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Reading Financial Statements Course Transcript

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Reading Financial Statements

Hi, and welcome to Module 1 of our course on understanding financial statements.- The purpose of this course is to help you read a company’s annual report, including how to read a set of financial statements.- In this first module we start with the financial statements – specifically the balance sheet and the related notes to the financial statements. 

 In module 2, we take you through the income statement and statement of cash flows, and conclude by covering the key contents of an annual report.- We use Microsoft’s 2010 annual report and financial statements to demonstrate the key concepts.- This course assumes that you have a general understanding of the basic components that make up the three key financial statements. – We cover these in our Accounting Fundamentals course, which we consider the precursor to this course.- Now let’s get started.

Intro- Let’s start with a general overview of the three key financial statements, namely the balance sheet, also known as the statement of financial position; the income statement, also known as the statement of operations or the profit and loss statement; and finally, the statement of cash flows.- Let’s look at each of them individually, as a refresher for what each is used for.-

Bbalance sheet- The balance sheet, or statement of financial position, represents a snapshot of the financial position of the company at a point in time.- It contains the assets, liabilities and equity of a company.- The balance sheet is an important component in determining the financial strength of a company.-

Income statement- The income statement, also called the profit and loss statement, or the statement of operations, contains the transactions of a company for a period of time.- The income statement starts at a zero balance at the beginning of a fiscal year, and records all of the transactions affecting revenues and expenses throughout the year. – At the end of any period, it shows the amount of revenue earned, expenses incurred and the net profit after amortization, interest and taxes are factored in.- Therefore, the importance of the income statement is in showing the profitability of the company.-

Statement of cash flows- The statement of cash flows acts as a kind of bank statement for a company.- It shows the opening cash balance of the company, and then lists all of the transactions affecting cash, to arrive at the closing cash balance.- The closing cash balance will match the balance reflected on the balance sheet.- The difference between the bank statement and the statement of cash flows is that the cash transactions are sorted by activity type.- On the statement, cash flows are sorted by operating activities, investing activities and financing activities. – The statement of cash flows therefore is a very useful financial statement to understand where cash is being generated and where it is being used in the business.-

Simplified balance sheet- It’s time to start exploring the balance sheet in more detail.- Here is a simplified balance sheet that contains the most commonly used accounts.- The balance sheet is presented in a horizontal format, with the assets on one side and the balancing liabilities and equity showing on the other side. – It is also commonly presented in a vertical format- The balance sheet represents the financial position or strength of the company.- You can see that based on the total assets versus total liabilities, this company appears to be financially stable.- One item to explore further is the separation of assets and liabilities into current and non-current items and the equity components –

Current vs non-current- – The non-current assets represent property, plant & equipment as well as some intangible assets which may be copyrights to the product that they manufacture.- The non-current liabilities are made up of one item – a long term bank loan that was likely used to purchase the property, plant and equipment.- Finally, the equity is made up of common shares along with retained earnings. – Some general questions you might want to consider would be why the company has so much cash on hand, while carrying a $200,000 loan.- Further, the $1,000 retained earnings indicates that the company may only be minimally profitable.

Pop quiz Current vs non-current quiz

Demonstration: Microsoft balance sheet- Let’s look at Microsoft’s balance sheet, as an example of what a typical reporting company will include for its assets, liabilities and equity.- There are a few key items to note when you first look at the balance sheet.- First, Microsoft’s statements are in millions of dollars. By reducing the numbers in this manner, the statements are a lot more readable. The statement will always have a notation, if the numbers are not reported as whole dollars. – Also, you will see that both 2010 and 2009 accounts are reported. This is to provide the reader of the financial statement comparative results.- You can compare this year to last year to see how the balances have changed.- Finally, if you look at the bottom of the page, you will see the sentence “See accompanying notes”. This is stated because the balance sheet on its own doesn’t provide enough detail to allow a reader to understand what the company really owns and what it owes.- We’ll get to the financial statement notes a little later.- For now, let’s spend some time focusing on the accounts making up the balance sheet.- A lot of the balance sheet accounts should look familiar to you. For example, cash, accounts receivable, inventories, property plant and equipment, accounts payable, debt, common stock, and retained earnings, or for Microsoft, retained deficit indicating that they have been accumulating losses for a period of time.- There are likely several balance sheet accounts that are unfamiliar to you. Let’s take some time to explore those items in more detail.

Investments- Often times a company will hold investments for two reasons.- if it has excess cash that it doesn’t have a use for within the very near term, or if it is accumulating it to make a large purchase then it may make external investments.- In this case, investments will either be short term, where the investment will be held for less than a year, or long term where they will be held for more than a year.- The company may also make internal investments, for example in a joint venture or a subsidiary company.

Deferred income taxes- Deferred income taxes are an item you will often see in financial statements. – For Microsoft, you will see that they actually appear in several places on the balance sheet. They are found in the current and non-current asset sections, as well as in the non-current liabilities section.- But what exactly are deferred taxes?- The easiest way to explain them is related to tax rules versus accounting rules.- When a company prepares an income tax return they use tax rules. These are not always the same as the accounting rules. – For example, certain amounts that are allowed as deductions to calculate accounting income are not allowed to calculate taxable income in the same way. Therefore, the amount of tax owing will be higher than if accounting income was used.- If the deduction is never allowed for tax purposes, then a permanent difference occurs and no further work is required.- However, if the deduction will be allowed in the future, then this is a timing difference and therefore recorded in the accounts.- For example, depreciation or amortization on a piece of equipment might be calculated using the straight-line method for accounting purposes. However, for tax purposes, an accelerated method is used. Therefore, the amount of taxes owing will be different until the equipment is fully depreciated. – The reverse holds true for amounts allowed for tax purposes but not accounting purposes. For example, tax losses where the loss has a future benefit from a tax perspective, but none from an accounting perspective.

Deferred income taxes – The difference between accounting income and taxable income is the basis for deferred income taxes, or future income taxes, and is recorded on the balance sheet.- If there is less tax payable in the future it is an asset. – If there will be more tax payable in the future it is a liability.- Accounting rules don’t allow the two amounts to be netted against each other. Therefore, if a company has timing differences going both ways, then both an asset and a liability will be recorded, much like we see for Microsoft.

Goodwill- Goodwill is another account seen in many financial statements.- If a company is purchased for more than the fair value of its assets less liabilities, also known as net assets, then the difference between the purchase price and the fair value is recorded as goodwill.- It’s considered an asset because the reason for paying more for a company’s physical assets is because of the intangible value of the company.- Things like brand, customers, intellectual capital are factored in.- These factors are considered to be benefits that will last longer than one year and hence why goodwill is recorded as non-current.- The value of goodwill is measured each year to determine if it is still appropriate. If not, it is written down to the amount considered to be a fair value.

Intangible assets- Similar to goodwill, intangible assets are items of value that are used to generate revenue and have no physical substance. – Examples would be the Coca Cola trademark design or the Nike swoosh. These trademarks have a value to the organization, they are owned, and cannot be used by others, and they enhance the earning potential of the organization. – A patent to produce an innovative product had a cost to develop and apply for, and will result in future earnings, so those costs are considered the cost to develop or “purchase” the intangible asset.- Intangible assets appear on the balance sheet in the non current section. – Intangible assets are amortized much like physical assets are.

Unearned revenue- Unearned revenue arises when a company sells something it has not yet delivered. – In Microsoft’s case it is for a software licences and subscriptions over a period of time. – As the period expires a portion of the subscription amount is included in income. The balance is shown as a liability.

Commitments- Commitments are future obligations that a company has agreed to. – They are future liabilities for the company and are therefore disclosed in the financial statements so a reader is informed of the liability.

Contingencies- Contingencies are things that may or may not happen, depending on certain circumstances. – Readers of financial statements would want to know if there was likely to be a circumstance that could result in the company being liable. – When it is likely a loss will be suffered in the future, and the amount can be reasonably estimated, then the contingent liability must be recorded on the balance sheet. – An example of a contingency would be a lawsuit that has been taken against a company. – If the company believes it will be unsuccessful and can estimate the amount it will have to pay, then it would set the amount up as a liability.

Share equity intro- Under the shareholders’, or stockholders’, equity section of the balance sheet are where the shares of the company can be found.

Common shares- Equity is almost always made up of common shares, also known as common stock.- Common shares allow for participation in the profits of the company, after all debtors and preferred shareholders are paid. The participation normally comes in the form of a dividend.- Common shares also allow for voting rights in a company. Common shareholders are usually allowed to cast one vote for every share held.- Finally, if a company were to be dissolved, any residual amount after everyone else is paid would go to the common shareholders.

Preferred shares- Equity may include preferred shares.- Preferred shares, or preferred stock, are different than common shares in the way that shareholders participate.- Usually preferred shares offer a fixed dividend, however the dividend may not be paid annually. – Preferred share dividends will accumulate and be paid before common share dividends are paid.

Authorized vs outstanding- A balance sheet normally indicates shares authorized and those outstanding, but what is the difference?- Authorized shares are the total number of shares that a company has to sell.- Outstanding shares are the total number of shares that the company has sold.- The balance sheet may also show outstanding shares as issued or paid up shares. –

Contributed surplus- One final item that may appear in the equity section of a company’s balance sheet is contributed surplus.- A company may issue shares with a par value. Par value is simply the face value of the share on issuance.- Where a company receives more for the share than its par, or face, value, then the excess amount is referred to as contributed surplus.- Let’s look at a simple example.- If a company were to issue 180,000 shares for 40 cents each, and shares have a par value of 25 cents, how would this be shown on their balance sheet?- There would be two lines. – The first would be the paid up, or paid in, share capital of 180,000 multiplied by the 25 cent face value for a total amount of $45,000.- The second would be contributed surplus for the difference of 15 cents multiplied by the 180,000 shares for a total of $27,000.

Other comprehensive income- Other comprehensive income, or OCI, represents certain gains and losses that a company may have that are not otherwise recorded through the income statement. Instead, they go directly to retained earnings.- Examples of typical items within OCI include unrealized gains and losses on investments and hedging instruments. – OCI is recorded in the equity side of the balance sheet.

Exercise- Now that you’ve spent some time learning what the items are on a balance sheet, it’s time to put that learning into action.- Click on the link entitled “Balance sheet component matching exercise”.- Once you’ve worked through the questions, click on the “Balance sheet matching solution” to see how you did.- Good luck!

Statement of shareholders’ equity- Sometimes a statement of shareholders’ equity will show at the bottom of a company’s balance sheet.- Other times, it will show as a separate financial statement.- The statement of shareholders’ equity is made up of all of the equity transactions for the year.- It is usually broken into components. – One component shows all of the share or stock transactions that occurred during the year. – The other component is related to retained earnings and all of the transactions affecting it for the year.- The statement starts with the opening balance of each component, shows the activity for each, and then ends with the components’ closing balances.

Full disclosure- A critical part of reading a set of financial statements relate to the notes that accompany them.- Take for example Microsoft’s balance sheet. Without the notes to the financial statements, do you know how inventory is recorded, what is included in deferred income taxes or what commitments the company has made?- The actual financial statements themselves only tell part of the story.- In order to provide full disclosure, notes are provided to allow the reader of the financial statement to understand and make judgements of the financial activities of the company.

Intro – Types of financial statement notes- There are three types of notes to the financial statements-

Significant accounting policies – Perhaps the most important financial statement note is the first one that is presented, the significant accounting policies note.- This note presents important information such as which accounting standards the company follows, how inventory and investments are valued, what type of financial instruments the company has, revenue is recognized, property, plant & equipment is amortized, and any other significant policies that would help the reader to understand the statements.

Direct information- There are several notes to the financial statements that relate directly to the accounts shown on the financial statements.- Examples of these notes include a breakdown of the types of investments , debt and financial instruments, what is included in inventory, property, plant & equipment, intangible assets, income taxes and other key information to help a reader understand what makes up the numbers in much more detail.

Indirect information- The financial statements on their own do not provide the entire financial picture of an organization.- Because of this, there are notes to the financial statements included that are not related to any of the numbers on the statements.- These notes contain information such as any commitments, contingencies where there is a potential gain or a loss isn’t able to be estimated, and details related to stock-based compensation plans.

Exercise- Now that we’ve covered what types of notes are included as part of a complete set of financial statements, it’s your turn to put words into action.- Click on the link entitled “Noteworthy”- There are a series of questions to answer that will require you to read Microsoft’s 2010 financial statements including the accompanying notes. – Microsoft’s information is included as an attachment.- Once you’ve read through Microsoft’s information and answered the related questions, see how you did using the “Noteworthy solution”.- Have fun!-

Conclusion- That concludes this first module of understanding financial statements.- The balance sheet contains a lot of important information to help understand the financial strength of a company.- However, it is clear that the balance sheet alone only tells part of the story.- The notes to the financial statements are needed to help fill out the rest of the story and provide the reader of the financial statements all of the information needed in order to make judgments and decisions regarding the company.- I hope you join us for Module 2 where we discuss the other two primary financial statements as well as provide a general overview of all of the contents of a company’s annual report.

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