business journalism professors 2014: teaching financial statements by jimmy gentry

Understanding Financial Statements

Business Journalism Professors

Jan. 4, 2014

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Donald W. Reynolds National Center For Business Journalism At Arizona State University

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n  James K. Gentry, Ph.D. n  Clyde M. Reed Teaching Professor n  School of Journalism and Mass Communications n  University of Kansas n  jgentry@ku.edu

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Types of Statements n  Public n  Private

n  Financial statements conforming to public company statements

n  Non-profits

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Important Terms n  Unaudited n  Audited n  Accountants n  Certified Public Accountants (CPAs) n  GAAP, FASB, AICPA, PCAOB

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Assessing a Company n  Context n  Trends n  Rules n  Outsiders n  Insiders

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Annual Report,10-K n  Annual report,10-K wrap, 10-K n  Auditor’s report: Clean, qualified? n  MD&A or Management’s Discussion

and Analysis n  Financial statements and footnotes n  Management’s letter if annual report

Traditional Auditor’s Report n  Independent auditor’s opinion on whether

financial statements are presented fairly in all material respects, in accordance with GAAP: n  We looked at these statements n  They’re management’s responsibility; we’re just

here to express our opinion n  We followed the rules in our audits and here’s

what an audit involves n  In our opinion, the statements fairly present the

company’s position

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Auditor’s Report by Category

n  Clean or Unqualified n  Qualified n  Disclaimer n  Adverse

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New Auditor’s Report n  Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act

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Sarbanes-Oxley Act of 2002

n  Response to abuses with Enron and WorldCom as catalysts

n  New responsibilities, resources for SEC n  Created PCAOB n  Major emphasis on “internal controls” n  More disclosure for public companies

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Sarbanes-Oxley Act n  Analysts must state potential conflicts of interest n  Limited types of services accounting firms can

provide to public company clients n  Companies disclose in 10-K the fees pay to auditors n  Recent concerns n  Consulting

n  CEO, CFO attest to accuracy, completeness, fairness of financial statements

n  Rigorous penalties for fraud, other misdeeds n  Clawbacks

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Public Company Accounting Oversight Board n  Created by SOX to oversee accounting n  Began operating in 2003 n  SEC appoints five members to five-year

terms n  Two members must be or have been CPAs n  All members must be “financially literate” n  In 2008, Supreme Court upheld PCAOB but

said SEC couldn’t remove board members

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PCAOB’s Duties

n  Set rules on “auditing, quality control, ethics, independence, and other standards…”

n  Conduct “inspections” of accounting firms

n  Conduct “investigations and disciplinary proceedings”

n  Enforce compliance with SOX

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Section 404: Internal Controls n  “Management Assessment of Internal

Controls” n  Each 10-K must contain an “internal control

report” that: n  States management is responsible for internal

control structure and procedures n  Contains an assessment on effectiveness of

internal control structure and procedures

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Management on the Spot n  Section 404: Management must evaluate and

test internal controls over financial reporting, including anti-fraud programs, annually.

n  Management certifies that it does (or doesn’t) have adequate internal controls in place.

n  Independent board members easier to attract n  Auditor attests to adequacy of controls. n  Management to be forced to answer for

fraudulent activities, misconduct, etc.

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Private Company Impact n  Banks, insurers requiring companies to

embrace SOX. n  Now most private firms have audited financial

statements n  If private company owners want to sell to

public company, must be in compliance n  Private equity funds more willing to invest in

companies in compliance n  Best outside directors

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Non-Profit Impact n  Audit committees, independent members n  CEO, CFO attest to accuracy, completeness,

fairness of financial statements n  Financial statements more accessible n  Codes of ethics n  Rules governing transactions with “insiders”

Goal of accounting n  Record, classify and report financial

transactions. To provide managers across the organization with information that facilitates: n  Control of activities and expenditures n  Refinement of operational plans n  Accountability n  Reporting on project outcomes n  Writing of bids for new funds

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Goal of Finance n  Maximize shareholder wealth as

reflected in market price of the stock n  Achieving this goal requires financial

manager to focus on economic profit, not accounting profit

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Financial Decisions n  Investing decisions: Types of assets

firm wants to hold. n  Financing decisions: Acquisition of

funds needed to support long-term investments.

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Generally Accepted Accounting Principles n  Guidelines based on theory and

practice n  Evolved over time n  Procedures, concepts and standards

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GAAP n  Periodicity n  Going concern n  Economic entity n  Monetary unit n  Full disclosure n  Historical cost n  Consistency

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GAAP n  Materiality n  Industry practices n  Conservatism

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Specialized Industry GAAP n  Banking and thrift industries n  Benefit plans, including pension funds n  Broadcasting industry n  Cable television industry n  Computer software n  Finance companies n  Investment companies

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Cash or Operating Cycle n  Cash n  Purchase inventory n  Produce product n  Sell product n  Cash

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Cash or Operating Cycle (cont.) n  “Cash”

n  Cash n  Receivables and payables n  Debt

n  Inventory n  Raw materials n  Work in progress n  Finished goods

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Cash or Operating Cycle (cont.) n  Sell product

n  Accounts receivable n  Cash

n  Cash n  Collect receivables as cash

n  Pay off payables n  Start over

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Accrual Method n  Records revenues when the the “sale”

occurs n  Records expenses when the bill is

received n  IE, transactions enter the financial

records when they occur, not when cash changes hands

n  Accrual method, therefore, shows “scores,” not real spendable dollars

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About These Numbers: They’re Squishy n  Goods will not necessarily be paid for n  Goods are not necessarily going to be

kept n  Inventory might be out of date, obsolete

or unsellable n  Status of some inventory may be

uncertain n  Intangible assets are estimates

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About These Numbers: They’re Squishy (cont.) n  Machinery or other fixed assets might

be obsolete or falling apart long before the so-called useful life is up

n  Goodwill n  Accounting conventions n  Timing issues n  Bottom line: In many ways, statements

are a collection of estimates.

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Because They’re Squishy n  You need to know the rules and

assumptions used to create the numbers

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Income Statement or ... n  Statement of earnings n  Statement of operations n  Statement of income and

comprehensive income

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Income Statement n  Covers a period of time, typically a year

or quarter n  Reports income from ongoing activities n  Reports income from activities beyond

management’s control (comprehensive income)

n  Involves estimates

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Basic Income Statement n  Sales or revenues n  Expenses n  Taxes n  Net income or profit

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Income Statement n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit n  Other income/expenses n  Interest n  Income taxes n  Net income or profit

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Cost of Goods Sold n  Expenses incurred in the cost of

manufacturing or creating or acquiring the product the company sells.

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Cost of Goods Sold n  Manufacturer: What the company pays

for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.

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Cost of Goods Sold

n  Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.

n  Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.

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SGA n  Includes office expenses, accounting,

shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.

n  Often includes depreciation and amortization.

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Other Income/Expenses n  Discontinued items n  Unusual/extraordinary items n  Changes in accounting principle n  Impairment charge n  Sale of investment n  Minority interest

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Thinking Inside the Box n  Revenues n  Minus cost of goods sold n  Equals gross profit n  Minus operating expenses n  Equals operating profit n  Minus or plus other expenses/income n  Minus or plus interest expenses/income n  Minus income taxes n  Net income

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Inside the Box Earnings n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit

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‘One-Time’ Gains That Reoccur n  Don’t be fooled by extraordinary items

that make the net income look better than it really is

n  Extraordinary items should be both unusual in nature and infrequent in occurrence

n  Examples: Writedowns, restructurings, etc.

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Earnings Per Share n  Basic earnings per share

(Bloomberg) n  Diluted earnings per share (Wall

Street Journal, fully diluted)

Calculating EPS n  Basic: Net income for period divided by

weighted average number shares outstanding.

n  Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.

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Dividend n  Company’s board of directors decides to

distribute a portion of a company's net income to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share).

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Dividend Payout Ratio n  The percentage of a company’s net

income that is paid to shareholders in dividends.

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Dividend Payout Ratio Dividend per share Earnings per share Dividend payout Net Income for same period

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Dividend Yield n  How much a company pays out in dividends

each year in relation to its stock price. n  A way to measure how much cash flow you

are getting for each dollar invested in an equity position. Investors who require a minimum stream of cash flows from their investments can secure this by investing in stocks paying relatively high, stable dividend yields.

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Dividend Yield Dividend Stock price $1 vs. $1 $20 $40 5% 2.5% Strictly Financials

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Looking at Dividends n  In general, investors react poorly to a

decrease in dividends, and the stock price usually declines as investors seek other dividend-paying stocks.

n  A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors.

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Balance Sheet n  It balances n  Assets = Liabilities + Shareholders’

Equity

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Assets n  Current assets

n  Cash and cash equivalents n  Accounts receivable n  Inventories n  Prepaids

n  Investments and other assets

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Assets n  Property, plant and equipment, net

n  Land and improvement n  Buildings and improvements n  Equipment n  Less accumulated depreciation

n  Goodwill and other intangibles

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Goodwill and Impairment n  Difference between what a business

pays to buy another company and the book value (total assets minus total liabilities) of that company

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Liabilities n  Current liabilities

n  Accounts payable n  Accrued liabilities n  Income taxes n  Current maturity of long-term debt

n  Noncurrent liabilities n  Long-term debt n  Deferred income taxes

n  Commitments and contingencies

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Shareholders’ Equity n  Capital stock

n  Preferred stock n  Common stock

n  Additional paid-in capital n  Retained earnings n  Treasury stock

n  Total shareholders’ equity n  Total L + OE

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Statement of Cash Flows n  Record of cash provided by cash

sources and of cash consumed by cash uses.

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Cash Flows (cont.) n  Information about use of cash n  Information about investing and

financing n  Ability to continue as a going concern n  Ability to generate future positive cash

flows n  Ability to meet obligations and pay

dividends

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Cash Flows n  From operations n  From investing n  From financing

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Flexibility n  Companies have some flexibility in

categories for entries. n  Total change in cash, however, will not

change. n  Overwhelming majority of all accounting

standards deal with balance sheet and income statement, not cash flows statement.

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Free Cash Flow n  Powerful tool for making a company

successful n  Powerful indicator for investors n  Cash that is left over after productive

capacity is maintained or expanded n  Permits expansion, paying down debt,

buying back shares, etc.

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Free Cash Flow (cont.) n  Several ways to calculate it n  Companies create their own models n  Gross way to do it:

n  Cash from operating activities n  Minus capital expenditures n  Equals free cash flow

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American Standard Model

n  Cash from operating activities n  Minus capital expenditures n  Plus proceeds from disposal of property n  Plus proceeds from sale and

leasebacks n  Equals free cash flow

Free Cash Models n  ‘Gross’ method n  American Standard method n  VF method

n  Cash from operating minus cash from investing

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Keys to Looking at Cash n  Cash from operations n  Capital expenditures (cap ex) n  Free cash n  Cash and cash equivalents at the end

of the year

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Looking at the Numbers n  Note changes in amounts year to year, especially

revenues and expenses n  Note numbers that are significantly larger or smaller

than the previous period n  Look at trend line for sales/revenues, operating

income and net income. Calculate percentage change for each.

n  Look at cash flow n  Look at free cash flow n  Tie the numbers to the footnotes.

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Techniques n  Calculate percentage change n  Trend analysis n  Common size analysis n  Ratio analysis