Accounting Analysis

Dr. Liu Yali ( ) Associate professor Certified Public Accountant China

Address:
Room 920 Dongling School of Economics and Management University of Science & Technology Beijing Beijing, P.R.China Mobile 135 5265 6361 Email: liuyali@manage.ustb.edu.cn

Grading Policy for Accounting Analysis:

Attendance and Discussion in class (20 points) Group representation (20 points) Final exam (60 points)

About Group representation:

Choosing with two public companies (listed similar products that are companies)

competitors to each other; Reading annual reports and paying attention Reporting your analysis and conclusion about Handing in your financial analysis report. to the structure of the report; the two companies in class(representation);

Text book:
Understanding Financial Statements
Lyn M. Fraser, Aileen Ormiston

Peking University Press

Price RMB 34 Tel:(010)6275067262752015

Enron CEO

Primary objective of the course:

Help you get behind the numbers, dazzling presentations, and shiny covers to assess the actual condition and performance of the company.

ORGANIZATION OF THE COURSE

Chapter1:anoverview Chapters2-4:discussionindetailforfinancial statements Chapter5:FinancialReportingQuality Chapter6:theanalysisoffinancialstatements

CHAPTER 1: FINANCIAL STATEMENTS:AN OVERVIEW

HOW DO YOU THINK ABOUT THE ROLE OF FINANCIALREPORTINGINCAPITALMARKETS Why should listed companies open their financial statements? Why should listed companies financial statements be auditedbyCPA? Whoaretheusersofaccountinginformation?

information users (offering funds) Savings(investors) Lemons problem?

SEC
regulation

Financial Intermediaries

Information Intermediaries

Business ideas(firms) Information providers (raising funds) Figure1: Information Providing System in Capital

Twotypesofintermediariesinthecapitalmarkets:
Financial Intermediaries: venture capital firms banks mutual funds and insurance companies Information intermediaries: auditors financial analysts and bond-rating agencies

Key Capital Market Intermediaries: Functions, Incentives, and Consequences

Intermediary Intended Market Function Incentives Consequences

Venture Capitalists

Investment public markets by underwriting and the public issue Banks distributing new issues Rewards tied to accuracy of Sell-side Provide research reports and investment recommendations to earnings forecasts, and Analysts individual and professional investors investment banking fees
on new and existing securities

Screen early stage investment Rewards tied to returns at Driven by the IPO[1] market opportunities, and develop risky but liquidation of stake in public or IPO (Initial Public Offering). It is the promising ventures through M&A market. first sale of a corporation's common investment, support and oversight shares to public investors. The main purpose of an IPO is to raise capital for Help companies raise capital in Proportion of proceeds raised in the corporation. Represent the interest of the seller, rather than the buyer, of securities Bias in favor of seller of securities to maintain access to information, and to obtain investment banking deals, and/or generated to generate trading volume. Focus on short-term earnings forecasts. Rewards tied to earnings Focus on forecasting short-term forecasts and short-term stock earnings and short-term stock price return performance from investment recommendations Paid as a function of the size of Focus on attracting new funds, which are assets under management, and often driven by short-term performance relative performance of the of the fund; relative performance fund vs a benchmark evaluation potentially results in herd behavior. Rewarded for new client Unwillingness to confront the client to acquisition, client retention, and increase the probability of retention, generating non-audit fees. and to attract non-audit work.

Buy-side Analysts Mutual Funds Auditors

Provide proprietary research reports and recommendations to fund managers Buy and sell securities to earn superior risk-adjusted returns

Enhance credibility of financial information reported by the company, and attest to its conformance with GAAP

Financialreportingplaysacriticalroleinthe functioningofboththeinformationintermediaries andfinancialintermediaries.Information intermediariesaddvaluebyeitherenhancingthe credibilityoffinancialreports(asauditorsdo) or byanalyzingtheinformationinthefinancial statements(asanalystsandtheratingagenciesdo)

Financialintermediariesrelyontheinformationin thefinancialstatementstoanalyzeinvestment opportunities,andsupplementthisinformationwith othersourcesofinformation

VOLUMEOFINFORMATION(annualreports):
1)Financial Statements: balance sheet, income statement, statement of cash flow, statement of shareholders equity, notes 2)Auditors report 3)Management discussion and analysis (MD&A)

1)Financial Statements
Wheretofindacompanysfinancialstatements? Whatdofinancialstatementsreflect? Whatsthesubjectoffinancialstatements?

Arefinancialstatementspreparedaccordingtotheaccrual basisorcashbasisofaccounting? Theaccrualmethodmeansthattherevenueisrecognizedin theaccountingperiodwhenthesaleismaderatherthanwhen thecashisreceived.

Funds movement for an enterprise

OUTSIDE 1FundRaising

Funds

Marketable securities Input Work in process

Finished

2Investing Purchasing Raw material INSIDE

Products & goods

Funds
3Profit distribution

salaries Fixed assets(depreciation) Retained earnings Dividend outside

inside

Annual Common Size Balance Sheet

Results as of Jan 0, 2000 ASSETS Current Assets: Cash and cash equivalents Short-term investments Total cash and short-term investments Accounts receivable, net Inventories, net Current deferred taxes Jan 0, 2000

Other current assets Total current assets Property, plant, and equipment Less: accumulated depreciation

LIABILITIES Current Liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued liabilities Income taxes payable

Results as of Jan 0, 2000 Jan 0, 2000

Other current liabilities Total current liabilities Long-term debt Deferred income taxes payable Other deferred liabilities

Other liabilities Total liabilities Minority interest STOCKHOLDERS' EQUITY

R.E.C. Inc. Consolidated Balance Sheet at Dec. 31,2007 and 2006 (in $thousands)
31/12/2007 ASSETS Current Assets: Cash Marketable securities(Note A) Accounts receivable, net Inventories, net(Note A) Prepaid expenses Total current assets Property, plant, and equipment (Note A, C, and E) Land Buildings and leasehold improvements Equipment 811 18,273 21,523 40,607 811 11,928 13,768 26,507 65,846 4,061 5,272 8,960 47,041 512 56,264 2,382 8,004 8,350 36,769 759 31/12/2006

2007
LIABILITIES AND STOCKHOLDERS EQUITY Current Liabilities: Accounts payable Notes payable-banks (Note B) Current maturities of long-term debt (Note C) Accrued liabilities Total current liabilities 14,294 5,614 1,884 5,669 27,461

2006

7,591 6,012 1,516 5,313 20,432

Deferred federal income taxes payable (Note A and D) Long-term debt (Note C) Commitments (Note E) Total liabilities

843 21,059 49,363

635 16,975 38,042

STOCKHOLDERS' EQUITY Common stock, par value $1 (Note F) 4,803 4,594

Annual Common Size Income Statement

Results for the Years Ending Jan 0, 2000 Net sales Less: Cost of goods sold Gross profit Sales, general and administrative Research and development (R&D) Restructuring, impairment, and amortization Purchased in-process R&D Jan 0, 2000 Jan 0, 2000

Other operating expenses Total operating expenses Operating profit (loss) Other income (expenses), net excluding interest expense Earnings (loss) before interest and taxes Interest expense Earnings (loss) before taxes

R.E.C. Inc. Consolidated Statements of Earnings for the years ended Dec. 31,2007,2006 and 2005 (in $thousands Except Per Share Amounts)
2007 Net sales Less: Cost of goods sold (Note A) Gross profit Sales and administrative expenses (Notes A and E) Advertising Depreciation and amortization (Note A) Repairs and maintenance Operating profit Other income (expenses) Interest income Interest expense Earnings before income taxes income taxes (Note A and D) Net earnings Basic earnings per common share (Note G) Diluted earnings per common share (Note G) 215, 600 129,364 86,236 45,722 14,258 3,998 3,015 19,243 422 (2,585) 17,080 7,686 9,394 1.96 1.93 2006 153,000 91,879 61,121 33,493 10,792 2,984 2,046 11,806 838 (2,277) 10,367 4,457 5,910 1.29 1.26 2005 140,700 81,606 59,094 32,765 9,541 2,501 3,031 11,256 738 (1,274) 10,720 4,824 5,896 1.33 1.31

Annual Consolidated Statement of Cash Flows

Results for the Years Ending

Jan 0, 1900 Jan 0, 1900 Jan 0, 1900 Cash flows from operating activities: Income (loss) from continuing operations $ -$ -$ -

Adjustments to reconcile to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Restructuring and impairment charges Increase (decrease) in provision for deferred income taxes (Gain) loss on sales of investments, acquisitions, and securities (Gain) loss on sales of property, plant, and equipment

Other non-cash items, net Changes in assets and liabilities: (Increase) decrease in receivables (Increase) decrease in inventories

Annual Consolidated Statement of Cash Flows(continue)

Results for the Years Ending Cash flows from investing activities: Purchases of property, plant, and equipment Sales of property, plant, and equipment Purchases of marketable securities and short-term investments Sales of marketable securities and short-term investments Acquisitions, net of cash acquired Other investing activities, net Net cash provided by (used in) investing activities Cash flows from financing activities: Short-term borrowings, net Proceeds from long-term borrowings Payment of long-term borrowings Proceeds from sales of common stock Repurchase of common stock / treasury stock Dividends to shareholders -

Jan 0, 2000 Jan 0, 2000 Jan 0, 2000

Annual Summary Analysis Statement of Cash Flows

Results for the Years Ending Jan 0, 2000 Inflows Proceeds from operating activities Sales of property, plant, and equipment Sales of marketable securities and short-term investments Divestiture of acquisitions, net of cash acquired Proceeds from other investing activities, net Proceeds from short-term borrowings, net Proceeds from long-term borrowings Proceeds from sales of common stock Proceeds from other financing activities, net Proceeds from discontinued operations Gains from effect of exchange rate changes on cash, net Total Inflows Outflows Losses from operating activities Purchases of property, plant, and equipment Purchases of marketable securities and short-term investments Acquisitions, net of cash acquired Losses from other investing activities, net Payment of short-term borrowings, net Payment of long-term borrowings Repurchase of common stock / treasury stock Payment of dividends to shareholders Payment of other financing activities, net Losses from discontinued operations $ 0

$ $

0.0

Notestofinancialstatements: -Asummaryofthefirmsaccountingpolicies(includingany changesinaccountingpolicies) -detailsaboutparticularaccounts -certainsupplementaryinformation

Accountingpolicies,Estimates-ChoicesandChanges Inpreparingfinancialstatements,managementmakechoices on accounting policies and makes estimations in the applicationsofthosepolicies.

Anexample:thedepreciationoffixedassets -depreciablebase(costlesssalvagevalue) -depreciationperiod

 1 Straightlinemethod

Depreciationexpenseperyear
= Cost - salvage value Depreciation period

AnITproductsfactoryboughtahigh-techmachineat $200000,whichisestimatedtohaveafive-yearusefullife and0salvage. annualdepreciationexpense=

 2 Acceleratedmethod Recognizehigherdepreciationexpenseintheearly yearsofitsusefullife. Usuallyattwicethestraightlinerate Thedepreciationexpenserecognizedforyear1:

Whatstheresulttochangetheestimateduseful lifefromfiveyearstotenyears?

Whatsobjectivefortaxpurposesandthe objectiveforreportingpurposes? Howdothemanagementmakeaccounting policychoicetorealizethesepurposes?

2)Auditors report

-unqualified report -Qualified report -Adverse opinion -Disclaimer of opinion

In theory, the auditing firm performing the audit and issuing the report is independent of the firm being audited.

Accounting firm Ernst & Young KPMG

Client Sprint Corp. GE Corp.

Auditing Fee Non-auditing Fee (thousand dollar) (thousand dollar) 2 500 23 900 63 800 79 700 62 300 84 200 27 000

Motorola Corp. 3 900 Pricewaterhouse J.P. Morgan Coopers Chase Andersen Enron 21 300 25 000

Sarbanes-Oxley Act of 2002 prohibits Audit firms from providing certain nonaudit services when conducting an external audit of a firm

VALUE OF THIS COURSE

Learnhowto"readbetween-the-lines"offinancial statements. Itwillbeveryusefulforyourcareerasafinancial analyst,investmentbanker,consultant,corporate director,etc.