INRODUCTION TO FINANCIAL STATEMENT ANALYSIS

1. INRODUCTION TO FINANCIAL STATEMENT ANALYSIS Chapter 1

2. CHAPTER 1 OBJECTIVES • Understand the decision emphasis of financial statement analysis and why a comprehensive approach is needed to meet this objective. • Indicate who uses financial statements and how they use them to make decisions.

3. CHAPTER 1 OBJECTIVES (CONT.) • Show the importance of generally accepted accounting principles (GAAP) to analysis, which organizations determine GAAP, why GAAP differs among countries, and the benefits of harmonizing GAAP. • Determine the various concepts of capital maintenance and attributes of asset measurement.

4. CHAPTER 1 OBJECTIVES (CONT.) • Articulate the benefits and limitations of the nominal dollar capital maintenance concept and historical cost valuation in financial reporting and analysis. • Explain how inconsistent terminology, data volume, transaction complexity, information variability, and financial statement limitations can affect financial statement analysis.

5. OVERALL PERSPECTIVE • Analysis—separation of something into its parts to study its nature, proportion, function, and interrelationship • Analytical process—provides insights about how the entirety operates, where it came from, and where it is going

6. OVERALL PERSPECTIVE (CONT.) • Financial statement analysis • Art and science of examining corporate financial statements • Financial statements—corporate monetary disclosures

7. OVERALL PERSPECTIVE (CONT.) • Objective of this book: Students will • Learn how to analyze financial statements • Critically evaluate corporate disclosures and related information

8. COMPREHENSIVE ANALYSIS • Business environment—an analyst must understand the context in which a company does business • Components of business environment • Overall economy • Legal environment • Political climate • Cultural context

9. COMPREHENSIVE ANALYSIS (CONT.) • Data sources— • amount and variety of information sources needed to conduct analysis • Qualities of data sources • Timing-current versus historical • Potential bias-objective versus subjective • Type-quantitative versus qualitative

10. CATEGORIES OF ANALYSTS • Equity investors—owners who seek to maximize return on investment, subject to a given risk level • Credit granters—lenders who seek payment of principal and interest in a timely manner • Corporate managers—owners’ agents who seek information to plan and control their entity’s operations

11. CATEGORIES OF ANALYSTS (CONT.) • Merger and acquisitions specialists—professionals who, for a fee, realign corporations to maximize shareholder value • Internal and external auditors—independent evaluators who attest to the fairness of managerial representations (external auditors) and corporate employees who seek to improve business operations (internal auditors)

12. CATEGORIES OF ANALYSTS (CONT.) • Regulators—representatives of government entities who judge an entity’s compliance with existing laws and regulatory requirements • Corporate employees—individuals, or their collective bargaining agents, who seek to maximize compensation for their services

13. REPORTING STANDARDS • Authoritative pronouncements that when taken together with accepted financial reporting conventions compose generally accepted accounting principles (GAAP)

14. REPORTING STANDARDS (CONT.) • Collaborative partnership • Securities and Exchange Commission (SEC)—quasi-governmental agency that has the legal authority to set reporting standards • Financial Accounting Standards Board (FASB)—private U.S. standard setting body that determines most authoritative pronouncements

15. REPORTING STANDARDS (CONT.) • Financial reporting standards consist of • Corporate financial statements • Notes to the financial statements • Supplemental financial statement disclosures

16. REPORTING STANDARDS (CONT.) • International dimension • Countries determine national generally accepted accounting principles • Differences in business formation, development, and activity produce various national standards • GAAP is classified into models, such as the Anglo American and European Models of accounting or financial reporting

17. REPORTING STANDARDS (CONT.) International Accounting Standards Committee (IASC)—collaborative effort by the accounting bodies of many nations to reduce financial reporting alternatives and harmonize accounting standards; lacks enforcement power of national bodies, such as the FASB

18. DISCLOSURE CHALLENGES • Desirable qualitative characteristics of financial reporting • Relevant information matters to analysts by helping them predict the future • Reliable information can be verified and is unbiased

19. DISCLOSURE CHALLENGES (CONT.) • Capital maintenance selection • Amount of investment that must be recovered through revenues before income is earned; alternative concepts exist that result in different degrees of relevance and reliability in the financial statements

20. DISCLOSURE CHALLENGES (CONT.) • Nominal dollar concept of capital maintenance—recognizes income after recovering the number of dollars invested in the asset sold; ignores overall inflation rate or price changes for specific goods; underlies the current system of financial reporting in the U.S. and most countries

21. DISCLOSURE CHALLENGES (CONT.) • General purchasing power concept of capital maintenance—income results when an entity recovers more revenues than the general purchasing power equivalent of its investment; not GAAP

22. DISCLOSURE CHALLENGES (CONT.) • Physical capital concept of capital maintenance—income results when an entity recovers more revenues than the current cost of its investment; not GAAP

23. DISCLOSURE CHALLENGES (CONT.) • Historical cost—principle that governs asset measurement; used with the nominal dollar concept of capital maintenance to compose financial reporting system

24. DISCLOSURE CHALLENGES (CONT.) • Information complexities—obstacles that hinder financial statement disclosures and analysis • Inconsistent terminology and financial statement formats vary among companies and over time • Numerous information sources provide substantive amounts of data

25. DISCLOSURE CHALLENGES (CONT.) • Information complexities (cont.) • Transaction complexities reflect the increasingly complicated ways in which business is conducted • Data sources vary greatly with respect to their relevance and reliability • Financial statements report only selected events in constant monetary units and on the basis of historical cost