Analyzing a Company’s Financial Reporting

Lecture 8

What you should expect

Understand the Financial Statements

•What are the financial statements saying?•What are the financial statements not saying?•What are the accounting principles that govern the statements?•How do internal controls work to enhance reporting reliability?•What are the sensitive areas in the financial reports?•How do I recognize a “red flag”?•How does Wall Street view the financial statements?

Develop a Critique for Your Firm’s Financial Statements

Questions to Ask

How Firm Valuation Issues AriseDiversity in Generally Accepted Accounting Principles (GAAP)

Examples:

Examples:

─Show securities at cost─Show securities at market value when below cost─Show securities at cost plus interest earned but not yet paid─Show securities at approximate market value

─Recognize revenue in the period when products or services are delivered─Recognize revenue in the period when product is ready for delivery ─Recognize revenue in the period when payment is received from customer or client

Another Example

Why is Accounting for Current Enterprise Transactions So Difficult?

• The numbers are important but equally important are the principles and practices that lie behind them– Revenue recognition– Accruals– Asset vs. expense– Valuation– Depreciation and amortization– Currrency translation

Why is Accounting for Enterprise Transactions so Difficult?

• Sophisticated Issues– Special Purpose Entities– Derivatives– Lease Accounting – Expensing stock options– Restructuring charges– Recognizing debt associated with pension benefits

Information QualityNot where it needs to beAppropriateness of financial Meets

Objectives

Information

In Reflecting 41%

Business Performance

For Management Decision Making 26%

For Forward looking Management 16%

Planning and Strategy

The Limitations of GAAP Accounting

The Objective:Faithfully represent the business and provide information about future cash

flows

The practical Problem:Measurement is difficult and subject to speculation“Tell us that you know, but leave the speculation to us”

The Tradeoff:Relevance versus reliability

The SEC Final Rule on Sarbanes-Oxley

The certification statement regarding fair presentation of financial statements and other financial information is not limited to a representation that the financial statements and other financial information have been presented in accordance with “generally accepted accounting principles” and is not otherwise limited by reference to generally accepted accounting principles. We believe that Congress intended this statement to provide assurances that the financial information disclosed in a report, viewed in its entirely, meets a standard of overall material accuracy and completeness that is broader than financial reporting requirements under generally accepted accounting principles[emphasis added]

U.S. Securites and Exchange Commission, Final Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release Nos. 33-8124, 34-46427; File No. S7-21-02, http://www.sec.gov/rules/final/33-8124.html

How Should You Deal with the Issues?

Understand GAAP and its limitations─Appreciate the relevance-reliability tradeoff─Recognize the diversity in accounting applications─Recognize the critical accounting policies─Recognize unresolved issues in GAAP─Recognize where choices can be made

How does your firm treat depreciation accounting?Be alert to poor application of GAAP

─How sensitive are earning to estimates?─How would you characterize the revenue recognition-aggressive or conservative?─Does the application of GAAP “faithfully represent” the business?

Market is demanding transparency as well as compliance with GAAP ─Transparency on performance

─Transparency on asset and liability position

The Focus for the Non-Financial Professional

Take the position of the shareholder (owner)

How much did I make this year?

What is my financial position?

─ my share of assets?

─ my obligations?

How much can I expect to make in the future?

What is my stock worth?

Accounting Essentials for Non-Financial Professionals

1. Navigating the Financial Statements

2. Highlighting Some Key Issues:

The use of estimates in financial reports Revenue recognition Recognizing variable interest entities (SPEs) Distinguishing liabilities and equity Accounting for stock based compensation

Navigating the Financial Statements

A. Understand what each statement is saying

─ What is recognized and what is not recognized?─ What are the accounting principles employed?─ How do firms in the same industry differ?

B. Identify the sensitive issues

The financial statements are the lens on the businessThe eye on the lens is the eye of the shareholdersThe lens can be out of focus

Viewing the Business Through the Financial Statements

Business Activities:•Financial Activities•Investing Activities•Operating Activities

Financial Activities Investing Activities Operating Activities

Raise monies from investors

Invest in business assets

Employ assets in trading to “add value”

Return value to investors

The Financial Reports

Management Discussion and Analysis

The Four Financial Statements

Footnotes to the Financial Statements

─Balance Sheet─Income Statement─Cash Flow Statement─Shareholders’ Equity Statement (required by the SEC, not GAAP)

Cash Accounting

2003 CASH

2004 CASH

The Cash Flow Statement

Cash From Operations- Cash investing

= Net cash from operations

- Net cash paid to investors- Shareholders- Debtholders

= Change in cash

Report Cash Added

Cash generated by business

Cash remaining after distribution to investors

Qualcomm Cash Flows: Bottom Line Summary(in millions of dollars)

Cash Flow from Operations 1,782

Cash spent on investments 1,029

Net cash from operations 753

Net cash paid to investors:

To shareholders 103

To debtholders 12 115

Change in cash 638

Does Cash Accounting Draw a Sensible Picture of the Business for the Shareholders?

How much did I make this period?

Investments add to earnings rather than reduce them

Earnings are made (or lost) other than by cash

•Sales on credit•Inputs purchased on credit•Services paid for with stock

How Accrual Accounting Works

Focusing the lens to capture the economics of the businessRecognize revenues when delivery has occurred even if cash has not been receivedExpenses are recognized in the same accounting period as the revenues to which they relateInvestments are placed on the balances sheet, rather than charged to current operations

─Examples:Inventory and Property, plant and equipment

Non-cash effects on shareholder value are recognized (the accruals)─Examples:

Sales on credit─Revenue and accounts receivable

Wages not paid and pensions─Wages expenses and wages payable─Pension expense and pension liability

Thinking about Poor Accrual Accounting

Inappropriate “capitalization”─Recognizing investments as assets rather than expenses

(R&D and brand building)─Recognizing expenses as assets

Here’s the Rub!

Accrual accounting ideally gives a better picture than cash accounting, but accrual accounting requires estimates.

Estimates are really forecasts of the future. They will usually turn out to be wrong, but they should be an unbiased, best guess.

The Accrual Accounting Picture2003The Balance Sheet

2004The Balance Sheet

AssetsLiabilities

EquityAssets

Liabilities

Equity

Report Additions to Equity

The Equity Statement

•Net Additions from share issues and payouts•Additions from the business

The Income Statement

Revenues-Expenses Net income

Navigating the Equity Statement

A. Understand What the Statement is Saying

B. Identify the Sensitive Issues

1. Additions from transactions with shareholders

2. Additions from running the business for the shareholders

Share issues (+)Share repurchases (-)Dividends (-)

Navigating the Income Statement

1. What the Statement is Saying

2. Sensitive Issues

Revenues = Cash + revenue accruals- Expenses = Cash + misclassified + expense

= Net income =

•Misclassification of investments: the “capitalization” question

•Estimates for revenue and expense accruals

Misclassification Estimates

Investments accruals

Revenue Recognition: The Realization Principle

Revenues should be recognized when

The earnings process with respect to the revenue is complete or virtually complete.

The first criterion means that the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenue (usually cash inflow). For most firms, this criterion is satisfied at the time of delivery (by delivering the merchandise or service , the firm has preformed at least most of what it is suppose to do to be entitled to the revenue).

The amount and timing of cash flows from the revenue are reasonably determinable.

The second criterion requires that revenue be recognized in the income statement only if cash has already been collected or the amount and timing of cash to be collected can be estimated with reasonable precision.

Revenue Recognition: The Realization Principle

Implications:

If the firm sold and delivered a product, it should recognize revenue even if it did not collect cash, as long as there is reasonable certainly of collection.

If the firm collected cash but has not delivered the product yet, it should not recognize revenue.

If the firm delivered the product but cannot determine the sufficient precision when and how much cash will be collect, it should not recognize the revenue.

Revenue Recognition: Multiple Deliverables

Qualcomm: Equipment and services

The Key Question: Is revenue recognition aggressive or conservative?

Equipmentdelivery

Service period End of contract

Expense Recognition: The Matching PrincipleThe matching principle requires that each cost be reported as an expense in the same period in which the revenues that the cost helped generate are recognized.

To implement the matching principle, management should first apply the realization principle and decide which revenues to recognize. Then, it should identify all the costs that helped generate those revenues and report them as an expense in the same income statement together with the revenues.

Implications:•Expenditures that generate future revenues are investments•Costs that generate current revenues are expenses

For examples;•Inventory cost is recognized when goods are sold (as cost of goods sold)•Depreciation is recognized over the service life of an asset•Mismatching : the WorldCom con

The Key Questions:•Is the capitalization of expenses appropriate?•Have all costs to generate current expenses been recognized?

Navigating the Balance Sheet1. What the statement is saying?

Assets

Liabilities

Equity

Equity = Asset - LiabilitiesAsset represent

•Probable future benefits•Measurable with reasonable reliability•Resulting from past transaction or events

Liabilities represent•Probable future sacrifice of economic benefits•Measurable with reasonable reliability•Resulting from past transaction or events

2. The Sensitive Issues• Recognition of assets and liabilities• Measurements of assets and liabilities

Measurement in the Balance SheetHistorical Cost Accounting

•Original cost adjusted for accruals to recognize revenues and expenses─PPE: historical cost less accumulated depreciation─Unearned revenue─Accrued expenses─Capitalized costs

Fair Value Accounting•Marking assets to market

─“Trading” and “available-for-sale” securities─Derivatives

•Quasi or estimated fair value─Receivables─Pension liabilities

•Conditional fair valuing: impairment─Inventory: lower of cost or market─PPE─Goodwill

Measurement in the Balance Sheet: QualcommMark-to-Market

Cash and Cash Equivalents $2,045Short-term marketable securities 2,516Long-term marketable securities 611 (out of $811)Accounting Payable 195

Quasi Fair ValueAccounts Receivable, net 484Financing Receivable, net 6

Conditional Fair Value applied to the following historical cost items:Goodwill 347Inventories 110PPE 622

Historical Cost but usually Close to Fair ValueFinancing Debt 226

All other assets and liabilities are at historical cost, adjusted for accruals

The Balance Sheet: The Key Questions

Recognition:•Are liabilities missing? If so, is there transparent footnote disclosure?•What are the contingencies?•What are the executory contracts not recognized?

Measurement:•Are mark-to-market prices from liquid markets?•Are estimated fair values unbiased?•Have impairments been made? Are they unbiased?•Are accruals unbiased?

(Broad) Questions to Ask

Revenue recognition

─Can the revenue recognition policy be characterized as aggressive or conservative?

─How much of the revenue is due to revenues deferred from the past, net of revenues currently deferred ? (Are we baking or eating cookies?)

Is the firm recognizing all expenses necessary to generate revenue?

─Are costs appropriately capitalized?─Are accrued expense liabilities appropriately recognized?

What will be effect of current estimates on future earnings?─Restructuring charges?─Impairments and write-downs?─Allowances?

Are fair values reliable?

Are there transactions that might be interpreted as form over substance?

─Structured finance transactions?─Unconsolidated variable interest entities?─Doubtful arrangements to recognize revenue?

The catch-all question: Do the accounting and the disclosures faithfully and transparently represent the business activities?

(Broad) Questions to Ask