Financial Decision Making 8 questions 4 papers

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Financial Decision Making: An Introduc�on to Financial Reports Lita Epstein

Editor in Chief, AVP: Steve Wainwright

Sponsoring Editor: Cheryl Cechvala

Development Editor: Shannon LeMay-Finn

Assistant Editor: Amanda Nixon

Produc�on Editor: Lauren LePera

Copyeditor: Lachina Publishing Services

Senior Product Manager: Peter Galuardi

Cover Design: Jelena Mirkovic Jankovic

Prin�ng Services: Bordeaux

Produc�on Services: Lachina Publishing Services

ePub Development: M & R Consultants Corpora�on

Permission Editor: The D'Stair Permissions Agency

Cover Image: thumb/iStock/Thinkstock and Tim Pla�/Iconica/Ge�y Images

ISBN-10: 1621781356

ISBN-13: 978-1-62178-135-6

Copyright © 2014 Bridgepoint Educa�on, Inc.

All rights reserved.

GRANT OF PERMISSION TO PRINT: The copyright owner of this material hereby grants the holder of this publica�on the right to print these materials for personal use. The holder of this material may print the materials herein for personal use only. Any print, reprint, reproduc�on or distribu�on of these materials for commercial use without the express wri�en consent of the copyright owner cons�tutes a viola�on of the U.S. Copyright Act, 17 U.S.C. §§ 101-810, as amended.

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About the Author Lita Epstein, MBA, earned her Master's degree at Emory University's Goizueta Business School, where she ran the accoun�ng lab for MBAs and Execu�ve MBAs. A�er comple�ng her MBA, she worked as the associate director of development for The Carter Center and then as assistant manager of facili�es management for the Emory clinics. She is the author of more than 35 books, including The Business Owner's Guide to Reading and Understanding Financial Reports, Bookkeeping for Dummies, and Reading Financial Reports for Dummies.

Prior to earning her Master's degree, Lita worked as a newspaper reporter, magazine editor and press secretary for a U.S. Congressman. She earned her undergraduate degree in Community Development at Rutgers University.

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Acknowledgments The author would like to acknowledge the many people who were involved in the development of this text. Special thanks are due to Cheryl Cechvala, sponsoring editor; Shannon LeMay-Finn, development editor; Amanda Nixon, assistant editor; and Lauren LePera, produc�on editor. Thanks also to the following Ashford contributors for helpful advice and sugges�ons: Stanley Atkinson, Diane Hamilton, Wayne Hollman, John Kuhn, and Michael Powers.

The author would also like to thank the following reviewers for their valuable feedback and insight:

Bob Ainsworth, Clark University Richard Miller, Wesleyan University Gerald Solomon, Georgetown University

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Preface Reading and analyzing financial reports can seem like a daun�ng task, but taking the �me to learn the clues that these documents o�en hold can help with making be�er business and managerial decisions. In this book, we introduce the student to the basics of financial repor�ng and how the reports are generated. We also give the student the tools to analyze them.

Accountants are responsible for developing these reports, but it's the management and execu�ve team that can use the collected data to understand the finances of the business. The world of accoun�ng has a language of its own. We review the basics of that language to help students understand the informa�on they see.

I wrote this book so students who are working in the world of business know how to use these financial reports to quickly and rela�vely painlessly gather the informa�on they need to make key decisions about revenue, expenses, and resource alloca�on. Knowing what informa�on appears in which statements and how that informa�on is gathered will help students more effec�vely and efficiently make decisions as employees, supervisors, and managers. Their knowledge of how to quickly find the informa�on needed and what that informa�on means in a business se�ng will be an asset to any real-world company at which they choose to work.

As students move up in the business world and need to make hiring and budget decisions, the skills they will take away from this book will enable them to make sound strategic decisions. They will also have the tools to gain a compe��ve edge over similar companies in the industry in which they work.

Special Features

Financial Decision Making includes a number of features to enhance students' abili�es to use financial reports for decision making:

World of Business: These boxed features include brief real-world examples to help students understand how key issues being discussed in the text impact the business world. Ques�ons for discussion are included at the end of each boxed feature.

New World of Financial Oversight: These boxed features discuss recent or upcoming changes in the financial repor�ng world that impact how financial informa�on must be disclosed to the public. Students are given the needed resources to inves�gate these changes in greater detail.

Task Boxes: These boxes encourage students to use real world financial reports to prac�ce cri�cal skills discussed in the text.

Links to Credible Resources: Every student must know where to find the cri�cal informa�on from key players in the world of financial repor�ng. We provide informa�on so the students will know how to access each of these sources, such as the U.S. Securi�es and Exchange Commission (which has the primary responsibility to be sure financial repor�ng is accurate and fairly represents the financial condi�on of major U.S. corpora�ons); the Financial Accoun�ng Standards Board (which has primary responsibility for developing and upda�ng the U.S. GAAP); the American Ins�tute of CPAs (which is responsible for the ongoing training of accountants and auditors); and many other en��es important to the world of financial repor�ng.

Takeaways: Each chapter ends with key managerial decisions that can be made using the informa�on learned within the chapter.

For Discussion and Applica�on: Following the takeaways, students will be given the opportunity to synthesize and reflect on the major concepts presented in the chapter with exercises and discussion ques�ons.

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1 What Are Financial Statements and How Can You Use Them?

© emily2k/iStock/Thinkstock

Learning Objec�ves

A�er reading this chapter, you should be able to:

1. List and explain the types of financial statements and the individuals who use them. 2. Describe the purpose of the annual report and the elements that it comprises. 3. Describe the purpose of the Form 10-K and the elements that it comprises. 4. Define the concept of generally accepted accoun�ng principles (GAAP) and explain how they are used in prac�ce. 5. Iden�fy accounts that make up the annual report and Form 10-K.

Introduc�on

You are probably at least a li�le familiar with financial statements, and you may have used or created them as part of your financial responsibili�es as a manager or employee. But to be a truly effec�ve manager, it's important to understand more than just the basics. And that's what this book is all about: understanding how you can use financial statements to make be�er and more informed decisions as a manager.

One key responsibility for many managers is the regular prepara�on of a budget. In fact, all companies must plan a budget prior to the start of a new year. Most companies pick managers from various departments to spearhead the budget process.

In this text, we'll follow a fic�onal commi�ee at the fic�onal Best General Company that was formed to create a budget for the coming fiscal year. Let's first meet the members of the commi�ee: Bob, a financial analyst at the company, has been asked to form the budget commi�ee. He chooses three other employees to join him: Susan, a marke�ng manager; Juan, a sales manager; and Mai, the purchasing manager.

Together this group will need to review the year-to-date spending and compare it to the budget to analyze how well the company is doing. As part of their research, they will also need to compare their company's financial results to similar companies in the same sector. This will help them determine how they are performing against their compe�tors.

A�er reviewing the previous year's results, they will also be able to determine areas where improvement is needed, or, conversely, iden�fy areas in which their company excels. Using all of this informa�on, commi�ee members will be able to develop a framework that department heads can use to develop a budget for the next year. This will include a projec�on of revenues—that is, whether revenues are expected to go up or down. Revenues drive the budget because resources the company can use during the next year will depend on the revenue that is expected to be generated.

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For example, if the budget commi�ee projects an increase of 10% in revenues, it can instruct managers that they can increase their expenses by a certain percentage. On the other hand, if the economic condi�ons lead the budget commi�ee to project lower revenue than the previous year, managers will be asked to reduce their expenses by a certain percentage.

The profit goals will drive the percentage of budget increases and decreases as well. For example, if the company is expected to increase its revenue by 10%, the execu�ve commi�ee may want to increase expected net profit by a certain percentage. Therefore, managers will not be given leeway to increase expenses by the full 10% of expected revenues.

The budget commi�ee may also recommend to the execu�ve commi�ee expansion in certain divisions or departments that are producing the best results—and possibly a reduc�on in resources to departments whose contribu�on to revenue is decreasing.

In this book, we will follow the Best General Company budget commi�ee and give examples of how it can use financial statements to determine how well the company is doing and make appropriate decisions. As part of this process, we will introduce financial statements and how they can be used to manage the finances of each department discussed.

Along the way, we will explore who reads financial reports and what they hope to gain by reading them. By analyzing such reports, readers learn not only whether a company made money during a given period, but also how efficiently the company used its resources. Let's get started by discussing financial statements and why they are so important.

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Companies that are publicly traded must file annual financial reports with the SEC.

didecs/iStock/ThinkStock

1.1 What Are Financial Statements and Why Are They Important? No manager or execu�ve can develop plans to improve a company's financial performance and results without first analyzing what happened over the past year, or past several years. This is where financial statements come in; they provide a snapshot of the financial health of a company for a specific period of �me, and give both internal and external readers informa�on needed to make financial decisions about a company.

Mid-level managers and supervisors, for example, can use financial reports to iden�fy a trend. They can compare several years' worth of reports, and then make decisions about how to improve their department's results based on an analysis of these trends.

Similarly, if a company's profits are dropping, managers, such as those par�cipa�ng on our Best General Company budget commi�ee, can use financial reports to determine the contribu�ng factors. Conversely, if managers spot an improving trend, they can use financial statements to iden�fy the key products or services contribu�ng to this improvement, and look for ways to grow their company's market share in the most profitable products or services.

Managers should always be alert to trends that affect revenues or expenses, whether up or down. The sooner a changing trend is recognized, the quicker a fix can be put in place to meet or exceed year-end goals.

Managers have access to two types of reports: external financial reports and internal financial reports. External financial reports are made available to the general public, including investors, bankers, vendors, and suppliers, and must be prepared according to strict accoun�ng rules, which are discussed below. Internal financial reports, in contrast, are confiden�al and can only be shared with employees of the company or the company's board of directors.

Let's review the key differences between these types of reports and the informa�on found in each.

External Reports

All companies must prepare external reports for their bankers and investors. Companies that sell shares on the public stock markets (that is, public companies) must file these reports with the Securi�es and Exchange Commission (SEC), a federal agency that enforces securi�es law and regulates the securi�es industry, which includes the stock and op�on markets.

Three Key Documents

A standard set of financial statements consists of the following three key documents:

The balance sheet (or statement of financial posi�on): This statement shows a company's assets (what the company owns), its liabili�es (what the company owes), and its equity (what claims investors have on the assets). It is essen�ally a snapshot of the company's financial posi�on as of a par�cular date. We dig into this statement in Chapter 2. The income statement (or statement of earnings, or profit and loss statement): This statement provides informa�on about a company's revenues and expenses. We explore this statement in Chapter 3. The statement of cash flows: This statement reveals how much cash flowed into and out of the business. The statement allows managers to determine whether the company received and spent more or less cash in the current year (versus the prior year) in each of the cri�cal areas of opera�ons. Opera�ons include all the day-to-day ac�vi�es in running the business. These ac�vi�es will vary depending on the type of business that is being run. We explore this statement in Chapter 4.

In addi�on, if the company is incorporated, the company's annual report will include a statement of shareholders' equity, which will detail the claims owners have against the company's assets. This can be found at the bo�om of the income statement or on a separate page. We will explore the statement of shareholders' equity in the same chapter as the income statement.

Using External Reports

Let's say Juan, the sales manager at Best General Company, takes on the first task for the budget commi�ee. Working with Susan, the marke�ng manager, he needs to determine what level of sales to project for the next year. This number is cri�cal to the en�re budge�ng process because it sets the revenue goal, which will drive what financial resources will be available to every department.

Juan and Susan need to analyze the sales trends for the current year and compare these results to previous years. They will then need to collect data that will enable them to project sales levels for the next year.

They also need to compare Best General Company's sales to those of others in the industry. If Best General Company is doing be�er than the other companies, they need to iden�fy what the company does differently to stay on top of the compe��on and plan strategies to keep Best General Company on top. If they find that their company is not doing as well, they need to analyze what the compe��on is doing to a�ain be�er results, and come up with a plan to improve their own performance.

Suppose they discover that Best General Company's revenues are falling. How can the budget commi�ee use the external financial statements to find out why?

1. From the income statement, they may find that revenues for the Best General Company have been falling for not just one year, but the past few years. 2. A second stop would be the balance sheet, which could reveal that the Best General Company's cash flow is threatened because of a rising trend in accounts

receivable (an account that tracks money due from customers). This could mean customers are paying their bills more slowly—or not at all.

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Internal Reports

3. The third stop would be the statement of cash flows, which would enable them to determine whether the company received or spent more or less cash in the current year versus the prior year in each of the cri�cal areas of its day-to-day opera�ons.

Someone examining a company's external reports would not be able to probe all that deeply into the company's finances because much of the needed detail would be in internal reports that are confiden�al and available only to insiders (which we discuss next). The budget commi�ee will have access to the internal reports for the Best General Company but will not have access to the internal reports for their compe�tors.

However, outsiders can find more about these key financial statements in the Notes to the Financial Statements, which are published publicly. These notes provide more detail about the numbers on the statements. We will explore these notes and their rela�onship to the financial statements as we delve into each of the statements in the chapters that follow.

External financial report readers can also find out more informa�on from a company's execu�ves in another sec�on of the reports filed with the SEC called the Management's Discussion and Analysis. In this sec�on, execu�ves discuss the prior year's results, as well as key plans for the company in the following year. This sec�on of the external reports can be helpful for Juan and Susan to find out where their compe�tors are planning to focus their a�en�on in the next year.

The financial statements, notes to the financial statements, and the management's discussion and analysis are all parts of an annual report that must be sent to shareholders and filed with the SEC. (Quarterly reports that are not as detailed are sent to shareholders and are also filed with the SEC.) In addi�on to an annual report, a more formal financial repor�ng structure, called the SEC Form 10-K, must also be filed.

Internal Reports

As noted above, internal reports are released only to certain employees in the company to help execu�ves and managers delve deeper into the numbers.

Public companies prefer to release as li�le of their financial informa�on as possible to minimize the informa�on available to their compe�tors. Of course, public companies must divulge a certain amount of informa�on because government regulators require it, but the devil is in the details. A financial report reader won't find many of the details needed to make business decisions in the public reports.

Instead, such informa�on is found in confiden�al reports prepared for internal audiences only. Confiden�al reports may detail the sales by product, the cost of goods purchased by product, and a summary of customers who are late paying their invoices, as well as a number of other details. There is no limit to the types of internal reports that can be developed. These reports do not have to meet any rules since they are for internal use only.

This book focuses primarily on public financial repor�ng. However, we will also explore common formats for internal reports that enable execu�ves and managers to make decisions. The company's accoun�ng department prepares both types of reports. As we explore the various financial statements, we will also discuss how these reports are prepared.

Who Reads Financial Reports?

Many people read a company's financial reports to get the informa�on they need to (1) gauge the financial health of a company and (2) make decisions about the company. The following are examples of individuals who might be interested in these reports, and what they hope to learn by reading them:

Execu�ves and managers: These are the individuals who make financial decisions for the company. They base most of their decisions on the informa�on found in both internal and external financial reports. If execu�ves and managers see a major difference between what was budgeted versus the final result, they will inves�gate to find out why there is a difference; for example, they will talk to key managers and employees about their target goals. Non-accoun�ng managers use these reports to determine whether they met their goals and, if they did not, to determine what happened. Employees: Employees also use financial reports to determine whether they met their goals. For example, salespeople depend on internal reports to determine their commissions and to be certain they received credit for all their sales. If the internal reports differ from what the salesperson believes he or she sold in the month, the salesperson will need to provide the evidence and determine what might be missing from the report. If the salesperson finds the internal report does not accurately reflect his or her sales, then all other reports based on these numbers may be wrong as well (or it may mean the wrong salesperson received credit for a sale and the rest of the reports are accurate). Employees may also make career and re�rement investment decisions based on the financial reports. For example, if an employee is seeking an opportunity to move up in the company, he or she may use informa�on from the financial reports to determine where the company is planning to grow and seek a posi�on in one of the growth departments. Creditors: Creditors, such as banks or other lending ins�tu�ons, use financial reports to determine whether to lend money to the company. A creditor who has already loaned money to the company may also use the reports to determine whether the company is mee�ng minimum loan requirements set in the agreement. Vendors: Vendors, such as suppliers or service providers, use financial reports to determine whether to extend credit. If a vendor does not think the company's finances are strong enough, it could require cash on delivery. Investors: Investors depend on financial reports to decide whether to invest in a company. Once they invest, they con�nue to analyze reports to decide whether to hold on to the investment or to sell it. Government agencies: Government agencies use financial reports to be sure that public companies comply with regula�ons set at both the state and federal levels. They also want to be sure that companies report their numbers accurately to inform the public about their financial posi�on. Analysts: Analysts use financial reports to develop analy�cal reviews and to prepare reports for investors or creditors. In addi�on to using the financial reports, analysts will ques�on key execu�ves about the financial results on an analyst call at the end of each repor�ng period.

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Mars is one of the largest privately owned companies in the United States.

©Vincent Kessler/Reuters/Corbis

Financial reporters: Financial reporters use financial reports to write stories for their audience about a company's financial health. They may also par�cipate in analyst calls to develop their news stories. Compe�tors: Compe�tors read each other's financial reports to make decisions about their own companies. That's why companies expose the least amount of detail possible in their financial statements. They hope to keep their compe�tors guessing about how they earn the results reported.

Financial reports serve many purposes. For managers and employees, they can be an excellent resource for recommending growth opportuni�es. Employees who can understand and analyze financial reports become a very valuable resource to their employers.

For example, suppose an opera�ons employee no�ces that the expenses for shipping outgoing packages have increased drama�cally and will result in exceeding the amount budgeted for this expense. She decides to inves�gate shipping alterna�ves and prepare a report for her manager that shows she can meet, or even reduce, budgeted expenses. She will impress the manager—and if she works for a company that provides incen�ves for cost control, she may even receive a bonus.

Public vs. Private Companies

As noted earlier, only public companies—those whose stocks are sold on the public stock markets—must prepare financial reports for public consump�on. Companies that do not sell their stock on the open market (rather, all shares are split among the company's founders, employees, investors, and select others) are private companies and do not need to reveal details about their finances.

Most private companies are small businesses, but because of the advantages of remaining private, there are large corpora�ons that choose to stay private as well (see Table 1.1). (For more informa�on about one large private company, read the "World of Business" feature box on Mars, Inc.)

Table 1.1: Forbes' 2013 top five private companies based on gross revenue

Private company Gross revenue (in billions of U.S. dollars)

Industry

Cargill $137 Food, drink, and tobacco

Koch Industries $115 Numerous industries (popular brands include Brawny and Quilted Northern)

Dell $57 Technology hardware and equipment

Bechtel $38 Construc�on

Mars $33 Food, drink, and tobacco (primarily candy)

Source: Murphy, A. (2013). America's largest private companies. Forbes. Retrieved from h�p://www.forbes.com/largest-private-companies/ (h�p://www.forbes.com/largest-private-companies/)

World of Business

Mars: From Kitchen to Candy Titan

M&M's, Twix, Dove Bars. You have no doubt tried a candy treat made by Mars, one of the most successful private companies in the United States. Since Mars is a private company—s�ll owned and operated by the family that founded it—it does not provide detailed financial reports to outsiders. However, the company does choose to share its gross earnings statements. And with gross earnings of more than $30 billion, it ranks in the top five of the Forbes list of biggest private companies (see Table 1.1).

Frank and Ethel Mars started the company in their kitchen in Tacoma, Washington, in 1911. The first candy bar that became a worldwide success was the Milky Way, which became known as the Mars bar in Europe in the 1920s. Today the company operates in over 50 countries and sells its products in more than 100 countries. In addi�on to candy, Mars manufactures pet food (Whiskas and Pedigree), rice products (Uncle Ben's), and prepared foods (Suzi Wan), as well as vending systems, electronics for automated payment systems, and other informa�on technology related to its manufacturing opera�ons.

On its website, Mars explains why it stays private in one of its five principles: Freedom. The company states: "Mars is one of the world's largest family-owned corpora�ons. This family ownership is a deliberate choice. Many companies began as Mars did, but as they grew larger and required new sources of funds, they sold stocks or incurred restric�ve debt to fuel their business. To extend their growth, they exchanged a por�on of their freedom. We believe growth and prosperity can be achieved another way."

Sources: Mars, Inc. (2012a). The five principles of Mars. Retrieved from h�p://www.mars.com/global/about-mars/the-five-principles-of-mars.aspx (h�p://www.mars.com/global/about-mars/the-five-principles-of-mars.aspx) and Mars, Inc. (2012b). Mars business segments. Retrieved from h�p://www.mars.com/global/about-

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mars/mars-pia/business-summaries.aspx (h�p://www.mars.com/global/about-mars/mars-pia/business-summaries.aspx)

Consider This:

1. If you were working for Mars or another private company, how might limited access to financial results impact your ability to do your job? 2. Do you think there would be advantages to working for a private company that could take ac�on without worrying about shareholders'

reac�on? If so, what might those advantages be?

Private companies enjoy three key benefits:

1. Confiden�ality: They do not need to file quarterly financial statements with the SEC and various state agencies. 2. Flexibility: They have greater leeway when it comes to compensa�ng owners and execu�ves. They don't have to worry about shareholders voicing concern about

execu�ve pay and bonuses. Co-owners can take out as much money as they want from the company without having to answer to shareholders. 3. Greater financial freedom: Private companies decide for themselves how to raise money for their business. Public companies have no control over who owns

their stock once it is sold on the open market.

However, private companies face some difficul�es when they want to raise addi�onal cash. They can't just issue more stock. Instead, they must arrange for a loan with a financial ins�tu�on or sell addi�onal shares of stock to exis�ng owners. They can also seek help from a private investor, but they will need to provide extensive financial repor�ng to that investor before he or she will make a decision.

Note that a private company must file financial reports with the SEC when it has more than 500 common shareholders and $10 million in assets. Such companies are considered semi-private. One such semi-private company is Publix Super Market. This company has more than 155,000 shareholders, but its stock is not sold on the open market. Rather, its public offerings are available only to its employees, former employees, their families, and non-employee members of the board of directors (Publix Super Market, Inc. Form 10-K, 2012).

Where to Find Financial Reports

The official repository of the financial reports of public companies is the SEC's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) website. EDGAR provides users with access to all reports filed with the SEC.

Most public companies also provide downloads of their financial reports on their own websites, o�en in an "Investor Rela�ons" or "About Us" sec�on. These sec�ons are usually accessed via a link at the bo�om of the company's main page.

Major financial news websites can be a reliable source of informa�on about both public and private companies. Two excellent business news search engines are Google Business News and Yahoo Finance. Business magazine websites, such as Businessweek, Forbes, Fortune, Entrepreneur, Inc., and Fast Company can also be valuable resources, as can local business newspapers, par�cularly when seeking informa�on about private companies.

Task Box 1.1: Researching Public and Private Companies

Pick one public and one private company, preferably in the same sector (service, retail, manufacturing, etc.) and develop a short summary of each company's revenue, expenses, and number of employees.

Discuss any difficul�es you may have experienced as you tried to find financial informa�on about each company. Compare the informa�on you were able to gather about the public company versus the private company. For example:

Were you able to find out how many employees each company has? Were you able to find out how much each company earned in revenues? Were you able to find out how much each company spent on goods or services to be sold? Were you able to find out how much each company's net profit was for the year? How much more difficult was it to find out basic details about the private company versus the public company?

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1.2 What Is an Annual Report? As we men�oned earlier, all public companies must provide their shareholders with an annual report of the company's ac�vi�es, according to the Securi�es Act of 1933. The budget commi�ee of Best General Company can inves�gate these annual reports to research where their compe�tors perform well; based on what they find, they can develop recommenda�ons for improving Best General's financial results. Let's take a closer look at the informa�on the budget commi�ee can expect to find in an annual report.

The SEC requires that this report include:

an opening le�er from the Chief Execu�ve Officer (CEO), financial informa�on, results from con�nuing opera�ons, market segment informa�on (informa�on about where the company sells its products and to whom), new product plans, subsidiary ac�vi�es (a subsidiary is a company that is completely or par�ally owned or controlled by another company), and research and development ac�vi�es regarding future programs.

The annual report must be provided to shareholders before the annual mee�ng to elect directors. Companies must post their annual report along with any issues to be voted on at the annual mee�ng on their website. They must also post proxy materials, which give shareholders informa�on about the issues to be voted on at the annual mee�ng and a proxy with which they can vote on these issues.

The annual report does not have a required format. Generally companies include the following sec�ons, but not necessarily in this order:

Highlights Le�er from the President or CEO Auditors' Report Management's Discussion and Analysis (MD&A) Management's Discussion of Financial Responsibility Financial Statements Notes to the Financial Statements Other Informa�on

Let's take a closer look at each of these sec�ons.

Highlights

Companies put their best foot forward when they prepare the Highlights sec�on of their annual report. If the company is doing well, this sec�on usually includes glossy pictures and a good deal of posi�ve news about what the company has done in the prior year and what it plans to do in the future. This sec�on highlights the best performing subsidiaries, divisions, or departments and probably does not men�on those that lost money.

This sec�on and the Le�er from the President or Chief Execu�ve Officer are usually presented in large, easily readable type with many pictures, while the rest of the report is o�en in small, harder-to-read type with no pictures. When reading the report for important informa�on about the company's future, or key decisions that have recently been made, it's important to remember to read the fine print.

Le�er From the President or Chief Execu�ve Officer (CEO)

The le�er tends to be a puff piece that highlights the successes of the past year and discusses future plans for the company. It may be officially from the President or CEO, but it's more likely that it was wri�en by the public rela�ons or marke�ng staff and approved by the execu�ve.

Auditors' Report

All public companies must provide financial reports that have undergone an audit—a process by which outside cer�fied public accountants (CPAs) examine the books for accuracy and to ensure the company is maintaining its accounts according to generally accepted accoun�ng principles (GAAP). (See Sec�on 1.4 for more informa�on about GAAP.) Audits are typically performed by outside auditors, such as those from a major cer�fied public accoun�ng firm.

Auditors complete their audit under the guidelines set by the American Ins�tute of Cer�fied Public Accountants, called generally accepted audi�ng standards. These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatements—meaning there are no errors that could have an impact on the value of the company.

The auditors' report (or le�er from the auditors) is usually located either before or a�er the financial statements in the annual report. The report reveals whether auditors raised any red flags about the financial reports. If they have, the auditors will specify the ques�ons they have about how the financial informa�on was collected or presented.

When auditors examine a company's financial repor�ng, they don't check every transac�on, so these reports can never provide 100% assurance that the informa�on is accurate. Auditors instead review the accoun�ng processes and make a statement about those processes. They also conduct spot checks on various transac�ons to be sure that company personnel are following the processes put in place.

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In 2009, General Motors filed for Chapter 11 bankruptcy.

Bill Cobb/SuperStock

The auditors' report includes the following three paragraphs:

Introductory paragraph: This includes informa�on about the �me period covered by the report and who is responsible for the financial statements. In most cases, you will see that management is responsible for the financial statements and that the auditors provide an opinion about the financial statements using informa�on gathered during their audit. Scope paragraph: This includes informa�on about how the auditors performed their audit, including a statement that they have used generally accepted audi�ng standards. Opinion paragraph: This includes the opinion of the auditors regarding the financial statements. If the auditors find no problems, they will simply state that the financial statements were prepared "in conformity with generally accepted accoun�ng principles" (GAAP).

As long as the auditors' report follows the above format, it's called a standard auditor's report. If there are no qualifiers or red flags that limit the auditors' opinions, the report is known as an unqualified audit report.

If, on the other hand, the auditors find a problem, the report is known as a nonstandard auditors' report. In a nonstandard auditors' report, auditors must explain their opinions and note problem areas in a qualified audit report. In other words, the only difference between a standard and a nonstandard audit report is that the nonstandard report includes problems the auditors found in the opinion paragraph. Otherwise, the structure is the same.

If the auditors' report denotes problems or raises ques�ons, answers can be found in the Management's Discussion and Analysis sec�on of the annual report. Some discussion may also be found in the Management's Discussion of Financial Responsibility sec�on of the annual report. (We discuss both of those later in this chapter.)

Common issues that may be raised in a nonstandard auditors' report include the following:

Change in auditors: Whenever a new accoun�ng firm handles the audit, it will note the change in auditors. This may or may not indicate a problem. The auditors will not explain why the change was made. If there was any hint of scandal, the coverage could be found in news stories. Change in accoun�ng policies: The auditors will note if the company changed an accoun�ng policy or accoun�ng method. The change may or may not indicate a problem. If the auditors agree with the change, they will state that they agree and why. If the auditors ques�on the change, a response will likely be found in the Management's Discussion and Analysis sec�on. More informa�on about the change and how it has affected the financial statements will also be found in the Notes to the Financial Statements. Material uncertain�es: The auditors will note if there is an area of concern regarding an event that could have financial consequences but for which they cannot determine the full financial impact. An uncertainty can include damages the company must pay if they lose a pending lawsuit or the poten�al loss of market share because of a new compe�tor. They may also point out the poten�al loss of a major customer. If there is any uncertainty that might materially impact future earnings, the auditors will include a paragraph about the uncertainty and give a qualified opinion. Going-concern problems: If the auditors ques�on whether the company will be able to stay in business, they will indicate that they have a going-concern problem. Such problems can include ongoing losses, cash deficiency, or a significant contract dispute. This is a major red flag and o�en indicates that the company is near bankruptcy. (We discuss General Motors' road to bankruptcy in "World of Business." Auditors in 2008 ques�oned whether GM would con�nue as a going-concern.) Specific disclosures: Some�mes the auditors will discuss a financial concern but s�ll give a company a nonqualified opinion. In a case like this, the auditors do not see signs of a significant problem, but they want the public to know about the issue. For example, if the company is doing business with another company that has officers involved in both firms, the auditors will note that. Qualified opinion: Any �me the auditors issue a nonstandard report, they will issue a qualified opinion in the final paragraph of the report. A qualified opinion in the auditors' report should be researched further in other sec�ons of the annual report, such as the Management's Discussion and Analysis and the Notes to the Financial Statements. Major issues may also be covered in external news reports.

World of Business

A Going Concern: Hint of Bankruptcy in GM's Annual Report

The world knew General Motors (GM), which filed for bankruptcy in 2009, was in trouble in 2008, and the final death knell was sounded when accoun�ng firm Deloi�e and Touche LLP placed this paragraph in the Auditors' Report of the 2008 GM annual report submi�ed to the SEC (General Motors Corpora�on, 2008):

The accompanying consolidated financial statements for the year ended December 31, 2008, have been prepared assuming that the Corpora�on will con�nue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Corpora�on's recurring losses from opera�ons, shareholders' deficit, and inability to generate sufficient cash flow to meet its obliga�ons and sustain its opera�ons raise substan�al doubt about its ability to con�nue as a going concern. Management's plans concerning these ma�ers are also discussed in Note 2 to the consolidated financial statements. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. (p. 138)

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Also in that annual report, it was made clear that GM was pushing for a government bailout. In the risk factors sec�on of another form filed with the SEC, GM management stated the following (General Motors Corpora�on, 2008):

If we are not able to obtain adequate financing from the U.S. government or other sources or to execute our Viability Plan or if our Viability Plan does not result in an en�ty capable of sustaining itself over the long-term, or if we are unable to restructure our Series D conver�ble debentures prior to June 1, 2009, we could poten�ally be required to seek relief through a filing under the U.S. Bankruptcy Code, either through a prepackaged plan of reorganiza�on or under an alterna�ve plan, which could include liquida�on. (p. 22)

Note that Series D Conver�ble debentures are a type of debt that can be converted in equity (shares of stock).

GM entered Chapter 11 bankruptcy on June 1, 2009. It was the fourth-largest bankruptcy filing in U.S. history. The company claimed $172.81 billion in debt and $89.29 billion in assets. The U.S. government gave GM $49.5 billion, and GM repaid $23.1 billion of that money. The U.S. government s�ll owned 500 million shares of GM stock, or 32% of the company, as of this wri�ng. If the government wants to recoup the rest of its investment in GM, the stock will need to sell for $52.80 per share. As of January 16, 2014, the stock closed at $39 per share. (Muller 2012)

Source: Welch, D. (June 1, 2009). GM files for bankruptcy. Businessweek. Retrieved from h�p://www.businessweek.com/stories/2009-06-01/gm-files-for- bankruptcybusinessweek-business-news-stock-market-and-financial-advice (h�p://www.businessweek.com/stories/2009-06-01/gm-files-for-bankruptcybusinessweek-business-news-stock- market-and-financial-advice)

Consider This:

1. When a company files for bankruptcy, employees lose jobs not only in the bankrupt company, but also in companies that service or supply that company. What types of other companies were likely impacted by GM's bankruptcy?

2. If your company went bankrupt, what other companies would be impacted? How many people do you think could poten�ally lose their jobs?

Management's Discussion and Analysis (MD&A)

The Management's Discussion and Analysis (MD&A) sec�on of the annual report contains many details about management's plans for the future of the company, as well as discussion of the successes and failures of the last year. The SEC reads the MD&A closely to be sure companies present all cri�cal informa�on about the current opera�ons, capital (net worth of the company), and liquidity (ability to generate enough cash to pay the bills).

Management must include forward-looking statements about known marke�ng condi�ons and economic trends that may impact the company's liquidity. It must also discuss material events as well as uncertain�es that could affect future opera�ons. For example, if the company manufactures a product in a country that faces poli�cal upheaval or a labor strike, it must discuss this possibility and the impact it may have on the company's ability to manufacture and sell this product at the same low cost.

Companies focus on three key areas:

Company opera�ons: Companies will discuss sales and whether they increased or decreased, product line performance, how products are distributed, and product improvements. Companies will also discuss, without much detail, research and development projects. Capital resources: Companies will discuss acquisi�ons (companies they plan to buy or have recently bought) and expansions of exis�ng opera�ons. They will also discuss any major capital expenses incurred in the past year or planned for the future as well as their debt posi�on and whether they plan to take on new debt. Liquidity: Companies will discuss their cash posi�on and their ability to pay their bills.

The SEC pays special a�en�on to these key discussion points in the MD&A (U.S. Securi�es and Exchange Commission, 2003):

Revenue recogni�on: A company can only add revenue to the books when it is earned, which means when a sale is completed and the goods or services have been delivered. This is known as the recogni�on of revenue. If the company operates retail stores, the recogni�on of revenue may be rela�vely straigh�orward: Revenue is recognized when a customer buys the product. However, revenue recogni�on is not as clearly defined for many businesses. For example, when a company buys a computer system from another company that includes hardware, so�ware, training, and other services, revenue may not all be recognized at the same �me. The company may recognize the revenue from the purchase of the hardware at the �me it is delivered, but it will not be able to recognize the revenue from service and training un�l the obliga�on has been fulfilled. A contractor who is paid upfront for a project may not be able to recognize the revenue un�l it is earned. In the MD&A, management will discuss its revenue recogni�on methods and compare them to other companies. Discussion of revenue recogni�on may also be found in the Notes to the Financial Statements. Restructuring changes: If the company plans any type of restructuring, or has completed a restructuring plan, management will discuss these plans in the MD&A. This can include closing down factories, disbanding a major division, discon�nuing opera�ons, or any other major change in the way the company operates. Management will discuss the costs of employee severance, facility shutdowns, and any other expenses that will be incurred by the decision and how these costs will impact the financial statements. Losses of assets: The company must report any losses of assets in a �mely manner to shareholders. For example, this can include the damage or destruc�on of a factory a�er a major storm. A company also may report impairment of an asset because of advancements in technology. Pension plans: Pension plans can be a major drain on a company's assets, and the methods for accoun�ng for these plans require many assump�ons that cannot be proven, such as the amount of interest or capital gains that will be earned on the investments. Also, the company must make educated guesses about how much will be needed to make payments to re�red employees. If the company does have a pension plan, expect to find discussion about how the company finances that plan and if the company expects any difficulty mee�ng the requirements of that plan.

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Environmental and product liabili�es: Most companies risk damage to the environment or other people's proper�es if products they sell fail to operate as expected. Some companies operate in industries, such as oil, gas, and chemicals, that regularly risk the poten�al of environmental damage if something goes wrong. For example, Exxon Mobil faces what could be millions of dollars in damages from the March 29, 2013, oil pipeline rupture in Arkansas. The United States Environmental Protec�on Agency (EPA) operates a Superfund to clean up the na�on's hazardous waste sites, which were created by disposal of wastes by many different companies over many years. Companies that are iden�fied as polluters must contribute to this fund. If a company is involved in nego�a�ng a se�lement with the EPA, it would discuss that involvement here. (Perpetua 2013 and U.S. Environmental Protec�on Agency 2013 and 2014)

The discussion in this sec�on of the annual report can get very technical. As the Best General Company budget commi�ee is reviewing the external reports of their compe�tors, they can call the investor rela�ons department of a company if they have any ques�ons about what is discussed. The investor rela�ons department is the primary department that answers ques�ons from readers of the company's financial reports.

Task Box 1.2: Using Financial Reports to Assess Risk Management

To help you get started with reading financial reports, we will examine General Electric (GE), the sixth largest company on the Fortune 500 list, with more than $150 billion in revenue. GE operates in five major business segments: energy, technology, infrastructure, capital finance, and consumer and industrial goods. The company has won awards for its innova�ve financial repor�ng, which includes many interac�ve features. Its financial reports can be accessed here.

To prac�ce using financial reports to assess a company's compe�tors, download the MD&A for GE. Read the Global Risk Management sec�on of the report. (We use GE as an example because it does an excellent job of laying out its risk management program.)

How does GE manage its risks? Note how various aspects of risk management are assigned to key GE commi�ees. Think about how your company manages risk and compare it to what GE does.

Management's Discussion of Financial Responsibility

This sec�on of the annual report is rela�vely new—it became a requirement a�er the financial repor�ng scandals of the late 1990s and early 2000s. Congress passed the Sarbanes-Oxley Act of 2002, and the new requirements are discussed in sec�on 302, "Corporate Responsibility for Financial Reports." (Read more about the Sarbanes-Oxley Act in "The New World of Financial Report Oversight.") Some companies call this the "Management's Responsibility for Financial Statements" le�er.

Officially, sec�on 302 states that the CEO and chief financial officer (CFO) must each prepare a statement to accompany the audit report to cer�fy that "based on such officer's knowledge, the financial statements, and other financial informa�on included in the report, fairly present in all material respects the financial condi�on and results of opera�ons of the issuer as of, and for, the periods presented in the report."

While execu�ves have been asked to provide financial repor�ng le�ers in the past, this new requirement s�pulates that they must include a cer�fied statement, signed, notarized, and available to the public, that indicates management takes full responsibility and can be held legally accountable for what's in the financial reports. Thanks to Sarbanes-Oxley (SOX), execu�ves can now, in theory, be held personally responsible for their ac�ons; they can face up to a five-year prison term, fines, and other disciplinary ac�on if they are proven of wrongdoing. They could also face civil and criminal li�ga�on, as well as be barred by the SEC from serving as a corporate officer or director.

One net result of this change is that CEOs and CFOs are looking for ways to shield their money and property from shareholder lawsuits and federal prosecu�on. The key ques�ons le� to be answered are whether we will actually see this law enforced and whether it protects investors and the public from scandals like those we have seen in the past. (Marden, 2003)

New World of Financial Report Oversight

The Sarbanes-Oxley Act of 2002 (SOX), also known as the Public Company Accoun�ng Reform and Investor Protec�on Act, set new or enhanced standards for external repor�ng. Thanks to SOX, top management must now individually cer�fy the accuracy of financial report informa�on. SOX also increased the independence of outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors.

1. Do you believe this new requirement has impacted how companies file their reports? 2. How would you expect this law has impacted the role of the CEO and CFO?

Financial Statements

The main sec�on of any annual report is the financial statements. These include the key documents introduced earlier in the chapter: the balance sheet, the income statement (which may include the statement of shareholders' equity), and the statement of cash flows.

Notes to the Financial Statements

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The financial statements are a summary of numbers, but to really understand what they mean and how they were developed, one must read the Notes to the Financial Statements. These include informa�on about such things as accoun�ng methods, key financial commitments, mergers (two companies joining forces) and acquisi�ons (the purchase of one company by another), pension and re�rement benefits, company segments, and significant events. Let's take a closer look at what you can expect to find in each note.

Accoun�ng Methods

Most companies focus the first note on any changes to their accoun�ng methods. Here they also outline the rules under which they developed their financial statements. The note is commonly called "Summary of Significant Accoun�ng Prac�ces." If the company is large, and owns many affiliates, the note will likely discuss how the financial statements are a consolida�on of its affiliates and how this impacts the financial statements.

You can see an example of how a company presents its consolida�on in General Electric's (n.d.) Notes to the Financial Statements in its 2012 annual report. GE goes on to discuss how it recognizes sales of goods and services, its deprecia�on and amor�za�on, losses on financing receivables, investment securi�es, inventories, intangible assets, and a number of other specific methods related to its opera�ons.

The final sec�on of the note discusses accoun�ng changes. Other companies may include informa�on about the accoun�ng methods used for their pensions, employee stock incen�ve plans, and income taxes.

Sales and Discon�nued Opera�ons

If the company is involved in the sales of major assets or businesses it held, it will include a note detailing this informa�on. If the company has closed or is planning to close a facility, this note will also detail the financial impacts of discon�nued opera�ons. GE presents the details of its sales and discon�nued opera�ons in Note 2.

Investment Securi�es

If a company holds investment securi�es, it will include a note detailing the informa�on. GE details its investment securi�es in Note 3. You can see that GE holds debt (bonds) from other U.S. corpora�ons, state and municipal governments, mortgage-backed securi�es, and other en��es. Note that the balance sheet would only show a number for Marketable or Investment Securi�es.

Current Receivables

Any details about the Accounts or Current Receivables line item on the balance sheet will be found in a note. GE discusses its receivables in Note 4.

This note usually includes details about a company's major customers. For example, GE details how much of its receivables come from which sectors. You can also read that GE revenues from the U.S. government dropped to 4% of GE sales of goods and services in 2012 and 2011, from 5% in 2010. GE details this informa�on in Note 6.

Major Assets

The notes also contain line items about other key assets. For example, inventory held by the company will likely be in a separate note detailing that informa�on. GE discusses its inventories in Note 5. There should also be a note about the Property, Plant, and Equipment (GE details that in Note 7) and Goodwill and Other Intangible Assets (GE details these in Note 8).

Goodwill is an account used to track addi�onal money paid for an acquisi�on over and above the actual value of the known assets. For example, say a company buys another company for $1 million. However, the known assets are only worth $900,000. The difference of $100,000 would be added to Goodwill. Goodwill usually reflects the value of nonassets, such as customer base or premium loca�ons.

Other Intangible Assets, such as patents and copyrights not included in their own line item, would be included in this line item of the balance sheet. Any major asset that doesn't have a separate note will be under a note called "Other Assets" (GE details them in Note 9).

Key Financial Commitments

You will also find details about a company's key financial commitments in the notes. For example, in Note 10, GE details its short-term and long-term borrowing. In Note 11, the company describes its investment contracts and insurance liabili�es.

Mergers and Acquisi�ons

If a company is in the process of merging with another company or in the process of buying another company, there will be a note detailing the impact this transac�on will have on the financial statements. GE did not men�on merger or acquisi�on plans in the year being discussed.

Pension and Re�rement Benefits

If a company provides a pension plan to its employees, it will provide details about its pension obliga�ons in a note to the financial statements. GE details these obliga�ons in Note 20.

Included will be details about the number of employees covered, the cost of the pension plans, the actuarial assump�ons—es�mates of the value of an asset or person, used to help determine the value of future payments on re�rement benefits—and a detailed projec�on of the benefit obliga�ons. This note also details how the company invests its pension assets.

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Other Liabili�es

Any liability that doesn't have a note of its own will be detailed in an "Other Liabili�es" note. GE uses Note 13 to discuss other liabili�es.

Details About Company Segments

Most companies will also include a note that details their company segments. GE provides that informa�on in Note 1. Company segments are used to group opera�ng departments and divisions under a specific execu�ve team.

Notes to Financial Statements

Companies tend to hide any problems they have in the Notes to the Financial Statements. When the Best General Company budget commi�ee starts looking for details about their compe�tors' results, the notes to the financial statements should be one of their first sites to mine. As we discuss the parts of each of the financial statements in Chapters 2, 3, and 4, we will delve deeper into the informa�on one can expect to find in the notes.

Other Informa�on

In this sec�on, you will find informa�on about the backgrounds and qualifica�ons of the company's key execu�ves and managers, officers, board members, loca�ons, and any new facili�es they opened in the past year.

Task Box 1.3: Viewing a Full Annual Report

General Electric is one of the most innova�ve companies when it comes to annual reports. Its annual report is highly interac�ve, le�ng readers explore topics of deeper interest. Few companies put as many resources into producing an interac�ve report for the public.

Go to GE's website for its 2012 report. You'll find the highlights and CEO le�er on that page. You'll also find the 2012 pro forma financial statements. Don't confuse these with the required financial statements. Pro forma statements tend to focus on what the company wants to highlight.

Click on the word "Downloads" on the top right of the first page. You'll be able to download all the other parts of the annual report, as well as the company's Form 10-K and proxy statements; these give shareholders informa�on about the items on which they will need to vote, such as new board members or company-specific issues. Download each sec�on and review the informa�on in each.

1. Based on what you read in these statements, what do you think are GE's top priori�es for the future? 2. What reorganiza�ons are discussed in the Management's Discussion and Analysis? 3. What accoun�ng method was changed, according to the auditors' report? Explain the change a�er reading Note 1 in the Notes to the

Financial Statements.

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Form 10-K is required by the SEC to insure that investors are receiving an accurate picture of a company's business and financial condi�on.

Melanie Stetson Freeman/MACSM/Associated Press

1.3 What Is a Form 10-K? While the annual report is published for the benefit of shareholders and investors, public companies must also submit a formal yearly update to the SEC. They do this using a form called the Form 10-K.

The purpose of the Form 10-K is to provide comprehensive details of the company's business and financial condi�on. This report must include audited financial statements, and it must be filed in addi�on to the annual report. Much of the informa�on in the Form 10-K is similar to that presented in the annual report, but the Form 10-K requires addi�onal details in a specified format, and it is o�en more formal and technical in tone.

Table 1.2 compares the Form 10-K and the annual report. O�en companies use the Form 10-K as part of the required financial statements within their annual report to shareholders. The por�ons from the Form 10-K are usually printed on thinner paper in smaller print, making it more difficult to read.

Table 1.2: Comparing the Form 10-K and the annual report

Line item Form 10-K Annual report

Item 1 – Business The company must include basic informa�on about both posi�ve and nega�ve developments that impact the company since the beginning of the fiscal year. It will include much greater detail about each segment or division of the company.

Companies will usually include some informa�on about major changes in the previous year or planned changes for the next year, but in a less formal way and more for the purposes of promo�ng their successes. Rarely will companies highlight any failures.

Item 1A – Risk Factors The company must detail risk factors in the industry segments in which it operates.

While managers may discuss risk factors in general terms in the MD&A sec�on, and provide some discussion in parts of the Notes to the Financial Statements, there is no formal risk factors sec�on in the annual report.

Item 1B – Unresolved Staff Comments

If there are any comments from SEC staff that are unresolved, they will be discussed here. This will only be found in the Form 10-K.

Not required.

Item 2 – Proper�es Key property holdings will be discussed in detail. Some of this informa�on may be found in the Notes to the Financial Statements. A company could discuss some key property addi�ons in the narra�ve of the annual report, but it is not required.

Item 3 – Legal Proceedings The company must detail informa�on about significant pending lawsuits or other legal proceedings.

This informa�on can usually be found in the Notes to the Financial Statements.

Item 4 – Mine Safety Disclosures

Most companies leave this sec�on blank. Only companies with mines must discuss safety issues here.

Not required.

Item 5 – Market for Registrant's Common Equity, Related Stockholder Ma�ers and Issuer Purchases of Equity Securi�es

Companies discuss details about any changes to their equity securi�es, the number of holders of shares of stock, and the dividends paid. If the company is repurchasing its stock and taking it off the market, the company will discuss this as well.

Summary financial details about shareholder ma�ers can be found on the income statement or statement of shareholders' equity. More details can be found in the Notes to the Financial Statements.

Item 6 – Selected Financial Data

Companies summarize their key financial data over the last five years.

Companies will usually offer pro forma financial statements that highlight the past five years, but the informa�on will not be as complete as the Form 10-K. This part of the annual report usually conveys only the good news.

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Item 7 – Management's Discussion and Analysis of Financial Condi�on and Results of Opera�ons

Company execu�ves discuss their business results over the past year and discuss future plans.

Similar informa�on is found in the MD&A sec�on, but the Form 10-K usually includes more detail.

Item 7A – Quan�ta�ve and Qualita�ve Disclosures about Market Risk

Companies discuss interest rate risk, foreign currency exchange risk, commodity price risk, and equity price risk. Companies will also discuss how they manage these market risk exposures.

While there may be some discussion of risk in the MD&A sec�on and the Notes to the Financial Statements, the informa�on is usually more detailed in the Form 10-K.

Item 8 – Financial Statements and Supplementary Data

Includes the key financial statements, such as the income statement, balance sheet, statement of cash flows, and any other relevant data.

O�en companies use the statements filed with their Form 10-K in their annual report. Others may present the same informa�on in a more graphically pleasing way.

Item 9 – Changes in and Disagreements with Accountants on Accoun�ng and Financial Disclosures

If there are any disagreements with accountants, they will be discussed in this sec�on.

Usually informa�on about disagreements with accountants can be found in the Auditor's Le�er and the management's response to that le�er (if there is one). Other disagreements may be discussed in the Notes to the Financial Statements in the sec�on on accoun�ng policy or accoun�ng methods.

Item 10 – Directors, Execu�ves, Officers and Corporate Governance

Companies include informa�on about the backgrounds and experience of their directors and corporate officers. They also must include informa�on about their code of ethics and how it is implemented.

Informa�on about a company's directors and corporate officers is o�en included in the annual report.

Item 11 – Execu�ve Compensa�on

Companies provide details about how they compensate their execu�ves, including informa�on about salaries paid and incen�ves earned.

This informa�on is usually found in the proxy materials sent with the annual report to shareholders.

Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Ma�ers

Companies provide details of the holdings of key execu�ves and major shareholders.

This informa�on is usually found in the proxy materials sent with the annual report to shareholders.

Item 13 – Certain Rela�onships and Related Transac�ons, and Director Independence

Companies provide details about rela�onships between the company and its directors, officers, and family.

There is no comparable sec�on in the annual report.

Item 14 – Principal Accountant Fees and Services

The company provides details about the fees paid to its accoun�ng firm, as well as the services provided.

There is no comparable sec�on in the annual report.

In the past, all companies could wait un�l 90 days a�er the end of the fiscal year to file a Form 10-K, but in 2002, the SEC changed the rules. Now, companies with over $700 million in publicly owned stock must file their Form 10-K within 60 days of their year-end. Companies with publicly owned stock worth between $75 million and $700 million must file their Form 10-K within 75 days (see Table 1.3). Only smaller companies can wait 90 days. Once the form is filed with the SEC, it can be accessed on the SEC's EDGAR database.

Table 1.3: Filing deadlines for Form 10-K

Company size (in revenue)

When to file Form 10-K a�er end of year

Within 60 days Within 75 days Within 90 days

Over $700 million X

Between $75 – $700 million X

Under $75 million X

Many companies also provide copies of the Form 10-K in the Investor Rela�ons sec�on of their website. For example, GE has a financial repor�ng page in the Investor Rela�ons sec�on of its website. From that page, you can access not only the Form 10-K, but also a sec�on called "SEC Filings" that details other forms filed with the SEC.

There are four key parts to the Form 10-K: Business Opera�ons, Financial Data, Informa�on about Directors and Execu�ves, and Addi�onal Exhibits. Let's take a look at each of these parts (U.S. Securi�es and Exchange Commission, Form 10-K, 2012f).

Part 1: Business Opera�ons

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This sec�on provides details about the basic business opera�ons and any new developments since the prior report. Risk factors for the business also are discussed. If there are any unresolved comments from the SEC, they will be discussed in this sec�on. This sec�on also includes discussions about key property holdings and ongoing legal proceedings.

Item 1 – Business: The company must provide basic informa�on, such as any developments that impacted the incorpora�on of the business since the beginning of the fiscal year. A company does not have to restate its historical development of the corpora�on. For example, GE discusses a merger of one wholly owned subsidiary, General Electric Capital Services, into General Electric Capital Corpora�on.

The company must then discuss how it is doing in each of the various industry segments in which it operates. It must discuss its opera�ons in each segment and how it plans to do business in the future. For example, GE discusses plans to sell its share of NBC Universal to Comcast in 2013. GE then goes on to detail all the industry segments in which it operates.

Item 1A – Risk Factors: The company must discuss any key risk factors in the industry segments in which it operates. GE discusses global, economic, and poli�cal risks first and then provides some informa�on about the changes to laws and regula�ons that could impact its opera�ons. GE also discusses pending legal ac�ons, the increasing costs of health and pension benefits, and a number of other risks. (In "World of Business," we list the types of risk factors the SEC wants to see discussed.)

Item 1B – Unresolved Staff Comments: These relate to staff comments from the SEC on previous filings. If there are any pending issues with the SEC, they will be discussed here. GE has no unresolved staff comments.

Item 2 – Proper�es: The company will discuss informa�on about its key property holdings, such as principal plants, mines, or other physical proper�es.

Item 3 – Legal Proceedings: The company will discuss any significant pending lawsuits or other legal proceedings.

Item 4 – Mine Safety Disclosures: If the company operates mines, it will discuss safety issues here.

Task Box 1.4: Analyzing GE's Form 10-K

Download GE's 2012 Form 10-K (h�p://www.ge.com/ar2012/pdf/10K-2012.pdf) (General Electric, 2013). Review the business segments in which GE operates. Pick one segment that interests you and be prepared to discuss the opera�ons of that segment as presented in the Form 10-K. Then pick one risk factor and be prepared to discuss that factor as presented in Form 10-K. Think about your company's risks and how they are managed by your company.

Part II: Financial Data

Part II focuses on the financial opera�ons of the business. Here companies list details of their outstanding stock holdings, summary of selected financial data, MD&A, quan�ta�ve disclosures about market risk, the financial statements, changes or disagreements with the accountants, internal controls and procedures, and other informa�on. Let's take a look at each of these sec�ons.

Item 5 – Market for Registrant's Common Equity, Related Stockholder Ma�ers and Issuer Purchases of Equity Securi�es: This sec�on must include informa�on about the company's equity securi�es, the number of holders of its shares of stock, and the dividends paid. If the company is repurchasing its stock and taking it off the market, the company will discuss this as well.

Item 6 – Selected Financial Data: This sec�on is not the financial statements; instead, it is a review of key financial informa�on over the last five years. More complete informa�on about the last three years is located in Item 8.

Item 7 – Management's Discussion and Analysis of Financial Condi�on and Results of Opera�ons: The company execu�ves discuss its business results over the past financial year. O�en this sec�on is the same as the MD&A in the annual report to shareholders, but some�mes it contains more detail in terms of what is reported to the SEC. Essen�ally the informa�on required here is the same as we discussed above for the annual report MD&A.

World of Business

Risks the SEC Wants Companies to Discuss

The SEC wants companies to discuss the risks they face in order to provide an idea of the challenges the business might face in the future.

Here are the risks the SEC (2011, "Discussion") suggests companies discuss in Part II of the Form 10-K:

A consumer company might discuss ways in which it seeks to meet changing tastes. A manufacturing company that relies on natural resources may discuss how it assesses commodity risks and conducts resource management programs. A financial ins�tu�on may discuss ways that management monitors liquidity and assures adequate capital under various scenarios, such as a rise in interest rates or a ra�ngs downgrade. A global company may discuss how it handles exchange rate risks. Companies may discuss how they handle compe��on, build their brands, or manage in an economic downturn.

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Companies also may discuss how they ensure compliance with laws and regula�ons, or how they are addressing the impact of new or an�cipated laws and regula�ons.

Source: U.S. Securi�es and Exchange Commission [SEC]. (2011, July 1). How to Read a 10-K. Retrieved from h�p://www.sec.gov/answers/reada10k.htm (h�p://www.sec.gov/answers/reada10k.htm)

Consider This:

1. Think about risks that are unique in the industry in which you work. What risks should your company discuss in the risk sec�on of the financial report?

2. If you were asked to write the risk sec�on of your company's financial report, what would you highlight as the number one risk?

Item 7A – Quan�ta�ve and Qualita�ve Disclosures About Market Risk: This sec�on discusses a company's interest rate risk, foreign currency exchange risk, commodity price risk, and equity price risk. The company will also discuss how it manages these market risk exposures.

1. Interest rate risk involves the possibility that interest rates could rise or fall, and the company must discuss how this risk may affect its profits. If the company carries a large debt load and interest rates rise, then the cost of borrowings will likely go up, which means profits could go down. If the company is a financial company dependent on interest rate income, when rates go down, the company's profits could go down.

2. Foreign currency exchange risk affects companies that operate on a global basis. The value of a currency can change in seconds—and usually does in the foreign currency marketplace. If a company operates in more than one country or buys manufactured goods from outside the United States, it faces the risk that the value of the currencies involved could change the price the company pays for the goods. Companies also discuss how they manage this risk in this sec�on.

3. Commodity price risk affects every company that must buy or manufacture the products it sells. The underlying commodi�es used to make these products can go up or down in price and therefore affect the cost of manufacturing the products. Companies discuss how they handle commodity risks in this sec�on.

4. Equity price risk affects companies that either invest in other companies or that hold and then sell securi�es. When stock prices are rising, the company will likely make more profits, but if stock prices drop, the company could take a loss. Companies discuss how they will handle these risks in this sec�on.

Item 8 – Financial Statements and Supplementary Data: This sec�on contains the financial reports and the notes to these reports. (We will take a close look at each of these statements in their respec�ve chapters.)

Item 9 – Changes in and Disagreements With Accountants on Accoun�ng and Financial Disclosure: If there is any disagreement with the accountants, it will be discussed in this sec�on. A situa�on in which a company does not agree with what its accountants want is o�en a red flag.

Item 9A – Controls and Procedures: In this sec�on, the company discusses the controls and procedures it has in place to be sure its financial repor�ng accurately reflects the company's financial posi�on.

Item 9B – Other Informa�on: This sec�on includes any informa�on that was required to be reported to the SEC on a different form, such as a Form 8-K (discussed below), but that has not yet been reported.

Part III: Informa�on About Directors and Execu�ves

This sec�on of the Form 10-K contains informa�on about the directors and the execu�ve officers, their compensa�on, company ownership, and equity compensa�on plans. It also contains informa�on about the accoun�ng firm used. O�en this informa�on is presented as part of the proxy statement provided to shareholders so they can vote on key issues at the annual mee�ng.

Item 10 – Directors, Execu�ve Officers, and Corporate Governance: This sec�on includes informa�on about the backgrounds and experience of the company's directors and execu�ve officers, as well as its code of ethics and how it is implemented.

Item 11 – Execu�ve Compensa�on: This sec�on details how the company compensates its execu�ves. This includes details about the salaries paid and incen�ves the company execu�ves earned.

Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Ma�ers: This sec�on details the holdings of key execu�ves and major shareholders. It is par�cularly important for investors, who need to know how many of the outstanding shares are owned by major shareholders and key execu�ves, or how much control is centered among a few key people.

Item 13 – Certain Rela�onships and Related Transac�ons, and Director Independence: This sec�on details rela�onships between the company and its directors, officers, and their family. The key piece of informa�on in this sec�on is how many of the directors are independent. Many recent financial scandals involved companies where family or execu�ves controlled the board and there were not enough independent directors watching what insiders were doing. One example of a company having too much family control was Adelphia (see "World of Business"), where family members were found guilty in 2004 of concealing personal loans totaling $2.3 billion.

Item 14 – Principal Accountant Fees and Services: The company must report the fees it paid to its accoun�ng firm, as well as detail the services provided.

World of Business

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In 2004, Adelphia CEO John Rigas and his sons were found guilty of conspiracy, bank fraud, and securi�es fraud a�er orchestra�ng one of the most extensive financial frauds using money from a public company for private purposes.

Luis Lanzano/Associated Press

Adelphia: Massive Fraud at a Public Company

In 2002, the SEC filed charges against Adelphia Communica�ons Corp., its founder, John J. Rigas; his three sons; and two senior execu�ves. The SEC called it "one of the most extensive financial frauds ever to take place at a public company" (2002, para. 1). The SEC charged that these individuals:

fraudulently excluded billions of dollars in liabili�es from its consolidated financial statements by hiding them on the books of off- balance sheet affiliates; falsified opera�ons sta�s�cs and inflated earnings to meet Wall Street's expecta�ons; and concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds for Rigas Family stock purchases and the acquisi�on of luxury condominiums in New York and elsewhere. (2002, para. 2)

In addi�on to the SEC charges, the United States A�orney's Office for the Southern District of New York filed related criminal charges against some of these defendants. In 2004, John Rigas was found guilty of concealing $2.3 billion in loans and stealing more than $100 million in company assets. His son Timothy Rigas, the company's CFO, also was found guilty. His son James Rigas was found not guilty. In 2005, John was sentenced to 15 years and Timothy was sentenced to 20 years. Michael Rigas, who was the chief opera�ng officer, pleaded guilty to one count of making a false entry in an accoun�ng record and was placed on proba�on but was not sentenced to jail �me.

Sources: U.S. Securi�es and Exchange Commission [SEC]. (2002, July 24). SEC charges Adelphia and Rigas family with massive financial fraud [Press Release]. Retrieved from h�p://www.sec.gov/news/press/2002-110.htm (h�p://www.sec.gov/news/press/2002-110.htm) and Taub, S. (2006, March 6). Proba�on for Adelphia's Michael Rigas. CFO. Retrieved from h�p://ww2.cfo.com/accoun�ng-tax/2006/03/proba�on-for-adelphias-michael-rigas/ (h�p://ww2.cfo.com/accoun�ng-tax/2006/03/proba�on-for-adelphias-michael-rigas/)

Consider This:

1. If you were working for a public company and realized money was being tapped for private use, what would you do? 2. Should there be limits on the number of insiders who can serve on the Board of Directors of a public company?

Part IV: The Extras—Addi�onal Exhibits

In this sec�on, the company provides a list of all exhibits included with the Form 10-K. Required exhibits include the company's bylaws, copies of its material contracts, and a list of its subsidiaries.

Other Required Government Repor�ng

In addi�on to the annual Form 10-K, companies must file an abbreviated version, the Form 10-Q, on a quarterly basis. Major events that shareholders should know about are filed on a Form 8-K.

Form 10-Q

The Form 10-Q is a quarterly report that all public companies must file with the SEC. Large corpora�ons with more than $75 million in outstanding shares of stock must file the form within 40 days a�er the end of a quarter. Smaller companies must file within 45 days.

The line items in the Form 10-Q resemble the informa�on required on the Form 10-K. However, not all the items required on a Form 10-K must be presented on a Form 10-Q. Part I of the Form 10-Q includes the financial statements, MD&A, quan�ta�ve and qualita�ve disclosures about market risk, and controls and procedures. Part II of the Form 10-Q includes informa�on about legal proceedings, risk factors, unregistered sales of equity securi�es, and defaults on senior securi�es (not making payments on debt on �me). If the company operates a mine, it must include mine safety informa�on. Any informa�on that should be disclosed on a Form 8-K can also be disclosed as part of the Form 10-Q, if not yet disclosed (U.S. Securi�es and Exchange Commission, Form 10-Q, 2012g).

Form 8-K

The Form 8-K is used to inform the SEC and shareholders of a major event: a change in corporate leadership, a bankruptcy filing, a merger or acquisi�on, material modifica�on of the rights of shareholders, a change of accoun�ng firm, or one of many other events. The form must be filed within four days a�er the event. The SEC website contains a full list of events that trigger a Form 8-K filing (U.S. Securi�es and Exchange Commission, Form 8-K, 2012e).

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GAAP principles are followed in order to adhere to a common standard and to ensure that a company's financials are reported accurately.

© AndreyPopov/iStock/Thinkstock

1.4 What Are Generally Accepted Accoun�ng Principles? All companies must complete their financial reports based on a set of generally accepted accoun�ng principles (GAAP). In this sec�on, we will review what the GAAP is and explore how it impacts financial repor�ng. Then we will explore how the GAAP rules are developed.

A Basic Defini�on

The GAAP is essen�ally a collec�on of principles to assure that a company's financial statements are presented accurately and fairly. These rules give companies the parameters of what they must disclose in public financial reports, and they give companies guidelines for how to measure their assets, liabili�es, revenues, expenses, and equity.

The Financial Accoun�ng Standards Board (FASB) develops and updates the GAAP rules and sets standards for U.S. companies to follow. The FASB was first designated as the organiza�on responsible for establishing accoun�ng standards in 1973, but the origins of the GAAP go back to 1936, when the American Ins�tute of Accounts first used the phrase "generally accepted accoun�ng principles." The board is made up of seven members who are appointed by the SEC and serve full �me for five-year terms. Board members must sever all �es with accoun�ng firms or ins�tu�ons for which they worked in the past while they serve on the FASB (FASB, 2013).

Today, the GAAP fills bookshelves in an accountant's office. Each principle includes highly technical explana�ons about how a company must report its financial informa�on on each line item of the financial statements. As a non-financial employee or manager, you will likely never have to read the GAAP, but it is important to have a basic understanding of the rules behind the numbers you see on the financial statements.

The FASB uses these considera�ons when designing new GAAP requirements (FASB, 1980, p. CON 2-2.):

1. Relevance: Informa�on needed to forecast a company's future earnings or to correct prior expecta�ons fills this requirement. The informa�on must be �mely, which means it must be available to business decision makers before it loses its usefulness. For example, if companies could wait a few years before repor�ng, outsiders would not have the informa�on they need to make decisions about loaning to or inves�ng in the company.

2. Reliability: All informa�on in the financial reports must be verifiable, factual, and accurate. The company can't choose to show only the good news and hide the bad news.

3. Comparability: Companies can choose different accoun�ng methods to track various types of assets and liabili�es, but they must disclose the methods that they use so that results among companies will be comparable. For example, a number of different methods of tracking inventory are permi�ed, but the companies must disclose the method they are using.

4. Consistency: Companies must use the same accoun�ng principles and methods from year to year so that financial report readers can compare results of prior years. If a company changes its accoun�ng principles or the methods upon which its financial reports are based, it must explain the change and provide informa�on about how the change affects previous financial reports.

The GAAP Affects Financial Repor�ng

The GAAP affects every number you see on the financial reports of a public company. This is because, as noted, GAAP standards have been wri�en for every line item. Private companies do not have to use the GAAP because they do not have to report to the SEC, but many do because investors and lenders o�en require audited financial statements in order to invest or provide loans. (American Ins�tute of CPAs, 2001).

GAAP guides accountants by giving them a standard by which to measure and present financial results. It prevents companies from presen�ng only data that makes themselves look good. For example, GAAP requires costs to be measured based on when the expense was incurred. It does not allow the expense to be adjusted for infla�on or other factors. It also requires that expenses be reported during the same period as any assets were a�ained or created through those expenses.

GAAP rules do differ between governmental agencies and nongovernmental agencies, but the primary goals are the same. The key goal for GAAP is to enable financial report readers to compare the results with the company's past performance, as well as with similar businesses.

Development of the GAAP Rules

GAAP rules are not set in stone. As business and technology changes, they can be adjusted to reflect the changing business environment. O�en changes start with the audi�ng industry, because these professionals tend to be the first to see emerging trends not covered by the exis�ng GAAP rules. Changes can also be needed if new legisla�on or regula�on changes financial repor�ng requirements.

Professionals who see a need for change will contact the FASB, which will then decide what technical issues to add to its agenda for changing the GAAP. The board looks at a number of factors before deciding that a principle needs to be changed (FASB, 2014):

1. Importance of the issue: The FASB will gauge how troublesome the issue is to users, preparers, auditors, and others. It will also consider how many different kinds of companies are affected and whether the issue involves a long-term change or is just a short-term problem. Only issues that are likely to persist over �me

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will be selected for considera�on. 2. Technical feasibility: The FASB will determine whether a solu�on can be developed immediately or whether another technical issue must be resolved first. If the

board determines another issue must be resolved first, it will postpone working on the first issue. 3. Prac�cal consequences: The FASB will gauge whether the improved accoun�ng solu�on is likely to be generally accepted and to what extent addressing a

par�cular issue may cause others, such as the SEC or Congress, to act. For example, if FASB sets a rule that the corpora�ons oppose, they may put pressure on the SEC or the Congress to overrule the FASB or to get a new law passed to change the FASB rule.

4. Convergence possibili�es: The FASB will gauge whether its ac�on on an issue could lead to the elimina�on of significant differences in standards or prac�ces between the United States and other countries. It seeks to improve the quality of U.S. standards and bring them closer to interna�onal standards.

5. Resources: The FASB must determine whether it has the adequate resources and exper�se available within the FASB to work on an issue or whether it must recruit others to develop a new principle.

If the FASB determines it wants to work on the issue, a long process begins. It can take years before a new principle is added or a change is made to the GAAP. The process includes board mee�ngs that are open to the public, dra�s that are circulated for public comment, then addi�onal public board mee�ngs. O�en this process is repeated one or more �mes before a change is made to a GAAP principle.

In addi�on to the work done within the United States, the FASB coordinates with the Interna�onal Accoun�ng Standards Board (IASB) to be sure the new rules will meet the needs of the global community. Many countries have already adopted the interna�onal financial repor�ng standards (IFRS) developed by the IASB, but the decision has not yet been made in the United States. Foreign companies that file reports within the United States can file those reports based on the interna�onal standards (IFRS Founda�on, no date).

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A company's accounts are divided up into six types, star�ng with the accounts on the balance sheet followed by the accounts on the income statement: assets, liabili�es, equity, revenue, cost of goods sold, and expenses.

1.5 An Overview of Accounts Essen�ally, every line item found on the financial statements reflects an account in the company's books, but some line items are actually a summary of several individual accounts. For example, the line item Cash is a total of what a company has in all its bank accounts, as well as its cash registers and pe�y cash drawers. Most companies have numerous bank accounts and hundreds, if not thousands, of places money could be held on the day the balance sheet is developed. So the number for Cash will not represent just one account on the books.

As the Best General Company's budget commi�ee begins its work, it needs to ask for a list of year-to-date balances in all the accounts, not just those that appear on the financial statements. That detail will enable them to see which accounts are running near, at, or above the budgeted amounts allocated in the previous budget cycle. Commi�ee members would likely want to inves�gate any accounts running significantly over or under budget. In order to prepare a new budget, they want to know where changes are needed. As part of their development process, they may even want to meet with any department managers whose actual revenues and expenses are significantly different from those budgeted in the prior year.

Every company has what is called a Chart of Accounts (shown in Figure 1.1), which lists all the possible accounts into which a financial transac�on can be entered into the books. This Chart of Accounts is developed based on the line items of a balance sheet and income statement. Generally, the order of the Chart of Accounts is assets, liabili�es, equity, revenue, costs of goods sold, and expenses. Let's take a brief look at the types of accounts in each of these six categories. We will cover them in depth in Chapter 2 (The Balance Sheet) and Chapter 3 (Elements of an Income Statement).

Figure 1.1: Chart of Accounts sheet

Balance Sheet Accounts

The balance sheet includes three of the key account types: assets, liabili�es, and equity. (See Figure 2.1 in Chapter 2 for a sample balance sheet.) There are two types of assets: current and long-term. There are also two types of liabili�es: current and long-term. Current assets or liabili�es include accounts that will be used or paid in the next 12 months. Long-term assets or liabili�es will be used or paid over more than a 12-month period.

Different types of companies will own different types of assets, so you won't always see the same line items on every balance sheet. The most common types of balance sheet accounts include:

1. Current asset accounts. These can include cash, marketable securi�es (things that can be quickly turned into cash, such as cer�ficates of deposit and tradable bonds or stocks), accounts receivable (the total amounts customers owe to the company who buy on store credit), and inventory, as well as many other things a company owns that it will use over a 12-month period.

2. Long-term asset accounts. These can include land, buildings, leasehold improvements (when a company leases property it will renovate; the value of these renova�ons is included in this line item), vehicles, furniture and fixtures, and equipment. These are all tangible assets (assets one can touch and feel). There is also a class of assets called intangible assets (assets that are difficult to perceive), which include copyrights, patents, and trademarks.

3. Current liabili�es accounts. These include accounts payable (outstanding bills that need to be paid), sales taxes collected (taxes that have been collected from customers that need to be paid to the local, state, or federal government), accrued payroll taxes (taxes collected from employees that need to be paid to the

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local, state, or federal government), and credit cards payable (money due to credit card companies that has not yet been paid). 4. Long-term liabili�es accounts. These include loans payable (debts such as mortgages and car loans) and bonds payable (bonds that must be repaid). 5. Equity accounts. These include stock (shares of the company sold to the public or private investors) and retained earnings (profits reinvested into the company).

Income Statement Accounts

Income statement accounts are grouped under revenue (sales) accounts, costs of goods sold accounts, or expense accounts. Costs that can be directly related to the sale of goods fall under cost of goods sold. All other expenses a company incurs will fall under the expense sec�on of the income statement. Common income statement accounts include:

1. Revenue accounts. These include sales of goods or services, sales discounts (any discounts offered to the customer off the retail price), and sales returns and allowances (returns of merchandise). Companies do not usually show sales discounts or sales returns. The income statement will likely only include a Net Revenue number.

2. Cost of goods sold accounts. These include purchases (costs of products purchased or manufactured for sale), purchase discounts (discounts the company received when it purchased the goods), purchase returns and allowances (returns of products purchased), and freight charges (any costs incurred for shipping the products to the company). Most companies only show one line item for these costs, called Cost of Goods Sold.

3. Expense accounts. These include any costs related to genera�ng revenue for the company that cannot be directly related to the sales of goods sold. For example, adver�sing can rarely be �ed to the sale of one par�cular item, so these expenses fall under an expense account rather than a Cost of Goods Sold account. This is o�en the longest sec�on of the income statement. Accounts include opera�ng expenses, such as adver�sing, equipment rental, insurance, store or office rental, legal and accoun�ng fees, meals, entertainment, salaries, office expenses, postage, repairs and maintenance, supplies, travel, telephone, u�li�es, vehicle, and any other expenses a company incurs to operate the business. In addi�on, there will be interest expenses on the company's debt, deprecia�on and amor�za�on expenses (these track the use of the company's assets, but are not a cash expense; we take a close look at deprecia�on and amor�za�on in Chapter 3). Taxes are also tracked as an expense account.

This is not a complete list of all possible line items on the financial statements—only the most common ones. As we examine the balance sheet and income statements more closely in the coming chapters, we will look at actual balance sheets and income statements from major companies in various industries to explore the variety of accounts reflected on these statements.

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Summary and Resources

Chapter Summary

Financial statements, found in both the Annual Reports and the Form 10-K, play an important role in the world of business. External repor�ng must meet strict guidelines set by the GAAP, while internal repor�ng can be designed to meet the needs of management without having to worry about these rules. Without financial reports, managers and execu�ves could not make informed decisions about their departments or the company as a whole. Investors would not be able to make ra�onal decisions about whether to invest in a company. Regulators would not be able to measure whether a company was accurately repor�ng its results to the public and the government. Lenders would not have the informa�on they need to make decisions about whether to lend money to a company. And employees would not be able to determine whether their company con�nued to be viable or they should search for new posi�ons. Annual reports are sent to shareholders to inform them about the company's ac�vi�es for the year, as well as the company's financial results. These annual reports are submi�ed to the SEC for review along with a more formal repor�ng structure on the SEC's Form 10-K. Since all these audiences need to be able to compare and evaluate financial statements from mul�ple companies, the statements need to be presented in a consistent fashion and based on a similar set of rules. For public companies, these rules are set by the FASB and enforced by the independent auditors who go into a company and make sure that the rules, which are known as the GAAP, are being followed. Once the company's books are audited, annual reports are then sent to shareholders and the SEC. The Form 10-K is also submi�ed to the SEC. Many accounts are used to create the financial reports, including: cash, which is cri�cal to any company in order for it to keep opera�ng; sales, which tracks the revenue being generated; and costs and expenses, which tracks what is needed to operate the company.

Takeaways for Chapter 1

Managers can't make decisions in a vacuum. They must understand their own company's financial results as well as those of their compe�tors. Financial results are presented based on a standard set of rules called GAAP. These rules enable companies to compare their results. They are developed by the FASB. Companies prepare annual reports for their shareholders and prepare more technical and detailed reports for the SEC on the Form 10-K.

Discussion Ques�ons

1. Why is it more difficult to find informa�on about private companies? 2. Why should an employee or manager be interested in reading the financial reports of the company for which he or she works? Why might an investor be

interested in reading financial reports for a company in which he or she might invest? 3. What are some key things you can expect to find in the Management's Discussion and Analysis (MD&A) sec�on and how will you use them to make decisions? 4. What are some key details you can expect to find in the Notes to Financial Statements and how can you use them? 5. What are some of the key news sources you can use to research informa�on about a company?

Further Reading/Resources

Business Magazines and Websites It can be helpful to read business magazines and explore financial websites to find out more about your own company as well as your compe�tors. Some credible op�ons include:

Businessweek (h�p://www.businessweek.com/) —Good source for an overview of business news about industries and individual companies. Entrepreneur (h�p://www.entrepreneur.com/) —Focuses on the people who start up their own businesses and the success of those businesses. Fast Company (h�p://www.fastcompany.com/) —Focuses on small and growing companies. Forbes (h�p://www.forbes.com/) —Provides financial and business news in the U.S. and around the world. Fortune (h�p://money.cnn.com/magazines/fortune/) —Focuses on key business leaders, as well as coverage of business and economic news. Google Business News (h�ps://news.google.com/news/sec�on?pz=1&cf=all&ned=us&topic=b&ict=ln&siidp=bb46a34695df703a2da5c567a0aaa7a7268e) —Collects the key business ar�cles of the day from various news sources. Inc. (h�p://www.inc.com/) —Emphasizes up-and-coming businesses and their leaders. Yahoo Finance (h�p://finance.yahoo.com/) —Good search engine for researching companies and industries.

Governmental Websites You can find out more informa�on about the key governmental and private agencies, their role in financial repor�ng, and financial repor�ng rules by visi�ng these websites:

Financial Accoun�ng Standards Board (h�p://www.fasb.org/home) Form 8-K (h�p://www.sec.gov/about/forms/form8-k.pdf) Form 10-K (h�p://www.sec.gov/about/forms/form10-k.pdf) Form 10-Q (h�p://www.sec.gov/about/forms/form10-q.pdf) Office of Investor Educa�on and Advocacy (h�p://www.sec.gov/investor) Security and Exchange Commission, EDGAR (h�p://www.sec.gov/edgar.shtml#.U1bsJcfTar0)

Key Terms

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Click on each key term to see the defini�on.

accounts payable (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks bills to be paid by the company.

accounts receivable (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks the money due from customers who bought from the company on credit.

accrued payroll taxes (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Taxes collected from employees that need to be paid to the local, state, or federal government.

acquisi�ons (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Items (or other companies) that the company plans to buy or has recently bought.

actuarial assump�ons (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Es�mates of the value of an asset or person. Insurance companies commonly use these to determine the cost of an insurance policy. Companies also use these when trying to determine a value for a financial asset that has an uncertain value, such as the future payments on re�ree benefits.

amor�za�on (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The reduc�on in the value of an intangible asset, such as a copyright or a patent, over a period of �me that is due to the "using up" of that asset. It can also be the process of decreasing the amount owed on a long-term debt.

analyst call (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Conversa�ons among key execu�ves and analysts to discuss a summary of the company's financial results at the end of a quarter or year.

annual report (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Document sent to shareholders to provide them with informa�on about the company's financial ac�vi�es throughout the previous year.

assets (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Items a company owns.

audit (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An impar�al, third-party review of a company's opera�ons and financial statements to confirm that the reports are materially correct and that proper internal controls are being used.

balance sheet (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Also known as a statement of financial posi�on, this statement shows a company's assets (what the company owns), its liabili�es (what the company owes), and its equity (what claims investors have on the assets). It is essen�ally a snapshot of the company's financial posi�on as of a par�cular date.

bonds payable (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks bonds that must be repaid.

capital (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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The net worth of a company.

credit cards payable (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks money due to credit card companies that has not yet been paid.

current assets or liabili�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Accounts that will be used or paid within the next twelve months.

defaults on senior securi�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Debt payments that are not made on �me, such as bond interest or principal payments.

deprecia�on (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The reduc�on of the value of an asset over the life span of the asset.

Electronic Data Gathering, Analysis, and Retrieval (EDGAR) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

System that collects, validates, and indexes reports from public companies who must report to the U.S. Securi�es and Exchange Commission. Anyone can search this database online to get detailed financial reports from public companies.

equity (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Claims investors have against the assets of a company, usually in the form of stock owned by the investors.

external financial reports (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Informa�on about the financial health of a company provided to individuals or ins�tu�ons who do not work for the company, including bankers, vendors, investors, and compe�tors.

Financial Accoun�ng Standards Board (FASB) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Organiza�on that develops and updates the GAAP rules and sets standards for U.S. companies to follow; its board members are appointed by the SEC.

financial statements (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Documents that provide a summary of the financial health of a company for a specific period of �me. They give both internal and external readers informa�on needed to make financial decisions about a company.

Form 8-K (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A form filed by public companies with the SEC to report special events, such as a change in officers of the company.

Form 10-K (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An annual form filed by public companies with the SEC that provides comprehensive details about the company's business and financial condi�ons.

Form 10-Q (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A quarterly form filed by public companies with the SEC that provides comprehensive details about the company's business and financial condi�ons.

freight charges (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Any costs incurred for shipping the products to the company.

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generally accepted accoun�ng principles (GAAP) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Rules companies must follow when collec�ng and presen�ng their financial data and results.

generally accepted audi�ng standards (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Rules auditors must follow when reviewing the company's books and financial opera�ons.

going-concern problem (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A situa�on that indicates that a company may not be able to stay in business for the long-term; generally, it is an indica�on that the company may con�nue to lose money, have a cash deficiency, or suffer a significant contract dispute.

income statement (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Also known as a statement of earnings, or a profit and loss statement, this statement provides informa�on about a company's revenues and expenses over a specific period of �me.

intangible assets (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Things the company owns that cannot be felt or touched, such as copyrights and patents.

internal financial reports (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Confiden�al reports that can only be shared with employees of the company or the company's board of directors. They provide more details about the company's financial results.

Interna�onal Accoun�ng Standards Board (IASB) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The independent standard-se�ng body of the Interna�onal Financial Repor�ng Standards Founda�on. The board's 15 full-�me members develop and publish Interna�onal Financial Repor�ng Standards. The board members come from various countries and work closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accoun�ng standard-se�ers, and others in the accountancy profession.

interna�onal financial repor�ng standards (IFRS) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A set of rules that most interna�onal companies follow. The IRFS are similar in many ways to the U.S. GAAP. There is a move interna�onally to converge the U.S. GAAP and the IRFS rules.

leasehold improvements (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Renova�ons done by companies when they lease a property; the renova�ons are assets whose expense will be gradually wri�en off over a period of �me.

liabili�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Debts a company owes to its lenders.

liquidity (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

All assets that can easily be bought or sold to raise cash.

loans payable (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks long-term debts that are paid over a number of years, such as mortgages and car loans.

long-term assets or liabili�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

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Assets whose useful life will be more than 12 months or debts that will be paid over more than 12 months.

Management's Discussion and Analysis (MD&A) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A sec�on of the annual report in which the management team discusses the successes and failures of the company in the previous year, as well as future plans for the company.

market segment informa�on (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Informa�on about where the company sells its products and to whom the products are sold.

marketable securi�es (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Assets that can quickly be turned into cash, such as money market funds and tradable stocks and bonds.

material misstatements (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Errors in the financial statements that could have an impact on the value of the company.

mergers (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The decision of two or more companies to join forces and become one en�ty.

Notes to the Financial Statements (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Part of the annual report that provides details about the line items on the financial statements.

opera�ons (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

All the day-to-day ac�vi�es in running a business.

private companies (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Companies whose shares of stock are held by and traded privately among individuals. O�en private companies are wholly owned by family members or a close-knit group of investors. These companies are not required to report their financial results publicly.

proxy materials (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Documents that give shareholders informa�on they will need to vote on issues that will be discussed at the annual mee�ng. They include details about the board of directors and key execu�ve personnel, including their backgrounds and compensa�on.

public companies (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Companies whose shares of stock are sold on the public stock markets. Public companies must provide financial reports periodically to the public.

purchase discounts (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The discounts a company receives when it purchases the goods it plans to sell.

purchase returns and allowances (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account that tracks returns of products purchased.

purchases (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The goods bought by the company to be sold to customers of the company.