Chapter 5 Understanding Financial Statements and the Financial Reporting Environment
Hudson’s Bay Company This chapter focuses on Hudson’s Bay Company, Canada’s oldest corporation, founded in 1670 as a fur-trading enterprise, to help us understand how users analyze financial statements to get information to use in their decision-making.
Who Are The Main Users And What Do They Need? • Managers • Managers at all levels within a company use accounting information to run the business • When accounting information is used by managers to make business decisions, it is being used to fulfill a management function
Shareholders Elect Directors Oversee Managers Who Are The Main Users And What Do They Need? • Directors • The board of directors ensures that managers make decisions that benefit shareholders • When accounting information is used by directors to oversee management of the business, it is being used in a governance role
Who Are The Main Users And What Do They Need? • Creditors • Creditors use accounting information to decide whether to enter into contracts with a company • When accounting information is used by creditors to administer contracts, it is being used in a contracting role • Loan covenants are terms of a loan agreement which, if broken, entitle the lender to demand immediate repayment or renegotiation of the loan
Who Are The Main Users And What Do They Need? • Investors • When accounting information is used to assess stock price, it is being used in a valuation role • Investors (and their advisors) look to accounting information to help evaluate the financial strength of a business and ultimately to estimate its value
What Do Users Get? The primary objective of external financial reporting is to provide economic information that is useful to creditors and investors. Reliability Relevance Useful financial statement information must possess four main characteristics. Consistency Comparability
The Role of Auditors • Auditors, who are experts in financial reporting, issue a one-page report that states whether the company’s financial statements appear to have been prepared using GAAP • Anunqualified audit reportindicates that the financial statements are useful and that creditors and investors can trust what is reported • Auditors“qualify”their reports when financial statements do not follow GAAP or when they cannot complete an audit
The Role of Stock Analysts and Credit Analysts • Stock analysts produce multi-page reports that evaluate an individual company’s past performance, make predictions about its future earnings, and conclude with a recommendation about whether investors should buy, hold, or sell stock in a company • Credit analysts also evaluate a company’s past performance but their goal is to assess the risk that the company will be unable to pay its liabilities • An earnings forecast is a prediction of the amount of earnings expected for future accounting periods
A Business Model • There are four parts to the business: • Obtain financingfrom lenders and investors, which is used to invest in assets, • Invest in assets, which are used to generate revenues, • Generate revenues, which produce net income, • Produce net income, which is needed to satisfy lenders and investors.
generate (2) Assets (3) Revenues produce Invested in Investing Financing Operating (1) Debt & Equity Financing (4) Net Income A Model of HBC’s Business
Let’s take a few minutes and review HBC’s balance sheet and see what we can learn. • Less debt in 2004, • Looks to investors for most financing needs, • Holds some cash and short-term investments, and • Has significant amount of inventory due to the retail industry
Analyzing Financial Statement Levels To help interpret amounts on the financial statements, it’s useful to have points of comparison or “benchmarks.” Prior Periods Competitors Time series analysis compares a company’s results for one period to its own results over a series of time periods. Cross-sectional analysis compares the results of one company with those of others in the same section of the industry.
Analyzing Financial Statement Ratios The goal ofratio analysisis to get to the heart of how well each company performedgiven the resources it had available.
generate (2) Assets (3) Revenues (b) Asset Turnover produce Invested in (c) Net Profit Margin (a) Debt-to-Assets (1) Debt & Equity Financing (4) Net Income A Framework for Financial Statement Ratio Analysis
Total Liabilities Total Assets Debt-to-Assets Ratio = $1,808,157 $4,008,821 Debt-to-Assets Ratio = = 45.1% Debt-To-Assets Ratio This ratio provides the percentage of assets financed by debt. A higher ratio means greater financial risk.
Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Asset Turnover Ratio Asset Turnover Sales Revenue AverageTotal Assets =
Asset Turnover $7,069,736 ($4,008,821+$4,022,036)/2 = = 1.76 Asset Turnover Ratio Asset Turnover Sales Revenue AverageTotal Assets = This ratio measures how well assets are used to generate sales. A higher ratio means greater efficiency.
Net Profit Margin Ratio Net Profit Margin Ratio Net Income Sales Revenue $59,738 $7,069,736 = = = .845% Net Profit Margin Ratio This ratio measures the ability to generate sales while controlling expenses. A higher ratio means better performance.
Summary of Financial Statement Ratio Analysis Here is a comparison of the ratios for Hudson’s Bay Corporation, Sears Canada and Wal-Mart • By reviewing this chart, we see that Wal-Mart: • was financed with the largest proportion of debt, • had the largest asset turnover, and • earned a higher net profit margin than HBC.
Evaluating Sources of Income Information Other Than Annual Financial Statements • To provide timely information for all external users, most public companies announce quarterly and annual earnings through a press release that is sent to news agencies • A common tactic for emphasizing the positive is to make up “what-if” or pro forma numbers that suggest how the company’s results would have looked had certain events not occurred during the period
Annual Reports • Summarized Financial Data • Management’s Discussion and Analysis (MD&A) • Management statement of responsibility • Auditor’s report • Financial statements • Notes • Recent Stock Price Data • Unaudited Quarterly Data • Directors and Officers
Quarterly Reports • Short Letter to shareholders • Condensed & Unaudited Income Statement, Balance Sheet, and Statement of Cash Flows • Released on a timely basis
Canadian Securities Administrators (CSA) Filings • Public companies are required to electronically file documents with the stock exchanges where their shares trade and with the Canadian Securities Administrators.
Investor Information Websites There are thousands of investor websites that contain information about publicly traded companies. Be careful when using these websites, especially in the case of financial ratios since you are rarely told what formulas were used to calculate the ratios.
The Financial Reporting Environment • Why Would Management Misrepresent the Financial Results? • Creating Business Opportunities • Satisfy Loan Covenants • Increase Equity Financing • Attract Business Partners • Satisfying Personal Greed • Enhance Job Security • Increase Personal Wealth • Obtain Bigger Paycheque
The Financial Reporting Environment • Examples of How Management Can Misrepresent the Financial Results • Ship unordered products (and record revenue and receivable). • Delay recording of expenses until next period. • Under report liabilities. • Over report assets.
The Financial Reporting Environment • Why Would Management NOTMisrepresent the Financial Results? • Personal Satisfaction • “Do The Right Thing” • Follow Full Disclosure Principle • Desire Honest Reporting Reputation • New corporate fraud laws in Canada & United States • Prison Terms • Large $ Fines
Directors Oversee Stock Analysts Offer Advice Investors Make Investment Decisions Managers Prepare Creditors Make Lending Decisions Credit Analysts Offer Advice Auditors Verify The Financial Reporting Process
How To Avoid Becoming a Victim of Financial Reporting Fraud If you want to avoid being misled by financial reports, you should ensure you understand a company’s business and its financial statements before investing in it.