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1 FRAMEWORK FOR FINANCIAL STATEMENT ANALYSIS CHAPTER OUTLINE INTRODUCTION {EED FOR FINANCIAL STATEMENT ANALYSIS, FOCUS ON INVESTMENT DECISIONS Classes of Users Fiswnstal Infermatnen aml Cupid Markets THE FINANCIAL REPORTING SYSTEM Genetul Prnetples and Mearuroment Rules THE U.S. FINANCIAL REPORTING SYSTEM. Secunties und Exchange Commission onaneral Accounting Stardaris Beard Pst oct Braman INTERNATIONAL ACCOUNTING STANDARDS: Inverrationg! Organization of Seeurites Commissions, International Aezonnting Stondards Board Eurepoun Finanem) Reporting Standacas SEC REPORTING REQUIREMENTS FOR FOREIGN, REGISTRANTS CHAPTER OBJECTIVES The guals af dhs chapter seein. 1 Explain why finane al statericnt analysis m nesded, 2. Dances the gensral principles of the financial repert= ng systers, 2. Compare the les of the Finaneral Aecoumting Stans ards Board arc! the Securines and Exclauge Coun- smssten in setting 1.5. GAAP PRINCIPAL FINANCIAL STATEMENTS, “The Balance Sheet tonto the Balen Sh “The Income Stacement ements of hie Ie Suton Statoinent of Compechensive Income Statement aPC ash Ets Statoment of Stockholders’ Lguly oceneten Contingencies iste and Cncertoomin snedules Supplementary OTHER SOURCES OF FINANCIAL INFORMATION Management Paseussson and Anulyts Other Dats Sources ROLE OF THE AUDITOR Repeung on Uncertainties Other Auditor Services Changing Auditors Auditing Outside of the Unnted States SUMMARY Review the elements of the PASAY comeeptust ‘eamework 5, Dnouss the progrcss in setting global accounming, standards gad the role of the Jaternationsl Account ing Standands Board fines describe the priseypal finaneta statements Balanoe Shoe, Income Statement Statement of CHAPTER 1 I RAMPWORIC FOR FINANCIAL STATEMENT ANALYSIS Campreheasive Income, Statement of Cash Flows, 8. Describe the usefulness of the Management Discussion and Statemnent of Stockholders’ Equily and Anelysis and othar sources of financial information, 7. Discuss the usefulness of financial statement foo 9. Discuss the role of the independent zuditor and infor- notes and supplementary dara. ‘mation conveyed by the suds opinion, INTRODUCTION Why are financial statements useful? Because they help investors ond creditors make better ecunumnic decisions. The goal of this book is to enhance financial statement users” wader standing ef fnancial reporting in order te facilitate improved cccision makiug. We will ex- amine the impact of the differential application of accounting methods and estimstes on financial statements, with panicular emphasis on the effect of accounting choices on reported. ccarmings, stockholders’ equity. cash flow, and various measures of corporate performance (exclnding, bur not limted to, fnancia ratios). We will also stress the use of cash flow analy- sis to evaluate the financial health of an enterprise, Finaneial statements are, at best, only an approximation of economic reality because of the selective reporting of economic events by th: accounting system, compounded by alter- native accounting methods and estimates. The tendency to delay accounting recognition of some transactions and valuation changes means that financial statements tend to lag bebind reality as wel This chapter provides a framework for the stuxly of financial statement analysis. This framework consists of the users being served, the information system available to them, and the institutional structure within which they interac NEED FOR FINANCIAL STATEMENT ANALYSIS ‘The United States has the most complex financial reporting system in the workd. Detailed ac- ‘counting principles are augmented by extensive disclosure requirements. The financial state meats of large naltiaaionals add up to dozens of pages, and many of these finns voluntarily ‘Publish additional “fact books” for dissemination to financial analysts and other interested users. Finaneial reporting in other major Geveloped countries and many emerging markets has 4tso evolved substantially in recent years, with ab increasing emphasis on providing informa- tion useful to both domestic and foreign czeditors and equity investors. International Ac- ‘counting Standards have bevomne a credible rival te US, standards, Ti an ideal world, the user of financial statements could focus only on the hottor lines ‘of financia! reporting: net income anc stockholders’ equity. If financial statements were com- ‘parable among companies (regacless of country), consistent over time, and always fully re- flecting the economic position of the fim, fancial statement analysis would be simple, andl this text a very short one. ‘The financial reporting system is nor perfect. Economic events and accounting enties do not coreespond precisely; they diverge actoss the dimensions of timing, recognition, ard measurement, Financial analysis and investment decisions are further complicated by varia ‘tons in accounting zrestment among countries in each of these dimensions. Econornie events ind accounting recagaition of those events frequently take place at dif- ‘erent tines. One cxaraple ofthis phenomenon is the recognition of capital gains and losees couly upon sale in most cases. Appreciation ofa realestate investment, which took place over a period of many years, for example, receives income statement recognition only in the pe- riod management chooses for its disposal.) “However. in counties (such ay the Uiited Kingdom] where peri ose evaluation is permied, balance sheet renigation af marker value shonges may oocur mh 004er HOCUS OS ISR SIME SE DEE HESS. 3 Similaely: long lived axsers are written Gown, angst aF ihe bine, in she fiscal pend a management's chores, [he period af recogmmaen may Be nether the pestad in which the in= pauument tock place nor the period of sale or disposal, Accounning fur dléscontinved opeca- ‘wots. nthe same mannet. results ta recogen Bla [oss on a perivel davferent Fem when the lows ocetned oF tie disposal i corsamnntel? In addinon, aany econonne events de not receive accounting recagpibon at all. Most oneracts, for example, are not reflected ie financial starements when entered inte, despize \gnifiean! effects en finanesal condition aud operating and financial nk Some contacts. such a Ieases and heilgimy achivites, are recoenized an the nancval statements by some csamapantes bul disclosed oely i Foornates by achers. Disclosure requirements for derivatives ind hedging actsittes ae in place in many Jurisdictions, hus eecognition and measurement 1s only recentiy required” in the United St Vurther. genera accepted accounting principles (GAAD) in the United Status and else shore permit econerme events that do Heceive accounting recognition to be recognized in different ways by different finaneial siatemen: preparers, Inventory and deprecisiwen of fixed assets arg only 10 of the Sigavfigant areas where comparability may be Lacking. Finaracsal repos often continn supplementary data that, although net included i the stare- iments themselves, help the Snanctal statenient wsee te imerpeet che statements or adjust measures ff exrponate periormance (sich a financial anes) t) make the’ more eompacuble. consistent ‘ver tig, ond more representative of economic reality. When makiog adjustments te financial Siatemients, we wll seck to discern Substance from foam and explo! the infomation wontained in footnotes and supplementary

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