ACCT 2010 - Principles of Accounting I

Chapter five:
Communicating and Analyzing
Accounting Information

Prof. Qingkai(Kai) Dong

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 Learning Objectives
After studying this chapter, you should be able to:
5-1 Recognize the people involved in the accounting communication
process (regulators, managers, directors, auditors, information
intermediaries, and users), their roles in the process, and the
guidance they receive from legal and professional standards.
5-2 Identify the steps in the accounting communication process,
including the issuance of press releases, annual reports, quarterly
reports, and SEC filings, as well as the role of online information
services in this process.
5-3 Recognize and apply the different financial statement and
disclosure formats used by companies in practice and analyze the
gross profit percentage.
5-4 Analyze a company’s performance based on return on assets and its
components and the effects of transactions on financial ratios.

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 Understanding the Business
A QUESTION OF ETHICS

Sarbanes-Oxley Act: Corporate Governance:

A law that strengthens financial Procedures to ensure that the
reporting and corporate company is managed in the
governance for public companies. interests of the shareholders.

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 Learning Objective 5-1
5-1 Recognize the people involved in the accounting
communication process (regulators, managers, directors,
auditors, information intermediaries, and users), their
roles in the process, and the guidance they receive from
legal and professional standards.

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 Exhibit 5.1: Ensuring the Integrity of Financial Information

Access the text alternative for slide images.

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 Regulators (SEC, FASB, PCAOB, Stock Exchanges)

Securities and Exchange Commission

Protects investors and maintains the integrity of the securities
markets.

Financial Accounting Standards Board

Sets generally accepted accounting principles (GAAP).

Public Company Accounting Oversight Board

Sets auditing standards for independent auditors (CPAs) of
public companies.

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 Managers are primarily responsible for the information in the
financial statements and disclosures.

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.

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 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.
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 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 P
CAOB.
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.

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 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.

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 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 (for example, S&P Global Market Intelligence).
• Information on the web ((for example, [Link],
[Link]).
• Example: [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. Example: Twitter influencers
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 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:
Firm Stock Earnings per Share Earnings per Share
Recommendation Forecast for 2021 Forecast for 2022
Credit Suisse Neutral 3.72 4.13
Wells Fargo Overweight 3.98 4.42
RBC Capital Outperform 4.07 4.35
Deutsche Bank Buy 4.01 4.42
Consensus of 38 analysts Buy 3.94 4.28

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 Exhibit 5.2

Yahoo! Finance
Information on
Apple

Access the text alternative for slide images.

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 How Data Analytics Are Affecting What Auditors Do

DATA ANALYTICS

Modern data analytics are changing the world of auditing.

The availability of more data has allowed access to entire
populations of transactions instead of smaller statistical
samples as in the past.

Data Analytics eases identification of trends, patterns, and

outliers, which become the focus for further investigation.

This information helps auditors better anticipate potential areas of

high audit risk

Auditors must understand accounting systems and apply predictive

models and data visualization tools to data!

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 Information Services and Your Job Search

FINANCIAL ANALYSIS
Information services have become the primary tool for
professional analysts, who use them to analyze competing
firms.
Information services are also an important source of
information for job seekers.
The best place to begin learning about potential employers is
to visit their websites.
• Read the material in the employment section and the
investor relations section of the site.

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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.

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 Learning Objective 5-2
5-2 Identify the steps in the accounting communication
process, including the issuance of press releases, annual
reports, quarterly reports, and SEC filings, as well as the
role of online information services in this process.

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 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.
Example: AMD conference call and slides

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 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.

Access the text alternative for slide images.

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 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.
• Example: AMD

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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 (for example, 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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 Learning Objective 5-3
5-3 Recognize and apply the different financial statement and
disclosure formats used by companies in practice and
analyze the gross profit percentage.

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 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.

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 Exhibit 5.4
Balance Sheet of
Apple Inc.

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 Classified Income Statement
Manufacturing and merchandising companies that sell goods
report the subtotal Gross Profit. Gross Profit (also called Gross
Margin) is the difference between net sales and cost of goods
sold.

Operating Income is computed by subtracting operating

expenses from gross profit.
Nonoperating (other) Items are revenues, expenses, gains
and losses that do not relate to the company’s primary
operations. These items are added to or subtracted from
Operating Income to obtain Income before Income Taxes.
Provision for Income Taxes (Income Tax Expense) is subtracted
from Income before Income Taxes to obtain Net Income.
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 Exhibit 5.5: Income Statement of Apple Inc.

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 Earnings per Share

Net Income
Earnings per Share* =
Weighted Average Number of Shares of Common Srock Outstanding

* (1) If there are preferred stock dividends, the amount is subtracted from
net income in the numerator,
(2) the denominator for weighted average shares is a complex
computation, and
(3) outstanding shares are those that are currently held by the
shareholders.

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 Statement of Comprehensive Income
FINANCIAL ANALYSIS

Both the FASB and the IASB require an additional statement entitled the
Statement of Comprehensive Income, which can be presented separately
or in combination with the income statement.

Other Comprehensive Income includes items discussed in more

advanced accounting classes.
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 Gross Profit Percentage
KEY RATIO ANALYSIS
How effective is management in selling goods and services
for more than the costs to purchase or produce them?
Gross Profit*
Gross Profit Percentage=
Net Sales

*Gross Profit = Net Sales − Cost of Sales

Comparisons Over Time Comparison With Competitor

Apple HP
2018 2019 2020 2020
38.3% 37.8% 38.2% 18.4%

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 Exhibit 5.6: Statement of Stockholders’ Equity

APPLE INC.
Consolidated Statements of Shareholders’ Equity(in millions)

Accumulated Total
Common Stock Other Sharehol
and Additional Retained Comprehensive ders’
Paid-In Capital Earnings Income/(Loss) Equity
Balances as of September 28, 2019 $ 45,174 $ 45,898 $ (584) $90,488

Net income – 57,411 – 57,411

Other comprehensive income/(loss) – – 178 178

Dividends and dividend equivalents declared – (14,087) – (14,087)

Stock issued – – 5,605

Stock repurchased – (74,256) – (74,256)

Balances as of September 26, 2020 $ 50,779 $ 14,966 $ (406) $ 65,339

*Apple’s statements have been simplified for purposes of our discussion.

Source: Apple Inc.

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 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.

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 Statement of Cash Flows – Indirect Method

Cash Flows from Operating Activities can be reported

using either:
• The direct method or.
• The indirect method.

The indirect method begins with a reconciliation of net

income on an accrual basis to cash flows from operations.

Net income (loss )

+/ − Adjustments for noncash items
Cash provided by operating activities

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 Exhibit 5.7

Cash Flow
Statement of
Apple

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 Example: AMD

(1) What is the revenue recognition rule?

(2) What is the revenue breakdown by different product

segments?

(3) Is AMD involved in litigation cases?

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 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:

Access the text alternative for slide images.

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 Additional Detail Supporting Reported Numbers

The second category of notes provides supplemental

information concerning the data shown on the financial
statements.

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 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.

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 Voluntary Disclosures
GAAP and SEC regulations set only the minimum level of required
financial disclosures. Many companies provide additional information.

Net sales by product for 2020, 2019, and 2018 were as follows (in millions):

Net sales by product: 2020 2019 2018

iPhone $ 137,781 $ 142,381 $ 164,888
Mac 28,622 25,740 25,198
iPad 23,724 21,280 18,380
Wearables, Home, and Accessories 30,620 24,482 17,381
Services 53,768 46,291 39,748
Total net sales $ 274,515 $ 260,174 $ 265,595

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 Differences in Accounting Methods Acceptable under IFRS and
U.S. GAAP

INTERNATIONAL PERSPECTIVE
Many countries have adopted International Financial Reporting Standards (IFRS)
issued by the International Accounting Standards Board (IASB). IFRS are similar to
U.S. GAAP, but there are several important differences. The FASB and IASB are
working together to eliminate some of these differences.

Difference U.S. GAAP IFRS Chapter

Last-in first-out (LIFO) method for inventory Permitted Prohibited 7
Reversal of inventory write-downs Prohibited Required 7
Basis for property, plant, and equipment Historical cost Fair value or historical cost 8
Development costs Expensed Capitalized 8
Debt to be refinanced Current Noncurrent 9
Recognition of contingent liabilities Probable More likely than not 9
Stockholders’ equity accounts Common stock Share capital 11
Paid-in capital Share premium
Interest received on cash flow statement Operating Operating or investing 12
Interest paid on cash flow statement Operating Operating or financing 12

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 Learning Objective 5-4
5-4 Analyze a company’s performance based on return on
assets and its components and the effects of transactions
on financial ratios.

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 Return on Assets (ROA)
KEY RATIO ANALYSIS
How well has management used the company’s total
investment in assets financed by both debt holders and
stockholders?

Net Income*
Return on Assets =
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

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 Exhibit 5.8: ROA Profit Driver Analysis

Net Profit Total Asset

ROA = ×
Margin Turnover
Net Income Net Income Net Sales
= ×
Average Net Sales Average Total
Total Assets Assets

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 How Transactions Affect Ratios 1

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

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?

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 How Transactions Affect Ratios 2

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:

Debit Credit
Research and development expense (+E, −SE) 1,000
Cash (−A) 1,000

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 How Transactions Affect Ratios 2

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:

Debit Credit
Research and development expense (+E, −SE) 1,000
Cash (−A) 1,000

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.
Net Income ÷ Net Sales = Net Profit Margin
As reported: $ 57,411 $ 274,515 0.209
Transaction effect: (1,000) −
After transaction: $ 56,411 $ 274,515 0.205

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 How Transactions Affect Ratios 3

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:

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 How Transactions Affect Ratios 3

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:

Avg. Total Assets = ($323,888 + $338,516 − $1,000) ÷ 2 = $330,702

The ratio was 0.173. It would decrease to 0.171.

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 How Transactions Affect Ratios 3

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:

Avg. Total Assets = ($323,888 + $338,516 − $1,000) ÷ 2 = $330,702

The ratio was 0.173. It would decrease to 0.171.

Net Income ÷ Avg. Total Assets = Return to Assets

As reported: $ 57,411 $ 330,202 0.173
Transaction effect: (1,000) (500)
After transaction: $ 56,411 $ 330,702 0.171

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 How Transactions Affect Ratios 4

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?

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 How Transactions Affect Ratios 4

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:

Debit Credit
Accounts payable ( −L) 4,000
Cash (−A) 4,000

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 How Transactions Affect Ratios 4

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:

Debit Credit
Accounts payable ( −L) 4,000
Cash (−A) 4,000

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.
Current Assets ÷ Current Liabilities = Current Ratio
As reported: $ 145,450 $ 105,392 1.38
Transaction effect: (4,000) (4000)
After transaction: $ 141,450 $ 101,392 1.40

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 How Transactions Affect Ratios 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:

Ratio Changes Given Same Change in

Numerator and Denominator

Numerator and
Denominator Ratio < 1 Ratio > 1
Increase both Increases Decreases
Decrease both Decreases Increases

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 Thank you!

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