OMM 622 Financial Decision-Making

I HAVE 2 DISCUSSIONS NEED TO BE DONE

DICSUSSION 1

Contents of an Annual Report

Discuss the following scenario: Staff members from the marketing department of your firm are doing a splendid job selling products to customers. Many of the customers are so pleased that they are also buying shares in the company’s stock, which means that they receive a copy of the firm’s annual report. Unfortunately, questions sometimes arise that the marketing staff members are woefully inadequate at answering. Technical questions about the firm’s financial condition and performance are referred to the chief financial officer, but the director of marketing has asked you to write a memo in which you explain the key elements in an annual report so that marketing representatives are better prepared to respond to questions of a more general nature.

For your initial post, write a clear, concise memo (no more than 250 words) that describes the contents of an annual report so marketing personnel can understand the basic requirements of an annual report. Reference this week’s readings and lecture to help organize and explain your thoughts. In addition, answer the following questions:

· Do you think all marketing staff members should be equipped to speak with the public about the firm’s financial matters?

· What are some of the benefits of improving employee financial literacy?

DISCUSSION 2

Financial Statement Analysis

The financial statement analysis is due in Week Six. To help you begin your preparation of this work, select a company that you will do the analysis of. Write at least a 200 word summary identifying the firm that you selected, summarizing why you selected it, and explaining the items that a financial analyst might find useful within its Annual Report. 

Additionally, read the Forbes article: “

12 Lessons from the Warby Parkers Annual Report (Links to an external site.)Links to an external site.

” and explain which of these 12 lessons may apply to your company selection.

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Jan 30, 2014 @ 10:00 AM

12 Lessons From

Warby Parker

‘s Annual Report

Ross Crooks

,

Contributor

Opinions expressed by Forbes Contributors are their own.

Eyewear startup Warby Parker just released its

2013 Annual Report

, a perfect example of how important tone is in creating great visual content. The unique approach to a year-end report uses a calendar format, highlighting company events on each day. Some events are significant company milestones; others are little anecdotes showcasing office life and culture. It is more than a welcome deviation from the financial results and strategic initiatives that typically fill the pages of such a document. The dynamic layout is downright addictive.

This makes the report an excellent example of a brand showcasing its ideas and culture in a visually engaging way. At its core, the strategy of content marketing is not just about distribution and visibility. It is about telling the world who you are and what you stand for. This approach, when authentic, turns customers into brand fanatics.

Here are 12 important lessons all brands can learn from Warby Parker’s approach to creating great content.

1. Be Visual

Presenting your content in a visual format has a number of benefits. First, humans recognize and process images much faster than text; this is why visual content has much greater appeal. Second, using a diversity of image types makes your content continuously fresh, which encourages readers to explore more. Here, the combination of photography, illustration, videos and data visualization keeps the eyes interested and moving around the page. More time on site means more engagement with your brand.

2. Show Your Personality

Business

is becoming increasingly personal—not in the barista-knows-my-order sort of way but more in the way that we crave more personal connection in a web-based world. People want to know that the businesses they support are run in a way they can relate to, that its employees are people they might hang out with and potentially even share a meal of 100% pork.

3. Only Share Company News That Is Really News

In an attempt to generate attention and additional content, brands often spin less-than-remarkable developments into supposed news events. It shouldn’t be a surprise that your audience sees right through this. If it’s not news, it’s bad news. You are better off just posting a picture of your fax machine dressed as Governor Chris Christie.

4. Show People Underneath The Hood

The growth in content consumption is not just because people are looking for a satisfactory distraction from work. That may be part of it, but there are also audiences with an appetite for real information. The vast knowledge-sharing that the web has facilitated has brought with it an increased curiosity and hunger for understanding. Don’t make the mistake of thinking that everything you do in the back end of your business is boring. Turn it into engaging content that will deepen your audience’s understanding of what your world is all about.

5. Talk About Your People

Your audience wants to know that there are humans behind your brand, and they want to know about those humans. Don’t make the mistake of hiding your people, relationships, interactions and office pranks behind a shield of professional language. These things are as interesting (sometimes more interesting) than what you are selling. In today’s marketing landscape, whether you are a product or service-oriented business, you are selling your culture, and your culture is your people.

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

Learning Objectives

After 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 accounting principles (GAAP) and explain how they are used
in practice.

5. Identify accounts that make up the annual report and Form 10-K.

© emily2k/iStock/Thinkstock

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Introduction

Pre-Test

1. What are the key parts of an annual report?
a. balance sheet, income statement, and cash flow statement
b. revenues, expenses, assets, and liabilities
c. auditor’s report, management’s discussion and analysis, financial statements,

and notes to the financial

statements

d. highlights, president’s or CEO’s letter, key executive officers, and financial

statements

2. Who reads financial reports?
a. government agencies
b. investors
c. bankers
d. all of the above

3. What rules must be followed when preparing a financial report?
a. GAAP
b. auditor’s rules
c. SEC rules
d. rules set by executives

4. What are the key account groupings of financial statements?
a. assets, liabilities, equity, revenue, cost of goods sold, and expenses
b. cash, debt, stock, sales, expenses, and retained earnings
c. sales, assets, liabilities, expenses, and costs
d. sales, assets, equity, costs, and expenses

5. Who must receive a Form 10-K?
a. the auditors
b. the SEC
c. the state treasurer
d. the investors

Answers can be found at the end of the chapter.

Introduction
You are probably at least a little familiar with financial statements, and you may have
used or created them as part of your financial responsibilities as a manager or employee.
But to be a truly effective 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 state-
ments to make better and more informed decisions as a manager.

One key responsibility for many managers is the regular preparation 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.

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Introduction

In this text, we’ll follow a fictional committee at the fictional Best General Company that
was formed to create a budget for the coming fiscal year. Let’s first meet the members of
the committee: Bob, a financial analyst at the company, has been asked to form the budget
committee. He chooses three other employees to join him: Susan, a marketing 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 competitors.

After reviewing the previous year’s results, they will also be able to determine areas where
improvement is needed, or, conversely, identify areas in which their company excels.
Using all of this information, committee 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
projection of revenues—that is, whether revenues are expected to go up or down. Rev-
enues drive the budget because resources the company can use during the next year will
depend on the revenue that is expected to be generated.

For example, if the budget committee 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 conditions lead the budget committee to project lower rev-
enue 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 executive commit-
tee 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 committee may also recommend to the executive committee expansion in cer-
tain divisions or departments that are producing the best results—and possibly a reduc-
tion in resources to departments whose contribution to revenue is decreasing.

In this book, we will follow the Best General Company budget committee and give exam-
ples 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 state-
ments 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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Section 1.1What Are Financial Statements and Why Are They Important?

1.1 What Are Financial Statements and
Why Are They Important?

No manager or executive can develop plans to improve a company’s financial perfor-
mance and results without first analyzing what happened over the past year, or past sev-
eral years. This is where financial statements come in; they provide a snapshot of the
financial health of a company for a specific period of time, and give both internal and
external readers information needed to make financial decisions about a company.

Mid-level managers and supervisors, for example, can use financial reports to identify 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 participating on
our Best General Company budget committee, can use financial reports to determine the
contributing factors. Conversely, if managers spot an improving trend, they can use finan-
cial statements to identify the key products or services contributing 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 finan-
cial reports. External financial reports are made available to the general public, includ-
ing investors, bankers, vendors, and suppliers, and must be prepared according to strict
accounting rules, which are discussed below. Internal financial reports, in contrast, are
confidential 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 information found
in each.

External Reports

All companies must prepare external
reports for their bankers and inves-
tors. Companies that sell shares on
the public stock markets (that is,
public companies) must file these
reports with the Securities and
Exchange Commission (SEC), a fed-
eral agency that enforces securities
law and regulates the securities
industry, which includes the stock
and option markets.

didecs/iStock/ThinkStock

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

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Section 1.1What Are Financial Statements and Why Are They Important?

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

• The balance sheet (or statement of financial position): This statement shows a
company’s assets (what the company owns), its liabilities (what the company
owes), and its equity (what claims investors have on the assets). It is essentially a
snapshot of the company’s financial position as of a particular date. We dig into
this statement in Chapter 2.

• The income statement (or statement of earnings, or profit and loss statement):
This statement provides information 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 critical areas of operations. Operations include all the day-to-
day activities in running the business. These activities will vary depending on the
type of business that is being run. We explore this statement in Chapter 4.

In addition, 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 bottom of the income statement or on a sepa-
rate 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 committee. Working with Susan, the marketing manager, he needs to determine
what level of sales to project for the next year. This number is critical to the entire budget-
ing 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 better than the other companies, they need to identify
what the company does differently to stay on top of the competition 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 competition is doing to attain better 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 committee 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.

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Section 1.1What Are Financial Statements and Why Are They Important?

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.

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 critical areas of its day-to-day operations.

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 inter-
nal reports that are confidential and available only to insiders (which we discuss next). The
budget committee will have access to the internal reports for the Best General Company
but will not have access to the internal reports for their competitors.

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 relationship 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 information from a company’s
executives in another section of the reports filed with the SEC called the Management’s
Discussion and Analysis. In this section, executives discuss the prior year’s results,
as well as key plans for the company in the following year. This section of the external
reports can be helpful for Juan and Susan to find out where their competitors are planning
to focus their attention in the next year.

The financial statements, notes to the financial statements, and the management’s discus-
sion 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 addition to an annual report, a more formal financial
reporting 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 executives and managers delve deeper into the numbers.

Public companies prefer to release as little of their financial information as possible to
minimize the information available to their competitors. Of course, public companies
must divulge a certain amount of information 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 information is found in confidential reports prepared for internal audiences
only. Confidential 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 devel-
oped. These reports do not have to meet any rules since they are for internal use only.

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Section 1.1What Are Financial Statements and Why Are They Important?

This book focuses primarily on public financial reporting. However, we will also explore
common formats for internal reports that enable executives and managers to make deci-
sions. The company’s accounting 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 information 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:

• Executives and managers: These are the individuals who make financial deci-
sions for the company. They base most of their decisions on the information found
in both internal and external financial reports. If executives and managers see a
major difference between what was budgeted versus the final result, they will
investigate to find out why there is a difference; for example, they will talk to key
managers and employees about their target goals. Non-accounting 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 inter-
nal 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 accu-
rately 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 retirement 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 information from the financial reports
to determine where the company is planning to grow and seek a position in one of
the growth departments.

• Creditors: Creditors, such as banks or other lending institutions, 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 meeting 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 continue 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 regulations set at both the state and federal lev-
els. They also want to be sure that companies report their numbers accurately to
inform the public about their financial position.

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Section 1.1What Are Financial Statements and Why Are They Important?

• Analysts: Analysts use financial reports to develop analytical reviews and to pre-
pare reports for investors or creditors. In addition to using the financial reports,
analysts will question key executives about the financial results on an analyst call
at the end of each reporting period.

• Financial reporters: Financial reporters use financial reports to write stories for
their audience about a company’s financial health. They may also participate in
analyst calls to develop their news stories.

• Competitors: Competitors 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 competitors
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 opportunities. Employees who can under-
stand and analyze financial reports become a very valuable resource to their employers.

For example, suppose an operations employee notices that the expenses for shipping
outgoing packages have increased dramatically and will result in exceeding the amount
budgeted for this expense. She decides to investigate shipping alternatives 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 incentives 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 consumption. 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 corporations that choose to stay private as well (see Table 1.1). (For
more information 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 Construction

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

Source: Murphy, A. (2013). America’s largest private companies. Forbes. Retrieved from http://www.forbes.com/largest-private-companies/

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http://www.forbes.com/largest-private-companies/

Section 1.1What Are Financial Statements and Why Are They Important?

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—still 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 addition 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 information technology related to its
manufacturing operations.

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 corporations. 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 restrictive debt to fuel their
business. To extend their growth, they exchanged a portion of their freedom. We believe growth
and prosperity can be achieved another way.”

Sources: Mars, Inc. (2012a). The five principles of Mars. Retrieved from http://www.mars.com/global/about-mars/the-
five-principles-of-mars.aspx and Mars, Inc. (2012b). Mars business segments. Retrieved from http://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 action without worrying about shareholders’ reaction? If so, what might those
advantages be?

.Vincent Kessler/Reuters/Corbis

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

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http://www.mars.com/global/about-mars/the-five-principles-of-mars.aspx

http://www.mars.com/global/about-mars/the-five-principles-of-mars.aspx

http://www.mars.com/global/about-mars/mars-pia/business-summaries.aspx

http://www.mars.com/global/about-mars/mars-pia/business-summaries.aspx

Section 1.1What Are Financial Statements and Why Are They Important?

Private companies enjoy three key benefits:

1. Confidentiality: 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 compensating owners
and executives. They don’t have to worry about shareholders voicing concern
about executive 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 difficulties when they want to raise additional
cash. They can’t just issue more stock. Instead, they must arrange for a loan with a finan-
cial institution or sell additional shares of stock to existing owners. They can also seek
help from a private investor, but they will need to provide extensive financial reporting 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, often in an “Investor Relations” or “About Us” section. These sections are usu-
ally accessed via a link at the bottom of the company’s main page.

Major financial news websites can be a reliable source of information 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, For-
tune, Entrepreneur, Inc., and Fast Company can also be valuable resources, as can local busi-
ness newspapers, particularly when seeking information about private companies.

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Section 1.2What Is an Annual Report?

1.2 What Is an Annual Report?
As we mentioned earlier, all public companies must provide their shareholders with an
annual report of the company’s activities, according to the Securities Act of 1933. The bud-
get committee of Best General Company can investigate these annual reports to research
where their competitors perform well; based on what they find, they can develop recom-
mendations for improving Best General’s financial results. Let’s take a closer look at the
information the budget committee can expect to find in an annual report.

The SEC requires that this report include:

• an opening letter from the Chief Executive Officer (CEO),
• financial information,
• results from continuing operations,
• market segment information (information about where the company sells its

products and to whom),
• new product plans,
• subsidiary activities (a subsidiary is a company that is completely or partially

owned or controlled by another company), and
• research and development activities regarding future programs.

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

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 difficulties you may have experienced as you tried to find financial information
about each company. Compare the information 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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Section 1.2What Is an Annual Report?

The annual report does not have a required format. Generally companies include the fol-
lowing sections, but not necessarily in this order:

•

Highlights

• Letter 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 Information

Let’s take a closer look at each of these sections.

Highlights

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

This section and the Letter from the President or Chief Executive Officer are usually pre-
sented in large, easily readable type with many pictures, while the rest of the report is
often in small, harder-to-read type with no pictures. When reading the report for impor-
tant information about the company’s future, or key decisions that have recently been
made, it’s important to remember to read the fine print.

Letter From the President or Chief Executive Officer (CEO)

The letter tends to be a puff piece that highlights the successes of the past year and dis-
cusses future plans for the company. It may be officially from the President or CEO, but
it’s more likely that it was written by the public relations or marketing staff and approved
by the executive.

Auditors’ Report

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

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Section 1.2What Is an Annual Report?

Auditors complete their audit under the guidelines set by the American Institute of Certi-
fied Public Accountants, called generally accepted auditing 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 letter from the auditors) is usually located either before or after
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-
tions they have about how the financial information was collected or presented.

When auditors examine a company’s financial reporting, they don’t check every transac-
tion, so these reports can never provide 100% assurance that the information is accurate.
Auditors instead review the accounting processes and make a statement about those pro-
cesses. They also conduct spot checks on various transactions to be sure that company
personnel are following the processes put in place.

The auditors’ report includes the following three paragraphs:

• Introductory paragraph: This includes information about the time 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 information
gathered during their audit.

• Scope paragraph: This includes information about how the auditors performed
their audit, including a statement that they have used generally accepted auditing
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
accounting 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 prob-
lems the auditors found in the opinion paragraph. Otherwise, the structure is the same.

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

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Section 1.2What Is an Annual Report?

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

• Change in auditors: Whenever a new accounting 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 accounting policies: The auditors will note if the company changed
an accounting policy or accounting 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 question the change, a response will likely be found in
the Management’s Discussion and Analysis section. More information about the
change and how it has affected the financial statements will also be found in the
Notes to the Financial Statements.

• Material uncertainties: 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 potential loss of
market share because of a new competitor. They may also point out the potential
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 question whether the company will be
able to stay in business, they will indicate that they have a going-concern prob-
lem. Such problems can include ongoing losses, cash deficiency, or a significant
contract dispute. This is a major red flag and often indicates that the company
is near bankruptcy. (We discuss General Motors’ road to bankruptcy in “World
of Business.” Auditors in 2008 questioned whether GM would continue as a
going-concern.)

• Specific disclosures: Sometimes the auditors will discuss a financial concern but
still 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 time the auditors issue a nonstandard report, they will
issue a qualified opinion in the final paragraph of the report. A qualified opin-
ion in the auditors’ report should be researched further in other sections 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.

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Section 1.2What Is an Annual Report?

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 accounting firm Deloitte and Touche LLP
placed this paragraph in the Auditors’ Report
of the 2008 GM annual report submitted to the
SEC (General Motors Corporation, 2008):

The accompanying consolidated
financial statements for the year
ended December 31, 2008, have been
prepared assuming that the Corporation
will continue as a going concern. As
discussed in Note 2 to the consolidated
financial statements, the Corporation’s
recurring losses from operations,
shareholders’ deficit, and inability to generate sufficient cash flow to meet its
obligations and sustain its operations raise substantial doubt about its ability
to continue as a going concern. Management’s plans concerning these matters
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)

Also in that annual report, it was made clear that GM was pushing for a government bailout. In
the risk factors section of another form filed with the SEC, GM management stated the following
(General Motors Corporation, 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 entity capable of sustaining itself over the long-term, or if we are
unable to restructure our Series D convertible debentures prior to June 1, 2009,
we could potentially be required to seek relief through a filing under the U.S.
Bankruptcy Code, either through a prepackaged plan of reorganization or under
an alternative plan, which could include liquidation. (p. 22)

Note that Series D Convertible 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 still owned 500 million shares of GM stock, or 32% of the company, as of this writing.
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 http://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 potentially lose their jobs?

Bill Cobb/SuperStock

In 2009, General Motors filed for Chapter 11
bankruptcy.

eps81356_01_c01_001-044.indd 15 3/25/14 3:07 PM

http://www.businessweek%20.com/stories/2009-06-01/gm-files-for-bankruptcybusinessweek-business-news-stock-market-and-financial-advice

http://www.businessweek%20.com/stories/2009-06-01/gm-files-for-bankruptcybusinessweek-business-news-stock-market-and-financial-advice

Section 1.2What Is an Annual Report?
Management’s Discussion and Analysis (MD&A)

The Management’s Discussion and Analysis (MD&A) section of the annual report contains
many details about management’s plans for the future of the company, as well as discus-
sion of the successes and failures of the last year. The SEC reads the MD&A closely to be
sure companies present all critical information about the current operations, 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 marketing condi-
tions and economic trends that may impact the company’s liquidity. It must also discuss
material events as well as uncertainties that could affect future operations. For example, if
the company manufactures a product in a country that faces political 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 operations: Companies will discuss sales and whether they increased
or decreased, product line performance, how products are distributed, and prod-
uct improvements. Companies will also discuss, without much detail, research
and development projects.

• Capital resources: Companies will discuss acquisitions (companies they plan to
buy or have recently bought) and expansions of existing operations. They will also
discuss any major capital expenses incurred in the past year or planned for the
future as well as their debt position and whether they plan to take on new debt.

• Liquidity: Companies will discuss their cash position and their ability to pay their
bills.

The SEC pays special attention to these key discussion points in the MD&A (U.S. Securi-
ties and Exchange Commission, 2003):

• Revenue recognition: 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 recognition of revenue. If the company operates
retail stores, the recognition of revenue may be relatively straightforward: Rev-
enue is recognized when a customer buys the product. However, revenue recogni-
tion is not as clearly defined for many businesses. For example, when a company
buys a computer system from another company that includes hardware, software,
training, and other services, revenue may not all be recognized at the same time.
The company may recognize the revenue from the purchase of the hardware at the
time it is delivered, but it will not be able to recognize the revenue from service and
training until the obligation has been fulfilled. A contractor who is paid upfront
for a project may not be able to recognize the revenue until it is earned. In the
MD&A, management will discuss its revenue recognition methods and compare
them to other companies. Discussion of revenue recognition may also be found in
the Notes to the Financial Statements.

• Restructuring changes: If the company plans any type of restructuring, or has com-
pleted a restructuring plan, management will discuss these plans in the MD&A.
This can include closing down factories, disbanding a major division, discontin-
uing operations, or any other major change in the way the company operates.

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Section 1.2What Is an Annual Report?

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 timely man-
ner to shareholders. For example, this can include the damage or destruction of
a factory after 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 accounting for these plans require many assumptions 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 retired 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 meeting the requirements of that plan.

• Environmental and product liabilities: Most companies risk damage to the envi-
ronment or other people’s properties if products they sell fail to operate as expected.
Some companies operate in industries, such as oil, gas, and chemicals, that regu-
larly risk the potential 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
Protection Agency (EPA) operates a Superfund to clean up the nation’s hazardous
waste sites, which were created by disposal of wastes by many different compa-
nies over many years. Companies that are identified as polluters must contribute
to this fund. If a company is involved in negotiating a settlement with the EPA,
it would discuss that involvement here. (Perpetua 2013 and U.S. Environmental
Protection Agency 2013 and 2014)

The discussion in this section of the annual report can get very technical. As the Best Gen-
eral Company budget committee is reviewing the external reports of their competitors,
they can call the investor relations department of a company if they have any questions
about what is discussed. The investor relations department is the primary department
that answers questions 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 innovative financial
reporting, which includes many interactive features. Its financial reports can be accessed here.

To practice using financial reports to assess a company’s competitors, download the MD&A for
GE. Read the Global Risk Management section 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 committees. Think about how your company manages risk and compare it to what GE does.

eps81356_01_c01_001-044.indd 17 3/25/14 3:07 PM

http://www.ge.com/investor-relations/financial-reporting

Section 1.2What Is an Annual Report?
Management’s Discussion of Financial Responsibility

This section of the annual report is relatively new—it became a requirement after the
financial reporting scandals of the late 1990s and early 2000s. Congress passed the
Sarbanes-Oxley Act of 2002, and the new requirements are discussed in section 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” letter.

Officially, section 302 states that the CEO and chief financial officer (CFO) must each pre-
pare a statement to accompany the audit report to certify that “based on such officer’s
knowledge, the financial statements, and other financial information included in the
report, fairly present in all material respects the financial condition and results of opera-
tions of the issuer as of, and for, the periods presented in the report.”

While executives have been asked to provide financial reporting letters in the past, this
new requirement stipulates that they must include a certified 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), executives can now, in theory, be held personally responsible for their actions;
they can face up to a five-year prison term, fines, and other disciplinary action if they are
proven of wrongdoing. They could also face civil and criminal litigation, 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 prosecution. The key ques-
tions left 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 Accounting Reform
and Investor Protection Act, set new or enhanced standards for external reporting. Thanks
to SOX, top management must now individually certify the accuracy of financial report
information. 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?

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Section 1.2What Is an Annual Report?
Financial Statements

The main section 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

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 information about such things as accounting methods, key financial com-
mitments, mergers (two companies joining forces) and acquisitions (the purchase of one
company by another), pension and retirement benefits, company segments, and signifi-
cant events. Let’s take a closer look at what you can expect to find in each note.

Accounting Methods
Most companies focus the first note on any changes to their accounting methods. Here
they also outline the rules under which they developed their financial statements. The
note is commonly called “Summary of Significant Accounting Practices.” If the company
is large, and owns many affiliates, the note will likely discuss how the financial statements
are a consolidation of its affiliates and how this impacts the financial statements.

You can see an example of how a company presents its consolidation 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 depreciation and amortization, losses on
financing receivables, investment securities, inventories, intangible assets, and a number
of other specific methods related to its operations.

The final section of the note discusses accounting changes. Other companies may include
information about the accounting methods used for their pensions, employee stock incen-
tive plans, and income taxes.

Sales and Discontinued Operations
If the company is involved in the sales of major assets or businesses it held, it will include
a note detailing this information. If the company has closed or is planning to close a facil-
ity, this note will also detail the financial impacts of discontinued operations. GE presents
the details of its sales and discontinued operations in Note 2.

Investment Securities
If a company holds investment securities, it will include a note detailing the information.
GE details its investment securities in Note 3. You can see that GE holds debt (bonds) from
other U.S. corporations, state and municipal governments, mortgage-backed securities,
and other entities. Note that the balance sheet would only show a number for Marketable
or Investment Securities.

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Section 1.2What Is an Annual Report?

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 information 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 information. GE discusses its
inventories in Note 5. There should also be a note about the Property, Plant, and Equip-
ment (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 additional money paid for an acquisition 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 differ-
ence of $100,000 would be added to Goodwill. Goodwill usually reflects the value of non-
assets, such as customer base or premium locations.

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 liabilities.

Mergers and Acquisitions
If a company is in the process of merging with another company or in the process of buy-
ing another company, there will be a note detailing the impact this transaction will have
on the financial statements. GE did not mention merger or acquisition plans in the year
being discussed.

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Section 1.2What Is an Annual Report?

Pension and Retirement Benefits
If a company provides a pension plan to its employees, it will provide details about its
pension obligations in a note to the financial statements. GE details these obligations in
Note 20.

Included will be details about the number of employees covered, the cost of the pension
plans, the actuarial assumptions—estimates of the value of an asset or person, used to
help determine the value of future payments on retirement benefits—and a detailed pro-
jection of the benefit obligations. This note also details how the company invests its pen-
sion assets.

Other

Liabilities

Any liability that doesn’t have a note of its own will be detailed in an “Other Liabilities”
note. GE uses Note 13 to discuss other liabilities.

Details About Company Segments
Most companies will also include a note that details their company segments. GE pro-
vides that information in Note 1. Company segments are used to group operating depart-
ments and divisions under a specific executive 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 committee starts looking for details about their
competitors’ 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 information one can expect to find in the notes.

Other Information

In this section, you will find information about the backgrounds and qualifications of
the company’s key executives and managers, officers, board members, locations, and any
new facilities they opened in the past year.

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Section 1.3What Is a Form 10-K?

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
condition. This report must include
audited financial statements, and it
must be filed in addition to the annual
report. Much of the information in
the Form 10-K is similar to that pre-
sented in the annual report, but the
Form 10-K requires additional details
in a specified format, and it is often
more formal and technical in tone.

Table 1.2 compares the Form 10-K
and the annual report. Often compa-
nies use the Form 10-K as part of the
required financial statements within
their annual report to shareholders.

The portions from the Form 10-K are usually printed on thinner paper in smaller print,
making it more difficult to read.

Melanie Stetson Freeman/MACSM/Associated Press

Form 10-K is required by the SEC to insure that
investors are receiving an accurate picture of a com-
pany’s business and financial condition.

Task Box 1.3: Viewing a Full Annual Report

General Electric is one of the most innovative companies when it comes to annual reports.
Its annual report is highly interactive, letting readers explore topics of deeper interest. Few
companies put as many resources into producing an interactive report for the public.

Go to GE’s website for its 2012 report. You’ll find the highlights and CEO letter 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 information about the items on which they will need to vote, such
as new board members or company-specific issues. Download each section and review the
information in each.

1. Based on what you read in these statements, what do you think are GE’s top priorities
for the future?

2. What reorganizations are discussed in the Management’s Discussion and Analysis?
3. What accounting method was changed, according to the auditors’ report? Explain the

change after reading Note 1 in the Notes to the Financial Statements.

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Section 1.3What Is a Form 10-K?

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
information about both positive and
negative 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
information 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
promoting 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
section, and provide some discussion
in parts of the Notes to the Financial
Statements, there is no formal risk fac-
tors section 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 – Properties Key property holdings will be dis-
cussed in detail.

Some of this information may be found
in the Notes to the Financial Statements.
A company could discuss some key
property additions in the narrative of
the annual report, but it is not required.

Item 3 – Legal
Proceedings

The company must detail information
about significant pending lawsuits or
other legal proceedings.

This information can usually be found
in the Notes to the Financial Statements.

Item 4 – Mine Safety
Disclosures

Most companies leave this section
blank. Only companies with mines
must discuss safety issues here.

Not required.

Item 5 – Market for
Registrant’s Com-
mon Equity, Related
Stockholder Matters
and Issuer Purchases of
Equity Securities

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

Summary financial details about
shareholder matters 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 Finan-
cial Data

Companies summarize their key finan-
cial data over the last five years.

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

Item 7 – Manage-
ment’s Discussion and
Analysis of Financial
Condition and Results
of Operations

Company executives discuss their
business results over the past year and
discuss future plans.

Similar information is found in the
MD&A section, but the Form 10-K
usually includes more detail.

Item 7A – Quantitative
and Qualitative Dis-
closures about Market
Risk

Companies discuss interest rate risk,
foreign currency exchange risk, com-
modity 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 section and the
Notes to the Financial Statements, the
information is usually more detailed in
the Form 10-K.

(continued)

eps81356_01_c01_001-044.indd 23 3/25/14 3:07 PM

Section 1.3What Is a Form 10-K?
Line item Form 10-K Annual report

Item 8 – Financial State-
ments and Supplemen-
tary Data

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

Often companies use the statements
filed with their Form 10-K in their
annual report. Others may present the
same information in a more graphi-
cally pleasing way.

Item 9 – Changes in
and Disagreements
with Accountants on
Accounting and Finan-
cial Disclosures

If there are any disagreements with
accountants, they will be discussed in
this section.

Usually information about disagree-
ments with accountants can be found
in the Auditor’s Letter and the manage-
ment’s response to that letter (if there
is one). Other disagreements may be
discussed in the Notes to the Financial
Statements in the section on accounting
policy or accounting methods.

Item 10 – Directors,
Executives, Officers and
Corporate Governance

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

Information about a company’s direc-
tors and corporate officers is often
included in the annual report.

Item 11 – Executive
Compensation

Companies provide details about how
they compensate their executives,
including information about salaries
paid and incentives earned.

This information 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
Matters

Companies provide details of the
holdings of key executives and major
shareholders.

This information is usually found
in the proxy materials sent with the
annual report to shareholders.

Item 13 – Certain Rela-
tionships and Related
Transactions, and Direc-
tor Independence

Companies provide details about rela-
tionships between the company and its
directors, officers, and family.

There is no comparable section in the
annual report.

Item 14 – Principal
Accountant Fees and
Services

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

There is no comparable section in the
annual report.

In the past, all companies could wait until 90 days after 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. Com-
panies 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 1.2: Comparing the Form 10-K and the annual report (continued)

eps81356_01_c01_001-044.indd 24 3/25/14 3:07 PM

Section 1.3What Is a Form 10-K?

Table 1.3: Filing deadlines for Form 10-K

Company size (in revenue)
When to file Form 10-K after 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 Relations section
of their website. For example, GE has a financial reporting page in the Investor Relations
section of its website. From that page, you can access not only the Form 10-K, but also a
section called “SEC Filings” that details other forms filed with the SEC.

There are four key parts to the Form 10-K: Business Operations, Financial Data, Informa-
tion about Directors and Executives, and Additional Exhibits. Let’s take a look at each of
these parts (U.S. Securities and Exchange Commission, Form 10-K, 2012f).

Part 1: Business Operations

This section provides details about the basic business operations and any new develop-
ments 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 section. This section
also includes discussions about key property holdings and ongoing legal proceedings.

Item 1 – Business: The company must provide basic information, such as any develop-
ments that impacted the incorporation of the business since the beginning of the fiscal
year. A company does not have to restate its historical development of the corporation.
For example, GE discusses a merger of one wholly owned subsidiary, General Electric
Capital Services, into General Electric Capital Corporation.

The company must then discuss how it is doing in each of the various industry segments
in which it operates. It must discuss its operations 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 political risks first and
then provides some information about the changes to laws and regulations that could
impact its operations. GE also discusses pending legal actions, 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.)

eps81356_01_c01_001-044.indd 25 3/25/14 3:42 PM

Section 1.3What Is a Form 10-K?

Part II: Financial Data

Part II focuses on the financial operations of the business. Here companies list details of
their outstanding stock holdings, summary of selected financial data, MD&A, quantita-
tive disclosures about market risk, the financial statements, changes or disagreements
with the accountants, internal controls and procedures, and other information. Let’s take
a look at each of these sections.

Item 5 – Market for Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities: This section must include information about the
company’s equity securities, the number of holders of its shares of stock, and the divi-
dends paid. If the company is repurchasing its stock and taking it off the market, the com-
pany will discuss this as well.

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

Item 7 – Management’s Discussion and Analysis of Financial Condition and Results
of Operations: The company executives discuss its business results over the past finan-
cial year. Often this section is the same as the MD&A in the annual report to share-
holders, but sometimes it contains more detail in terms of what is reported to the SEC.
Essentially the information required here is the same as we discussed above for the
annual report MD&A.

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

Download GE’s 2012 Form 10-K (General Electric, 2013). Review the business segments in which
GE operates. Pick one segment that interests you and be prepared to discuss the operations
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.

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 – Properties: The company will discuss information about its key property hold-
ings, such as principal plants, mines, or other physical properties.

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.

eps81356_01_c01_001-044.indd 26 3/25/14 3:07 PM

Section 1.3What Is a Form 10-K?

Item 7A – Quantitative and Qualitative Disclosures About Market Risk: This section
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 section.

3. Commodity price risk affects every company that must buy or manufacture the
products it sells. The underlying commodities used to make these products can

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 institution may discuss ways that management monitors liquidity and

assures adequate capital under various scenarios, such as a rise in interest rates or a
ratings downgrade.

• A global company may discuss how it handles exchange rate risks.
• Companies may discuss how they handle competition, build their brands, or manage

in an economic downturn.
• Companies also may discuss how they ensure compliance with laws and regulations,

or how they are addressing the impact of new or anticipated laws and regulations.

Source: U.S. Securities and Exchange Commission [SEC]. (2011, July 1). How to Read a 10-K. Retrieved from
http://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 section of the financial report?

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

eps81356_01_c01_001-044.indd 27 3/25/14 3:07 PM

http://www.sec.gov/answers/reada10k.htm

Section 1.3What Is a Form 10-K?

go up or down in price and therefore affect the cost of manufacturing the prod-
ucts. Companies discuss how they handle commodity risks in this section.

4. Equity price risk affects companies that either invest in other companies or that
hold and then sell securities. 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 section.

Item 8 – Financial Statements and Supplementary Data: This section contains the finan-
cial reports and the notes to these reports. (We will take a close look at each of these state-
ments in their respective chapters.)

Item 9 – Changes in and Disagreements With Accountants on Accounting and Financial
Disclosure: If there is any disagreement with the accountants, it will be discussed in this
section. A situation in which a company does not agree with what its accountants want is
often a red flag.

Item 9A – Controls and Procedures: In this section, the company discusses the controls
and procedures it has in place to be sure its financial reporting accurately reflects the com-
pany’s financial position.

Item 9B – Other Information: This section includes any information 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: Information About Directors and Executives

This section of the Form 10-K contains information about the directors and the executive
officers, their compensation, company ownership, and equity compensation plans. It also
contains information about the accounting firm used. Often this information is presented
as part of the proxy statement provided to shareholders so they can vote on key issues at
the annual meeting.

Item 10 – Directors, Executive Officers, and Corporate Governance: This section includes
information about the backgrounds and experience of the company’s directors and execu-
tive officers, as well as its code of ethics and how it is implemented.

Item 11 – Executive Compensation: This section details how the company compensates
its executives. This includes details about the salaries paid and incentives the company
executives earned.

Item 12 – Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters: This section details the holdings of key executives and
major shareholders. It is particularly important for investors, who need to know how
many of the outstanding shares are owned by major shareholders and key executives, or
how much control is centered among a few key people.

Item 13 – Certain Relationships and Related Transactions, and Director Independence:
This section details relationships between the company and its directors, officers, and

eps81356_01_c01_001-044.indd 28 3/25/14 3:07 PM

Section 1.3What Is a Form 10-K?

their family. The key piece of information in this section is how many of the directors are
independent. Many recent financial scandals involved companies where family or execu-
tives 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 accounting firm, as well as detail the services provided.

World of Business

Adelphia: Massive Fraud at a Public Company
In 2002, the SEC filed charges against Adelphia
Communications Corp., its founder, John J.
Rigas; his three sons; and two senior executives.
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 liabilities from its consolidated
financial statements by hiding them
on the books of off-balance sheet
affiliates; falsified operations statistics
and inflated earnings to meet Wall
Street’s expectations; and concealed
rampant self-dealing by the Rigas
Family, including the undisclosed use
of corporate funds for Rigas Family
stock purchases and the acquisition of
luxury condominiums in New York and
elsewhere. (2002, para. 2)

In addition to the SEC charges, the United States Attorney’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 operating officer, pleaded guilty to one count of making a
false entry in an accounting record and was placed on probation but was not sentenced to jail time.

Sources: U.S. Securities and Exchange Commission [SEC]. (2002, July 24). SEC charges Adelphia and Rigas family with
massive financial fraud [Press Release]. Retrieved from http://www.sec.gov/news/press/2002-110.htm and Taub, S.
(2006, March 6). Probation for Adelphia’s Michael Rigas. CFO. Retrieved from http://ww2.cfo.com/accounting-tax
/2006/03/probation-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?

Luis Lanzano/Associated Press

In 2004, Adelphia CEO John Rigas and his
sons were found guilty of conspiracy, bank
fraud, and securities fraud after orchestrat-
ing one of the most extensive financial
frauds using money from a public company
for private purposes.

eps81356_01_c01_001-044.indd 29 3/25/14 3:07 PM

http://www.sec.gov/news/press/2002-110.htm

http://ww2.cfo.com/accounting-tax/2006/03/probation-for-adelphias-michael-rigas/

http://ww2.cfo.com/accounting-tax/2006/03/probation-for-adelphias-michael-rigas/

Section 1.4What Are Generally Accepted Accounting Principles?

Part IV: The Extras—Additional Exhibits

In this section, 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 Reporting

In addition 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 corporations with more than $75 million in outstanding shares of stock must file the
form within 40 days after the end of a quarter. Smaller companies must file within 45 days.

The line items in the Form 10-Q resemble the information 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, quantitative and quali-
tative disclosures about market risk, and controls and procedures. Part II of the Form 10-Q
includes information about legal proceedings, risk factors, unregistered sales of equity
securities, and defaults on senior securities (not making payments on debt on time). If
the company operates a mine, it must include mine safety information. Any information
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. Securities 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 acquisition, material modification
of the rights of shareholders, a change of accounting firm, or one of many other events.
The form must be filed within four days after the event. The SEC website contains a full
list of events that trigger a Form 8-K filing (U.S. Securities and Exchange Commission,
Form 8-K, 2012e).

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

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Section 1.4What Are Generally Accepted Accounting Principles?

A Basic Definition

The GAAP is essentially a collection 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, liabilities, revenues, expenses, and equity.

The Financial Accounting Stan-
dards Board (FASB) develops and
updates the GAAP rules and sets
standards for U.S. companies to fol-
low. The FASB was first designated
as the organization responsible for
establishing accounting standards
in 1973, but the origins of the GAAP
go back to 1936, when the American
Institute of Accounts first used the
phrase “generally accepted account-
ing principles.” The board is made up
of seven members who are appointed
by the SEC and serve full time for
five-year terms. Board members
must sever all ties with accounting
firms or institutions 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 explanations about how a company must report its financial information
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 considerations when designing new GAAP requirements (FASB,
1980, p. CON 2-2.):

1. Relevance: Information needed to forecast a company’s future earnings or to
correct prior expectations fills this requirement. The information must be timely,
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 reporting,
outsiders would not have the information they need to make decisions about
loaning to or investing in the company.

2. Reliability: All information 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 accounting methods to track
various types of assets and liabilities, 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 permitted, but the compa-
nies must disclose the method they are using.

© AndreyPopov/iStock/Thinkstock

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

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Section 1.4What Are Generally Accepted Accounting Principles?

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

The GAAP Affects Financial Reporting

The GAAP affects every number you see on the financial reports of a public company.
This is because, as noted, GAAP standards have been written 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 often require audited financial statements in
order to invest or provide loans. (American Institute of CPAs, 2001).

GAAP guides accountants by giving them a standard by which to measure and present
financial results. It prevents companies from presenting 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 inflation or other factors. It
also requires that expenses be reported during the same period as any assets were attained
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 simi-
lar 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. Often changes start with the auditing indus-
try, because these professionals tend to be the first to see emerging trends not covered
by the existing GAAP rules. Changes can also be needed if new legislation or regulation
changes financial reporting 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 differ-
ent 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
time will be selected for consideration.

2. Technical feasibility: The FASB will determine whether a solution can be devel-
oped immediately or whether another technical issue must be resolved first. If
the board determines another issue must be resolved first, it will postpone work-
ing on the first issue.

eps81356_01_c01_001-044.indd 32 3/25/14 3:08 PM

Section 1.5An Overview of Accounts

3. Practical consequences: The FASB will gauge whether the improved accounting
solution is likely to be generally accepted and to what extent addressing a par-
ticular issue may cause others, such as the SEC or Congress, to act. For example,
if FASB sets a rule that the corporations 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 possibilities: The FASB will gauge whether its action on an issue
could lead to the elimination of significant differences in standards or practices
between the United States and other countries. It seeks to improve the quality of
U.S. standards and bring them closer to international standards.

5. Resources: The FASB must determine whether it has the adequate resources
and expertise 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 meetings that are open to the public, drafts that are circulated for public
comment, then additional public board meetings. Often this process is repeated one or
more times before a change is made to a GAAP principle.

In addition to the work done within the United States, the FASB coordinates with the Inter-
national Accounting Standards Board (IASB) to be sure the new rules will meet the needs
of the global community. Many countries have already adopted the international finan-
cial reporting 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 international standards (IFRS Foundation, no date).

1.5 An Overview of Accounts
Essentially, every line item found on the financial statements reflects an account in the com-
pany’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 petty 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 committee 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. Committee members
would likely want to investigate 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 manag-
ers whose actual revenues and expenses are significantly different from those budgeted
in the prior year.

eps81356_01_c01_001-044.indd 33 3/25/14 3:08 PM

Section 1.5An Overview of Accounts

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 transaction 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, liabilities, equity, rev-
enue, 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

A company’s accounts are divided up into six types, starting with the accounts on the balance sheet
followed by the accounts on the income statement: assets, liabilities, equity, revenue, cost of goods sold,
and expenses.

Best General Company Chart of Accounts

1000

1100

1200

1300

1400

1500

2000

2100

2200

2300

2400

3000

3100

4000

5000

6000

6100

6200

Cash and Cash Equivalents

Accounts Receivable

Inventories

Other Current Assets

Property, Plant & Equipment – Net

Other Non-Current Assets

Accounts Payable

Short-Term Debt

Other Current Liabilities

Long-Term Debt

Other Non-Current Liabilities

Common Stock

Retained Earnings

Revenue

Cost of Goods Sold

Operating

Expenses

Selling, General and Administrative

Research, Development, and Engineering

Assets
Assets
Assets
Assets
Assets
Assets
Liabilities
Liabilities
Liabilities
Liabilities
Liabilities

Equity

Equity
Revenue
Expenses
Expenses
Expenses
Expenses

Account Number Account Name Account Type

Balance Sheet Accounts

The balance sheet includes three of the key account types: assets, liabilities, 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 liabilities: current and long-term.

eps81356_01_c01_001-044.indd 34 3/25/14 3:08 PM

Section 1.5An Overview of Accounts

Current assets or liabilities include accounts that will be used or paid in the next 12 months.
Long-term assets or liabilities 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 securities (things
that can be quickly turned into cash, such as certificates 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 renovations 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 liabilities 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 local,
state, or federal government), and credit cards payable (money due to credit card
companies that has not yet been paid).

4. Long-term liabilities accounts. These include loans payable (debts such as mort-
gages 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 section 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 pur-
chased 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 ship-
ping the products to the company). Most companies only show one line item for
these costs, called Cost of Goods Sold.

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Summary and Resources

3. Expense accounts. These include any costs related to generating revenue for the
company that cannot be directly related to the sales of goods sold. For example,
advertising can rarely be tied to the sale of one particular item, so these expenses
fall under an expense account rather than a Cost of Goods Sold account. This is
often the longest section of the income statement. Accounts include operating
expenses, such as advertising, equipment rental, insurance, store or office rental,
legal and accounting fees, meals, entertainment, salaries, office expenses, post-
age, repairs and maintenance, supplies, travel, telephone, utilities, vehicle, and
any other expenses a company incurs to operate the business. In addition, there
will be interest expenses on the company’s debt, depreciation and amortization
expenses (these track the use of the company’s assets, but are not a cash expense;
we take a close look at depreciation and amortization 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.

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 reporting must meet strict
guidelines set by the GAAP, while internal reporting can be designed to meet the
needs of management without having to worry about these rules.

• Without financial reports, managers and executives could not make informed
decisions about their departments or the company as a whole. Investors would
not be able to make rational decisions about whether to invest in a company.
Regulators would not be able to measure whether a company was accurately
reporting its results to the public and the government. Lenders would not have
the information they need to make decisions about whether to lend money to a
company. And employees would not be able to determine whether their com-
pany continued to be viable or they should search for new positions.

• Annual reports are sent to shareholders to inform them about the company’s
activities for the year, as well as the company’s financial results. These annual
reports are submitted to the SEC for review along with a more formal reporting
structure on the SEC’s Form 10-K.

• Since all these audiences need to be able to compare and evaluate financial state-
ments from multiple companies, the statements need to be presented in a consis-
tent 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 submitted to the SEC.

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Summary and Resources

• Many accounts are used to create the financial reports, including: cash, which is
critical to any company in order for it to keep operating; 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 competitors.
• 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 tech-
nical and detailed reports for the SEC on the Form 10-K.

Post-Test
1. What can a financial report reader learn by reading financial reports?
a. the number of sales a company made during the year
b. which employees made the most sales and when
c. how much money the company made and how financially efficient the com-

pany was
d. all the competitors a company has

2. What are the financial statements included in an annual report?
a. balance sheet and income statement
b. Form 10-K and proxy statement
c. statement of financial position and profit and loss statement
d. balance sheet, income statement, cash flow statement, and statement of share-

holders’ equity

3. What is the primary wording an auditor uses to indicate a company is in trouble
and may be headed to bankruptcy?

a. opinion paragraph
b. material uncertainties
c. going-concern problems
d. qualified opinion

4. What are some key things to look for when reading the notes to the financial
statements that are not found in the financial statements themselves?

a. accounting methods and any changes to those methods
b. details about the company’s retirement obligations and whether they can

meet those obligations
c. details about the company’s borrowings
d. all of the above

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Summary and Resources

5. What are the four main parts of a Form 10-K?
a. Balance Sheet, Income Statement, Cash Flow Statement, and Statement of

Shareholders’ Equity
b. Financial Statements, Management’s Discussion and Analysis, Notes to the

Financial Statements, and Auditors’ Report
c. Business Operations, Financial Data, Information about Directors and Execu-

tives, and Additional Exhibits
d. There are more than four parts.

6. How does GAAP affect financial reporting?
a. It sets the rules that everyone must follow.
b. It gives accountants a standard way to measure and present financial data,

and it prevents companies from showing only the good news.
c. It details the reports companies must file with the government.
d. Its complexity keeps many accountants employed.

7. What organization drafts the accounting rules companies must follow in the
United States?

a. FASB
b. SEC
c. Congress
d. IRS

8. What are the key account groupings that are used for financial reports?
a. Cash, expenses, sales, inventory, and liabilities
b. Assets, liabilities, equity, sales, cost of goods sold, and expenses
c. Sales, cost of goods sold, cash, inventory, and liabilities
d. Cash, sales, expenses, shareholders’ equity, and retained earnings

9. What are three accounts that appear on the balance sheet?
a. Cash, Accounts Receivable, and Accounts Payable
b. Cash, Sales, and Expenses
c. Cash, Liabilities, and Equity
d. Cash, Cost of Goods Sold, and Sales

10. What are three accounts that appear on the income statement?
a. Sales, Accounts Receivable, and Accounts Payable
b. Sales, Office Expenses, and Salaries
c. Sales, Liabilities, and Equity
d. Sales, Vehicle Expenses, and Furniture

Answers: 1 (c), 2 (d), 3 (c), 4 (d), 5 (c), 6 (b), 7 (a), 8 (b), 9 (a), 10 (b)

Answers and Rejoinders to Chapter Pre-Test
1. c. While an annual report does include highlights, a president’s letter, and a list

of key executive officers, the key information can be found in the auditor’s
report, management’s discussion and analysis, financial statements, and notes
to the financial statements.

2. d. Government agencies, investors, and bankers all read financial reports.
3. a. GAAP, which stands for generally accepted accounting principles, provides

the rules all must follow when preparing annual reports.

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Summary and Resources

4. a. While other answer choices include accounts used in preparing financial state-
ments, the most complete list is in answer (a).

5. b. Other readers can access the Form 10-K, but the SEC requires it be filed with
them by their deadline.

Rejoinders to Chapter Post-Test
1. Financial report readers can learn whether a company made money during a

period of time. They can also learn how efficiently the company was run from
a financial standpoint. Details about the number of sales or who made the most
sales will likely not be found. The company may name a few key competitors but
will probably not provide a full list.

2. These four statements make up the financial statements of both the annual report
and the Form 10-K. The statement of financial position is just another name
for the balance sheet. The profit and loss statement is just another name for the
income statement. The proxy statement is sent out to the board of directors as
well as to the shareholders so they can vote on key issues.

3. When auditors indicate there is a “going-concern problem,” it means the audi-
tors question whether the company will be able to stay in business. Problems can
include ongoing losses, cash deficiency, or a significant contract dispute. This is a
major red flag and often indicates that the company is near bankruptcy.

4. All this information, as well as many other details behind the numbers on the
financial statements, is located in the Notes to the Financial Statements. The
financial statements are purely line items with numbers. To find out details about
those numbers, you must read the Notes to the Financial Statements.

5. Business Operations, Financial Data, Information about Directors and Executives,
and Additional Exhibits are the four main parts of the Form 10-K. The sections
named in answer choices (a) and (b) can be found in the Form 10-K, but they are
all part of Financial Data.

6. The GAAP rules guide accountants by giving them a standard by which to mea-
sure and present financial results. They also prevent companies from presenting
only data that makes the company look good. While it may also be true that their
complexity keeps many accountants employed, that does not in and of itself
impact financial reporting. Answer (a) is incomplete. GAAP does not detail the
reports a company must file with the government, but it does set rules for how
the numbers must be reported to the government.

7. The Financial Accounting Standards Board (FASB) develops the GAAP rules
companies must follow. The FASB also coordinates with the international com-
munity through the International Accounting Standards Board (IASB) to be sure
the financial standards are being met globally. The SEC appoints members of the
FASB.

8. Assets, liabilities, equity, sales, cost of goods sold, and expenses are the key
account groupings that make up the Chart of Accounts and are used to develop
the financial statements.

9. Cash, Accounts Receivable, and Accounts Payable are the three accounts that
appear on the balance sheet. Sales, Cost of Goods Sold, and Expenses are sections

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Summary and Resources

of the income statement. Liabilities and Equity are sections of the balance sheet
under which accounts can be placed.

10. Sales, Office Expenses, and Salaries are all accounts found on the income state-
ment. Accounts Receivable and Accounts Payable are accounts found on the
balance sheet. Liabilities and Equity are sections of the balance sheet. Vehicle
Expenses are found on the income statement, but Furniture is an asset on the bal-
ance sheet.

Discussion Questions
1. Why is it more difficult to find information 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 Dis-
cussion and Analysis (MD&A) section 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 State-
ments and how can you use them?

5. What are some of the key news sources you can use to research information
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 competitors. Some credible options include:

Businessweek—Good source for an overview of business news about industries and
individual companies.

Entrepreneur—Focuses on the people who start up their own businesses and the suc-
cess of those businesses.

Fast Company—Focuses on small and growing companies.
Forbes—Provides financial and business news in the U.S. and around the world.
Fortune—Focuses on key business leaders, as well as coverage of business and eco-

nomic news.
Google Business News—Collects the key business articles of the day from various news

sources.
Inc.—Emphasizes up-and-coming businesses and their leaders.
Yahoo Finance—Good search engine for researching companies and industries.

Governmental Websites
You can find out more information about the key governmental and private agencies,
their role in financial reporting, and financial reporting rules by visiting these websites:

Financial Accounting Standards Board
Form 8-K

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http://www.businessweek.com/

http://www.entrepreneur.com/

http://www.fastcompany.com/

http://www.forbes.com/

money.cnn.com/magazines/fortune/

https://news.google.com/news/section?pz=1&cf=all&ned=us&topic=b&ict=ln&siidp=bb46a34695df703a2da5c567a0aaa7a7268e

http://www.inc.com/

http://finance.yahoo.com/

http://www.fasb.org/home

http://www.sec.gov/about/forms/form8-k

Summary and Resources

Form 10-K
Form 10-Q
Office of Investor Education and Advocacy
Security and Exchange Commission, EDGAR

Key Terms
accounts payable An account that tracks
bills to be paid by the company.

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

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

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

actuarial assumptions Estimates of
the value of an asset or person. Insur-
ance 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 retiree benefits.

amortization The reduction in the value
of an intangible asset, such as a copyright
or a patent, over a period of time 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 Conversations among key
executives and analysts to discuss a sum-
mary of the company’s financial results at
the end of a quarter or year.

annual report Document sent to share-
holders to provide them with information
about the company’s financial activities
throughout the previous year.

assets Items a company owns.

audit An impartial, third-party review
of a company’s operations and financial
statements to confirm that the reports are
materially correct and that proper internal
controls are being used.

balance sheet Also known as a statement
of financial position, this statement shows
a company’s assets (what the company
owns), its liabilities (what the company
owes), and its equity (what claims inves-
tors have on the assets). It is essentially a
snapshot of the company’s financial posi-
tion as of a particular date.

bonds payable An account that tracks
bonds that must be repaid.

capital The net worth of a company.

credit cards payable An account that
tracks money due to credit card compa-
nies that has not yet been paid.

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

defaults on senior securities Debt pay-
ments that are not made on time, such as
bond interest or principal payments.

depreciation The reduction of the value
of an asset over the life span of the asset.

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http://www.sec.gov/about/forms/form10-k

http://www.sec.gov/about/forms/form10-q

http://www.sec.gov/investor.shtml

http://www.sec.gov/edgar.shtml

Summary and Resources

Electronic Data Gathering, Analysis, and
Retrieval (EDGAR) System that collects,
validates, and indexes reports from public
companies who must report to the U.S.
Securities and Exchange Commission.
Anyone can search this database online to
get detailed financial reports from public
companies.

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

external financial reports Information
about the financial health of a company
provided to individuals or institutions
who do not work for the company, includ-
ing bankers, vendors, investors, and
competitors.

Financial Accounting Standards Board
(FASB) Organization that develops and
updates the GAAP rules and sets stan-
dards for U.S. companies to follow; its
board members are appointed by the SEC.

financial statements Documents that
provide a summary of the financial health
of a company for a specific period of time.
They give both internal and external read-
ers information needed to make financial
decisions about a company.

Form 8-K A form filed by public compa-
nies with the SEC to report special events,
such as a change in officers of the company.

Form 10-K An annual form filed by pub-
lic companies with the SEC that provides
comprehensive details about the compa-
ny’s business and financial conditions.

Form 10-Q A quarterly form filed by pub-
lic companies with the SEC that provides
comprehensive details about the compa-
ny’s business and financial conditions.

freight charges Any costs incurred for
shipping the products to the company.

generally accepted accounting principles
(GAAP) Rules companies must follow
when collecting and presenting their
financial data and results.

generally accepted auditing stan-
dards Rules auditors must follow when
reviewing the company’s books and
financial operations.

going-concern problem A situation that
indicates that a company may not be able
to stay in business for the long-term; gen-
erally, it is an indication that the company
may continue to lose money, have a cash
deficiency, or suffer a significant contract
dispute.

income statement Also known as a
statement of earnings, or a profit and loss
statement, this statement provides infor-
mation about a company’s revenues and
expenses over a specific period of time.

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

internal financial reports Confiden-
tial reports that can only be shared with
employees of the company or the com-
pany’s board of directors. They provide
more details about the company’s finan-
cial results.

International Accounting Standards
Board (IASB) The independent standard-
setting body of the International Financial
Reporting Standards Foundation. The
board’s 15 full-time members develop
and publish International Financial
Reporting Standards. The board mem-
bers come from various countries and
work closely with stakeholders around
the world, including investors, analysts,
regulators, business leaders, account-
ing standard-setters, and others in the
accountancy profession.

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Summary and Resources

international financial reporting stan-
dards (IFRS) A set of rules that most inter-
national companies follow. The IRFS are
similar in many ways to the U.S. GAAP.
There is a move internationally to con-
verge the U.S. GAAP and the IRFS rules.

leasehold improvements Renovations
done by companies when they lease a
property; the renovations are assets whose
expense will be gradually written off over
a period of time.

liabilities Debts a company owes to its
lenders.

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

loans payable 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 liabilities 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) A section 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 information Information
about where the company sells its prod-
ucts and to whom the products are sold.

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

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

mergers The decision of two or more
companies to join forces and become one
entity.

Notes to the Financial Statements Part
of the annual report that provides details
about the line items on the financial
statements.

operations All the day-to-day activities in
running a business.

private companies Companies whose
shares of stock are held by and traded pri-
vately among individuals. Often private
companies are wholly owned by family
members or a close-knit group of inves-
tors. These companies are not required to
report their financial results publicly.

proxy materials Documents that give
shareholders information they will need
to vote on issues that will be discussed at
the annual meeting. They include details
about the board of directors and key
executive personnel, including their back-
grounds and compensation.

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

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

purchase returns and allowances
An account that tracks returns of products
purchased.

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

retained earnings An account that tracks
profits reinvested into the company.

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Summary and Resources

sales discounts An account of any dis-
counts offered to the customer to reduce
the retail price.

sales returns and allowances An account
that tracks returns of merchandise.

sales taxes collected An account that
tracks taxes that have been collected from
customers that need to be paid to the
local, state, or federal government.

Sarbanes-Oxley Act of 2002 Also known
as the Public Company Accounting
Reform and Investor Protection Act, sets
new or enhanced standards for external
reporting.

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 more or less cash in the
current year versus the prior year.

statement of shareholders’ equity
Document that details the claims owners
have against the company’s assets.
It can be found at the bottom of the
income statement or on a separate page.

stock Shares of ownership in a company
that is sold to insiders and outsiders.

subsidiary activities The activities of
a company wholly owned by a large
corporation.

tangible assets Things the company
owns that one can touch and feel, such as
vehicles, furniture, and equipment.

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