Transcript Understanding the Corporate Annual Report: Nuts, Bolts, and Chapter 3
Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws
Chapter 3 Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Chapter 3 will cover:
• Statement of financial condition (balance sheet) • Statement of shareholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Statement of Financial Condition Shows:
• What a firm o
wns
(assets) • What a firm
owes
– to outsiders (liabilities) – to owners (shareholders’ equity) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Statement of Financial Condition is:
Prepared at a specific point in time: • End of year • End of quarter Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
At all times. . .
The balance sheet must balance • Assets = Liabilities + Shareholders’ Equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Assets
Current assets include: • Cash • Cash equivalents • Other assets expected to be converted into cash within one year or one operating cycle, whichever is longer Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Operating Cycle
• Time required to purchase/manufacture goods, sell the goods, and collect the cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Cash
Cash is cash in any form: • Awaiting deposit • On deposit Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Cash Equivalents
• Short-term, highly liquid investments • Readily convertible into cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Marketable Securities
• Short-term investments • Earn a return on cash not needed immediately • Valuation depends upon the intent of investment Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Receivables (Accounts Receivable)
• Customer balances outstanding on credit sales • Carried at net realizable value Net realizable value: • Actual amount less allowance for estimated uncollectible accounts Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Allowance Account
• Important in assessing earnings quality • There should be a consistent relationship among the changes in sales, accounts receivable, & the allowance account
Caution flag
raised if sales & accounts receivable are increasing, but allowance account is decreasing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Inventories
Are items that are: • Held for sale • Used in the manufacture of products Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
A Retail Company
• Has only one type of inventory • Merchandise inventories purchased for resale Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
A Manufacturing Company
Has three types of inventory: • Raw materials • Work in process • Finished goods Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Cost Flow Assumption for Inventory
Determines: • Value on balance sheet • Expense of cost of goods sold on income statement Is important for analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Commonly Used Cost Flow Assumptions
• LIFO (last in, first out) • FIFO (first in, first out) • Average cost Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
LIFO
• Matches current costs with current revenue on income statement • Undervalues balance sheet inventory during inflation • Overvalues balance sheet inventory during deflation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
FIFO
• Values balance sheet inventory close to current cost • Understates cost of goods sold during inflation • Overstates cost of goods sold during deflation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
For Taxes & Reporting Purposes:
• Companies must use the same method if LIFO is chosen for tax purposes • Many companies have switched to LIFO during inflation to pay lower taxes (with higher cost of goods sold expense) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Accounting Convention of Conservatism
If actual value falls below cost: • Inventory written down Inventory never written up in value Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Common Size Balance Sheet
• Expresses all items on balance sheet as percent of total assets • Useful in trend & structural analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Deferred Income Taxes
Result from temporary differences in recognizing revenue & expense for: • Tax purposes (payments to I.R.S.) • Reporting purposes (preparation of financial statements) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Examples of Temporary Differences
Accounting for: • Depreciation expense • Installment sales • Leases • Warranty & service contracts • Pensions & other employee benefits • Subsidiary investment earnings Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Permanent Differences
Do not affect deferred taxes Example: • Accounting for municipal bond revenue • Recognized as income for reporting but not tax Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Deferred Taxes
Can appear on balance sheet as: • Asset and/or liability • Current and/or noncurrent Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Property, Plant, & Equipment
• Tangible, long-lived assets • Also called fixed assets or capital assets • Produce benefit for more than one year Carrying value on balance sheet: • Cost less accumulated depreciation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Land is an Exception
• Carried at cost; not depreciated • Assumed to have unlimited useful life Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Goodwill
• Results from one company acquiring another • Price paid more than fair market value of net identifiable assets (Identifiable assets less liabilities assumed) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Carrying Value of Goodwill
• Company evaluates value • Decreased value requires write-off • Increased value is not recorded Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Liabilities
• Represent claims against assets Current liabilities: • Payment expected within one year (or one operating cycle, whichever is longer) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Accounts Payable
• Short-term obligation • Arise from supplier credit Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Short-term Borrowings
Are promissory notes to: • Suppliers • Financial institutions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Taxes Payable
Taxes expensed but not yet paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Dividends Payable
Dividends declared but not yet paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Long-term Borrowings
Obligations with maturities beyond one year: • Bonds • Long-term notes payable • Mortgages • Obligations under leases Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Long-term Borrowings
Continued: The current portion (amount due within one year) • Is included in current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Postemployment Liabilities
Includes certain postemployment obligations For example: • Accrued amount for expected medical bills of retired employees & spouses Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Pension Accounting
Two types of plans: 1.
Defined benefit: employer specifies amount contributed Example: • 401 (k) Pension expense is amount contributed Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Pension Accounting
Continued: 2.
Defined benefit: specifies amount that will be paid to employees after retirement Pension expense is estimated based on assumptions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Information About Defined Benefit Plans
• Is disclosed in notes • You may need several accounting courses to understand notes Or read this book Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Leases
Operating lease • Conventional rental agreement Capital lease • Treated as if it were a purchase of asset Requires recognition of asset & liability on balance sheet Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Hybrid Securities
Example: • Mandatorily redeemable preferred stock • Have characteristics of debt & equity • Carried between liabilities & equity on balance sheet Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Shareholders’ Equity or Stockholders’ Equity
• Ownership interests in company • Residual interest in assets that would remain after satisfying all of the liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Preferred Stock
• Usually carries fixed annual dividend • But no voting rights Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Common Stock
• Usually does not receive a fixed return (Dividends declared at discretion of company’s directors) • But has voting rights Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Common Stock
Continued: • Carried at par or stated value • Number of shares sold multiplied by par or stated value • Bears no relationship to market price Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Retained Earnings
• Sum of all company profits less any payments made to shareholders in cash or stock dividends • Are not piles of unused cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Accumulated Other Comprehensive Income or Loss
• Items “like” a revenue or expense but are not the same • “Unrealized gains & losses” • Not counted as part of earnings • Changes go to equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Accumulated Other Comprehensive Income or Loss Include:
• Unrealized gains/losses in marketable securities classified as available for sale • Specific type of pension liability adjustment • Gains & losses on derivative financial instruments • Foreign currency translation adjustments Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Treasury Stock
Company repurchases their own shares for: • Employee stock option & retirement plans • Building holdings for prospective mergers • Increasing earnings per share by reducing shares outstanding Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Treasury Stock
Continued: • Preventing takeovers by reducing shareholders • Investing excess cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Stock Options
• Increasingly popular form of employee compensation • Cost of options is not recognized as expense Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Stock Options
Continued: Options: Gives the holder right to purchase company shares at a stated price by a certain date If price rises, holder exercises options, makes a profit Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Stock Options
Continued: Difference between option price & market price: • Is deductible for tax purposes Information about stock options disclosed in notes Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Statement of Shareholders’ Equity
• One of four required financial statements • Shown for three-year period • Explains changes in all shareholders’ equity accounts Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Shareholders’ Equity Accounts Include:
• Common stock • Preferred stock • Additional paid in capital • Retained earnings • Accumulated other comprehensive income (loss) • Treasury stock Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Caution Flags
• Reductions in allowance for doubtful accounts when accounts receivable & sales are increasing • Sales & receivables – Growing at different rates – Moving in opposite directions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
More Caution Flags
• Categories of inventories moving in opposite directions • Sales & inventories – Growing at different rates – Moving in opposite directions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Even More Caution Flags
• Excessive use of “other” for material, unexplained items • Write-down in value of goodwill • Borrowings growing faster than assets being financed • Debt rising when assets are decreasing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Yet, More Caution Flags
• Financial statement notes obscure rather than enlighten • Understanding notes requires Ph.D. in accounting Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing
Final Caution Flags
• Substantial income from unpredictable/possibly unsustainable sources (e.g., pension plans) • Extensive use of stock options for employee compensation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing