Chapter 02 Financial Reporting And Analysis Ppt 5u46o

Financial Statement Analysis K R Subramanyam John J Wild

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Reporting and Analysis

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CHAPTER

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Statutory Financial Reports

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GAAP Types Typesof ofing ingrules rulesand andguidelines guidelines o Statements of Financial ing Standards o Statements of Financial ing Standards o APB Opinions. o APB Opinions. o ing Research Bulletins (ARB). o ing Research Bulletins (ARB). o AIA pronouncements. The AIA issues guidelines o AIA pronouncements. The AIA issues guidelines

for forcertain certaintopics topicsyet yettotobe beaddressed addressedby bythe theFASB FASBininits its Statements StatementsofofPosition Position(SOP) (SOP)or orfor forthose thoseinvolving involving industry-specific industry-specificmatters mattersininits itsIndustry IndustryAudit Auditand and ing ingGuidelines. Guidelines. o EITF Bulletins. EITF Bulletins are issued by the FASB’s o EITF Bulletins. EITF Bulletins are issued by the FASB’s Emerging EmergingIssues IssuesTask TaskForce. Force. o Industry practices. o Industry practices.

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Environmental Factors

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Environmental Factors

Securities and Exchange Commission (SEC)

o o o o o

Independent, quasi-judicial government agency ister securities regulations & disclosures Can modify & set GAAP, if necessary Rarely directly challenges FASB Major player in global ing

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Environmental Factors International InternationalFinancial FinancialReporting Reporting Standards Standards(IFRS) (IFRS)

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Environmental Factors Managers of Companies oo Primary responsibility for fair & accurate Primary responsibility for fair & accurate

reports reports oo Applies ing to reflect business Applies ing to reflect business activities activities oo Managerial discretion is necessary in Managerial discretion is necessary in ing ing oo Major lobbyist on GAAP Major lobbyist on GAAP

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Environmental Factors Auditing oo SEC requires Audit Report SEC requires Audit Report oo Audit opinion can be: Audit opinion can be: oo clean (fairly presented) clean (fairly presented) oo qualified (except for) qualified (except for) oo disclaimer (no opinion) disclaimer (no opinion)

oo Check Auditor quality & independence Check Auditor quality & independence

Auditors

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Environmental Factors Corporate Governance oo Board of directors oversight Board of directors oversight oo Audit committee of the board Audit committee of the board oo oversee ing process oversee ing process oo oversee internal control oversee internal control oo oversee internal/external audit oversee internal/external audit

oo Internal Auditor Internal Auditor

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Environmental Factors Internal s

External s

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Alternative information sources Economic, Economic,Industry Industry&&Company CompanyNews News o

Impacts current & future financial condition and performance

Voluntary VoluntaryDisclosure Disclosure Motivation - Legal liability, Expectations Adjustment, Signaling, Managing expectations

Information InformationIntermediaries Intermediaries

o

Industry devoted to collecting, processing, interpreting & disseminating company information

o

Includes analysts, advisers, debt raters, buy- and sell-side analysts, and forecasters

o

Major determinant of GAAP

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Desirable Qualities of ing Information

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Financial ing Important ing Principles o Historical Cost - fair & objective values from arm’s-length o Historical Cost - fair & objective values from arm’s-length

bargaining bargaining o Accrual ing - recognize revenues when earned, o Accrual ing - recognize revenues when earned, expenses expenseswhen whenincurred incurred

o Materiality - threshold when information impacts decision o Materiality - threshold when information impacts decision

making making o Conservatism - reporting or disclosing the least optimistic o Conservatism - reporting or disclosing the least optimistic information informationabout aboutuncertain uncertainevents eventsand andtransactions transactions

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Financial ing Relevance Relevanceof ofing ingInformation Information Relation Relationbetween betweening ingNumbers Numbersand andStock StockPrices Prices

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Financial ing Limitations of ing Information ooTimeliness - periodic disclosure, not real-time Timeliness - periodic disclosure, not real-time

basis basis

ooFrequency - quarterly and annually Frequency - quarterly and annually ooForward Looking - limited prospective Forward Looking - limited prospective

information information

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Accruals-The Cornerstone Illustration - Case Facts ooEstablish company and invest $700 equity Establish company and invest $700 equity ooPurchase plain T-shirts for $5 each Purchase plain T-shirts for $5 each ooFixed screen cost of $100 Fixed screen cost of $100 ooVariable print cost of $0.75 per T-shirt Variable print cost of $0.75 per T-shirt ooSold 25 T-shirts at $10 each for cash Sold 25 T-shirts at $10 each for cash ooSold 25 T-shirts at $10 each on credit Sold 25 T-shirts at $10 each on credit

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Accruals- The Cornerstone Case Illustration – Cash ing Statement of Cash Flows Receipts T-Shirt sales

Assets $250

Payments T-Shirt purchases $500 Screen purchase 100 Printing charges 75 Total payments Net cash outflow

Cash

Balance Sheet (Cash basis)

$275

Equity Beginning Equity $700 Less net cash outflow (425) $(675) Total equity $275 $(425)

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Accruals-The Cornerstone Case Illustration – Accrual ing Income Statement Revenues T-Shirt sales

Balance Sheet (Accrual basis) $500.00

Expenses T-Shirts costs $250.00 Screen depreciation 50.00 Printing charges 37.50 Total expenses

(337.50)

Net income

$162.50

Assets Cash T-Shirt inventory Receivables Total assets

$275.00 337.50 250.00 $862.50

Equity Beginning equity Add net income Total equity

$700.00 162.50 $862.50

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Accruals-The Cornerstone

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Accruals-The Cornerstone Foundations of Accrual ing Revenue RevenueRecognition Recognition––recognize recognizerevenues revenueswhen when (1) (1) Earned Earned (2) (2) Realized Realizedor orRealizable Realizable Expense ExpenseMatching Matching––match matchwith withcorresponding correspondingrevenues revenues - -Product Productcosts costs - -Period Periodcosts costs

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Accruals-The Cornerstone Relation between Cash Flows and Accruals

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Accruals-The Cornerstone Short-Term and Long-Term Accruals

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Accruals-The Cornerstone Accruals and Cash Flows - Myths ooMyth: Since company value depends on future cash Myth: Since company value depends on future cash

flows, flows,only onlycurrent currentcash cashflows flowsare arerelevant relevantfor for valuation. valuation. ooMyth: All cash flows are value relevant. Myth: All cash flows are value relevant. ooMyth: All accrual ing adjustments are value Myth: All accrual ing adjustments are value irrelevant. irrelevant. ooMyth: Cash flows cannot be manipulated. Myth: Cash flows cannot be manipulated. ooMyth: All income is manipulated. Myth: All income is manipulated. ooMyth: It is impossible to consistently manage Myth: It is impossible to consistently manage income incomeupward upwardininthe thelong longrun. run.

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Accruals-The Cornerstone Accruals and Cash Flows - Truths ooTruth: Accrual ing (income) is more Truth: Accrual ing (income) is more

relevant relevantthan thancash cashflow. flow. ooTruth: Cash flows are more reliable than Truth: Cash flows are more reliable than accruals. accruals. ooTruth: Accrual ing numbers are subject Truth: Accrual ing numbers are subject to toing ingdistortions. distortions. ooTruth: Company value can be determined by Truth: Company value can be determined by using usingaccrual accrualing ingnumbers. numbers.

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Economic concepts of income

Economic Economicincome income o o o o o o o o

Measures Measureschanges changesininShareholders Shareholderswealth. wealth. Cash Cashflows flows++Present Presentvalue valueofofexpected expectedfuture futurecash cashflows. flows. Useful Usefulwhen whenthe theobjective objectiveofofanalysis analysisisisdetermining determiningthe theexact exact return returntotothe theshareholder shareholderfor forthe theperiod. period. Less Lessuseful usefulfor forforecasting forecastingfuture futureearnings earningspotential. potential.

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ing concept of income Based Basedon onthe theconcept conceptof ofaccrual accrualing ing oo Main purpose is income measurement Main purpose is income measurement oo Two main processes – Two main processes – oo Revenue recognition Revenue recognition oo Expense matching Expense matching oo

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ing Vs Economic income Reasons Reasonsfor fordifference difference oo Alternative income concepts Alternative income concepts oo Historical cost Historical cost oo Transaction basis Transaction basis oo Conservatism Conservatism oo Earnings management Earnings management

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Fair value ing Asset Assetand andliability liabilityvalues valuesare aredetermined determinedon onthe the basis basisof oftheir theirfair fairvalues values(typically (typicallymarket marketprices) prices) on onthe themeasurement measurementdate date(i.e., (i.e.,approximately approximately the thedate dateof ofthe thefinancial financialstatements). statements).

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Historical cost Vs Fair value

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Advantages & Disadvantages Advantages Advantages o o o o o o o o o o

Reflects Reflectscurrent currentinformation. information. Consistent Consistentmeasurement measurementcriteria. criteria. Comparability Comparability No Noconservative conservativebias bias More Moreuseful usefulfor forequity equityanalysis analysis

Disadvantages Disadvantages o o o o o o o o

Lower Lowerobjectivity objectivity Susceptibility Susceptibilitytotomanipulation. manipulation.Use UseofofLevel Level33inputs. inputs. Lack Lackofofconservatism. conservatism. Excessive Excessiveincome incomevolatility. volatility.

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Implications for Analysis oo Focus on the balance sheet. Focus on the balance sheet. oo Restating income. Restating income. oo Analyzing use of inputs. Analyzing use of inputs. oo Analyzing financial liabilities. Analyzing financial liabilities.

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ing Analysis Demand for ing Analysis oo Adjust for ing distortions so financial Adjust for ing distortions so financial

reports reportsbetter betterreflect reflecteconomic economicreality reality

oo Adjust general-purpose financial statements to Adjust general-purpose financial statements to

meet meetspecific specificanalysis analysisobjectives objectivesof ofaaparticular particular

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ing Analysis Sources of ing Distortions ing ingStandards Standards––attributed attributedtoto 1) political 1) politicalprocess processofofstandard-setting, standard-setting, 2) ing 2) ingprinciples principlesand andassumptions, assumptions,and and 3) conservatism 3) conservatism o Estimation Errors – attributed to estimation errors inherent in accrual o Estimation Errors – attributed to estimation errors inherent in accrual ing ing o Reliability vs Relevance – attributed to over-emphasis on reliability at o Reliability vs Relevance – attributed to over-emphasis on reliability at the theloss lossofofrelevance relevance o Earnings Management – attributed to window-dressing of financial o Earnings Management – attributed to window-dressing of financial statements statementsby bymanagers managerstotoachieve achievepersonal personalbenefits benefits o

o

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ing Analysis Analysis Objectives Comparatives ComparativesAnalysis Analysis––demand demandfor forfinancial financialcomparisons comparisons across time acrosscompanies companiesand/or and/oracross across time o Income Measurement - demand for (1) equity wealth o Income Measurement - demand for (1) equity wealth changes changesand and(2) (2)measure measureofof earning tototwo earningpower. power.These Thesecorrespond correspond twoalternative alternative income concepts income concepts (1) (1)Economic EconomicIncome Income(or (or empirically, empirically,economic economirofit) profit) (2) (2)Permanent PermanentIncome Income(or (or empirically, empirically,sustainable sustainableprofit) profit) o

o

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ing Analysis Earnings Management – Frequent Source of Distortion Earning EarningManagement Managementstrategies: strategies:

Increasing IncreasingIncome Income––managers managersadjust adjustaccruals accrualstotoincrease increase reported reportedincome income o Big Bath – managers record huge write-offs in one period to o Big Bath – managers record huge write-offs in one period to relieve relieveother otherperiods periodsofofexpenses expenses o Income Smoothing – managers decrease or increase reported o Income Smoothing – managers decrease or increase reported income incometotoreduce reduceits itsvolatility volatility o o

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ing Analysis Earnings Management – Motivations Contracting ContractingIncentives Incentives- - managers managersadjust adjustnumbers numbersused usedinin contracts contractsthat thataffect affecttheir theirwealth wealth(e.g., (e.g.,compensation compensationcontracts) contracts) o Stock Prices – managers adjust numbers to influence stock o Stock Prices – managers adjust numbers to influence stock prices pricesfor forpersonal personalbenefits benefits(e.g., (e.g.,mergers, mergers,option optionororstock stock offering) offering) o Other Reasons - managers adjust numbers to impact o Other Reasons - managers adjust numbers to impact 1) labor demands, 1) labor demands, 2) management changes, and 2) management changes, and 3) societal views 3) societal views o o

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ing Analysis Earnings Management – Mechanics o

Incoming Shifting: Accelerate or delay recognition of revenues or expenses to shift income from one period to another

o

Classificatory Earnings Management: 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

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ing Analysis Process of ing Analysis ing inganalysis analysisinvolves involvesseveral severalinter-related inter-relatedprocesses processesand and tasks tasksthat thatcan canbe begrouped groupedinto intotwo twobroad broadareas: areas: ooEvaluating Earning Quality: Steps Evaluating Earning Quality: Steps 1) 1) 2) 2) 3) 3) 4) 4)

o

Identify Identifyand andassess assesskey keying ingpolicies policies Evaluate Evaluateextent extentofofing ingflexibility flexibility Determine Determinethe thereporting reportingstrategy strategy Identify Identifyand andassess assessred redflags flags

oAdjusting AdjustingFinancial FinancialStatements: Statements:

Identify, Identify,measure, measure,and andmake makenecessary necessaryadjustments adjustmentstotofinancial financial statements to better serve one’s analysis objectives; statements to better serve one’s analysis objectives;

Chapters Chapters3-6 3-6focus focuson onadjusting adjusting(recasting) (recasting)the thestatements statements

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Auditing And Financial Statement Analysis