Understanding and Evaluating Financial Statements Kellogg s

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Understanding and Evaluating Financial Statements
NYSSCPA
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RONAld J. HuefnerCPA, CMA, Ph.D

• SUNY DISTINGUISHED TEACHING PROFESSOR (retired)

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Speaker Background

• BA, Canisius College, Buffalo
• MBA, Ph.D., Cornell University
• CPA (New York), CMA
• Long-time accounting professor at SUNY Buffalo

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Speaker Background

• Author or co-author of several books and over 40
  articles in academic and professional journals

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Speaker Background

• Served as
• President of Buffalo Chapter, NYSSCPA
• Vice-President and member of Board of Directors
  and Executive Committee, NYSSCPA
• Trustee, Foundation for Accounting Education

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Speaker Background

• Served as
• Chair of Higher Education Committee
• Chair of Strategic Planning Task Force
• Chair of Task Force on Chapters
• Recipient of NYSSCPA Distinguished Service Award

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NYSSCPA Media Programs

• Customized seminars
• Invitations to educational conferences
• The Excellence in Financial Journalism Award
• Media bank of CPA members

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Review of Press Kits

• Speaker background
• Annual report of Kelloggs
• Proxy statement

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PROGRAM OVERVIEW

• Financial statements
• Auditors report
• Ratio analysis
• Proxy statements

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Ongoing Example

• Annual Report of Kellogg Company for 2009
• March 2010 Proxy Statement for Kellogg

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PART 1ACCOUNTING STANDARDS AND FINANCIAL
STATEMENTS
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Overview Part 1

• Introduction to generally accepted accounting
  principles
• Introduction to basic financial statements

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Generally Accepted Accounting Principles (GAAP)

• Established via formal standard-setting processes
• Used by all public companies

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Who Establishes GAAP?

• FASB (Financial Accounting StandardsBoard) for
  businesses and non-profits
• SEC (U.S. Securities and Exchange Commission)
  has legal authority, provides oversight (public
  companies)
• GASB (Government Accounting Standards Board)
  for government entities

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Alternatives to GAAP

• Other comprehensive basis of accounting (OCBOA)
• Tax basis
• Cash basis
• Regulatory basis
• Used by some small, non-public companies

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Alternatives to GAAP

• IFRS (International Financial Reporting
  Standards), set by International Accounting
  Standards Board (IASB)
• IASB is an independent, privately-funded
  standard-setter based in London, England

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IFRS

• Used (required or permitted) in over 100
  countries
• All of Europe
• Canada
• China, Japan, India, Korea
• Argentina, Brazil, Mexico
• Australia

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Big Question for U.S.

• Should U.S. switch from GAAP to IFRS?
• SEC permits IFRS for foreign companies on U.S.
  markets
• SEC Roadmap decide in 2011?
• Convergence or adoption?

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Whats Happening Currently?

• Major effort to revise many U.S. standards
• Converge as many as possible
• Then what to do?
• Big political question

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Financial statementsTHE ANNUAL REPORT
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Whats in an Annual Report?

• Balance sheet
• Income statement
• Statement of cash flows
• Statement of changes in stockholders equity
• Notes to the financial statements
• More

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Balance Sheet

• Assets Liabilities Equity
• Snapshot at a point in time
• Mixed measures Historical cost, fair (market)
  values, discounted cash flows
• See Kelloggs, page 28

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Income Statement

• Revenues and expenses
• Activity for the period
• Basic principles
• Revenue recognition
• Matching
• Accrual
• See Kelloggs page 27

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Statement of Cash Flows

• Inflows and outflows of cash
• Three sections operations, investing, financing
• Cash from operations is key
• money generated from main business
• See Kelloggs page 30

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Statement of Changes in Stockholders Equity

• Details changes in the ownership equity accounts
• See Kelloggs page 29

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Notes to theFinancial Statements

• Lots of detailed information
• Summary of accounting principles
• Explain one time events and special circumstances
• Separate information on lines of business

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Examples from Kelloggs

• Accounting policies (pp. 31-33)
• Details on acquisitions and dispositions (pp.
  33-36)
• Details on debt (pp. 39-40)

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Some Basic Principles

• Conservatism
• Going Concern
• Materiality
• Substance Over Form

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SOME SPECIFIC TOPICS OF INTEREST
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Inventory Methods

• Specific identification
• FIFO
• LIFO
• Average cost
• Kelloggs p. 31

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Receivables

• Outstanding balances owed by customers and others
• Allowances (reductions of value)
• Bad debts
• Returns
• Discounts
• See Kelloggs p. 31

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Depreciation

• A process of expensing the cost of limited-life
  assets
• Not observable, thus based on formulas
• See Kelloggs p. 31

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Business Combinations

• Acquiring other companies
• Goodwill and other intangible assets
• See Kelloggs pp. 31-32, 33-35
• Concept of impairment test for goodwill and other
  assets

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Leases

• Most companies lease assets
• Two ways to account for leases
• CAPITALIZE (as if purchased financed)
• OPERATING (no asset or liability recorded, just
  rental expense)
• Can structure the lease to get the accounting you
  want

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Leases

• See Kelloggs p. 38
• About 99 accounted for as operating leases
• Called off-balance-sheet financing
• Probably will change

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Pensions and Other Benefits

• Many companies have big future obligations for
  employee pension and health benefits
• See Kelloggs pp. 43-47
• Look at funded status

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Fair Value Disclosures

• Fair value measurement is increasing
• Fair values are applied to many financial assets
  and liabilities
• Several ways to do it

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Fair Value Methods

• Level 1 quoted prices for identical items in
  active markets
• Level 2 prices in inactive markets, or based on
  directly or indirectly observable inputs (e.g.,
  similar assets)

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Fair Value Methods

• Level 3 based on models and assumptions,
  generated by management inputs are unobservable
• See Kelloggs pp. 50-52

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Contingencies

• Existing risks, outcome unknown
• Lawsuits
• Environmental obligations
• Tax audits
• Product liability
• See Kelloggs p. 53

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Managements Discussion and Analysis

• A lengthy discussion of
• Results of operations
• Liquidity and capital resources
• Off-balance-sheet contractual arrangements
• Critical accounting estimates
• Future outlook

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Managements Discussion and Analysis

• This is prepared by management it is not part of
  the audited report
• Gives insight and understanding about the company
• See Kelloggs pp. 13-26

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Reports to the SEC

• Form 10-K (annual report, incorporates annual
  report to stockholders)
• Form 10-Q (quarterly report)
• Proxy statements
• News releases
• Form 8-K O
• Public availability

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PART 2THE AUDITORS REPORT
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Audits

• Question What is an audit?
• Answer Assurance that financial statements are
  not materially misstated

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Whos Responsible?

• Financial statements are the responsibility of
  company management
• Auditor examines and tests those statements to
  see if they conform with good accounting

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Needed for a Good Audit

• Broadly trained and sufficiently experienced
• Understand the risks and nature of the business
• Design procedures to provide reasonable assurance
  of possible material misstatement
• Retain professional skepticism
• Reality check/smell test

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Auditors Report

• INDEPENDENT AUDITORS' REPORT
• To the Board of Directors and Stockholders
  ofBlank CompanyCity, State
• We have audited the accompanying consolidated
  balance sheets of Blank Company and subsidiaries
  as of December 31, 20x1 and 20x2, and the related
  consolidated statements of income, stockholders'
  equity, and cash flows for the years then ended.
  These financial statements are the responsibility
  of the Company's management. Our responsibility
  is to express an opinion on these financial
  statements based on our audits.
• We conducted our audits in accordance with
  generally accepted auditing standards. Those
  standards require that we plan and perform the
  audit to obtain reasonable assurance about
  whether the financial statements are free of
  material misstatement. An audit includes
  examining, on a test basis, evidence supporting
  the amounts and disclosures in the financial
  statements. An audit also includes assessing the
  accounting principles used and significant
  estimates made by management, as well as
  evaluating the overall financial statement
  presentation. We believe that our audits provide
  a reasonable basis for our opinion.
• In our opinion, such consolidated financial
  statements present fairly, in all material
  respects, the financial position of the companies
  at as of December 31, 20x1 and 20x2, and the
  results of their operations and their cash flows
  for the years then ended in conformity with
  generally accepted accounting principles.
• DELOITTE TOUCHEMarch 15, 20x3

• Plain vanilla
• Unqualified or clean opinion
• Three paragraphs
• Introductory
• Scope
• Opinion

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What are Generally Accepted Auditing Standards
(GAAS)?

• The procedures auditors follow
• Since Sarbanes-Oxley, set by the Public Companies
  Accounting Oversight Board (PCAOB)
• PCAOB also monitors the work of auditors

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Limitations of an Audit

• Auditor always knows less about company than does
  management
• Audits depend on testing and sampling
• Auditors are paid by the companies they audit

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Limitations of an Audit

• Accounting necessarily involves many estimates
  and judgments

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Attempts to Improve Auditing (Sarbanes-Oxley)

• Prohibitions against consulting services for
  audit clients
• Limitations on movement of people from auditor to
  client
• Clarification of management responsibility

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Kelloggs Audit Report

• See page 58
• A longer format than standard
• Also note managements statements on page 57

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Qualified Audit Opinions

• Scope Limitation
• Departure from GAAP
• Inadequate Disclosure
• Accounting Change
• These are rare

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Adverse Opinions and Disclaimers of Opinion

• Adverse - financial statements do not present
  fairly the financial position, results of
  operations or cash flows
• Disclaimer - no opinion at all. Usually due to
  significant scope restriction

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Other Reports by Auditors

• Reviews
• Compilations
• Special reports

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Common Audit Issues

• Overstatement of revenue
• Understated costs/expenses
• Aggressive accounting policies
• Related party transactions
• Inventory existence valuation
• Inadequate collectibility reserves

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Inappropriate Revenue Recognition

• Large or unusual transactions occurring shortly
  before end of an important period
• Shipping products before a sale is consummated
• Bill and hold transactions
• of completion accounting where there are
  uncertainties
• Unrecorded sales allowances and returns

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Understated Costs and Expenses

• Failure to record or accrue significant invoices
• Improper or insufficiently supported
  capitalization of costs or deferral
• Unusually slow depreciation

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Aggressive Accounting Policies

• Use of very aggressive accounting principles or
  practices for income recognition, capitalization
  and deferral of costs, amortization
• Lack of supporting documentation

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Related Party Transactions

• Significant transactions or amounts which appear
  unusual or whose purpose is unclear with related
  parties

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Indicators of Possible Inventory Overstatement

• Unusually large quantities of high cost items
• Unclear or ineffective cut-off procedures
• Little or no write-downs to market or provisions
  for obsolescence
• Questionable procedures for determining or
  aggregating inventory costs
• Gross profit percentage higher than expected

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Collectibility of Receivables

• Current provision or aggregate reserves seem low
• Large past due receivable balances or large
  receivables from related parties or unfamiliar
  sources

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How the Numbers Tell the Story

• Overstated inventory
• Overstated revenue
• Understated costs and expenses

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PART 3EVALUATING A COMPANY
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Things to Look for in Evaluating a Company

• Trends
• Sales increases
• Quality of assets
• Contingencies
• Valuation (especially fair values)

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Trends

• Three years of income, cash flow, equity changes
• Two years of balance sheets
• Elsewhere, 5 or 10 year summaries (see Kelloggs,
  p. 12)

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Examples from Kelloggs

• Sales increased 8.8 from 2007 to 2008, and
  declined 1.9 from 2008 to 2009
• Net income increased 4 from 2007 to 2008, and
  increased 5.4 from 2008 to 2009

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Introduction toFinancial Analysis

• Who evaluates financial statements?
• How to identify red flags O
• How to use ratios

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Who Evaluates Financial Statements?

• Creditors
• Banks
• Insurance companies
• Private placement purchasers
• Others
• Suppliers
• Customers
• Employees
• Former employees

• Auditor
• Analytic procedures
• Red flags O
• Management
• Internal audit
• Investors
• Security analyst
• Portfolio managers

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Types of Ratios

• Liquidity
• Leverage
• Asset utilization
• Profitability

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Operating Ratios
Management of current assets and liabilities

• Examples
• Current ratio
• Net working capital
• Days sales outstanding
• Days of inventory on hand

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Current Ratio

• Current assets / current liabilities
• For Kelloggs, 2,558 /2,288 1.1
• Trend probably more important than absolute amount

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Net Working Capital

• Net working capital current assets minus
  current liabilities
• For Kelloggs, 2,558 - 2,288 300 million
• Again, watch the trend

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Days Sales Outstanding

• A measure of how quickly the company collects
  from its customers
• DSO receivables / daily sales
• Kelloggs 1,093/34.5 31.7 days

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Days of Inventory on Hand

• A measure of how many days worth of inventory the
  company holds
• DI Inventory / Daily cost of goods sold
• Kelloggs 910/19.7 46.2 days

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Profitability
The return you get on sales, assets and equity

• Examples
• Profit margin
• Asset turnover
• Return on assets (ROA)
• Return on equity (ROE)
• Leverage
• Earnings per Share (EPS)
• Price/Earnings Ratio

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Profit Margin

• How much profit does the company earn per dollar
  of sales?
• Profit margin Net income / Net sales
• Kelloggs 1,208/12,575 9.6

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Asset Turnover

• How much sales are generated per dollar of
  assets?
• Asset turnover Net sales / Total assets
• Kelloggs 12,575 / 11,200 1.12

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Return on Investment?

• A poorly-defined term
• Investment may mean
• Assets
• Equity
• Better to say ROA or ROE than ROI

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Return on Assets (ROA)

• How much does the company earn on its investment
  in assets?
• ROA Net income / Total assets
• Kelloggs 1,208 / 11,200 10.8

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Return on Equity (ROE)

• How much does the company earn on the investment
  by its owners (stockholders)?
• ROE Net income / Stockholders equity
• Kelloggs 1,208/2,275 53.1

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ROA versus ROE

• Kelloggs ROA was 10.8 while its ROE was 53.1.
  Why the big difference?
• Answer LEVERAGE using debt rather than equity
  to finance the company

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Common Example of Leverage

• You buy a house for 300,000
• Mortgage 270,000, your equity 30,000
• House value grows to 306,000
• ROA 6,000/300,000 2
• ROE 6,000/30,000 20

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Leverage

• Extent to which equity is leveraged
  (supplemented with debt) in financing the company
• Leverage Total assets / Stockholders equity
• Kelloggs 11,200 / 2,275 4.92 times

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Linkage

• ROA Margin x Asset Turnover 9.6 x 1.12
  10.8
• ROE Margin x Asset Turnover x Leverage (or ROA
  x Leverage) 9.6 x 1.12 x 4.92 53
• Useful for analyzing changes

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Earnings per Share
NYSS of CPAs

• Primary
• Fully diluted

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Earnings per Share
Net Income Weighted Average Shares Outstanding

• Primary
• Fully diluted

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Earnings per Share

• Given on Income Statement
• Kelloggs 3.17 (basic), 3.16 (fully diluted)
• Difference between the two is usually trivial

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Price/Earnings Ratio

• Market price per share / Earnings per share
• Market price at end of 2009 (see p. 54) 53.20
• P/E ratio 53.20 / 3.17 16.8

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PART 4THE PROXY STATEMENT
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Background

• Public companies are technically governed by
  stockholders, who vote for directors and on major
  proposals
• Companies hold an annual meeting of stockholders

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What is a Proxy Statement?

• Communication to stockholders, soliciting their
  votes and voting rights

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Contents of a Proxy Statement

• Voting procedures information
• Nominees for director
• Compensation of directors
• Details on executive compensation

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Contents of a Proxy Statement

• Audit committee and other board committees
• Audit and non-audit fees
• Specific proposals for stockholder vote

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Kelloggs Proxy Statement

• Details about the upcoming stockholders meeting
  (pp. 1-3)
• Stock ownership information (pp. 4-6)
• Corporate governance (pp. 7-10)

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Kelloggs Proxy Statement

• Membership of Board of Directors and Board
  Committees (pp. 11-13)
• Election of directors (pp. 14-18)
• Compensation and benefits for directors (pp.
  19-22)

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Kelloggs Proxy Statement

• Details about executive compensation and benefits
  (pp. 23-60)
• Vote on appointment of auditor and fee
  disclosures (pp. 62-64)
• Shareholder proposal (pp. 64-66)

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Wrap-Up

• Weve given an overview of
• Accounting standards
• Financial statements
• Auditing
• Financial statement analysis
• Proxy statements

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Rons Contact

• rhuefner_at_buffalo.edu
• Happy to serve as a contact
• But, keep in mind, you have deadlines and I
  (being retired) dont ?