Chapter 5 Study Notes

A. Regulators
1. SEC (Securities and Exchange Commission)
a. Government agency charged with the responsibility to determine the requirements for
financial statement and other disclosure reporting for publicly traded companies.
b. Sanctions are enforced on companies and auditors who do not properly comply with the
established standards.
2. FASB (Financial Accounting Standards Board) establishes the rules – GAAP (Generally
Accepted Accounting Principles).
3. PCAOB (Public Companies Accounting Oversight Board, created by the Sarbanes-Oxley Act
of 2002) sets auditing standards for independent auditors and the stock exchanges.

B. Managers
1. Management of a company has the primary responsibility for the financial statements and
related disclosures.
2. The highest officers in the company have the ultimate responsibility for financial information.
They sign the statement of management responsibility for reports filed with the SEC.
a. CEO – Chairman and Chief Executive Officer
b. CFO – Chief Financial officer
3. Officers as well as accounting staff are bound by GAAP in the reports they communicate to
external users.

C. Board of Directors (Audit Committee)

1. Responsible for ensuring that processes are in place for maintaining the integrity of the
company’s accounting, financial statement preparation, and financial reporting.
2. Audit committee must be composed of independent directors with financial knowledge.
3. Responsible for hiring the company’s independent auditors.

D. Auditors
1. Independent auditors (CPAs) are engaged to attest to the fairness of financial statements.
a. Publicly traded companies are required by SEC to have “audits”.
b. Many privately owned companies also have audits performed in order to meet agreements
with their lenders and investors.
c. The presence of the audit report should reduce risk to creditors and owners.
2. The “Big 4” CPA firms audit the majority of publicly traded companies as well as many
privately held companies. Other CPA firms perform the remainder of the audits.
3. An unqualified (clean) audit attests to the fairness of financial statements and related
disclosures.
4. The audit lends credibility to the statements and disclosures.

E. Information Intermediaries: Financial Analysts and Information Services

1. Financial analysts use modern technology to gather and analyze information about companies
and industries. Analysts consider annual reports, personal contacts, the overall economic
environment, and various trends to make predictions about expected future earnings and stock
prices. Analysts then make “buy/sell/hold” recommendations to investors.
2. Analysts are financial researchers who often work for brokerage firms, investment banks,
mutual fund companies, bank trust departments, and investment advisory companies.
3. Specialization by specific companies or industries is common.
 4. Analysts transfer knowledge of accounting, the company, and the industry to others who lack
this level of expertise.
5. Not all analysts draw the same conclusions about a company in preparing earnings forecasts or
stock price predictions. Information services allow investors to monitor the recommendations
of various analysts.
6. Financial analysts access a wide variety of commercial on-line information services to gather
the information they need. A wide range of analysts contribute to these data bases.
7. EDGAR (Electronic Data Gathering and Retrieval) Services
a. Sponsored by SEC.
b. Companies file their SEC forms electronically through EDGAR.
c. Users can retrieve information from EDGAR within 24 hours of its submission.
d. Free service, available on the web at www.sec.gov/cgi-bin/srch-edgar.
8. Compustat (www.compustat.com) and Thompson Research (research.thomsonib.com)
provide broad access to financial statements and news information.
9. Bloomberg (www.bloomberg.com) and Factiva (www.factiva.com) are more general
information services.
10. Most large companies provide direct on-line access to their financial statements.
11. Other websites where investors can gain information about companies:
a. www.investor.centers.com
b. finance.yahoo.com
c. www.marketguide.com
d. www.hoovers.com

F. Users: Institutional and Private Investors, Creditors, and Others

1. Institutional investors include private and public pension funds, mutual funds, endowment
and charitable foundation funds, and trust funds.
a. These investors invest on behalf of others.
b. Such institutional shareholders control the majority of publicly traded stock.
c. Many of these funds employ “in-house” analysts.
2. Private investors (often individuals) buy stock directly from a company. Retail investors buy
stock through stockbrokers since they normally lack expertise in this area.
3. Creditors lend money to companies. These lenders use financial information to determine if
borrowers are good credit risks. Lenders are the primary external user group for financial
statements of private companies.
4. Other users of financial information include customers, suppliers, competitors, and employees.
Each evaluates the financial “health” of companies.
5. The cost-benefit constraint is considered so that the “cost” of providing information does not
outweigh the “benefit” of that information.

G. Guiding Principles for Communicating Useful Information.

1. Information must be relevant to be useful: it must be capable of influencing decisions by
allowing assessment of past activities and predictions of future activities.
2. Information must be reliable to be useful: it must be accurate, unbiased, and verifiable.
3. Information should be consistent within a company so that it can be viewed over time.
4. Information should be comparable: comparable information allows comparisons across
business because similar accounting methods have been applied.
5. All material amounts must be disclosed. Material amounts are amounts that are large enough
to influence a user’s decision.
6. Conservatism requires that a company adopt accounting methods that will be least likely to
overstate assets and overstate revenues.
 THE STEPS IN THE ACCOUNTING COMMUNICATION PROCESS

A. Press Releases
1. Companies announce timely information about quarterly and annual earnings. Such
announcements often precede the issuance of the financial reports by several weeks.
Frequently press releases are followed by a conference call where senior managers answer
analysts’ questions.
2. The market often reacts to the difference of expected earnings and actual earnings (unexpected
earnings, not just to the amount of earnings.

B. Annual Reports
1. Privately held company reports include:
a. The four financial statements: Income Statement, Retained Earnings Statement (or
Stockholders’ Equity Statement), Statement of Cash Flows, and Balance Sheet.
b. Notes to the financial statements.
c. Report of Independent Accountants (Auditor’s Opinion).
2. Publicly traded company reports include nonfinancial and financial information.
a. Nonfinancial information often includes:
1. Letter to shareholders.
2. Description of philosophy, products, past outcomes, and future expectations.
3. Photographs of products, facilities, and personnel.
b. Financial information includes:
1. Summarized financial data for several years.
2. Management’s discussion and analysis of financial condition and results of operations.
3. The four required financial statements.
4. Notes to the financial statements.
5. The Report of Independent Accountants.
6. The Report of Management Responsibility.
7. Recent stock price data.
8. Summaries of unaudited quarterly financial data.

C. Quarterly Reports
1. Privately held companies typically prepare interim reports for creditors because of loan
agreements. They usually contain an unaudited income statement and balance sheet (often in a
condensed format).
2. Publicly traded companies prepare an unaudited income statement and balance sheet. The
other two statements and notes may also be included.

D. SEC Reports (10-K, 10-Q, 8-K)

1. Publicly traded companies must file several reports with the SEC throughout the year.
2. These filings include annual reports, quarterly reports, and current event reports.
a. Form 10-K Annual Report
1. Provides information in addition to financial data.
2. Includes detailed descriptions of company products, product development, sales and
marketing, manufacturing, competitors, owned and leased properties, legal
proceedings, and contracts.
b. Form 10-Q Quarterly Report
1. Contains unaudited information from the quarterly report.
2. Statement of stockholders’ equity, statement of cash flows, notes to the financial
statements, and management discussion are included.
 c. Form 8-K Current Report
1. Used to report any material event not previously reported in the 10-Q or 10-K.
2. Provides important information to investors.

** Just for your review!

THE DIFFERENT FINANCIAL STATEMENT AND DISCLOSURE FORMATS

A. Classified Balance Sheet (also known as Statement of Financial Position or Statement of

Financial Condition)
1. Presents assets in the order of liquidity, liabilities in the order of maturity dates, and
stockholders’ equity by source.
2. Two common reporting formats are:
a. Report format: Assets are first, followed by liabilities and stockholders’ equity (top to
bottom).
b. Account format: Assets are on the left with liabilities and stockholders’ equity on the right
(side by side).
3. Assets are classified by liquidity – the average period of time required to convert a noncash
asset into cash. Classifications include:
a. Current assets
1. Will be turned into cash or will be used up with the next year or operating cycle,
whichever is longer.
2. Examples: cash, accounts receivable, inventory, prepaid expenses.
b. Long-term investments
1. Noncurrent assets that are not used in operating the business.
2. Examples: stock and bond investments (if not planned to be sold in the next year), land
held for future expansion (not in use now), bond sinking funds.
c. Property, plant, and equipment, net of accumulated depreciation
1. Noncurrent tangible assets used in operating the business.
2. Accumulated depreciation amounts are included in this caption.
3. Book values (carrying values) (original cost – accumulated depreciation) are reported.
4. Examples: land, buildings, equipment.
d. Intangible assets
1. Noncurrent, long-lived assets with no physical or tangible substance which convey
legal rights and privileges to the owner.
2. Recorded at cost when purchased, and amortized over their useful lives.
3. “Created intangible assets aren’t recorded since they have no “cost” basis.
4. Examples: patents, trademarks, copyrights, goodwill.
e. Other (miscellaneous) assets
1. Noncurrent assets of a prepaid nature relating to goods and services expected to help
generate revenue in the future.
2. Example: “deferred charges”.
4. Liabilities are classified in the order of their maturity dates. Classifications include:
a. Current liabilities
1. Will be turned into cash or will be used up with the next year or operating cycle,
whichever is longer.
2. Examples: accounts payable, short-term notes payable, current portion of long-term
debt.
b. Long-term liabilities
1. All other debts of a company which are not current liabilities.
2. Examples: bonds payable, mortgage payable (except current portion), lease obligations.
 5. Stockholders’ equity: net assets. It’s the residual claim of the owners. Classified by source.
a. Contributed capital
1. The amount the owners invested in the corporation.
2. Often presented in two accounts.
a. Common stock
i. The par value printed on the stock certificate.
ii. Par value is the legal minimum amount stockholders must pay for their shares.
iii. Has no relationship to the market value of the shares.
b. Capital in excess of par
i. Also called Additional Paid-In Capital, Contributed Capital In Excess Of
Par, Or Paid-In Capital.
ii. Represents any amount above par which investors paid for their stock.
3. Contributed capital should set forth various disclosures about the company’s stock:
a. The number of shares authorized (the number of shares that legally can be issued).
b. The number of shares issued (issued to investors).
c. The number shares outstanding (issued and not repurchased by the company).
b. Retained earnings
1. The accumulated earnings of the company that have not been paid out in dividends.
c. Accumulated other comprehensive income
1. Includes the net unrealized gains and losses on securities, net minimum pension
liability adjustments, and net foreign currency translation adjustment.
2. These items are directly debited or credited to the stockholders’ equity account and
“bypass” the income statement.

B. Classified Income Statement (also known as Statement of Earnings or Statement of

Operations, or Profit and Loss Statement)
1. Single-step
a. All revenues, income, and gains are listed first.
b. Costs (cost of goods sold), expenses, and losses are subtracted to derive net income.
2. Multiple-step
a. Gross profit is determined first.
1. Sales – sales returns and allowances and sales discounts = Net Sales
2. Net sales less cost of goods sold = gross profit.
3. Cost of goods sold:

Beginning inventory
+ Cost of Purchases
Goods Available for Sale
- Ending Inventory
Cost of Goods Sold

Purchases
- Purchase Discounts
- Purchase Returns and Allowances
Net Purchases
+ Freight-in
Cost of Purchases

b. Next Income From Continuing Operations should be presented.

 1. Operating Expenses are related to a company’s primary operations.
2. Operating Expenses can be separated into Selling and General and Administrative
expenses.
3. Gross Profit – Operating Expenses = Income from Continuing Operations
4. Income from Continuing Operations is also called Operating Income.
c. Nonoperating Gains and Losses (Other Revenues and Expenses) are presented next.
1. These are gains and losses that do not relate to a company’s primary operations.
2. Examples: interest income, interest expense, gain on the sale of a plant asset.
3. Operating Income + Nonoperating Gains and Losses (net) =
Income Before Income Taxes
d. Income Before Income Taxes – Income Tax Expense = Net Income
e. Net Income is followed by Earnings Per Share (EPS)

Net Income available to common shareholders

EPS =
Weighted average # of common shares outstanding

If a company has a complex capital structure (stock options, debt or equity securities
convertible into common stock), both basic EPS and diluted EPS may need to be
disclosed.
f. Nonrecurring items may also be presented. These could be:
1. Discontinued operations.
2. Extraordinary items.
3. Cumulative effect of changes in accounting methods.
g. Common-Size Income Statement
1. Reports each line item as a percent of net sales.
2. Makes year-to-year comparisons easier.

C. Statement of Cash Flows has three classifications.

1. Cash Flows from:
a. Operating activities: cash flows associated with earning income.
b. Investing activities: cash flows associated with buying and selling investments and
productive assets other than inventory and supplies.
c. Financing activities: cash flows associated with debt principal and equity transactions.
2. There are two acceptable methods of developing the operating section:
a. Direct method.
b. Indirect method (reconciliation approach)

D. Notes to the Financial Statements

1. Necessary because this additional information provides important details about the amounts in
those statements.
2. Disclosures help users perform financial statement analysis which is useful in the decision
making process.
3. The first note is typically a summary of significant accounting policies of the company.
a. States the methods (inventory, depreciation, etc.) employed by the company in arriving at
the amounts presented in the statements.
4. Another set of notes provides supplemental information concerning the data in the financial statements.
Examples: information about regional revenues, major customers, unusual transactions, lease
payments.
5. The last category of notes contains information which impacts the company financially but is
not shown in the financial statements
a. Examples: “subsequent events”, contracts, pending litigation.
 E. Voluntary disclosures
1. SEC and GAAP set minimum requirements for voluntary disclosures.
2. Many companies go beyond the minimum disclosure level.
3. Voluntary disclosures provide additional information which is useful to decision makers.

F. Constraints
1. Provide practical guidelines to reduce the volume and cost of reporting while maintaining the
value of the information for the users.
2. Materiality Constraint
a. Subjective
b. If items are of low significance (small dollar amounts), the accounting for them does not
need to conform precisely to specific rules and methods because this departure would not
affect users’ decisions about the company.
3. Conservatism Constraint
a. The company should select the accounting method that is least likely to overstate assets
and revenues.
b. Care should also be taken to not understate liabilities and expenses
c. The outcome is to avoid stating net income and net assets.

RATIOS:
ANALYZE A COMPANY’S PERFORMANCE BASED ON RETURN ON EQUITY AND ITS
COMPONENTS.
Evaluating a company’s performance is the primary goal of financial statement analysis. A
framework for using data in the evaluation should include return on equity (ROE) analysis.

ROE Profit Driver Analysis

Net Income
ROE =
Average Stockholders' Equity

OR
DuPont Analysis:
ROE = Net Profit Margin x Asset Turnover x Financial Leverage

Net Income
Net Profit Margin =
Net Sales

Net Sales
Asset Turnover =
Average Total Assets

Average Total Assets

Financial Leverage =
Average Stockholders' Equity

Net Income Net Sales Average Total Assets

ROE = x x
Net Sales Average Total Assets Average Stockholders' Equity