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Jimmy Gentry presents "Teaching Financial Statements" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 4, 2014. Gentry is the Clyde M. Reed Teaching Professor at the University of Kansas' School of Journalism and Mass Communications. The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists. For more information about business journalism training, please visit http://businessjournalism.org.
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Understanding Financial Statements
Business Journalism Professors
Jan. 4, 2014
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Donald W. Reynolds National Center For Business Journalism At Arizona State University
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n James K. Gentry, Ph.D. n Clyde M. Reed Teaching Professor n School of Journalism and Mass Communications n University of Kansas n [email protected]
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Types of Statements n Public n Private
n Financial statements conforming to public company statements
n Non-profits
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Important Terms n Unaudited n Audited n Accountants n Certified Public Accountants (CPAs) n GAAP, FASB, AICPA, PCAOB
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Assessing a Company n Context n Trends n Rules n Outsiders n Insiders
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Annual Report,10-K n Annual report,10-K wrap, 10-K n Auditor’s report: Clean, qualified? n MD&A or Management’s Discussion
and Analysis n Financial statements and footnotes n Management’s letter if annual report
Traditional Auditor’s Report n Independent auditor’s opinion on whether
financial statements are presented fairly in all material respects, in accordance with GAAP: n We looked at these statements n They’re management’s responsibility; we’re just
here to express our opinion n We followed the rules in our audits and here’s
what an audit involves n In our opinion, the statements fairly present the
company’s position
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Auditor’s Report by Category
n Clean or Unqualified n Qualified n Disclaimer n Adverse
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New Auditor’s Report n Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act
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Sarbanes-Oxley Act of 2002
n Response to abuses with Enron and WorldCom as catalysts
n New responsibilities, resources for SEC n Created PCAOB n Major emphasis on “internal controls” n More disclosure for public companies
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Sarbanes-Oxley Act n Analysts must state potential conflicts of interest n Limited types of services accounting firms can
provide to public company clients n Companies disclose in 10-K the fees pay to auditors n Recent concerns n Consulting
n CEO, CFO attest to accuracy, completeness, fairness of financial statements
n Rigorous penalties for fraud, other misdeeds n Clawbacks
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Public Company Accounting Oversight Board n Created by SOX to oversee accounting n Began operating in 2003 n SEC appoints five members to five-year
terms n Two members must be or have been CPAs n All members must be “financially literate” n In 2008, Supreme Court upheld PCAOB but
said SEC couldn’t remove board members
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PCAOB’s Duties
n Set rules on “auditing, quality control, ethics, independence, and other standards…”
n Conduct “inspections” of accounting firms
n Conduct “investigations and disciplinary proceedings”
n Enforce compliance with SOX
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Section 404: Internal Controls n “Management Assessment of Internal
Controls” n Each 10-K must contain an “internal control
report” that: n States management is responsible for internal
control structure and procedures n Contains an assessment on effectiveness of
internal control structure and procedures
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Management on the Spot n Section 404: Management must evaluate and
test internal controls over financial reporting, including anti-fraud programs, annually.
n Management certifies that it does (or doesn’t) have adequate internal controls in place.
n Independent board members easier to attract n Auditor attests to adequacy of controls. n Management to be forced to answer for
fraudulent activities, misconduct, etc.
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Private Company Impact n Banks, insurers requiring companies to
embrace SOX. n Now most private firms have audited financial
statements n If private company owners want to sell to
public company, must be in compliance n Private equity funds more willing to invest in
companies in compliance n Best outside directors
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Non-Profit Impact n Audit committees, independent members n CEO, CFO attest to accuracy, completeness,
fairness of financial statements n Financial statements more accessible n Codes of ethics n Rules governing transactions with “insiders”
Goal of accounting n Record, classify and report financial
transactions. To provide managers across the organization with information that facilitates: n Control of activities and expenditures n Refinement of operational plans n Accountability n Reporting on project outcomes n Writing of bids for new funds
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Goal of Finance n Maximize shareholder wealth as
reflected in market price of the stock n Achieving this goal requires financial
manager to focus on economic profit, not accounting profit
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Financial Decisions n Investing decisions: Types of assets
firm wants to hold. n Financing decisions: Acquisition of
funds needed to support long-term investments.
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Generally Accepted Accounting Principles n Guidelines based on theory and
practice n Evolved over time n Procedures, concepts and standards
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GAAP n Periodicity n Going concern n Economic entity n Monetary unit n Full disclosure n Historical cost n Consistency
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GAAP n Materiality n Industry practices n Conservatism
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Specialized Industry GAAP n Banking and thrift industries n Benefit plans, including pension funds n Broadcasting industry n Cable television industry n Computer software n Finance companies n Investment companies
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Cash or Operating Cycle n Cash n Purchase inventory n Produce product n Sell product n Cash
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Cash or Operating Cycle (cont.) n “Cash”
n Cash n Receivables and payables n Debt
n Inventory n Raw materials n Work in progress n Finished goods
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Cash or Operating Cycle (cont.) n Sell product
n Accounts receivable n Cash
n Cash n Collect receivables as cash
n Pay off payables n Start over
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Accrual Method n Records revenues when the the “sale”
occurs n Records expenses when the bill is
received n IE, transactions enter the financial
records when they occur, not when cash changes hands
n Accrual method, therefore, shows “scores,” not real spendable dollars
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About These Numbers: They’re Squishy n Goods will not necessarily be paid for n Goods are not necessarily going to be
kept n Inventory might be out of date, obsolete
or unsellable n Status of some inventory may be
uncertain n Intangible assets are estimates
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About These Numbers: They’re Squishy (cont.) n Machinery or other fixed assets might
be obsolete or falling apart long before the so-called useful life is up
n Goodwill n Accounting conventions n Timing issues n Bottom line: In many ways, statements
are a collection of estimates.
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Because They’re Squishy n You need to know the rules and
assumptions used to create the numbers
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Income Statement or ... n Statement of earnings n Statement of operations n Statement of income and
comprehensive income
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Income Statement n Covers a period of time, typically a year
or quarter n Reports income from ongoing activities n Reports income from activities beyond
management’s control (comprehensive income)
n Involves estimates
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Basic Income Statement n Sales or revenues n Expenses n Taxes n Net income or profit
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Income Statement n Sales or revenues n Cost of goods sold n Gross profit n Operating expenses
n Sales, general and administrative n Depreciation, amortization
n Operating profit n Other income/expenses n Interest n Income taxes n Net income or profit
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Cost of Goods Sold n Expenses incurred in the cost of
manufacturing or creating or acquiring the product the company sells.
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Cost of Goods Sold n Manufacturer: What the company pays
for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.
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Cost of Goods Sold
n Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.
n Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.
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SGA n Includes office expenses, accounting,
shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.
n Often includes depreciation and amortization.
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Other Income/Expenses n Discontinued items n Unusual/extraordinary items n Changes in accounting principle n Impairment charge n Sale of investment n Minority interest
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Thinking Inside the Box n Revenues n Minus cost of goods sold n Equals gross profit n Minus operating expenses n Equals operating profit n Minus or plus other expenses/income n Minus or plus interest expenses/income n Minus income taxes n Net income
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Inside the Box Earnings n Sales or revenues n Cost of goods sold n Gross profit n Operating expenses
n Sales, general and administrative n Depreciation, amortization
n Operating profit
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‘One-Time’ Gains That Reoccur n Don’t be fooled by extraordinary items
that make the net income look better than it really is
n Extraordinary items should be both unusual in nature and infrequent in occurrence
n Examples: Writedowns, restructurings, etc.
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Earnings Per Share n Basic earnings per share
(Bloomberg) n Diluted earnings per share (Wall
Street Journal, fully diluted)
Calculating EPS n Basic: Net income for period divided by
weighted average number shares outstanding.
n Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.
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Dividend n Company’s board of directors decides to
distribute a portion of a company's net income to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share).
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Dividend Payout Ratio n The percentage of a company’s net
income that is paid to shareholders in dividends.
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Dividend Payout Ratio Dividend per share Earnings per share Dividend payout Net Income for same period
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Dividend Yield n How much a company pays out in dividends
each year in relation to its stock price. n A way to measure how much cash flow you
are getting for each dollar invested in an equity position. Investors who require a minimum stream of cash flows from their investments can secure this by investing in stocks paying relatively high, stable dividend yields.
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Dividend Yield Dividend Stock price $1 vs. $1 $20 $40 5% 2.5% Strictly Financials
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Looking at Dividends n In general, investors react poorly to a
decrease in dividends, and the stock price usually declines as investors seek other dividend-paying stocks.
n A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors.
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Balance Sheet n It balances n Assets = Liabilities + Shareholders’
Equity
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Assets n Current assets
n Cash and cash equivalents n Accounts receivable n Inventories n Prepaids
n Investments and other assets
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Assets n Property, plant and equipment, net
n Land and improvement n Buildings and improvements n Equipment n Less accumulated depreciation
n Goodwill and other intangibles
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Goodwill and Impairment n Difference between what a business
pays to buy another company and the book value (total assets minus total liabilities) of that company
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Liabilities n Current liabilities
n Accounts payable n Accrued liabilities n Income taxes n Current maturity of long-term debt
n Noncurrent liabilities n Long-term debt n Deferred income taxes
n Commitments and contingencies
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Shareholders’ Equity n Capital stock
n Preferred stock n Common stock
n Additional paid-in capital n Retained earnings n Treasury stock
n Total shareholders’ equity n Total L + OE
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Statement of Cash Flows n Record of cash provided by cash
sources and of cash consumed by cash uses.
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Cash Flows (cont.) n Information about use of cash n Information about investing and
financing n Ability to continue as a going concern n Ability to generate future positive cash
flows n Ability to meet obligations and pay
dividends
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Cash Flows n From operations n From investing n From financing
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Flexibility n Companies have some flexibility in
categories for entries. n Total change in cash, however, will not
change. n Overwhelming majority of all accounting
standards deal with balance sheet and income statement, not cash flows statement.
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Free Cash Flow n Powerful tool for making a company
successful n Powerful indicator for investors n Cash that is left over after productive
capacity is maintained or expanded n Permits expansion, paying down debt,
buying back shares, etc.
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Free Cash Flow (cont.) n Several ways to calculate it n Companies create their own models n Gross way to do it:
n Cash from operating activities n Minus capital expenditures n Equals free cash flow
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American Standard Model
n Cash from operating activities n Minus capital expenditures n Plus proceeds from disposal of property n Plus proceeds from sale and
leasebacks n Equals free cash flow
Free Cash Models n ‘Gross’ method n American Standard method n VF method
n Cash from operating minus cash from investing
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Keys to Looking at Cash n Cash from operations n Capital expenditures (cap ex) n Free cash n Cash and cash equivalents at the end
of the year
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Looking at the Numbers n Note changes in amounts year to year, especially
revenues and expenses n Note numbers that are significantly larger or smaller
than the previous period n Look at trend line for sales/revenues, operating
income and net income. Calculate percentage change for each.
n Look at cash flow n Look at free cash flow n Tie the numbers to the footnotes.
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Techniques n Calculate percentage change n Trend analysis n Common size analysis n Ratio analysis