financial statements i by jimmy gentry
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Jimmy Gentry presents "Financial Statements I" during the annual 2012 Reynolds Business Journalism Seminars, hosted by the Donald W. Reynolds National Center for Business Journalism. For more information about free training for business journalists, please visit businessjournalism.org.TRANSCRIPT
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 [email protected]
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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”