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Transcript
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 2 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 3 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 4 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. 5 Auditor’s opinion An auditor’s opinion is one of four types: 6 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. 7 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. 8 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. 9 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 10 • 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 11 Net income v. comprehensive income Net income appears in the income statement; Other comprehensive income is the adjustment to net income. Net income 12 Other comprehensive income Comprehensive income Shareholders’ equity Common stock at par + + + - Additional paid in capital Preferred stock Other comprehensive income Treasury stock Shareholders’ equity 13 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: 14 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. 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 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 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 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 20 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 25 Source of data: Center for Research in Security Prices Executives and board members got out of the stock (1999 – mid-2001) 26 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: 27 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. 28 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. 30 Question 2 Which opinion is best? A. Adverse B. Qualified C. Unqualified 31