Understanding
Financial
Statements
NINTH EDITION
Lyn M. Fraser
Aileen Ormiston
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1
Copyright Notice
All rights reserved. No part of this publication
may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any
means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior
written permission of the publisher. Printed in
the United States of America.
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Chapter 1: Financial
Statements
An Overview
maze (māz), n. 1. An intricate,
usually confusing network of
passages, some blind and
some leading to a goal. 2.
Anything made up of many
confused or conflicting
elements. 3. A mental state of
confusion or perplexity.
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Map or Maze
A map helps its user reach a
desired destination through
clarity of
representation.
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Map or Maze
A maze attempts to confuse its
user by purposefully
introducing conflicting
elements and complexities
that prevent reaching the
desired goal.
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Map or Maze
A maze of information
Auditor’s Report MD&A
Income Statement
Notes
Statement of Cash Flows
Statement of Shareholders’ Equity
Balance Sheet
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Map or Maze
Business financial statements have
the potential for being map and
maze.
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Financial Statements as a
Map
Form the basis for understanding
the financial position of a firm
Allow users to assess historical and
prospective financial
performance
Present clear representations of
firm’s financial health, leading to
informed business decisions
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Financial Statements as a
Maze
Overwhelming amount of information
Unreliable auditing
Constantly changing and complex
policies and reporting
requirements
Considerable discretion given to
management, influencing content
and presentation
Key information hidden or omitted
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Main Objectives of This
Book
Ensure that financial statements serve
as a map, not a maze
Demonstrate how to read and evaluate
business financial statements
Provide the tools and techniques
needed to complete a comprehensive
financial statement analysis
Encourage intelligent decision making
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Usefulness
Financial statements and
accompanying notes contain a wealth
of information.
• Financial position of the company
• Success of operations
• Policies and strategies of
management
• Insight into future performance
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Usefulness
Financial statement users should be
able to find and interpret
information to answer questions
about a company.
Financial statements and other data
generated by corporate financial
reporting can help users develop
answers to the following
questions (and many others).
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Usefulness
Questions One Might Ask
Would an investment generate attractive
returns?
What is the degree of risk inherent in the
investment?
Should existing investing holdings be
liquidated?
Will cash flows be sufficient to service
interest and principal payments on
debt?
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Usefulness
Questions One Might Ask
Does the company provide a good
opportunity for employment,
advancement, and employee
benefits?
How well does this company compete
in its operating environment?
Is this firm a good prospect as a
customer?
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Volume of Information
Annual Reports
Annual reports contain a great
quantity of information.
• Financial statements
• Notes to the financial statements
• Auditor’s report
• Five-year summary of key
financial data
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Volume of Information
Annual Reports
• High and low stock prices
• Management’s discussion and
analysis of operations
• Material included at the
imagination and discretion of
management
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Volume of Information
Financial Statements
Prepared according to generally
accepted accounting principles
(GAAP)
Intended to present financial
information that is
understandable and relevant and
reliable for decision-making
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Volume of Information
Generally Accepted Accounting
Principles
Two authorities primarily responsible
for establishing GAAP in the United
States
• Securities and Exchange
Commission (SEC), a public-sector
organization
• Financial Accounting Standards
Board (FASB), a private-sector
organization
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Volume of Information
Securities and Exchange
Commission
Regulates US companies that issue
securities to the public
Requires regular filing of
• Annual reports (10-K)
• Quarterly reports (10-Q)
• 8-K reports in particular
circumstances
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Volume of Information
Securities and Exchange
Commission
Has congressional authority to set
accounting policies
Has issued rulings called Accounting
Series Releases (ASRs) and
Financial Reporting Rulings (FRRs)
For the most part, rule making has
been delegated to the FASB.
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Volume of Information
Financial Accounting Standards
Board
Issues Statements of Financial
Accounting Standards (SFASs)
and interpretations
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Volume of Information
The SEC and the FASB
Work closely together in the
development of accounting policy
SEC has played a largely supportive
role.
Corporate scandals have brought the
challenges and pressures the FASB
faces to the forefront.
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Volume of Information
The SEC and the FASB
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Volume of Information
The SEC and the FASB
SEC and the FASB continue to
examine potential rule changes
and new rules.
Changes will most likely evolve
through joint projects between U.S.
rule-making bodies and the
International Accounting Standards
Board (IASB).
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Volume of Information
Globalization
IASB was created in 1973 with the goal
of adopting uniform international
accounting standards.
Consistency in financial statements
would benefit investors and creditors.
Companies could list securities in any
market with one set of statements.
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Where to Find a
Company’s Financial
Statements
Form 10-K
• Filed annually with the SEC
• Contains uniform content
• Same order for all filing companies
• Can be accessed through the
Electronic Data Gathering, Analysis,
and Retrieval (EDGAR) database at
www.sec.gov
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Where to Find a
Company’s Financial
Statements
Annual report
• Financial statements
• Other public relations material
• Sent to shareholders and prospective
investors
Corporate Web site
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The Financial Statements
Annual reports contain four basic
financial statements.
• Balance Sheet
• Income Statement or Earnings
Statement
• Statement of Stockholders’ Equity
• Statement of Cash Flows
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The Financial Statements
The Balance Sheet
Also called the statement of
financial position
Shows the financial position of the
firm on a particular date
• Assets
• Liabilities
• Stockholders’ equity
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The Financial Statements
The Income Statement
Also called the earnings statement
Presents the results of operations
for the accounting period
• Revenues
• Expenses
• Net profit or loss
• Net profit or loss per share
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The Financial Statements
The Statement of Stockholder’s
Equity
Reconciles the beginning and ending
balances of all accounts that
appear in the stockholders’ equity
section of the balance sheet
Some firms prepare a statement of
retained earnings which reconciles
the beginning and ending balances
of the retained earnings account.
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The Financial Statements
The Statement of Cash Flows
Provides information about the
cash inflows and outflows during an
accounting period
• Operating activities
• Financing activities
• Investing activities
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Notes to the Financial
Statements
An integral part of the statements
Provide a summary of the firm’s
accounting policies
Explain any changes in accounting
policies
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Notes to the Financial
Statements
Present detail about particular
accounts
• Inventory
• Property, plant, and equipment
• Investments
• Long-term debt
• Equity accounts
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Notes to the Financial
Statements
Include other information
• Major acquisitions or divestitures
• Officer and employee retirement,
pension, and stock option plans
• Leasing arrangements
• Term, cost, and maturity of debt
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Notes to the Financial
Statements
Include other information
• Pending legal proceedings
• Income taxes
• Contingencies and commitments
• Quarterly results of operations
• Operating segments
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Notes to the Financial
Statements
Supplementary information required
by SEC and FASB
• Reserves for companies operating in
extractive industries
• Effect of foreign currency
translations
• Financial information for each
reportable segment of a firm with
several lines of business
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Auditor’s Report
Report of an independent or
external auditor
Attests to the fairness of the
presentation of financial
statements
Sarbanes-Oxley (SOX) Act of 2002
• Internal control report
• Management’s assessment of
internal control structures
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Auditor’s Report
Impact of SOX on Internal
Auditing
Need for internal auditors to assess
effectiveness of internal
controls and to disclose
weaknesses in a firm’s internal
controls system
Strengthened internal controls
Enhanced value of internal audit
function
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Auditor’s Report
Unqualified reports
Statements present information in
conformity with GAAP.
Qualified reports
“In our opinion, except for the
(nature of the departure explained),
the financial statements present
fairly…”
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Auditor’s Report
Adverse opinion
Financial statements have not been
presented fairly in accordance with
GAAP.
Disclaimer of opinion
Auditor cannot evaluate the fairness of
the statements and expresses no
opinion.
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Auditor’s Report
Unqualified opinion with explanatory
language
Additional explanatory paragraphs
Occurs under many circumstances
• Change in accounting principle
• Uncertainty caused by future events
• Events that may present business risk
and/or going-concern problems
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Sarbanes-Oxley Act of
2002
Passed by Congress in hopes of
ending future accounting
scandals and renewing investor
confidence in the marketplace
Established the Public Company
Accounting Oversight Board
(PCAOB)
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Sarbanes-Oxley Act of
2002
The PCAOB
Private, non-profit organization
Registers, inspects, and disciplines
auditors
Writes auditing rules
Sets quality control and ethics
standards
SEC has oversight of the board.
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Sarbanes-Oxley Act of 2002
Title II
Prohibits nonaudit services during an
external audit
• Bookkeeping
• Design and implementation of financial
information systems
• Valuation, appraisal, actuarial, internal
audit, broker, dealer, or investment
banking services
• Management or human resources
functions
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Sarbanes-Oxley Act of 2002
Titles III, IV, and IX
Corporate responsibility
Harsher penalties for violations
CEO and CFO must certify accuracy
of financial statements.
Officers who certify inaccurate
reports could face up to
$1,000,000 in fines and/or a jail
sentence of up to 10 years.
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Management Discussion
and Analysis (MD&A)
Sometimes labeled “Financial
Review”
Contains information that cannot
be found in the financial data
Includes coverage of favorable or
unfavorable trends and
significant events or
uncertainties in particular areas
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MD&A
Elements of discussion
Internal and external sources of
liquidity
Any material deficiencies in liquidity
and how they will be remedied
Commitments for capital expenditures,
the purpose of such commitments,
and expected sources of funding
Anticipated changes in the mix and
cost of financing resources
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MD&A
Elements of discussion
Unusual or infrequent transactions
that affect income from
continuing operations
Events causing material changes in
cost/revenue relationships (e.g.
future price increase)
Breakdown of sales increases into
price & volume components
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MD&A
Usefulness
Companies do a good job of
describing historical events.
Very few firms provide accurate
and meaningful forecasts.
Explanations about why changes
have occurred in profitability and
liquidity are helpful.
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Five-Year Summary of
Selected Financial Data and
Market Data
• Net sales or operating revenues
• Income or loss from continuing
operations per common share
• Total assets
• Long-term obligations and
redeemable preferred stock
• Cash dividends per common share
• Two years of high and low common
stock prices by quarter
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Pandora (A.K.A. “PR
Fluff”)
• Colored photographs
• Charts
• Shareholders’ letter from the CEO
• Other items to make the report
attractive
Getting to what is needed through
the “PR fluff” can be a challenge.
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Proxy Statement
Used to solicit shareholder votes
Important in assessing who
manages the firm, how
management is paid, and
potential conflict-of-interest
issues
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Proxy Statement
Contents
• Voting procedures and information
• Background of nominated directors
• Director and executive compensation
• Proposed changes in compensation
plans
• Audit committee report
• Breakdown of audit and non-audit
fees
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Missing and Hard-to-Find
Information
• Employee relations with management
• Morale and efficiency of employees
• Reputation of the firm
• Firm’s prestige in the community
• Effectiveness of management
• Provisions for management
succession
• Potential exposure to regulation
changes
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Missing and Hard-to-Find
Information
These qualities impact the firm’s
operating success both directly
and indirectly but are difficult to
quantify.
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Missing and Hard-to-Find
Information
Publicity in the Media
• Affects public perception of firm
• Can impact financial performance
Companies Operating in Several
Lines of Unrelated Business
• Breakdown of financial data is
found in notes to financial
statements
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Complexities
GAAP
Provide some measure of
uniformity
Allow management considerable
discretion in applying regulations
Use of the accrual rather than the
cash basis of accounting
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Complexities
Accounting Choices
Accounting choices and estimates
impact financial statement numbers.
Quality of financial reporting is
impacted if accounting choice does
not reflect economic reality.
Financial data must be appropriated to
particular time periods even though
a firm’s life is continuous.
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The Future of Financial
Statements
FASB tends to develop detailed rules.
IASB uses broader principles.
FASB and IASB are working together
to develop one set of standards.
Significant changes being worked on
include lease accounting,
classification of financial
instruments, inventory accounting,
and revenue recognition.
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The Future of Financial
Statements
Proposal for statements to show
subtotals for five general
categories
• Business
• Discontinued operations
• Financing
• Income taxes
• Equity
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Quality of Financial
Reporting
Financial statements should
• reflect an accurate picture of a
company’s financial condition and
performance
• be useful to assess the past and
predict the future
The closer the picture to financial
reality, the higher the quality of
the financial statements.
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Reporting
Timing of Revenue and Expense
Recognition
The Matching
Principle
Expenses are matched with the
generation of revenues to determine
net income.
Matching process involves judgments by
management regarding the timing of
expense and revenue recognition.
The more conservative the approach,
the higher the quality of earnings.
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Quality of Financial
Reporting
Discretionary Items
• Budget level and timing of
expenditures
• Marketing and advertising
• Research and development
• Capital expansion
• Replacement of plant assets
• Development of new product lines
• Disposal of an operating division
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Quality of Financial
Reporting
Discretionary Items
The financial analyst should carefully
scrutinize management’s policies
with respect to discretionary items.
Such analysis can provide insight into
strengths and weaknesses of a
company and contribute to an
assessment of its ability to perform
successfully in the future.
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The Journey Through the
Maze Continues
Ch. 2:The Balance Sheet
Ch. 3:Income Statement and Statement
of Stockholders’ Equity
Ch. 4:Statement of Cash Flows
Ch. 5:A Guide to Earnings and Financial
Reporting Quality
Ch. 6:The Analysis of Financial
Statements
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