11 Topic 2_Information Organization

8/7/2019 11 Topic 2_Information Organization

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Organization of Information

in Financial Statements

Topic 2


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Topic 2 Information Organization 2

Agenda

Understand main sources of financial information and

rules that regulate them Understand information organization on the primary

financial statements (balance sheet, income statementand cash flow statement)

Case studies Apply this knowledge to better understand underlying income

and cash flows: Analyzing effects of discontinued operations Parker-Hannifin

Analyzing cash availability Northwest Airlines


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Who Makes the Rules?


Depends: Country

Regulatory and industry influences

Public or private company

Generally Accepted Accounting Principles Different GAAPs can produce different answers

Companies can be subject to multiple GAAPs But only one GAAP used in each set of financial statements

US GAAP and IFRS are two types of GAAP


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US GAAP Hierarchy


Category D(least

authoritative)

Category C

Category B

AICPAAccounting

Interpretations

FASBImplementationGuides (Q&A)

Widely recognizedand prevalent

industry practices

FASB TechnicalBulletins

AICPA IndustryAudit and

Accounting Guides

AICPAStatementsof Position

FASB EmergingIssues Task Force

AICPA AcSEC PracticeBulletins

FASB= Financial Accounting Standards BoardAPB = Accounting Principles BoardAICPA = American Institute of CPAsAcSEC = AICPA SEC practice section

Category A(most

authoritative)

FASB Standards,

Interpretations, &Staff Positions

APBOpinions

AICPA

AccountingResearch Bulletins


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US GAAP: New FASB Codification


Accounting Standards Codification (July 2009)

ASC seen in recent 10Qs and 10Ks New organization for alphabet soup of US GAAP

No change to rulesonly changed the structure New structure (examples)

Topic (assets 3XX)

Subtopic (inventory - 330)

Sections (general 330-10)

Topics follow the IASB structure

FASB, EITF,AICPA, FSP,

APB, etc.

ASC 330-10


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Global Standards


International Financial Reporting Standards(IFRS)

Broad adoption

122 countries currently use or are in process of

adopting 40% of global Fortune 500

Required by European Union since 2005 (publiccompanies)


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Current Rules: IFRS in the US


SEC currently allows full compliance IFRS

Foreign companies only

No GAAP reconciliation required

Years ending after November 15, 2007

Carve-outs require a GAAP reconciliation Reconcile to full compliance IFRS

Exception: IFRS as adopted by the EU No reconciliation through 2009


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Future: IFRS for US Companies?


Fall 2008 SEC roadmap: proposed1) Voluntary: large US public companies use IFRS in 2010* If both criteria are met:

Top 20 companies within an industry

Industry is IFRS dominant

SEC estimates 110 companies eligible for volunteering

2) Mandatory: IFRS in 2014 for all public companies

February 2010: SEC reaffirmed support forIFRS

No voluntary 2010 adoption permitted Timing of eventual adoption is uncertain

* Years ending after Dec. 15, 2010


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Sample GAAP Differences (1)


IFRS1) More principles-based

2) LIFO prohibited

3) Can reverse impairment charges(except goodwill)

4) Deferred taxes: non-current only

United States1) More rules-based

2) LIFO permitted

3) Cannot reverse any impairmentcharges (including goodwill)

4) Deferred taxes: both current andnon-current


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Sample GAAP Differences (2)


IFRS5) Cash flow statement

Usually starts with operatingincome

Interest paid in statement

6) PP&E and intangibles: option ofrevaluing (report at fair value)

United States5) Cash flow statement

Starts with net income

Interest paid in footnote

6) PP&E and intangibles: norevaluation (historical cost only)

Rules change frequently: speak to an expert and perform updated research


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Helpful Resources


US GAAP FASB.org SEC.gov

IFRS IASB.org (official site of the international board)

IASplus.com (Deloittes site)

Best place is the company that you are analyzing Footnote #1

Critical accounting policies

Other companies Peers

International competitors


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Securities and Exchange Commission


SEC

Heavily influences US rules Role in general rule making

Appoints trustees to FASB

Observer in all rule making proceedings

Make their own rules (Staff Accounting Bulletins)SABs = clarification of existing GAAP

Authority over ~12,800 public entities

Policing

Regulate audit firms Public Company Audit Oversight Board (PCAOB)

Comment Letter process

Enforcement Division


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Basic SEC Filings


SEC Form / Schedule Document Name Description and Contents

10-K

(20-F for a foreign issuer)

Annual Filing Comprehensive overview of the registrant

Required to be filed after the close of the fiscal year end

Contains required audited financial statements and MD&A filings

Specific information in a required order

Annual Report to Shareholders(Not a required SEC filing)

Annual Report toShareholders

Marketing and communication document with shareholders and potential investors

Filing with SEC is not required, but generall y done Contains similar information as 10-K

Companies have considerable discretion in determining what types ofinformation it contains and how it is to be presented

May contain non-f inancial details not reported elsewhere

10-Q Quarterly Filing Required to be filed after the close of the fiscal quarter Contains required unaudited financial statements and MD&A filings for a view of

financial position throughout the fiscal year Specific information in a required order

Def 14-A Proxy Statement Official notification to shareholders of matters to brought be to a vote at ashareholders meeting

May be solicited for changing company officers or many other matters

Usually contains disclosures required in Part III of Form 10 -K: Directors and executive officers, including background information

Remuneration of directors and officers

Security ownership of certain beneficial (5% or more) owners and management

Certain relationships and related transactions

S-1, S-2 or S-3

(F-1, F-2 or F-3 for foreign issuer)

Offering Registration(Prospectus)

Required filing for the issuance of publicly traded stock S-1: complete disclosure; for companies filing under 1934 Act for less than 1

year

S-2: limited disclosure; for companies filing under the 1934 Act for more than 1year, but not meeting minimum voting stock requirements

S-3: minimal disclosure; for companies filing under the 1934 Act for more than 1year and meeting minimum voting stock requirements


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Where to Find Important Items


U.S. Company Non-U.S. Company*

Share Price currentand historicals

Numerous databases, Bloomberg, financialpress

Numerous databases, Bloomberg, financialpress

EPS and ExpectedGrowth RatesEstimates

First Call or Multex for consensus estimate

Specific research report if stock is not widelycovered

First Call or Thomson I/B/E/S for consensusestimate

Specific research report if stock is not widelycovered

Dividend per Share 10-Q: income statement, MD&A or footnotes

10-K / Annual Report: table of selected historicalfinancial data, equity footnote, income statementor MD&A

Check the news for any recent announcements

Income statement or footnotes of latest interimreport or 20-F / Annual Report

Check the news for any recent announcements

Shares Outstanding

Front page(s) of 10-Q or 10-K, whichever ismost recent

Proxy statement may be most recent

Check the news for recent stock splits

Balance sheet or footnotes of interim report or20-F / Annual Report, whichever is most recent


Options Footnotes of 10-K / Annual Report


Footnotes of 20-F / Annual Report


Balance Sheet Items Balance sheet in 10-Q or 10-K / Annual Report,whichever is most recent

Balance sheet in interim report or 20 -F / AnnualReport, whichever is most recent

Income Statement Current and previous year stubs from 10-Q and

last year from 10-K / Annual Report

Current and previous year stubs from interim

report and last year from 20-F / Annual Report

Depreciation andAmortization

Cash flow statement from 10-Q and 10-K /Annual Report

Cash flow statement from interim report and 20-F / Annual Report, if disclosed

May be broken out in footnote regarding cashflow items

Non-Recurring Items Line on income statement, footnotes, and MD&A Line on income statement, footnotes, and MD&A

* For most companies under IAS. Disclosure will depend on country specific accounting policies and disclosure requirements.


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Summary: Key Financial Reports

Annual reports (10-K) (Audited)

Management Discussion and Analysis (MD&A) contains managements narrative of

key events, success factors, risks and plans of the company (item 7)

Financial statements contain audited balance sheet, income statement, statementof cash flows, statement of changes in owners equity, and footnotes (item 8)

Quarterly reports (10-Q) (Unaudited)

Contains information similar to the annual report information, but filed every quarter

Current reports (8-K) (Unaudited) Required to be filed within 4 business days of a significant event (e.g., major asset

sale, change in ownership, bankruptcy, change of auditor)

Foreign companies are required to reconcile their non-US GAAP basedfinancial statements with US GAAP in their Form 20-F filing

Effective March 2008, the SEC began accepting IFRS-prepared financial

statements from some foreign registrants without requiring reconciliation to USGAAP.


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Information Organization on Balance Sheet


Contains summary of assets

owned by the firm, liabilitiesincurred to finance theseassets, and shareholders

equity representing theamount of financingprovided by owners at aspecific date

Basic Accounting Equation:

Assets =

Liabilities+ Equity

E.g., Pfizer


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Information Organization on Income Statement (1)

Inventory sold to earn revenues

Overheads incurred to earn revenues administrative salaries, depreciation, etc.

One-time charges for streamlining currentoperations and integrating acquisitions

Expenses related to innovation activities bythe company including expenses for R&Dunderway at acquired companies

Results from operations that are no longerpart of the company. Note that the incomeis net of taxes (Revenue Expense Tax)

Tax expense on earnings from operations

E.g., Pfizer

Earnings per share (EPS) and relateddisclosures


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Information Organization on Income Statement (2)

Routine operations of the firm (abovethe line). The income fromcontinuing operations is generallyunderstood to be the equivalent ofpermanent earnings, however, it mayinclude items that are non-persistentin nature, e.g., restructuring charges

Non-recurring results due to thedecision to discontinue certainoperations (shown below the line).This has two components: resultsfrom running the operations till soldand gain or loss on sales of thoseoperations .

E.g., Pfizer


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Information Organization On Cash Flow Statement

Operating cash flows result fromevents or transactions related to theproduction and delivery of goods and

services to customers. If the indirectmethod is used, net income is thestarting point and from this two types ofadjustments are made to arrive atCFO: (1) remove non-cash items, (2)remove non-operating cash flows.

Investing cash flows result from

purchase or sale of productive assetslike plant and equipment, of marketablesecurities, and from acquisitions ofother companies or divestitures

Financing cash flows result whencompany sells its own stocks or bonds,pays dividends or buys back treasury

stock, or borrows money and repaysthe amounts borrowed.

Cash from the Balance Sheet

E.g., Pfizer

Supplemental cash flow information


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Cash from Operations Pfizer

Add back non-cash expenses.Changes in policies with expect to

expensing of these items have noeffect on CFO.

Activities that are non-operatinginvesting activities. Inferring thebook values of assets sold ordiscontinued as of date of disposal:Book Value = Cash Received (CFI)+ Loss (-Gain) on disposal (CFO)

Changes in balances of currentassets and liabilities. These reflectcash flows from operating activities.

Net income is transformed intonet cash flow from operations.


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Earnings Components

The information layout in the income statement

helps identify:1) permanent (i.e., sustainable, likely to be repeated in

future periods),

2) transitory (i.e., one-off, or non-recurring), and

3) value-irrelevant components of earnings.

Each component affects future cash flowsdifferently.


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Non-Recurring Components of Earnings Special items

Definition: All items of income or expense that are eitherinfrequent OR unusual given the nature of operations of the firm

Operating environment determines whether unusual/infrequent Examples: corporate restructuring charges, write downs and

write offs of inventory, gain or loss on sale or abandonment ofproperty and equipment

Reporting: part of income from continuing operations, above the

line (i.e. pre-tax) Extraordinary items (very rare)

Definition: all items of income or expense that are both infrequentAND unusual given the nature of the operations of the firm

Very rare

Examples: losses from unexpected major natural disaster;expropriation of assets by a foreign government Reporting: reported net of tax, below the line (i.e., post-tax)

Discontinued Operations See slides 31-37


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Discontinued Operations (Disc Ops)

By definition, discontinued operations will not generatefuture operating cash flows

Defined as a component of an entity sold or held forsale Comprises operations and cash flows that can be clearly

distinguished from the rest of the entity

May be a reportable segment or operating segment, a reportingunit, a subsidiary, or an asset group

Sale of assets to be made in a single transaction, together withthe associated liabilities

Disclosure: effects of discontinued operations are

reported below the line and not part of income fromcontinuing operations

Example: Parker-Hannifin Corp.


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Disc Ops Parker-Hannifin (1) In fiscal 2005, Parker-Hannifin discontinued and sold a unit that developed and

manufactured chemical car care products and maintenance equipment. As a result of discontinuing operations, the company presented results in the

income statement by moving the results of the business unit below the line alongwith the gain on sale of operations (all are net of tax).

The company presented the results of cash generated from the business unit forthe part of the year that it was with Parker-Hannifin separately on the cash flowstatement. The company had no investments or financing activities associatedwith the business unit for the part of the year that it was part of Parker-Hannifin.

Upon discontinuing, the company would have reported the assets and liabilitiesof the business unit separately on the balance sheet as held for sale. Howeverthe unit was sold before the end of the fiscal year and the assets and liabilitieshave been therefore removed from the closing balance sheet.

The following are the results of the operations for this business unit for currentyear and the prior two fiscal years as disclosed in the footnotes:


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Disc Ops Parker-Hannifin (2)


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What is the income from operations before taxes for years ending 2004and 2003 as reported in the original filings when the division was part ofthe company?

For 2004: $480,126 (from 2005 I/S) + $13,942 (footnote) = $494,068

For 2003: $287,997 (from 2005 I/S) + $9,385 (footnote) = $297,382

What was the book value of net assets of discontinued operations as ofthe date of disposal?

Gain on sale (or + Loss on sale) = Cash Received on Sale Book value ofassets disposed

Therefore, Book value of assets disposed = Cash Received on Sale Gain onsale (or + Loss on sale)

Gain on Sale = Gain on Sale (reported in the footnote) + Tax, i.e., pre-tax gain

Book value = $120,000 (from the CFI section) ($52,547 + $16,914) = $50,539


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Parker-Hannifins fiscal 2004 income statementas reported in its 2004 filings:


Net income are same figures reported in 2004 and 2003 comparativecolumns in the 2005 filings (slide 31), but everything else has changed!


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Effects of Disc Ops on the Financial Statements Ongoing operations renamed continuing operations

Past income statements change (re-casted ) To reflect new facts and circumstances

Entire income statement changes except net income and EPS

Assets and liabilities of business to be sold (if not yet soldby end of reporting period) Treated as Current on balance sheet Labeled Assets (Liabilities) Held for Sale

Depreciation and amortization stop while assets in Disc Ops Prospective only (prior periods do not change)

Subsequent move from Disc Ops back to Cont Ops: Depreciation and amortization catch-up

Impairment charge?

Recast income statements (again)

In most recent balance sheet


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Adjusting for Non-Recurring Earnings

Components: Pre-Tax and Post-Tax


LA-Z-BOY INCORPORATEDFOR THE FISCAL YEAR ENDED APRIL 26, 2003

(Amounts in thousands,

except per share data) Fiscal year ended 4/26/03 4/27/02 4/28/01

-----------------------------------------------------------------------------------------------

Sales................................................. $2,111,830 $2,153,952 $2,248,491

Cost of sales......................................... 1,617,261 1,691,657 1,794,474

------------ ------------- ------------

Gross profit....................................... 494,569 462,295 454,017

Selling, general and administrative................... 331,695 353,906 333,223

Loss on divestiture................................... -- 11,689 --

------------ ------------- ------------

Operating income................................... 162,874 96,700 120,794

Interest expense.......................... ............ 10,510 10,063 17,960

Other income, net..................................... 2,633 2,299 9,210

------------ ------------- ------------

Pre-tax income..................................... 154,997 88,936 112,044

Income tax expense.................................... 58,899 27,185 43,708------------ ------------- ------------

Income before cumulative effect of

accounting change................................ 96,098 61,751 68,336

Cumulative effect of accounting change

(net of tax of $17,920) ........................... ( 59,782) -- --

------------ ------------- ------------

Net income......................................... $36,316 $61,751 $68,336

============ ============= ============

Exercise: Identify the non-recurring items.


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Exercise: La-Z-Boy (cont.)


Calculate the impact on 2002 and 2003 Operating Income and NetIncome as if the non-recurring items never happened.

2003 2002Reported Adjustment Normalized Reported Adjustment Normalized

Sales 2,111,830 2,111,830 2,153,952 2,153,952

Cost of sales 1,617,261 1,617,261 1,691,657 1,691,657

Gross profit 494,569 494,569 462,295 462,295

SG&A 331,695 331,695 353,906 353,906

Loss on divestiture -- -- 11,689 (11,689) --

Operating income 162,874 162,874 96,700 108,389

Interest expense 10,510 10,510 10,063 10,063

Other income, net 2,633 2,633 2,299 2,299

Pre-tax income 154,997 154,997 88,936 100,625

Income tax expense 58,899 58,899 27,185 *4,091 31,276

Income before cumulative

effect of accounting change 96,098 96,098 61,751 69,349

Cumulative effect of accountingchange (net of tax of $17,920)

(59,782) 59,782 -- -- --

Net income 36,316 96,098 61,751 69,349

* Estimated as 11,689 35%


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Simultaneous Non-Cash Financing

and Investing Activities

Many transactions involve no exchange of cash but can cause changesin balance sheet asset and liability accounts, e.g.,

Purchasing a building by incurring a mortgage to the seller

Acquiring an asset by entering into a capital lease

Issuing stock for non-cash assets in connection with a business

acquisition

SFAS 95 requires firms to disclose these non-cash simultaneoustransactions

Either in narrative or in a schedule

Schedule is sometimes included as a separate section of the statement ofcash flows (supplemental cash flow information)


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Analysis of Cash Northwest Airlines Cash Burn Ratio and Months to Burnout

Useful when analyzing cash-strapped companies (which could be veering towardsbankruptcy)

Cash burn (monthly) = [Cash Used for Operations + Cash Used for CapitalExpenditures + Cash Used for Acquisitions]/12

Months to burnout = [Cash + Cash Equivalents + Short Term Marketable Securities] /Cash burn

Exercise: Use the data available from financial statements for December31, 2004 to compute NWAs monthly cash burn and months to burnout.Does the cash burn make sense given that Northwest Airlines filed for

bankruptcy protection within months of filing these statements?

Calculate the Altman Z-score for NWA for both years. Refer to RCJMpages 251 to 253 for interpretation of the score. Stock price per sharewas $10.93 and $12.64 as of end of fiscal years 2004 and 2003. Z-score = 1.2 x Working capital / Total assets

+ 1.4 x Retained earnings / Total assets

+ 3.3 x EBIT / Total assets

+ 0.6 x Market value of equity / Book value of debt

+ 1.0 x Sales / Total assets


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NORTHWEST AIRLINES CORPORATION

CONSOLIDATED BALANCE SHEETS (continued) (in millions)


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Effects of Changes in AccountingThree main types of changes:1. Changes in Accounting Principles: Example: change in inventory cost flow valuation

from LIFO to FIFO. Must do a retroactive application, which means that the current

year and the comparative statements of prior years must be adjusted to reflect the newaccounting principle. (Note: prior to Dec 15, 2005 the impact of such a change wascompletely given effect in the year of change without changing the comparativestatements of prior years.) If the change in accounting principle is a mandated change, the regulator (FASB or

SEC) will usually specify how the change should be reflected in financial statements.2. Changes in Accounting Estimates: Example: change in depreciation rate, change in

% allowance for bad debts, etc. Implemented prospectively. However, if the change hasa material effect on current period statements, the effect must be separately highlightedin the current years financial statements.

3. Changes due to Correction of Errors: This includes effects of undoing erroneousapplication of GAAP or misstated financial statements. In such cases, the comparativefinancial statements are all required to be restated going back in time to the point when

the error happened. Disclosure requirements: In case of errors and changes in accounting principles, a

detailed explanation for the change is required along with a justification for the change.In case of changes in estimates, explanations are required only if material.


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Information Organization

Future Developments

Increasing use of fair value accounting Effect on income statement would be to increase amounts of

unrealized income/loss

Currently, fair value accounting is used for some financial assetsand the effect is reported as comprehensive income in thestatement of shareholders equity. Companies also have a choiceof using fair value for a wide variety of nonfinancial assets.

Example: Pfizers comprehensive income disclosure

Rollout of International Financial Reporting System (IFRS)

SEC is proposing to allow foreign companies to follow IFRSrather than GAAP


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Comprehensive Income

Measures changes in equity of a company

that result from transactions with non-owners Not all changes in equity are reported on the

income statement

Those are Other Comprehensive Incomecomponents

Examples: unrealized gains and losses onrevaluing certain assets at fair value at each

balance sheet date, foreign currency translations,etc.


C h i I Pfi


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Comprehensive Income - Pfizer

Extract from Statement of Shareholders Equity:

Extract from footnote on Other Comprehensive Income:


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Takeaways Financial statements are inter-related and reflect different

aspects of a firms fundamentals: Available economic resources (balance sheet)

Usage of economic resources to generate profits (income statement)

Usage of economic resources to generate cash (cash flow statement)

Information on income statement is organized to show

separately: routine vs. non-routine results; continuing vs.discontinued operations.

Analysis of cash flows can help assess financial viability.

Changes in accounting affect information organization in the

financial statements. Value-irrelevant components of earnings

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11 Topic 2_Information Organization