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Additional Aspects of Financial

Reporting and Financial Analysis

Additional Aspects of Financial

Reporting and Financial Analysis

Chapter5

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1. Describe an auditor’s report.

2. Explain the disclosure in management’s discussions and analysis.

3. Understand the meaning of an operating segment.

4. Describe the disclosure in a segment report.

5. Explain interim reporting.

ObjectivesObjectives

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6. Prepare an interim report.

7. Understand intracompany and intercompany comparisons.

8. Prepare horizontal and vertical percentage analysis.

9. Perform ratio analysis.

ObjectivesObjectives

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Market EfficiencyMarket Efficiency

The prices of securities traded in the

capital market fully reflect all publicly

available information.

The prices of securities traded in the

capital market fully reflect all publicly

available information.

Evidence from research on an efficient market hypothesis tends to show--

These prices are adjusted almost

immediately based on new information and

in an unbiased manner.

These prices are adjusted almost

immediately based on new information and

in an unbiased manner.

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Auditor’s Report (Opinion)Auditor’s Report (Opinion)

The auditor is independent. The audit was performed on specified

financial statements. The financial statements are the responsibility

of the company’s management; the opinion is the responsibility of the auditors.

The audit was conducted according to generally accepted auditing standards.

An auditor’s standard report includes these

statements...

An auditor’s standard report includes these

statements...

ContinuedContinuedContinuedContinued

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The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements.

The audit included examination, assessment, and evaluation stages.

The audit provides a reasonable basis for an opinion.

An opinion is expressed concerning the fair presentation.

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An unqualified opinion contains three paragraphs.

An unqualified opinion contains three paragraphs.


The first (introductory) paragraph lists the

financial statements that were audited, declares

that management is responsible for those

statements, and asserts that the auditor is responsible for

expressing an opinion on them.

The first (introductory) paragraph lists the

financial statements that were audited, declares

that management is responsible for those

statements, and asserts that the auditor is responsible for

expressing an opinion on them.

The second (scope) paragraph describes what

the auditor has done.

The second (scope) paragraph describes what

the auditor has done.

The third (opinion) paragraph gives the auditor’s opinion.

The third (opinion) paragraph gives the auditor’s opinion.

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An unqualified opinion is not a “clean bill of health.”

An unqualified opinion provides no assurance of the future success of the company.

An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements.


There are three things that the audit report does not say.

There are three things that the audit report does not say.

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Management’s Discussion and Analysis (MD&A)


The MD&A provides a narrative explanation of the financial

statements so that investors can judge the “quality” of earnings

and the likelihood that past performance is indicative of

future performance in regard to cash flows.

The MD&A provides a narrative explanation of the financial

statements so that investors can judge the “quality” of earnings

and the likelihood that past performance is indicative of

future performance in regard to cash flows.

The MD&A provides information regarding liquidity, capital resources, and the results

of operations, as well as other information necessary to understand its financial

condition and changes in financial condition.

The MD&A provides information regarding liquidity, capital resources, and the results

of operations, as well as other information necessary to understand its financial

condition and changes in financial condition.

Where knowledge of segment information is useful to

understanding a company’s business, the discussion is to

focus on each relevant, reportable operating segment, as well as on the whole company.

Where knowledge of segment information is useful to

understanding a company’s business, the discussion is to

focus on each relevant, reportable operating segment, as well as on the whole company.

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Liquidity Capital Resources Results of Operations General Information



Major discussion issues that may involve intracompany and

intercompany comparisons.

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Segment ReportingSegment Reporting

that engages in business activities to earn revenues and incur expenses,

whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and

for which financial information is available.

An operating segment is a component of a company--

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Segment ReportingSegment Reporting

An operating segment is considered significant and is a reportable segment if it satisfies at least one of the

following tests:

An operating segment is considered significant and is a reportable segment if it satisfies at least one of the

following tests:

Revenue TestProfit TestAsset Test

13TEAL COMPANYOperating Segment Financial Resultsfor Year Ended December 31, 2000

Reportable Operating Segments All Other Total A B C Segments Results

Segment revenues $ 300 $2,530 $ 370 $ 600 $ 3,800 Segment operating profit (pretax) $ 70 $ 495 $ 105 $ 140 $ 810 General corporate expenses (100)Corporate interest expense (80) Pretax income from cont’g operations $ 630 Segment assets at 12/31/2000 $1,800 $9,400 $2,000 $2,800 $16,000 Gen. corp. assets 3,000 Total assets 12/31/2000 $19,000

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Interim Income TaxesInterim Income Taxes

Estimated Annual Income:

First quarter $20,000 actual incomeSecond quarter 26,000 actual incomeThird quarter 25,000 estimated incomeFourth quarter 29,000 estimated income

$100,000 estimated annual income

ContinuedContinued

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Estimated Effective Income Tax Rate:

ContinuedContinued

$ 3,/4 3m

15% x $20,000 = $ 3,00030% x ($100,000 - $20,000) = 24,000

Estimated total tax = $27,000

27% Effective tax rate =$27,000 Estimated income tax$100,000 Estimated Income

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Estimated Income Tax for First Six Months:$ 3,

/4 3m$46,000 x 27% = $12,420 estimated income tax on first six months’ income

Estimated Income Tax for Second Quarter:$ 3,

/4 3m$12,420 estimated income tax on first six months

of income(5,220) estimated income tax on first-quarter

income$7,200 estimated income tax on second-quarter

income

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Preparation of Disclosure of Summarized Interim Financial Data


When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum.

When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum.

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Sales or gross revenues, income taxes, extraordinary

items (net of tax), the cumulative effect of a change in accounting

principle, and net income.

Sales or gross revenues, income taxes, extraordinary

items (net of tax), the cumulative effect of a change in accounting

principle, and net income.

Earnings per share for each

period presented.

Earnings per share for each

period presented.

Seasonal revenues, costs, and expenses.

Seasonal revenues, costs, and expenses.

Significant changes in

estimates of income taxes.


estimates of income taxes.

Contingent items.Contingent items.Changes in accounting

principles or estimates.

Changes in accounting

principles or estimates.


financial position.


financial position.

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SEC ReportsSEC Reports

Two SEC forms that are important to

accountants are--

Two SEC forms that are important to

accountants are--

Form 10-K

Form 10-Q

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Form 10-K is the most common SEC annual report

form and is required to be filed with the SEC within 90 days of

a company’s fiscal year-end.

Form 10-K is the most common SEC annual report

form and is required to be filed with the SEC within 90 days of

a company’s fiscal year-end.

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Form 10-Q is used to report a company’s quarterly financial information to the SEC and is

required to be filed within 45 days of the end of the company’s first

three fiscal quarters.

Form 10-Q is used to report a company’s quarterly financial information to the SEC and is

required to be filed within 45 days of the end of the company’s first

three fiscal quarters.

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Financial Analysis ComparisonFinancial Analysis Comparison

Financial Analysis

ComparisonsIntracompany Intercompany

Percentage Analyses

HorizontalVertical

Ratio

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Horizontal AnalysisHorizontal Analysis

In horizontal analysis, changes in a company’s operating results

and financial position over time are shown in percentages as well

as in dollars.

In horizontal analysis, changes in a company’s operating results

and financial position over time are shown in percentages as well

as in dollars.

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from 12/31/00 to 12/31/01

Base Year% =


Sales $138,000 $130,00012/31/01 12/31/00

$8,000

$8,000

$130,000% = = 6.2%

Now, using the data from Exhibit 5-5, let’s try gross profit from

December 31, 1999 to December 31, 2001.

Now, using the data from Exhibit 5-5, let’s try gross profit from

December 31, 1999 to December 31, 2001.

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from 12/31/99 to 12/31/01

Base Year% =


Gross profit $55,900 $42,000

12/31/01 12/31/ 99

$13,900

$13,900

$42,000% = = 33.1%

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Vertical Analysis (Income Statement)Vertical Analysis (Income Statement)

In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars.

In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars.

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2001

Amount Percent

Sales $138,000 Sales returns (8,000)Sales, net $130,000 Cost of goods sold (74,100)Gross profit $ 55,900

Sales, net $130,000 100.0

106.2Sales, $138,000

Sales, net, $130,000=

106.2


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2001

Amount Percent


Sales, net $130,000 100.0

(6.2)%Sales returns, ($8,000)

Sales, net , $130,000=

106.2(6.2)


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2001

Amount Percent


Sales, net $130,000 100.0

(57.0)%Cost of goods sold, ($74,100)

Sales, net , $130,000=

106.2(6.2)

(57.0)


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2001

Amount Percent


Sales, net $130,000 100.0

43.0%Gross profit, $55,900

Sales, net , $130,000=

106.2(6.2)

(57.0)43.0


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Vertical Analysis (Balance Sheet)Vertical Analysis (Balance Sheet)

2001

Amount Percent

Cash $ 3,900Receivables (net) 7,600Inventories 8,900Prepaid Items 1,000Total current assets $ 21,400Noncurrent assets (net) 107,800Total Assets $129,200

3.2%Cash, $3,900

Total Assets, $129,200=

3.0

Total Assets $129,200 100.0

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2001

Amount Percent


3.0


5.9%Receivables (net), $7,600

Total Assets, $129,200=

5.9

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Using this approach on the rest of the

assets, this section can be completed.

Using this approach on the rest of the

assets, this section can be completed.

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2001

Amount Percent


3.0


5.9 6.9 .8

16.6 83.4

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In calculating vertical analysis amounts for

liabilities and stockholders’ equity, all items are divided

by “total liabilities and stockholders’ equity.”

In calculating vertical analysis amounts for

liabilities and stockholders’ equity, all items are divided

by “total liabilities and stockholders’ equity.”


3.9%Accounts Payable, $5,000

Total L& SE, $129,200=

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Ratio AnalysisRatio Analysis

Stockholders’ Profitability RatiosStockholders’ Profitability Ratios

Earnings per share is probably the most frequently cited ratio in a financial analysis.

Net Income - Preferred Dividends

Average Common Shares Outstanding

$11,000 $1,200

5,400

= $1.81

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Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an

investment in the stock of a company.

Market Price per Common Share

Earnings per Share

$14.25

$1.81

= 7.9 times

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Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as

compared with the ending market price of the stock.

Dividends per Common Share

Market Price per Common Share

$1.00

$14.25

= 7.0%

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Company Profitability RatiosCompany Profitability Ratios

Profit margin is used to evaluate a company’s efficiency in controlling costs

and expenses in relation to sales.

Net Income

Net Sales

$11,000

$130,000

= 8.5%

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Return on total assets indicates how efficiently a company uses its economic resources.

Net Income + Interest Expense (net of tax)

Average Total Assets

$11,000 + ($3,000 x 0.7)

($129,200 + $112,000)/2

= 10.9%


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Return on stockholders’ equity shows the residual returns on the owners’ equity.


Net Income

Average Stockholders’ Equity

$11,000

($93,000 + $79,000)/2

= 12.8%

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The current ratio is used to evaluate a company’s short-run liquidity.

Liquidity RatiosLiquidity Ratios

Current Assets

Current Liabilities

$21,400

$11,200

= 1.91 times

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The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities.

Liquidity RatiosLiquidity Ratios

Quick Assets

Current Liabilities

$11,500

$11,200

= 1.03 times

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Inventory turnover indicates the number of times the inventory is “turned over” or

sold during that period.

Activity RatiosActivity Ratios

Cost of Goods Sold

Average Inventory

$74,100

($8,900 + $10,100)/2

= 7.8 times or 47 days365

7.8

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Receivables turnover indicates how many times receivables are “turned

over” or collected each period.


Net Credit Sales

Average Net Receivables

$130,000 x 0.70

($7,600 + $8,600)/2

= 11.2 times or 33 days365

11.2

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The payables turnover ratio measures the number of times accounts payable

turns over during the year.


Cost of Goods Sold

Average Accounts Payable

$74,100

($5,000 + $6,600)/2

= 12.8 times or 29 days 365

12.8

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The debt ratio indicates the percentage of total assets contributed by creditors.

Stability RatiosStability RatiosStability RatiosStability Ratios

Total Liabilities

Total Assets

$36,200

$129,200

= 28%

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Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings.


Pretax Operating Income

Interest Expense

$15,700 + $3,000

$3,000

= 6.2 times

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Book value per common share shows the net assets per share of stock.


Common Stockholders’ Equity

Outstanding Common Shares

$93,000 - ($140 x 150)

5,400

= 13.33 per common share

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Cash flow from operations to sales ratio is used to evaluate the cash generated from sales.

Cash Flow RatiosCash Flow RatiosCash Flow RatiosCash Flow Ratios

Cash Flow From Operations

Sales

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Cash flow from operations to net income ratio enables users to understand how the earnings of net income relates to the cash

flow from operations.



Net Income

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Cash flow from operations per share is expressly prohibited. However, users

may wish to compute it for internal use.



Average Shares of Common Stock Outstanding

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Cash flow from operations divided by the amount of debt maturing next year ratio measures the

ability of a company to make principal payments.



Debt Maturing Next Year

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Chapter5

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