Financial Reporting-How They Do It

Basic financial statements conform to a universal format, making it fairly easy to become familiar with them and to identify key fundamental elements. Many accounting conventions are purposely conservative so that the opportunities to distort financial statements are limited.

As an example of the conservative approach, assets are always included at cost. So even if an asset has increased in value significantly, that will not be reflected in the asset listing. Current market values of real estate often are substantially higher than the values shown in financial statements, not only as a result of inflation, but due to depreciation as well. The company writes off a portion of a building's value over time, so rather than showing an increase in investment value reflecting the true market situation, financial statement rules mandate that the reported value of real assets decline over time.

Extreme distortions between reported asset value and current market value will be included in the notes of the financial statement. These notes contain much valuable and important information, not only about assets but about all segments of the financial statement. You do not need to take a course in accounting or bookkeeping in order to understand what is included in the corporate financial statement. There are no special secrets known only to accountants; the format and rules of reporting are fairly simple and easy to follow.

Financial Statement Basics

There are three basic financial statements: (1) the balance sheet, (2) the statement of income, and (3) the statement of cash flow. Further information is found in any supplemental schedules (providing greater detail for specific accounts where needed), the auditor's report, and the all-important notes to the financial statements. As described below, each financial statement serves a specific purpose and provides you with important information that can be used to better make investment decisions.

The Balance Sheet

The first financial statement is the balance sheet. This statement reports the dollar value of accounts as of a specified date, usually the end of the latest fiscal year or the end of the most recent fiscal quarter. The reporting date of the balance sheet corresponds with the ending date of the period reported in the statement of income. (For example, the statement of income will report transactions from January 1 through December 31; the accompanying balance sheet reports balances as of December 31.)

Assets. There are three sections to the balance sheet. The first is assets. These are the dollar values of valuables the company owns (such as bank accounts, inventories, and assets) and accounts due from others. Assets owned by the organization are further divided into subclas-sifications based on the type of asset. This subdividing becomes important in fundamental analysis because many trends and ratios you will use depend on distinctions between different types of accounts.

The first three groups are tangible assets. The first group—and the one that is always listed first on the balance sheet—is current assets. These are called current because they are readily available to the organization to fund operations. Current assets include the dollar balances of all cash accounts; accounts receivable (the total of all outstanding accounts, less a reserve for bad debts); dollar value of inventory on hand; and other current assets, including marketable securities, notes receivable, and other accounts that can be converted to cash within one year.

The second group within the assets section is noncurrent assets. These are also called fixed assets and represent assets that are depreciated over many years (rather than being treated as current-year expenses). All property, plant, and equipment are included in this section. When a company purchases a capital asset, such as real estate, machinery and equipment, autos and trucks, or office furniture, such an asset cannot be treated as a business expense in the year purchased. Instead, it is set up as an asset and depreciated over a number of years. So the company takes a deduction for depreciation each year until the value of the asset is fully depreciated. (For many corporations, depreciation may also be listed as amortization and/or depletion.) Depreciation recovery periods, as they are called, may last between 3 and 32 years or longer, depending on the type of asset involved. Long-term assets are subtotaled and then reduced by the value of an account called accumulated depreciation. In this way, the dollar value of all long-term assets is reduced by the amount of depreciation claimed over the years. Eventually, all assets subject to depreciation are reduced to a zero balance. Land investments are reported in a separate category from real estate improvements, because land is not subject to depreciation.

The next group is called deferred assets. Deferrals are expenses that apply to the following period, and will be reassigned as expenses in the following year.

The fourth group is called intangible assets. These are assets that have no physical value. For example, some companies acquire subsidiaries and assign a goodwill value to the name; that would qualify as an intangible asset. (If you acquired rights to the brand name "Oreo," you would have a tasty intangible asset because buyers ask for the product by name.) Goodwill is the amount paid in an acquisition above a company's book value. In other cases, a company may acquire a contractual right upon buying up another business. The seller agrees not to open a competing business within a specified number of years. While it is possible that no money exchanged hands, this contractual agreement has value (lowered competition and customer loyalty from previous owner), so an intangible asset called a "covenant not to compete" may be established. In calculating book value per share, intangible assets are excluded—the total of assets to be used in the calculation are reduced by the assigned dollar value of intangible assets.

Assets are added together and the total is reported on one line on the balance sheet. The sum of all liabilities and shareholders' equity will add up to the same dollar amount as total assets.

Liabilities. The second of three sections of the balance sheet is liabilities, the obligations owed by the company. These are divided into groups that always are listed in the same order.

The first group in this section is current portion of long-term debt (current liabilities). These are liabilities that will be paid within the coming 12 months. Included are accounts payable (amounts due to vendors); taxes payable (to local, state, and federal agencies for payroll and other taxes); and 12 months' worth of payments on any loans or notes outstanding.

Current liabilities are distinguished in this manner for a very important reason. One of the most important fundamental tests involves comparisons between current assets and current liabilities (more on those tests in later chapters). The net difference between current assets and liabilities is called working capital.

The next group is long-term liabilities, which includes all debts payable beyond the coming 12 months. Important fundamental tests and ratios involve comparisons between long-term debt and equity. These two together are broadly referred to in fundamental analysis as a company's capitalization.

The final group is deferred credits. These amounts represent income that will be recorded in a future year, being held, or deferred, in the current year. They are not true liabilities, but income owed to a future year. Companies may receive income payments in advance of their earned period, so they are listed along with liabilities, to be reversed and transferred to income when they become earned.

Shareholders' equity. The third section of the balance sheet is shareholders' equity. As the name implies, this is the value of the company. It consists of the difference between assets (what is owned) and liabilities (what is owed). Shareholders' equity is divided into two primary groups.

First is capital stock, which is the dollar amount of shares outstanding as of the time they were issued and sold, plus any additional paid-in capital, and less any adjustments. Second is retained earnings, which represents all profits from past years reduced by payments of taxes and dividends paid to stockholders.

The relationship between the sections of the balance sheet is shown in Figure 4.1.

Figure 4.1 shows the format normally used for the preparation of the balance sheet. This is, however, the most basic form. Most corporate balance sheets are comparative, showing the balances for the current year as well as the prior year. Many further break down results for different subsidiary companies.

FIGURE 4.1 The Balance Sheet

KEY POINT

The balance sheet is a summary of account balances as of a single date, which is the end of the latest reporting period.

Shareholders' equity is normally reported in a separate statement, and this may be considered a fourth financial statement by itself. However, the separate report actually is a detailed breakdown of shareholders' equity as reported on the balance sheet.

Notes may be referenced and included to explain certain important features for particular accounts. Finally, many additional details may be provided with supplementary schedules, breaking down and elaborating on the balances in accounts receivable (including aging of accounts and a detailed description of the reserve for bad debts), long-term assets, liabilities, and shareholders' equity.