1.Recently the Securities and Exchange Commission has been concerned with the independence of external auditing firms. It is especially concerned about how large non-audit (such as consulting) fees might impact how aggressively auditing firms pursue accounting issues they uncover in their audits. Congress recently passed legislation that prohibits accounting firms from providing BOTH consulting and auditing services to the same client.How might consulting fees affect auditor independence? What other conflicts of interest might exist for auditors?

2.You are evaluating your companys recent operating performance and are trying to decide on the relative weights you should put on the income statement, balance sheet, and statement of cash flows. Discuss the information each of these statements providesANDits role in evaluating operating performance.

Karlton Lough, CPA / JD Financial Reporting & Control FISV 5526 Framework for Analysis and Valuation Berkshire Hathaway's Acquisition Criteria 1. Large purchases (and large pretax earnings). 2. Demonstrated consistent earning power (future projections are of no interest to us, nor are 'turnaround' situations). 3. Businesses earning good returns on equity while employing little or no debt. 4. Management in place (we can't supply it). 5. Simple businesses (if there's lots of technology, we won't understand it). 6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). 4 Steps in Financial Statement Analysis and Valuation Step 1: Business Environment and Accounting Information Financial Accounting Information: Demand & Supply Demand for financial accounting information extends to numerous users that include: Managers and employees Investment analysts and information intermediaries Shareholders and directors Customers and strategic partners Regulators and tax agencies Voters and their representatives Supply of Accounting Information Primary SEC filing requirements Form 10-K: annual Form 10-Q: quarterly Benefits of disclosure Lower costs of funds and labor Economic benefits form reliable disclosures Costs of disclosure Preparation and dissemination, competitive disadvantages, litigation potential, and political costs Financial Statements The Accounting Equation Berkshire Hathaway's Balance Sheet Walgree n's Investing Activities Financing Activities Initial Questions about the Balance Sheet Many investment-type companies such as Berkshire Hathaway and high-tech companies such as Cisco Systems carry high levels of cash. Why is that? Is there a cost to holding too much cash? Is it costly to carry too little cash? The relative proportion of short-term and long-term assets is largely dictated by companies' business models. Why is this the case? Why is the composition of assets on balance sheets for companies in the same industry similar? By what degree can a Initial Questions about the Balance Sheet continued What are the trade-offs in financing a company by owner versus nonowner financing? If nonowner financing is less costly, why don't we see companies financed entirely with borrowed money? How do shareholders influence the strategic direction of a company? How can long-term creditors influence strategic direction? Most assets and liabilities are reported on the balance sheet at their acquisition price, called historical cost. Would reporting assets and liabilities at fair values be more Income Statement An income statement reports on operating activities. It lists amounts for sales (and revenues) less all expenses (and costs) over a period of time. Sales less expenses yield the \"bottomline\" net income amount. Berkshire Hathaway's Income Statement Net Income as a Percent of Sales Walgreen's Initial Questions about the Income Statement Assume that a company sells a product to a customer who promises to pay in 30 days. Should the seller recognize the sale when it is made or when cash is collected? When a company purchases a long-term asset such as a building, its cost is reported on the balance sheet as an asset. Should a company, instead, record the cost of that building as an expense when it is acquired? If not, how should a company report the cost of that asset over the course of its useful life? Manufacturers and merchandisers report the cost of a product as an expense when the Initial Questions about the Income Statement continued If an asset, such as a building, increases in value, that increase in value is not reported as income until the building is sold, if ever. What concerns arise if we record increases in asset values as part of income, when measurement of that increase is based on appraised values? Employees commonly earn wages that are yet to be paid at the end of a particular period. Should their wages be recognized as an expense in the period that the work is performed, or when the wages are paid? Companies are not allowed to report profit on transactions relating to their own stock. That is, they don't report income when stock is sold, Statement of Equity The statement of equity reports on changes in the accounts that makeup equity Contributed capital Earned capital (retained earnings and accumulated other comprehensive income) Berkshire Hathaway's Statement of Stockholders' Equity Walgreen's Statement of Cash Flows The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time. Walgreen 's Initial Questions about the Statement of Cash Flows What is the usefulness of the statement of cash flows? Do the balance sheet and income statement provide sufficient cash flow information? What types of information are disclosed in the statement of cash flows and why are they important? What kinds of activities are reported in each of the operating, investing and financing sections of the statement of cash flows? How is this information useful? Is it important for a company to report net cash inflows (positive amounts) relating to operating Initial Questions about the Statement of Cash Flows continued Why is it important to know the composition of a company's investment activities? What kind of information might we look for? Are positive investing cash flows favorable? Is it important to know the sources of a company's financing activities? What questions might that information help us answer? How might the composition of operating, investing and financing cash flows change over a company's life cycle? Is the bottom line increase in cash flow the key number? Why or why not? Financial Statement Linkages The income statement and the balance sheet are linked via retained earnings. Retained earnings, contributed capital, and other equity balances appear both on the statement of stockholders' equity and the balance sheet. The statement of cash flows is linked to the income statement as net income is a component of operating cash flow. Information Beyond Financial Statements Management Discussion and Analysis (MD&A) Independent Auditor Report Financial Statement Footnotes Regulatory Filings and Proxy Statements Competitive Analysis Industry competition Bargaining power of buyers Bargaining power of suppliers Threat of substitution Threat of entry Five Forces of Competitive Intensity Cambridge Business Publishers, 2013 Step 2: Adjusting and Assessing Financial Information Financial Accounting is not an exact science GAAP allows companies choices in preparing financial statements (inventories, property, and equipment). Companies must choose among the alternatives that are acceptable under GAAP. Financial statements also depend on countless estimates. Profitability Analysis Step 3: Forecasting Financial Numbers The theoretical linkage between earnings and stock prices is as follows: current earnings predict future earnings future earnings help determine expected future dividends these future dividends, when discounted, determine current stock price Step 4: Company Valuation In most cases, we think of the worth of a company as the current value of expected payoffs. Modules 12, 13, and 14 describe how to compute value using dividends, cash flows, and earnings as the payoffs. Market-based valuation is described in Module 15. Appendix 1A: Accessing SEC Filings Appendix 1B: Oversight of Financial Accounting SEC oversees all publicly traded companies Financial Accounting Standards Board (FASB) Public Company Accounting Oversight Board (PCAOB) Audit Report Financial statements are management's responsibility. Auditor responsibility is to express an opinion on those statements. Auditing involves a sampling of transactions, not investigation of each transaction. Audit opinion provides reasonable assurance that the statements are free of material misstatements, not a guarantee. Auditors review accounting policies used by management and the estimates used in preparing the statements. Financial statements present fairly, in all material respects a company's financial condition, in conformity with GAAP