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© 2005 by Robert F. Halsey, all rights reserved
ACC7500 Financial Reporting
and Statement Analysis
Prof. Bob Halsey302 Luksic Hall
© 2005 by Robert F. Halsey, all rights reserved
Introduction Course focus on footnotes
Most of the action is here Review ACC7000/FIBD notes if you haven’t already
Syllabus/Schedule/Resources Text: Wild, Subramanyam and Halsey (WSH), FSA, 8th ed. Blackboard (http://blackboard.babson.edu/ ) Bring mini-cases to class Outside help: Wednesday afternoons or by appt., email,
phone. I’m a nice guy and I’m here to help
Questions are ok … really! Please, let’s share our ideas, but keep focused and not
too many tangents
© 2005 by Robert F. Halsey, all rights reserved
Course content Financial statements
Overview Cash Flow Accruals Core earnings Projections Foreign Currency
Translation Deferred Taxes
Earnings Management Valuation
DCF Residual Income ROE Disaggregation
review
Off Balance Sheet Leasing VIEs Derivatives Pensions
Investments Passive Equity method Consolidations
Equity transactions Equity carve outs Convertibles Stock Options
© 2005 by Robert F. Halsey, all rights reserved
Grace’s Dress Company
Transaction Analysis
© 2005 by Robert F. Halsey, all rights reserved
Initial capital contribution of $1,000 into the business; borrow $500 to be repaid $100 per period @ 2% per period. Purchase 10 dresses $500 on account and fixtures, furniture and equipment for $500 in cash (depreciate over 5 periods):
amount Sales Cost of goods Sold Gross profit Wage expense Depreciation expense Interest expense Net profit ASSETS Amount LIABILITIES amount
Cash Accounts payable Accounts Receivable Wages payable Inventories Note Payable Furn, Fix & Equip EQUITY Accumulated Depreciation Contributed Capital Furn, Fix & Equip (net) Earned Capital Total Assets Total Liabilities and Equity
© 2005 by Robert F. Halsey, all rights reserved
Sell 5 dresses for $600 on account that cost $250; employees earn wages of $100 to be paid next month; record depreciation expense, pay interest on note, repay principal, and pay off account payable:
amount Sales Cost of goods Sold Gross profit Wage expense Depreciation expense Interest expense Net profit
ASSETS Amount LIABILITIES amount Cash Accounts payable Accounts Receivable Wages payable Inventories Note Payable Furn, Fix & Equip EQUITY Accumulated Depreciation Contributed Capital Furn, Fix & Equip (net) Earned Capital Total Assets Total Liabilities and Equity
© 2005 by Robert F. Halsey, all rights reserved
DuPont Mini-case
Review of Financial Statements
© 2005 by Robert F. Halsey, all rights reserved
Transitory Items Sales- Cost of Goods Sold (COGS) Gross Margin (GM)- General, Sales and Admin. Costs (SGA)- Interest- Taxes
Earnings From Continuing Operations± Discontinued Operations (net of tax)
± Extraordinary Items (net of tax)± Changes in accounting Principles (net of tax) Net Earnings- Dividends Change in Retained Earnings
© 2005 by Robert F. Halsey, all rights reserved
Transitory Items
Items below the line (e.g., Cont. Ops.) Discontinued operations Extraordinary items (will reduce in the future) Changes in accounting principles
Transitory items above the line Gains (losses) on asset sales / debt repurchase
(no longer an extraordinary item) Restructuring expenses (write-downs and
accruals)
© 2005 by Robert F. Halsey, all rights reserved
Frequency of Extraordinary Items
0%
2%
4%
6%
8%
10%
12%
14%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Pro
po
rtio
n o
f C
om
pa
nie
s
Re
po
rtin
g
Pos count % Neg count % Total
Magnitude of Extraordinary Items
0.0%
1.0%
2.0%
3.0%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Year
Me
dia
n a
bs
olu
te
ma
gn
itu
de
as
a
pe
rce
nt
of
sa
les
Median pos % Median neg % Total
© 2005 by Robert F. Halsey, all rights reserved
Frequency of Special Items
0%
10%
20%
30%
40%
50%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Year
Pro
po
rtio
n o
f co
mp
anie
s re
po
rtin
g
Pos count % Neg count % Total
Magnitude of Special Items
0%
1%
2%
3%
4%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Year
Med
ian
ab
solu
te
valu
e as
a p
erce
nt
of
sale
s
Median pos % Median neg % Total
© 2005 by Robert F. Halsey, all rights reserved
Discontinued Operations
Separately identifiable business segment being disposed Disclosure – segregate operating results from continuing
operations: Income (loss) from operations from BOY to
measurement date (net of tax) Gain (loss) on disposal (net of tax)
Operating income from measurement date to disposal date
Gain (loss) from disposal Recognize losses, defer gains
Adjust income statement retroactively for comparative years
May also segregate assets & cash flows
© 2005 by Robert F. Halsey, all rights reserved
Effect of Disc Ops on Inc. Stmt.
© 2005 by Robert F. Halsey, all rights reserved
Frequency of Discontinued Operations
0%2%4%6%8%
10%12%14%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Year
Pro
po
rtio
n o
f c
om
pa
nie
s r
ep
ort
ing
Pos count % Neg count % Total
Magnitude of Discontinued Operations
0%
1%
2%
3%
4%
5%
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Year
Me
dia
n a
bs
olu
te
ma
gn
itu
de
as
a
pe
rce
nt
of
sa
les
Median pos % Median neg % Total
© 2005 by Robert F. Halsey, all rights reserved
HP mini-case
1. Briefly describe the accounting for assets and income of discontinued operations. That is, how are sales, expenses, profits and net assets reported in the financial statements?
2. What were the sales and net profits for the discontinued operations in 1999?
3. Prepare a summary balance sheet of the discontinued operations as of 7/31/99.
4. How are the assets, liabilities and equity of the discontinued operations reflected in HP’s balance sheet?
5. How do discontinued operations affect analysis of the financial condition of the company? That is, within the framework of the DuPont analysis, how does the accounting for discontinued operations affect net profit margin, turnover and financial leverage?
6. What adjustments might you wish to make to HP’s reported financial results in your analysis of the company?
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
© 2005 by Robert F. Halsey, all rights reserved
HP Mini-case #5
Reported w/o DONPM (NI/Sales) 3491/42370 8.20% (3491-387)/42370 7.30%TAT (Sales/TA) 42370/35297 1.2 42370/(35297-3533) 1.3LEV (TA/TE) 35297/18295 1.9 (35297-3533)/(18295-3533) 2.2
ROE 19% 21%
© 2005 by Robert F. Halsey, all rights reserved
Asset Measurement mini-case
Intangible Assets
© 2005 by Robert F. Halsey, all rights reserved
ACC7500 asset measurement mini-case
The use of historical costing is justified on the basis of objectivity and verifiability, which arguably lessen potential bias in financial statements by reducing the degree of subjectivity in the amounts reported. This focus on objectivity often means that information which would otherwise be relevant to financial statement users might be omitted since it is usually more subjective in nature. The book value of stockholder’s equity is reported in conformity with GAAP and often is different from the market value of the company, which is equal to the market price of the firm’s shares multiplied by the numbers of common shares outstanding.
Remembering that the characteristic of an asset is the expectation that it will produce future benefits (net cash inflows), identify three “assets” which might be omitted from the balance sheet and, thereby, contribute to the difference between the market value and the book value of the company (i.e., think of “assets” which investors might view as important for the determination of firm value, but which are excluded from the balance sheet because their measurement is too subjective):
© 2005 by Robert F. Halsey, all rights reserved
Sarbanes-Oxley
Management more accountable - Sarbanes-Oxley assertions: I have reviewed the report F/S not materially misleading F/S fairly represent the financial condition of Co. Internal controls are sufficient
© 2005 by Robert F. Halsey, all rights reserved
EY Resigns Over Selectrica Internal Control Deficiencies1. Accounts receivable and services revenue incorrectly included a
general reserve position in the allowance for doubtful accounts as of December 31, 2004, and incorrectly recorded a receivable as uncollectible as of March 31, 2005, for which payment was subsequently received after March 31 but prior to the completion of the quarterly close process.
2. Cash equivalents as well as short-term and long-term investments were not classified in the accordance with generally accepted accounting principles during the treasury process for Selectica's India subsidiary.
3. Selectica failed to reverse deferred revenue when all criteria for revenue recognition had occurred.
4. The company failed to record the expenses related to the benefits extended when employees were fired.
5. Deficiencies in its financial statement close process included insufficient controls over the monitoring of the terms of employment agreements and bonus programs and determining the related appropriate accounting treatment.
6. The company also cited insufficient controls over the monitoring of accrued liabilities recorded upon the sale of the company's E-insurance business to Accenture in December 2003. The company said it had incorrectly not reversed the accrual when the related obligation expired on December 31, 2004. An adjustment as of that date to decrease accrued liabilities and decrease G&A expense was recorded prior to the issuance of the December 31, 2004, financial statements.
© 2005 by Robert F. Halsey, all rights reserved
Who sets accounting standards? SEC created by 1933,1935 acts of Congress to
regulate securities industry and to establish reporting requirements
SEC has delegated standard setting to private industry: FASB
But, Public Company Accounting Oversight Board (PCAOB) controls FASB’s funds. SEC oversees PCAOB
Bottom line: accounting standard setting is very much a political process. Compromises limit the effectiveness of accounting standards.