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Communicating and Interpreting Accounting

Information

Chapter 5

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.


Players in the Accounting
Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS

An unqualified opinion states that the


financial statements are fair
presentations in all material respects in
conformity with GAAP.
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Players in the Accounting
Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Information
Partners, Managers, Staff
Intermediaries Guided by GAAS
Analysis and Advice
Financial analysis, Financial analysts make
Information services
predictions concerning
companies’ future earnings
and stock prices.
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Players in the Accounting
Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Information
Partners, Managers, Staff
Intermediaries Guided by GAAS
Analysis and Advice
Financial analysis, Web Info Services:
Information services www.sec.gov; www.compustat.com;
www.finance.yahoo.com;
www.bloomberg.com;
www.hoovers.com; www.factiva.com
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Management
Preparation
CFO, CEO, Accounting Staff
Guided by GAAP

Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS

Information Government
Intermediaries Regulators
Analysis and Advice Verification
Financial analysis, SEC Members
Information services Guided by SEC regs.

Users
Analysis and Decision
Investors, Lenders, etc. Public
companies only
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Ensuring the Integrity of Financial Information
Communication Process
Regulators
Standard Setting and
Verification SEC

Stock Exchanges
PCAOB FASB Corporate
Auditing Standards Accounting Standards Governance
Standards

Management
Primary Responsibility
CFO, CEO, Accounting staff

Directors
Auditors (CPAs) Oversight
Verification Audit Committee
Partners, Managers, Staff
(Independent directors)

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Users: Institutional and Private Investors,
Creditors, and Others

Management
Primary Responsibility
CFO, CEO, Accounting Staff

Information Users
Intermediaries Analysis and Decision
Analysis and Advice Institutional and private
Financial analysts, investors, Lenders,
Information services Suppliers, Customers, etc.

5-7
Guiding Principles for Communicating
Useful Information

Primary Objective of External Financial Reporting


To provide economic information to external users
for decision making.

Primary Qualitative Characteristics


Relevance: Timely and Predictive Feedback Value
Reliability: Accurate, Unbiased, and Verifiable

Secondary Qualitative Characteristics


Comparability: Across businesses
Consistency: Over time
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Guiding Principles for Communicating
Useful Information

Primary Objective of External Financial Reporting


To provide economic information to external users
for decision making.
The full-disclosure principles require . . .
Primary Qualitative Characteristics
1. Relevance:
A complete set
Timely andof financial
Predictive statements,
and Feedback Value
and Unbiased, and Verifiable
Reliability: Accurate,
2.Notes to the financial statements
Secondary Qualitative Characteristics
Comparability: Across businesses
Consistency: Over time
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International Accounting Standards Board and
Global Differences in Accounting Standards

International Financial Reporting Standards

Difference in Accounting Standards US GAAP IFRS


Extraordinary items Permitted Prohibited
LIFO for inventory Permitted Prohibited
Reversal of inventory write-downs Prohibited Required
Basis of property, plant, and equipment Historical cost Fair Value or
Historical cost

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Annual Reports
For privately held companies, annual reports
are simple documents that include:
1. Four basic financial statements.
2. Related notes (footnotes).
3. Report of independent accountants (auditor’s
opinion) if the statements are audited.

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Annual Reports
For public companies, annual reports are
elaborate due to SEC reporting
requirements:
1. A Nonfinancial Section
 A letter to the stockholders, a description of
management’s philosophy, products,
successes, etc.
2. A Financial Section
 See next slide for a detailed listing . . .
5-12
Annual Reports

1. Summarized financial data


for 5- or 10-years.
2. Management Discussion
and Analysis (MD&A). 6. Recent stock price
3. The four basic financial information.
statements. 7. Summaries of the unaudited
4. Notes (footnotes). quarterly financial data.
5. Independent Accountant’s 8. Lists of directors and
Report and the officers of the company and
Management Certification. relevant addresses.

5-13
Quarterly Reports

Usually begin with short letter to stockholders


Condensed unaudited income statement and balance
sheet for the quarter.
Often, cash flow statement and statement of stockholders’
equity are omitted. Some notes to the financial statements
also may be omitted.

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SEC Reports – 10-K, 10-Q, 8-K
Form 10-K Annual Report
•Due within 90 days of the fiscal year-end.
•Contains audited financial statements.

Form 10-Q Quarterly Report


•Due within 45 days of the end of the quarter.
•Financial statements can be unaudited.

Form 8-K Current Report


•Due within 15 days of the major event date.
•Financial statements can be unaudited.

5-15
Classified Balance Sheet
Callaway Golf Company
Consolidated Balance Sheet
December 31,
(in thousands, except share data and per share data) 2006 2005
ASSETS
Current assets:
Cash and cash equivalents $ 46,362 $ 49,481
Accounts receivable, net 118,133 98,082
Inventories, net 265,110 241,577
Other current assets 63,595 49,450
Total current assets 493,200 438,590

Property, plant and equipment, net 131,224 127,739


Intangible assets, net 175,159 175,191
Other assets 46,364 22,978
$ 845,947 $ 764,498
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Classified Balance Sheet
Callaway Golf Company
Consolidated Balance Sheet
December 31,
(in thousands, except share data and per share data) 2006 2005
LIABILITIES & STOCKHOLDERS" EQUITY
Current Liabilities:
Accounts payable and accrued
expenses $ 143,455 $ 140,184
Notes payable, current portion 80,000 21
Total current liabilities 223,455 140,205
Long-term liabilities:
Other liabilities 43,388 28,245
Minority interest 1,987
Commitment and contingencies (Note13)
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Classified Balance Sheet
Callaway Golf Company
Consolidated Balance Sheet
Contributed
December 31,
capital is
(in thousands, except share data and per share data) 2006 2005
normally
SHAREHOLDERS' EQUITY
shown in two
Shareholders' equity:
accounts:
Common stock, $.01 par value,
85,096,782 and 84,950,694 issued 1.Common
and outstanding at December 31, Stock
2006 and 2005, respectively $ 851 $ 850
2.Additional
Additional paid-in capital 141,192 164,202
Retained earnings 435,074 430,996
Paid-in Capital
Total shareholders' equity 577,117 596,048
Total liabilities and shareholders' equity $ 845,947 $ 764,498

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Classified Income Statement

Income statements may contain three sections:


1. Continuing operations
2. Nonrecurring Items
A. Discontinued operations
B. Extraordinary items
3. Earnings per share

5-19
Classified Income Statement

General Format for the Classified Income Statement

Net sales
− Cost of goods sold
Gross profit
− Operating expenses
Income from operations
± Nonoperating revenues/expenses and gains/losses
Income before income taxes
− Income tax expense
Net income

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Earnings Per Share

Net Income*
EPS =
Average Number of Shares of Common Stock
Outstanding During the Period

Basic EPS

*If there are preferred dividends, the


amount is subtracted from the Net
Income in the numerator.

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Common-Size Income Statement
Matrix, International
Income Statement
Month Ended January 31, 2009
Revenues:
Sales revenue $ 66,000 94.56%
Rental income 3,800 5.44%
Total revenues 69,800 100.00%
Total revenue is
Costs and expenses: equal to 100%.
Cost of sales 36,000 51.58%
Salaries & benefits expense 16,000 22.92%
General & administrative expenses 8,100 11.60%
Depreciation expense 2,500 3.58%
Total costs and expenses 62,600 89.68%
Operating income 7,200 10.32%
Other revenues and gains (expenses and losses)
Investment income 1,000 1.43%
Interest expense (60) -0.09%
Gain on sale of land 3,000 4.30%
Income before income taxes 11,140 15.96%
Income tax expense 3,899 5.59%
Net income $ 7,241 10.37%

Earnings per share $ 0.40

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Statement of Cash Flows
Recall that the Statement of Cash Flows is divided
into three major sections.
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.
We will examine the indirect method of preparing
the statement. This format begins with a
reconciliation of accrual income to cash flows
from operations.

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CALLAWAY GOLF COMPANY
Consolidated Statement of Cash Flows
For the Year Ended December 31
(in thousands)
2006
Cash flows from operating activities:
Net income $ 23,290
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation & amortization 32,274
Other non-cash items 14,035
Changes in assets and liabilities, net of effects
from acquisitions:
Accounts receivable, net (12,128)
Inventories, net (16,842)
Other assets (4,475)
Accounts payable and accrued expenses (10,803)
Income taxes payable (6,936)
Other liabilities (1,128)
Net cash provided by operating activities $ 17,287 5-24
CALLAWAY GOLF COMPANY
Consolidated Statement of Cash Flows
For the Year Ended December 31
(in thousands)
2006
Cash flows from operating activities:
Net income Change in Account Balance During $ 23,290
Year
Adjustments to reconcile
Increasenet income to net cash
Decrease
provided by operating
Current Subtract activities:
from net Add to net income.
Assets income.
Depreciation & amortization 32,274
Current Add toitems
Other non-cash net income. Subtract from net
14,035
Liabilities income.
Changes in assets and liabilities, net of effects
from acquisitions:
Accounts receivable, net (12,128)
Inventories, net (16,842)
Other assets (4,475)
Accounts payable and accrued expenses (10,803)
Income taxes payable (6,936)
Other liabilities (1,128)
Net cash provided by operating activities $ 17,287 5-25
Consolidated Statement of Cash Flows
2006
Cash flows from investing activities
Capital expenditures $ (32,453)
Acquisition, net of cash acquired 374
Investment in marketable securities (10,008)
Proceeds from sale of assets 469
Net cash used in investing activities $ (41,618)
Cash flows from financing activities:
Issuance of common stock 9,606
Acquisition of treasury stock (52,872)
Proceeds from line of credit (net) 80,000
Other financing activities 2,549
Dividends paid, net (19,212)
Net cash used in financing activities $ 20,071
Effect of exchange rate changes on cash 1,141
Net decrease in cash and cash equivalents (3,119)
Cash and cash equivalents at beginning of year 49,481
Cash and cash equivalents at end of year $ 46,362 5-26
Notes to Financial Statements
Descriptions of the key accounting rules
that apply to the company’s statements.

Additional detail supporting reported


numbers.

Relevant financial information not


disclosed on the statements.

5-27
Return on Equity (ROE) Analysis

Return
Net Income
on =
Average Stockholders’ Equity1
Equity

ROE measures how much the firm


earned for each dollar of
stockholders’ investment.

1(beginning equity + ending equity) ÷ 2


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ROE Profit Driver Analysis
Net Profit Asset Financial
ROE = × ×
Margin Turnover Leverage

Average
Net Income
Net Sales Total Assets
Average Net Income
=
× Average × Average
Stockholders’ Net Sales
Total Assets Stockholders’
Equity
Equity

5-29
Profit Drivers and Business Strategy

High-value or product-differentiation.
Rely on R&D and product promotion to convince
customers of the superiority of your product.

Low-Cost.
Rely on efficient management of accounts receivable,
inventory and productive assets to produce
high asset turnover.

5-30
Chapter Supplement: Nonrecurring Items

General Format for the Classified Income Statement


In addition, companies may have nonrecurring
items. These
Net salesnonrecurring items may include:
− Cost of goods sold
1. Discontinued operations,
Gross profit
2. Extraordinary items,
− Operating expenses
Income from operations
These±items are reported
Nonoperating separately
revenues/expenses andbecause
gains/losses
they areIncome
not useful in predicting
before income taxes future income
of the−company.
Income tax expense
Net income

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Discontinued Operations

Sale or abandonment of a segment of a


business.

Income or loss on Gain or loss on


segment’s operation for disposal of the
the period. segment.

Show net of applicable taxes.


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Extraordinary Items

Unusual Infrequent

Show net of applicable taxes.


5-33
End of Chapter 5

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.