AC 755 BU Accounting Primerica Incs Financial Performance Report

preparing a document and  present for  financial information, analysis, and recommendations to senior management. for Primerica Inc.

This  report must include the following components:

Executive Summary.  Although this should be the first section of the report,  write it last since you will be summarizing the content of  paper in the summary.

Financial overview

Competitor analysis

Financial analysis

Recommendations/Suggestions

References (If you use any outside sources (i.e. competitor analysis), must properly cited the sources.)

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Primerica Inc (NYS: PRI)
Exchange rate used is that of the Year End reported date
As Reported Annual Balance Sheet
Report Date
Currency
Audit Status
Consolidated
Scale
Fixed-maturity securities available-for-sale, at fair value
Fixed-maturity security held-to-maturity, at amortized cost
Short-term investments available-for-sale, at fair value
Equity securities, at fair value
Trading securities, at fair value
Policy loans & other invested assets
Policy loans
Total investments
Cash & cash equivalents
Accrued investment income
Reinsurance recoverables
Deferred policy acquisition costs, net
Renewal commissions receivable
Agent balances, due premiums & other receivables
Goodwill
Intangible assets, net
Income tax receivable
Deferred income taxes
Operating lease right-of-use assets
Other assets
Separate account assets
Total assets
Future policy benefits
Unearned & advance premiums
Policy claims & other benefits payable
Other policyholders’ funds
Notes payable – short term
Notes payable – long term
Surplus note
Income tax payable
Deferred income taxes
Operating lease liabilities
Other liabilities
Payable under securities lending
Separate account liabilities
Total liabilities
Redeemable noncontrolling interests in consolidated entities
Common stock
12/31/2022
USD
Not Qualified
12/31/2021
USD
Not Qualified
Yes
Thousands
2495456
1444920
69406
35404
3698
48713
4097597
489240
20885
4015909
3081886
200043
254276
127707
185525
101333
40500
428259
2305717
15348877
7390800
15422
538250
483769
592905
1444469
36876
91457
45995
580780
100938
2305717
13627378
368
Yes
Thousands
2702567
1379100
85243
42551
24355
30612
4264428
392501
18702
4268419
2943782
231751
257675
179154
195825
81799
47942
441253
2799992
16123223
7138649
16437
585382
501823
15000
592102
1378585
15311
226000
53920
615710
94529
2799992
14033440
7271
394
Paid-in capital
5224
Retained earnings (deficit)
1973403
2004506
Accumulated other comprehensive income (loss), net of income tax – unrealized
-11404
foreign currency translation
8611 gains (losses)
Accumulated other comprehensive income (loss), net of income tax –240868
net unrealized investment gains63777
(losses) on available-for-s
Net unrealized investment gains (losses) not other-than-temporarily impairedNet unrealized investment gains (losses) other-than-temporarily impaired Total permanent stockholders’ equity (deficit)
1721499
2082512
As Reported Annual Income Statement
Report Date
Currency
Audit Status
12/31/2022
USD
Not Qualified
12/31/2021
USD
Not Qualified
Consolidated
Yes
Scale
Thousands
Direct premiums
3230120
Ceded premiums
-1629892
Net premiums
1600228
Commissions & fees
944676
Fixed-maturity securities (available-for-sale)
90975
Fixed-maturity security (held-to-maturity)
63922
Equity securities
1509
Policy loans & other invested assets
1046
Cash, cash equivalents & short-term investments
5943
Total return on deposit asset underlying 10% coinsurance agreement
-65
Gross investment income
163330
Investment expenses
-6343
Investment income net of investment expenses
156987
Interest expense on surplus note
-63922
Net investment income
93065
Realized investment gains (losses)
1444
Other investment gains (losses)
-2439
Investment gains (losses)
-995
Other revenues, net
83159
Total revenues
2720133
Benefits & claims
665749
Amortization of deferred policy acquisition costs
356143
Sales commissions
462764
Insurance expenses
235405
Insurance commissions
30261
Contract acquisition costs
68431
Interest expense
27237
Goodwill impairment loss
60000
Loss on extinguishment of debt
Other operating expenses
320394
Total benefits & expenses
2226384
Income before income taxes – domestic
394773
Income before income taxes – foreign
98976
Income before income taxes
493749
Current federal income tax expense (benefit)
149034
Current foreign income tax expense (benefit)
51692
Current state & local income tax expense (benefit)
5029
Total current income tax expense (benefit)
205755
Deferred federal income taxes (benefit)
-49683
Deferred foreign income taxes (benefit)
-27163
Yes
Thousands
3122148
-1616264
1505884
1042813
80362
62207
1632
1019
456
1875
147551
-4756
142795
-62207
80588
4665
1207
5872
74575
2709732
722753
251179
522308
202605
34532
52788
30618
76000
8927
296851
2198561
399149
112022
511171
115657
43687
5440
164784
-10589
-13890
Deferred state & local income taxes (benefit)
Total deferred income tax expense (benefit)
Income taxes
Net income (loss)
Net income (loss) attributable to noncontrolling interests
Net income (loss) attributable to Primerica, Inc.
Income attributable to unvested participating securities
Net income to common
Weighted average shares outstanding-basic
Weighted average shares outstanding-diluted
Year end shares outstanding
Net earnings (loss) per share – basic
Net earnings (loss) per share – diluted
Dividends per common share
Number of full time employees
Number of part time employees
Number of common stockholders
Foreign currency translation adjustments
-3134
-79980
125775
367974
5038
373012
1684
371328
37997
38106
36824
9.77
9.74
2.2
2646
162
-20015
-1114
-25593
139191
371980
1377
373357
1533
371824
39530
39652
39368
9.41
9.38
1.88
2891
552
154
7033
12/31/2022
USD
Not Qualified
12/31/2021
USD
Not Qualified
Consolidated
Yes
Scale
Thousands
Previous retained earnings (accumulated deficit)
2004506
Cumulative effect from the adoption of new accounting standards, net
Dividends
83783
Repurchases of common stock
320332
Retained earnings (accumulated deficit)
1973403
Yes
Thousands
1705786
74637
2004506
As Reported Annual Retained Earnings
Report Date
Currency
Audit Status
As Reported Annual Cash Flow
Report Date
Currency
Audit Status
Consolidated
Scale
Net income (loss)
Change in future policy benefits & other policy liabilities
Deferral of policy acquisition costs
Amortization of deferred policy acquisition costs
Deferred tax provision
Income taxes
Investment losses (gains)
Accretion & amortization of investments
Depreciation & amortization
Reinsurance recoverables
Agent balances, due premiums & other receivables
Renewal commissions receivable
Trading securities sold, matured, or called (acquired), net
Share-based compensation
Goodwill impairment loss
Loss on extinguishment of debt
12/31/2022
USD
Not Qualified
12/31/2021
USD
Not Qualified
Yes
Thousands
367974
225896
-503336
356143
-79980
26414
995
3329
34174
231902
-475
19845
19962
22361
60000
–
Yes
Thousands
371980
462733
-552192
251179
-25593
1426
-5872
5118
29836
8312
6046
-23459
-8817
16842
76000
8927
Other operating assets & liabilities, net
-27539
34490
Net cash flows from operating activities
757665
656956
Available-for sale investments sold, matured or called – fixed-maturity securities
23628 – sold
131953
Available-for sale investments sold, matured or called – fixed-maturity 359717
securities – matured or called 454135
Available-for-sale investments sold, matured or called – short-term investments
28251 – sold
50065
Available-for-sale investments sold, matured or called – short-term investments
85302 – matured or called 40000
Equity securities – sold
16
718
Equity securities – matured or called
3063
Available-for-sale investments acquired – fixed-maturity securities
-580485
-901591
Available-for-sale investments acquired – short-term investments
-97415
-176125
Equity securities – acquired
-187
-3391
Purchases of property & equipment & other investing activities, net -25805
-24688
Cash collateral received (returned) on loaned securities, net
6409
22375
Sales (purchases) of short-term investments using securities lending collateral,
-6409 net
-22375
Purchase of business, net of cash acquired
3867
-494459
Net cash flows from investing activities
-200048
-923383
Dividends paid
-83783
-74636
Common stock repurchased
-356306
-18751
Proceeds from revolving credit facility
125000
Repayment of revolving credit facility
-125000
Proceeds from issuance of debt
597300
Debt issuance costs
-5332
Repayment of debt
-383691
Payment on note issued to seller of business
-12364
Tax withholdings on share-based compensation
-5135
-6652
Finance leases
-262
-264
Net cash flows from financing activities
-457850
107974
Effect of foreign exchange rate changes on cash
-3028
3385
Change in cash & cash equivalents
96739
-155068
Cash & cash equivalents, beginning of period
392501
547569
Cash & cash equivalents, end of period
489240
392501
Income taxes paid
178218
154812
Interest paid
27060
33905
12/31/2020
USD
Not Qualified
12/31/2019
USD
Not Qualified
Yes
Thousands
2464611
1346350
38023
16300
30199
3895483
547569
17618
4273904
2629644
259448
45275
4035
69255
46567
456967
2659520
14905285
6790557
17136
519711
447765
374415
1345772
21048
202448
52806
566068
72154
2659520
13069400
393
Yes
Thousands
2356996
1184370
40684
43233
32927
3658210
256876
17361
4169823
2325750
227100
45275
1020
69472
47265
384634
2485745
13688531
6446569
15470
339954
388663
374037
1183728
20224
188997
53487
510443
28723
2485745
12036040
412
12/31/2018
USD
Not
Available
Yes
Thousands
2069635
970390
8171
37679
13610
31501
3130986
262138
17057
4141569
2133920
265258
48111
59336
341172
2195501
12595048
6168157
15587
313862
370644
373661
969685
22699
164405
486772
52562
2195501
11133535
427
1705786
1578
128128
1835885
1593281
-5765
64595
-32
1652491
1489520
-21064
-7253
-117
1461513
12/31/2020
USD
Not Qualified
12/31/2019
USD
Not Qualified
Yes
Thousands
2907149
-1580766
1326383
751271
82805
57473
1751
1244
1202
4253
148728
-7441
141287
-57473
83814
-4996
61069
2217541
615569
224321
376636
188117
32134
28839
245195
1710811
506730
88837
26749
4714
120300
853
-547
Yes
Thousands
2753866
-1569729
1184137
713804
81828
48325
1845
1069
4758
13429
151254
-8856
142398
-48325
94073
4965
55525
2052504
493820
254552
357198
178817
25051
28811
237144
1575393
477111
76289
32239
3033
111561
6628
-7469
12/31/2018
USD
Not
Available
Yes
Thousands
2667104
-1581164
1085940
677607
79356
37485
1955
1670
2922
3643
127031
-8116
118915
-37485
81430
-2121
56987
1899843
457583
239730
335384
168156
24490
28809
229607
1483759
416084
50691
36028
2681
89400
17399
-14809
-40
266
120566
386164
1671
384493
40065
40185
39306
9.6
9.57
2230
594
140
7343
-841
110720
366391
1654
364737
42181
42314
41207
8.65
8.62
2201
602
137
15299
2590
91990
324094
1893
322201
43854
43985
42694
7.35
7.33
2166
533
115
-25059
12/31/2020
USD
Not Qualified
12/31/2019
USD
Not Qualified
Yes
Thousands
1593281
-1240
64346
208073
1705786
Yes
Thousands
1489520
57630
205000
1593281
12/31/2018
USD
Not
Available
Yes
Thousands
1375090
24610
44140
190134
1489520
12/31/2020
USD
Not Qualified
12/31/2019
USD
Not Qualified
Yes
Thousands
386164
574060
-512634
224321
266
-5008
4996
751
17697
-100185
-32348
26694
19027
–
Yes
Thousands
366391
297832
-424106
254552
-841
-5187
-4965
-720
18300
-12825
-11965
-29601
17533
–
12/31/2018
USD
Not
Available
Yes
Thousands
324094
266513
-432390
239730
2590
2365
2121
-1894
12417
37261
16291
-8808
17251
–
39616
643417
67760
429147
2581
-522123
-3272
-27622
43431
-43431
-53529
-64346
-231431
-5739
-274
-301790
2595
290693
256876
547569
123305
27853
21115
485513
42202
403969
8250
3136
-633106
-898
-25437
-23839
23839
-201884
-57630
-225037
-7186
-281
-290134
1243
-5262
262138
256876
115051
28053
526
478067
51726
362413
2093
-626826
-8169
-521
-13517
-37224
37224
-232801
-44140
-210146
-6711
-260997
-2093
-17824
279962
262138
88348
27899
UNDERSTANDING
FINANCIAL
STATEMENTS
global EDITION
e l e v en T H E D I T I O N
Lyn M. Fraser
Aileen Ormiston
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Haskins
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Team Lead, Program Management: Ashley Santora
Program Manager: Mary Kate Murray
Team Lead, Project Management: Jeff Holcomb
Associate Acquisitions Editor, Global Edition:
Suchismita Ukil
Associate Project Editor, Global Edition:
Amrita Kar
Project Manager, Global Edition: Sudipto Roy
Manager, Media Production, Global Edition:
Vikram Kumar
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Global Edition: Trudy Kimber
Operations Specialist: Carol Melville
Creative Director: Blair Brown
Art Director: Jon Boylan
Vice President, Director of Digital Strategy and
Assessment: Paul Gentile
Manager of Learning Applications: Paul
DeLuca
Director, Digital Studio: Sacha Laustsen
Digital Studio Manager: Diane Lombardo
Digital Studio Project Manager: James Bateman
Digital Content Team Lead: Noel Lotz
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Full-Service Project Management, Composition,
and Interior Design: SPi Global
Cover Designer: Lumina Datamatics, Inc.
Cover Art: © Sukpaiboonwat/Shutterstock
Printer/Binder: RR Donnelley Westford, USA
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Pearson Education Limited
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and Associated Companies throughout the world
Visit us on the World Wide Web at:
www.pearsonglobaleditions.com
© Pearson Education Limited 2016
The rights of Lyn M. Fraser and Aileen M. Ormiston to be identified as the authors of this work have been
asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
Authorized adaptation from the United States edition, entitled Understanding Financial Statements, 11th edition,
ISBN 9780-133-87403-7, by Lyn M. Fraser and Aileen M. Ormiston, published by Pearson Education © 2016.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without
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United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London
EC 1N 8TS.
All trademarks used herein are the property of their respective owners. The use of any trademark in this
text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does
the use of such trademarks imply any affiliation with or endorsement of this book by such owners.
ISBN-10: 1-292-10155-5
ISBN-13: 978-1-292-10155-2
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
10 9 8 7 6 5 4 3 2 1
Typeset by SPi Global
Printed and bound by RR Donnelley Westford in the United States of America
For Eleanor
—Lyn M. Fraser
For Katelyn
—Aileen Ormiston
This page intentionally left blank
C o ntent s
Preface to the Eleventh Edition  10
Organization of the Eleventh Edition  11
Uses for the Eleventh Edition  13
Acknowledgments  14
About the Authors  16
CHAPTER 1 Financial Statements: An Overview   17
Map or Maze   17
Usefulness  20
Volume of Information   20
Global Economy  23
Where to Find a Company’s Financial Statements   24
The Financial Statements   24
Notes to the Financial Statements   24
Auditor’s Report  26
Financial Reporting Reforms   27
Management Discussion and Analysis   28
Five-Year Summary of Selected Financial Data and Market Data   30
Pandora (a.k.a. “PR Fluff”)   30
Proxy Statement  31
Missing and Hard-to-Find Information   31
Characteristics, Assumptions, Principles and Basis of Accounting   32
Complexities and the Quality of Financial Reporting   33
Accounting Choices  33
Timing of Revenue and Expense Recognition   34
Discretionary Items  35
The Journey Through the Maze Continues   35
Appendix 1A
Sage Inc.  36
Self-Test  48
Study Questions and Problems   51
Case 1.1 Intel Case   52
Case 1.2 Applied Materials Comprehensive Analysis Case Using the
Financial Statement Analysis Template   53
Case 1.3 Mattel Inc.   54
Case 1.4 Biolase, Inc.   55
5
6  Contents
CHAPTER 2 The Balance Sheet  63
Financial Condition  64
Consolidation  64
Balance Sheet Date   64
Comparative Data  66
Balance Sheet Format   66
Common-Size Balance Sheet   66
Assets  67
Current Assets  67
Cash and Cash Equivalents   69
Marketable Securities  69
Accounts Receivable  69
Inventories  72
Inventory Accounting Methods   73
Prepaid Expenses  76
Property, Plant, and Equipment   76
Straight line  77
Accelerated  77
Goodwill  79
Other Assets  79
Liabilities  80
Current Liabilities  80
Accounts Payable  80
Short-Term Debt  81
Current Maturities of Long-Term Debt   81
Accrued Liabilities  81
Unearned Revenue or Deferred Credits   82
Deferred Federal Income Taxes   83
Long-Term Debt  86
Capital Lease Obligations   86
Pensions and Postretirement Benefits   87
Commitments and Contingencies   88
Stockholders’ Equity  88
Common Stock  89
Additional Paid-In Capital   89
Retained Earnings  90
Other Equity Accounts   90
Quality of Financial Reporting—The Balance Sheet   91
Other Balance Sheet Items   92
Self-Test  92
Study Questions and Problems   97
Case 2.1 Intel Case   102
Case 2.2 Applied Materials Comprehensive Analysis Case Using the
Financial Statement Analysis Template   103
Contents  7
Case 2.3 Walgreen Co. and Subsidiaries   104
Case 2.4 Hydrogenics Corporation   108
CHAPTER 3
Income Statement and Statement of Stockholders’
Equity  119
The Income Statement   120
Common-Size Income Statement   122
Net Sales  122
Cost of Goods Sold   124
Gross Profit  124
Operating Expense  127
Operating Profit  130
Other Income (Expense)   130
Equity Earnings  131
Earnings Before Income Taxes/Effective Tax Rate   132
Special Items  133
Net Earnings  134
Earnings per Common Share   134
Comprehensive Income  134
The Statement of Stockholders’ Equity   136
Earnings Quality, Cash Flow, and Segmental Accounting   137
Appendix 3A
A Guide to Earnings Quality   139
Self-Test  157
Study Questions and Problems   161
Case 3.1 Intel Case   164
Case 3.2 Applied Materials Comprehensive Analysis Case Using the
Financial Statement Analysis Template   165
Case 3.3 Logitech International S.A.   166
Case 3.4 Hydrogenics Corporation   170
CHAPTER 4 Statement of Cash Flows   177
Why Cash Flow is Important: An Example   178
Statement of Cash Flows: Basic Principle   179
Preparing a Statement of Cash Flows   181
Calculating Cash Flow from Operating Activities   186
Indirect Method  186
Cash Flow from Investing Activities   189
Cash Flow from Financing Activities   189
Change in Cash   190
Analyzing the Statement of Cash Flows   191
Cash Flow from Operations   191
Nocash Corporation  192
8  Contents
Sage Inc.: Analysis of the Statement of Cash Flows   194
Sage Inc. Analysis: Cash Flow from Operating Activities   194
Summary Analysis of the Statement of Cash Flows   195
Analysis of Cash Inflows   196
Analysis of Cash Outflows   197
Qualitative Issues Relating to the Statement of Cash Flows   198
Are We There Yet?   199
Appendix 4A
Statement of Cash Flows—Direct Method   200
Self-Test  204
Study Questions and Problems   207
Case 4.1 Intel Case   214
Case 4.2 Applied Materials Comprehensive Analysis Case Using the
Financial Statement Analysis Template   215
Case 4.3 Avnet Inc.   216
Case 4.4 Hydrogenics Corporation   218
CHAPTER 5 The Analysis of Financial Statements   220
Objectives of Analysis  221
Sources of Information   222
Proxy Statement  222
Auditor’s Report  222
Management Discussion and Analysis   223
Supplementary Schedules  223
Form 10-K and Form 10-Q   223
Other Sources  223
Tools and Techniques   225
Common-Size Financial Statements   226
Key Financial Ratios   226
Liquidity Ratios: Short-Term Solvency   227
Cash Conversion Cycle or Net Trade Cycle   232
Activity Ratios: Asset Liquidity, Asset Management Efficiency   232
Leverage Ratios: Debt Financing and Coverage   234
Profitability Ratios: Overall Efficiency and Performance   237
Market Ratios  239
Analyzing the Data   241
Background: Economy, Industry, and Firm   242
Short-Term Liquidity  243
Operating Efficiency  245
Capital Structure and Long-Term Solvency   245
Profitability  249
Relating the Ratios—The Du Pont System   250
Projections and Pro Forma Statements   252
Summary of Analysis   252
Financial Statements: A Map   253
Contents  9
Appendix 5A
The Analysis of Segmental Data   255
Self-Test  260
Study Questions and Problems   266
Case 5.1 Intel Case   272
Case 5.2 Applied Materials Comprehensive Analysis Case Using the Financial
Statement Analysis Template  273
Case 5.3 Facebook, Inc.   274
Case 5.4 Hydrogenics Corporation   284
Appendixes
A Summary of Financial Ratios   285
B Solutions to Self-Tests  288
C Glossary  290
Index  299
P r e f a ce t o the E l e v enth E diti o n
Major changes have been incorporated into this eleventh edition of Understanding
Financial Statements in order to continue improving the usefulness of the text for professors, students, and readers of the material. We have made many of the revisions in
response to specific requests and comments from users of the text.
New to this Edition
• Learning objectives have been added to all chapters.
• Chapter 1 now includes a section on the characteristics, assumptions, principles
and basis of accounting.
• Chapter 2 has an expanded section on types of long-term debt.
• Four new cases have been added to each chapter; spoiler alert: look for
­Facebook in Chapter 5.
• International accounting rules (IFRS) are discussed in relation to relevant topics in
each chapter, and Chapters 2–5 include a comprehensive case of an international
firm (Hydrogenics, a Canadian company).
• The test bank has been completely revised, and problems with solutions have
been added to the website.
As always, our intent is to present the material in a way that helps readers make practical sense of complex financial information, leading to intelligent (and profitable!)
decision-making.
Our preface to previous editions has
included an update on our children, all
of whom are now grown-up and leading
interesting lives of their own, so our feature this year is of the new member of the
team, Aileen’s granddaughter, Katelyn.
While our children have all supported
this work through its various iterations,
Katelyn has responded to Understanding
Financial Statements in a unique manner
that should ­certainly encourage interest
in our book.
Lyn M. Fraser
10
O r g a ni z a ti o n o f the E l e v enth E diti o n
Chapter 1 provides an overview of financial statements and presents approaches
to overcoming some of the challenges, obstacles, and blind alleys that may
confront the user of financial statements: (1) the volume of information, with
examples of specific problems encountered in such areas as the auditor’s report
and the management discussion and analysis section as well as material that is
sometimes provided by management but is not useful for the analyst; (2) the
complexity of the accounting rules that underlie the preparation and presentation of financial statements; (3) the variations in quality of financial reporting,
including management discretion in some important areas that affect analysis;
and (4) the importance of financial information that is omitted or difficult to find
in conventional financial statement presentations.
Chapters 2, 3, 4, and 5 describe and analyze financial statements for a mythical but potentially real company, Sage Inc., which sells recreational products
through retail outlets in the southwestern United States. The specifics of this particular firm should be helpful in illustrating how financial statement analysis can
provide insight into a firm’s strengths and weaknesses. But the principles and
concepts covered throughout the book apply to any set of published financial
statements (other than for specialized industries, such as financial institutions
and public utilities).
Because one company cannot provide every account and problem the user
will encounter in financial statements, additional company examples are introduced throughout the text where needed to illustrate important accounting and
analytical issues.
Chapters 2 through 4 discuss in detail a basic set of financial statements: the
balance sheet in Chapter 2, the income (earnings) statement and statement of
stockholders’ equity in Chapter 3, and the statement of cash flows in Chapter 4.
The emphasis in each of these chapters is on what the financial statements convey about the condition and performance of a business firm as well as how the
numbers have been derived. Appendix 3A discusses and illustrates issues that
relate to the quality of earnings—and thus the usefulness—of financial reporting. The chapter contains a step-by-step checklist of key items to help the analyst
assess the quality of reporting, and real-company examples of each step are
provided.
With this material as background, Chapter 5 covers the interpretation and
analysis of the financial statements discussed in Chapters 2 through 4. This process involves the calculation and interpretation of financial ratios, an examination
of trends over time, a comparison of the firm’s condition and performance with
its competitors, and an assessment of the future potential of the company based
on its historical record. Chapter 5 also reviews additional sources of information
that can enhance the analytical process. Appendix 5A shows how to evaluate the
11
12  Organization of the Eleventh Edition
segmental accounting data reported by diversified companies that operate in several
unrelated lines of business.
Self-tests at the ends of Chapters 1 through 5 provide an opportunity for the
reader to assess comprehension (or its absence) of major topics; solutions to the selftests are given in Appendix B. For more extensive student assignments, study questions and problems are placed at the end of the chapters. Cases drawn from actual
company annual reports are used to highlight in a case-problem format many of the
key issues discussed in the chapters.
Appendix A covers the computation and definition of the key financial ratios that
are used in Chapter 5 to evaluate financial statements.
Appendix B contains solutions to self-tests for Chapters 1 through 5.
Appendix C presents a glossary of the key terms used throughout the book.
The ultimate goal of this book is to improve the reader’s ability to translate financial statement numbers into a meaningful map for business decisions. It is hoped
that the material covered in the chapters and the appendixes will enable each reader
to approach financial statements with enhanced confidence and understanding of a
firm’s historical, current, and prospective financial condition and performance.
U s e s f o r the E l e v enth E diti o n
Understanding Financial Statements is designed to serve a wide range of readers
and purposes, which include:
1. Text or supplementary text for financial statement analysis courses;
2. Supplementary text for accounting, finance, and business management
classes that cover financial statement analysis;
3. Study material for short courses on financial statements in continuing
­education and executive development programs;
4. Self-study guide or course material for bank credit analysis training
programs;
5. Reference book for investors and others who make decisions based on the
analysis of financial statements.
13
Ac k n o w l ed g m ent s
We would like to acknowledge with considerable appreciation those who have contributed to the publication of this book.
We would like to thank the reviewers who made critical comments and suggestions for the eleventh edition: Phoebe Blackburn, Bristol Community College; Donald
Danner, Aurora University; Stephan Fafatas, Washington and Lee; Micah Frankel,
California State University East Bay; John Giles, North Carolina State University; Paul
Lechner, Saint Xavier University; Charles Leflar, University of Arkansas.
We would like to thank the individuals who made critical comments and suggestions for the tenth edition. In particular, we would like to thank Terrence Willyard,
Baker College—Jackson Campus; Patricia H. Holmes, Des Moines Area Community
College; Donald Benoit, Mitchell College; Harriet Maccracken, Arizona State University; Cynthia Peck, Anderson University; Matthew J. Haertzen, Northern Arizona University; Leslie B. Fletcher, Georgia Southern University; Michelle Lounsbery, Bellevue
University; Ashwin M. Madia, Ph.D., North Hennepin Community College; Metropolitan State University Carlson School of Management—University of Minnesota;
Peggy James, Greenville Technical College; Bob Gregory, Bellevue University; Douglas
E. Kulper, University of California Santa Barbara; Carole Weber-Brown, Alexandria
Technical College; David J. Manifold, Caldwell Community College & Technical Institute; Richard Weldon, University of Florida; Linda Abernathy, Kirkwood Community
College; Elaine Henry, University of Miami; Rick Johnston, Purdue University; and
Chris Prestigiacomo, University of Missouri.
Many individuals have made critical comments and suggestions for the previous editions of the text. In particular, we would like to thank David K. Hensley,
The ­University of Iowa; Robert Roller, LeTourneau University; Corolyn Clark, Saint
Joseph’s University; Dr. Elisa Muresan, School of Business, Long Island University;
Dane Sheldon, University of Miami; Dan Dowdy, Mary Baldwin College; H. ­Francis
Bush, Virginia Military Institute; Bob Gregory, Bellevue University; Patricia Doherty,
Boston University School of Management; Wei He, University of Texas of the ­Permian
Basin; Kenton Walker, University of Wyoming; Sean Salter, University of Southern
Mississippi; Paul Fisher, Rogue Community College; Ray Whitmire, Texas A&M
University–Corpus Christi; Micah Frankel, California State University, ­Hayward;
Seok-Young Lee, The University of Texas at Dallas; Sadhana Alangar, Cleary
­University; Scott Pardee, Middlebury College; Jill Whitley, University of Sioux Falls;
John Baber; Maurice Johnson, Fashion Institute of Technology/SUNY; Melanie Mogg,
University of Minnesota, Carlson School of Management; Richard Fendler, Georgia
State ­University; William Seltz, Harvard University; Robert Ewalt, Bergen Community
­College; Richard Frederics, Lasell College; Tom Geurts, Marist College; Jen Adkins,
North Central State College; Irvin Morgan, Bentley College; Jack Cathey, University
of North Carolina–Charlotte; and Glenda Levendowski, Arizona State University.
14
Acknowledgments  15
The authors would like to express grateful appreciation to Tim Carse for his careful
and attentive proofreading of the manuscript during the production process.
Special thanks go to Jacqui Jesse for her excellent and creative work in preparing
PowerPoints to accompany the book.
We would also like to thank the editorial, production, and marketing departments
of Pearson for their assistance at each stage of the writing and production process.
Rosalind Shahuna has been superb in meeting this schedule, and the authors are
appreciative of her exceptionally efficient handling of the process in a patient and
cordial manner.
The list would be incomplete without mentioning the pets in our households who
helped keep us in good humor throughout the revision of this edition: Toot, AddieMae,
Escalante, Mooli, Teddy, Torin, and Tisha.
Lyn M. Fraser
Aileen Ormiston
Pearson would like to thank and acknowledge Gary Rangel (Monash University
Malaysia) for his contribution to the Global Edition, and Pauline Ho (Hong Kong Community College of Hong Kong Polytechnic University) and Emmanouil Noikokyris
(Kingston University) for reviewing the Global Edition.
A b o ut the Auth o r s
Lyn M. Fraser has taught undergraduate and graduate classes in financial statement analysis at Texas A&M University and has conducted numerous seminars
on the subject for executive development and continuing education courses.
A Certified Public Accountant, she is the coauthor with Aileen Ormiston of
Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws
(Prentice Hall, 2003) and has published articles in the Journal of Accountancy, the
Journal of Commercial Bank Lending, the Magazine of Bank Administration, and the
Journal of Business Strategies. She has been recognized for Distinguished Achievement in Teaching by the Former Students Association at Texas A&M University
and is a member of Phi Beta Kappa. Lyn’s most recent publication is a new
mystery novel, Debits and Credits, published by Mainly Murder Press in 2014.
Aileen Ormiston teaches in the Accounting Department in the W.P. Carey School
of Business at Arizona State University and has taught in the MBA, honors,
and online programs. She received her bachelor’s degree in accounting from
Michigan State University and a master’s degree in finance from Texas A&M
University. Prior to embarking on her teaching career, Aileen worked in cost
accounting and also as an auditor in public accounting. She taught accounting
and general business courses for 30 years at Mesa Community College, one of
13 universities and colleges that received a grant from the Accounting Education
Change Commission. As a result of her pioneering work in changing accounting education, she was the recipient of the “Innovator of the Year” award from
the League for Innovation in the Community College. For her service to honors
students, Aileen has been named a Phi Theta Kappa mentor.
16
Chapter
1
Financial Statements
An Overview
–
maze (maz),
n. 1. An intricate, usually confusing network of passages, some blind
and some leading to a goal. 2. Anything made up of many confused or conflicting
elements. 3. A mental state of confusion or perplexity.1
Learning Objectives
After studying this chapter, you should be able to:
• Explain why and how financial statements are useful for decision-making
• Describe the organizations that govern accounting rulemaking
• Describe the components of a Form 10-K
• Explain the challenges and complexities inherent in the accounting rules
• Understand management’s impact on the quality of financial reporting
Map or Maze
A map helps its user reach a desired destination through clarity of representation.
A maze, on the other hand, attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.
Business financial statements have the potential for being both map and maze.
1 The American Heritage Dictionary of the English Language, New York: American Heritage
Publishing Co., Inc. 1969.
17
18  chapter 1  Financial Statements
As a map, financial statements form the basis for understanding the financial
position of a business firm and for assessing its historical and prospective financial
performance. Financial statements have the capability of presenting clear representations of a firm’s financial health, leading to informed business decisions.
Unfortunately, there are mazelike interferences in financial statement data that
hinder understanding the valuable information they contain. The sheer quantity of
information contained in financial statements can be overwhelming and intimidating.
Independent auditors attest to the fairness of financial statement presentations, but the
auditors are hired by the companies they are auditing; many lawsuits have been filed
and won against accounting firms for issuing “clean” auditors’ reports on companies
that subsequently failed or had major difficulties. The complexity of accounting policies underlying the preparation of financial statements can lead to confusion and variations in the quality of information presented. In addition, these rules are constantly
evolving and changing. Management discretion in a number of areas influences
financial statement content and presentation in ways that affect and even impede
evaluation. Some key information needed to evaluate a company is not available in
the financial statements, some is difficult to find, and much is impossible to measure.
Stockbyte/Getty Images
One of the main objectives of this book is to ensure that financial statements
serve as a map, not a maze—that they lead to a determination of the financial health
of a business enterprise that is as clear as possible for purposes of making sound
business decisions about the firm.
Ongoing financial turmoil, major corporate failures, and the staggering collapse of financial markets underscore the need for financial analysts, financial advisors, creditors, investors, and individuals managing personal assets to have a basic
understanding of financial statements. While this book focuses on firms operating
primarily in nonfinancial industries, many of the underlying principles discussed in
the book apply as well to the kinds of financial services and investment management
firms—the Wall Street banks—that triggered the economic collapse of 2008, the most
serious economic crisis in modern history.
One example of an essential “map-like” principle conveyed in this book over
all its editions is the importance of cash flow from operations as a key performance
measure. This concept is fully discussed and illustrated in Chapter 4. Many firms
have gone bankrupt while presenting rosy net income figures because of their inability to generate cash from operations. Lehman Brothers is a classic case.
In the three years prior to its bankruptcy in 2008, the largest in U.S. history,
Lehman Brothers reported steadily increasing and robust net income figures of
$3.3 billion in 2005, $4.0 billion in 2006, and $4.2 billion in 2007. Cash flow from
operations, however, which should have provided at least a hint of the financial
Chapter 1  Financial Statements  19
disaster to come, was negative in those three years: $12.2 billion in 2005, $36.4 billion
in 2006 and a whopping $45.6 billion in 2007. As asset values tumbled, a company
that already had staggering levels of debt had to borrow more and more to cover
its failure to generate cash. The bankruptcies of the early 2000s such as Enron and
WorldCom had similar map-like red flags. (See, for example, “I Told My Daughter
Not to Invest in Enron” in Understanding the Corporate Annual Report—Nuts, Bolts,
and a Few Loose Screws, Lyn M. Fraser and Aileen Ormiston, Prentice Hall, 2003).
The material in this book will convey information about how to read and
evaluate business financial statements, and the authors will attempt to present the
information in a straightforward manner, with relevant examples, that will be readily accessible to any reader, regardless of background or perspective. The book is
intended for use by those who want to learn more about the content and interpretation of financial statements for such purposes as making sound investment and credit
decisions about a company, evaluating a firm for current or prospective employment,
surviving and advancing professionally in the current economic climate, and perhaps even passing an important examination or course. Throughout the book, the
authors attempt to simplify and explain complex accounting and financial issues in a
way that allows readers not only to understand the information presented in annual
reports but to identify areas of potential strength and weakness—based on the
­reader’s ­interpretation rather than on the “spin” provided by company management.
justasc/Shutterstock
The reader can expect more than a dull exposition of financial data and accounting rules. Throughout these pages we will attempt—using timely examples, illustrations, and explanations—to get behind the numbers, accounting policies, and
tax laws to assess how well companies are actually performing. The chapters and
appendixes in the book show how to approach financial statements to obtain practical, useful information from their content. Although the examples in the book are
based on corporate financial statements, the discussion also applies to the financial
statements of small business firms that use generally accepted accounting principles.
The emphasis throughout the book is on analysis. In the first four chapters of the
book, we will look at the contents of an annual report and break the financial statements into parts for individual study to better understand the whole of their content
as a map to intelligent decision making. To fully analyze a firm, it is important to
20  chapter 1  Financial Statements
assess the quality of the information supplied by management. This material will be
covered in Appendix 3A, on the quality of earnings. The final chapter of the book
combines all parts learned in prior chapters with analytical tools and techniques to
illustrate a comprehensive financial statement analysis.
Usefulness
Financial statements and their accompanying notes contain a wealth of useful information regarding the financial position of a company, the success of its operations,
the policies and strategies of management, and insight into its future performance.
The objective of the financial statement user is to find and interpret this information
to answer questions about the company, such as the following:
• Would an investment generate attractive returns?
• What is the degree of risk inherent in the investment?
• Should existing investment holdings be liquidated?
• Will cash flows be sufficient to service interest and principal payments to
­support the firm’s borrowing needs?
• Does the company provide a good opportunity for employment, future
advancement, and employee benefits?
• How well does this company compete in its operating environment?
• Is this firm a good prospect as a customer?
The financial statements and other data generated by corporate financial reporting can help the user develop answers to these questions as well as many others. The
remainder of this chapter will provide an approach to using effectively the information contained in a corporate annual report. Annual reports in this book will refer to
the information package published by U.S. companies primarily for shareholders and
the general public. The Securities and Exchange Commission (SEC) requires large,
publicly held companies to file annually a 10-K report, which is generally a more
detailed document and is used by regulators, analysts, and researchers. The basic set
of financial statements and supplementary data is the same for both documents, and
it is this basic set of information—financial statements, notes, and required supplementary data—that is explained and interpreted throughout this book.
Volume of Information
The user of a firm’s annual report can expect to encounter a great quantity of information that encompasses the required information—financial statements, notes to the
financial statements, the auditor’s report, a five-year summary of key financial data,
high and low stock prices, management’s discussion and analysis of operations—as
well as material that is included in the report at the imagination and discretion of
management. To understand how to navigate the vast amount of information available to financial statement users, background on the accounting rule-making environment is necessary. Financial statements are currently prepared according to generally
accepted accounting principles (GAAP) that have been adopted in order to achieve a
presentation of financial information that is understandable by users as well as relevant and reliable for decision making. The accounting rules that have been issued
in order to achieve these objectives can be complicated and sometimes confusing.
Chapter 1  Financial Statements  21
The two authorities primarily responsible for establishing GAAP in the United States
are the SEC, a public-sector organization, and the Financial Accounting Standards
Board (FASB), a private-sector organization.
The SEC regulates U.S. companies that issue securities to the public and requires
the issuance of a prospectus for any new security offering. The SEC also requires regular filing of
• Annual reports (10-K)
• Quarterly reports (10-Q)
• Other reports dependent on particular circumstances, such as a change in
­auditor, bankruptcy, financial restatements, or other important events (all filed
as 8-K reports)
The SEC has congressional authority to set accounting policies and has issued rulings called Accounting Series Releases (ASRs) and Financial Reporting Rulings (FRRs).
For the most part, however, accounting rule making has been delegated to the FASB.
Prior to September 15, 2009, FASB issued Statements of Financial Accounting
Standards (SFASs) and interpretations. Effective September 15, 2009, the FASB
Accounting Standards CodificationTM became the source of authoritative GAAP. The
FASB’s three primary goals in developing the Codification were (1) to simplify user
access by codifying in one source all authoritative GAAP in the United States; (2) to
ensure that the codified content accurately represented authoritative U.S. GAAP as
of July 1, 2009; and (3) to create a codification research system that is up to date for
the released results of standard-setting activity.2
After 50-plus years and more than 2,000 standards, the FASB recognized the need
for a better system to research accounting standards. The Codification includes not only
SFASs, but also standards from other accounting organizations and relevant rules written by the SEC. The FASB Accounting Standards CodificationTM Research System will
be updated concurrently with the release of Accounting Standards Updates. Accounting
Standards Updates will also be issued for amendments to the SEC content of the
Codification. All updates and prior standards will be organized by related topics.3
The SEC and FASB have worked closely together in the development of
accounting policy, with the SEC playing largely a supportive role. But at times the
SEC has pressured the FASB to move on the issuance of accounting standards or to
change its policies (inflation accounting, oil and gas accounting). Pressures on the
FASB stem from the private sector and have been highly controversial at times.
2 FASB Accounting Standards Codification: Notice to Constituents (v 4.1) About the Codification.
Financial Accounting Foundation, 2010.
3 The five topic areas of the Codification include the following: (1) General Principles (Topic Codes
105–199). These topics relate to broad conceptual matters. Topics include generally accepted accounting
principles. (2) Presentation (Topic Codes 205–299). These topics relate only to presentation matters and
do not address recognition, measurement, or derecognition matters. Topics include income statement,
balance sheet, earnings per share, and so forth. (3) Financial Statement Accounts (Topic Codes 305–799).
The Codification organizes topics in a financial statement order, including assets, liabilities, equity,
­revenue, and expenses. Topics include receivables, revenue recognition, inventory, and so forth.
(4) Broad Transactions (Topic Codes 805–899). These topics relate to multiple financial statement accounts
and are generally transaction oriented. Topics include business combinations, derivatives, nonmonetary
transactions, and so forth. (5) Industry (Topic Codes 905–999). These topics relate to accounting that is
unique to an industry or type of activity. Topics include airlines, software, real estate, and so forth.
22  chapter 1  Financial Statements
Figure 1.1 FASB/SEC Relationship
SEC
Gives power to set accounting rules
Passes on role
of making
accounting
rules but retains
veto power
FASB
CONGRESS
Lobbies for
favorable
accounting
rules
Uses accounting rules
REPORTING
COMPANIES
Figure 1.1 illustrates the relationship between the SEC and the FASB. An example of
a measure that was vehemently opposed by the business sector was the FASB’s proposal to require companies to deduct from profits compensation to executives in the
form of stock options. The FASB first began exploring this issue in 1984, but it was
not resolved until 1995 because of business and ultimately political intervention.
Business lobbyists gained congressional support that effectively forced the FASB to
compromise its stance on this issue.4 As a result of the opposition, FASB Statement
No. 123, “Accounting for Stock-Based Compensation,” only required that companies
disclose in the notes to the financial statements the effects on profits of new
employee stock options based on the fair value at the date of grant. The controversy
that arose with regard to stock-based compensation caused the SEC to take a closer
look at the FASB’s standard-setting process. In 1996, the SEC made public its concern
that the standard-setting process is too slow; however, the SEC rejected suggestions
from business executives that the private sector should have more influence in the
process. The SEC vowed to maintain the FASB’s effectiveness and independence.5
Corporate scandals such as Enron and WorldCom brought to the forefront
the challenges and pressures the FASB faces when creating accounting rules. The
issue of stock-based compensation was reopened by the FASB in 2002. A new FASB
proposal adopted in December 2002 to force the expensing of all employee stock
compensation from profits once again resulted in congressional interference, delaying the new rule from taking effect until after June 15, 2005. The SEC and the FASB
continue to examine potential rule changes or new rules in a variety of areas such
as off–balance-sheet financing and overhauling the financial statements; however,
these changes will most likely evolve as a result of joint projects between the U.S.
rule-making bodies and the International Accounting Standards Board (IASB).
4 To learn more about this controversy see Stephen Barr, “FASB Under Siege,” CFO, September 1994.
5 “SEC Calls for More Efficient FASB but Rejects Stronger Outside Influence,” Journal of Accountancy,
May 1996.
Chapter 1  Financial Statements  23
Global Economy
The globalization of business activity has resulted in the need for a uniform set of
accounting rules in all countries. Investors and creditors in international markets
would benefit from financial statements that are consistent and comparable regardless of the firm’s location. To address this need, the IASB, formerly the International
Accounting Standards Committee, was formed in 1973. The eventual goal of the IASB
is the adoption of uniform international accounting standards. Accomplishing this
objective would allow companies to list securities in any market without having to
prepare more than one set of financial statements. The need for international accounting standards has been underscored by global corporate scandals. While Enron was
the catalyst for rethinking accounting standards in the United States, Europe also had
a comparable scandal when Italian dairy food giant Parmalat filed for bankruptcy
after committing financial fraud. Today the FASB and the IASB are working on a convergence of standards. The concept of a convergence of standards was discussed as
early as the 1950s, but the pace of convergence began moving at a much faster pace in
the 2000s. The Norwalk Agreement in 2002 was a result of the FASB and IASB agreeing to work toward convergence between U. S. GAAP and IFRS (international financial reporting standards). The European Union began requiring publicly traded
companies to use IFRS in 2005 and over 100 other countries had adopted IFRS or a
version of IFRS by 2009. As of 2007 foreign firms registered with the SEC have been
allowed to file annual reports based on IFRS with no reconciliation to U. S. GAAP;
however, U.S. firms may not use IFRS for SEC reporting purposes.6
The SEC has supported convergence of standards and spent years on a work
plan to determine if IFRS should be adopted in the U.S.; however, a final staff report
released in July 2012 by the SEC did not make a recommendation. The SEC has
expressed concern about items such as the expense of transitioning to IFRS, insufficient influence over IASB standards setting, and the reliance in the U.S. legal environment of contract language that refers to U. S. GAAP.7
Pixotico/Shutterstock
While the rest of the world moves toward acceptance of IFRS to reduce ­complexity
in a global world, complexity for multinational firms in the U.S. will continue as a
result of the SEC’s lack of a recommendation to move toward IFRS adoption. Ford
Motor Company, for example, has indicated a plan to adopt IFRS to save time and
money, finding it easier to convert from IFRS, which will be used in 60 different
international jurisdictions, to U. S. GAAP which is only used in one jurisdiction.8
6 See International Convergence of Accounting Standards-A Brief History (Norwalk CT: FASB, 2013).
7 Final Staff Report: Work Plan for the Consideration of Incorporating International Financial Reporting Standards
into the Financial Reporting System for U.S. Issuers (Washington D.C.: SEC, July 2012).
8 “Will IFRS Be Mandated Under New SEC Chair White?” http//ifrs.wordpress.com April 10, 2013.
24  chapter 1  Financial Statements
The focus throughout the textbook is on U. S. GAAP; however, the process illustrated
for financial statement analysis can be used for annual reports based on IFRS. Differences
that occur between U. S. GAAP and IFRS will be discussed where appropriate. A case
has been added to each chapter in the book to illustrate analysis of an international firm.
Where to Find a Company’s Financial Statements
Corporate financial statements are available from several sources. First, all publicly
held companies must file a Form 10-K annually with the SEC. The information in
this document is mandated by the SEC and contains uniform content, presented in
the same order for all filing companies. Figure 1.2 shows a sample of required 10-K
items. Documents filed with the SEC can usually be accessed through the Electronic
Data Gathering, Analysis, and Retrieval (EDGAR) database at the SEC’s Web site,
www.sec.gov. Some companies mail the firm’s 10-K report to shareholders rather
than producing a separate annual report. Other firms send a slickly prepared annual
report that includes the financial statements as well as other public relations material
to shareholders and prospective investors. Finally, most corporations now post their
annual report (or provide a link to the EDGAR database) on their corporate Web site.
The Financial Statements
A corporate annual report contains four basic financial statements, illustrated in
Appendix 1A for Sage Inc., pp. 36 to 48.
1. The balance sheet or statement of financial position shows the financial position—
assets, liabilities, and stockholders’ equity—of the firm on a particular date,
such as the end of a quarter or a year.
2. The income or earnings statement presents the results of operations—revenues,
expenses, net profit or loss, and net profit or loss per share—for the accounting
period.
3. The statement of stockholders’ equity reconciles the beginning and ending balances
of all accounts that appear in the stockholders’ equity section of the balance sheet.
Some firms prepare a statement of retained earnings, frequently combined with
the income statement, which reconciles the beginning and ending balances of the
retained earnings account. Companies choosing the latter format will generally
present the statement of stockholders’ equity in a footnote disclosure.
4. The statement of cash flows provides information about the cash inflows and outflows
from operating, financing, and investing activities during an accounting period.
Each of these statements will be illustrated, described, and discussed in detail in
later chapters of the book.
Notes to the Financial Statements
Immediately following the four financial statements is the section entitled Notes to
the Financial Statements (Appendix 1A, pp. 36 to 48). The notes are, in fact, an integral part of the statements and must be read in order to understand the presentation
on the face of each financial statement.
The first note to the financial statements usually provides a summary of the
firm’s accounting policies. If there have been changes in any accounting policies during the reporting period, these changes will be explained and the impact quantified
Chapter 1  Financial Statements  25
Figure 1.2 Form 10-K Components
Item #
Item Title
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Submission of Matters to a Vote of Security Holders
Item 5.
Market for Registrant’s Common Equity and Related Stockholder
Matters
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
Item 10.
Directors and Executive Officers of the Registrant
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions
Item 14.
Principal Accountant Fees and Services
Item 15.
Exhibits, Financial Statement Schedules, and Reports on Form 8-K
in a financial statement note. Other notes to the financial statements present details
about particular accounts, such as
• Inventory
• Property, plant, and equipment
• Investments
• Long-term debt
• Equity accounts
The notes also include information about
• Any major acquisitions or divestitures that have occurred during the accounting
period
26  chapter 1  Financial Statements
• Officer and employee retirement, pension, and stock option plans
• Leasing arrangements
• The term, cost, and maturity of debt
• Pending legal proceedings
• Income taxes
• Contingencies and commitments
• Quarterly results of operations
• Operating segments
Certain supplementary information is also required by the governmental and
accounting authorities—primarily the SEC and the FASB—that establish accounting policies. There are, for instance, supplementary disclosure requirements relating
to reserves for companies operating in the oil, gas, or other areas of the extractive
industries. Firms operating in foreign countries show the effect of foreign currency
translations. If a firm has several lines of business, the notes will contain a section
showing financial information for each reportable segment.
Auditor’s Report
Related to the financial statements and notes is the report of an independent or
external auditor (Appendix 1A, pp. 36 to 48.) Management is responsible for the
preparation of financial statements, including the notes, and the auditor’s report
attests to the fairness of the presentation. In addition, beginning in 2005, the
Sarbanes-Oxley Act of 2002, Section 404, requires that an internal control report be
added to the annual report. In this report, management must state its responsibility
for establishing and maintaining an adequate internal control structure so that accurate financial statements will be produced each year. Management must also include
an assessment of the effectiveness of the internal control structure and procedures
in the report. The external auditors are required to audit the internal control assessment of the company as well as the financial statements.
Sarbanes-Oxley, commonly shortened to SOX, has had a major impact on internal auditing. Section 404 of SOX requires companies to include in their annual
reports a statement regarding the effectiveness of internal controls and the disclosure
of any material weaknesses in a firm’s internal controls system. This requirement has
greatly boosted the need for internal auditors and SOX compliance specialists, but
more important, has enhanced the value of the internal audit function within
companies, as businesses have strengthened internal controls in response to SOX.
Internal auditors have become the “rock stars” of the accounting industry.9
An unqualified report, illustrated for Sage. Inc. in Appendix 1A, states that the
financial statements present fairly, in all material respects, the financial position, the
results of operations, and the cash flows for the accounting period, in conformity with
GAAP. Some circumstances warrant reports other than an unqualified opinion and are
called qualified reports. A departure from GAAP will result in a qualified opinion and
the use of the following language in the opinion sentence: “In our opinion, except for
the (nature of the departure explained), the financial statements present fairly. . .” If the
departure from GAAP affects numerous accounts and financial statement relationships,
then an adverse opinion is rendered, which states that the financial statements have
not been presented fairly in accordance with GAAP. A scope limitation means that the
9 Rachel Sams, “New Accounting Laws Make Internal Auditors ‘Rock Stars,’” Baltimore Business Journal,
June 2, 2006, and Peter Morton, “The New Rock Stars,” CA Magazine, October 2006.
Chapter 1  Financial Statements  27
extent of the audit work has been limited. This will result in a qualified opinion unless
the limitation is so material as to require a disclaimer of opinion, which means the auditor
cannot evaluate the fairness of the statements and therefore expresses no opinion on
them. Lack of independence by the auditor will also result in a disclaimer of opinion.
Many circumstances warrant an unqualified opinion with explanatory language
such as: a consistency departure due to a change in accounting principle, uncertainty caused by future events such as contract disputes and lawsuits, or events
that the auditor wishes to describe because they may present business risk and
going-concern problems. Unqualified reports with explanatory language result in
additional paragraphs to the standard report.
Financial Reporting Reforms
In theory, the auditing firm performing the audit and issuing the report is “­ independent”
of the firm being audited. The annual report reader should be aware, however, that the
auditor is hired by the firm whose financial statements are under review. The mega
accounting firm PricewaterhouseCoopers (PwC) agreed in August of 2014 to a
$25 million penalty for an egregious new form of auditing corruption. Having committed to helping regulators by providing impartial surveillance of large international
banks, PwC obscured some of the same accounting misconduct it was supposed to
uncover. Like other accounting firms, PwC is hired and paid by the companies it audits,
and in this instance watered down a report for one of the world’s biggest banks, Bank of
Tokyo-Mitsubishi UFJ. PwC did not actually break a law but was accused of lacking the
integrity and objectivity expected of consultants.10 Over time, a lack of independence
and conflicts of interest between companies and their hired auditors led to a series of
accounting scandals that eroded investors’ confidence in the capital markets. The collapse of Enron and WorldCom was a catalyst for some of the most sweeping corporate
reforms since the Securities Act of 1934 was passed. Congress was quick to pass the
Sarbanes-Oxley Act of 2002 in hopes of ending future accounting scandals and renewing investor confidence in the marketplace. A discussion of the sections of SOX that
directly impact the area of understanding financial reporting follows.11
Prior to SOX, auditors followed a self-regulatory model. Title I of the act established the Public Company Accounting Oversight Board (PCAOB), a private, nonprofit organization that has been given the authority to register, inspect, and discipline auditors of all publicly owned companies; however, the SEC appoints the board
members and has ultimate oversight of the PCAOB. In addition, the PCAOB now has
the authority to write auditing rules, and set quality control and ethics standards.
Title II of SOX addresses the area of auditor independence, prohibiting audit firms
from providing certain nonaudit services when conducting an external audit of a
firm. Prohibited services include bookkeeping; design and implementation of financial
information systems; valuation and appraisal services; actuarial services; internal audit
services; management or human resource functions; and broker, dealer, or investment
banking services. Title II also encourages auditor independence by requiring the rotation
of audit partners every five years if the audit partner is the primary partner responsible
for a particular audit client. Another issue relating to auditor independence occurs when
a company hires its chief financial officer (CFO) or other finance personnel from the
ranks of the external audit firm. Section 206 of Title II inserts a one-year waiting period
10 Ben Protess and Jessica Silver-Greenberg, “Bank Overseer Is Now Facing Major Penalty,” The New York
Times, August 18, 2014, A1.
11 Sarbanes-Oxley Act of 2002.
28  chapter 1  Financial Statements
before an employee from the external audit firm may go to work for a client in the
position of chief executive officer (CEO), CFO, or controller or any equivalent executive
officer position; in any financial oversight role; or preparing any financial statements.
Titles III and IV of SOX focus on corporate responsibility; Title IX attaches
harsher penalties for violations. Section 302 requires that the CEO and CFO of a
publicly owned company certify the accuracy of the financial statements. An officer
who certifies a report that is later found to be inaccurate could face up to $1 million
in fines and/or a jail sentence of up to 10 years according to Section 906. These two
sections work in conjunction with Section 404 (discussed previously) to encourage CEOs and CFOs to take responsibility for strong internal controls to prevent
accounting fraud and financial statement misrepresentation.
Despite the enactment of SOX in 2002, corruption and unethical behavior continue.
The subprime mortgage crisis surfaced in 2007, precipitating the demise of financial
institutions such as Lehman Brothers and the eventual bailout that included AIG, Bank
of America, Citigroup, Fannie Mae, and Freddie Mac. Just as Enron and WorldCom
were the catalysts for SOX, the crisis with financial institutions led to the passing of the
Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Sam Antar, convicted felon and the former CFO of the defunct consumer-electronics chain Crazy
Eddie, helped mastermind one of the largest corporate frauds in the 1980s. In a 2011
interview with CFO magazine, Antar tells of his regret that he is no longer in the fraud
game at a time when he claims corporate fraud is experiencing a resurgence. He states,
“Nothing’s changed. Wall Street analysts are just as gullible, internal controls remain
weak, and the SEC is underfunded and, at best ineffective. Madoff only got caught
because the economy tanked.”12 Based on such comments as well as recent history, the
need for users of financial statements to gain a basic understanding of financial statement content and analysis for decision-making purposes is at an all-time high.
Management Discussion and Analysis
The Management Discussion and Analysis (MD&A) section, sometimes labeled
“Financial Review,” is of potential interest to the analyst because it contains information that cannot be found in the financial data. The content of this section includes
coverage of any favorable or unfavorable trends and significant events or uncertainties in the areas of liquidity, capital resources, and results of operations. In particular,
the analyst can expect to find a discussion of the following:
1. The internal and external sources of liquidity
2. Any material deficiencies in liquidity and how they will be remedied
3. Commitments for capital expenditures, the purpose of such commitments, and
expected sources of funding
4. Anticipated changes in the mix and cost of financing resources
5. Unusual or infrequent transactions that affect income from continuing operations
6. Events that cause material changes in the relationship between costs and revenues (such as future labor or materials price increases or inventory adjustments)
7. A breakdown of sales increases into price and volume components
See Figure 1.3 for a more detailed explanation of these items.
Alas, there are problems as well with the usefulness of the MD&A section. One goal
of the SEC in mandating this section was to make information about future events and
12 Laton McCartney, “Where There’s Smoke, There’s Fraud,” CFO, March 2011.
Chapter 1  Financial Statements  29
Figure 1.3 MD&A Discussion Items: What Do They Mean?
Item
Translation
1. Internal and external sources
of liquidity
From where does the company obtain cash—
sales of products or services (internal source)
or through borrowing and sales of stock
(external sources)?
2. Material deficiencies in liquidity
and how they will be remedied.
If the firm does not have enough cash to
continue to operate in the long term, what is it
doing to obtain cash and prevent bankruptcy?
3. Commitments for capital
­expenditures, the purpose of such
commitments, and expected sources
of funding.
How much is the company planning to spend
next year for investments in property, plant,
and equipment or acquisitions? Why? How
will it pay for these items?
4. Anticipated changes in the mix
and cost of financing resources.
Will the percentage of debt and equity change
in the future relative to prior years—i.e., will
the company borrow more or less, sell more
stock, or generate significant profits or losses?
5. Unusual or infrequent transactions
that affect income from continuing
operations.
Will revenues or expenses be affected in the
future by events not expected in the normal
course of business operations?
6. Events that cause material changes
in the relationship between costs and
revenues.
Will significant changes occur that cause
­revenues (or expenses) to increase or decrease
without a corresponding change in expenses
(or revenues)?
7. Breakdown of sales increases into
price and volume components.
Did the company’s sales increase because it
sold more products or services, or was the
increase the result of price increases (with
even a possible decrease in volume)?
trends that might affect future business operations publicly available. According to data
compiled by Audit Analytics and analyzed by CFO magazine, the MD&A was the topic
cited most frequently in 2009 by the SEC in its reviews of U.S. publicly traded companies’
annual and quarterly filings. Based on a review of SEC comment letters, the SEC wants
more than a historical description of operating results, liquidity, and capital resources
and would like companies to disclose how they develop critical accounting estimates.13
The events of 2001, including the economic downturn, September 11, and the
collapse of Enron, appear to have affected the quantity of precautionary and explanatory information companies have added to their MD&A sections of subsequent
annual reports. Some firms include a plethora of statements covering every possible
negative event that could possibly occur, such as:
We may not be able to expand, causing sales to decrease.
We may be unable to successfully develop new products.
We may not be successful in our marketing efforts.
Our operating results may fluctuate, causing our stock price to decline.
Our suppliers may not meet our demand for materials.
Our products may have significant defects.
13 Sarah Johnson, “The SEC Has a Few Questions For You,” CFO, May 2010.
30  chapter 1  Financial Statements
And on and on! These statements may be true, but an assessment of the probability
that these events may occur would be more useful to the reader of this information.
More helpful has been the addition to the MD&A of explanations about why changes
have occurred in profitability and liquidity. Many companies offer explanations of why
certain accounts such as accounts receivable or inventories increased or decreased in its
section on liquidity and capital resources. This change is welcome, but those companies
still have not offered much in the way of forward-looking information in the MD&A.
The “Liquidity and Capital Resources” section of the MD&A for Sage Inc.
(see Appendix 1A, pp. 36 to 48) reveals that the firm generates cash from operations
(an internal source of liquidity) and also uses debt to fund operations (an external
source of liquidity). Because cash from operations has been greater than the amounts
borrowed in 2014 and 2016, no material deficiencies are indicated. Capital expenditures are predicted to be $15,900,000 in 2017, and it is anticipated that these funds
will be used to open new stores. The funding sources will be cash from operations
and ­borrowings. Based on the information given there is no indication that there will
be a change in the mix and cost of financing resources.
The “Results of Operations” section of the MD&A for Sage Inc. does not include
a discussion of any unusual or infrequent transactions, nor is any information given
that would suggest a change in the relationship between revenues and expenses in
the future. What can be determined from this section is that the 40.9% sales increase
in 2016 resulted primarily from volume increases. In fact, the athletic footwear area
contributed to a decline in comparable store sales due to both volume and selling
price decreases. Other information that can be obtained from this section of the
MD&A includes explanations of why gross profit, operating expenses, other income
and expenses, and taxes have changed from one year to the next.
Five-Year Summary of Selected Financial Data and Market Data
A five-year summary of selected financial data required by the SEC includes net sales or
operating revenues, income or loss from continuing operations, income or loss from continuing operations per common share, total assets, long-term obligations and redeemable
preferred stock, and cash dividends per common share. Companies often choose to
include more than five years of data and/or additional items. The summary offers the
user of financial statements a quick look at some overall trends; however, the discussion
in this book will focus on the financial statements themselves, not the summary data.
The market data required by the SEC contains two years of high and low common stock prices by quarter. Since the financial statements do not include market
values of common stock, this item is useful when analyzing how well the firm does
in the marketplace.
Pandora (a.k.a. “PR Fluff”)
In addition to the material required for presentation, many companies add to the
annual report an array of colored photographs, charts, a shareholders’ letter from
the CEO, and other items to make the report and the company attractive to current
and prospective investors. Some of these creations also appear on corporate Web
sites. Getting to what is needed through the “PR fluff” can be a challenge.
Public relations material, including the shareholders’ letter, is often informative but can also be misleading. The chairman (and CEO) and president (and chief
Chapter 1  Financial Statements  31
Barry Robson/DK Images
­operating officer) of Lehman Brothers painted a positive picture for the future of
Lehman Brothers in their jointly written 2007 letter to shareholders. They discussed
that 2007 was “another year of record net revenues, net income, and earnings per
share.” They proudly shared how the Lehman team—with their “careful management of liquidity”—had built a bank able to survive the rapid shifts in liquidity that
were occurring in the second half of 2007 as a result of the housing market, credit
freeze, and repricing of credit-related securities. Toward the end of the letter, the two
executives lamented that the marketplace did not reward them for their superb performance, as evidenced by their stock price declining “for the first time in five years.”
Lehman Brothers declared bankruptcy the following year, 2008. As discussed in
this chapter, red flags existed well before that event, including negative cash flow
from operations and staggering levels of debt. It should also be noted that the 2007
Lehman Brothers Annual Report consisted of 129 pages, beginning with 40 glossy
photographs and many pages before the reader could find any hard financial data.
Proxy Statement
The SEC requires companies to solicit shareholder votes in a document called the
proxy statement, as many shareholders do not attend shareholder meetings. The
proxy statement contains voting procedures and information, background information about the company’s nominated directors, director compensation, executive
compensation and any proposed changes in compensation plans, the audit committee report, and a breakdown of audit and nonaudit fees paid to the auditing firm.
This information is important in assessing who manages the firm and how management is paid and potential conflict-of-interest issues.
The proxy material helps investors and creditors by providing information
about the longevity and compensation of top management as well as corporate
governance, audit-related matters, director and executive compensation including
option grants, and related party transactions.
Missing and Hard-to-Find Information
Some of the facts needed to evaluate a company are not available in the financial
statements. These include such intangibles as employee relations with management,
the morale and efficiency of employees, the reputation of the firm with its customers,
32  chapter 1  Financial Statements
the firm’s prestige in the community, the effectiveness of management, provisions for
management succession, and potential exposure to changes in regulations—such as
environmental or food and drug enforcement. Publicity in the media, which affects
public perception of a firm, can also impact its performance. How firms handle product recalls and data breaches, for example, can have a positive or a negative impact
with regard to sales, profits and stock prices.
These qualities impact the firm’s operating success both directly and indirectly
but are difficult to quantify.
Some relevant facts are available in the financial statements but may be difficult
for an average user to find. For example, the amount of long-term debt a firm has
outstanding is disclosed on the face of the balance sheet in the noncurrent liability
section. However, “long-term” could apply to debt due in 12.5 months or 2 years or
15 years. To determine when cash resources will be required to meet debt principal
payments, the user must find and analyze the note to the financial statements on
long-term debt with its listing of principal, interest, and maturity of a firm’s longterm debt instruments.
Another important form of supplementary information is that reported by
diversified companies operating in several unrelated lines of business. These conglomerates report financial information for the consolidated entity on the face of its
financial statements. For a breakdown of financial data by individual operating segments, the analyst must use information in notes to the financial statement.
The Enron collapse highlighted that some companies use complicated financing
schemes that may or may not be completely revealed in the notes to the financial
statements. Even with notes available, most average users may find these items
beyond their comprehension unless they acquire a Ph.D. in accounting or finance or
read the authors’ discussion of Enron in their other book, Understanding the Corporate
Annual Report—Nuts, Bolts, and a Few Loose Screws (Pearson 2003).
Characteristics, Assumptions, Principles, and Basis of Accounting
Investors, creditors and analysts use a firm’s financial statements to predict the
future value of a company and the ability of that firm to repay debt. It is helpful to
have a basic understanding of the key accounting characteristics, assumptions, and
principles used to produce this data.
Materiality refers to the fact that the dollar amount of the information must be
­significant enough to make a difference in decision-making. If the information is not
significant enough to make a difference in a decision it is considered to be “immaterial”.
Comparability allows users to compare financial information of an entity to other
entities as well as comparing financial information of that entity to itself from one
time period to another.
Consistency is related to comparability and means that the same accounting
methods and choices should be used from one time period to another. Changes in
accounting choices can distort trends that would be helpful in analyzing companies.
The Going Concern Assumption assumes that business entities will operate indefinitely unless there is strong evidence to the contrary. Bankrupt firms are no longer
considered to be going concerns.
Chapter 1  Financial Statements  33
The Time Period Assumption indicates a specified time period that business firms
use to report financial information. A one-year time frame is generally used with
interim reporting occurring monthly and quarterly.
The Monetary Unit Assumption is the assumed unit of measurement when preparing financial statements. Generally, the national currency of the country in which the
company operates is used for financial reporting purposes.
The Revenue Recognition Principle requires that four conditions be met for a transaction to be recorded as a revenue item. The four conditions are (1) the revenues must be
earned (the sale is complete), (2) the amount of the revenue must be measurable, (3) the
costs of generating the revenue can be determined, and (4) the revenue must be realizable.
The Matching Principle requires revenues and expenses to be properly matched
in the same time period. Once revenue has been recognized in an accounting
period, expenses incurred to generate that revenue need to be recorded in the same
­accounting period. Revenues and expenses, therefore, are recorded when events
take place, ­without regard to receipt or payment of cash.
The Accrual Basis of Accounting is based on both the revenue recognition and the
matching principles. The accrual method means that the revenue is recognized in
the accounting period when the sale is made rather than when the cash is received.
Expenses are recognized in the period incurred rather than when cash is paid.
The Cash Basis of Accounting recognizes revenues when cash is received and recognizes expenses when cash is paid.
GAAP-based financial statements are prepared according to the accrual basis
of accounting. See Figure 1.4 for an illustration of the key differences between the
accrual and the cash basis of accounting.
Complexities and the Quality of Financial Reporting
Interpreting financial statements can be challenging because of the complexities inherent in the accounting rules that underlie financial reporting. GAAP, as established by
the FASB and SEC, provide a measure of uniformity but also allow corporate management considerable discretion in applying the regulations. The potential exists for
management to “manipulate” the bottom line (profit or loss) and other accounts in
financial statements. Ideally, financial statements should reflect an accurate picture of
a company’s financial condition and performance. The information should be useful
both to assess the past and predict the future. The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality, the
higher is the quality of the financial statements and reported earnings.
Many opportunities exist for management to affect the quality of financial statements. While financial reporting quality is covered throughout the textbook and
Appendix 3A covers earnings quality in detail, some illustrations follow.
Accounting Choices
Accounting choices and estimates can have a significant impact on the outcome of
financial statement numbers. An example is the valuation of inventory (discussed
in detail in Chapter 2). Companies can select from several acceptable methods that
34  chapter 1  Financial Statements
Figure 1.4 Accrual vs. Cash Basis of Accounting
Assume Mary Mason plans to sell caps at the Olympic Games outside one of the venues.
The sales price and costs Mary will incur are as follows:
Sales price per cap
$ 15
Cost per cap
$
Fee for booth per day
$200
8
Mary purchases 100 caps for cash. On the first day Mary sells caps, she is able to sell all 100 caps. She is
paid in cash for 30 caps and has credit card receipts for the other 70 caps sold. The fee for the booth must
be paid at the end of each week. Mary can calculate her profit on the first day using either the accrual or
the cash basis of accounting.
Accrual Basis
Cash Basis
Sales (+15 * 100 caps)
$1,500
Less expenses:
$450
Sales (+15 * 30 caps)
Less expenses:
Cost of caps (+8 * 100)
$800
Cost of caps (+8 * 100)
$800
Booth fee
200
Booth fee
  -0-
1,000
Net Income
$ 500
800
Net Loss
($350)
As you can see, the amount of profit is significantly different depending on whether the accrual basis or
the cash basis of accounting is used. Which method is best? That depends on the user and the reason the
information is needed. While the accrual basis of accounting gives a more realistic picture of profitability,
the cash basis of accounting offers a better factual picture of the entity’s cash account. Most users and
decision makers want both types of information. If the four financial statements previously described are
prepared, both accrual and cash basis information are presented. The balance sheet, income statement
and statement of stockholders’ equity are prepared on the accrual basis, and the statement of cash flows
offers a picture of the firm’s transactions on a cash basis.
include, for instance, assuming that the oldest, lowest cost of goods are sold first, or
that the most recent, highest cost of goods are sold first. The choice of inventory valuation methods affects both the amount of inventory on the balance sheet and the associated cost of selling inventory in the income statement. Because companies are allowed
to select from several possible methods, comparability can be affected if companies
within the same industry make different choices. And the quality of financial reporting can also be impacted if the accounting choice does not reflect economic reality.
Furthermore, financial statements are prepared on certain dates at the end of
accounting periods, such as a year or a quarter. Whereas the firm’s life is continuous,
financial data must be appropriated to particular time periods.
Timing of Revenue and Expense Recognition
One of the generally accepted accounting principles that provides the foundation
for preparing financial statements is the matching principle: expenses are matched
with the generation of revenues to determine net income for an accounting period.
Chapter 1  Financial Statements  35
Reference was made earlier to the fact that published financial statements are based
on the accrual rather than the cash basis of accounting, which means that revenues
are recognized when earned and expenses are recognized when incurred, regardless
of when the cash inflows and outflows occur. This matching process involves judgments by management regarding the timing of expense and revenue recognition.
Although accounting rules provide guidelines helpful in making the necessary and
appropriate allocations, these rules are not always precise.
For example, suppose that a company learns near the end of an accounting
period that a material accounts receivable is probably uncollectible. When will the
account be written off as a loss—currently, or in the next accounting period when a
final determination is made? Pose the same question for obsolete inventory sitting
on the warehouse shelves gathering dust. These are areas involving sometimes arbitrary managerial decisions. Generally speaking, the more conservative management
is in making such judgments (conservatism usually implies the choice that is least
favorable to the firm), the higher the quality of earnings resulting from the matching
of revenues and expenses in a given accounting period.
Discretionary Items
Many expenditures made by a business firm are discretionary in nature. Management
exercises control over the budget level and timing of expenditures for the repair and
maintenance of machinery and equipment, marketing and advertising, research and
development, and capital expansion. Policies are also flexible with respect to the
replacement of plant assets, the development of new product lines, and the disposal
of an operating division. Each choice regarding these discretionary items has both
an immediate and a long-term impact on profitability, perhaps not in the same direction. A company might elect to defer plant maintenance in order to boost current
period earnings; ultimately, the effect of such a policy could be detrimental.
For some industries, such as beverages and retail marketing, advertising and
marketing expenditures are essential to gaining and maintaining market share.
Research and development can be critical for ongoing success of industries such as
computing and electronics, health, and auto.
The financial analyst should carefully scrutinize management’s policies with
respect to these discretionary items through an examination of expenditure trends
(absolute and relative amounts) and comparison with industry competitors. Such
an analysis can provide insight into a company’s existing strengths and weaknesses
and contribute to an assessment of its ability to perform successfully in the future.
The Journey Through the Maze Continues
Numerous other examples exist to illustrate the difficulty in finding and interpreting
financial statement information. Many such examples are discussed in the chapters
that follow. Annual reports provide a wealth of useful information, but finding
what is relevant to financial decision making may involve overcoming mazelike
­challenges. The remaining chapters in this book are intended to help readers find
and effectively use the information in financial statements and supplementary data.
36  chapter 1  Financial Statements
Appendix 1A: Sage Inc.
Sage Inc.
2016 Annual Report
Chapter 1  Financial Statements  37
Management’s Discussion and Analysis of Financial
Condition and Results of Operations
Net Sales
Net sales increased 40.9% in 2016 compared to 8.7% in 2015 due primarily to new store
openings and the addition of e-commerce sales. Comparable store sales increased
10.4% and were attributable to sales increases in exercise apparel, athletic footwear,
and golf equipment. Net sales increased 8.7% in 2015 compared to 2014 due primarily
to new store sales. Comparable store sales decreased 1.8% mostly attributable to sales
decreases in athletic footwear combined with a decrease in average unit retail price.
Three segments contribute to the Company’s overall sales and include Sporting
Apparel, Footwear, and Sporting Gear and Equipment. All three segments contributed significantly to the 40.9% overall sales increase from 2015 to 2016. From 2014 to
2015 the Sporting Apparel and Sporting Gear and Equipment contributed positively
to the sales increase, 13.3% and 11.9%, respectively, while Footwear sales decreased
6.1%. Due to competition in the footwear industry, the Company lowered retail
prices on footwear products in order to increase sales.
Gross Profit
Gross profit has decreased over the past three years. The gross profit margin decreased
from 42.0% to 39.9% between fiscal year 2014 and 2015, due primarily to the lower margins resulting from realignment in the retail prices of athletic footwear. The gross profit
margin increased slightly from fiscal year 2015 to fiscal year 2016 from 39.9% to 40.0%.
Operating Expenses
Although selling and administrative expenses increased over the past three years
as a percentage of sales, the actual amount of selling and administrative expenses
declined each year. The Company recognized expenses during fiscal 2016 related to
the Company’s e-commerce operations, while no expenses related to e-commerce
were recorded in prior years. Higher costs associated with new store openings in
all three years have been offset by lower payroll costs associated with cost-cutting
efforts and closing of underperforming stores.
Advertising costs increased from $9,541,000 in 2014 to $10,792,000 in 2015 and
$14,258,000 in 2016 as the Company began an advertising campaign to promote its
new e-commerce unit.
Depreciation and amortization expenses have increased from $2,501,000 in 2014
to $3,998,000 in 2016 as a result of new store openings.
Impairment charges for the years ended 2016, 2015, and 2014 amounted to
$3,015,000, $2,046,000, and $3,031,000, respectively and are mainly attributable to
store relocations and store closings.
Other Income (Expense)
Interest income increased from 2014 to 2015 as a result of higher average interest rates,
but decreased from 2015 to 2016 due to lower average balances in cash equivalents.
Interest expense increased from 2014 to 2016 as a result of higher interest rates
and higher levels of corporate borrowings related to new store openings.
38  chapter 1  Financial Statements
Income Tax
The Company’s effective tax rate was 45%, 43%, and 45% for 2016, 2015, and 2014,
respectively.
Liquidity and Capital Resources
Operating Activities
The following table provides information about the Company’s cash flows:
(In Thousands)
2016
2015
2014
Net cash provided (used) by operating activities
Net cash used for investing activities
Net cash provided by financing activities
$10,024
(13,805)
2,728
($3,767)
(4,773)
6,464
$5,629
(3,982)
111
Cash flows from operations are seasonal, with the Christmas season being the
peak selling season. Inventory is increased prior to peak selling seasons to meet
increased demand for products and is subsequently reduced due to sales demand
after the season is complete. After failing to generate cash from operations in 2015
the Company returned to a positive cash flow from operations in 2016 primarily due
to the use of short-term supplier credit to finance increases in inventory levels in the
fourth quarter. The significant increase in sales in 2016 resulted in higher accounts
receivable at year-end compared to 2015 and 2014.
Investing Activities
Investing cash flows consist primarily of capital expenditures as a result of the
Company’s current expansion plans and the opening of new stores. Capital expenditures in 2016 were $14,100,000 and are expected to be approximately $15,900,000
in 2017. Funding sources for these expenditures will be cash flows from operating
activities and borrowings, including the Company’s credit line if necessary.
Financing Activities
Borrowings are the primary source of cash from financing activities. Cash used in
financing activities consists mainly of debt repayments and dividends.
We believe that we have the financial resources needed to meet business requirements for the next 12 months, including capital expenditures.
Chapter 1  Financial Statements  39
Auditor’s Report
Board of Directors and Stockholders
Sage Inc.
We have audited the accompanying consolidated balance sheets of Sage Inc., and
subsidiaries as of December 31, 2016 and 2015 and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the three years in
the period ended December 31, 2016. 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 the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audits 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, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Sage Inc. and
subsidiaries at December 31, 2016 and 2015 and the consolidated results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2016 in conformity with accounting principles generally accepted in
the United States of America.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Sage Inc.’s internal
control over financial reporting as of December 31, 2016, based on criteria established
in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission, and our report dated February 15, 2017
expressed an unqualified opinion thereon.
J. J. Michaels and Company
Dime Box, TX
February 15, 2017
40  chapter 1  Financial Statements
Sage Inc.
Consolidated Balance Sheets
December 31, 2016 and 2015 (in Thousands)
Assets
Current Assets
 Cash and cash equivalents
 Accounts receivable, less allowance for doubtful accounts
   of $448 in 2016 and $417 in 2015
Inventories
Prepaid expenses and other assets
   Total current assets
Property, Plant, and Equipment
Land
Buildings and leasehold improvements
Equipment
Less accumulated depreciation and amortization
   Net property, plant, and equipment
Goodwill
Other Assets
Total Assets
Liabilities and Stockholders’ Equity
Current Liabilities
Accounts payable
Accrued liabilities
Income taxes payable
Short-term debt
 Current maturities of long-term debt
   Total current liabilities
Deferred Federal Income Taxes
Long-Term Debt
Commitments and Contingencies (See Notes 3 and 5)
  Total liabilities
Stockholders’ Equity
 Common stock, par value $0.01, authorized, 10,000,000…

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