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NYSSCPA
Understanding and
Evaluating Financial
Statements
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NYSSCPA
RONALD J. HUEFNER
CPA, CMA, PH.D
SUNY DISTINGUISHED TEACHING
PROFESSOR (retired)
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NYSSCPA
Speaker Background
BA, Canisius College, Buffalo
MBA, Ph.D., Cornell University
CPA (New York), CMA
Long-time accounting professor
at SUNY – Buffalo
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NYSSCPA
Speaker Background
Author or co-author of several
books and over 40 articles in
academic and professional
journals
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NYSSCPA
Speaker Background
Served as:
President of Buffalo Chapter, NYSSCPA
Vice-President and member of Board of
Directors and Executive Committee,
NYSSCPA
Trustee, Foundation for Accounting
Education
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Speaker Background
Served as:
Chair of Higher Education Committee
Chair of Strategic Planning Task Force
Chair of Task Force on Chapters
Recipient of NYSSCPA
Distinguished Service Award
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NYSSCPA Media Programs
Customized seminars
Invitations to educational
conferences
The Excellence in Financial
Journalism Award
Media bank of CPA members
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Review of Press Kits
Speaker background
Annual report of Kellogg’s
Proxy statement
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PROGRAM OVERVIEW
Financial statements
Auditor’s report
Ratio analysis
Proxy statements
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Ongoing Example
Annual Report of Kellogg
Company for 2009
March 2010 Proxy Statement for
Kellogg
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NYSSCPA
PART 1:
ACCOUNTING STANDARDS
AND FINANCIAL STATEMENTS
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Overview – Part 1
Introduction to generally accepted
accounting principles
Introduction to basic financial
statements
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Generally Accepted
Accounting Principles
(GAAP)
Established via formal standard-
setting processes
Used by all public companies
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Who Establishes GAAP?
FASB (Financial Accounting Standards
Board) for businesses and non-profits
SEC (U.S. Securities and Exchange
Commission) has legal authority,
provides oversight (public companies)
GASB (Government Accounting Standards
Board) for government entities
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Alternatives to GAAP
Other comprehensive basis of
accounting (OCBOA)
Tax basis
Cash basis
Regulatory basis
Used by some small, non-public
companies
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Alternatives to GAAP
IFRS (International Financial
Reporting Standards), set by
International Accounting
Standards Board (IASB)
IASB is an independent,
privately-funded standard-setter
based in London, England
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IFRS
Used (required or permitted) in
over 100 countries
All of Europe
Canada
China, Japan, India, Korea
Argentina, Brazil, Mexico
Australia
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NYSSCPA
Big Question for U.S.
Should U.S. switch from GAAP to
IFRS?
SEC permits IFRS for foreign
companies on U.S. markets
SEC Roadmap: decide in 2011?
Convergence or adoption?
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What’s Happening
Currently?
Major effort to revise many U.S.
standards
Converge as many as possible
Then what to do?
Big political question
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FINANCIAL STATEMENTS:
THE ANNUAL REPORT
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What’s in an Annual Report?
Balance sheet
Income statement
Statement of cash flows
Statement of changes in
stockholder’s equity
Notes to the financial statements
More
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Balance Sheet
Assets = Liabilities + Equity
Snapshot at a point in time
Mixed measures: Historical cost,
fair (market) values, discounted
cash flows
See Kellogg’s, page 28
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Income Statement
Revenues and expenses
Activity for the period
Basic principles
Revenue recognition
Matching
Accrual
See Kellogg’s page 27
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Statement of Cash Flows
Inflows and outflows of cash
Three sections: operations,
investing, financing
Cash from operations is key
money generated from main business
See Kellogg’s page 30
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Statement of Changes
in Stockholders’ Equity
Details changes in the ownership
equity accounts
See Kellogg’s page 29
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Notes to the
Financial Statements
Lots of detailed information
Summary of accounting principles
Explain one time events and special
circumstances
Separate information on lines of
business
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Examples from Kellogg’s
Accounting policies (pp. 31-33)
Details on acquisitions and
dispositions (pp. 33-36)
Details on debt (pp. 39-40)
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Some Basic Principles
Conservatism
Going Concern
Materiality
Substance Over Form
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SOME SPECIFIC TOPICS OF
INTEREST
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Inventory Methods
Specific identification
FIFO
LIFO
Average cost
Kellogg’s p. 31
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Receivables
Outstanding balances owed by
customers and others
Allowances (reductions of value):
Bad debts
Returns
Discounts
See Kellogg’s p. 31
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Depreciation
A process of expensing the cost
of limited-life assets
Not observable, thus based on
formulas
See Kellogg’s p. 31
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Business Combinations
Acquiring other companies
Goodwill and other intangible assets
See Kellogg’s pp. 31-32, 33-35
Concept of impairment test for
goodwill and other assets
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Leases
Most companies lease assets
Two ways to account for leases:
CAPITALIZE (as if purchased & financed)
OPERATING (no asset or liability
recorded, just rental expense)
Can structure the lease to get the
accounting you want
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Leases
See Kellogg’s p. 38
About 99% accounted for as
operating leases
Called “off-balance-sheet
financing”
Probably will change
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Pensions and Other
Benefits
Many companies have big future
obligations for employee
pension and health benefits
See Kellogg’s pp. 43-47
Look at funded status
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Fair Value Disclosures
Fair value measurement is increasing
Fair values are applied to many
financial assets and liabilities
Several ways to do it
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Fair Value Methods
Level 1: quoted prices for
identical items in active markets
Level 2: prices in inactive
markets, or based on directly or
indirectly observable inputs (e.g.,
similar assets)
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Fair Value Methods
Level 3: based on models and
assumptions, generated by
management – inputs are
unobservable
See Kellogg’s pp. 50-52
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Contingencies
Existing risks, outcome unknown
Lawsuits
Environmental obligations
Tax audits
Product liability
See Kellogg’s p. 53
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Management’s
Discussion and Analysis
A lengthy discussion of:
Results of operations
Liquidity and capital resources
Off-balance-sheet & contractual
arrangements
Critical accounting estimates
Future outlook
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Management’s
Discussion and Analysis
This is prepared by
management; it is not part of the
audited report
Gives insight and understanding
about the company
See Kellogg’s pp. 13-26
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Reports to the SEC
Form 10-K (annual report,
incorporates annual report to
stockholders)
Form 10-Q (quarterly report)
Proxy statements
News releases
Form 8-K O
Public availability
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PART 2:
THE AUDITOR’S REPORT
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Audits
Question: What is an audit?
Answer: Assurance that financial
statements are not
materially misstated
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Who’s Responsible?
Financial statements are the
responsibility of company
management
Auditor examines and tests
those statements to see if they
conform with good accounting
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Needed for a Good Audit
Broadly trained and sufficiently experienced
Understand the risks and nature of the
business
Design procedures to provide reasonable
assurance of possible material misstatement
Retain professional skepticism
Reality check/“smell test”
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NYSSCPA
INDEPENDENT AUDITORS' REPORT
Auditors’ Report [To the Board of Directors and Stockholders of]
Blank Company
[City, State]
We have audited the accompanying consolidated balance sheets of
Blank Company and subsidiaries as of December 31, 20x1 and 20x2, and
the related consolidated statements of income, stockholders' equity, and
“Plain vanilla” cash flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
Unqualified or “clean” We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and perform the
opinion audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing
Three paragraphs the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for
Introductory our opinion.
In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial position of the companies at [as of]
Scope December 31, 20x1 and 20x2, and the results of their operations and their
cash flows for the years then ended in conformity with generally accepted
Opinion accounting principles.
DELOITTE & TOUCHE
March 15, 20x3
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NYSSCPA
What are Generally Accepted
Auditing Standards (GAAS)?
The procedures auditors follow
Since Sarbanes-Oxley, set by the
Public Companies Accounting
Oversight Board (PCAOB)
PCAOB also monitors the work
of auditors
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NYSSCPA
Limitations of an Audit
Auditor always knows less about
company than does management
Audits depend on testing and
sampling
Auditors are paid by the
companies they audit
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Limitations of an Audit
Accounting necessarily involves
many estimates and judgments
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Attempts to Improve Auditing
(Sarbanes-Oxley)
Prohibitions against consulting
services for audit clients
Limitations on movement of
people from auditor to client
Clarification of management
responsibility
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NYSSCPA
Kellogg’s Audit Report
See page 58
A longer format than standard
Also note management’s
statements on page 57
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Qualified Audit Opinions
Scope Limitation
Departure from GAAP
Inadequate Disclosure
Accounting Change
These are rare
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Adverse Opinions and
Disclaimers of Opinion
Adverse - financial statements do not
present fairly the financial position,
results of operations or cash flows
Disclaimer - no opinion at all. Usually
due to significant scope restriction
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Other Reports by Auditors
Reviews
Compilations
Special reports
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Common Audit Issues
Overstatement of revenue
Understated costs/expenses
Aggressive accounting policies
Related party transactions
Inventory existence & valuation
Inadequate collectibility reserves
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Inappropriate Revenue Recognition
Large or unusual transactions occurring
shortly before end of an important period
Shipping products before a sale is
consummated
Bill and hold transactions
% of completion accounting where there are
uncertainties
Unrecorded sales allowances and returns
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Understated Costs and Expenses
Failure to record or accrue
significant invoices
Improper or insufficiently
supported capitalization of costs
or deferral
Unusually slow depreciation
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Aggressive Accounting Policies
Use of very aggressive accounting
principles or practices for income
recognition, capitalization and
deferral of costs, amortization
Lack of supporting documentation
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Related Party Transactions
Significant transactions or
amounts which appear unusual or
whose purpose is unclear with
related parties
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Indicators of Possible
Inventory Overstatement
Unusually large quantities of high cost items
Unclear or ineffective cut-off procedures
Little or no write-downs to market or
provisions for obsolescence
Questionable procedures for determining or
aggregating inventory costs
Gross profit percentage higher than expected
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Collectibility of Receivables
Current provision or aggregate
reserves seem low
Large past due receivable balances
or large receivables from related
parties or unfamiliar sources
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How the Numbers Tell the Story
Overstated inventory
Overstated revenue
Understated costs and expenses
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NYSSCPA
PART 3:
EVALUATING A COMPANY
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Things to Look for in
Evaluating a Company
Trends
Sales increases
Quality of assets
Contingencies
Valuation (especially fair values)
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Trends
Three years of income, cash
flow, equity changes
Two years of balance sheets
Elsewhere, 5 or 10 year
summaries (see Kellogg’s, p. 12)
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Examples from Kellogg’s
Sales increased 8.8% from 2007
to 2008, and declined 1.9% from
2008 to 2009
Net income increased 4% from
2007 to 2008, and increased 5.4%
from 2008 to 2009
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Introduction to
Financial Analysis
Who evaluates financial statements?
How to identify red flags O
How to use ratios
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Who Evaluates Financial
Statements?
Auditor Creditors
— Banks
— Analytic procedures — Insurance companies
— Red flags O — Private placement
purchasers
Management
Others
— Internal audit — Suppliers
Investors — Customers
— Employees
— Security analyst — Former employees
— Portfolio managers
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Types of Ratios
Liquidity
Leverage
Asset utilization
Profitability
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Operating Ratios
Management of current assets and liabilities
Examples:
Current ratio
Net working capital
Days sales outstanding
Days of inventory on hand
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Current Ratio
Current assets / current liabilities
For Kellogg’s, $2,558 /$2,288 =
1.1
Trend probably more important
than absolute amount
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Net Working Capital
Net working capital = current
assets minus current liabilities
For Kellogg’s, $2,558 - $2,288 =
$300 million
Again, watch the trend
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Days Sales Outstanding
A measure of how quickly the
company collects from its
customers
DSO = receivables / daily sales
Kellogg’s: $1,093/$34.5 = 31.7
days
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NYSSCPA
Days of Inventory on Hand
A measure of how many days
worth of inventory the company
holds
DI = Inventory / Daily cost of
goods sold
Kellogg’s: $910/$19.7 = 46.2 days
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NYSSCPA
Profitability
The return you get on sales, assets and equity
Examples:
Profit margin
Asset turnover
Return on assets (ROA)
Return on equity (ROE)
Leverage
Earnings per Share (EPS)
Price/Earnings Ratio
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NYSSCPA
Profit Margin
How much profit does the
company earn per dollar of
sales?
Profit margin – Net income / Net
sales
Kellogg’s: $1,208/$12,575 = 9.6%
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Asset Turnover
How much sales are generated
per dollar of assets?
Asset turnover = Net sales / Total
assets
Kellogg’s: $12,575 / $11,200 =
$1.12
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Return on Investment?
A poorly-defined term
“Investment” may mean:
Assets
Equity
Better to say ROA or ROE than
ROI
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Return on Assets (ROA)
How much does the company
earn on its investment in assets?
ROA = Net income / Total assets
Kellogg’s: $1,208 / $11,200 =
10.8%
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Return on Equity (ROE)
How much does the company
earn on the investment by its
owners (stockholders)?
ROE = Net income /
Stockholders’ equity
Kellogg’s: $1,208/$2,275 = 53.1%
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ROA versus ROE
Kellogg’s ROA was 10.8% while
its ROE was 53.1%. Why the big
difference?
Answer: LEVERAGE – using debt
rather than equity to finance the
company
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Common Example of Leverage
You buy a house for $300,000
Mortgage $270,000, your equity
$30,000
House value grows to $306,000
ROA = $6,000/$300,000 = 2%
ROE = $6,000/$30,000 = 20%
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NYSSCPA
Leverage
Extent to which equity is
“leveraged” (supplemented with
debt) in financing the company
Leverage = Total assets /
Stockholder’s equity
Kellogg’s: $11,200 / 2,275 = 4.92
times
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NYSSCPA
Linkage
ROA = Margin x Asset Turnover
= 9.6% x 1.12 = 10.8%
ROE = Margin x Asset Turnover x
Leverage (or ROA x Leverage) =
9.6% x 1.12 x 4.92 = 53%
Useful for analyzing changes
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NYSS of CPAs
NYSSCPA
Earnings per Share
Primary
Fully diluted
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Earnings per Share
Net Income
Weighted Average Shares Outstanding
Primary
Fully diluted
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Earnings per Share
Given on Income Statement
Kellogg’s: $3.17 (basic), $3.16
(fully diluted)
Difference between the two is
usually trivial
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Price/Earnings Ratio
Market price per share / Earnings
per share
Market price at end of 2009 (see
p. 54): $53.20
P/E ratio: $53.20 / $3.17 = 16.8
90
NYSSCPA
PART 4:
THE PROXY STATEMENT
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NYSSCPA
Background
Public companies are technically
governed by stockholders, who
vote for directors and on major
proposals
Companies hold an annual
meeting of stockholders
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What is a Proxy Statement?
Communication to stockholders,
soliciting their votes and voting
rights
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Contents of a Proxy
Statement
Voting procedures & information
Nominees for director
Compensation of directors
Details on executive
compensation
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Contents of a Proxy
Statement
Audit committee and other board
committees
Audit and non-audit fees
Specific proposals for
stockholder vote
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Kellogg’s Proxy Statement
Details about the upcoming
stockholders’ meeting (pp. 1-3)
Stock ownership information (pp.
4-6)
Corporate governance (pp. 7-10)
96
NYSSCPA
Kellogg’s Proxy Statement
Membership of Board of
Directors and Board Committees
(pp. 11-13)
Election of directors (pp. 14-18)
Compensation and benefits for
directors (pp. 19-22)
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NYSSCPA
Kellogg’s Proxy Statement
Details about executive
compensation and benefits (pp.
23-60)
Vote on appointment of auditor
and fee disclosures (pp. 62-64)
Shareholder proposal (pp. 64-66)
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NYSSCPA
Wrap-Up
We’ve given an overview of:
Accounting standards
Financial statements
Auditing
Financial statement analysis
Proxy statements
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NYSSCPA
Ron’s Contact
rhuefner@buffalo.edu
Happy to serve as a contact
But, keep in mind, you have
deadlines and I (being retired)
don’t
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