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.
