Financial AccountingA Decision-Making Approach, 2nd Edition

King, Lembke, and Smith

John Wiley & Sons, Inc.

Prepared byDr. Denise English,

Boise State University

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After reading Chapter 15, you should be able to:

1. Describe the importance of the Securities and Exchange Commission for users of financial information and provide a general overview of SEC reporting requirements.

2. Explain what is meant by consolidated financial statements, their advantages and limitations for decision makers, and the basic approach to preparing them.

3. Describe current requirements with respect to segment reporting and how such information can be useful for decision making.

4. Describe how interim financial reporting may help decision makers.

CHAPTER FIFTEEN

USING FINANCIAL STATEMENT

INFORMATION

After reading Chapter 15, you should be able to:

5. Identify the types of notes and supplemental information expected to be found in financial reports and link this information to decisions about enterprise activities.

6. Identify, describe, and use financial ratios to evaluate financial statements and identify specific characteristics of an enterprise.

7. Explain why understanding personal financial reporting is important, and how it differs from corporate financial reporting.

CHAPTER FIFTEEN

USING FINANCIAL STATEMENT

INFORMATION

The Securities and Exchange Commission

The Securities and Exchange Commission (SEC) is a government agency having primary responsibility for regulating the financial reporting of companies with publicly traded securities.

The SEC was established in 1934 to oversee the issuance and trading of securities by publicly held companies and to assure full and fair disclosure by those companies.

The SEC was given authority over reporting and disclosure requirements, but does not regulate a company’s activities. Nor does it guarantee the results of decisions made by information users.

Authority and Impact of the SEC

The SEC has generally taken the position that it would prefer to see accounting standards established by the private sector bodies, such as the FASB.

If the private-sector body issues a standard with which the SEC disagrees, the SEC typically accepts the standard but requires companies to disclose in notes to the financial statements what the effects of using the SEC’s preferred method would be.

A company that files misleading financial statements may face civil, or criminal penalties levied by the SEC. The SEC can also stop all trading in a company’s securities, denying the company access to the capital markets.

SEC Filing and Reporting Requirements

Public companies are required to file a number of reports with the SEC, the most common of which are:

Registration statement--must be filed before securities can be issued and must include audited financial statements from the registrant.

Form 10-K--must be filed annually, cover the last annual accounting period, and include audited financial statements.

Form 10-Q--must be filed quarterly and covers the most recent three-month period; it is less detailed than the 10-K, but must include financial statements which can be unaudited.

Form 8-K--must be filed within fifteen days of the occurrence of an unscheduled material event, such as bankruptcy, change of auditor, or the disposal of a major segment of business.

Management’s Discussion and Analysis

The Management’s Discussion and Analysis (MD&A) section of the annual report presents management’s detailed analysis of the company’s position and operations, along with a line-by-line discussion of changes in the financial statements.

In addition, it focuses on the company’s liquidity, capital resources, matters expected to have a significant effect on the company, and the effects of inflation.

It helps decision makers understand the “why” behind the numbers.

Level of Financial Statement Disclosure

A primary issue relating to the usefulness of information reported in financial statements relates to the type of reporting that best presents the overall picture of a company’s activities and position, while at the same time permits decision makers to grasp the details of the different aspects of the business enterprise.

The general approach to resolving this issue has been for the authoritative bodies to require companies to present consolidated financial statements along with additional disclosures relating to different business-line and geographic areas of the business.

Consolidated Financial Statements

Financial statements that report on the combined financial position and activities of a parent company and other companies that it controls (subsidiaries) are called consolidated financial statements.

The parent and its subsidiaries are legal entities, but the consolidated entity is not. The consolidated entity has economic reality, though, and provides a basis for defining the reporting entity.

A parent company has control if it can direct subsidiary policies and, in effect, use the subsidiary’s assets as its own. A controlling interest in the subsidiary may occur when a majority, or even a significant amount (larger than other shareholders) is owned.

The portion of stock owned by others (than the parent company) are referred to as minority or noncontrolling interests.

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Consolidated Statements and Decision Making

Consolidated statements are prepared primarily for those who have a long-run interest in the parent company, such as owners and long-term creditors.

It would be difficult for a decision maker to analyze each subsidiary in addition to the parent and make an overall evaluation without consolidated financial statements.

If only interest in a subsidiary exists, however, consolidated financial statements will not be as useful.

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Consolidated Statements and Decision Making

When examining consolidated financial statements, if the parent and subsidiary entities are dissimilar, some difficulty in interpreting financial statements may occur.

Another limitation of consolidated financial statements is that not all of the assets reported in the balance sheet are directly available for the parent’s use.

Under GAAP, consolidated financial statements must be presented whenever general-purpose statements are issued to the public.

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Principles of Consolidated Financial Statements

Consolidated financial statements for a combined entity are presented as if the related companies were actually a single company.

An additional step is taken to remove the effects of transactions or relationships between the affiliated companies. The main items that are eliminated are as follows:

– Parent’s investment in subsidiary;– Stockholders’ equity of the subsidiary(ies);– Intercompany receivables/payables;– Intercompany sales and profits.

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Segment Disclosures

By analyzing a company’s different activities, a decision maker is in a better position to assess a company’s future and judge the economic impact of possible future events.

The FASB has mandated that certain disaggregated information be included with corporate financial statements. These additional disclosures provide information about the following:

– a company’s different operating segments;– the different geographic areas in which it operates;– the company’s major customers.

Interim Financial Reporting

Interim financial reports, issued between annual reports, help meet the need for timely information. All publicly traded companies are required to file interim reports quarterly with the SEC.

At a minimum, interim reports must include: – Sales revenue, income tax expense, and net income;– Earnings per share for each period presented;– Disposal of a segment of the business, extraordinary items, unusual or

infrequently occurring items, and accounting changes;– Significant changes in income taxes;– Contingent items;– Significant changes in financial position.

Notes and Other Financial Statement Information

The notes to the financial statements are provided by management to supplement the numbers in the financial statements.

Some forms of disclosure are mandated by GAAP, but management frequently has some discretion in deciding whether to include certain details in the body of the financial statements, or in the notes.

Because notes are designed to explain and expand on the information included in the body of the financial statements, they do not replace the information on the statements.

Summary of Required Note Disclosures

Exhibit 15-3(partial)

Accounts Receivable

Inventories

Investments

Property, Plant, and Equipment

•allowance for doubtful accounts•accounts pledged or assigned•valuation methods (e.g., lower of cost or market)•costing methods (e.g., FIFO, LIFO)•major categories of inventories•special inventory financing arrangements•valuation methods•alternate valuations (e.g. market value)•depreciation methods•interest included in cost•accumulated depreciation•collateral arrangements for borrowings

Summary of Required Note Disclosures

Exhibit 15-3(partial)

Financial Instruments

Long-term Debt

Pensions

Other PostretirementBenefits (e.g., medicalinsurance)

•description, nature, and purpose•principal amounts and fair values•gains and losses from changes in fair values•description of each type or issue of debt•maturities of debt by year•special terms or provisions•description of plans•amounts of all components used in computation of employers’ cost and obligation•description of plans•amounts of all components used in computation of employers’ cost and obligation•estimated effect of change in health care cost

Summary of Required Note Disclosures

Exhibit 15-3(partial)

Income Taxes

Stockholders’ Equity

Contingencies

•amounts and classification of deferred taxes•reconciliation of reported income tax expense with taxes computed at the statutory rate•par or stated value of stock•number of shares authorized, issued, outstanding•details of employee stock incentive plans•value of stock options granted•description of unresolved events that could have a significant effect on the company in the future

Summary of Significant Accounting Policies

All companies are required to provide a summary of significant accounting policies used to prepare the financial statements.

Other supplemental information often includes quarterly financial information and five-year or ten-year financial summaries.

Content of Summary of Significant Accounting Policies

Consolidation policy--a brief statement of which subsidiaries are consolidated and, if not all are consolidated, what the basis for exclusionis. Also, the treatment of intercompany transactions is described. Cash and Cash Equivalents--a description of what securities are considered cash equivalents, as well as any policies that might affect theavailability of cash.Accounts Receivable--an explanation of any receivables that are special or that have nonroutine collection patterns.Inventories--a description of inventory valuation methods used (e.g., cost, lower of cost or market) and inventory costing methods used (e.g. LIFO, FIFO). Special inventory valuation practices, such as for inventory being constructed under long-term contract, are described.Other Current Assets--a description of content, if significant.

Exhibit 15-4(partial)

Content of Summary of Significant Accounting Policies

Investments--a description of investments and how they are valued.Property, Plant, and Equipment--a brief statement about how fixed assets are valued and depreciated. Sometimes, the depreciation periods are disclosed. More detail is usually given in a subsequent note.Liabilities--valuation and classification descriptions. This item may be omitted because liabilities are always discussed in detail in a separate note.Owner’s Equity--often omitted because policies relating to owners’ equity are fairly standard. Computations for earnings per share may be described, as might the method of accounting for treasury stock, if any.Subsequent notes may describe stock options or special owners’ equitytransactions.

Exhibit 15-4(partial)

Content of Summary of Significant Accounting Policies

Revenue Recognition--a description of when revenues and other types of income are recognized.Specialized Industry Practices--a description of recognition andmeasurement policies unique to the industry. Other Items--an explanation of special accounting treatment accordedparticular transactions or events, such as the adoption of a new accounting method.Foreign Currency Translation--a description of the currencies used inthe company’s business and how they are restated to dollars.Use of Estimates--a caveat explaining that accounting employs estimates that affect reported amounts and that estimates could differfrom actual amounts.

Exhibit 15-4(partial)

Content of Summary of Significant Accounting Policies

Concentrations--when applicable, a description of the company’s limited number of suppliers, customers, transportation channels, or similar factors that could adversely affect the company under certain conditions.Reclassifications--a description of any amounts that have been reclassified from prior year financial statements to conform with current classification.

Exhibit 15-4(partial)

Financial Analysis

Financial statement analysis often involves comparing reported information about a company over different time periods and between different companies during the same period of time. Three financial analysis approaches are:– horizontal analysis– vertical analysis– ratio analysis.

Horizontal Analysis

An analysis of financial statement data over a period of years is horizontal or trend analysis.

Typically the amounts for the current and one or two earlier periods are compared to determine both the dollar amount and percentage change from period to period.

Change

2001 2000 Dollar PercentNet Sales $25,350 $23,120 $2,230 9.65%

Vertical Analysis

An analysis of the individual components of the financial statements is referred to as vertical analysis.

In vertical analysis, the dollar amounts in the financial statement are restated as percentages to show their proportion of the totals.

Statements presented in percentages are referred to as common-size financial statements.

Common Common 2001 Size 2000 Size

Net sales $25,350 100.0 $23,120 100.0Operating expenses 20,070 79.2 17,280 74.7Net income 5,280 20.8 5,840 25.3

Ratio Analysis

Comparisons within financial statements and across time often are made with the help of summary measures and ratios as discussed in previous chapters.

Financial ratios can be analyzed with respect to liquidity, solvency, profitability, and return to investors.

LiquiditySolvencyProfitabilityReturn to investors

Summary of Key Ratios Exhibit 15-5(partial)

1. Accounts receivable turnover:

2. Asset turnover:

3. Cash flow per share:

4. Cash flow to current maturities of debt:

5. Cash flow to total debt:

6. Current ratio:

Net sales revenueAccounts receivable

Net sales revenue Total assets

Cash provided by operations - preferred dividends Number of common shares outstanding

Cash provided by operations Current maturities of debt

Cash provided by operations Total debt

Current assets Current liabilities

Summary of Key RatiosExhibit 15-5

(partial)

7. Days sales in receivables:

8. Days sales in inventory:

9. Debt to equity:

10. Diluted earnings per share:

11. Dividend payout:

Accounts ReceivableCredit sales / 365 days

Inventory Cost of goods sold / 365 days

Long-term debt excluding deferred taxes Stockholders’ Equity

Net income- preferred dividends+ adjustment for conversion of securities Common shares outstanding +additional shares from potential conversion

Dividends paid Net income

Summary of Key RatiosExhibit 15-5

(partial)

12. Dividend yield:

13. Dividends to operating cash flow:

14. Earnings per share:

15. Gross margin percentage:

16. Inventory turnover:

Cash dividend per share Market price per share

Dividends paid Cash provided by operations

Net income- preferred dividends Common shares outstanding

Net sales - cost of goods sold

Net sales

Cost of goods sold Inventory

Summary of Key RatiosExhibit 15-5

(partial)

17. Long-term debt to total assets:

18. Net income margin:

19. Operating cycle:

20. Price-earnings ratio:

21. Quick ratio:

Long-term debt Total assets

Net income Net sales revenue

Accounts receivable Credit sales/365 days

Market price per share of common stock Earnings per share

Quick assets Current liabilities

+ Inventory Cost of goods sold/365 days

Summary of Key RatiosExhibit 15-5

(partial)

22. Return on assets:

23. Return on common equity:

24. Return on total equity:

25. Times interest earned:

26. Times preferred dividends earned:

Net incomeTotal assets

Net income - preferred dividends Stockholders’ equity - preferred stock claims

Operating income Interest on long-term debt

Net income Preferred dividends

Net income Stockholders’ equity

Liquidity

Liquidity measures provide an indication of an entity’s position with respect to cash and assets that may be converted into cash in the relatively near future.

Some liquidity measures are:– current ratio– quick ratio– accounts receivable turnover– days sales in receivables– inventory turnover– days sales in inventory– operating cycle– cash flow to current maturities of debt

Solvency

Solvency measures help decision makers evaluate an entity’s ability to meet its obligations in a timely manner.

Some solvency measures are:– Long-term debt to total assets– Debt to equity– Times interest earned– Cash flow to total debt.

Profitability

Profitability measures provide indications of a company’s operating success.

Some profitability measures are:– Gross profit (margin) percentage– Net income margin (return on sales)– Return on common equity– Asset turnover– Return on assets.

Return to investors

Return measures focus on more direct measures of returns to investors.

Some return measures are:– Earnings per share– Diluted earnings per share– Dividend payout– Dividends to operating cash flow– Cash flow per share.

Personal Financial Reporting

Individuals are often asked to provide personal financial information when seeking a large loan, or entering a business venture. Personal financial statements are also used for purposes such as reviewing the adequacy of resources accumulated for retirement, analysis of asset holdings, and estate planning.

Two personal financial statements are generally prepared:– Statement of financial condition (personal balance

sheet);– Statement of changes in net worth (personal income

statement).

Personal Financial Reporting

Assets should be reported at their fair values, and liabilities at the lower of the discounted future cash payments or the current cash settlement amount on a personal balance sheet. In addition, an estimated income tax liability must be reported for the difference between the current fair values of the assets and liabilities and their tax bases.

Changes in the values of the assets and liabilities are reported in the personal income statement, as is the change in the estimated income tax that would have to be paid on the changes; distinction between realized and unrealized changes in net worth should also be drawn.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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