Financial Statement Review

Most companies produce financial statements on an annual and quarterly basis. The main five statements that are reported are the:

  • Audit Report
  • Balance sheet
  • Income statement
  • Statement of cash flows
  • Statement of shareholder’s equity
  • Statement of comprehensive income
  • Footnotes
SEC Filings and Company Reports
  • 10-K Annual Report(a 20-F for foreign registrants).
    • This is due within 60-90 days of the year end depending on the size of the company.
    • This includes the annual report to shareholders.
    • The 10-K includes audited financial statements
  • The 10-Q Quarterly Report
    • This form is due within 40-45 days of quarter end depending on size.
    • The SEC requires that all publicly traded companies file this report quarterly
    • It contains similar information to the 10-Q, although it’s usually not as detailed and the financial statements are usually unaudited
    • Only 3 of these are filed each year, because in the fourth quarter the 10-K takes its place
    • This is a quarterly report to shareholders
  • Form 8-K, the Current Report
    • This form is used to report important, or ‘material’ events
    • It’s due within 4 days of the event
    • Involves a press release

What’s in a 10-K Report?

 

Report of the Independent Auditors

Audited financial statements are preceded by an audit report that has been done by the independent auditors. Audit reports follow a standard format, with the first paragraph identifying the financial statements that were audited, and points out that management is responsible for the financial statements.

The second paragraph of the audit report states that the audit was done in accordance to the standards of the accounting oversight board. SOX(Sarbanes-Oxley) eliminated the right of the AICPA to self-regulate their profession. The PCAOB took over.

The third paragraph contains the auditor’s opinion regarding the fairness of the financial statements.

The fourth paragraph gives the auditors’ opinion on whether the company’s internal control system is effective, and outlines the standards that were followed when they did the internal control audit.

Sometimes a fifth paragraph will contain information if the company has adopted any new accounting policies. When this happens, it can signal a potential lack of consistency in the numbers reported in previous years.

Types of Audit Reports

A clean or unqualified opinion means that the information in the financial statements appear to be accurate and reliable.

A qualified opinion means that the financial statements aren’t reliable for users to make decisions from.

Disclaimer of opinion is when the auditor doesn’t express an opinion because they can’t figure out whether the financial statements are reliable or not.

An adverse opinion is issued when there are material weaknesses in the reporting.

A going concern qualification is when the auditor basically says the company is headed for bankruptcy.

The Balance Sheet

The balance sheet is the snapshot of the company’s resources and the claims against those resources at a given point in time. The basic accounting equation for the balance sheet is always:

Assets=Liabilities + Owners’ Equity

Sometimes a firm will have minority interests listed on their balance sheet. This is when a parent company has subsidiaries that it controls but doesn’t wholly own. If company ABC owns 80% of company XYZ, then ABC will list 100% of XYZ’s assets with its own assets, and 100% of XYZ’s liabilities as well, but it doesn’t own all 100%… it only owns 80%. Another group, called the minority interest, owns the other 20%.

Assets

The balance sheet lists current and non-current assets. Current assets are usually any assets that will be used up within a year, or one operating cycle. This includes things like cash and accounts receivable.

Non-current assets are longer-term assets that include things like land, buildings, and equipment. Some companies record the property, plant, and equipment ‘net’ of depreciation in their footnotes, while some include it on their balance sheet.

Intangible assets are things like Goodwill or patents. Goodwill isn’t amortized, instead it is tested for impairment usually once a year. Patents or license agreements on the other hand, have a ‘definite life’, so they are amortized over time and expensed as they are used up.

Liabilities

Liabilities are classified as current liabilities just like current assets. These are liabilities that are expected to be satisfied within one year. Since current liabilities are usually satisfied by current assets, the liquidity of a firm can be measured by comparing the two, this is called the current ratio.

Current Ratio: Current assets/Current liabilities

Statement of Stockholders’ Equity

The statement of stockholders’ equity explains the changes in the equity balances during the period. There are two type of equity, which are contributed capital and retained capital.

An important equation to remember is: Beginning RE + NI – dividends = Closing RE

The Statement of Comprehensive Income

The statement of comprehensive income contains certain gains or losses that by-passed the income statement and were recorded directly in equity. The characteristics of these transactions are that they are unrealized, and that aren’t expected to be realized in the short-term. Some examples are foreign exchange gains or losses, pension related gains or losses, and investment or derivative gains or losses.

Comprehensive income is net income plus other comprehensive income. There are three acceptable forms of reporting comprehensive income. They include:

  1. A combined statement of net income and comprehensive income
  2. A separate statement of comprehensive income
  3. A statement imbedded in the statement of stockholders’ equity

The statement imbedded in the stockholders’ equity is the most popular form of reporting comprehensive income.

When it comes to comprehensive income, there are annual amounts and cumulative amounts. For the annual amount of comprehensive income, you simply add net income to ‘other comprehensive income’.

For cumulative comprehensive income, you know that:

  • Retained earnings = cumulative retained net income
  • Accumulated other comprehensive income = cumulative retained OCI
  • and Accumulated CI = Retained earnings + accumulated OCI

The Income Statement

The income statement reports net income or net loss for the period. There are two formats that the income statement can follow:

  1. Multi-step income statement
  2. Single step income statement

The main difference between the two income statement formats is that the multi-step income statement has subtotals as it goes down towards net income.

The Statement of Cash Flows

The statement of cash flows explains the changes in cash during the period. There are three sections:

  • The operating activities
    • This can be reported under either the indirect or direct method. Indirect starts with net income and is the most popular reporting method.
  • The investing activities
  • The financing activities

The Footnotes to the Financial Statements

There are three main types of footnotes that you’ll find in financial reports.

  •  Footnotes about accounting policy choices
  • Footnotes about reported balances
  • Footnotes about unreported balances

Common-Sized Balance Sheets

A common-sized balance sheet has each account stated as a percentage of total assets. This allows users to compare firms of different sizes across industries or time. It also lets the users gain deeper understandings of the relative financial position of a given company. It’s also useful for identifying relationships used in forecasting.

Common-Sized Income Statements

In a common-sized income statement, each balance is stated as a percentage of sales. This has the same advantages as a common-sized balance sheet… mainly allowing users to compare similar companies that are different sizes.

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