Financial Reporting

and Analysis

2
CHAPTER

McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved

 Form 10-K 10-Q
(Annual Report) (Quarterly Report)

20-F 8-K
(Registration Statement/ (Current Report)
Annual Report [Foreign])

Statutory Financial Reports

14-A Other
(Proxy Statement/
Prospectus) SEC Filings
 Earnings Announcements

 Key summary measures (pre-audit)

 Often one to six week lag
 Informative to market
 Lacks supporting financial details
 GAAP Defined
• Statements of Financial Accounting Standards
• APB Opinions.
• Accounting Research Bulletins (ARB).
• AICPA pronouncements. The AICPA issues
guidelines for certain topics yet to be addressed
by the FASB in its Statements of Position (SOP)
or for those involving industry-specific matters in
its Industry Audit and Accounting Guidelines.
• EITF Bulletins. EITF Bulletins are issued by the
FASB’s Emerging Issues Task Force.
• Industry practices.
 Environmental Factors
Unions AICPA Lenders
Securities and
Exchange Investors Politicians
Commission
Accountants Others

Provide input to

Financial Accounting Standards Board

Help set
Generally Accepted Accounting Principles
 Environmental Factors

Securities and Exchange Commission (SEC)

 Independent, quasi-judicial government agency

 Administer securities regulations & disclosures
 Can modify & set GAAP, if necessary
 Rarely directly challenges FASB
 Major player in global accounting
 Environmental Factors

International Financial Reporting

Standards (IFRS)
 Set by International Accounting
Standards Board
 Not currently accepted in U.S.
 SEC under pressure to accept IAS
 Environmental Factors
Managers of Companies

 Setresponsibility
 Main by International
for fair &Accounting
accurate reports
 Applies accounting
Standards to reflect business
Board
activities
 Not currently
 Managerial accepted
discretion in in
is necessary U.S.
accounting
 SEC
 Major underonpressure
lobbyist GAAP to accept
IAS
 Environmental Factors
Auditing

 SEC requires
 Set Audit Report Accounting
by International
 Audit opinion can
Standards Board be:
- clean (fairly presented)
 Not -currently accepted
qualified (except for) in U.S.
- disclaimer (no opinion) Auditors
 SEC under pressure to accept
 Check Auditor quality & independence
IAS
 Environmental Factors
Corporate Governance

 Board
 Set of
bydirectors oversightAccounting
International
 Audit committee of
Standards Board the board
- oversee accounting process
-oversee
Not currently accepted in U.S.
internal control
- oversea internal/external audit
 SEC under
 Internal Auditor
pressure to accept
IAS
 Environmental Factors

Internal Users External Users

Managers Lenders
Officers Shareholders
Internal Auditors Governments
Sales Managers Labor Unions
Budget Officers External Auditors
Controller Customers
 Environmental Factors

Equity Investors
 Active & Speculative Investors rely on
financial reports

Creditors
 Solvency & Liquidity analysis relies
on financial reports
 Environmental Factors
Economic, Industry & Company News
 Impacts current & future financial condition and
performance

Voluntary Disclosure
 Many factors encourage voluntary disclosure by
managers

Information Intermediaries
 Industry devoted to collecting, processing, interpreting
& disseminating company information
 Includes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
 Major determinant of GAAP
 Desirable Qualities of
Accounting Information

• Relevance - the capacity of information to

affect a decision
• Reliability - For information to be reliable it
must be verifiable, representationally
faithful, and neutral. Verifiability means
the information is confirmable.
Representational faithfulness means the
information reflects reality, and neutrality
means it is truthful and unbiased.
 Financial Accounting
Important Accounting Principles

• Historical Cost - fair & objective values from

arm’s-length transactions
• Accrual Accounting - recognize revenues
when earned, expenses when incurred
• Materiality - threshold when information
impacts decision making
• Conservatism - reporting or disclosing
the least optimistic information
about uncertain events and transactions
Financial Accounting
Relevance of Accounting Numbers
Relation between Accounting Numbers and Stock Prices
 Financial Accounting

Limitations of Accounting Numbers

• Timeliness - periodic disclosure, not

• real-time basis
• Frequency - quarterly and annually
• Forward Looking - limited prospective
information
 Accruals--The Cornerstone
Case Illustration -- Facts

• Establish company and invest $700

equity
• Purchase plain T-shirts for $5 each
• Fixed screen cost of $100
• Variable print cost of $0.75 per T-shirt
• Sold 25 T-shirts at $10 each for cash
• Sold 25 T-shirts at $10 each on credit
 Accruals--The Cornerstone
Case Illustration – Cash Accounting

Statement of Cash Flows Balance Sheet

Receipts Assets
T-Shirt sales $250 Cash $275  

Payments
T-Shirt purchases $500 Equity
Screen purchase 100 Beginning Equity $700
Printing charges 75 Less net cash outflow (425)
Total payments $(675) Total equity $275
Net cash outflow $(425)
 Accruals--The Cornerstone
Case Illustration – Accrual Accounting

Income Statement Balance Sheet

Revenues Assets
T-Shirt sales $500.00 Cash $275.00
T-Shirt inventory 337.50
Expenses Receivables 250.00
T-Shirts costs $250.00 Total assets $862.50
Screen depreciation 50.00
Printing charges 37.50 Equity
Total expenses (337.50) Beginning equity $700.00
Add net income 162.50
Net income $162.50 Total equity $862.50
Accruals--The Cornerstone

Net Operating
= + Accruals
Income Cash Flow
 Accruals--The Cornerstone
Foundations of Accrual Accounting

Revenue Recognition – recognize revenues when

(1) Earned
(2) Realized or Realizable
Expense Matching – match with corresponding revenues
-Product costs
-Period costs
Accruals--The Cornerstone
Relation between Cash Flows and Accruals

Operating cash flow (OCF)

-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
 Accruals--The Cornerstone
Short-Term and Long-Term Accruals

Short-Term Accruals: Yield current assets and current

liabilities (also called working
capital accruals)

Long-Term Accruals: Yield non-current assets and non-

current liabilities (arise mainly from
capitalization)

Note: Analysis research suggests short-term accruals

are more useful in company valuation
 Accruals--The Cornerstone
Relevance of Cash Flows and Income over a Company’s Life Cycle

Free cash
+ flow
Operating
Financing
cash flow
cash flow Income

Inception Growth Maturity Decline

Investing
cash flow
 Accruals--The Cornerstone
Comparison of Stock Price, Net Income, and Free Cash Flows
                         

                       

   

   

   

   

   

                         
 Accruals--The Cornerstone
Relation between Stock Prices and Various Income and Cash
 
Flow  Measures
   
for  a Large
 
Sample
   
of  Companies
       

                         
 
Accruals--The Cornerstone
  Relation between  Stock Returns
    and  both
  Income
  and
  Operating
     

Cash Flows for Different Horizons of a Large Sample of Companies

                       
 
Accruals--The Cornerstone
Accruals and Cash Flows --- Myths
                       

• Myth: Since company value depends on future

. cash flows, only current cash flows are relevant
for valuation.
• Myth: All cash flows are value relevant.
• Myth: All accruals accounting adjustments are
value irrelevant.
• Myth: Cash flows cannot be manipulated.
• Myth: All income is manipulated.
• Myth: It is impossible to consistently manage
income upwards in long run.

                       
 
Accruals--The Cornerstone
Accruals and Cash Flows --- Truths
                       

.
• Truth: Accrual accounting (income) is more
relevant than cash flow.
• Truth: Cash flows are more reliable than
accruals.
• Truth: Accrual accounting numbers are
subject to accounting distortions.
• Truth: Company value can be determined by
using accrual accounting numbers.

                       
 Accounting Analysis
Demand for Accounting Analysis

 Adjust for accounting distortions so financial

reports better reflect economic reality

 Adjust general-purpose financial statements

to meet specific analysis objectives of a
particular user
 Accounting Analysis
Sources of Accounting Distortions
 Accounting Standards – attributed to (1) political
process of standard-setting, (2) accounting
principles and assumptions, and (3) conservatism
 Estimation Errors – attributed to estimation errors
inherent in accrual accounting
 Reliability vs Relevance – attributed to over-
emphasis on reliability at the loss of relevance
 Earnings Management – attributed to window-
dressing of financial statements by
managers to achieve personal benefits
 Accounting Analysis
Sources of Analysis Objectives
 Comparatives Analysis – demand for financial comparisons
across companies and/or across
time
 Income Measurement -- demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income concepts
(1) Economic Income (or
empirically, economic profit)
(2) Permanent Income (or
empirically, sustainable profit)

Chapter 6 discusses these measures in detail

 Accounting Analysis
Earnings Management – Frequent Source of Distortion

Three common strategies:

 Increasing Income – managers adjust accruals
to increase reported
income
 Big Bath – managers record huge
write-offs in one period to
relieve other periods of
expenses
 Income Smoothing– managers decrease or
increase reported income
to reduce its volatility
 Accounting Analysis
Earnings Management – Motivations

 Contracting Incentives -- managers adjust numbers

used in contracts that affect their wealth (e.g.,
compensation contracts)
 Stock Prices – managers adjust numbers to influence
stock prices for personal benefits (e.g., mergers,
option or stock offering)
 Other Reasons -- managers adjust numbers to impact
(1) labor demands, (2) management changes, and (3)
societal views
 Accounting Analysis
Earnings Management – Mechanics

 Incoming Shifting – Accelerate or delay

recognition of revenues or
expenses to shift income from
one period to another
 Classificatory – Selectively classify revenues
Earnings and expenses in certain parts
Management of the income statement to
affect analysis inferences
regarding the recurring nature
of these items
 Accounting Analysis
Process of Accounting Analysis

Accounting analysis involves several inter-related processes

and tasks that can be grouped into two broad areas:
 Evaluating Earning Quality –
Identify and assess key accounting policies
Evaluate extent of accounting flexibility
Determine the reporting strategy
Identify and assess red flags
 Adjusting Financial Statements --
Identify, measure, and make necessary adjustments
to financial statements to better serve one’s analysis
objectives; Chapters 3-6 focus on adjusting
(recasting) the statements