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Analyzing a Company’s Financial Reporting
Lecture 8
What you should expect
Understand the Financial Statements
•What are the financial statements saying?•What are the financial statements not saying?•What are the accounting principles that govern the statements?•How do internal controls work to enhance reporting reliability?•What are the sensitive areas in the financial reports?•How do I recognize a “red flag”?•How does Wall Street view the financial statements?
Develop a Critique for Your Firm’s Financial Statements
Questions to Ask
How Firm Valuation Issues AriseDiversity in Generally Accepted Accounting Principles (GAAP)
Examples:
Examples:
─Show securities at cost─Show securities at market value when below cost─Show securities at cost plus interest earned but not yet paid─Show securities at approximate market value
─Recognize revenue in the period when products or services are delivered─Recognize revenue in the period when product is ready for delivery ─Recognize revenue in the period when payment is received from customer or client
Another Example
Why is Accounting for Current Enterprise Transactions So Difficult?
• The numbers are important but equally important are the principles and practices that lie behind them– Revenue recognition– Accruals– Asset vs. expense– Valuation– Depreciation and amortization– Currrency translation
Why is Accounting for Enterprise Transactions so Difficult?
• Sophisticated Issues– Special Purpose Entities– Derivatives– Lease Accounting – Expensing stock options– Restructuring charges– Recognizing debt associated with pension benefits
Information QualityNot where it needs to beAppropriateness of financial Meets
Objectives
Information
In Reflecting 41%
Business Performance
For Management Decision Making 26%
For Forward looking Management 16%
Planning and Strategy
The Limitations of GAAP Accounting
The Objective:Faithfully represent the business and provide information about future cash
flows
The practical Problem:Measurement is difficult and subject to speculation“Tell us that you know, but leave the speculation to us”
The Tradeoff:Relevance versus reliability
The SEC Final Rule on Sarbanes-Oxley
The certification statement regarding fair presentation of financial statements and other financial information is not limited to a representation that the financial statements and other financial information have been presented in accordance with “generally accepted accounting principles” and is not otherwise limited by reference to generally accepted accounting principles. We believe that Congress intended this statement to provide assurances that the financial information disclosed in a report, viewed in its entirely, meets a standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principles[emphasis added]
U.S. Securites and Exchange Commission, Final Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release Nos. 33-8124, 34-46427; File No. S7-21-02, http://www.sec.gov/rules/final/33-8124.html
How Should You Deal with the Issues?
Understand GAAP and its limitations─Appreciate the relevance-reliability tradeoff─Recognize the diversity in accounting applications─Recognize the critical accounting policies─Recognize unresolved issues in GAAP─Recognize where choices can be made
How does your firm treat depreciation accounting?Be alert to poor application of GAAP
─How sensitive are earning to estimates?─How would you characterize the revenue recognition-aggressive or conservative?─Does the application of GAAP “faithfully represent” the business?
Market is demanding transparency as well as compliance with GAAP ─Transparency on performance
─Transparency on asset and liability position
The Focus for the Non-Financial Professional
Take the position of the shareholder (owner)
How much did I make this year?
What is my financial position?
─ my share of assets?
─ my obligations?
How much can I expect to make in the future?
What is my stock worth?
Accounting Essentials for Non-Financial Professionals
1. Navigating the Financial Statements
2. Highlighting Some Key Issues:
The use of estimates in financial reports Revenue recognition Recognizing variable interest entities (SPEs) Distinguishing liabilities and equity Accounting for stock based compensation
Navigating the Financial Statements
A. Understand what each statement is saying
─ What is recognized and what is not recognized?─ What are the accounting principles employed?─ How do firms in the same industry differ?
B. Identify the sensitive issues
The financial statements are the lens on the businessThe eye on the lens is the eye of the shareholdersThe lens can be out of focus
Viewing the Business Through the Financial Statements
Business Activities:•Financial Activities•Investing Activities•Operating Activities
Financial Activities Investing Activities Operating Activities
Raise monies from investors
Invest in business assets
Employ assets in trading to “add value”
Return value to investors
The Financial Reports
Management Discussion and Analysis
The Four Financial Statements
Footnotes to the Financial Statements
─Balance Sheet─Income Statement─Cash Flow Statement─Shareholders’ Equity Statement (required by the SEC, not GAAP)
Cash Accounting
2003 CASH
2004 CASH
The Cash Flow Statement
Cash From Operations- Cash investing
= Net cash from operations
- Net cash paid to investors- Shareholders- Debtholders
= Change in cash
Report Cash Added
Cash generated by business
Cash remaining after distribution to investors
Qualcomm Cash Flows: Bottom Line Summary(in millions of dollars)
Cash Flow from Operations 1,782
Cash spent on investments 1,029
Net cash from operations 753
Net cash paid to investors:
To shareholders 103
To debtholders 12 115
Change in cash 638
Does Cash Accounting Draw a Sensible Picture of the Business for the Shareholders?
How much did I make this period?
Investments add to earnings rather than reduce them
Earnings are made (or lost) other than by cash
•Sales on credit•Inputs purchased on credit•Services paid for with stock
How Accrual Accounting Works
Focusing the lens to capture the economics of the businessRecognize revenues when delivery has occurred even if cash has not been receivedExpenses are recognized in the same accounting period as the revenues to which they relateInvestments are placed on the balances sheet, rather than charged to current operations
─Examples:Inventory and Property, plant and equipment
Non-cash effects on shareholder value are recognized (the accruals)─Examples:
Sales on credit─Revenue and accounts receivable
Wages not paid and pensions─Wages expenses and wages payable─Pension expense and pension liability
Thinking about Poor Accrual Accounting
Inappropriate “capitalization”─Recognizing investments as assets rather than expenses
(R&D and brand building)─Recognizing expenses as assets
Here’s the Rub!
Accrual accounting ideally gives a better picture than cash accounting, but accrual accounting requires estimates.
Estimates are really forecasts of the future. They will usually turn out to be wrong, but they should be an unbiased, best guess.
The Accrual Accounting Picture2003The Balance Sheet
2004The Balance Sheet
AssetsLiabilities
EquityAssets
Liabilities
Equity
Report Additions to Equity
The Equity Statement
•Net Additions from share issues and payouts•Additions from the business
The Income Statement
Revenues-Expenses Net income
Navigating the Equity Statement
A. Understand What the Statement is Saying
B. Identify the Sensitive Issues
1. Additions from transactions with shareholders
2. Additions from running the business for the shareholders
Share issues (+)Share repurchases (-)Dividends (-)
Navigating the Income Statement
1. What the Statement is Saying
2. Sensitive Issues
Revenues = Cash + revenue accruals- Expenses = Cash + misclassified + expense
= Net income =
•Misclassification of investments: the “capitalization” question
•Estimates for revenue and expense accruals
Misclassification Estimates
Investments accruals
Revenue Recognition: The Realization Principle
Revenues should be recognized when
The earnings process with respect to the revenue is complete or virtually complete.
The first criterion means that the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenue (usually cash inflow). For most firms, this criterion is satisfied at the time of delivery (by delivering the merchandise or service , the firm has preformed at least most of what it is suppose to do to be entitled to the revenue).
The amount and timing of cash flows from the revenue are reasonably determinable.
The second criterion requires that revenue be recognized in the income statement only if cash has already been collected or the amount and timing of cash to be collected can be estimated with reasonable precision.
Revenue Recognition: The Realization Principle
Implications:
If the firm sold and delivered a product, it should recognize revenue even if it did not collect cash, as long as there is reasonable certainly of collection.
If the firm collected cash but has not delivered the product yet, it should not recognize revenue.
If the firm delivered the product but cannot determine the sufficient precision when and how much cash will be collect, it should not recognize the revenue.
Revenue Recognition: Multiple Deliverables
Qualcomm: Equipment and services
The Key Question: Is revenue recognition aggressive or conservative?
Equipmentdelivery
Service period End of contract
Expense Recognition: The Matching PrincipleThe matching principle requires that each cost be reported as an expense in the same period in which the revenues that the cost helped generate are recognized.
To implement the matching principle, management should first apply the realization principle and decide which revenues to recognize. Then, it should identify all the costs that helped generate those revenues and report them as an expense in the same income statement together with the revenues.
Implications:•Expenditures that generate future revenues are investments•Costs that generate current revenues are expenses
For examples;•Inventory cost is recognized when goods are sold (as cost of goods sold)•Depreciation is recognized over the service life of an asset•Mismatching : the WorldCom con
The Key Questions:•Is the capitalization of expenses appropriate?•Have all costs to generate current expenses been recognized?
Navigating the Balance Sheet1. What the statement is saying?
Assets
Liabilities
Equity
Equity = Asset - LiabilitiesAsset represent
•Probable future benefits•Measurable with reasonable reliability•Resulting from past transaction or events
Liabilities represent•Probable future sacrifice of economic benefits•Measurable with reasonable reliability•Resulting from past transaction or events
2. The Sensitive Issues• Recognition of assets and liabilities• Measurements of assets and liabilities
Measurement in the Balance SheetHistorical Cost Accounting
•Original cost adjusted for accruals to recognize revenues and expenses─PPE: historical cost less accumulated depreciation─Unearned revenue─Accrued expenses─Capitalized costs
Fair Value Accounting•Marking assets to market
─“Trading” and “available-for-sale” securities─Derivatives
•Quasi or estimated fair value─Receivables─Pension liabilities
•Conditional fair valuing: impairment─Inventory: lower of cost or market─PPE─Goodwill
Measurement in the Balance Sheet: QualcommMark-to-Market
Cash and Cash Equivalents $2,045Short-term marketable securities 2,516Long-term marketable securities 611 (out of $811)Accounting Payable 195
Quasi Fair ValueAccounts Receivable, net 484Financing Receivable, net 6
Conditional Fair Value applied to the following historical cost items:Goodwill 347Inventories 110PPE 622
Historical Cost but usually Close to Fair ValueFinancing Debt 226
All other assets and liabilities are at historical cost, adjusted for accruals
The Balance Sheet: The Key Questions
Recognition:•Are liabilities missing? If so, is there transparent footnote disclosure?•What are the contingencies?•What are the executory contracts not recognized?
Measurement:•Are mark-to-market prices from liquid markets?•Are estimated fair values unbiased?•Have impairments been made? Are they unbiased?•Are accruals unbiased?
(Broad) Questions to Ask
Revenue recognition
─Can the revenue recognition policy be characterized as aggressive or conservative?
─How much of the revenue is due to revenues deferred from the past, net of revenues currently deferred ? (Are we baking or eating cookies?)
Is the firm recognizing all expenses necessary to generate revenue?
─Are costs appropriately capitalized?─Are accrued expense liabilities appropriately recognized?
What will be effect of current estimates on future earnings?─Restructuring charges?─Impairments and write-downs?─Allowances?
Are fair values reliable?
Are there transactions that might be interpreted as form over substance?
─Structured finance transactions?─Unconsolidated variable interest entities?─Doubtful arrangements to recognize revenue?
The catch-all question: Do the accounting and the disclosures faithfully and transparently represent the business activities?
(Broad) Questions to Ask