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Section I
Introduction and Resources
Module 1.a.
Companies Under Investigation
Aldelphi
Arthur Andersen
AOL
Bristol Myers Squibb
Computer Associates International
Deloitte & Touche
Enron
Ernst & Young
Global Crossing
Investigation cont’d
Halliburton
Imclone
Kmart
KPMG
Peregrine
PricewaterhouseCoopers
Qwest
Tyco
Worldcom Inc.
Xerox
Why?
Quality of earnings
Where were the auditors?
Responsibility of management
What is accounting?
Often called the language of
business
– Measures financial aspects of a
business
– Communicates this information to
decision makers
Why should everyone in
business study accounting??
Many business decisions are based on
accounting information.
Since accounting information is prepared
according to “rules,” an understanding of
these rules is necessary for the
appropriate use of the information.
Personal need for understanding financial
statements
The Accounting Equation
Assets = Claims or
Assets = Liabilities + Equity
Asset: something of value
Liability: something owed (creditors’
share of the assets)
Equity: what remains (owners’ share of
the assets)
Four Basic Financial Statements
Balance Sheet
– Assets = Liabilities + Equity
Income Statement
– Revenues - Expenses = Net income
Statement of Changes in Equity
– Beginning equity + Contributions + Net income Distributions = Ending equity
Statement of Cash Flows
– Cash inflow - Cash outflow = Net cash flow
The Annual Report includes:
financial statements
notes to the financial statements
auditor’s report
5-year summary of key financial data
high and low stock selling prices
management discussion & analysis of
operations (“forward-looking” info)
On-line Annual Reports
Most companies provide their annual reports
online. Click on the link below to look at
Delta Airlines’ most recent annual report.
Pay particular attention to how Delta
addresses the challenges following 9/11 (the
first page or two of the AR). How much
cash aid did Delta receive from the federal
government?
Delta Annual Report
(note it will download in PDF format—you may have to
open up the window from the bottom toolbar)
Notes
Are an INTEGRAL part of the statements
Provide summary of accounting policies
Present detail about particular accounts
(e.g. inventory, investments, etc.)
Include other information (e.g. leasing
arrangements, pending legal proceedings,
income taxes, etc.)
Notes (more stuff included)
Contain some supplementary information
required by SEC and FASB
Examples include:
– information on foreign currency translations
for firms doing business in/with foreign
countries
– information by segment for firms with several
lines of business
Auditor’s Report
Unqualified (what you want!) -- states
that statements present information in
conformity with GAAP (sometimes with
explanatory language)
Sometimes qualified or adverse
opinions are issued (not what you
want!)
Disclaimer
Keep in mind that auditor is hired by the
firm -- always the possibility of conflict of
interest
Look at an auditor’s opinion
Federal Express Annual Report
Click on the link above and try to find the
auditor’s opinion (Hint: It’s after the notes)
What type of opinion is it and who were
their auditors in 2002?
Example of a qualified opinion
The accompanying consolidated financial statements
have been prepared assuming Carolco Pictures Inc. and
subsidiaries will continue as a going concern. As more
fully described in Note B, the Company has incurred
continuing significant losses and has a deficiency in
assets $64,521,000 at December 31, 1994. Further, the
Company has experienced significant cash flow
difficulties and does not have sufficient cash resources
and financing sources to meet its operating expenses
and scheduled debt service obligations, and continue to
fund its principal business activity. These conditions
raise substantial doubts about the Company's ability to
continue as a going concern. (Management's plans in
regard to these matters are also described in Note B).
The 1994 consolidated financial statements do not
include any adjustments that might result from the
outcome of this uncertainty.
Carolco Pictures produced the Terminator movies!
MD&A (Financial Review)
1.Internal/external sources of liquidity
2.Any material deficiencies in liquidity and
how they will be remedied
3.Commitments for capital
expenditures/sources of funding
4.Anticipated changes in mix and cost of
financing resources
MD&A (continued)
5.Unusual/infrequent transactions which
affect income from continuing operations
6.Events causing material changes in
cost/revenue relationships (e.g. future
price increase)
7.Breakdown of sales increases in price &
volume components
“PR Fluff”
Amount sometimes varies INVERSELY
with performance...
Can visit many corporate websites to view
some interesting “creations”
SEC Filings
http://www.sec.gov
10K
10Q
8K
Prospectus
What is insider trading?
What is the CEO/CFO certification?
Do rules = uniformity?
GAAP provide some measure but they
allow considerable discretion
Accounting choices and estimates affect
amounts on financial statements
Depreciation of fixed assets is a good
example (choice of method, different
“good faith” estimates possible)
Accounting Period
Another complexity
Although the firm’s life is continuous,
financial data is presented for arbitrary
time periods -- year, quarter and the like
Leads to need for more adjustments and
estimates
Statements are prepared on “accrual”
basis
Cash versus “Accrual”
Financial statements are prepared on an
“accrual” basis
Attempt to MATCH expenses with revenue
in a given accounting period
Revenues reported when “earned” rather
than when received in cash
Expenses are recorded when incurred
rather than when paid in cash
More Sources of “Confusion”
Earnings per share
Consolidation of parent and subs
Reporting leases
Reporting pensions
Translation of foreign operations
Off-balance sheet financing
Accounting for derivatives
(continued…….)
Even MORE Confusion...
“Comprehensive” income reporting
Two sets of books (yes, it’s legal!!) financial vs. tax reporting
Pro forma earning
Quality of Financial Reporting
Management has considerable discretion
within GAAP
Potential exists to “manipulate” the
profit/loss reported
The closer the financial data presented
represent financial reality, the higher the
quality of the financial statements and
reported earnings
A business man was interviewing applicants for the position
of divisional manager. He devised a simple test to select
the most suitable person for the job. He asked each
applicant the question, "What is two and two?" The first
interviewee was a journalist. His answer was "Twentytwo."
The second applicant was an engineer. He pulled out a
slide rule and showed the answer to be between 3.999
and 4.001.
The next person was a lawyer. He stated that in the case
of Jenkins vs. Commr of Stamp Duties (Qld), two and
two was proven to be four.
The last applicant was an accountant. The business man
asked him, "How much is two and two?"
The accountant go up from his chair, went over to the door
and closed it then came back and sat down. He leaned
across the desk and said in a low voice, "How much do
you want it to be?”
He got the job.
Means to Affect Quality
Accounting policies and estimates
– choices and changes
Timing of revenues and expenses
Discretionary items
Nonrecurring and nonoperating items
ALL ARE WITHIN THE PURVIEW OF
MANAGEMENT
Accounting Policies/Estimates
Choices
– Management may choose among acceptable
accounting policies
– Management has opportunity to make
estimates when applying policies
Changes
– Policy or estimate may be changed
Timing of Revenues/Expenses
Matching process involves judgments by
management regarding recognition of
revenues and/or expenses
Usually the more conservative the
approach (least favorable to management)
the higher the quality of earnings
Discretionary Items
Budget level and timing of expenditures for
many items are discretionary, e.g.
– advertising/marketing
– repairs/maintenance
– research and development
– capital expansion
Nonrecurring and Nonoperating
Items
Nonrecurring and nonoperating items are
not part of normal ongoing business
Earnings figure should reflect future
operating potential
Therefore segregate such things as major
asset sales, accounting changes, asset
impairments, extraordinary items
Look at an example of an
accounting change
Coca Cola Annual Report
Is the accounting change shown net of
tax?
Look at page 70 of the annual report.
What SFAS caused the change?
What about Inflation???
Historical cost principle prevails in financial
reporting
Impact of inflation is uneven -- relevance
vs. reliability tradeoff
Produces both purchasing power gains
and losses -- e.g. debt is good in
inflationary situation
Missing Information
Morale/efficiency of employees
Reputation/public perceptions of firm
Effectiveness of management
team/provisions for succession
Potential exposure to regulatory
changes
IMPACT OPERATING SUCCESS BUT
ARE DIFFICULT TO QUANTIFY
What about publicity?
Affects public perception of firm and can
impact financial performance
Proven correlation between financial
returns and reputation
Recent examples are adverse publicity for
Coca Cola and Northwest Airlines -countered by the respective companies to
minimize impact
What Info is Hard to Find?
Many items must be extracted from
notes, supplementary schedules, MD&A
section in order to interpret financial
statement numbers - the facts are there,
but they are not self-evident!
Coverage in Chapters 2-5 is geared to
helping FIND and EFFECTIVELY USE
information in financial statements and
supplementary materials
The End!
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