Users of financial statements:
• 1. Credit and equity investors – focus of
• 2. Government – regulatory bodies (public
utility commissions, tax authorities (IRS
• 3. General public, special interest groups
and others. See shareholder proposals.
Principal components of the
• 1. Balance sheet
• 2. Income statement
• 3. Statement of comprehensive income the
• 4. Statement of cash flows (formerly
statement of changes in working capital).
• 5. Statement of stockholders’ equity.
• 6. Footnotes and supplementary data.
Preparation of financial
• 1. Using generally accepted accounting
• 2. Uses accrual method of accounting – revenues
are recognized when goods are delivered or
when services are performed and expenses are
recognized as services are used, rather than
when cash is collected or paid.
• 3. Performance is measured using the matching
principle – related revenues and costs are
accounted for in the same period.
Promulgation of accounting
• 1. Securities and Exchange Commission (the
• 2. The Financial Accounting Standards Board
(FASB) successor to the Accounting
• 3. The emphasis in the past has been
promulgation of standards by the private
sector, though the SEC steps in on occasion.
• The SEC recognizes FASB statements as
Qualitative characteristics of
• 1. Relevant – requires information that provides
information useful in decision making. Enron.
• 2. Timeliness – less timely information is less
• 3. Reliability –
– A. Verifiability and representational faithfulness – has
the financial data been properly measured and has it
been properly described in the financial statements?
– B. Neutrality – is the financial statement data biased?
The data should be relevant and reliable. Standards
should not be promulgated on the basis of perceived
economic impact. (expensing of stock options)
• 4. Consistency – are the same accounting
principles used over time (trends)?
• 5. Comparability – do similar companies
use the same accounting principles?
• 6. Materiality – FASB statements
frequently do not apply to immaterial items.
Though occasionally a quantitative measure
is used to define a materiality threshold,
materiality is generally subject to
management’s or the auditor’s judgment.
• Staff Accounting Bulletin 99 – requires the
consideration of qualitative factors as well as
quantitative measures of materiality.
• 1. Obscuring changes in earnings trends
• 2. Hiding the failure to achieve analysts forecasts.
• 3. Changing a reported loss to income or vice
versa. Channel stuffing (Sunbeam).
• 4. Obscuring changes in significant business
• 5. Increasing management compensation.
• 6. Affecting compliance with regulatory
requirements, loan covenants, or other contracts.
• 7. Concealing unlawful acts.
• 1. Promulgated by the International
Organization of Securities Commissions.
• 2. Basle I and II
Principal Financial Statements
• Balance Sheet – provides a snapshot of a
corporation’s assets, liabilities and stockholders’
equity at a given point in time. In the US, this is
usually done quarterly and annually.
• Assets and liabilities are listed in descending order
of liquidity, frequently with subtotals such as
current assets and current liabilities.
• Primarily prepared based on historical cost, but
there are exceptions. Think conservative.
Marketable securities available for sale are carried
at market value. Long-term assets may become
impaired and written down, oil reserves may be
written down. Recoveries aren’t written up.
• Income statement – presentation of
revenues and expenses over some time
period – usually quarterly or annually.
• The opportunity exists for game playing
with the classification of items as
• Operating versus non-operating
• Recurring or nonrecurring
• Extraordinary –unusual and infrequent
• Revenue recognition
• Statement of Comprehensive Income
• Includes direct-to-equity adjustments:
• Cumulative translation adjustments – SFAS
52 (Chapter 15)
• Minimum pension liability – SFAS 87
• Unrealized gains and losses on available-
for-sale securities – SFAS 115 (Chapter 16)
• Deferred gains and losses on cash flow
hedges – SFAS 133 (Chapter 16) (ENZN)
• Statement of cash flows:
• Classifies cash receipts and disbursements into
– Investing – purchase or sale of PP&E, subsidiary or
business segment, investments in other firms.
– Financing – issuance or retirement of debt and equity
securities, dividends paid.
– Significant noncash investing and financing activities
(capitalized leases) must be disclosed separately with
the statement or in the footnotes.
– Must disclose : interest paid and taxes paid
• Statement of stockholders’ equity – reports
the amounts and changes in:
• Preferred stock
• Common stock
• Additional paid in capital
• Retained earnings
• Treasury stock
• ESOP adjustments
• Can be difficult to determine whether some
securities are equity or debt.(trust preferred)
• Contains information about the accounting
principles used, adoption of accounting principles,
assumptions and estimates (fair values), additional
information regarding fixed assets, inventories,
income taxes, pension and post-employment
benefits, terms of debt obligations, loss and gain
contingencies, marketable securities, hedging,
business risks, business segments, significant
customers or vendors, related parties and other
• Usually audited though some may be
unaudited. Examples are jobs in progress
and present value of cash flows from oil and
• Losses are accrued if it is probable (more
likely than not) that assets have been
impaired or a liability incurred AND the
amount of the loss can be reasonably
estimated. The most likely amount should
be accrued if the loss lies within a range. If
there is no best estimate, the minimum
amount in the range is reported.
• Footnote disclosure is required of
(unrecognized) loss contingencies when it is
reasonably possible (more than remote but
less than probable). See SFAS 5.
• Contingencies tend to be subjective and
involve judgment to measure and analyze.
• Examples: environmental remediation,
litigation, expropriation, self-insurance,
debt guarantees, repurchase agreements.
• Requires the disclosure of significant risks and
• Description of major business activities and
• Inclusion of a statement that the financial
statements requires the use of estimates.
• Description of the uncertainty surrounding the use
of significant estimates.
• Description of concentrations, for example,
concentrations in customers, suppliers or markets.
Management discussion and analysis
• Management is required to discuss:
– Significant effects of currently known trends, events and uncertainties.
May include forward-looking data.
– Liquidity and capital resources – including transactions and event with
material current of expected long-term liquidity implications.
– Discussion of discontinued operations, extraordinary items, and other
unusual or infrequent events with current or expected material effects on
financial condition or results of operations.
– Disclosure of a segment’s disproportionate need for cash flows or
contribution to revenues and profits.
– Impact of off-balance-sheet arrangements on liquidity and disclosure
about contractual obligations and commercial commitments
– Disclosures about trading activities including non-exchange traded
– Effects of transactions with related parties including persons (such as
former employees) that may not meet the technical definition of related
Role of the auditor
• Responsible for seeing that the financial
statements conform to GAAP
• Examines the company’s and accounting
and internal control systems
• Audit is performed according to generally
accepted auditing standards (GAAS).
• Provides “reasonable assurance”
• Free of material misstatements
• Examined on a test basis
• Opinion highlights “going concern”
• May highlight consistency problems
• See opinions on page 23 and 24