GAAP – A Discussion of Notes to Consolidated Financial Statements

John F. Williams

The Opportunity

Recent headlines make it obvious that we need to do a better job of scrutinizing the companies we invest in and do business with. If you are interested in researching a public corporation for the purpose of either employment, or investment, these are some terms you may encounter.

The Solution

Due to the volumes of information written and courses of study available on some of the areas covered in this article, we must presuppose that the reader has some knowledge of these areas. This, then is intended not as a refresher, but as a gentle reminder of things already learned, but not used in quite some time.

Very little information is REQUIRED to be publicized even for publicly traded companies. However, the less information (of a voluntary nature) the company divulges, the less likely their stock value will follow the market. The types and amounts of information divulged (aside from that required by the SEC) is strictly a management / shareholder issue.

The following information can be found in the notes to consolidated financial statements of some corporate annual reports. This information can [occasionally] provide some valuable insights into the inner accounting practices of the particular corporation you are reviewing. This is a subset of areas and terms of accounting and how they may be dealt with…

These various areas will be dealt with in more detail in later articles in the order in which we receive the most interest or feedback.

Organization –

Example Inc. and its wholly-owned subsidiaries, Example Holdings Inc. and Example Systems Inc, etc. The company develops, manufactures, and markets example products primarily for the use in example situatuations and is considered to be one line of business. The Company manufactures its products in plants located in the United States and example country(s).

(This is to help you get an idea of the macro level of how the business fits together.)

The consolidated financial statements of the Company have been prepared in accordance with the Generally Accepted Accounting Principles (GAAP) used in the United States of America. The following are example summaries of the more significant of such policies, stated in a manner that may be far simpler than in real life. However, it may provide some insights on what to expect or look for.

(Although these are usually fairly generic, they can when put together as a whole, help clear the picture a little…)

Use of Estimates in Preparing Financial Statements -

The preparation of financial statements in conformity with GAAP in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation -

The consolidated financial statements include those of Example Inc. and its wholly-owned subsidiaries, Example Holdings Inc. and Example Systems Inc, etc. All material intercompany balances and transactions have been eliminated in consolidation.

Receivables -

The allowances for uncollectable accounts receivables is based on the Company’s historical bad debt experience and on management’s evaluation of collectibility of the individualo outstanding balances.

Revenue Recognition-

The company recognizes revenues when the product is shipped which meets the criteria required by Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, which was issued by the Securities and Exchange Commission in December 1999. The adoption of SAB No. 101, which provides guidance on the recognition, presentation and disclosure of revenue in financial statements, during 2000 was not (or was) significant to the Company’s financial statements.

Inventories (if the company has inventories) -

Inventories are stated at the lower of cost (computed on a first-in, first-out or other basis) or market.

Income Taxes -

The Company utilizes an asset and liability approach for financial accounting and reporting for income taxes. Deferred income taxes are provided for temporary differences in the bases of assets and liabilities as reported for financial statement and income tax purposes.

Long-Lived Assets -

The Company evaluates the carrying value of long-term assets based on current and anticipated undiscounted cash flows and recognizes impairment when such cash flows will be less than the carrying values. Then the company usually states… there were no impairments (or what they were) as of December 31,XXXX [end of the accounting year]

Property and Equipment -

Property and equipment are recorded at cost. Depreciation and amoritization are computed using the straight-line (accelerated, etc) method over estimated useful lives as follows:

Building(s)	XX years	usually 20
Automobiles	X years	usually 3 – 5
Manufacturing equipment	XX years	usually 5 – 15
Furniture and fixtures	XX years	usually 3 – 10
Leasehold improvements	XX years	usually 3 – 25

Intangible assets -

Costs associated with obtaining patents, issued and pending, and trademarks are usually capitalized and are amortized over the life of the patent or trademark or expensed if not approved. Cost in excess of fair value of assets acquired is usually allocated to goodwill, and amortized over some period (usually 5 – 20 years). This is typically done on a straight-line basis.

Accrued Expenses -

Accrued expenses are stated as of the end of the accounting year (December 31,XXXX). Examples follow:

December 31	2001	2000
Accrued payroll taxes	$488,365	$324,433
Accrued payroll	817,649	835,875
Accrued bonuses	994,167	45,613
Accrued commissions	389,786	340,968
Accrued vacation	947,490	824,336
Other accrued expenses	1,846,803	1,665,480
Total	5,484,260	4,036,705

Research and Development (if any) -

Research and development costs are typically expensed as incurred.

Stockholders’ Equity -

Even if the company is not publicly traded, there are some stockholders… Any new or changed information such as – On April 4, 2002, the Company’s Board of Directors approved a 3 for 2 (or whatever) split of the Company’s common stock effective April 17, 2002 for stockholders of record as of April 17, 2002. If a stock split has been approved, then the following statement should be seen. All historical share and per share amounts have been restated to reflect the stock split.

Earnings per Common Share -

Net income per common share is usually computed using the weighted average number of shares of the Company’s common shares outstanding, and the diluted method, which includes the dilutive common shares from stock options and warrants (if any), as calculated using the treasury stock (or other) method.

Stock-Based Compensation -

The Company accounts for its stock compensation arrangements according to Acounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, [APB 25] with intentions to continue. The Company has adopted th edisclosure-only provisoins of the Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation.

Concentration of Credit Risk -

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash and cash equivalents and accounts receivable. The Company provides credit, in the normal course of business, primarily to client customer 1, and customer example 2, and packers and distributors. The Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses.

Foreign Currency Translation Adjustment -

(Assuming foreign subsidiaries) The financial statements of the Company’s foreign subsidiaries are generally measured using local currencies as the functional currency. Assets and liabilities are translated into U.S. dollars at year-end rates of exchange and results of operations are translated at average rates for the year. Gains and losses resulting from these translations are included in accumulated other comprehensive loss as a separate component of stockholders’ equity. [This phraseology will be fairly consistent over most global corporations]

Recently Issued Financial Accounting Standards -

This section is not typically found, but is a nice bit of information for stockholders and potential stockholders…

SFAS 1333, Accounting for Derivative Instruments and Hedging Activities

, as amended, requires that all derivative instruments be recognized as either assets or liabilities at their fair market value. The Company adopted this statement beginning January 1, 2001. The effect on the Company’s financial statements of adopting this statement was not significant.

In June 2001, SFAS No. 141, Business Combinations, and SFAS No. 142 Goodwill and Other Intangible Assets were issued. Statement 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Statement 142 became effective January 1, 2002 and eliminates the amortization of goodwill relating to past and future acquisitions. Instead, goodwill is subject to an impairment assessment that must be performed upon adoption of Statement 142 and at least annually thereafter, etc., etc., etc.

Short Term Investments –

Trading securities are recorded at estimated fair market value with unrealized gains and losses included in income. The basis of cost used in determining realized gains and losses is specific identification. The estimated fair value of all securities is determined by quoted market prices.

Deferred Compensation -

This will provide some insights as to how various plans were managed – ESOP [Employee Stock Option Plan(s)], 401k(s), Corporate Officer compensation plans, etc.

Severance Costs –

This amount is usually included in operating expenses as severance costs.

Acquisitions (if any) -

This will include purchase price, and in what manner – that is $$ in cash, assumption of liabilities, etc. Where the purchase price was paid (share or stakeholders), and what amount was allocated to goodwill (if any) and how it was amortized.

Conclusion

“Doing the homework” has become increasingly important when investing or considering doing business with a company. Many of us have studied these concepts in college or business school, but there have been a number of changes to accounting rules and customs. Also, unless you’re in an accounting profession, reviewing financials may not be a skill you use every day and the terms may become unfamiliar. Bookmark this list as a reference, and let us know if you encounter terms you’d like to see included or explained in more detail.