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Chapter 3
Financial
Statements
Chapter 3 Outline
3.1 Accounting
Principles
• Generally accepted
accounting principles
• Auditors
• Accounting conventions
• Measuring costs and value
• Recognition principles
• Managing financial
statements
• The effect of recent
accounting scandals
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3.2 Financial
Statements
• The balance sheet
• The income statement
• The statement of cash flows
3.3 The Tax System
• Interest and dividends
received
• Depreciation
• Capital gains
• Tax rates
3.1 Accounting principles
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Accounting is simply an organized method of
summarizing all of a company’s transactions and
presenting them in such a way that external users can
understand the company’s affairs.
Clearly, problems arise when the company tries to
present its accounting statements in a way that does
not fairly represent its situation, either to creditors,
like the bank, or to the common shareholders.
Consequently, external users of the company’s
financial statements must become skilled in analyzing
the statements and spotting signs that things may not
be quite as management presents them.
Generally Accepted Accounting
Principles
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It is important to realize that management prepares the
company’s financial statements, not the company’s auditors.
Auditors, such as Deloitte & Touche LLP (Deloitte), attest to
whether or not the financial statements fairly represent the
company’s financial position according to generally
accepted accounting principles (GAAP).
Companies reporting in the U.S. follow the principles
promulgated by the Financial Accounting Standards Board
(FASB), whereas members of the European Economic
Community, and other countries, follow the principles
promulgated by the International Accounting Standards
Board (IASB).
Independent auditors
Independent auditors review the financial statements
prepared by a company’s management and provide a
report, addressed to the company’s board of directors
and shareholders, that generally consists of the
following:
1. A statement that the financial statements are the
responsibility of the company, and that the auditor is
providing an opinion on the financial statements, not
the accounting records themselves.
2. A description of the scope of the audit, and that it
was conducted according to generally accepted
auditing standards,
3. The auditor’s opinion, which is one of four types.
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Auditor’s opinion
An auditor’s opinion is one of four types:




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Unqualified opinion - the auditor finds that the financial
statements are presented fairly in accordance with generally
accepted accounting principles.
Qualified opinion - the auditor finds that the financial
statements are presented fairly in accordance with generally
accepted accounting principles except for a matter of
qualification.
Adverse opinion - the auditor concludes that the financial
statements are not presented fairly according to GAAP.
Disclaimer of opinion - the auditor’s examination is severely
restricted or the auditor finds some condition is present that
prevents the application of generally accepted auditing
standards.
Accounting conventions:
basic principles
 The
purpose of financial statements is to provide
information, at least annually, to a wide range of
external users, including investors, employees,
lenders, governments, and the general public.
 The underlying assumptions in the financial
statements are that transactions are recorded on
the accrual basis, and that the entity is a going
concern, and hence will continue indefinitely.
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Accounting conventions:
basic principles
 Financial
statements should possess the
qualitative characteristics of
understandability, relevancy, reliability, and
comparability.
 The
relevancy of financial statements includes
consideration of the materiality of the
information, the reliability of the information
and related estimates, and prudence.
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Measuring costs and value
 Business
entities measure and report
monetary amounts for the various
elements in its financial statements.
 The basis for measuring costs differs
among accounts, and may differ among
entities for the same accounts.
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Measuring costs and value
Historical cost
Current cost
• What it cost the entity when it purchased the
asset or took on the obligation.
• What it would cost to replace the asset or settle
the liability.
Net realizable
value
• What the company would reasonably get for
the asset if it had to dispose of it in an orderly
sale, or the settlement value for a liability.
Present value
• The sum of the discounted expected future cash
flows arising from the asset or expected to be
paid in the case of a liability.
Fair value
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• The amount reasonably expected to be
received for an asset or settled in the case of a
liability, between knowledgeable, willing parties
to the transaction.
Recognition principles
Type
When Recognized
Example
Asset
Likely that the future economic
benefit will flow to the entity and that
the value can be measured reliably
Purchase of
equipment
Liability
Likely that the outflow of resources
will result and that the amount of the
obligation can be measured reliably
Borrowing by issuing
a debt obligation
Income
Increase in future economic benefit
from an increase in an asset or a
decrease in a liability can be
measured reliably
Sale of goods or
services, or waiver
of a debt obligation
Expense
Decrease in future economic benefit
from a decrease in an asset or an
increase in a liability
Depreciation of
equipment or
accrual of wages to
employees
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Net income v. comprehensive income
 Net
income appears in the income
statement;
 Other comprehensive income is the
adjustment to net income.
Net income
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Other
comprehensive
income
Comprehensive
income
Shareholders’ equity
Common stock at par
+
+
+
-
Additional paid in capital
Preferred stock
Other comprehensive income
Treasury stock
Shareholders’ equity
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Managing financial statements
Accounting principles offer some flexibility because
it is simply not possible to design a one-size-fits-all
set of principles. For example:
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


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Mark-to-market - writing the value of an asset up or
down, depending on its current market value
Available-for-sale - method of accounting for marketable
securities in which unrealized gains or losses are reported
as part of accumulated other comprehensive income
Trading securities - method of accounting for marketable
securities that occurs when unrealized gains or losses are
reported in net income
Held-to-maturity - method of accounting used when
marketable debt securities are reported at cost
Enron’s History
 Enron was born in 1985 from the merger of Houston
Natural Gas and InterNorth.
 Enron incurred massive debt and no longer had
exclusive rights to its pipelines.
 Needed new and innovative business strategy
 Kenneth Lay, CEO, hired McKinsey & Company to
assist in developing business strategy. They
assigned a Jeffrey Skilling to Enron.


His background was in banking and asset and liability
management.
His recommendation: that Enron create a “Gas Bank”—to
buy and sell gas
Enron’s History (cont’d)
Created Energy derivative. Lay created a new division in 1990
called Enron Finance Corp. and hired Skilling to run it
 Enron soon had more contracts than any of its competitors
and, with market dominance, could predict future prices with
great accuracy, thereby guaranteeing superior profits.
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
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Fastow was a Kellogg MBA hired by Skilling in 1990—Became CFO in
1998
Started Enron Online Trading in late 90s
Created Performance Review Committee (PRC) that became
known as the harshest employee ranking system in the
country---based on earnings generated, creating fierce
internal competition
The Motivation
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

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Enron delivered smoothly growing earnings (but not cash flows.)
Wall Street took Enron on its word but didn’t understand its
financial statements.
It was all about the price of the stock. Enron was a trading
company and Wall Street normally doesn’t reward volatile
earnings of trading companies. (Goldman Sacks is a trading
company. Its stock price was 20 times earnings while Enron’s was
70 times earnings.)
Enron reported 20 straight quarters of increasing income in its
last 5 years.
Enron, that had once made its money from hard assets like
pipelines, generated more than 80% of its earnings “wholesale
energy operations and services.”
The Role of Stock Options
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Enron (and many other companies) avoided hundreds
of millions of dollars in taxes by its use of stock
options.
Corporate executives received large quantities of
stock options. When they exercised these options,
the company claimed compensation expense on their
tax returns.
Accounting rules let them omit that same expense
from the earnings statement. The options only
needed to be disclosed in a footnote.
Options allowed them to pay less taxes and report
higher earnings while, at the same time, motivating
them to manipulate earnings and stock price.
Enron’s Corporate Strategy
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
Enron’s core business was losing money—shifted its focus
from bricks-and-mortar energy business to trading of
derivatives (most derivatives profits were more imagined than
real with many employees lying and misstating systematically
their profits and losses in order to make their trading
businesses appear less volatile than they were)
Enron’s top management gave its managers a blank order to
“just do it”
Deals in unrelated areas such as weather derivatives, water
services, metals trading, broadband supply and power plant
were all justified.
Confuse, confuse, confuse
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Source: Bob Jenson, Trinity University
Aggressive nature of Enron
 Because
Enron believed it was leading a
revolution, it pushed the rules.
 Competition was fierce among Enron traders, to
the extent that they were afraid to go to the
bathroom and leave their computer screen
unattended and available for perusal by other
traders.
Enron’s use of special purpose
entities (SPEs)
To:
 hide bad investments and poor-performing assets
 manage earnings—Blockbuster Video deal--$111 million
gain
 execute related-party transactions at desired prices
 report over $1 billion of false income
 hide debt
 manipulate cash flows, especially in 4th quarters
 book income just in time and in amounts needed, to
meet investor expectations
2001 - Notable Events
Date
Event
July 2001
Enron blamed for California’s energy crisis
August 14
Jeff Skilling left Enron; no reason given
Mid-August
Stock price falling
October 12
Discloses $638 billion loss in third quarter
October 16
Former CEO returned (Kenneth Lay)
November 8
Informed investors of restatement of almost
5 years of earnings
November 9
Dynergy offers buyout of Enron
November 28
Dynergy cancels buyout agreement
December 2
Filed bankruptcy
Enron’s revenues and income
Enron’s cash flow and
revenues
$120,000
$100,000
$80,000
Operating cash flow
Revenues
$60,000
$40,000
$20,000
$0
-$20,000
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Fiscal
Net Operating
year income cash flow Revenues
1987
-$29
$184
$5,916
1988
$109
$82
$5,708
1989
$226
$194
$9,836
1990
$202
$1,107
$13,165
1991
$242
$791
$5,563
1992
$306
$293
$6,325
1993
$333
$468
$7,972
1994
$453
$504
$8,984
1995
$520
-$15
$9,189
1996
$584
$1,040
$13,289
1997
$105
$501
$20,273
1998
$703
$1,640
$31,260
1999
$893
$1,228
$40,112
2000
$979
$4,779 $100,789
Source of data: Standard & Poor’s Compustat
$100
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0
Jul-01
Oct-00
Jan-00
Apr-99
Jul-98
Oct-97
Jan-97
Apr-96
Jul-95
Oct-94
Jan-94
Apr-93
Jul-92
Oct-91
Jan-91
Apr-90
Jul-89
Oct-88
Jan-88
Apr-87
Jul-86
Oct-85
Blackout period for retirement
sales: October 19 – November
13, 2001
Jan-85
Share price
Enron’s stock price
Month
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Source of data: Center for Research in Security Prices
Executives and board members got
out of the stock (1999 – mid-2001)
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NAME
POSITION AT ENRON
Norman Blake
Steve Kean
Cindy Olson
Michael McConnell
Rick Buy
Ken Harrison
Joe Hirko
Mark Koenig
Jeff McMahon
Lou Pai
Rick Causey
Robert Jaedicke
Ken Rice
Joe Sutton
John Duncan
Stan Horton
J. Clifford Baxter
Mark Frevert
James Derrick
Robert Belfer
Jeffrey Skilling
Andy Fastow
Member of Board of Directors
Executive Vice President, Chief of Staff
Executive Vice President
Executive Vice President
Chief Risk Officer
Member of Board of Directors
CEO, Enron Communications
Executive Vice President
Treasurer
CEO, Enron Energy Services
Chief Accounting Officer
Member of Board of Directors
CEO, Enron Broadband Services
Vice-Chairman
Member of Board of Directors
CEO, Enron Transportation
Vice-Chairman
Chief Executive Office, Enron Europe
General Counsel
Member of Board of Directors
Chief Executive Officer, Enron Corp.
Chief Financial Officer
SHARES
PRICE PER
GROSS PROCEEDS
SOLD
SHARE
21,200
$1,705,328
$80.44
64,932
$5,166,414
$79.57
83,183
$6,505,870
$78.21
32,960
$2,506,311
$76.04
140,234
$10,656,595
$75.99
1,011,436
$75,416,636
$74.56
473,837
$35,168,721
$74.22
129,153
$9,110,466
$70.54
39,630
$2,739,226
$69.12
3,912,205
$270,276,065
$69.09
208,940
$13,386,896
$64.07
13,360
$841,438
$62.98
1,234,009
$76,825,145
$62.26
688,996
$42,231,283
$61.29
35,000
$2,009,700
$57.42
830,444
$47,371,361
$57.04
619,898
$34,734,854
$56.03
986,898
$54,831,220
$55.56
230,660
$12,563,928
$54.47
2,065,137
$111,941,200
$54.21
1,307,678
$70,687,199
$54.06
687,445
$33,675,004
$48.99
The effect of recent accounting
scandals
As a consequence of accounting scandals,
particularly that of Enron, the U.S. Congress
passed the Sarbanes-Oxley Act (SOX) in 2002.
The main provisions are as follows:


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The establishment of a Public Company Accounting
Oversight Board to register and inspect public
accounting firms and establish audit standards.
The separation of audit functions from other
services, such as consulting, provided by the big
accounting firms, with the auditors rotating every 5
years so that they do not get too close to the
companies they are auditing.
SOX, continued
 The implementation
of much stricter
governance standards, including internal
controls
 Auditors report to the company’s audit
committee, which is to be composed of
independent members of the board of
directors with the power to engage
independent consultants.
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Up next … Financial statements
Question 1
The independent accountants attest that:
A. There is no fraud.
B. Statements are prepared according to
GAAP.
C. They are independent.
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Question 2
Which opinion is best?
A. Adverse
B. Qualified
C. Unqualified
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