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UNDERSTANDING FINANCIAL STATEMENTS

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UNDERSTANDING FINANCIAL STATEMENTS AN OVERVIEW Chapter 1 Financial Statements -- MAP Form basis for understanding the financial position of a firm Allow users to ... – PowerPoint PPT presentation

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Title: UNDERSTANDING FINANCIAL STATEMENTS


1
UNDERSTANDING FINANCIAL STATEMENTS
  • AN OVERVIEW
  • Chapter 1

2
Financial Statements -- MAP
  • Form basis for understanding the financial
    position of a firm
  • Allow users to assess historical and prospective
    financial performance
  • Present picture of firms financial health,
    leading to informed business decisions

3
Financial Statements -- MAZE
  • Contain large amounts of information
  • Accounting policies and reporting requirements
    are complex and constantly changing
  • Allow management considerable discretion
  • Hide or omit key information

4
Conclusion
  • Financial statements are potentially both MAP and
    MAZE
  • The better one can read and understand the
    financial statements, the more useful they are as
    a MAP to intelligent decision-making

5
Why use financial statements?
  • Savvy use of financial statements allows user to
    assess
  • financial position of the company
  • success of its operations
  • policies and strategies of management
  • insight into future performance
  • Financial statements are ancient history, BUT
    they can help project the future

6
Questions one might ask
  • Would an investment generate attractive returns?
  • What is the degree of risk inherent in the
    investment?
  • Should existing investing holdings be liquidated?
  • Is this firm a good prospect as a customer?

7
More questions one might ask
  • Will cash flows be sufficient to service interest
    and principal payments on debt?
  • Does company provide a good opportunity for
    employment?
  • How well does this company compete in its
    operating environment?

8
Financial Statement Analysis
  • Can help find answers
  • Can help wade through large quantities of
    information in the firms annual report

9
The Annual Report includes
  • financial statements
  • notes to the financial statements
  • auditors report
  • 5-year summary of key financial data
  • high and low stock selling prices
  • management discussion analysis of operations
    (forward-looking info)

10
Basic Financial Statements
  • Balance Sheet
  • Income Statement (Earnings Statement)
  • Statement of Shareholders Equity (or Statement
    of Retained Earnings which is often incorporated
    as part of the Income Statement)
  • Statement of Cash Flows

11
Notes
  • Are an INTEGRAL part of the statements
  • Provide summary of accounting policies
  • Present detail about particular accounts (e.g.
    inventory, investments, etc.)
  • Include other information (e.g. leasing
    arrangements, pending legal proceedings, income
    taxes, etc.)

12
Notes (more stuff included)
  • Contain some supplementary information required
    by SEC and FASB
  • Examples include
  • information on foreign currency translations for
    firms doing business in/with foreign countries
  • information by segment for firms with several
    lines of business

13
Auditors Report
  • Unqualified (what you want!) -- states that
    statements present information in conformity with
    GAAP
  • Sometimes qualified or adverse opinions are
    issued (not what you want!)
  • Keep in mind that auditor is hired by the firm --
    always the possibility of conflict of interest

14
Other Required Information
  • Five-year summary of selected financial data
  • Market data (high and low stock sale prices) for
    past two years
  • MDA -- source of FORWARD-LOOKING INFORMATION

15
MDA (Financial Review)
  • 1. Internal/external sources of liquidity
  • 2. Any material deficiencies in liquidity and how
    they will be remedied
  • 3. Commitments for capital expenditures/sources
    of funding
  • 4. Anticipated changes in mix and cost of
    financing resources

16
MDA (continued)
  • 5. Unusual/infrequent transactions which affect
    income from continuing operations
  • 6. Events causing material changes in
    cost/revenue relationships (e.g. future price
    increase)
  • 7. Breakdown of sales increases in price volume
    components

17
PR Fluff
  • Amount sometimes varies INVERSELY with
    performance...
  • Can visit many corporate websites to view some
    interesting creations

18
Are there any RULES?
  • YES!
  • Accounting rules have been issued in order to
    insure that financial information is relevant,
    reliable and understandable by users
  • Who makes the rules for the United States ???

19
SEC
  • Stands for Securities and Exchange Commission
  • Regulates US companies that issue securities to
    the public
  • Has Congressional authority to set accounting
    policies, but
  • Usually delegates accounting rule-making
    to.

20
FASB
  • Stands for Financial Accounting Standards Board
  • Comprised of 7 full-time paid members
  • Issues Statements of Financial Accounting
    Standards (SFAS) and Interpretations
  • Lengthy deliberation process

21
As for the rest of the world.
  • International Accounting Standards Committee
    (IASC) formed in 1973 with goal of determining
    international GAAP
  • Good idea but a SLOW process
  • Caution If you are going to invest in foreign
    companies, take time to research their accounting
    standards!
  • Now, back to the United States.

22
Do rules uniformity?
  • GAAP provide some measure but they allow
    considerable discretion
  • Accounting choices and estimates affect amounts
    on financial statements
  • Depreciation of fixed assets is a good example
    (choice of method, different good faith
    estimates possible)

23
Accounting Period
  • Another complexity
  • Although the firms life is continuous, financial
    data is presented for arbitrary time periods --
    year, quarter and the like
  • Leads to need for more adjustments and estimates
  • Statements are prepared on accrual basis

24
Cash versus Accrual
  • Financial statements are prepared on an accrual
    basis
  • Attempt to MATCH expenses with revenue in a given
    accounting period
  • Revenues reported when earned not when received
    in cash
  • Expenses are matched with revenues in the same
    accounting period

25
More Sources of Confusion
  • Earnings per share
  • Consolidation of parent and subs
  • Reporting leases
  • Reporting pensions
  • Translation of foreign operations
  • Off-balance sheet financing
  • Accounting for derivatives
  • (continued.)

26
Even MORE Confusion...
  • Comprehensive income reporting
  • Two sets of books (yes, its legal!!) - financial
    vs. tax reporting

27
Quality of Financial Reporting
  • Management has considerable discretion within
    GAAP
  • Potential exists to manipulate the profit/loss
    reported
  • The closer the financial data presented represent
    financial reality, the higher the quality of the
    financial statements and reported earnings

28
Means to Affect Quality
  • Accounting policies and estimates
  • choices and changes
  • Timing of revenues and expenses
  • Discretionary items
  • Nonrecurring and nonoperating items
  • ALL ARE WITHIN THE PURVIEW OF MANAGEMENT

29
Accounting Policies/Estimates
  • Choices
  • Management may choose among acceptable accounting
    policies
  • Management has opportunity to make estimates when
    applying policies
  • Changes
  • Policy or estimate may be changed

30
Timing of Revenues/Expenses
  • Matching process involves judgments by management
    regarding recognition of revenues and/or expenses
  • Usually the more conservative the approach (least
    favorable to management) the higher the quality
    of earnings

31
Discretionary Items
  • Budget level and timing of expenditures for many
    items are discretionary, e.g.
  • advertising/marketing
  • repairs/maintenance
  • research and development
  • capital expansion

32
Nonrecurring and Nonoperating Items
  • Nonrecurring and nonoperating items are not part
    of normal ongoing business
  • Earnings figure should reflect future operating
    potential
  • Therefore segregate such things as major asset
    sales, accounting changes, asset impairments,
    extraordinary items

33
What about Inflation???
  • Historical cost principle prevails in financial
    reporting
  • Impact of inflation is uneven -- relevance vs.
    reliability tradeoff
  • Produces both purchasing power gains and losses
    -- e.g. debt is good in inflationary situation

34
Missing Information
  • Morale/efficiency of employees
  • Reputation/public perceptions of firm
  • Effectiveness of management team/provisions for
    succession
  • Potential exposure to regulatory changes
  • IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO
    QUANTIFY

35
What about publicity?
  • Affects public perception of firm and can impact
    financial performance
  • Proven correlation between financial returns and
    reputation
  • Recent examples are adverse publicity for Coca
    Cola and Northwest Airlines -- countered by the
    respective companies to minimize impact

36
What Info is Hard to Find?
  • Many items must be extracted from notes,
    supplementary schedules, MDA section in order to
    interpret financial statement numbers - the facts
    are there, but they are not self-evident!
  • Coverage in Chapters 2-5 is geared to helping
    FIND and EFFECTIVELY USE information in financial
    statements and supplementary materials

37
MAP VS MAZE?
  • The idea is that by the time readers finish this
    book, financial statements will be much more of a
    map than a maze...

38
Preview Coming Attractions
  • Ch. 2 The Balance Sheet
  • Ch. 3 The Income Statement and Statement of
    Stockholders Equity
  • Ch. 4 Statement of Cash Flows
  • Ch. 5 The Analysis of Financial Statements
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