Financial Reporting

and Analysis

2
CHAPTER
 Financial Reporting
 
Environment  
 
Regulators Industry Alternative Information  
   
  Practices Sources  
 
 
Economy and Industry  
Information  
 
   
FASB GAAP Managers Voluntary  
 
Disclosure  
AICPA  
 
 
Analysts  
 
Statutory Financial Reports  
(Financial Statements)  
 
 
 
 

Investors
and
Corporate
SEC Litigation Auditors Creditors
Governance
Other
Users
Enforcement and Monitoring Mechanisms Users
 Form 10-K 10-Q
(Annual Report) (Quarterly Report)

20-F 8-K
(Registration Statement/ (Current Report)
Annual Report [Foreign])

Statutory Financial Reports

14-A Other
(Proxy Statement/
Prospectus) SEC Filings
 Earnings Announcements

• Key summary measures (pre-audit)

• Often one to six week lag
• Informative to market
• Lacks supporting financial details
 Environmental Factors
GAAP
Generally Accepted Accounting Principles

FASB APB AICPA(CAP)

Level I Standards and Opinions Accounting
(Most authoritative) Interpretations Research Bulletins

FASB AICPA AICPA

Level II Technical Industry Audit & Statement of
Bulletins Accounting Guidelines Position

FASB AICPA
Level III Emerging Issues Task Force Practice Bulletins

FASB AICPA Recognized and

Level IV
Implementation Interpretations Widely Used Industry
(Least authoritative)
Guides Practices
 Environmental Factors
Unions AICPA Lenders
Securities and
Exchange Investors
  Politicians
Commission
Accountants Others

Provide input to

Financial Accounting Standards Board

Help set
Generally Accepted Accounting Principles
 Environmental Factors

Securities and Exchange Commission (SEC)

• Independent, quasi-judicial government agency

• Administer securities regulations & disclosures
• Can modify & set GAAP, if necessary
• Rarely directly challenges FASB
• Major player in global accounting
 Environmental Factors

International Accounting Standards (IAS)

• Set by International Accounting

Standards Board
• Not currently accepted in U.S.
• SEC under pressure to accept IAS
 Environmental Factors
Managers of Companies

• Setresponsibility
• Main by International
for fair &Accounting
accurate reports
• Applies accounting
Standards to reflect business
Board
activities
• Not currently
• Managerial accepted
discretion in in
is necessary U.S.
accounting
• SEC
• Major underonpressure
lobbyist GAAP to accept
IAS
 Environmental Factors
Auditing

• SEC requires
• Set Audit Report Accounting
by International
• Audit opinion can
Standards Board be:
- clean (fairly presented)
• Not -currently accepted
qualified (except for) in U.S.
Auditors
- disclaimer (no opinion)
• SEC under pressure to accept
• Check Auditor quality & independence
IAS
 Environmental Factors
Corporate Governance

• Board
• Set of
bydirectors oversightAccounting
International
• Audit committee of
Standards Board the board
- oversee accounting process
-•oversee
Not currently accepted in U.S.
internal control
- oversea internal/external audit
• SEC under
• Internal Auditor
pressure to accept
IAS
 Environmental Factors

Internal Users External Users

Managers Lenders
Officers Shareholders
Internal Auditors Governments
Sales Managers Labor Unions
Budget Officers External Auditors
Controller Customers
 Environmental Factors

Equity Investors
• Active & Speculative Investors rely on
financial reports

Creditors
• Solvency & Liquidity analysis relies
on financial reports
 Environmental Factors
Economic, Industry & Company News
• Impacts current & future financial condition and
performance

Voluntary Disclosure
• Many factors encourage voluntary disclosure by
managers

Information Intermediaries
• Industry devoted to collecting, processing, interpreting
& disseminating company information
• Includes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
• Major determinant of GAAP
 Financial Accounting
Objectives

Stewardship Information Perspective

• Safeguard assets • Amount …of
• Increase equity value • Timing prospective
• Protect creditors • Uncertainty net cash
∴Accountability & inflows
Performance ∴ Predictability & Decision
Measurement Usefulness

Historical Emphasis Modern Emphasis

(but still important)
 Financial Accounting
Hierarchy of Accounting Qualities

Users of accounting Decision makers and their characteristics

information
Benefits > Costs Materiality
Constraints

Understandability

User-specific Decision usefulness

qualities

Primary qualities Relevance Reliability

Ingredients of Predictive Feedback Neutrality Verifiability

primary qualities value value
Representational
Timeliness faithfulness

Secondary qualities Comparability and

consistency
 Financial Accounting
Important Accounting Principles

• Do uble En tr y - duality from accounting equation, A=L+E

• Hist or ic al Co st - fair & objective values from arm’s-
length transactions
• Ac crua l A cco un ting - recognize revenues when
earned, expenses when incurred
• Full Disclo sure - measure and/or disclose material
events and transactions
• Ma ter ia lit y - threshold when information impacts
decision making
• Co nservatis m - reporting or disclosing
the least optimistic information
about uncertain events and transactions FASB
 Financial Accounting
Relevance of Accounting Numbers
Relation between Accounting Numbers and Stock Prices

100%
80%
Percent of Stock Price

Book Value
Explained

60%
Earnings
40%
Combined
20%
0%
65 70 75 80 85 90 95
Year
 Financial Accounting

Limitations of Accounting Numbers

• Timeliness - periodic disclosure, not

• real-time basis
• Frequency - quarterly and annually
• Forward Looking - limited prospective
information
Accruals--The Cornerstone

Net Operating
=   + Accruals
Income Cash Flow
 Accruals--The Cornerstone
Foundations of Accrual Accounting

Revenue Recognition – recognize revenues when

(1) Earned
(2) Realized or Realizable
Expense Matching – match with corresponding revenues
-Product costs
-Period costs
Accruals--The Cornerstone
Relation between Cash Flows and Accruals

Operating cash flow (OCF)

-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
 Accruals--The Cornerstone
Short-Term and Long-Term Accruals

Short-Term Accruals: Yield current assets and current

liabilities (also called working
capital accruals)

Long-Term Accruals: Yield non-current assets and non-

current liabilities (arise mainly from
capitalization)

Note: Analysis research suggests short-term accruals

are more useful in company valuation
 Accruals--The Cornerstone
Relevance of Cash Flows and Income over a Company’s Life Cycle

Free cash
+ flow
Operating
Financing
cash flow
cash flow Income

Inception Growth Maturity Decline

Investing
cash flow
 Accruals--The Cornerstone
Comparison of Stock Price, Net Income, and Free Cash Flows
                         

  Fiscal year 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

                       
Wal-Mart
  4.22 5.33 8.25 13.47 16.28 13.25 11.44 10.19 11.87 19.91  
Stock price

  Net income 0.18 0.24 0.28 0.35 0.44 0.51 0.58 0.60 0.67 0.78   

  0.04 (0.01) (0.05) (0.17) (0.48) (0.50) (0.19) (0.21) 0.84 0.60   
Free cash flow

   
Kmart
  18.94 16.62 15.50 24.50 23.25 19.63 13.63 5.88 11.13 11.00   
Stock price

  Net income 2.00 0.81 1.89 2.02 2.07 (2.13) 0.64 (1.24) (0.45) 0.51   

  Free cash flow 1.76 (2.26) 0.20 (0.47) (2.15) 1.29 2.71 0.48 0.61 1.35  

                         
 Accruals--The Cornerstone
Relation between Stock Prices and Various Income and Cash
 
Flow  Measures
   
for  a Large
 
Sample
   
of  Companies
       

 
70.00
57.62
60.00
Percent of Price Explained

50.00 44.36
40.00 33.02 32.62
30.00
20.00
10.00
1.00
0.00
NIBX NI OCF FCF NCF

NIBX = Net Income before Extraordinary Items and Discontinued Operations; NI = Net Income;
OCF = Operating Cash Flow; FCF = Free Cash Flows; NCF = Net Cash Flow (Change in Cash).
                         
 
Accruals--The Cornerstone
  Relation between  Stock Returns
    and  both
  Income
   and Operating
     

Cash Flows for Different Horizons of a Large Sample of Companies

Explaine d

.
45.00
40.26
Pe rce nt of Stock Re turns

40.00

35.00

30.00

25.00 OCF
20.00 NI
16.20
15.00
10.88
10.00

5.00 3.24 3.18

0.10
0.00
Quarter Annual Four-Year
Time Horizon

  Source: Dechow, P                      
 
Accruals--The Cornerstone
Accruals and Cash Flows --- Myths
                       

• Myth: Since company value depends on future cash flows,

.
only current cash flows are relevant for valuation.
• Myth: Company value equals discounted future cash flows.
• Myth: All cash flows are value relevant.
• Myth: All accruals accounting adjustments are value
irrelevant.
• Myth: Cash flows cannot be manipulated.
• Myth: All income is manipulated.
• Myth: It is impossible to consistently
• manage income upwards in long run.
• Myth: Accounting rules are irrelevant
for valuation.

                       
 
Accruals--The Cornerstone
Accruals and Cash Flows --- Truths
                       

• Truth: Accrual accounting (income) is more

.
relevant than cash flow.
• Truth: Cash flows are more reliable than accruals.
• Truth: Accrual accounting numbers are subject
to accounting distortions.
• Truth: Company value can be
determined by using
accrual accounting
numbers.

                       
 Accounting Analysis
Demand for Accounting Analysis

• Adjust for accounting distortions so financial

reports better reflect economic reality

• Adjust general-purpose financial statements

to meet specific analysis objectives of a
particular user
 Accounting Analysis
Sources of Accounting Distortions
• Accounting Standards – attributed to (1) political
process of standard-setting, (2) accounting
principles and assumptions, and (3) conservatism
• Estimation Errors – attributed to estimation errors
inherent in accrual accounting
• Reliability vs Relevance – attributed to over-
emphasis on reliability at the loss of relevance
• Earnings Management – attributed to window-
dressing of financial statements by
managers to achieve personal benefits
 Accounting Analysis
Sources of Analysis Objectives
• Comparatives Analysis – demand for financial comparisons
across companies and/or across
time
• Income Measurement -- demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income concepts
(1) Economic Income (or
empirically, economic profit)
(2) Permanent Income (or
empirically, sustainable profit)

Chapter 6 discusses these measures in detail

 Accounting Analysis
Earnings Management – Frequent Source of Distortion

Three common strategies:

• Increasing Income – managers adjust accruals
to increase reported
income
• Big Bath – managers record huge
write-offs in one period to
relieve other periods of
expenses
• Income Smoothing– managers decrease or
increase reported income
to reduce its volatility
 Accounting Analysis
Earnings Management – Motivations

• Contracting Incentives -- managers adjust numbers

used in contracts that affect their wealth (e.g.,
compensation contracts)
• Stock Prices – managers adjust numbers to influence
stock prices for personal benefits (e.g., mergers,
option or stock offering)
• Government Favors – managers adjust numbers to
affect political actions (e.g., antitrust actions, IRS
pressures, government subsidies)
• Other Reasons -- managers adjust numbers to impact
(1) labor demands, (2) management changes, and (3)
societal views
 Accounting Analysis
Earnings Management – Mechanics

• Incoming Shifting – Accelerate or delay

recognition of revenues or
expenses to shift income from
one period to another
• Classificatory – Selectively classify revenues
and expenses in certain parts
of the income statement to
affect analysis inferences
regarding the recurring nature
of these items
 Accounting Analysis
Process of Accounting Analysis

Accounting analysis involves several inter-related processes

and tasks that can be grouped into two broad areas:
Evaluating Earning Quality –
Identify and assess key accounting policies
Evaluate extent of accounting flexibility
Determine the reporting strategy
Identify and assess red flags
Adjusting Financial Statements --
Identify, measure, and make necessary adjustments
to financial statements to better serve one’s analysis
objectives; Chapters 3-6 focus on adjusting
(recasting) the statements