2
CHAPTER
Financial Reporting
and Analysis
Financial Reporting
Environment
Regulators
FASB
AICPA
Industry
Practices
GAAP
Enforcement and Monitoring Mechanisms
SEC
Corporate
Governance
Managers
Auditors
Statutory Financial Reports
(Financial Statements)
Alternative Information
Sources
Economy and Industry
Information
Voluntary
Disclosure
Users
Analysts
Investors
and
Creditors
Other
Users
Litigation
Form 10-K
(Annual Report)
10-Q
(Quarterly Report)
Other
SEC Filings
14-A
(Proxy Statement/
Prospectus)
Statutory Financial Reports
8-K
(Current Report)
20-F
(Registration Statement/
Annual Report [Foreign])
Earnings Announcements
? Key summary measures (pre-audit)
? Often one to six week lag
? Informative to market
? Lacks supporting financial details
Environmental Factors
GAAP
Generally Accepted Accounting Principles
Level I
(Most authoritative)
Level II
Level III
Level IV
(Least authoritative)
FASB
Standards and
Interpretations
APB
Opinions
AICPA(CAP)
Accounting
Research Bulletins
FASB
Technical
Bulletins
AICPA
Industry Audit &
Accounting Guidelines
AICPA
Statement of
Position
AICPA
Practice Bulletins
FASB
Emerging Issues Task Force
FASB
Implementation
Guides
AICPA
Interpretations
Recognized and
Widely Used Industry
Practices
Environmental Factors
Financial Accounting Standards Board
Generally Accepted Accounting Principles
Provide input to
Help set
Securities and
Exchange
Commission
Unions
Investors
Accountants
Politicians
Lenders
Others
AICPA
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 Accounting Standards (IAS)
? Set by International Accounting
Standards Board
? Not currently accepted in U.S,
? SEC under pressure to accept IAS
Environmental Factors
Managers of Companies
? Set by International Accounting
Standards Board
? Not currently accepted in U.S,
? SEC under pressure to accept
IAS
? Main responsibility for fair & accurate reports
? Applies accounting to reflect business
activities
? Managerial discretion is necessary in
accounting
? Major lobbyist on GAAP
Environmental Factors
Auditing
? Set by International Accounting
Standards Board
? Not currently accepted in U.S,
? SEC under pressure to accept
IAS
? SEC requires Audit Report
? Audit opinion can be,
- clean (fairly presented)
- qualified (except for)
- disclaimer (no opinion)
- adverse (not fairly presented)
? Check Auditor quality & independence
Auditors
Environmental Factors
Corporate Governance
? Set by International Accounting
Standards Board
? Not currently accepted in U.S,
? SEC under pressure to accept
IAS
? Board of directors oversight
? Audit committee of the board
- oversee accounting process
- oversee int r al control
- oversea internal/external audit
? Internal Auditor
Environmental Factors
Internal Users External Users
Managers
Officers
Internal Auditors
Sales Managers
Budget Officers
Controller
Lenders
Shareholders
Governments
Labor Unions
External Auditors
Customers
Environmental Factors
Creditors
Equity Investors
? Active & Speculative Investors rely on
financial reports
? Solvency & Liquidity analysis relies
on financial reports
Environmental Factors
Voluntary Disclosure
Economic,Industry & Company News
? Impacts current & future financial condition and
performance
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
? Many factors encourage voluntary disclosure by
managers
Financial Accounting
Stewardship
? Safeguard assets
? Increase equity value
? Protect creditors
?Accountability &
Performance
Measurement
Information Perspective
? Amount …of
? Timing prospective
? Uncertainty net cash
inflows
?Predictability & Decision
Usefulness
Objectives
Historical Emphasis
(but still important)
Modern Emphasis
Financial Accounting
Hierarchy of Accounting Qualities
Constraints
User-specific
qualities
Primary qualities
Ingredients of
primary qualities
Understandability
Relevance Reliability
Feedback
value
Predictive
value
Comparability and
consistency
Neutrality Verifiability
Secondary qualities
Benefits > Costs Materiality
Users of accounting
information
Decision makers and their characteristics
Decision usefulness
Representational
faithfulness Timeliness
Financial Accounting
? Double Entry - duality from accounting equation,A=L+E
? Historical Cost - fair & objective values from arm’s-length
transactions
? Accrual Accounting - recognize revenues when earned,
expenses when incurred
? Full Disclosure - measure and/or disclose material events
and transactions
? Materiality - threshold when information impacts decision
making
? Conservatism - reporting or disclosing
the least optimistic information
about uncertain events and transactions
Important Accounting Principles
FASB
Financial Accounting
Relevance of Accounting Numbers
0%
20%
40%
60%
80%
100%
65 70 75 80 85 90 95
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B o o k V a l u e
E a r n i n g s
C o m b i n e dRelation between Accounting Numbers and Stock Prices
Financial Accounting
? Timeliness - periodic disclosure,not
? real-time basis
? Frequency - quarterly and annually
? Forward Looking - limited prospective
information
Limitations of Accounting Numbers
Accruals--The Cornerstone
? 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
Case Illustration -- Facts
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 – Cash Accounting
Statement of Cash Flows 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
Case Illustration – Accrual Accounting
Balance Sheet Income Statement
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
Relation between Cash Flows and 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)
Accruals--The Cornerstone
Short-Term and Long-Term Accruals
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
+
Income
Investing
cash flow
Free cash
flow Financing
cash flow
Operating
cash flow
Decline Growth Maturity Inception
Accruals--The Cornerstone
Relevance and Reliability Trade off
Relevance
Reliability
Cash Flows
Accrual
Accounting
Analyst
Forecasts
Accruals--The Cornerstone
Comparison of Stock Price,Net Income,and Free Cash Flows
Wal-Mart
Stock price
Net income
Free cash flow
Kmart
Stock price
Net income
4.22
5.33
8.25
13.47
16.28
13.25
11.44
10.19
11.87
19.91
Fiscal year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
0.18
0.24
0.28
0.35
0.44
0.51
0.58
0.60
0.67
0.78
0.04
(0.01)
(0.05)
(0.17)
(0.48)
(0.50)
(0.19)
(0.21)
0.84
0.60
18.94 16.62
15.50
24.50
23.25
19.63
13.63
5.88
11.13
11.00
1.76
(2.26)
0.20 (0.47) (2.15) 1.29 2.71 0.48 0.61 1.35
Net income
2.00 0.81
1.89
2.02
2.07
(2.13)
0.64
(1.24)
(0.45)
0.51
Accruals--The Cornerstone
Relation between Stock Prices and Various Income and Cash
Flow Measures for a Large Sample of Companies
NIBX = Net Income before Extraordinary Items and Discontinued Operations; NI = Net Income;
OCF = Operating Cash Flow; FCF = Free Cash Flows; NCF = Net Cash Flow (Change in Cash),
5 7, 6 2
4 4, 3 6
3 3, 0 2 3 2, 6 2
1, 0 0
0, 0 0
1 0, 0 0
2 0, 0 0
3 0, 0 0
4 0, 0 0
5 0, 0 0
6 0, 0 0
7 0, 0 0
N I B X NI O C F F C F NCF
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Accruals--The Cornerstone
Relation between Stock Returns and both Income and Operating
Cash Flows for Different Horizons of a Large Sample of Companies
Source,Dechow,P
0, 1 0
3, 1 8
1 0, 8 8
3, 2 4
1 6, 2 0
4 0, 2 6
0, 0 0
5, 0 0
1 0, 0 0
1 5, 0 0
2 0, 0 0
2 5, 0 0
3 0, 0 0
3 5, 0 0
4 0, 0 0
4 5, 0 0
Q u a r t e r A n n u a l F o u r - Y e a r
Ti m e H or i z on
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OCF
NI
,
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,Company value equals discounted future cash flows,
? 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,
? Myth,Accounting rules are irrelevant
for valuation,
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)
? Government Favors – managers adjust numbers to
affect political actions (e.g.,antitrust actions,IRS
pressures,government subsidies)
? 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
and expenses in certain parts
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