McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Statement Analysis K R Subramanyam John J Wild 2-2 2 CHAPTER Financial Reporting and Analysis 2-3 Statutory Financial Reports 2-4 GAAP Types of Accounting rules and guidelines o Statements of Financial Accounting Standards o APB Opinions. o Accounting Research Bulletins (ARB). o AICPA pronouncements. The AICPA issues guidelines for certain topics yet to be addressed by the FASB in its Statements of Position (SOP) or for those involving industry-specific matters in its Industry Audit and Accounting Guidelines. o EITF Bulletins. EITF Bulletins are issued by the FASB’s Emerging Issues Task Force. o Industry practices. Types of Accounting rules and guidelines o Statements of Financial Accounting Standards o APB Opinions. o Accounting Research Bulletins (ARB). o AICPA pronouncements. The AICPA issues guidelines for certain topics yet to be addressed by the FASB in its Statements of Position (SOP) or for those involving industry-specific matters in its Industry Audit and Accounting Guidelines. o EITF Bulletins. EITF Bulletins are issued by the FASB’s Emerging Issues Task Force. o Industry practices. 2-5 Environmental Factors 2-6 Environmental Factors Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC) o Independent, quasi-judicial government agency o Administer securities regulations & disclosures o Can modify & set GAAP, if necessary o Rarely directly challenges FASB o Major player in global accounting o Independent, quasi-judicial government agency o Administer securities regulations & disclosures o Can modify & set GAAP, if necessary o Rarely directly challenges FASB o Major player in global accounting 2-7 Environmental Factors International Financial Reporting Standards (IFRS) International Financial Reporting Standards (IFRS) 2-8 Environmental Factors Managers of Companies o Primary responsibility for fair & accurate reports o Applies accounting to reflect business activities o Managerial discretion is necessary in accounting o Major lobbyist on GAAP o Primary responsibility for fair & accurate reports o Applies accounting to reflect business activities o Managerial discretion is necessary in accounting o Major lobbyist on GAAP 2-9 Environmental Factors Auditing o SEC requires Audit Report o Audit opinion can be: o clean (fairly presented) o qualified (except for) o disclaimer (no opinion) o Check Auditor quality & independence o SEC requires Audit Report o Audit opinion can be: o clean (fairly presented) o qualified (except for) o disclaimer (no opinion) o Check Auditor quality & independence Auditors 2-10 Environmental Factors Corporate Governance o Board of directors oversight o Audit committee of the board o oversee accounting process o oversee internal control o oversee internal/external audit o Internal Auditor o Board of directors oversight o Audit committee of the board o oversee accounting process o oversee internal control o oversee internal/external audit o Internal Auditor [...]... of financial o Earnings Management – attributed to window-dressing of financial statements by managers to achieve personal benefits statements by managers to achieve personal benefits o o 2-35 Accounting Analysis Analysis Objectives Comparatives Analysis ––demand for financial comparisons Comparatives Analysis demand for financial comparisons across companies and/ or across time across companies and/ or... a particular meet specific analysis objectives of a particular user user 2-34 Accounting Analysis Sources of Accounting Distortions Accounting Standards ––attributed to Accounting Standards attributed to 1) political process of standard-setting, 1) political process of standard-setting, 2) accounting principles and assumptions, and 2) accounting principles and assumptions, and 3) conservatism 3) conservatism... Analyzing financial liabilities Analyzing financial liabilities 2-33 Accounting Analysis Demand for Accounting Analysis oo Adjust for accounting distortions so financial Adjust for accounting distortions so financial reports better reflect economic reality reports better reflect economic reality oo Adjust general-purpose financial statements to Adjust general-purpose financial statements to meet specific analysis. .. - reporting or disclosing the least o Conservatism - reporting or disclosing the least optimistic information about uncertain events and optimistic information about uncertain events and transactions transactions 2-15 Financial Accounting Relevance of Accounting Information Relevance of Accounting Information Relation between Accounting Numbers and Stock Prices Relation between Accounting Numbers and. .. management 2-29 Fair value accounting Asset and liability values are determined on Asset and liability values are determined on the basis of their fair values (typically market the basis of their fair values (typically market prices) on the measurement date (i.e., prices) on the measurement date (i.e., approximately the date of the financial approximately the date of the financial statements) statements) 2-30... future financial condition and performance Voluntary Disclosure Voluntary Disclosure Motivation - Legal liability, Expectations Adjustment, Signaling, Managing expectations Information Intermediaries Information Intermediaries o Industry devoted to collecting, processing, interpreting & disseminating company information o Includes analysts, advisers, debt raters, buy- and sell-side analysts, and forecasters... Comparatives Analysis demand for financial comparisons across companies and/ or across time across companies and/ or across time o Income Measurement - demand for (1) equity wealth o Income Measurement - demand for (1) equity wealth changes and (2) measure of changes and (2) measure of earning power These correspond to two alternative earning power These correspond to two alternative income concepts income concepts... Accounting Numbers and Stock Prices Relation between Accounting Numbers and Stock Prices 2-16 Financial Accounting Limitations of Accounting Information ooTimeliness - periodic disclosure, not real-time Timeliness - periodic disclosure, not real-time basis basis ooFrequency - quarterly and annually Frequency - quarterly and annually ooForward Looking - limited prospective Forward Looking - limited prospective... bias More useful for equity analysis More useful for equity analysis Disadvantages Disadvantages o o o o o o o o Lower objectivity Lower objectivity Susceptibility to manipulation Use of Level 3 inputs Susceptibility to manipulation Use of Level 3 inputs Lack of conservatism Lack of conservatism Excessive income volatility Excessive income volatility 2-32 Implications for Analysis o o o o o o o o Focus... with corresponding revenues - -Product costs Product costs - -Period costs Period costs 2-22 Accruals-The Cornerstone Relation between Cash Flows and Accruals 2-23 Accruals-The Cornerstone Short-Term and Long-Term Accruals 2-24 Accruals-The Cornerstone Accruals and Cash Flows - Myths ooMyth: Since company value depends on future cash Myth: Since company value depends on future cash flows, only current . reserved. Financial Statement Analysis K R Subramanyam John J Wild 2-2 2 CHAPTER Financial Reporting and Analysis 2-3 Statutory Financial Reports 2-4 GAAP Types of Accounting rules and guidelines o Statements. global accounting 2-7 Environmental Factors International Financial Reporting Standards (IFRS) International Financial Reporting Standards (IFRS) 2-8 Environmental Factors Managers of Companies o Primary. Numbers and Stock Prices Relation between Accounting Numbers and Stock Prices 2-16 Financial Accounting o Timeliness - periodic disclosure, not real-time basis o Frequency - quarterly and annually o Forward