Chapter 5
Communicating and Analyzing
Accounting Information
1
Overview
Key Players in Accounting Communication
The Disclosure Process
test less on first two
Financial Statements: A Review
Analyzing Accounting Information: Dupont Analysis
2
Exhibit 5.1 Ensuring the Integrity of Financial Information
3
Managers
Managers are primarily responsible for the information in the financial
statements and disclosures.
Chief Chief
Executive Financial
Officer Officer
highest officer of highest
the company financial/accounting officer
Both officers must personally certify that:
- Report filed with the SEC do not contain untrue statements or omitted facts.
- There are no significant deficiencies or material weaknesses in the internal
controls over financial reporting.
- They have disclosed to the auditors and audit committee any weaknesses in
internal controls or fraud.
The accounting staff also bear professional responsibility for the accuracy of
this information, although their legal responsibility is smaller.
4
Board of Directors (Audit Committee)
Board of Directors
The board of directors oversees the CEO and other senior
management and assures that the long-term interests of
shareholders are being served.
The board of directors are elected by the stockholders.
Audit Committee of the Board of Directors
• responsible for ensuring that processes are in place for maintaining the
integrity of the company’s accounting, financial statement preparation, and
financial reporting.
• responsible for hiring the company’s independent auditors
• must meet separately with the auditors to discuss management’s
compliance with their financial reporting responsibilities
• must be nonmanagement (independent) directors with financial knowledge
5
Auditors
Independent Auditors
The SEC requires publicly traded companies to have their financial
statements and their control systems over the financial reporting process
audited by an independent registered public accounting firm (independent
auditor) following auditing standards established by the PCAOB.
Many privately owned companies also have their statements audited.
By signing an unqualified (clean) audit opinion, a CPA firm assumes part of
the financial responsibility for the fairness of the financial statements and
related presentations. This opinion, which adds credibility to the statements,
is often required by lenders and private investors.
Subjecting the company’s statements to independent verification reduces
the risk that the company’s financial condition is misrepresented in the
statements.
6
The “Big 4”
EY KPMG
Deloitte PwC
These firms employs thousands of CPAs throughout the world.
They audit the great majority of publicly traded companies as well as many that
are privately held.
Some public companies and most private
companies are audited by smaller CPA firms.
7
Information Intermediaries: Information Services and Financial Analysts
Most investors rely on company websites, information services, and
financial analysts to gather and analyze information.
Companies file their SEC forms electronically using the EDGAR (Electronic
Data Gathering, Analysis, and Retrieval) service. Each fact in the report is
tagged to identify its source and meaning using a language called XBRL.
Information services allow investors to gather their own information about
the company and monitor analysts' recommendations.
• Fee-based services (e.g., S&P Global Market Intelligence)
• Information on the web (e.g., [Link], [Link],
[Link])
Financial analysts prepare reports including forecasts of future quarterly
and annual earnings per share and share price; a buy, hold, or sell
recommendation for the company’s shares; and explanations for these
judgments.
8
Exhibit 5.2 Yahoo! Finance Information on Apple
9
Analyst Reports
• Analysts also provide detailed reports on the state of the company, and
their forecasts for a firm’s future.
10
Earnings Forecasts
• In making their earnings forecasts, analysts rely heavily on their knowledge
of the way the accounting system translates business events into the
numbers on a company’s financial statements.
• Individual analysts often specialize in particular industries (such as sporting
goods or energy companies).
• Analysts are regularly evaluated based on the accuracy of their forecasts, as
well as the profitability of their stock picks.
Here is an example of how forecasts and stock recommendations might look
for Apple stock at a point in time:
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Users: Institutional and Private Investors, Creditors, and Others
Institutional Investors
Pension, mutual, endowment, and other funds that invest on the behalf of
others. Institutional shareholders control the majority of publicly traded
shares of U.S. companies!
Private Investors
Individuals, including large individual investors such as venture capitalists, who
purchase shares in companies.
Lenders or Creditors
Suppliers, banks, commercial credit companies, and other financial institutions
that lend money to companies.
Financial statements are also important to suppliers, customers, and even
competitors.
12
Overview
Key Players in Accounting Communication
The Disclosure Process
Financial Statements: A Review
Analyzing Accounting Information: Dupont Analysis
13
The Disclosure Process
SEC regulation FD, for “Fair Disclosure,” requires that companies
provide all investors equal access to all important company news.
Managers and other insiders are prohibited from trading their company’s
shares based on nonpublic (insider) information so that no party
benefits from early access.
Public companies announce quarterly and annual earnings through a press
release as soon as the verified figures (audited for annual and reviewed for
quarterly earnings) are available.
Many companies follow these press releases with a conference call during
which senior managers answer analysts’ questions about the results. These
calls are open to the public.
14
Exhibit 5.3 Earnings Press Release Excerpt for Apple Inc.
A press release is a written public news announcement normally distributed
to major news services.
15
Conference Calls
16
Measuring Interest in AI Transformation Through Conference Calls
17
The Disclosure Process: Annual Reports and Form 10-K
The annual reports for privately held companies are simple documents including:
1. Four basic financial statements.
2. Related notes (footnotes).
3. Report of Independent Accountants (Auditor’s Opinion) if the
statements are audited.
The annual reports of public companies (called Form 10-K) have additional SEC
reporting requirements such as:
Item 1. Business: Description of business operations and strategy.
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations: Management's views on the causes of its
successes and failures during the reporting period and the risks it faces in the
future.
Item 8. Financial Statements and Supplemental Data: The four basic
financial statements and related notes, the report of management, and the
auditor's report.
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Disclosure of Digital Strategy in Item 1 10-K
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The Disclosure Process: Quarterly and Other SEC Reports
Quarterly reports for private companies, usually prepared for lenders,
include less information than annual reports and are not audited.
Public companies file their quarterly reports on Form 10-Q with the
SEC. The Form 10-Q contains most of the information items provided in
the financial section of the 10-K and some additional items.
Public companies must file other reports with the SEC. These include
the current events report Form 8-K, which is used to disclose any
material event not previously reported that is important to investors
(e.g., auditor changes, mergers).
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Environmental, Social, & Governance (ESG) Reporting
Performance Beyond the Bottom Line
ESG Reports: Large public companies have started to publish a report on the
sustainability of their operations. ESG reports help investors assess the long-term
consequences of the company’s business strategy.
• E (for environmental) is how a company manages risks and opportunities
related to climate, pollution, waste, and other environmental factors.
• S (for social) includes labor and supply-chain standards, employee health and
safety, product quality and safety, privacy and data security, and diversity and
inclusion policies and efforts.
• G (for governance) information about a company’s corporate governance
including the board structure and diversity; executive compensation; and
policies on lobbying, political contributions, and bribery and corruption.
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Sustainability Reports
22
Sustainability Reports
Information on climate goals, emission for the company and supply chain partners
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Why do we care, why do we need them?
Targeted towards investors and other stakeholders,
these folks care about ESG or sustainability because:
E: Increasing salience of climate risks
S: Growing importance of human capital in
businesses
G: Corporate governance an importance piece of
driving value
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Climate Risks
The trend of rising temperatures is clear, and corresponds to the amount of carbon
inputs into the atmosphere
Below illustrates the climate model projections based on increase in carbon
emission(red), no increase (orange), decrease (green)
25
Human Capital
As firms digitalize, value of firms increasingly shifting towards intangible,
skills-based capital managing human capital is now much more important
for long-term growth in companies
Tambe et al (2020), NBER WP
26
Corporate Governance
Improving governance is a potential source of value – shareholder
activist try this by improving governance and driving returns
27 Lazard Report (2023)
How are ESG information used?
Who uses ESG metrics -
Investors use ESG measures to select a portfolio for
sustainable investments
Investors are voicing ESG concerns in shareholder
meetings
Boards increasingly are using ESG measures to create
targets for executive compensation
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ESG in investments
Investment funds nowadays, receive ratings for how sustainable their
portfolio looks
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ESG in Shareholder Governance
Increasing push by
shareholders to get or
even force companies
to enact ESG plans
The push for targets
on emission in
particular, increases
the need for more
ESG metrics
30
ESG in Compensation
Rising use of ESG metrics in compensation contracts – again information
on ESG needed to set targets for performance goals
31
Overview
Key Players in Accounting Communication
The Disclosure Process
Financial Statements: A Review
Analyzing Accounting Information: Dupont Analysis
32
A Closer Look at Financial Statement Formats and Notes
There are three additional characteristics of financial statements and
related disclosures that make them more useful:
1. Comparative financial statements. To allow users to compare
performance from period to period, companies report financial
statement values for the current period and one or more prior
periods. (2 years for balance sheets, 3 years for all other
statements)
2. Additional subtotals and classifications in financial
statements. You should not be confused when you notice slightly
different statement formats used by different companies.
3. Additional disclosures. Most companies present voluminous
notes that are necessary to understand a company’s performance
and financial condition.
33
Exhibit 5.4 Balance Sheet of Apple Inc.
34
Exhibit 5.5 Income Statement of Apple Inc.
35
Exhibit 5.6 Statement of Stockholders’ Equity
36
Statement of Cash Flows
The Statement of Cash Flows is divided into three sections:
Cash Flows from
Operating Activities. This
section reports cash flows
associated with earning
income.
Cash Flows from Investing
Activities. Cash flows in this section
are associated with the purchase and
sale of (1) productive assets (other
than inventory) and (2) investments in
other companies.
Cash Flows from Financing Activities.
These cash flows are related to financing the
business through borrowing and repaying
loans from financial institutions, stock
(equity) issuances and repurchases, and
dividend payments.
37
Exhibit 5.7 Cash Flow Statement of Apple
38
Notes to Financial Statements
All financial reports include additional information in
notes that follow the statements.
(1) Descriptions of the key accounting rules applied in the
company’s statements.
(2) Additional detail supporting reported numbers.
(3) Relevant financial information not disclosed on the
statements.
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Accounting Rules Applied in the Company’s Statements
One of the first notes is typically a summary of significant accounting
policies. This note tells the user which accounting methods the company has
adopted.
Apple’s accounting policy for property, plant, and equipment is as follows:
40
Additional Detail Supporting Reported Numbers
The second category of notes provides supplemental information
concerning the data shown on the financial statements.
41
Relevant Financial Information Not Disclosed on the Statements
The final category includes information that impacts the company
financially but is not shown on the statements.
42
Overview
Key Players in Accounting Communication
The Disclosure Process
Financial Statements: A Review
Analyzing Accounting Information: Dupont Analysis
43
Core Performance Metric: Return-on-Equity (ROE)
Net Income / Stockholder’s Equity
Why is it important?
Governance perspective
Valuation perspective
44
Traditional Dupont Analysis
Traditional Dupont analysis takes us a step deeper into
the components of ROE:
ROE = NI-to-sales x Sales-to-Asset x Assets-to-Equity
Traditional Dupont breaks down ROE into:
Profit Margin (NI/Sales): Profit per dollar of sales
Asset Turnover (Sales/Assets): Sales per dollar of
assets
Leverage (Assets/Equity): Assets per dollar of equity
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Return on Assets (ROA)
How well has management used the company’s total investment in assets
financed by both debt holders and stockholders?
Net Income*
Average Total Assets†
*In more complex ROA analyses, interest expense (net of
tax) and minority interest are added back to net income in
the numerator.
†(Beginning Total Assets + Ending Total Assets) ÷ 2
46
Exhibit 5.8 ROA Profit Driver Analysis
ROA Net Profit Total Asset
= Margin × Turnover
Net Income Net Sales
Net Income
Average = × Average Total
Net Sales
Total Assets Assets
47
Why Decompose ROA?
Tells us something about why ROA is different across
companies:
Exxon ROA Profit Margin Asset Turnover
2019 3.93% 5.61% 0.7
2018 6.05% 7.46% 0.811
2017 5.65% 8.31% 0.68
2016 2.37% 3.59% 0.66
2015 4.79% 6.22% 0.77
Pfizer ROA Profit Margin Asset Turnover
2019 9.75% 31.45% 0.31
2018 7.07% 20.79% 0.34
2017 12.57% 40.55% 0.31
2016 4.23% 13.66% 0.31
2015 4.13% 14.25% 0.29
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Net Profit Margin Ratio
How effective is management in generating profit on every dollar of sales?
Net Profit = Net Income
Margin Net Sales (or Operating Revenues)
A rising net profit margin signals more efficient management of
sales and expenses.
Note: Net sales is sales revenue less any returns from customers and other reductions. For companies in the
service industry, total operating revenues is equivalent to net sales.
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Gross Profit Percentage
How effective is management in selling goods and services for more
than the costs to purchase or produce them?
*Gross Profit = Net Sales − Cost of Sales
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Total Asset Turnover Ratio
How efficient is management in using its resources to generate sales?
The higher the asset turnover is, the more efficient assets are being
utilized to generate revenues.
Total Asset Net Sales (or Operating Revenues)
=
Turnover Average Total Assets*
Ratio
*Average is computed as: (Beginning balance + Ending balance) ÷ 2
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Leverage Ratio
Debt-to-Equity = Total Liabilities ÷ Total Equity = Total Assets ÷
Total Equity - 1
This ratio shows the relationship between the amount of capital
provided by owners and the amount provided by creditors.
In general, a high ratio indicates that a company relies heavily on
debt financing relative to equity financing. This increases the risk
that a company may not be able to meet its contractual financial
obligations during a business downturn.
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Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
Does a company have the short-term resources to pay its short-term
debt?
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How Transactions Affect Ratios (1 of 5)
How to determine the effects of transactions on ratios:
Three-Step Process
1. Journalize the transaction to determine its effects on various
accounts.
2. Determine which accounts belong to the financial statement
subtotals or totals in the numerator (top) and denominator
(bottom) of the ratio and the direction of their effects.
3. Evaluate the combined effects from step 2 on the ratio.
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How Transactions Affect Ratios (2 of 5)
What if only the numerator or denominator is affected?
Example 1: Apple incurred an additional $1,000 in research and
development expense paid for in cash. What would be the effect on the
net profit margin ratio?
The journal entry would be:
Note that the transaction would decrease the numerator Net Income and
have no effect on the denominator Net Sales. The ratio was 0.209 (using
numbers from Exhibit 5.5). It would decrease to 0.205.
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How Transactions Affect Ratios (3 of 5)
What if both the numerator and denominator are affected, but by different
amounts?
Example 2: Consider the same transaction as in Example 1. What would be
the effect on the return on assets ratio?
Note that the transaction would decrease the numerator Net Income by
$1,000. It would also decrease the ending total assets by $1,000 but have
no effect on beginning total assets. So the denominator, average total
assets, would only decrease by $500:
The ratio was 0.173. It would decrease to 0.171.
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How Transactions Affect Ratios (4 of 5)
What if the numerator or denominator are affected by the same amount?
Example 3: Apple paid $4,000 of accounts payable in cash. What would be
the effect on the current ratio?
The journal entry would be:
Note that the transaction would decrease the numerator, Current Assets, and
the denominator, Current Liabilities, by the same amount. The ratio was 1.38.
It would increase to 1.40.
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How Transactions Affect Ratios (5 of 5)
If a transaction affects the numerator and denominator of the ratio
by the same amount, the effect will depend on whether the original
ratio value was greater or less than 1.00:
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Overview
Key Players in Accounting Communication
Managers, regulators, auditors, information intermediaries
The Disclosure Process
Press Releases, Conference Calls
Financial Statements: Review
Notes on Financial Statements and Voluntary Disclosures
Analyzing Accounting Information: Dupont Analysis
Decomposing and understanding Return-on-Equity and
Return-on-Assets
59