2
CHAPTER
Financial Reporting
and Analysis
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Financial Reporting
Environment
Regulators
FASB
AICPA
Industry
Practices
GAAP
Enforcement and Monitoring Mechanisms
SEC
Corporate
Governance
Managers
Auditors
Statutory Financial Reports
(Financial Statements)
Alternative Information
Sources
Economy and Industry
Information
Voluntary
Disclosure
Users
Analysts
Investors
and
Creditors
Other
Users
Litigation
Form 10-K
(Annual Report)
10-Q
(Quarterly Report)
Other
SEC Filings
14-A
(Proxy Statement/
Prospectus)
Statutory Financial Reports
8-K
(Current Report)
20-F
(Registration Statement/
Annual Report [Foreign])
Earnings Announcements
Key summary measures (pre-audit)
Often one to six week lag
Informative to market
Lacks supporting financial details
Environmental Factors
GAAP
Generally Accepted Accounting Principles
Level I
(Most authoritative)
Level II
Level III
Level IV
(Least authoritative)
FASB
Standards and
Interpretations
APB
Opinions
AICPA(CAP)
Accounting
Research Bulletins
FASB
Technical
Bulletins
AICPA
Industry Audit &
Accounting Guidelines
AICPA
Statement of
Position
AICPA
Practice Bulletins
FASB
Emerging Issues Task Force
FASB
Implementation
Guides
AICPA
Interpretations
Recognized and
Widely Used Industry
Practices
Environmental Factors
Financial Accounting Standards Board
Generally Accepted Accounting Principles
Provide input to
Help set
Securities and
Exchange
Commission
Unions
Investors
Accountants
Politicians
Lenders
Others
AICPA
Environmental Factors
Securities and Exchange Commission (SEC)
Independent, quasi-judicial government agency
Administer securities regulations & disclosures
Can modify & set GAAP, if necessary
Rarely directly challenges FASB
Major player in global accounting
Environmental Factors
International Accounting Standards (IAS)
Set by International Accounting
Standards Board
Not currently accepted in .
SEC under pressure to accept IAS
Environmental Factors
Managers of Companies
Set by International Accounting
Standards Board
Not currently accepted in .
SEC under pressure to accept
IAS
Main responsibility for fair & accurate reports
Applies accounting to reflect business
activities
Managerial discretion is necessary in
accounting
Major lobbyist on GAAP
Environmental Factors
Auditing
Set by International Accounting
Standards Board
Not currently accepted in .
SEC under pressure to accept
IAS
SEC requires Audit Report
Audit opinion can be:
- clean (fairly presented)
- qualified (except for)
- disclaimer (no opinion)
Check Auditor quality & independence
Auditors
Environmental Factors
Corporate Governance
Set by International Accounting
Standards Board
Not currently accepted in .
SEC under pressure to accept
IAS
Board of directors oversight
Audit committee of the board
- oversee accounting process
- oversee internal control
- oversea internal/external audit
Internal Auditor
Environmental Factors
Internal Users External Users
Managers
Officers
Internal Auditors
Sales Managers
Budget Officers
Controller
Lenders
Shareholders
Governments
Labor Unions
External Auditors
Customers
Environmental Factors
Creditors
Equity Investors
Active & Speculative Investors rely on
financial reports
Solvency & Liquidity analysis relies
on financial reports
Environmental Factors
Voluntary Disclosure
Economic, Industry & Company News
Impacts current & future financial condition and
performance
Information Intermediaries
Industry devoted to collecting, processing, interpreting
& disseminating company information
Includes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
Major determinant of GAAP
Many factors encourage voluntary disclosure by
managers
Financial Accounting
Stewardship
z Safeguard assets
z Increase equity value
z Protect creditors
Accountability &
Performance
Measurement
Information Perspective
z Amount …of
z Timing prospective
z Uncertainty net cash
inflows
Predictability & Decision
Usefulness
Objectives
Historical Emphasis
(but still important)
Modern Emphasis
Financial Accounting
Hierarchy of Accounting Qualities
Constraints
User-specific
qualities
Primary qualities
Ingredients of
primary qualities
Understandability
Relevance Reliability
Feedback
value
Predictive
value
Comparability and
consistency
Neutrality Verifiability
Secondary qualities
Benefits > Costs Materiality
Users of accounting
information
Decision makers and their characteristics
Decision usefulness
Representational
faithfulnessTimeliness
Financial Accounting
• Double Entry - duality from accounting equation, A=L+E
• Historical Cost - fair & objective values from arm’s-length
transactions
• Accrual Accounting - recognize revenues when earned,
expenses when incurred
• Full Disclosure - measure and/or disclose material events
and transactions
• Materiality - threshold when information impacts decision
making
• Conservatism - reporting or disclosing
the least optimistic information
about uncertain events and transactions
Important Accounting Principles
FASB
Financial Accounting
Relevance of Accounting Numbers
Relation between Accounting Numbers and Stock Prices
Financial Accounting
• Timeliness - periodic disclosure, not
• real-time basis
• Frequency - quarterly and annually
• Forward Looking - limited prospective
information
Limitations of Accounting Numbers
Accruals--The Cornerstone
Net
Income
= Accruals
Operating
Cash Flow
+
Revenue Recognition – recognize revenues when
(1) Earned
(2) Realized or Realizable
Expense Matching – match with corresponding revenues
-Product costs
-Period costs
Accruals--The Cornerstone
Foundations of Accrual Accounting
Operating cash flow (OCF)
-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
Accruals--The Cornerstone
Relation between Cash Flows and Accruals
Short-Term Accruals: Yield current assets and current
liabilities (also called working
capital accruals)
Long-Term Accruals: Yield non-current assets and non-
current liabilities (arise mainly from
capitalization)
Accruals--The Cornerstone
Short-Term and Long-Term Accruals
Note: Analysis research suggests short-term accruals
are more useful in company valuation
Accruals--The Cornerstone
Relevance of Cash Flows and Income over a Company’s Life Cycle
+
Income
Investing
cash flow
Free cash
flow
Financing
cash flow
Operating
cash flow
DeclineGrowth MaturityInception
Accruals--The Cornerstone
Comparison of Stock Price, Net Income, and Free Cash Flows
Wal-Mart
Stock price
Net income
Free cash flow
Kmart
Stock price
Net income
Fiscal year 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
() () () () () () ()
() () () Free cash flow
() () ()
Accruals--The Cornerstone
Relation between Stock Prices and Various Income and Cash
Flow Measures for a Large Sample of Companies
NIBX = Net Income before Extraordinary Items and Discontinued Operations; NI = Net Income;
OCF = Operating Cash Flow; FCF = Free Cash Flows; NCF = Net Cash Flow (Change in Cash).
Accruals--The Cornerstone
Relation between Stock Returns and both Income and Operating
Cash Flows for Different Horizons of a Large Sample of Companies
Source: Dechow, P
.
Accruals--The Cornerstone
Accruals and Cash Flows --- Myths
.
• Myth: Since company value depends on future cash flows,
only current cash flows are relevant for valuation.
• Myth: Company value equals discounted future cash flows.
• Myth: All cash flows are value relevant.
• Myth: All accruals accounting adjustments are value
irrelevant.
• Myth: Cash flows cannot be manipulated.
• Myth: All income is manipulated.
• Myth: It is impossible to consistently
• manage income upwards in long run.
• Myth: Accounting rules are irrelevant
for valuation.
Accruals--The Cornerstone
Accruals and Cash Flows --- Truths
.
• Truth: Accrual accounting (income) is more
relevant than cash flow.
• Truth: Cash flows are more reliable than accruals.
• Truth: Accrual accounting numbers are subject
to accounting distortions.
• Truth: Company value can be
determined by using
accrual accounting
numbers.
Accounting Analysis
Demand for Accounting Analysis
Adjust for accounting distortions so financial
reports better reflect economic reality
Adjust general-purpose financial statements
to meet specific analysis objectives of a
particular user
Accounting Analysis
Sources of Accounting Distortions
Accounting Standards – attributed to (1) political
process of standard-setting, (2) accounting
principles and assumptions, and (3) conservatism
Estimation Errors – attributed to estimation errors
inherent in accrual accounting
Reliability vs Relevance – attributed to over-
emphasis on reliability at the loss of relevance
Earnings Management – attributed to window-
dressing of financial statements by
managers to achieve personal benefits
Accounting Analysis
Sources of Analysis Objectives
Comparatives Analysis – demand for financial comparisons
across companies and/or across
time
Income Measurement -- demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income concepts
(1) Economic Income (or
empirically, economic profit)
(2) Permanent Income (or
empirically, sustainable profit)
Chapter 6 discusses these measures in detail
Accounting Analysis
Earnings Management – Frequent Source of Distortion
Three common strategies:
Increasing Income – managers adjust accruals
to increase reported
income
Big Bath – managers record huge
write-offs in one period to
relieve other periods of
expenses
Income Smoothing– managers decrease or
increase reported income
to reduce its volatility
Accounting Analysis
Earnings Management – Motivations
Contracting Incentives -- managers adjust numbers
used in contracts that affect their wealth (.,
compensation contracts)
Stock Prices – managers adjust numbers to influence
stock prices for personal benefits (., mergers, option
or stock offering)
Government Favors – managers adjust numbers to
affect political actions (., antitrust actions, IRS
pressures, government subsidies)
Other Reasons -- managers adjust numbers to impact
(1) labor demands, (2) management changes, and (3)
societal views
Accounting Analysis
Earnings Management – Mechanics
Incoming Shifting – Accelerate or delay
recognition of revenues or
expenses to shift income from
one period to another
Classificatory – Selectively classify revenues
and expenses in certain parts
of the income statement to
affect analysis inferences
regarding the recurring nature
of these items
Accounting Analysis
Process of Accounting Analysis
Accounting analysis involves several inter-related processes
and tasks that can be grouped into two broad areas:
Evaluating Earning Quality –
Identify and assess key accounting policies
Evaluate extent of accounting flexibility
Determine the reporting strategy
Identify and assess red flags
Adjusting Financial Statements --
Identify, measure, and make necessary adjustments
to financial statements to better serve one’s analysis
objectives; Chapters 3-6 focus on adjusting
(recasting) the statements
