class 1 the language of accounting, the corporate annual report, and the sec
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Class 1Class 1The Language of Accounting,The Language of Accounting,The Corporate Annual Report,The Corporate Annual Report,
and the SECand the SEC
Companies Under InvestigationCompanies Under Investigation
AldelphiaAldelphiaArthur AndersenArthur AndersenAOLAOLBristol Myers SquibbBristol Myers SquibbComputer Associates InternationalComputer Associates InternationalDeloitte & ToucheDeloitte & ToucheEnronEnronErnst & YoungErnst & YoungGlobal CrossingGlobal Crossing
Investigation cont’dInvestigation cont’d
HalliburtonHalliburtonImcloneImcloneKmartKmartKPMGKPMGPeregrinePeregrinePricewaterhouseCoopersPricewaterhouseCoopersQwestQwestTycoTycoWorldcom Inc.Worldcom Inc.XeroxXerox
Why?Why?
Quality of earningsQuality of earnings
Where were the auditors?Where were the auditors?
Responsibility of managementResponsibility of management
What is accounting?What is accounting?
Often called the language of Often called the language of businessbusiness
– Measures financial aspects of a Measures financial aspects of a businessbusiness
– Communicates this information to Communicates this information to decision makersdecision makers
Why should Why should everyoneeveryone in in business study accounting??business study accounting??
Many business decisions are based on Many business decisions are based on accounting information.accounting information.
Since accounting information is prepared Since accounting information is prepared according to “rules,” an understanding of according to “rules,” an understanding of these rules is necessary for the these rules is necessary for the appropriate use of the information.appropriate use of the information.
Personal need for understanding financial Personal need for understanding financial statementsstatements
The Accounting EquationThe Accounting Equation
Assets = Claims orAssets = Claims or
Assets = Liabilities + EquityAssets = Liabilities + Equity
AssetAsset: something of value: something of value
LiabilityLiability: something owed (creditors’ : something owed (creditors’ share of the assets)share of the assets)
EquityEquity: what remains (owners’ share of : what remains (owners’ share of the assets)the assets)
Four Basic Financial StatementsFour Basic Financial Statements
Balance SheetBalance Sheet– Assets = Liabilities + EquityAssets = Liabilities + Equity
Income StatementIncome Statement– Revenues - Expenses = Net incomeRevenues - Expenses = Net income
Statement of Changes in EquityStatement of Changes in Equity– Beginning equity + Contributions + Net income - Beginning equity + Contributions + Net income -
Distributions = Ending equityDistributions = Ending equity
Statement of Cash FlowsStatement of Cash Flows– Cash inflow - Cash outflow = Net cash flowCash inflow - Cash outflow = Net cash flow
The Annual Report includes:The Annual Report includes:
financial statementsfinancial statements
notes to the financial statementsnotes to the financial statements
auditor’s reportauditor’s report
5-year summary of key financial data5-year summary of key financial data
high and low stock selling priceshigh and low stock selling prices
management discussion & analysis of management discussion & analysis of operations (“forward-looking” info)operations (“forward-looking” info)
On-line Annual ReportsOn-line Annual ReportsMost companies provide their annual Most companies provide their annual reports online. Click on the link below to reports online. Click on the link below to look at Delta Airlines’ most recent annual look at Delta Airlines’ most recent annual report. report. Delta Annual ReportDelta Annual Report
Describe the 2004 operating resultsDescribe the 2004 operating results
What steps has Delta taken to improve What steps has Delta taken to improve corporate governance?corporate governance?
NotesNotes
Are an INTEGRAL part of the statementsAre an INTEGRAL part of the statements
Provide summary of accounting policiesProvide summary of accounting policies
Present detail about particular accounts Present detail about particular accounts (e.g. inventory, investments, etc.)(e.g. inventory, investments, etc.)
Include other information (e.g. leasing Include other information (e.g. leasing arrangements, pending legal proceedings, arrangements, pending legal proceedings, income taxes, etc.)income taxes, etc.)
Notes (more stuff included)Notes (more stuff included)
Contain some supplementary information Contain some supplementary information required by SEC and FASBrequired by SEC and FASB
Examples include:Examples include:– information on foreign currency translations for firms information on foreign currency translations for firms
doing business in/with foreign countriesdoing business in/with foreign countries– information by segment for firms with several lines of information by segment for firms with several lines of
businessbusiness
Look at Look at Delta’sDelta’s notes…what is included in Notes notes…what is included in Notes 1 and 20?1 and 20?
Auditor’s ReportAuditor’s Report(Delta p. 50)(Delta p. 50)
Unqualified (what you want!) -- states that Unqualified (what you want!) -- states that statements present information in conformity statements present information in conformity with GAAP (sometimes with explanatory with GAAP (sometimes with explanatory language)language)Sometimes qualified or adverse opinions are Sometimes qualified or adverse opinions are issued (not what you want!)issued (not what you want!)DisclaimerDisclaimerKeep in mind that auditor is hired by the firm Keep in mind that auditor is hired by the firm -- always the possibility of conflict of interest-- always the possibility of conflict of interest
Look at an auditor’s opinionLook at an auditor’s opinion
Auditor’s ReportAuditor’s Report(Delta p. 50)(Delta p. 50)
Click on the link above and try to find the Click on the link above and try to find the auditor’s opinion (Hint: It’s after the notes)auditor’s opinion (Hint: It’s after the notes)
What type of opinion is it and who were What type of opinion is it and who were their auditors in 2004?their auditors in 2004?
Example of a qualified opinionExample of a qualified opinionThe accompanying consolidated financial statements The accompanying consolidated financial statements have been prepared assuming Carolco Pictures Inc. and have been prepared assuming Carolco Pictures Inc. and subsidiaries will continue as a going concern. As more subsidiaries will continue as a going concern. As more fully described in Note B, the Company has incurred fully described in Note B, the Company has incurred continuing significant losses and has a deficiency in continuing significant losses and has a deficiency in assets $64,521,000 at December 31, 1994. Further, the assets $64,521,000 at December 31, 1994. Further, the Company has experienced significant cash flow Company has experienced significant cash flow difficulties and does not have sufficient cash resources difficulties and does not have sufficient cash resources and financing sources to meet its operating expenses and financing sources to meet its operating expenses and scheduled debt service obligations, and continue to and scheduled debt service obligations, and continue to fund its principal business activity. These conditions fund its principal business activity. These conditions raise substantial doubts about the Company's ability to raise substantial doubts about the Company's ability to continue as a going concern. (Management's plans in continue as a going concern. (Management's plans in regard to these matters are also described in Note B). regard to these matters are also described in Note B). The 1994 consolidated financial statements do not The 1994 consolidated financial statements do not include any adjustments that might result from the include any adjustments that might result from the outcome of this uncertainty. outcome of this uncertainty. Carolco Pictures produced the Terminator movies!Carolco Pictures produced the Terminator movies!
MD&A (Financial Review)MD&A (Financial Review)
1.1.Internal/external sources of liquidityInternal/external sources of liquidity
2.2.Any material deficiencies in liquidity and Any material deficiencies in liquidity and how they will be remediedhow they will be remedied
3.3.Commitments for capital Commitments for capital expenditures/sources of fundingexpenditures/sources of funding
4.4.Anticipated changes in mix and cost of Anticipated changes in mix and cost of financing resourcesfinancing resources
MD&A (continued)MD&A (continued)
5.5.Unusual/infrequent transactions which Unusual/infrequent transactions which affect income from continuing operationsaffect income from continuing operations
6.6.Events causing material changes in Events causing material changes in cost/revenue relationships (e.g. future cost/revenue relationships (e.g. future price increase)price increase)
7.7.Breakdown of sales increases in price & Breakdown of sales increases in price & volume componentsvolume components
““PR Fluff”PR Fluff”
Amount sometimes varies INVERSELY Amount sometimes varies INVERSELY with performance...with performance...
Can visit many corporate websites to view Can visit many corporate websites to view some interesting “creations”some interesting “creations”
SEC FilingsSEC Filingshttp://http://www.sec.govwww.sec.gov
10K10K
10Q10Q
8K8K
ProspectusProspectus
What is insider trading? What is insider trading? SEC’s answerSEC’s answer
CEO/CFO certificationCEO/CFO certificationSection 302 of the Sarbanes-Oxley Act requires the Section 302 of the Sarbanes-Oxley Act requires the principal executive and financial officers of a company principal executive and financial officers of a company filing periodic reports to certify in each quarterly and filing periodic reports to certify in each quarterly and annual report that the report does not contain any annual report that the report does not contain any untrue statement of a material fact or omit to state a untrue statement of a material fact or omit to state a material fact necessary in order to make the material fact necessary in order to make the statements made, in light of the circumstances under statements made, in light of the circumstances under which such statements were made, not misleading, which such statements were made, not misleading, and the financial statements, and other financial and the financial statements, and other financial information included in the report, fairly present in all information included in the report, fairly present in all material respects the financial condition and results of material respects the financial condition and results of operations of the company.operations of the company.Section 906 of the Sarbanes-Oxley Act adds a Section 906 of the Sarbanes-Oxley Act adds a provision to the U.S. criminal laws that contains a provision to the U.S. criminal laws that contains a separate certification requirement. This provision separate certification requirement. This provision expressly created new criminal penalties for a expressly created new criminal penalties for a knowingly or willfully false certification.knowingly or willfully false certification.
Do rules = uniformity?Do rules = uniformity?
GAAP provide some measure but they GAAP provide some measure but they allow considerable discretionallow considerable discretion
Accounting choices and estimates affect Accounting choices and estimates affect amounts on financial statementsamounts on financial statements
Depreciation of fixed assets is a good Depreciation of fixed assets is a good example (choice of method, different example (choice of method, different “good faith” estimates possible) “good faith” estimates possible)
Accounting PeriodAccounting Period
Another complexityAnother complexity
Although the firm’s life is continuous, Although the firm’s life is continuous, financial data is presented for arbitrary financial data is presented for arbitrary time periods -- year, quarter and the liketime periods -- year, quarter and the like
Leads to need for more adjustments and Leads to need for more adjustments and estimatesestimates
Statements are prepared on “accrual” Statements are prepared on “accrual” basisbasis
Cash versus “Accrual”Cash versus “Accrual”
Financial statements are prepared on an Financial statements are prepared on an “accrual” basis“accrual” basis
Attempt to MATCH expenses with revenue Attempt to MATCH expenses with revenue in a given accounting periodin a given accounting period
Revenues reported when “earned” rather Revenues reported when “earned” rather than when received in cashthan when received in cash
Expenses are recorded when incurred Expenses are recorded when incurred rather than when paid in cashrather than when paid in cash
More Sources of “Confusion”More Sources of “Confusion”
Earnings per shareEarnings per share
Consolidation of parent and subsConsolidation of parent and subs
Reporting leasesReporting leases
Reporting pensionsReporting pensions
Translation of foreign operationsTranslation of foreign operations
Off-balance sheet financingOff-balance sheet financing
Accounting for derivativesAccounting for derivatives(continued…….)(continued…….)
Even MORE Confusion...Even MORE Confusion...
““Comprehensive” income reportingComprehensive” income reporting
Two sets of books (yes, it’s legal!!) - Two sets of books (yes, it’s legal!!) - financial vs. tax reportingfinancial vs. tax reporting
Pro forma earningPro forma earning
Quality of Financial ReportingQuality of Financial Reporting
Management has considerable discretion Management has considerable discretion within GAAPwithin GAAP
Potential exists to “manipulate” the Potential exists to “manipulate” the profit/loss reportedprofit/loss reported
The closer the financial data presented The closer the financial data presented represent financial reality, the higher the represent financial reality, the higher the quality of the financial statements and quality of the financial statements and reported earningsreported earnings
Means to Affect QualityMeans to Affect Quality
Accounting policies and estimatesAccounting policies and estimates– choices and changeschoices and changes
Timing of revenues and expensesTiming of revenues and expenses
Discretionary itemsDiscretionary items
Nonrecurring and nonoperating itemsNonrecurring and nonoperating items
ALL ARE WITHIN THE PURVIEW OF ALL ARE WITHIN THE PURVIEW OF MANAGEMENTMANAGEMENT
Accounting Policies/EstimatesAccounting Policies/Estimates
ChoicesChoices– Management may choose among acceptable Management may choose among acceptable
accounting policiesaccounting policies– Management has opportunity to make Management has opportunity to make
estimates when applying policiesestimates when applying policies
ChangesChanges– Policy or estimate may be changedPolicy or estimate may be changed
Timing of Revenues/ExpensesTiming of Revenues/Expenses
Matching process involves judgments by Matching process involves judgments by management regarding recognition of management regarding recognition of revenues and/or expensesrevenues and/or expenses
Usually the more conservative the Usually the more conservative the approach (least favorable to management) approach (least favorable to management) the higher the quality of earningsthe higher the quality of earnings
Discretionary ItemsDiscretionary Items
Budget level and timing of expenditures for Budget level and timing of expenditures for many items are discretionary, e.g.many items are discretionary, e.g.– advertising/marketingadvertising/marketing– repairs/maintenancerepairs/maintenance– research and developmentresearch and development– capital expansioncapital expansion
Nonrecurring and Nonoperating Nonrecurring and Nonoperating ItemsItems
Nonrecurring and nonoperating items are Nonrecurring and nonoperating items are not part of normal ongoing businessnot part of normal ongoing business
Earnings figure should reflect Earnings figure should reflect futurefuture operating potentialoperating potential
Therefore segregate such things as major Therefore segregate such things as major asset sales, accounting changes, asset asset sales, accounting changes, asset impairments, extraordinary itemsimpairments, extraordinary items
Look at an example of an Look at an example of an accounting changeaccounting change
Coca Cola Annual ReportCoca Cola Annual Report
Is the accounting change shown net of Is the accounting change shown net of tax? P. 17tax? P. 17
Look at page 24 of the annual report. Look at page 24 of the annual report. What SFAS caused the change?What SFAS caused the change?
What about Inflation???What about Inflation???
Historical cost principle prevails in financial Historical cost principle prevails in financial reportingreporting
Impact of inflation is uneven -- relevance Impact of inflation is uneven -- relevance vs. reliability tradeoffvs. reliability tradeoff
Produces both purchasing power gains Produces both purchasing power gains and losses -- e.g. debt is good in and losses -- e.g. debt is good in inflationary situationinflationary situation
Missing InformationMissing Information
Morale/efficiency of employeesMorale/efficiency of employees
Reputation/public perceptions of firmReputation/public perceptions of firm
Effectiveness of management Effectiveness of management team/provisions for successionteam/provisions for succession
Potential exposure to regulatory changesPotential exposure to regulatory changes
IMPACT OPERATING SUCCESS BUT IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFYARE DIFFICULT TO QUANTIFY
What about publicity?What about publicity?
Affects public perception of firm and can Affects public perception of firm and can impact financial performanceimpact financial performance
Proven correlation between financial Proven correlation between financial returns and reputationreturns and reputation
Recent examples are adverse publicity for Recent examples are adverse publicity for Coca Cola and Northwest Airlines -- Coca Cola and Northwest Airlines -- countered by the respective companies to countered by the respective companies to minimize impactminimize impact
What Info is Hard to Find?What Info is Hard to Find?
Many items must be extracted from notes, Many items must be extracted from notes, supplementary schedules, MD&A section in supplementary schedules, MD&A section in order to interpret financial statement order to interpret financial statement numbers - the facts numbers - the facts areare there, but they are there, but they are not self-evident!not self-evident!
Coverage in Chapters 2-5 is geared to Coverage in Chapters 2-5 is geared to helping FIND and EFFECTIVELY USE helping FIND and EFFECTIVELY USE information in financial statements and information in financial statements and supplementary materialssupplementary materials
That’s all!That’s all!