Jimmy Gentry presents "Understanding Financial Statements" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 2, 2014. Gentry is the Clyde M. Reed Teaching Professor at the University of Kansas' School of Journalism and Mass Communications. The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists. For more information about business journalism training, please visit http://businessjournalism.org.

1. Understanding
Financial Statements
Strictly Financials
Jan. 2, 2014

2. Donald W. Reynolds National Center
For Business Journalism
At Arizona State University
Strictly Financials
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3. n
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James K. Gentry, Ph.D.
Clyde M. Reed Teaching Professor
School of Journalism and Mass Communications
University of Kansas
jgentry@ku.edu
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4. Types of Statements
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Public
Private
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Financial statements conforming to public
company statements
Non-profits
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5. Important Terms
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Unaudited
Audited
Accountants
Certified Public Accountants (CPAs)
GAAP, FASB, AICPA, PCAOB
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6. Assessing a Company
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Context
Trends
Rules
Outsiders
Insiders
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7. Annual Report,10-K
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Annual report,10-K wrap, 10-K
Auditor’s report: Clean, qualified?
MD&A or Management’s Discussion
and Analysis
Financial statements and footnotes
Management’s letter if annual report
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8. Traditional Auditor’s Report
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Independent auditor’s opinion on whether
financial statements are presented fairly in all
material respects, in accordance with GAAP:
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We looked at these statements
They’re management’s responsibility; we’re just
here to express our opinion
We followed the rules in our audits and here’s
what an audit involves
In our opinion, the statements fairly present the
company’s position
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9. Auditor’s Report by Category
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Clean or Unqualified
Qualified
Disclaimer
Adverse
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10. New Auditor’s Report
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Combines traditional report with
“internal controls” requirement of
Sarbanes-Oxley Act
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11. Sarbanes-Oxley Act of 2002
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Response to abuses with Enron and
WorldCom as catalysts
New responsibilities, resources for SEC
Created PCAOB
Major emphasis on “internal controls”
More disclosure for public companies
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12. Sarbanes-Oxley Act
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Analysts must state potential conflicts of interest
Limited types of services accounting firms can
provide to public company clients
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Companies disclose in 10-K the fees pay to auditors
Recent concerns
Consulting
CEO, CFO attest to accuracy, completeness, fairness
of financial statements
Rigorous penalties for fraud, other misdeeds
Clawbacks
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13. Public Company Accounting
Oversight Board
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Created by SOX to oversee accounting
Began operating in 2003
SEC appoints five members to five-year
terms
Two members must be or have been CPAs
All members must be “financially literate”
In 2008, Supreme Court upheld PCAOB but
said SEC couldn’t remove board members
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14. PCAOB’s Duties
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Set rules on “auditing, quality control,
ethics, independence, and other
standards…”
Conduct “inspections” of accounting
firms
Conduct “investigations and disciplinary
proceedings”
Enforce compliance with SOX
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15. Section 404: Internal Controls
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“Management Assessment of Internal
Controls”
Each 10-K must contain an “internal control
report” that:
States management is responsible for internal
control structure and procedures
Contains an assessment on effectiveness of
internal control structure and procedures
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16. Management on the Spot
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Section 404: Management must evaluate and
test internal controls over financial reporting,
including anti-fraud programs, annually.
Management certifies that it does (or doesn’t)
have adequate internal controls in place.
Independent board members easier to attract
Auditor attests to adequacy of controls.
Management to be forced to answer for
fraudulent activities, misconduct, etc.
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17. Private Company Impact
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Banks, insurers requiring companies to
embrace SOX.
Now most private firms have audited financial
statements
If private company owners want to sell to
public company, must be in compliance
Private equity funds more willing to invest in
companies in compliance
Best outside directors
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18. Non-Profit Impact
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Audit committees, independent members
CEO, CFO attest to accuracy, completeness,
fairness of financial statements
Financial statements more accessible
Codes of ethics
Rules governing transactions with “insiders”
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19. Goal of accounting
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Record, classify and report financial
transactions. To provide managers across the
organization with information that facilitates:
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Control of activities and expenditures
Refinement of operational plans
Accountability
Reporting on project outcomes
Writing of bids for new funds
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20. Goal of Finance
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Maximize shareholder wealth as
reflected in market price of the stock
Achieving this goal requires financial
manager to focus on economic profit,
not accounting profit
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21. Financial Decisions
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Investing decisions: Types of assets
firm wants to hold.
Financing decisions: Acquisition of
funds needed to support long-term
investments.
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22. Generally Accepted
Accounting Principles
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Guidelines based on theory and
practice
Evolved over time
Procedures, concepts and standards
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23. GAAP
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Periodicity
Going concern
Economic entity
Monetary unit
Full disclosure
Historical cost
Consistency
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24. GAAP
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Materiality
Industry practices
Conservatism
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25. Specialized Industry GAAP
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Banking and thrift industries
Benefit plans, including pension funds
Broadcasting industry
Cable television industry
Computer software
Finance companies
Investment companies
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26. Cash or Operating Cycle
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Cash
Purchase inventory
Produce product
Sell product
Cash
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27. Cash or Operating Cycle
(cont.)
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“Cash”
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Cash
Receivables and payables
Debt
Inventory
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Raw materials
Work in progress
Finished goods
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28. Cash or Operating Cycle
(cont.)
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Sell product
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Cash
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Accounts receivable
Cash
Collect receivables as cash
Pay off payables
Start over
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29. Accrual Method
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Records revenues when the the “sale”
occurs
Records expenses when the bill is
received
IE, transactions enter the financial
records when they occur, not when
cash changes hands
Accrual method, therefore, shows
“scores,” not real spendable dollars
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30. About These Numbers:
They’re Squishy
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Goods will not necessarily be paid for
Goods are not necessarily going to be
kept
Inventory might be out of date, obsolete
or unsellable
Status of some inventory may be
uncertain
Intangible assets are estimates
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31. About These Numbers:
They’re Squishy (cont.)
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Machinery or other fixed assets might
be obsolete or falling apart long before
the so-called useful life is up
Goodwill
Accounting conventions
Timing issues
Bottom line: In many ways, statements
are a collection of estimates.
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32. Because They’re Squishy
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You need to know the rules and
assumptions used to create the
numbers
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33. Income Statement or ...
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Statement of earnings
Statement of operations
Statement of income and
comprehensive income
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34. Income Statement
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Covers a period of time, typically a year
or quarter
Reports income from ongoing activities
Reports income from activities beyond
management’s control (comprehensive
income)
Involves estimates
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35. Basic Income Statement
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Sales or revenues
Expenses
Taxes
Net income or profit
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36. Income Statement
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Sales or revenues
Cost of goods sold
Gross profit
Operating expenses
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Sales, general and administrative
Depreciation, amortization
Operating profit
Other income/expenses
Interest
Income taxes
Net income or profit
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37. Cost of Goods Sold
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Expenses incurred in the cost of
manufacturing or creating or acquiring
the product the company sells.
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38. Cost of Goods Sold
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Manufacturer: What the company pays
for inventory, i.e. raw materials and
supplies used to make its product(s).
Includes price of raw materials plus cost
of turning it into a product, and
transportation costs, i.e. direct factory
labor, overhead costs, energy costs.
Inventory is largest percent of CGS for
manufacturer.
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39. Cost of Goods Sold
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Retailer: What the company pays
suppliers for the products it sells on its
shelves. Only the cost of merchandise
purchased for resale, not the cost of
providing the service to customers.
Service business: Since it doesn’t make
or sell a product per se, typically find a
modest CGS.
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40. SGA
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Includes office expenses, accounting,
shipping department, advertising, R&D,
depreciation and other expenses that
can’t be directly attributed to particular
items for sale.
Often includes depreciation and
amortization.
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41. Other Income/Expenses
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Discontinued items
Unusual/extraordinary items
Changes in accounting principle
Impairment charge
Sale of investment
Minority interest
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42. Thinking Inside the Box
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Revenues
Minus cost of goods sold
Equals gross profit
Minus operating expenses
Equals operating profit
Minus or plus other expenses/income
Minus or plus interest expenses/income
Minus income taxes
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Net income
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43. Inside the Box Earnings
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Sales or revenues
Cost of goods sold
Gross profit
Operating expenses
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Sales, general and administrative
Depreciation, amortization
Operating profit
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44. ‘One-Time’ Gains That
Reoccur
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Don’t be fooled by extraordinary items
that make the net income look better
than it really is
Extraordinary items should be both
unusual in nature and infrequent in
occurrence
Examples: Writedowns, restructurings,
etc.
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45. Earnings Per Share
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Basic earnings per share
(Bloomberg)
Diluted earnings per share (Wall
Street Journal, fully diluted)
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46. Calculating EPS
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Basic: Net income for period divided by
weighted average number shares
outstanding.
Diluted: Net income for period divided
by weighted average number shares
outstanding for period, plus assumption
of exercise of all potentially dilutive
instruments.
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47. Dividend
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Company’s board of directors decides to
distribute a portion of a company's net income
to a class of its shareholders. The dividend is
most often quoted in terms of the dollar
amount each share receives (dividends per
share).
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48. Dividend Payout Ratio
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The percentage of a company’s net
income that is paid to shareholders in
dividends.
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49. Dividend Payout Ratio
Dividend per share
Earnings per share
Dividend payout
Net Income for same period
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50. Payout Ratio Calculation
Dividend payout
Net income same period
$622 million
$961 million
Ratio ratio = 64.7 percent
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51. Dividend Yield
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How much a company pays out in dividends
each year in relation to its stock price.
A way to measure how much cash flow you
are getting for each dollar invested in an
equity position. Investors who require a
minimum stream of cash flows from their
investments can secure this by investing in
stocks paying relatively high, stable dividend
yields.
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52. Dividend Yield Calculation
Annual dividend per share
Stock price per share
$1
$20
5%
vs.
$1
$40
2.5%
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53. Dividend Yield
Annual dividend per share
Stock price per share
$1.84
$60.64
Dividend yield = 3.03 percent
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54. Looking at Dividends
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In general, investors react poorly to a
decrease in dividends, and the stock price
usually declines as investors seek other
dividend-paying stocks.
A stable dividend payout ratio indicates a
solid dividend policy by the company's board
of directors.
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55. Balance Sheet
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It balances
Assets = Liabilities + Shareholders’
Equity
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56. Assets
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Current assets
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Cash and cash equivalents
Accounts receivable
Inventories
Prepaids
Investments and other assets
Strictly Financials
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57. Assets
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Property, plant and equipment, net
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Land and improvement
Buildings and improvements
Equipment
Less accumulated depreciation
Goodwill and other intangibles
Strictly Financials
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58. Goodwill and Impairment
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Difference between what a business
pays to buy another company and the
book value (total assets minus total
liabilities) of that company
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59. Liabilities
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Current liabilities
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Noncurrent liabilities
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Accounts payable
Accrued liabilities
Income taxes
Current maturity of long-term debt
Long-term debt
Deferred income taxes
Commitments and contingencies
Strictly Financials
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60. Shareholders’ Equity
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Capital stock
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Preferred stock
Common stock
Additional paid-in capital
Retained earnings
Treasury stock
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Total shareholders’ equity
Total L + OE
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61. Statement of Cash Flows
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Record of cash provided by cash
sources and of cash consumed by cash
uses.
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62. Cash Flows (cont.)
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Information about use of cash
Information about investing and
financing
Ability to continue as a going concern
Ability to generate future positive cash
flows
Ability to meet obligations and pay
dividends
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63. Cash Flows
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From operations
From investing
From financing
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64. Flexibility
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Companies have some flexibility in
categories for entries.
Total change in cash, however, will not
change.
Overwhelming majority of all accounting
standards deal with balance sheet and
income statement, not cash flows
statement.
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65. Free Cash Flow
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Powerful tool for making a company
successful
Powerful indicator for investors
Cash that is left over after productive
capacity is maintained or expanded
Permits expansion, paying down debt,
buying back shares, etc.
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66. Free Cash Flow (cont.)
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Several ways to calculate it
Companies create their own models
Gross way to do it:
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Cash from operating activities
Minus capital expenditures
Equals free cash flow
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67. American Standard Model
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Cash from operating activities
Minus capital expenditures
Plus proceeds from disposal of property
Plus proceeds from sale and
leasebacks
Equals free cash flow
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68. Free Cash Models
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‘Gross’ method
American Standard method
VF method
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Cash from operating minus cash from
investing
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69. Keys to Looking at Cash
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Cash from operations
Capital expenditures (cap ex)
Free cash
Cash and cash equivalents at the end
of the year
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70. Looking at the Numbers
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Note changes in amounts year to year, especially
revenues and expenses
Note numbers that are significantly larger or smaller
than the previous period
Look at trend line for sales/revenues, operating
income and net income. Calculate percentage
change for each.
Look at cash flow
Look at free cash flow
Tie the numbers to the footnotes.
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71. Techniques
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Calculate percentage change
Trend analysis
Common size analysis
Ratio analysis
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