1

CHAPTER 5Communicating and Interpreting

Accounting Information

ACCT 2301Professor Zining Li

2

Responsibility for accounting information

• Company management– CEO and CFO

• Independent auditor– Unqualified audit opinion (clean opinion)

• Board of directors– Audit committee

3

Users of accounting information

• Private investors• Financial analysts• Creditors (lenders)• Institutional investors

– Pension funds, mutual funds, endowment funds, etc.

4

Guiding Principles• Relevant: useful to assess past activity and predict

future performance• Reliable: accurate, unbiased, and verifiable• Consistent and comparable: similar accounting

methods are applied over time and across firms • Material: Amounts that are large enough to influence

decisions• Conservative: Care should be taken NOT to overstate

assets (revenues) or understate liabilities (expenses)

5

Disclosure of accounting information

• Press release – Earnings announcement

– Conference call

• Annual report• Quarterly reports• SEC reports

– Forms 10-K & 10-Q

– Form 8-K (current events)

6

Annual Report ( 10-K)• Basic financial statements (balance sheet, income

statement, statement of cash flows, statement of shareholders’ equity)

• Notes to the financial statements• Report of the Auditor• Other information: letter to shareholders,

management discussion and analysis (MD&A), financial data (past 5-10 years), stock price data, list of director and officers of the company

7

Quarterly Report ( 10-Q)

• Usually begin with short letter to stockholders• Condensed unaudited income statement and

balance sheet for the quarter• Often, cash flow statement and statement of

stockholders’ equity are omitted. Some notes to the financial statements also may be omitted

8

SEC report: 8-K Example• “On July 28, 2006, Pacific Sunwear of California,

Inc. (the “Company”) elected to extend the employment agreement between the Company and Seth R. Johnson, Chief Executive Officer, for an additional one-year period ending October 31, 2007. The full text of the Company’s notification to Mr. Johnson regarding this election is included as Exhibit 99.1 to this report and is incorporated herein by this reference.”

9

Classified Balance Sheet• Assets (by order of liquidity)

– Current assets (short-term)– Noncurrent assets– Total assets

• Liabilities (by order of time to maturity)– Current liabilities (short-term)– Noncurrent liabilities– Total liabilities

• Stockholder’s equity– Contributed capital– Retained earnings– Total stockholder’s equity– Total liabilities & stockholder’s equity

10

11

12

(in thousands, except share data and per share data) 2006 2005

SHAREHOLDERS' EQUITY

Shareholders' equity:

Common stock, $.01 par value, 85,096,782 and 84,950,694 issued and outstanding at December 31, 2006 and 2005, respectively 851$ 850$

Additional paid-in capital 141,192 164,202

Retained earnings 435,074 430,996

Total shareholders' equity 577,117 596,048

Total liabilities and shareholders' equity 845,947$ 764,498$

Consolidated Balance Sheet

December 31,

Callaway Golf Company

13

Accounting for new investments

Contributed Capital– Common Stock

• Par value is a legal amount per share

– Paid-in Capital

Example: Callaway set its par value at $0.01 per share. The company issued 1 million shares at the price of $16 per share. Common Stock is $10,000 and additional paid in capital is $15,990,000

14

Elements of the Income StatementRevenues

Cost of goods sold

Gross Profit

Operating costs and expenses

Operating Income

Nonoperating revenues and expenses and gains and losses

Pretax Income

Income tax expense

Net Income

–

=

–

=

–

=–

=

Earnings per share (EPS) must be reported on the income statement

15

Common-Size Income Statement

16

Statement of Cash Flows

Recall that the Statement of Cash Flows is divided into three major sections.

1. Cash flows from operating activities.2. Cash flows from investing activities.3. Cash flows from financing activities.

For the operating activities, companies can use either indirect method or direct method. The indirect method begins with a reconciliation of net income to “cash flows from operations”.

17

18

19

Return On Equity (Assets)

Return on Equity (ROE) = Net Income

Avg. Total Equity

Return on Assets (ROA) = Net Income

Avg. Total Assets

ROE = ROA X Financial Leverage ratio

20

Profit Driver Analysis

ROA = Net Profit X Asset Margin Turnover

Net Profit = Net IncomeMargin Sales

Asset = SalesTurnover Average Assets