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Communicating and Interpreting Accounting Information Chapter 5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-2 Learning Objectives Recognize the people involved in the accounting communication process (regulators, managers, directors, auditors, information intermediaries and users), their role in the process and the guidance they receive from legal and professional standards. 5-3 Management Players in the Preparation Accounting CEO, CFO, Accounting Staff Communication Guided by GAAP Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP. 5-4 Management Players in the Preparation Accounting CFO, CEO, Accounting Staff Communication Guided by GAAP Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. 5-5 Management Players in the Preparation Accounting CFO, CEO, Accounting Staff Communication Guided by GAAP Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Web Info Services: Financial analysts www/sec/gov make predictions www.compustat.com concerning www.djnr.com companies’ future www.bloomberg.com earnings and stock www.firstcall.com prices. www.hoover.com 5-6 Management Players in the Preparation CFO, CEO, Accounting Staff Accounting Guided by GAAP Communication Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Government Regulators Verification SEC Members Guided by SEC regs. Users Analysis and Decision Investors, Lenders, etc. Public companies only 5-7 Ensuring the Integrity of Financial Information Communication Process Regulators Standard Setting and Verification SEC Management Primary Responsibility CFO, CEO, Accounting Staff Auditors (CPAs) Verification Partners, Managers, Staff Directors Oversight Audit Committee (Independent directors) 5-8 Using Financial Reports Management Primary Responsibility CFO, CEO, Accounting Staff Information Intermediaries Analysis and Advice Financial analysts, Information services Users Analysis and Decision Institutional and private investors, Lenders, Suppliers, Customers, etc. 5-9 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time 5-10 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. The full-disclosure principles require . . . Primary Qualitative Characteristics 1. Relevance: A complete set financial statements, Timely andof Predictive and Feedback Value and Unbiased, and Verifiable Reliability: Accurate, 2.Notes to the financial statements Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time 5-11 International Accounting Standards Board and Global Differences in Accounting International Financial Reporting Standards Difference in Accounting Standards Extraordinary items LIFO for inventory Reversal of inventory write-downs Basis of property, plant, and equipment US GAAP Permitted Permitted Prohibited Historical cost IFRS Prohibited Prohibited Required Fair Value or Historical cost 5-12 Learning Objectives Identify the steps in the accounting communication process, including the issuance of press releases, annual reports, quarterly reports and SEC filings as well as the role of electronic information services in this process. 5-13 The Disclosure Process Press Releases are used to announce quarterly and annual earnings as soon as the verified figures are available. Earnings Press Release Excerpt for Callaway Golf Callaway® Golf CARLSBAD, Calif. -- Jan. 22, 2004-- Callaway Golf Company (NYSE:ELY) today reported record sales for the full year ended December 31, 2003, announcing net sales of $814 million compared with $793 million for the prior year. Net income for the full year was $46 million versus . . . . 5-14 Annual Reports For privately held companies, annual reports are simple documents that include: 1. Four basic financial statements. 2. Related notes (footnotes). 3. Report of independent accountants (auditor’s opinion) if the statements are audited. 5-15 Annual Reports For public companies, annual reports are elaborate due to SEC reporting requirements: 1. A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. 2. A Financial Section See next slide for a detailed listing . . . 5-16 Annual Reports - Financial Section 1. Summarized financial data for 5- or 10-years. 2. Management Discussion and Analysis (MD&A). 3. The four basic financial statements. 4. Notes (footnotes). 5. Independent Accountant’s Report and the Management Certification. 6. Recent stock price information. 7. Summaries of the unaudited quarterly financial data. 8. Lists of directors and officers of the company and relevant addresses. 5-17 Quarterly Reports Usually begin with short letter to stockholders Condensed unaudited income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. 5-18 SEC Reports Form 10-K Annual Report •Due within 90 days of the fiscal year-end. •Contains audited financial statements. Form 10-Q Quarterly Report •Due within 45 days of the end of the quarter. •Financial statements can be unaudited. Form 8-K Current Report •Due within 15 days of the major event date. •Financial statements can be unaudited. 5-19 Learning Objectives Recognize and apply the different financial statement and disclosure formats used by companies in practice. 5-20 Financial Statement Formats Let’s take a closer look at the asset section of the balance sheet! 5-21 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets Total current assets $ Property, plant and equipment, net Intangible assets, net Other assets $ 47,340 $ 100,664 185,389 50,069 383,462 108,452 63,867 151,760 44,948 369,027 164,763 169,851 30,490 748,566 $ 167,340 121,317 22,161 679,845 5-22 Callaway Golf Company Consolidated Balance Sheet (in thousands, except share data and per share data) ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets Total current assets Property, plant and equipment, net Intangible assets, net Other assets December 31, 2003 2002 Current assets assets that $ are 47,340 $ 108,452 63,867 will100,664 be turned into 185,389 151,760 cash50,069 or expire (be 44,948 383,462 369,027 used up) within 167,340 the164,763 longer of one 169,851 121,317 year 30,490 or the 22,161 $operating 748,566 $ cycle. 679,845 5-23 Callaway Golf Company Consolidated Balance Sheet Property, plant and December 31, equipment includes (in thousands, except share data and per share data) 2003 2002 ASSETS assets with useful Current assets: lives of more than Cash and cash equivalents $ 47,340 $ 108,452 Accounts receivable, net 63,867 one 100,664 year acquired Inventories, net 185,389 151,760 for use in the Other current assets 50,069 44,948 Total current assets 383,462 369,027 business rather than 164,763 for resale. The Property, plant and equipment, net 167,340 Intangible assets, net 169,851 121,317 amount is reported Other assets 30,490 22,161 net accumulated $ of 748,566 $ 679,845 depreciation. 5-24 Callaway Golf Company Consolidated Balance Sheet (in thousands, except share data and per share data) ASSETS Current assets: Cash and cash equivalents Accounts receivable, net Inventories, net Other current assets Total current assets Property, plant and equipment, net Intangible assets, net Other assets December 31, 2003 2002 Intangible $ 47,340 $ assets 108,452 100,664 63,867 have no physical 185,389 151,760 existence and a 50,069 44,948 383,462 369,027 long life. They include 164,763 patents, 167,340 169,851 121,317 copyrights, 30,490 22,161 trademarks, etc. $ 748,566 $ 679,845 5-25 Let’s now look at the liability section of a classified balance sheet. 5-26 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) LIABILITIES & STOCKHOLDERS" EQUITY Current Liabilities: Accounts payable and accrued expenses Notes payable, current portion Income taxes payable Total current liabilities Long-term liabilities: Other liabilities Commitment and contingencies (Note 13) $ 117,958 $ 98,352 240 11,962 130,160 3,160 7,649 109,161 29,023 27,297 5-27 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) LIABILITIES & STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable and accrued expenses Notes payable, current portion Income taxes payable Total current liabilities Long-term liabilities: Other liabilities Commitment and contingencies (Note 13) Current liabilities obligations $ are 117,958 $ 98,352 that will be paid 240 current 3,160 with 11,962 7,649 assets, normally 130,160 109,161 within one year. 29,023 27,297 5-28 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) LIABILITIES & STOCKHOLDERS" EQUITY Current Liabilities: Accounts payable and accrued expenses $ 117,958 $ 98,352 Long-term liabilities are debts that have Notes payable, current portion 240 3,160 maturity dates extending beyond one Income taxes payable 11,962 7,649 year Total from the balance sheet current liabilities 130,160 date. 109,161 Long-term liabilities: Other liabilities Commitment and contingencies (Note 13) 29,023 27,297 5-29 Finally, we get to the stockholders’ equity section of a classified balance sheet. 5-30 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) LIABILITIES & STOCKHOLDERS' EQUITY Shareholders' equity: Common stock, $.01 par value, 83,710,094 and 83,577,427 issued and outstanding at December 31, 2003 and 2002, respectively Additional paid-in capital Retained Earnings Total stockholders equity Total Liabilities and stockholders' equity $ 837 122,105 466,441 589,383 748,566 $ Contributed capital is often shown in $ $ two separate accounts 1. Common stock. 2. Additional paid-in capital. 836 103,097 439,454 543,387 679,845 5-31 Callaway Golf Company Consolidated Balance Sheet December 31, 2003 2002 (in thousands, except share data and per share data) LIABILITIES & STOCKHOLDERS' EQUITY Shareholders' equity: Common stock, $.01 par value, 83,710,094 and 83,577,427 issued and outstanding at December 31, 2003 and 2002, respectively Additional paid-in capital Retained Earnings Total stockholders equity Total Liabilities and stockholders' equity $ 837 122,105 466,441 589,383 748,566 $ 836 103,097 439,454 543,387 679,845 $ Retained earnings is$ the total earnings of the company less the total dividends declared since inception of operations. 5-32 Balance Sheet Ratios and Debt Contracts When a company borrows money, it often agrees to certain restrictions on activity. Ratios typically part of the borrowing agreement include: Total Liabilities ÷ Stockholders' Equity = Debt-to-Equity Ratio Current Assets ÷ Current Liabilities = Current Ratio 5-33 Classified Income Statement Income statements may contain five sections: 1. 2. 3. 4. Continuing operations Discontinued operations Extraordinary items Cumulative effect of changes in accounting methods 5. Earnings per share 5-34 Classified Income Statement General Format for the Classified Income Statement − − ± − Net sales Cost of goods sold Gross profit Operating expenses Income from operations Nonoperating revenues/expenses and gains/losses Income before income taxes Income tax expense Net income Gross sales minus any discounts, returns, and allowances during the period. 5-35 Classified Income Statement General Format for the Classified Income Statement − − ± − Net sales Cost of goods sold Gross profit Operating expenses Income from operations Nonoperating revenues/expenses and gains/losses Income before income taxes Income tax expense Net income Cost of inventory sold. 5-36 Classified Income Statement General Format for the Classified Income Statement − − ± − Net sales Cost of goods sold Gross profit Operating expenses Income from operations Nonoperating revenues/expenses and gains/losses Income before income taxes Income tax expense Net income Not related to the company’s primary operations. Usually includes interest income or expense and any gains or losses from the retirement of equipment. 5-37 Common-Size Income Statement Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income Month Ended January 31, 2004 (in thousands of dollars) Revenues: Restaurant sales $ Franchise fees Total revenues Costs and expenses: Cost of sales Salaries & benefits expense General & administrative expenses Depreciation expense Total costs and expenses Operating income Other revenues and gains (expenses and losses) Investment income Interest expense Gain on sale of land Income before income taxes Income tax expense Net income $ Earnings per share $ 66,000 3,800 69,800 94.56% 5.44% 100.00% 36,000 16,000 8,100 2,500 62,600 7,200 51.58% 22.92% 11.60% 3.58% 89.68% 10.32% 1,000 (60) 3,000 11,140 3,899 7,241 1.43% -0.09% 4.30% 15.96% 5.59% 10.37% 0.40 Total revenue is equal to 100%. 5-38 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Basic EPS 5-39 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Diluted EPS Stock options, debt securities, equity securities are assumed to be converted into common stock at the beginning of the period. 5-40 Statement of Cash Flows Recall that the Statement of Cash Flows is divided into three major sections. 1. Cash flows from operating activities. 2. Cash flows from investing activities. 3. Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. 5-41 Consolidated Statement of Cash Flows (in thousands) 2003 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Other non-cash items Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable, net Inventories, net Other assets Accounts payable and accrued expenses Income taxes payable Other liabilities Net cash provided by operating activities $ 45,523 44,496 17,593 12,698 4,897 (4,743) (7,297) 4,004 1,572 $ 118,743 This is the operating activities section of Callaway using the indirect method. Begin with accounting net income and arrive at cash provided by operating activities. 5-42 Consolidated Statement of Cash Flows (in thousands) 2003 While these items are on the income statement, they have no current cash effect. Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization Other non-cash items Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable, net Inventories, net Other assets Accounts payable and accrued expenses Income taxes payable Other liabilities Net cash provided by operating activities $ 45,523 44,496 17,593 12,698 4,897 (4,743) (7,297) 4,004 1,572 $ 118,743 5-43 Consolidated Statement of Cash Flows (in thousands) Change in Account Balance During Year 2003 Increase Decrease Cash flows from operating activities: Current Subtract from net Add to net income. Net income $ 45,523 AssetsAdjustments income. to reconcile net income to net cash provided by to operating activities: Current Add net income. Subtract from net 44,496 Liabilities Depreciation & amortization income. This table provides guidance for adjustments related to changes in current assets and current liabilities. Other non-cash items Changes in assets and liabilities, net of effects from acquisitions: Accounts receivable, net Inventories, net Other assets Accounts payable and accrued expenses Income taxes payable Other liabilities Net cash provided by operating activities 17,593 12,698 4,897 (4,743) (7,297) 4,004 1,572 $ 118,743 5-44 Consolidated Statement of Cash Flows (in thousands) 2003 Here is the rest of Callaway’s Statement of Cash Flows showing the cash balance on the company’s balance sheet. Cash flows from investing activities Capital expenditures Acquisition, net of cash acquired Proceeds from sale of assets Net cash used in investing activities Cash flows from financing activities: Payments on financing arrangements Issuance of common stock Acquisitiion of Common Stock Dividends paid, net Net cash used in financing activities Effect of exchange rate changes on cash Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $ $ $ $ (7,810) (160,321) 202 (167,929) (8,117) 17,994 (4,755) (18,536) (13,414) 1,488 (61,112) 108,452 47,340 5-45 Notes to Financial Statements Descriptions of the key accounting rules that apply to the company’s statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements. 5-46 Learning Objectives Analyze a company’s performance based on return on equity and its components. 5-47 Return on Equity (ROE) Return = on Equity Net Income Average Stockholders’ Equity1 ROE measures how much the firm earned for each dollar of stockholders’ investment. 1(beginning equity + ending equity) ÷ 2 5-48 ROE Profit Driver Analysis = Net Profit Margin Net Income Net Sales × × Net Income Average Stockholders’ Equity = Asset Turnover Net Sales Average Total Assets × Financial Leverage × ROE Average Total Assets Average Stockholders’ Equity 5-49 Profit Drivers and Business Strategy High-value or product-differentiation. Rely on R&D and product promotion to convince customers of the superiority of your product. Low-Cost. Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover. 5-50 Chapter Supplement A Other Items Reported on the Income Statement 5-51 Classified Income Statement General Format for the Classified Income Statement In addition, companies may have nonrecurring items. Net sales These nonrecurring items may include: − Cost of goods sold 1. Discontinued operations, Gross profit 2. Extraordinary items, − Operating expenses Income from operations 3. Cumulative effect of changes in accounting methods. ± Nonoperating revenues/expenses and gains/losses These items are reported separately because they are Income before income taxes not useful in predicting future income of the company. − Income tax expense Net income 5-52 Discontinued Operations Sale or abandonment of a segment of a business. Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Show net of applicable taxes. 5-53 Extraordinary Items Unusual Infrequent Show net of applicable taxes. 5-54 Cumulative Effect of Changes in Accounting Methods GAAP Method Change to Alternative GAAP Method The change must be to a preferable method and must be disclosed in notes to financial statements. Show net of applicable taxes. 5-55 End of Chapter 5