INRODUCTION INRODUCTION TO FINANCIAL TO FINANCIAL STATEMENT STATEMENT ANALYSISANALYSIS

Chapter 1Chapter 1

CHAPTER 1 OBJECTIVESCHAPTER 1 OBJECTIVES

Understand the decision emphasis Understand the decision emphasis of financial statement analysis and of financial statement analysis and why a comprehensive approach is why a comprehensive approach is needed to meet this objective.needed to meet this objective.

Indicate who uses financial Indicate who uses financial statements and how they use statements and how they use them to make decisions. them to make decisions.

CHAPTER 1 OBJECTIVES CHAPTER 1 OBJECTIVES (CONT.)(CONT.)

Show the importance of generally Show the importance of generally accepted accounting principles (GAAP) accepted accounting principles (GAAP) to analysis, which organizations to analysis, which organizations determine GAAP, why GAAP differs determine GAAP, why GAAP differs among countries, and the benefits of among countries, and the benefits of harmonizing GAAP.harmonizing GAAP.

Determine the various concepts of Determine the various concepts of capital maintenance and attributes of capital maintenance and attributes of asset measurement.asset measurement.

CHAPTER 1 OBJECTIVES CHAPTER 1 OBJECTIVES (CONT.)(CONT.)

Articulate the benefits and limitations of Articulate the benefits and limitations of the nominal dollar capital maintenance the nominal dollar capital maintenance concept and historical cost valuation in concept and historical cost valuation in financial reporting and analysis.financial reporting and analysis.

Explain how inconsistent terminology, Explain how inconsistent terminology, data volume, transaction complexity, data volume, transaction complexity, information variability, and financial information variability, and financial statement limitations can affect statement limitations can affect financial statement analysis.financial statement analysis.

OVERALL PERSPECTIVEOVERALL PERSPECTIVE

Analysis—separation of something Analysis—separation of something into its parts to study its nature, into its parts to study its nature, proportion, function, and proportion, function, and interrelationship interrelationship

Analytical process—provides Analytical process—provides insights about how the entirety insights about how the entirety operates, where it came from, and operates, where it came from, and where it is going where it is going

OVERALL PERSPECTIVE OVERALL PERSPECTIVE (CONT.)(CONT.)

Financial statement analysisFinancial statement analysis Art and science of examining Art and science of examining

corporate financial statements corporate financial statements Financial statements—corporate Financial statements—corporate

monetary disclosuresmonetary disclosures

OVERALL PERSPECTIVE OVERALL PERSPECTIVE (CONT.)(CONT.)

Objective of this book: Students Objective of this book: Students will will Learn how to analyze financial Learn how to analyze financial

statementsstatements Critically evaluate corporate Critically evaluate corporate

disclosures and related informationdisclosures and related information

COMPREHENSIVE COMPREHENSIVE ANALYSISANALYSIS

Business environment—an analyst must Business environment—an analyst must understand the context in which a understand the context in which a company does businesscompany does business

   Components of business environmentComponents of business environment

Overall economyOverall economy Legal environmentLegal environment Political climatePolitical climate Cultural context Cultural context

COMPREHENSIVE COMPREHENSIVE ANALYSIS (CONT.)ANALYSIS (CONT.)

Data sources—Data sources— amount and variety of information amount and variety of information

sources needed to conduct analysissources needed to conduct analysis Qualities of data sourcesQualities of data sources

Timing-current versus historicalTiming-current versus historical Potential bias-objective versus Potential bias-objective versus

subjectivesubjective Type-quantitative versus qualitativeType-quantitative versus qualitative

CATEGORIES OF CATEGORIES OF ANALYSTS ANALYSTS

Equity investors—owners who seek to Equity investors—owners who seek to maximize return on investment, subject maximize return on investment, subject to a given risk levelto a given risk level

Credit granters—lenders who seek Credit granters—lenders who seek payment of principal and interest in a payment of principal and interest in a timely mannertimely manner

Corporate managers—owners’ agents Corporate managers—owners’ agents who seek information to plan and who seek information to plan and control their entity’s operationscontrol their entity’s operations

CATEGORIES OF CATEGORIES OF ANALYSTS (CONT.)ANALYSTS (CONT.)

Merger and acquisitions specialists—Merger and acquisitions specialists—professionals who, for a fee, realign professionals who, for a fee, realign corporations to maximize shareholder corporations to maximize shareholder valuevalue

Internal and external auditors—Internal and external auditors—independent evaluators who attest to the independent evaluators who attest to the fairness of managerial representations fairness of managerial representations (external auditors) and corporate (external auditors) and corporate employees who seek to improve business employees who seek to improve business operations (internal auditors) operations (internal auditors)

CATEGORIES OF CATEGORIES OF ANALYSTS (CONT.) ANALYSTS (CONT.)

Regulators—representatives of Regulators—representatives of government entities who judge an government entities who judge an entity’s compliance with existing entity’s compliance with existing laws and regulatory requirementslaws and regulatory requirements

Corporate employees—individuals, Corporate employees—individuals, or their collective bargaining or their collective bargaining agents, who seek to maximize agents, who seek to maximize compensation for their servicescompensation for their services

REPORTING STANDARDSREPORTING STANDARDS

Authoritative pronouncements that Authoritative pronouncements that when taken together with when taken together with accepted financial reporting accepted financial reporting conventions compose generally conventions compose generally accepted accounting principles accepted accounting principles (GAAP)(GAAP)

REPORTING STANDARDS REPORTING STANDARDS (CONT.)(CONT.)

Collaborative partnershipCollaborative partnership Securities and Exchange Commission Securities and Exchange Commission

(SEC)—quasi-governmental agency (SEC)—quasi-governmental agency that has the legal authority to set that has the legal authority to set reporting standardsreporting standards

Financial Accounting Standards Board Financial Accounting Standards Board (FASB)—private U.S. standard setting (FASB)—private U.S. standard setting body that determines most body that determines most authoritative pronouncementsauthoritative pronouncements

REPORTING STANDARDS REPORTING STANDARDS (CONT.) (CONT.)

Financial reporting standards Financial reporting standards consist of consist of Corporate financial statementsCorporate financial statements Notes to the financial statementsNotes to the financial statements Supplemental financial statement Supplemental financial statement

disclosuresdisclosures

REPORTING STANDARDS REPORTING STANDARDS (CONT.)(CONT.)

International dimensionInternational dimension Countries determine national generally Countries determine national generally

accepted accounting principlesaccepted accounting principles Differences in business formation, Differences in business formation,

development, and activity produce development, and activity produce various national standards various national standards

GAAP is classified into models, such as GAAP is classified into models, such as the Anglo American and European the Anglo American and European Models of accounting or financial Models of accounting or financial reportingreporting

REPORTING STANDARDS REPORTING STANDARDS (CONT.)(CONT.)

International Accounting Standards International Accounting Standards Committee (IASC)—collaborative Committee (IASC)—collaborative effort by the accounting bodies of effort by the accounting bodies of many nations to reduce financial many nations to reduce financial reporting alternatives and reporting alternatives and harmonize accounting standards; harmonize accounting standards; lacks enforcement power of lacks enforcement power of national bodies, such as the FASBnational bodies, such as the FASB

DISCLOSURE CHALLENGESDISCLOSURE CHALLENGES

Desirable qualitative Desirable qualitative characteristics of financial characteristics of financial reportingreporting Relevant information matters to Relevant information matters to

analysts by helping them predict the analysts by helping them predict the futurefuture

Reliable information can be verified Reliable information can be verified and is unbiasedand is unbiased

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Capital maintenance selectionCapital maintenance selection Amount of investment that must be Amount of investment that must be

recovered through revenues before recovered through revenues before income is earned; alternative income is earned; alternative concepts exist that result in different concepts exist that result in different degrees of relevance and reliability in degrees of relevance and reliability in the financial statementsthe financial statements

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Nominal dollar concept of capital Nominal dollar concept of capital maintenance—recognizes income maintenance—recognizes income after recovering the number of after recovering the number of dollars invested in the asset sold; dollars invested in the asset sold; ignores overall inflation rate or price ignores overall inflation rate or price changes for specific goods; underlies changes for specific goods; underlies the current system of financial the current system of financial reporting in the U.S. and most reporting in the U.S. and most countriescountries

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

General purchasing power concept General purchasing power concept of capital maintenance—income of capital maintenance—income results when an entity recovers results when an entity recovers more revenues than the general more revenues than the general purchasing power equivalent of its purchasing power equivalent of its investment; not GAAP investment; not GAAP

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Physical capital concept of capital Physical capital concept of capital maintenance—income results maintenance—income results when an entity recovers more when an entity recovers more revenues than the current cost of revenues than the current cost of its investment; not GAAPits investment; not GAAP

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Historical cost—principle that Historical cost—principle that governs asset measurement; used governs asset measurement; used with the nominal dollar concept of with the nominal dollar concept of capital maintenance to compose capital maintenance to compose financial reporting systemfinancial reporting system

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Information complexities—Information complexities—obstacles that hinder financial obstacles that hinder financial statement disclosures and analysisstatement disclosures and analysis Inconsistent terminology and financial Inconsistent terminology and financial

statement formats vary among statement formats vary among companies and over timecompanies and over time

Numerous information sources Numerous information sources provide substantive amounts of dataprovide substantive amounts of data

DISCLOSURE CHALLENGES DISCLOSURE CHALLENGES (CONT.)(CONT.)

Information complexities (cont.) Information complexities (cont.) Transaction complexities reflect the Transaction complexities reflect the

increasingly complicated ways in which increasingly complicated ways in which business is conductedbusiness is conducted

Data sources vary greatly with respect Data sources vary greatly with respect to their relevance and reliabilityto their relevance and reliability

Financial statements report only Financial statements report only selected events in constant monetary selected events in constant monetary units and on the basis of historical costunits and on the basis of historical cost