Professor ZHOU Ning SCHOOL OF ECONOMICS AND MANAGEMENT BEIHANG UNIVERSITY zning80buaaeducn Chapter 14 Understanding Financial Statements The objectives of chapter 14 Additional information in annual report ID: 1029175
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1. Accounting For Managers Professor ZHOU NingSCHOOL OF ECONOMICS AND MANAGEMENTBEIHANG UNIVERSITYzning80@buaa.edu.cn
2. Chapter 14 Understanding Financial Statements
3. The objectives of chapter 14 Additional information in annual reportReview of criteria and conceptsAccounting alternativesMeaning of the financial statement14-3
4. Information in Annual Reports Primary financial statements: Balance Sheet, Income Statement, Statement of Cash Flows.Auditor’s opinion.Notes to financial statements.Management discussion and analysis.Operating segment info.Comparative data.Optional info on products, personnel, facilities….14-4
5. AuditorsCertified public accountants.Meet prescribed professional standards.Licensed by state.14-5
6. Auditors’ OpinionResults of auditors examination.Relates to financial statements and notes, not other parts of annual report.Format of auditors’ report determined by American Institute of Certified Public Accountants (AICPA).14-6
7. Responsibility of AuditorsExpress opinion on fairness of financial statements.Provide reasonable assurance that financial statements do not contain any material misstatements.Select and perform audit procedures such as: Test checks of accounting system, verify existence of assets, confirm accounts receivable with customers.Management, not auditors, primarily responsible for financial statement.14-7
8. Types of OpinionsClean opinion: Financial statements materially conform with GAAP.Qualified opinions because of:Lack of consistency.Existence of a major uncertainty.Doubt as to the entity’s ability to continue as a going concern.Disclaimer: Unable to express an opinion.Adverse opinion: Material departure from GAAP.14-8
9. Auditors’ Opinion14-9
10. Notes to Financial StatementsIntegral part of financial statements.First note summarizes accounting policies.Basis of consolidation, depreciation and inventory methods,….Other notes:Details of long-term debt.Composition of inventory.Reconciliation of book to federal tax rate.Details of deferred taxes.14-10
11. Segment ReportingRequired by GAAP.Supplements overall financial statements.Operating segment: components of corporation that are evaluated separately.Info required by segment:Revenues.Operating profit.Interest expense.Identifiable assets.14-11
12. Full DisclosureFundamental principle of financial statements.What constitutes full disclosure:Economic info that would cause informed investors to appraise company differently.Includes info that comes to light after fiscal year-end.e.g. plant fire after year-end.Differences of opinion on what should be disclosed.14-12
13. Comparative StatementsRequired in addition to current year’s:Previous year’s balance sheet.Previous two years’ income and cash flow statements.Most companies include summaries of important financial info for past five or ten years.Only restated for specified changes in accounting principles.14-13
14. Management’s Discussion and AnalysisDiscussion of:Operating results.Liquidity.Solvency.Important events.Class discussion: Understanding of the real annual report of company A 14-14
15. Securities and Exchange Commission (SEC) ReportsForm 10-K: financial data consistent with but more detailed annual report.SEC Regulation S-X governs preparation.Generally consistent with FASB standards.Financial data required to be included in notice of annual meeting to stockholders:Top executive compensation, common stock holdings of top executives,….Form 10-Q: quarterly interim statements.Form 8-K: significant events such as earnings announcements, major investment,….14-15
16. Case StudyComprehensive Case Study14-16
17. Review: Basic Accounting CriteriaCriteria: Relevant: Useful for investor decision making.Objective: Unbiased.Feasible: Its value should exceed cost of providing it.Tradeoff: relevance vs. objectivity and feasibilityProperty, plant and equipment at current or historical cost.14-17
18. Concepts 1 through 3Money Measurement: Accounting records limited to facts that can be expressed in monetary terms.Entity: Accounts are kept for entities, separate from persons associated with entities.Going concern: An entity will continue indefinitely and is not about to be liquidated.14-18
19. Concepts 4 and 5Cost: An asset is generally recorded at acquisition amount, which is basis for subsequent accounting.Exceptions: Impaired value, monetary assets at fair value.Dual aspect: Total amount of assets = total amount of liabilities plus owners’ equity.Debits = credits.14-19
20. Concepts 6 and 7Accounting period: Accounting measures activity for a specified interval of time, usually one year.Conservatism: Revenues are recognized when reasonably certain, expenses are recognized when reasonably possible.14-20
21. Concepts 8 and 9Realization: Recognize as revenue amount reasonably certain to be realized, that is, to be paid by customers.Matching: When a given event affects both revenues and expenses, effect on each is recognized in same accounting period.Direct matching (cost of goods sold).Costs associated with the period itself (rent).Costs not associated with future revenue (asset impairment).14-21
22. Concepts 10 and 11Consistency: Once an accounting method is selected, same method should be used for all subsequent events of same character unless sound reason to change.Materiality: Insignificant events may be disregarded, full disclosure of all important info.14-22
23. MisconceptionsCost concept: accounting reports nonmonetary assets at cost not at fair value or worth.Going concern concept: productive assets are held for future use; therefore current value is of limited importance.Matching concept: expenses occur when costs expire not when expenditures are made.14-23
24. Accounting AlternativesRequirements of regulatory agencies in certain industries.Choices within GAAP.Judgments and estimates throughout accounting.14-24
25. Income Tax PrinciplesBasically similar to GAAP with important exceptions:Depreciation expense.Depletion allowance.Ordinary income vs. capital gains.Cash based tax accounting.Primarily changes timing of recognition not amount.14-25
26. Basis of Choice of Accounting MethodMaximize earnings (and stock price).Conform to others in industry.Loan agreements and bond indentures.Managers’ bonuses.Belief that conservatism raises investor confidence.14-26
27. Efficient Market Hypothesis (EMH)All information that is publicly known is priced into share prices.Implies a change in a company’s accounting methods has no effect on price of its stock.14-27
28. SignalingAccounting choices signal management’s view of future.14-28
29. Implications of Accounting DiversityComplexity of businesses.Overcome somewhat by:Consistency from year to year.Same methods tend to be used within an industry.14-29
30. Inherent LimitationsAccounting reports are necessarily:Monetary.Influenced by estimates of future events.Life of assets.Collectibility of receivables.Sales and pricing of inventory.Wage agreements.Resolution of litigation.14-30
31. Ethical ProblemsForeign Corrupt Practices Act: bribing government officials.Booking revenues early.“Big bath” phenomenon:Writing off substantial amounts in year new management takes over.Consequences of challenging positions and judgments of top management.14-31
32. Meaning of Income StatementDominant financial statement.Measures changes in retained earnings during period (except for dividends and correction of errors).Judgments influence recording of revenues and expenses.14-32
33. CapitalizationChallenge to distinguish among capital costs, product costs, and expenses.Judgment influences accounting.14-33
34. Meaning of Balance SheetCollection of several types of items reported according to different concepts.Monetary items usually definite and at fair value.Unexpired costs: original cost allocated over life.Inventories: lower of cost or market.Investments: accounted for according to type.Paid-in capital: amount from issuance of stock.Retained earnings: earnings not paid out in dividends.14-34
35. Balance Sheet OmissionsValue of:Human resources.New products & R&D.Contingencies unknown to accountant.14-35
36. Statement of Cash FlowsDerived from data collected for BS & IS.Sources and uses of cash.Not affected by judgments.Flow statement as is IS.Limitation: Does not show how income was earned.14-36
37. Summary of Chapter 14Additional information in annual reportReview of criteria and conceptsAccounting alternativesMeaning of the financial statement14-37
38. Thank you 14-38