Chapter 3 Financial Statements

1. Chapter 3 Financial Statements

2. Chapter 3 Outline

3. 3.1 Accounting principles Accounting is simply an organized method of summarizing all of a company’s transactions and presenting them in such a way that external users can understand the company’s affairs. Clearly, problems arise when the company tries to present its accounting statements in a way that does not fairly represent its situation, either to creditors, like the bank, or to the common shareholders. Consequently, external users of the company’s financial statements must become skilled in analyzing the statements and spotting signs that things may not be quite as management presents them.

4. Generally Accepted Accounting Principles It is important to realize that management prepares the company’s financial statements, not the company’s auditors. Auditors, such as Deloitte & Touche LLP (Deloitte), attest to whether or not the financial statements fairly represent the company’s financial position according to generally accepted accounting principles (GAAP). Companies reporting in the U.S. follow the principles promulgated by the Financial Accounting Standards Board (FASB), whereas members of the European Economic Community, and other countries, follow the principles promulgated by the International Accounting Standards Board (IASB).

5. Independent auditors Independent auditors review the financial statements prepared by a company’s management and provide a report, addressed to the company’s board of directors and shareholders, that generally consists of the following: A statement that the financial statements are the responsibility of the company, and that the auditor is providing an opinion on the financial statements, not the accounting records themselves. A description of the scope of the audit, and that it was conducted according to generally accepted auditing standards, The auditor’s opinion, which is one of four types.

6. Auditor’s opinion An auditor’s opinion is one of four types: • Unqualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles. • Qualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles except for a matter of qualification. • Adverse opinion - the auditor concludes that the financial statements are notpresented fairly according to GAAP. • Disclaimer of opinion - the auditor’s examination is severely restricted or the auditor finds some condition is present that prevents the application of generally accepted auditing standards.

7. Accounting conventions: basic principles The purpose of financial statements is to provide information, at least annually, to a wide range of external users, including investors, employees, lenders, governments, and the general public. The underlying assumptions in the financial statements are that transactions are recorded on the accrual basis, and that the entity is a going concern, and hence will continue indefinitely.

8. Accounting conventions: basic principles • Financial statements should possess the qualitative characteristics of understandability, relevancy, reliability, and comparability. • The relevancy of financial statements includes consideration of the materiality of the information, the reliability of the information and related estimates, and prudence.

9. Measuring costs and value Business entities measure and report monetary amounts for the various elements in its financial statements. The basis for measuring costs differs among accounts, and may differ among entities for the same accounts.

10. Measuring costs and value

11. Recognition principles

12. Net income v. comprehensive income Net income appears in the income statement; Other comprehensive income is the adjustment to net income.

13. Shareholders’ equity

14. Managing financial statements Accounting principles offer some flexibility because it is simply not possible to design a one-size-fits-all set of principles. For example: • Mark-to-market -writing the value of an asset up or down, depending on its current market value • Available-for-sale - method of accounting for marketable securities in which unrealized gains or losses are reported as part of accumulated other comprehensive income • Trading securities - method of accounting for marketable securities that occurs when unrealized gains or losses are reported in net income • Held-to-maturity - method of accounting used when marketable debt securities are reported at cost

15. Enron’s History • Enron was born in 1985 from the merger of Houston Natural Gas and InterNorth. • Enron incurred massive debt and no longer had exclusive rights to its pipelines. • Needed new and innovative business strategy • Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a Jeffrey Skilling to Enron. • His background was in banking and asset and liability management. • His recommendation: that Enron create a “Gas Bank”—to buy and sell gas

16. Enron’s History (cont’d) • Created Energy derivative. Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it • Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits. • Fastowwas a Kellogg MBA hired by Skilling in 1990—Became CFO in 1998 • Started Enron Online Trading in late 90s • Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

17. The Motivation • Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didn’t understand its financial statements. • It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.) • Enron reported 20 straight quarters of increasing income in its last 5 years. • Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings “wholesale energy operations and services.”

18. The Role of Stock Options • Enron (and many other companies) avoided hundreds of millions of dollars in taxes by its use of stock options. • Corporate executives received large quantities of stock options. When they exercised these options, the company claimed compensation expense on their tax returns. • Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote. • Options allowed them to pay less taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price.

19. Enron’s Corporate Strategy • Enron’s core business was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were) • Enron’s top management gave its managers a blank order to “just do it” • Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

20. Confuse, confuse, confuse Source: Bob Jenson, Trinity University

21. Aggressive nature of Enron • Because Enron believed it was leading a revolution, it pushed the rules. • Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

22. Enron’s use of special purpose entities (SPEs) To: • hide bad investments and poor-performing assets • manage earnings—Blockbuster Video deal--$111 million gain • execute related-party transactions at desired prices • report over $1 billion of false income • hide debt • manipulate cash flows, especially in 4th quarters • book income just in time and in amounts needed, to meet investor expectations

23. 2001 - Notable Events

24. Enron’s revenues and income Source of data: Standard & Poor’s Compustat

25. Enron’s stock price Blackout period for retirement sales: October 19 – November 13, 2001 Source of data: Center for Research in Security Prices

26. Executives and board members got out of the stock (1999 – mid-2001)

27. The effect of recent accounting scandals As a consequence of accounting scandals, particularly that of Enron, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) in 2002. The main provisions are as follows: • The establishment of a Public Company Accounting Oversight Board to register and inspect public accounting firms and establish audit standards. • The separation of audit functions from other services, such as consulting, provided by the big accounting firms, with the auditors rotating every 5 years so that they do not get too close to the companies they are auditing.

28. SOX, continued The implementation of much stricter governance standards, including internal controls Auditors report to the company’s audit committee, which is to be composed of independent members of the board of directors with the power to engage independent consultants.

29. Up next … Financial statements

30. Question 1 The independent accountants attest that: There is no fraud. Statements are prepared according to GAAP. They are independent.

31. Question 2 Which opinion is best? Adverse Qualified Unqualified