Reading Financial Reports for Dummies (43 page)

Filling the GAAP

Although a CPA’s primary role as an auditor is to make sure that a company’s financial statements are presented fairly and accurately, he must also ensure that the
generally accepted accounting principles
(GAAP) are followed.

GAAP help a company determine the amount of financial information it must disclose and help it measure its assets, liabilities, revenues, expenses, and equity. That information makes up the financial statements, including the balance sheet (see Chapter 6), the income statement (see Chapter 7), and the statement of cash flows (see Chapter 8). The GAAP, which fill bookshelves in an accountant’s office, are highly technical explanations of how a company must report the financial information on each line item of these financial statements, such as how to calculate the value of each asset, liability, or equity on the balance sheet, or how to report revenue and expenses on the income statement.

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Accounting standards: Four

important qualities

The primary accounting-standard-setting body in the U.S. is the Financial Accounting Standards Board, or FASB (check out the sidebar “Exploring the FASB”). It’s responsible for developing the GAAP, as well as updating the already developed GAAP to reflect changes in the ways companies operate.

These changes occur as new ways of doing business become commonplace in the business world.

The FASB specifies four characteristics of useful accounting information that companies need to strive for in their financial reports. These four characteristics form the basis for designing the technical GAAP requirements:

✓

Relevance:
Relevant information includes information needed to forecast a company’s future earnings or confirm or correct prior expectations. The information must also be timely, which means it must be available to business decision-makers before it loses the power to influence decisions. For example, if companies had to report their earnings only every five years, the information wouldn’t be relevant to most company outsiders, who need to make decisions about the company more frequently than that.

✓

Reliability:
In order for accounting information to be considered reliable, it must be verifiable, factual, and accurate. The information must also be neutral. In other words, a company can’t cherry-pick the information it wants outsiders to see and hide any bad news that it doesn’t want to report.

✓

Comparability:
Not all companies must collect and present the information in exactly the same way. Some variation is allowed in accounting methods, but a company must disclose what accounting methods it uses. For example, as I discuss in Chapter 15, numerous methods are available for tracking inventory, so companies must state which method they use. This requirement makes comparing results from company to company easier.

✓

Consistency:
The company must use the same accounting principles and methods from year to year so that financial report readers can compare results with those of previous years. If a company changes the accounting principles or methods its financial reports are based on, it must tell the financial report readers about the change and provide information regarding how that change impacts previously reported financial results.

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Part V: The Many Ways Companies Answer to Others

Exploring the FASB

The FASB was first designated as the organiza-

relevance, reliability, comparability, and

tion responsible for establishing standards of

consistency.

financial accounting and reporting in 1973. Both

✓ Maintaining current standards that reflect

the SEC and the American Institute of Certified

changes in the methods of doing business

Public Accounts (AICPA) recognize the FASB

and in the economic environment.

as the authority for setting the standards for

financial reports.

✓ Reviewing promptly any significant areas

where financial reporting may be defi-

The FASB board is made up of seven members

cient and improving the reporting situation

who serve full time for five-year terms and are

through its standard-setting process.

eligible for one additional five-year term. To

serve on the FASB, board members must sever

✓ Promoting the international convergence of

all connections with firms or institutions they’ve

accounting standards to improve financial

been involved with before the appointment.

reporting.

The FASB’s mission is to establish and improve

✓ Improving the common understanding of

standards of financial accounting and reporting.

the nature and purpose of financial report

The board is responsible for the guidance and

information.

education of the public, which includes issuers,

You can access information about FASB work-

auditors, and users of financial information. The

ing projects and accounting standards online at

FASB carries out its mission by

www.fasb.org.

✓ Seeking to improve the usefulness of financial

reporting by focusing on four characteristics:

Changing principles: More work

for the FASB

GAAP aren’t set in stone. As business needs and the way companies do business change, so must the principles. The auditing industry is the most sensi-tive to emerging trends in day-to-day reporting practices, so it tends to be the profession that most frequently alerts the FASB to the need for new principles or changes in old principles. In addition to changes noticed in the field, new legislation or regulatory decisions can be the sources of needed changes in the GAAP.

After hearing from all sources about emerging issues, the FASB decides what technical issues it will add to its agenda to change the GAAP. The board looks at a number of factors when deciding whether an issue is worth being changed:

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✓

Pervasiveness of issue:
The board determines how troublesome the issue is to users, preparers, auditors, and others. It also considers whether the practice being questioned impacts many different kinds of companies and whether the issue is likely to be transitory or to persist for a long time. Only those issues that are likely to persist over time are considered for further action.

✓

Alternative solutions:
The board considers which of the one or more alternative solutions will improve financial reporting in terms of the key characteristics of relevance, reliability, consistency, and comparability.

✓

Technical feasibility:
The board determines whether a technically sound solution can be developed or whether the project under consideration must wait for another issue to be decided as part of a different project also underway. If another issue must be decided first, the board holds off working on the issue.

✓

Practical consequences:
The board weighs whether the improved accounting solution is likely to be generally accepted and to what extent addressing a particular issue may cause others, such as the SEC or Congress, to act.

✓

Convergence possibilities:
The board determines whether its action on the issue will lead to the elimination of significant differences in standards or practices between the U.S. and other countries, with resulting improvement in the quality of U.S. standards.

✓

Cooperative opportunities:
The board considers whether there’s international support by one or more other standard-setters for undertaking the project jointly or through other cooperative means with the FASB.

✓

Resources:
The board must determine whether adequate resources and expertise are available within the FASB or whether the FASB can leverage off the work of other standard-setters.

If the FASB decides it wants to work on an issue, it begins a long process that can take years before the issue is added to the GAAP. This process includes board meetings that are open to the public, exposure drafts circulated for public comment, and additional board meetings and comment periods, if necessary.

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Part V: The Many Ways Companies Answer to Others

Chapter 19

Digging into Government

Regulations

In This Chapter

▶ Looking at the 10-Q

▶ Getting acquainted with the 10-K

▶ Evaluating internal controls

▶ Checking out company compliance

▶ Becoming familiar with the way the board works

▶ Disclosing insider ownership

You’ve probably heard all kinds of complaints about the government bureaucracy involved in, and the paperwork required for, corporate reporting. Most corporate executives and managers responsible for answering to the government don’t find pleasure in reading through government reporting requirements. This stuff doesn’t make great bedtime reading, although some people do find these requirements good to read when they’re having a hard time falling asleep — boring!

No matter how boring and frustrating corporate staff may find these government requirements, corporations have no way to bypass the rules. Actually, as a company outsider who needs to know what’s happening behind closed doors, you should be glad such stringent regulations exist. Without them, you’d have no idea whether you’re getting accurate reports about what the company does and what its growth prospects are.

If you’re researching a company because you’re considering investing in it or have already invested, you shouldn’t depend solely on the information the company gives you in its annual and quarterly reports. Visit the Securities and Exchange Commission’s (SEC) Edgar Web site (www.sec.gov/edgar.

shtml) and read the details in the company’s public reports filed with the government.

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Part V: The Many Ways Companies Answer to Others

I find that one of the best ways to track news about particular companies and new SEC filings is by listing a mock portfolio on one of the financial news Web sites, such as Yahoo! Finance (finance.yahoo.com). Any news or SEC filing is linked to the opening page of each stock. An asterisk designates when something new is reported about a stock in your mock portfolio, so you know when new information about the company has been posted.

Checking Out the 10-Q

Every quarter, corporations must report their financial results to the SEC

(which has primary responsibility for the U.S. government’s oversight of public corporations) on Form 10-Q. The 10-Q isn’t a blank form that needs to be filled in. Instead, the SEC provides general instructions for the information that must be included and the format in which it must be presented. The 10-Q

includes two parts.

Financial information

The financial information required for Part I of Form 10-Q isn’t much different from that required for the annual reports. Four items are required:

✓

Item 1 — Financial statements:
Included in this section are the balance sheet (see Chapter 6), income statement (turn to Chapter 7), and statement of cash flows (discussed in detail in Chapter 8).

✓

Item 2 — Management’s discussion and analysis of financial condition
and results of operations:
This section includes a discussion and analysis by management of the company’s liquidity, resources, and operations, its financial condition, and any changes that occurred during the quarter. I discuss the requirements for this section in greater detail in Chapter 5.

✓

Item 3 — Quantitative and qualitative disclosures about market risk:
This section includes discussion about external conditions that impact the company’s market, including the impact of inflation, economic conditions that could impact revenue, and competitive forces that may impact the company’s future results.

✓

Item 4 — Controls and procedures:
This section requires management to disclose the controls and procedures the company has in place to protect its assets and the accuracy of its financial reports. I discuss this requirement in greater detail in the section “Investigating Internal Controls.”

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Other critical matters

Companies report other important corporation matters that don’t fall under the topic of financial results in Part II of the 10-Q. This section contains several possible items, but companies need to include only the items relevant to the particular quarter being reported. Following are the items in Part II:

✓

Item 1 — Legal proceedings:
Events involving legal proceedings must be reported only during the quarter in which they first became material and in any future quarters when information related to material developments is available.
Material developments
are proceedings that may have a significant impact on a company’s finances.

✓

Item 1A –
Risk factors:
This section reviews the risks disclosed related to a company’s business, financial condition, and cash flows, as well as results of operations that may be materially adversely affected by any of these risks. The trading price of the company’s common stock may decline due to these risks.

✓

Item 2 — Changes in securities and use of proceeds:
Anytime a corporation makes changes to the rights of holders of its registered
securities
(stocks and bonds sold on the public markets), the changes must be reported. These changes include changes to working capital and restrictions and limitations on the payment of dividends.

✓

Item 3 — Defaults upon senior securities:
If a company defaults on its payment of principal or interest on company debt and the default isn’t cured within 30 days, the company must report it. The only type of default that doesn’t need to be reported is one between a parent company and one of its subsidiaries.