ANALYZING FINANCIAL REPORTING

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1 ANALYZING FINANCIAL REPORTING MAY 18,

2 ANALYZING FINANCIAL REPORTING This publication is the property of Navigant. It should not be construed as professional advice on any specific facts or circumstances, and is not to be relied upon as legal advice under any circumstances. The contents are intended for general educational and informational purposes only and may not be quoted or referred to in any publications or proceedings without the prior written consent of Navigant Consulting Inc., to be given or withheld at our discretion. To request reprint permission for this presentation, please contact the Navigant Consulting Inc. office of General Counsel, at (312) The views set forth herein are the personal views of the authors and do not necessarily reflect the views of Navigant Consulting Inc. 2

3 TODAY S PRESENTERS JONATHAN MARKS, MANAGING DIRECTOR NAVIGANT MICHAEL PESCE, ASSOCIATE DIRECTOR NAVIGANT DANETTE SLEVINSKI, SVP, CHIEF COMPLIANCE OFFICER - NYU LUTHERAN DANIEL FETTERMAN, PARTNER KASOWITZ, BENSON, TORRES, & FREIDMAN LLP 3

4 TABLE OF CONTENTS The Core Financial Statements Components of a Financial Report Management Discussion and Analysis ( MD&A ) and Footnotes Why Analyze Financial Statements? Drivers of Financial Statement Problems (Why It s Done) Earnings Management (How It s Done) Key things to look for on the Financial Statements Classic Case Study Enron

5 BALANCE SHEET The balance sheet is represented by the accounting equation, which is a snap shot at a particular point in time. Assets = Liabilities + Owner s Equity Economic resources that are expected to benefit the business in the future. Something that has value, and the business owns or has control of. Ex. Cash, merchandise inventory, furniture Something the business owes and represents the creditor s claim on the business assets. Ex. Accounts payable, notes payable, salaries payable, LT debt The stockholders claim to the assets of the business is called equity. Equity represents the amount of assets that are left over after the company has paid its liabilities. It is the companies net worth. 5

6 BALANCE SHEET ASSETS Current Assets: Cash & Securities Receivables Inventories Non-Current Assets: Tangible Assets Buildings & Plants Land Equipment Intangible Assets Goodwill Intellectual Property LIABILITIES & EQUITY Current Liabilities Payables Accrued Expenses Short-term debt Unearned Revenue Long-term Liabilities Long-term debt Other long-term liabilities Shareholders Equity Stock Retained Earnings Assets = Liabilities + Owner s Equity 6

7 INCOME STATEMENT Summarizes the operating activities of the company over a particular period of time. Revenues - Expenses = Net Income Earnings that result from the delivery of goods or services to customers. Equity is increased by revenues. Ex. Sales revenue, service revenue, rent revenue The costs of selling goods or services. Expenses are the opposite of revenues and therefore, decrease equity. Ex. Rent expense, salaries expense, advertising expense, utilities expense The difference between revenues and expenses. At the end of each period, net income is closed to equity. If the difference is positive (income), it will increase equity. If the difference is negative (loss), it will decrease equity. 7

8 INCOME STATEMENT Net Sales Cost of Sales Gross Margin Selling, General and Administrative Expenses Operating Income Other Income (Expense) Dividend and Interest Income Interest Expense Income (Loss) Before Income Taxes and Extraordinary Loss Income Taxes Income (Loss) Before Extraordinary Loss Extraordinary Item: Loss on Earthquake Destruction Net Income (Loss) Net Income (Loss) Per Common Share 8

9 STATEMENT OF CASH FLOWS Classifies all transactions affecting cash into one of three categories: Operating Activities Investing Activities Financing Activities Cash related to transactions impacting net income Cash related to acquisition and sale of long-term assets and non-operating investment assets Cash related to transactions with creditors and owners Summarizes the information concerning the cash inflows (receipts) and cash outflows (payments) for a specified period of time. 9

10 COMPONENTS OF A FINANCIAL REPORT Audit Opinion - Management is ultimately responsible for the financial statements in accordance with GAAP. - Audits are not designed to specifically detect fraud. Financial Statements - Balance sheet - Income statement - Statement of cash flows - Statement of changes in equity Management s Discussion & Analysis ( MD&A ) - See next slide Footnote Disclosures - See next slide Internal Controls and Procedures, Executive Compensation, C- Suite certifications 10

11 MANAGEMENT S DISCUSSION & ANALYSIS ( MD&A ) AND FOOTNOTE DISCLOSURES Business Overview and Risk Factors - Describes key divisions, products, industries, markets, customers, competition. Significant Accounting Policies - Discusses the basis for which certain estimates are made in various accounts, among other things (i.e. revenue recognition, fair value of financial instruments, inventory, etc.). Regulatory and Compliance with Debt Covenants - Industry specific, others more intensive than others Recent Material Events - Were there any acquisitions / dispositions made during the year? - Asset write-downs, restructuring costs - Required disclosure of current and pending legal proceedings. - Were there any transactions with owners or other affiliated parties? - Going Concern 11

12 WHY ANALYZE FINANCIAL STATMENTS? To make informed decisions regarding the financial condition of an organization. Liquidity Availability of cash to meet obligations Solvency Ability to meet debts when they are due Profitability Excess of revenues over expenses Viability 12

13 DRIVERS OF FINANCIAL STATEMENT PROBLEMS (WHY ITS DONE?) Why might management want to understate income? New management Looking forward (IPO, other exit strategy) Going private/buyout Big bath theory Why might management want to overstate income? Make guidance given to the street Performance based compensation 13

14 EARNINGS MANAGEMENT (HOW IT S DONE?) Reserves and Income Smoothing Record reserves during profitable periods ( cookie jar ) Release reserves during unprofitable periods to meet analyst or investor expectations Understate reserves despite known circumstances (e.g., bad debt, legal settlements, etc.) 14

15 SOME KEY INDICATORS TO LOOK FOR Is the company profitable? What are the margins: gross, operating, net profit What portion of the income is from non-recurring/non-operating items? What percentage of expenses relate to debt service? How do operations and performance results compare to previous years and to budgets? What is the company reporting to the street? Consistent with budget? What is the quality of the earnings cash flow? Does revenue significantly increase at the end of the reporting period? Are there large reversals of revenue at the beginning of a reporting period? What is the capital structure? How does the company s results compare to its peers? 15

16 CLASSIC CASE STUDY: ENRON June 30, 2001 Income Statement June 30, 2001 Statement of Cash Flows 16

17 CLASSIC CASE STUDY: ENRON 17

18 CLASSIC CASE STUDY: ENRON 18

19 QUESTIONS AND ANSWERS 19

CONTACTS JONATHAN MARKS Navigant jtmarks@navingant.com MICHAEL PESCE Navigant mike.pesce@navigant.

20 CONTACTS JONATHAN MARKS Navigant MICHAEL PESCE Navigant DANETTE SLEVINSKI NYU Lutheran DANIEL FETTERMAN Kasowitz, Benson, Torres, Freidman LLP navigant.com 20

Chapter 1. assembled and processed

Chapter 1. assembled and processed 1 Introduction to Accounting and Business Chapter 1 Introduction to Accounting and Business Learning Objective 1 Describe the nature of a business, the role of accounting, and ethics in business. Nature