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Chapter5Communicatingandinterpretingaccountinginformation

Slide2:Regulation

ThestatutoryauthoritytoregulatefinancialreportinglieswiththeSecuritiesandExchangeCommission(SEC).
TheSECwasformedin1934afterthestockmarketcrashof1929thatleadtotheGreatDepression.Itistasked
withprotectingtheinterestsofinvestorsandregulatingthesecuritiesmarkets.Publiclytradedcompaniesare
requiredtofilevariousreportswithSECwhichitreviewsforirregularities.Ifitfindsthatacompanyhasnotmet
itsfilingrequirementsorthattheinformationfiledisquestionableaninvestigationisconducted.The
enforcementauthoritygivenbyCongressallowstheSECtobringcivilenforcementactionsagainstindividualsor
companiesallegedtohavecommittedaccountingfraud,providedfalseinformation,orengagedininsider
tradingorotherviolationsofsecuritieslaws.TheSECalsoworkswithcriminallawenforcementagenciesto
prosecuteindividualsandcompaniesalikeforoffenseswhichincludeacriminalviolation.

Sinceitsinception,theSEChasdeferredtotheprivatesectortoestablishaccountingstandards.Withits
oversight,theFinancialAccountingStandardsBoard(FASB)istherecognizedauthoritativerulemakingbodyfor
settingaccountingstandardsintheUnitedStates.

TheSarbanesOxleyActof2002(SOX)establishednewrulesthatgovernthepracticesoffirmsthatauditthe
financialstatementsofpubliclytradedcompanies.ThePublicCompanyAccountingOversightBoard(PCAOB)
wasestablishedtoadministertheprovisionsoftheactandissubjecttooversightbytheSEC.

ThemainreasontheSECwascreatedwastoregulatethesecuritiesmarketsandpreventabusesandfraud
relatedtotheofferingandsaleofsecurities.TheSECisresponsiblefortheoversightandregulationofstock
exchangesandthelicensureofsecuritiesbrokersanddealers.

Slide3:IntegrityofFinancialinformation

AsdiscussedamomentagotheSEChasprimaryresponsibilityforthefinancialreportingregulatoryenvironment
andhasoversightresponsibilityofthePublicAccountingOversightBoard(PCAOB),theFinancialAccounting
StandardsBoard(FASB)andthestockexchanges.

TheFASBestablishestheaccountingstandardsthatacompanysmanagementmustadheretowhenpreparing
andpresentingitsfinancialstatementsandrelatednotedisclosures.AcompanysChairmanandChiefExecutive
OfficerandChiefFinancialOfficerarerequiredtocertify
1. thatinformationprovidedtotheSECdoesnotincludematerialmisstatementsoromissions
2. thattherenomaterialweaknessinthecompanysinternalcontrolsand
3. Thatanyknownweaknessesorincidentsofmanagementfraudhavebeencommunicatedtotheauditor
andtheboardofdirectors.
Falseassertionsmadeinthecertificationlettermayresultinfinesofupto$5millionandprisontermsofupto
20years.

Stockexchangesalongwithstatelawsestablishcorporategovernancerequirementswhoseadherence
ultimatelylieswithacompanysboardofdirectors.
Acompanysboardiselectedbyitsshareholdersandisresponsiblefortheselectionandoversightofsenior
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management.Theboardmusthaveanauditcommittee,comprisedofindependentmembersthatare
knowledgeableinaccountingpracticesandfinancialreporting.Theirbeingindependentmeansthattheydonot
holdanytypeofmanagementpositionwiththecompany.Theauditcommitteeisresponsibleforretainingand
interactingwiththeindependentaccountingfirmthatconductstheannualfinancialstatementaudit.
IndependentauditorsaresubjecttotheoversightofthePublicAccountingOversightBoard(PCAOB)andare
responsibleforperformingauditsoftheannualfinancialstatementsandrelatednotedisclosuresaswellas
conductingreviewsofquarterlyfinancialstatementsanddisclosures.Theindependentauditorreportsdirectly
totheclientcompanysauditcommitteeandinteractswiththecompanysmanagementtoresolveissues
encounteredduringtheauditengagement.

Slide4:InformationIntermediaries
Financialintermediariesplayanimportantroleinthedisseminationoffinancialinformation.Investorsrelyon
analystsandinformationservicestodeliversophisticatedfinancialintelligencetomakeinformedasset
allocationdecisions.
Financialanalysts:
1. Typicallyworkinresearchdepartmentoflargebrokeragefirmsorinvestmentadvisoryfirms
2. Usuallyspecializeinspecificindustries
3. Receivedatafrominformationservicesanddirectinteractionwithcompanies
4. Issueearningsforecastsandinvestmentrecommendations
5. Enhancemarketefficiencybyacceleratingthespeedatwhichinformationreachesfinancialstatement
users
Informationservices:
1. Allowanalystsandinvestorstoelectronicallyaccessdetailedfinancialdata
2. Provideanefficientmeansofaccessingdatathroughsearchabledatabases
3. Oftenincludeanalyticaltoolsintheirfeebasedservices
4. Providefinancialandbusinessnewsfeeds
Slide5:FinancialInformationUsers
Financialstatementuserscomeindifferentshapesandsizesandhavevaryingneedsandlevelsof
sophistication.
Institutionalinvestorsaremangersofpensionplanfunds,mutualfunds,endowments,insurancecompany
portfoliosandotherfunds.Theyrepresentthelargesttypeofinvestorbycontrollingthemajorityofpublically
tradedsharesintheUnitedStates.Theyusuallyemploytheirownstaffoffinancialanalystsandplayasignificant
roleinthegovernanceofthecompaniestheyinvestin.
Privateinvestorsrangefromlarge,sophisticatedindividualinvestorsthatmakedirectinvestmentsinnon
publicallytradedcompaniestosmall,lesssophisticatedinvestorsthatpurchasesharesofpublicallytraded
companiesthroughbrokerssuchasEdwardJones.
Lendersandcreditorssuchassuppliers,banks,commercialcreditcompaniesandbondholdersusefinancial
statementinformationtoevaluatethecreditworthinessofexistingandprospectivecustomersandborrowers.
Tofacilitatetheirdecisionmaking,theyuseinformationthatispubliclyavailableforlargercustomersand

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borrowers.Whenitcomestosmallercustomersandborrowerstheyaretheprimaryusersofprivatecompany
financialstatements.

Slide6:InformationUsefulness
Thereareseveralqualitativecharacteristicsofaccountinginformationthatdeterminethedegreetowhichitis
usefultoitsconsumers.
Usersoffinancialstatementsaretypicallyengagedinmakingresourceallocationdecisions.Itmaybethatthey
areselectingstocksformakinganinvestment,ortheyareselectingavendortosupplyasubassemblyfora
producttheyareproducing.Ineithercasetheyareevaluatingalternativesandultimatelydecidingwhichoneis
thebestchoice.Attheheartofthisprocessistheabilitytocomparethevariousalternativesthatareavailable.

Whencompaniesarerequiredtousethesamegenerallyacceptableaccountingprinciplestopreparetheir
financialstatements,itgreatlyenhancestheabilityoffinancialstatementuserstocomparetheiroperating
resultsandfinancialpositions.Whenitissaidthataccountinginformationexhibitsthequalityofcomparabilityit
meansthatitfacilitatescomparingresultsofdifferentcompaniestooneanother.
Anotherimportantqualityofaccountinginformationisconsistency.Thisqualityisexhibitedwhenacompany
appliesgenerallyacceptedaccountingprinciplesinthesamewayfromoneperiodtoanother.Bydoingsoit
betterfacilitatesinterperiodanalysisofacompanysfinancialresults.

Asdiscussedinapreviouschapter,accountinginformationisrelevanttoitsuserswhenithelpsthemmake
predictionsaboutfutureperformance,providesfeedbackregardingpreviouspredictionsandisprovidedina
timeframethatallowsthemtoactuponit.Thereliabilityofaccountinginformationisenhancedwhenitisfree
frombias,verifiableandaccuratelyportrayswhatitpurportstoportray.

Reportingofaccountinginformationisdonewithinthecontextofthefollowconstraints.Thebenefitofthe
informationprovidedshouldexceedthecostincurredtoprovideit.Determiningthecostofproviding
informationisrelativelyattainablehowever,quantifyingthebenefitinformationprovidescanbemore
challenging.Asanexample,throughcostmeasurementtechniquesacompanycanidentifythecostoflaborand
informationprocessingresourcesusedtocreateaparticularreportformanagement.Itcanberatherdifficult
however,toidentifythecostssavedortherevenuesgainedfromtheenhanceddecisionmakingachieved
throughuseofthenewreport.

Whenacompanyisdeterminingwhetherornotaparticulareventorreportingitemissignificantenoughto
separatelyidentifyorhighlightinitsfinancialstatementsorisdeterminingtheappropriateaccounting
treatmentforaparticulartransactionitmustassessiftherelatedinformationwouldpotentiallyinfluencea
decisionmakerifitisdisclosedinaparticularwayversustheotheralternatives.Thisreferstothematerialityof
theeventoritemandwhetherornotitcouldchangeadecisionmakersperceptionoftheeventoritemwithin
thecontextofthefinancialstatementstakenasawhole.Simplyput,managementandaccountantshaveto
determineifsomethingislargeenoughinscaletowarrantafinancialstatementusersattention.Anexample
wouldbeforlargecompaniestoexpenseallitemspurchasedthatcostbelow$500evenifitbenefitsmultiple
periods.Atrashcanmightlastfor15yearsbutitsbeingcapitalizedanddepreciatedoveritsusefullifewould
notyieldamateriallydifferentpicturethansimplyexpensingitscostintheperioditwaspurchased.

Whenitcomestoaccountingforaparticulartransactionorevent,managementandaccountantsoftenhave
severalwaysinwhichtodosothatwouldbeaccordancewithgenerallyacceptedaccountingprinciples.When
oneparticularmethodofaccountinganddisclosuredoesnotemergeasbeingthebestfitgiventhe
circumstances,managementandaccountantsaretotakeaconservativeapproach.Indoingsotheyaretoselect
themethodthatresultsinloweramountsforrevenuesandassetsorhigheramountsforexpensesandliabilities.
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Slide7:TheDisclosureProcess
Thedisclosurecyclestartswithcompaniesissuingearningsorpressreleases.Quarterlyandannualearningsare
typicallyannouncedwithin4weeksoftheendofthereportingperiod.Theyaresentelectronicallytonews
servicesandinclude:
Keyfinancialfigures
Managementsdiscussionandanalysisoftheperiodsresultsanda
Condensedincomestatementandbalancesheet
Pressreleasesareusuallyfollowedbyconferencecallsbetweenmanagementandanalyststodiscussthe
periodsresultsandaddressquestionsandconcerns.

Annualreportsareissuedaftertheyearendclosingandauditprocessesarecompleted.Publicallytraded
companieswithayearendofDecember31streleasetheirannualreportsduringthethirdweekofMarch.
Annualreportsissuedbyprivatecompaniesarereleasedsoonerandrelativelysimplisticcomparedtothemore
elaboratereportsissuedbypublicallytradedcompanies.Annualreportsissuedbypublicallytradedcompanies
include:
NonfinancialSection

LetterfromChairman/CEO

Descriptionofproducts,philosophy,successes/failures,futureprospects

FinancialSection

Summarizeddatafor5to10years

Managementsdiscussionandanalysis

Thefourgeneralpurposefinancialstatementsandrelatednotes

IndependentAccountantsReportandManagementsCertification

Recentstockpriceinformation

Summariesofquarterlyfinancialdata

Listsofdirectorsandofficersofthecompany

Publicallytradedcompaniesalsoissuequarterlyreportswhich:
Beginwithashortlettertoshareholders

Andinclude:

Condensed/summarizedincomestatement(unaudited)

Condensed/summarizedbalancesheet(unaudited)

Statementofstockholdersequity,statementofcashflowsareoftenomitted

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Notestofinancialstatementsarelessextensive

Itisnotuncommonforprivatecompaniestopreparequarterlyreportsforcompliancepurposeswith
theirlenders.

CompanieswhosestockispublicallytradedmustsubmitvariousreportstotheSecuritiesandExchange
Commission(SEC).Thereportsare:
FiledQuarterly(10Q)andAnnually(10K)

Includeallinformationinannualandquarterlyreportswithmoredetaileddisclosuresregarding:

Businessmodelandoperations

Productofferings

Researchanddevelopmentactivities

Sales,marketingandmanufacturingpractices

Competitorenvironment

Providedetailedschedulesconcerningamountsreportedinthefinancialstatements

Form8Kisfiledasneededtoreportsignificanteventssuchasthedepartureofadirectororsenior
executive,bankruptcy,oramajorsaleoracquisitionofassets.Theformmustbefiledwithin4business
daysofthetriggeringevent.

Slide8:IncomeStatementRevisited
Inpreviouschapterswedistinguishedthesinglestepincomestatementformatfromthemultistepincome
statementformat.Recallthatthemultistepformatfeaturesseverallevelsofprofitabilityincludinggrossprofit
ormargin(whichisequaltorevenuesminuscostofgoodssold),incomefromoperations(whichisequalto
grossprofitminusoperatingexpenses),incomebeforetaxes(whichisequaltooperatingincomeadjustedfor
nonoperatingitemssuchasinterestexpense,interestrevenue,gainsandlosses)andnetincome(whichisequal
toincomebeforetaxeslessincometaxes).Thesinglestepformatsimplysubtractsallexpensesandlossesfrom
allrevenuesandgainstoderivenetincome.Themultistepformatpresentsinformationinawaythatismore
readilyusefulwhilethesinglestepapproachissimplisticanddoesimplythatonelevelofprofitabilityismore
importantthananother.

Bothformatsmayincludebelowthelineitems.Thelineistheincomelinefoundimmediatelyafterthe
provisionforincometaxes.Itemsreportedbelowthislinearenonrecurringinnatureandarereportednetof
tax.Netoftaxsimplymeansthatitemsreportedinthissectionoftheincomestatementhavebeenadjustedfor
theeffectincometaxes.Asanexample,ifacompanyhasanincometaxrateof40%andanonrecurringgainof
$100,000,theamountreportedbelowthelineontheincomestatementwouldbe$60,000($100,000minus
the$40,000oftaxesthatwouldbepaidonthatamountofgain).Thereasonthattheseitemsarereportednet
oftaxistheirpositionontheincomestatement.Theyarereportedafterincometaxesaresubtractedinthe
computationofincome.TheFASBfeltitwouldbeconfusingtohavetwoincometaxexpenselines.Insteadit
wasdecidedthatitemsreportedaftertheincometaxexpenselinewouldbeadjustedfortheeffectoftaxes.

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Therationaleforreportingnonrecurringitemsinaseparatesectionoftheincomestatementistoafford
financialstatementuserstheabilitytoeasilydistinguishresultsthatarerelatedtothetypicalandongoing
operationsofthecompanyfromthosethatarenotexpectedtooccurorcontinueinthefuture.Thetwotypesof
thenonrecurringitemsacompanycanreportarediscontinuedoperationsandextraordinaryitems.

Discontinuedoperationsarereportedwhenacompanysellsordisposesofasegmentofitsbusiness.The
amountreportedforthistypeofitemincludesrevenuesandexpensesgeneratedfromoperatingthesegment
duringthephaseoutperiodaswellasgainsandlossesfromthesaleordisposalofsegmentassets.
Extraordinaryitemsrelatetotransactionsthatareunusualandinfrequentforthereportingcompany.Asan
example,ifacompanylocatedinTempe,Arizonawithataxrateof40%sustainedalossof$4,000,000because
ofanavalanchedestroyingitswarehousefacilityitwouldlikelyreportanextraordinarylossof$2,400,000
($4,000,000adjustedforthe$1,600,000oftaxsavingsthelosswouldprovide).Forthoseofyoutakingthis
coursethatarenotfamiliarwiththeclimateofTempe,Arizona,italmostneversnowshereandcertainlydoes
notreceiveenoughsnowtohaveavalanches.

Whenacompanyreportsnonrecurringitemsitmustreportearningspersharedataforthemaswell.The
earningspersharedisclosuremuststartwithincomefromcontinuingoperationsandcontinuethroughtonet
income.Thisisdonesothatfinancialstatementuserscaneasilydeterminewhatearningspersharewouldhave
beenifthenonrecurringitemshadnotoccurred.

Toaidintheevaluationofacompanysincomestatement,analystsoftenusethecommonsizeformatwhereall
lineitemsarestatedasapercentofsalesrevenue.Thisallowstheusertoreadilyidentifychangesincost
structureandprofitabilitymeasuressuchasgrossprofitandoperatingincome.Acmescommonsizeincome
statementisalsocomparativeinthatitreportsmorethanjustthecurrentperiodsresults.FromAcmes
statementwecanseethatnetprofitmarginincreasedfrom6%ofsalesto9%ofsales.Themaincontributorsto
thistrendisaslightimprovementingrossprofitmarginandadecreaseinwageexpenserelativetototalsales.

Thecommonsizeincomestatementisalsoveryusefulincomparingtheresultsoftwoormorecompaniesthat
areofdifferentsize.Thecommonsizeformatovercomesthedifferenceinscalethatfinancialstatementusers
oftenencounterwhenevaluatingacompanythatislargerorsmallerthanitscompetitors.

Slide9:ReturnonEquityAnalysis
Inearlierchapterswediscussedtheassetturnoverandnetprofitmarginratiosandhowtheyareusedto
evaluatehowefficientacompanyisinusingitsassetstogeneratesalesandhowsuccessfulitisingettingas
muchofeverysalesdollartothebottomaspossible.Wealsodiscussedhowthosetworatioswhenfactored
togetherproducethereturnonassetratioandhowefficiencyandmarginarethetwoprimarydriversbehind
earningareturnonassetsdeployed.

Wewillnowlookatreturnonequity,whichevaluateshowwellacompanyusedthestockholdersinvestment
duringperiod.Itiscalculatedbydividingnetincomebyaveragestockholdersequityandmeasureshowmuch
incomewasearnedduringtheperiodforeachdollarofownerinvestment.Recallthatstockholdersequityis
comprisedofnotonlydirectinvestmentsmadebyownerswhentheypurchasestockbutalsotheindirect
investmentmadewhenearningsareretainedtofuelthecompanysgrowth.

Returnonequitycanbedecomposedintothreeelementstobetterunderstandwhatdrivesacompanys
performance.Wehavealreadydiscussedtwooftheseselements;netprofitmarginandassetturnover.The
thirdelementisfinancialleveragewhichmeasuresthedegreetowhichafirmsassetsarefinancedwithdebt.It
iscalculatedbydividingaverageassetsbyaveragestockholdersequity.Whenleverageisfactoredwithmargin
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andturnover,returnonequityistheresult.

Slide10:DuPontModelExample
UsingthelensoftheDuPontModeltoexamineacompanysreturnonequity,letsassumethefollowing:
Oursubjectcompanyhassalesrevenueof$1,000,000,netincomeof$100,000,averageassetsof$500,000and
averageequityof$500,000.Aswesawamomentago,theelementsoftheDuPontmodelthatcollectively
compriseearningspersharearenetprofitmargin,assetturnoverandfinancialleverage.Wecanseethatin
multiplyingeachofthemodelselementstogether,salesrevenueinthedenominatorofnetprofitmarginandin
thenumeratorofassetturnovercanceleachotherout.Andaverageassetsinthedenominatorofassetturnover
andinthenumeratoroffinancialleveragecanceleachotheroutaswell.Weareleftwithnetincomeinthe
numeratorandaverageequityinthedenominatorwhichisthecomputationforreturnonequity.

Whenweplugsalesrevenue,netincome,averageassetsandaverageequityintoourequation,wegetthe
followingresults:
Netprofitmarginis.10or10%whichmeansthat10centsofevery$1ofsalesreachesthebottomline.

Assetturnoveris2.0whichmeansthatforevery$1ofassetsthecompanyhasitgenerates$2ofsales.

Financialleverageis1.0whichmeansthatthecompanyhasnodebtorliabilitiesatall.Theyhave
financedtheirassets100%withequity.

Returnonequitycanbecalculatedbyeither:
1. multiplyingnetprofitmarginof.1,timesassetturnoverof2.0,timesfinancialleverageof1.0
2. orbydividingnetincomeof$100,000byaverageequityof$500,000.
Eitherapproachwillyieldareturnof.20or20%.Forevery$1ofequityinvesteddirectly(throughcontributed
capital)orindirectly(throughretainedearnings)bythecompanysowners,ithasgenerated20centsofincome.
Whenacompanyfinancesaportionofitsassetswithdebt,itsincomeisassociatedwitharelativelysmaller
amountofequity.Withallthingsbeingthesame,thisincreasesthereturnfortheowners.Todemonstrate,lets
assumethattheexamplecompanyissuesdebtof$250,000andrepurchases$250,000ofitsstock.Theeffecton
equityisthatitisnowhalfofwhatitwas.Thischangeinassumptionhasnoaffectontheprofitability(netprofit
margin)andnoaffectonefficiency(assetturnover).Itdoeshoweverhavearatherprofoundeffectonthe
financialleveragemultiplier.Ithasincreasedfrom1.0to2.0.Asexpected,thishasadoublingaffectonthe
companysreturnonequity.Itincreasefrom20%to40%.

Whileincreasingleveragecanenhanceacompanysreturnonequityitisimportanttonotethatitalsoincreases
thecompanyslevelofrisk.Unlikeequityfinancing,debtfinancingmustbeservicedwithinterestandeventually
thedebtscomedueormature.Servicingequitywithdividendsisattheoptionofacompanysboardandstock
doesnothaveamaturitydateassociatedwithit.Therefore,debtplacesaburdenonthecompanythatmaybe
detrimentaltoitsfinancialhealthduringtimesofeconomicdownturn.

Slide11:ImprovingROE
Toimprovereturnonequity,acompanyshouldstrivetofavorablyimpactone,twoorallthreeoftheDuPont
Modelprofitlevers.

Toimprovenetprofitmarginacompanycanendeavortoincreaseitssaleswhileholdingdownexpenses.It
couldincreasethesellingpriceofitsproductsandservicesorimplementcostreductionstrategiestoimprove
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profitabilityonexistingsalesvolume.

Toimproveassetturnoveracompanycanstrivetoincreaseitssalesvolumewhileholdingassetsattheircurrent
level.Alternatively,thecompanycoulddisposeofitslessproductiveandidleassets.Acompanycanimplement
strategiestoreduceitscurrentassetssuchasinventory(perhapsbyimplementingjustintimedelivery
techniques)andaccountsreceivable(throughrevisingitscreditpolicies).

Aswesawamomentago,acompanycanusefinancialleveragetoimproveitsreturnonequity.Todosoitcould
increaseborrowingand/orreduceitsequitythroughrepurchasingorretiringitsstock.
Mostcompaniesstrivetoimproveonseveralaspectsofprofitabilitysimultaneouslyratherthantakingalinear
approach.

TheEnd

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