGAAP GAAP

MethodMethodChange to

AlternativeGAAP GAAP

MethodMethodGAAP GAAP

MethodMethod



5-37


Now, let’s look at two common Now, let’s look at two common formats for presenting the formats for presenting the

continuing operations section.continuing operations section.1.1.Single-step income statementSingle-step income statement

2.2.Multiple-step income statementMultiple-step income statement

Now, let’s look at two common Now, let’s look at two common formats for presenting the formats for presenting the

continuing operations section.continuing operations section.1.1.Single-step income statementSingle-step income statement

2.2.Multiple-step income statementMultiple-step income statement


5-38

In the In the single-stepsingle-step format format, all revenues, income, , all revenues, income, and gains are listed first.and gains are listed first.

Costs, expenses, and losses are then subtracted Costs, expenses, and losses are then subtracted from total revenues to get net income.from total revenues to get net income.

In the In the single-stepsingle-step format format, all revenues, income, , all revenues, income, and gains are listed first.and gains are listed first.

Costs, expenses, and losses are then subtracted Costs, expenses, and losses are then subtracted from total revenues to get net income.from total revenues to get net income.


5-39

Cost of goods sold is shown along with a Cost of goods sold is shown along with a separation of non-operating income and separation of non-operating income and

expenses and non-recurring items.expenses and non-recurring items.

Cost of goods sold is shown along with a Cost of goods sold is shown along with a separation of non-operating income and separation of non-operating income and

expenses and non-recurring items.expenses and non-recurring items.


5-40

Two unusualTwo unusualexpenses that expenses that

may recur in themay recur in thefuture.future.


5-41

A nonrecurringA nonrecurringitem that isitem that ispresentedpresented

separately afterseparately afterincome fromincome fromoperations.operations.


5-42

Earnings Per Share

EPS =EPS =Net Income Available to Common ShareholdersNet Income Available to Common Shareholders

Weighted Average Number of Shares Outstanding During the Reporting Period


Basic EPSBasic EPSBasic EPSBasic EPS


5-43

Earnings Per Share

EPS =EPS =Net Income Available to Common ShareholdersNet Income Available to Common Shareholders



Diluted EPSDiluted EPSStock options, debt securities, Stock options, debt securities,

equity securities are assumed to equity securities are assumed to be converted into common stock be converted into common stock at the beginning of the period.at the beginning of the period.

Diluted EPSDiluted EPSStock options, debt securities, Stock options, debt securities,

equity securities are assumed to equity securities are assumed to be converted into common stock be converted into common stock at the beginning of the period.at the beginning of the period.


5-44

Both basic and Both basic and diluted EPS are diluted EPS are reported here.reported here.

Both basic and Both basic and diluted EPS are diluted EPS are reported here.reported here.


5-45

Accounting-Based Executive Bonuses

Executives are frequently paid bonuses based upon pretax earnings

growth of the company.

Pre-Tax EarningsGrowth Percent

=

Last Year Pretax Earnings

Current YearPretax Earnings

Last YearPretax Earnings−


5-46

Statement of Cash Flows

Recall that the Statement of Cash Flows Recall that the Statement of Cash Flows is divided into is divided into threethree major sections. major sections.

1.1. Cash flows from operating activities.Cash flows from operating activities.

2.2. Cash flows from investing activities.Cash flows from investing activities.

3.3. Cash flows from financing activities.Cash flows from financing activities.

We will examine the indirect method of We will examine the indirect method of preparing the statement. This format preparing the statement. This format begins with a begins with a reconciliationreconciliation of accrual of accrual income to cash flows from operations.income to cash flows from operations.


5-47

The operating The operating activities section of activities section of Callaway using theCallaway using the

indirect methodindirect method. . Begin with Begin with

accounting net accounting net income and arrive income and arrive

at cash provided by at cash provided by operating activities.operating activities.

The operating The operating activities section of activities section of Callaway using theCallaway using the

indirect methodindirect method. . Begin with Begin with

accounting net accounting net income and arrive income and arrive

at cash provided by at cash provided by operating activities.operating activities.


5-48

While these While these items are on items are on the income the income

statement, they statement, they have no have no

current cash current cash effect.effect.

While these While these items are on items are on the income the income

statement, they statement, they have no have no

current cash current cash effect.effect.


5-49

This table This table provides provides

guidance for guidance for adjustments adjustments

related to related to changes in changes in

current assets current assets and current and current liabilities.liabilities.

This table This table provides provides

guidance for guidance for adjustments adjustments

related to related to changes in changes in

current assets current assets and current and current liabilities.liabilities.


5-50

Here is the rest Here is the rest of Callaway’s of Callaway’s Statement of Statement of Cash Flows Cash Flows showing the showing the

cash balance cash balance on the on the

company’s company’s balance sheet.balance sheet.

Here is the rest Here is the rest of Callaway’s of Callaway’s Statement of Statement of Cash Flows Cash Flows showing the showing the

cash balance cash balance on the on the

company’s company’s balance sheet.balance sheet.


5-51

Notes to Financial Statements

Descriptions of the key accounting rules Descriptions of the key accounting rules applies to the company’s statements.applies to the company’s statements.

Descriptions of the key accounting rules Descriptions of the key accounting rules applies to the company’s statements.applies to the company’s statements.

Additional detail supporting reported Additional detail supporting reported numbers.numbers.

Additional detail supporting reported Additional detail supporting reported numbers.numbers.

Relevant financial information not Relevant financial information not disclosed on the statements.disclosed on the statements.

Relevant financial information not Relevant financial information not disclosed on the statements.disclosed on the statements.


5-52

Return on Equity (ROE)

1(beginning equity + ending equity) ÷ 2

Return Return onon

EquityEquity==

Net IncomeNet IncomeAverage Stockholder’s EquityAverage Stockholder’s Equity11

ROE measures how much the firm earned for each dollar of stockholders’ investment.


5-53

ROE Profit Driver Analysis

ROEROE Net ProfitMargin

Net ProfitMargin

AssetTurnover

AssetTurnover

FinancialLeverageFinancialLeverage= ××

Net IncomeAverage

Stockholders’Equity

Net IncomeAverage

Stockholders’Equity

Net IncomeNet Sales

Net IncomeNet Sales

Net SalesAverage

Total Assets

Net SalesAverage

Total Assets

AverageTotal Assets

AverageStockholders’

Equity

AverageTotal Assets

AverageStockholders’

Equity

× ×

=


5-54

The End of Chapter 5

chapter 5 communicating and interpreting accounting information

Documents

accounting staffguided

economic information

advicefinancial analysis

companies future earnings

external users

annual earnings

disclosure principles

stock prices