Section I Section I Introduction and ResourcesIntroduction and Resources

Module 1.a.Module 1.a.

Companies Under InvestigationCompanies Under Investigation

AldelphiAldelphiArthur AndersenArthur AndersenAOLAOLBristol Myers SquibbBristol Myers SquibbComputer Associates InternationalComputer Associates InternationalDeloitte & ToucheDeloitte & ToucheEnronEnronErnst & YoungErnst & YoungGlobal CrossingGlobal Crossing

Investigation cont’dInvestigation cont’d

HalliburtonHalliburtonImcloneImcloneKmartKmartKPMGKPMGPeregrinePeregrinePricewaterhouseCoopersPricewaterhouseCoopersQwestQwestTycoTycoWorldcom Inc.Worldcom Inc.XeroxXerox

Why?Why?

Quality of earningsQuality of earnings

Where were the auditors?Where were the auditors?

Responsibility of managementResponsibility of management

What is accounting?What is accounting?

Often called the language of Often called the language of businessbusiness

– Measures financial aspects of a Measures financial aspects of a businessbusiness

– Communicates this information to Communicates this information to decision makersdecision makers

Why should Why should everyoneeveryone in in business study accounting??business study accounting??

Many business decisions are based on Many business decisions are based on accounting information.accounting information.

Since accounting information is prepared Since accounting information is prepared according to “rules,” an understanding of according to “rules,” an understanding of these rules is necessary for the these rules is necessary for the appropriate use of the information.appropriate use of the information.

Personal need for understanding financial Personal need for understanding financial statementsstatements

The Accounting EquationThe Accounting Equation

Assets = Claims orAssets = Claims or

Assets = Liabilities + EquityAssets = Liabilities + Equity

AssetAsset: something of value: something of value

LiabilityLiability: something owed (creditors’ : something owed (creditors’ share of the assets)share of the assets)

EquityEquity: what remains (owners’ share of : what remains (owners’ share of the assets)the assets)

Four Basic Financial StatementsFour Basic Financial Statements

Balance SheetBalance Sheet– Assets = Liabilities + EquityAssets = Liabilities + Equity

Income StatementIncome Statement– Revenues - Expenses = Net incomeRevenues - Expenses = Net income

Statement of Changes in EquityStatement of Changes in Equity– Beginning equity + Contributions + Net income - Beginning equity + Contributions + Net income -

Distributions = Ending equityDistributions = Ending equity

Statement of Cash FlowsStatement of Cash Flows– Cash inflow - Cash outflow = Net cash flowCash inflow - Cash outflow = Net cash flow

The Annual Report includes:The Annual Report includes:

financial statementsfinancial statements

notes to the financial statementsnotes to the financial statements

auditor’s reportauditor’s report

5-year summary of key financial data5-year summary of key financial data

high and low stock selling priceshigh and low stock selling prices

management discussion & analysis of management discussion & analysis of operations (“forward-looking” info)operations (“forward-looking” info)

On-line Annual ReportsOn-line Annual ReportsMost companies provide their annual Most companies provide their annual reports online. Click on the link below to reports online. Click on the link below to look at Delta Airlines’ most recent annual look at Delta Airlines’ most recent annual report. Pay particular attention to how Delta report. Pay particular attention to how Delta addresses the challenges following 9/11 addresses the challenges following 9/11 (the first page or two of the AR). How much (the first page or two of the AR). How much cash aid did Delta receive from the federal cash aid did Delta receive from the federal government?government?Delta Annual ReportDelta Annual Report(note it will download in PDF format—you may have to (note it will download in PDF format—you may have to open up the window from the bottom toolbar)open up the window from the bottom toolbar)

NotesNotes

Are an INTEGRAL part of the statementsAre an INTEGRAL part of the statements

Provide summary of accounting policiesProvide summary of accounting policies

Present detail about particular accounts Present detail about particular accounts (e.g. inventory, investments, etc.)(e.g. inventory, investments, etc.)

Include other information (e.g. leasing Include other information (e.g. leasing arrangements, pending legal proceedings, arrangements, pending legal proceedings, income taxes, etc.)income taxes, etc.)

Notes (more stuff included)Notes (more stuff included)

Contain some supplementary information Contain some supplementary information required by SEC and FASBrequired by SEC and FASB

Examples include:Examples include:– information on foreign currency translations information on foreign currency translations

for firms doing business in/with foreign for firms doing business in/with foreign countriescountries

– information by segment for firms with several information by segment for firms with several lines of businesslines of business

Auditor’s ReportAuditor’s Report

Unqualified (what you want!) -- states that Unqualified (what you want!) -- states that statements present information in conformity statements present information in conformity with GAAP (sometimes with explanatory with GAAP (sometimes with explanatory language)language)Sometimes qualified or adverse opinions are Sometimes qualified or adverse opinions are issued (not what you want!)issued (not what you want!)DisclaimerDisclaimerKeep in mind that auditor is hired by the firm Keep in mind that auditor is hired by the firm -- always the possibility of conflict of interest-- always the possibility of conflict of interest

Look at an auditor’s opinionLook at an auditor’s opinion

Federal Express Annual ReportFederal Express Annual Report

Click on the link above and try to find the Click on the link above and try to find the auditor’s opinion (Hint: It’s after the notes)auditor’s opinion (Hint: It’s after the notes)

What type of opinion is it and who were What type of opinion is it and who were their auditors in 2002?their auditors in 2002?

Example of a qualified opinionExample of a qualified opinionThe accompanying consolidated financial statements The accompanying consolidated financial statements have been prepared assuming Carolco Pictures Inc. and have been prepared assuming Carolco Pictures Inc. and subsidiaries will continue as a going concern. As more subsidiaries will continue as a going concern. As more fully described in Note B, the Company has incurred fully described in Note B, the Company has incurred continuing significant losses and has a deficiency in continuing significant losses and has a deficiency in assets $64,521,000 at December 31, 1994. Further, the assets $64,521,000 at December 31, 1994. Further, the Company has experienced significant cash flow Company has experienced significant cash flow difficulties and does not have sufficient cash resources difficulties and does not have sufficient cash resources and financing sources to meet its operating expenses and financing sources to meet its operating expenses and scheduled debt service obligations, and continue to and scheduled debt service obligations, and continue to fund its principal business activity. These conditions fund its principal business activity. These conditions raise substantial doubts about the Company's ability to raise substantial doubts about the Company's ability to continue as a going concern. (Management's plans in continue as a going concern. (Management's plans in regard to these matters are also described in Note B). regard to these matters are also described in Note B). The 1994 consolidated financial statements do not The 1994 consolidated financial statements do not include any adjustments that might result from the include any adjustments that might result from the outcome of this uncertainty. outcome of this uncertainty. Carolco Pictures produced the Terminator movies!Carolco Pictures produced the Terminator movies!

MD&A (Financial Review)MD&A (Financial Review)

1.1.Internal/external sources of liquidityInternal/external sources of liquidity

2.2.Any material deficiencies in liquidity and Any material deficiencies in liquidity and how they will be remediedhow they will be remedied

3.3.Commitments for capital Commitments for capital expenditures/sources of fundingexpenditures/sources of funding

4.4.Anticipated changes in mix and cost of Anticipated changes in mix and cost of financing resourcesfinancing resources

MD&A (continued)MD&A (continued)

5.5.Unusual/infrequent transactions which Unusual/infrequent transactions which affect income from continuing operationsaffect income from continuing operations

6.6.Events causing material changes in Events causing material changes in cost/revenue relationships (e.g. future cost/revenue relationships (e.g. future price increase)price increase)

7.7.Breakdown of sales increases in price & Breakdown of sales increases in price & volume componentsvolume components

““PR Fluff”PR Fluff”

Amount sometimes varies INVERSELY Amount sometimes varies INVERSELY with performance...with performance...

Can visit many corporate websites to view Can visit many corporate websites to view some interesting “creations”some interesting “creations”

SEC FilingsSEC Filingshttp://http://www.sec.govwww.sec.gov

10K10K

10Q10Q

8K8K

ProspectusProspectus

What is insider trading?What is insider trading?

What is the CEO/CFO certification?What is the CEO/CFO certification?

Do rules = uniformity?Do rules = uniformity?

GAAP provide some measure but they GAAP provide some measure but they allow considerable discretionallow considerable discretion

Accounting choices and estimates affect Accounting choices and estimates affect amounts on financial statementsamounts on financial statements

Depreciation of fixed assets is a good Depreciation of fixed assets is a good example (choice of method, different example (choice of method, different “good faith” estimates possible) “good faith” estimates possible)

Accounting PeriodAccounting Period

Another complexityAnother complexity

Although the firm’s life is continuous, Although the firm’s life is continuous, financial data is presented for arbitrary financial data is presented for arbitrary time periods -- year, quarter and the liketime periods -- year, quarter and the like

Leads to need for more adjustments and Leads to need for more adjustments and estimatesestimates

Statements are prepared on “accrual” Statements are prepared on “accrual” basisbasis

Cash versus “Accrual”Cash versus “Accrual”

Financial statements are prepared on an Financial statements are prepared on an “accrual” basis“accrual” basis

Attempt to MATCH expenses with revenue Attempt to MATCH expenses with revenue in a given accounting periodin a given accounting period

Revenues reported when “earned” rather Revenues reported when “earned” rather than when received in cashthan when received in cash

Expenses are recorded when incurred Expenses are recorded when incurred rather than when paid in cashrather than when paid in cash

More Sources of “Confusion”More Sources of “Confusion”

Earnings per shareEarnings per share

Consolidation of parent and subsConsolidation of parent and subs

Reporting leasesReporting leases

Reporting pensionsReporting pensions

Translation of foreign operationsTranslation of foreign operations

Off-balance sheet financingOff-balance sheet financing

Accounting for derivativesAccounting for derivatives(continued…….)(continued…….)

Even MORE Confusion...Even MORE Confusion...

““Comprehensive” income reportingComprehensive” income reporting

Two sets of books (yes, it’s legal!!) - Two sets of books (yes, it’s legal!!) - financial vs. tax reportingfinancial vs. tax reporting

Pro forma earningPro forma earning

Quality of Financial ReportingQuality of Financial Reporting

Management has considerable discretion Management has considerable discretion within GAAPwithin GAAP

Potential exists to “manipulate” the Potential exists to “manipulate” the profit/loss reportedprofit/loss reported

The closer the financial data presented The closer the financial data presented represent financial reality, the higher the represent financial reality, the higher the quality of the financial statements and quality of the financial statements and reported earningsreported earnings

A business man was interviewing applicants for the position A business man was interviewing applicants for the position of divisional manager.  He devised a simple test to select of divisional manager.  He devised a simple test to select the most suitable person for the job.  He asked each the most suitable person for the job.  He asked each applicant the question, "What is two and two?" The first applicant the question, "What is two and two?" The first interviewee was a journalist.  His answer was "Twenty-interviewee was a journalist.  His answer was "Twenty-two." two."

The second applicant was an engineer.  He pulled out a The second applicant was an engineer.  He pulled out a slide rule and showed the answer to be between 3.999 slide rule and showed the answer to be between 3.999 and 4.001. and 4.001.

The next person was a lawyer.  He stated that in the case The next person was a lawyer.  He stated that in the case of Jenkins vs. Commr of Stamp Duties (Qld), two and of Jenkins vs. Commr of Stamp Duties (Qld), two and two was proven to be four. two was proven to be four.

The last applicant was an accountant.  The business man The last applicant was an accountant.  The business man asked him, "How much is two and two?" asked him, "How much is two and two?"

The accountant go up from his chair, went over to the door The accountant go up from his chair, went over to the door and closed it then came back and sat down.  He leaned and closed it then came back and sat down.  He leaned across the desk and said in a low voice, "How much do across the desk and said in a low voice, "How much do you want it to be?”you want it to be?”

He got the job. He got the job.

Means to Affect QualityMeans to Affect Quality

Accounting policies and estimatesAccounting policies and estimates– choices and changeschoices and changes

Timing of revenues and expensesTiming of revenues and expenses

Discretionary itemsDiscretionary items

Nonrecurring and nonoperating itemsNonrecurring and nonoperating items

ALL ARE WITHIN THE PURVIEW OF ALL ARE WITHIN THE PURVIEW OF MANAGEMENTMANAGEMENT

Accounting Policies/EstimatesAccounting Policies/Estimates

ChoicesChoices– Management may choose among acceptable Management may choose among acceptable

accounting policiesaccounting policies– Management has opportunity to make Management has opportunity to make

estimates when applying policiesestimates when applying policies

ChangesChanges– Policy or estimate may be changedPolicy or estimate may be changed

Timing of Revenues/ExpensesTiming of Revenues/Expenses

Matching process involves judgments by Matching process involves judgments by management regarding recognition of management regarding recognition of revenues and/or expensesrevenues and/or expenses

Usually the more conservative the Usually the more conservative the approach (least favorable to management) approach (least favorable to management) the higher the quality of earningsthe higher the quality of earnings

Discretionary ItemsDiscretionary Items

Budget level and timing of expenditures for Budget level and timing of expenditures for many items are discretionary, e.g.many items are discretionary, e.g.– advertising/marketingadvertising/marketing– repairs/maintenancerepairs/maintenance– research and developmentresearch and development– capital expansioncapital expansion

Nonrecurring and Nonoperating Nonrecurring and Nonoperating ItemsItems

Nonrecurring and nonoperating items are Nonrecurring and nonoperating items are not part of normal ongoing businessnot part of normal ongoing business

Earnings figure should reflect Earnings figure should reflect futurefuture operating potentialoperating potential

Therefore segregate such things as major Therefore segregate such things as major asset sales, accounting changes, asset asset sales, accounting changes, asset impairments, extraordinary itemsimpairments, extraordinary items

Look at an example of an Look at an example of an accounting changeaccounting change

Coca Cola Annual ReportCoca Cola Annual Report

Is the accounting change shown net of Is the accounting change shown net of tax?tax?

Look at page 70 of the annual report. Look at page 70 of the annual report. What SFAS caused the change?What SFAS caused the change?

What about Inflation???What about Inflation???

Historical cost principle prevails in financial Historical cost principle prevails in financial reportingreporting

Impact of inflation is uneven -- relevance Impact of inflation is uneven -- relevance vs. reliability tradeoffvs. reliability tradeoff

Produces both purchasing power gains Produces both purchasing power gains and losses -- e.g. debt is good in and losses -- e.g. debt is good in inflationary situationinflationary situation

Missing InformationMissing Information

Morale/efficiency of employeesMorale/efficiency of employees

Reputation/public perceptions of firmReputation/public perceptions of firm

Effectiveness of management Effectiveness of management team/provisions for successionteam/provisions for succession

Potential exposure to regulatory changesPotential exposure to regulatory changes

IMPACT OPERATING SUCCESS BUT IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFYARE DIFFICULT TO QUANTIFY

What about publicity?What about publicity?

Affects public perception of firm and can Affects public perception of firm and can impact financial performanceimpact financial performance

Proven correlation between financial Proven correlation between financial returns and reputationreturns and reputation

Recent examples are adverse publicity for Recent examples are adverse publicity for Coca Cola and Northwest Airlines -- Coca Cola and Northwest Airlines -- countered by the respective companies to countered by the respective companies to minimize impactminimize impact

What Info is Hard to Find?What Info is Hard to Find?

Many items must be extracted from notes, Many items must be extracted from notes, supplementary schedules, MD&A section in supplementary schedules, MD&A section in order to interpret financial statement order to interpret financial statement numbers - the facts numbers - the facts areare there, but they are there, but they are not self-evident!not self-evident!

Coverage in Chapters 2-5 is geared to Coverage in Chapters 2-5 is geared to helping FIND and EFFECTIVELY USE helping FIND and EFFECTIVELY USE information in financial statements and information in financial statements and supplementary materialssupplementary materials

The End!The End!

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