DECEMBER 2002

Financial Statements Workshop

Understanding Income Statements, Balance Sheets and Cash Flow Statements

Learn how to use an annual report's financial statements in this workshop. Diane Graese describes how to use the balance sheet, income statement, cash flow statement, and MD&A (Management Discussion and Analysis.)

The workshop uses the 1998 Diebold, Inc. online annual report as an example. You may review the complete report online if you would like to prepare for the discussion that follows.

Introduction

Welcome to the Better Investing School Financial Statements Workshop. The workshop consists of four individual sessions.

This session (#1) will present a brief history of financial statements and Generally Accepted Accounting Principles (GAAP). Sessions #2 and #3 will present the Balance Sheet and Income Statement, respectively. Session #4 will cover the Statement of Cash Flow.

Workshop Resources

The workshop uses the 1998 Diebold, Inc. online annual report as an example. We thank Diebold for permission to duplicate selected financial statements for workshop illustrations. The four annual report sections for this workshop are:

• MD&A - Management's Discussion and Analysis of Financial Condition and Results of Operations
• Balance Sheet (Consolidated Balance Sheet)
• Income Statement (Consolidated Income Statement)
• Cash Flows (Consolidated Statement of Cash Flows)

I will cite information in the illustrations as the workshop progresses. Selected lines on the financial statements have been highlighted in yellow to identify references used in the workshop sessions. Similarly, text in the MD&A illustration in a bold font identifies material referred to in the workshop.

Please note that the workshop illustrations taken from the Diebold annual report present dollars in thousands except per share amounts. However the text of the workshop sessions will present dollars in their full unit value i.e. $42,540,000 rather than $42,540 as in the financial statement illustration.

A Brief History of Financial Statements

Accounting statements are among the earliest surviving written records. The oldest examples are lists of property, otherwise known as assets. Asset statements reflected the WEALTH of the owner. And the owner was usually one person -- the pharaoh, king, or feudal lord.

By the mid-1800s and the Industrial Revolution, the nature of business ownership changed. Growing businesses sought financial resources from external sources. Lenders were concerned with the owner's ability to repay debt. Investors/co-owners wanted to see growth in the value of the enterprise. They both needed statements that show the PROFITABILITY of the business.

Congress passed the 16th Amendment to the U.S. Constitution in 1913. It authorized congress to impose a tax on income and intensified the focus on INCOME statements.

By the late 1920s, equity investing in America was at a new peak. It seemed everyone was investing. People borrowed money to pay for stocks with seemingly endless rising prices. They bought companies with no earnings. They bought based on cab driver's tips. Then came the reality check: the Crash of 1929 followed by the Great Depression.

Landmark Legislation

Congress reacted by passing legislation to prevent calamity in the future. The Securities Act of 1933 required that investors receive financial and other significant information concerning securities offered for public sale.

A second act, the Securities Exchange Act of 1934 enacted rules governing the operation of securities markets and brokerage firms. It established rules for purchasing securities with borrowed money (margin rules). It required investors to have access to current financial information. And it created the Securities and Exchange Commission (SEC) to oversee compliance.

Financial Reports

The two acts form the basis for modern financial reporting. They specify the FORM and CONTENT of financial statements and require specific DISCLOSURES. They also specify the timetable for filing all required statements with the SEC.

The SEC requires quarterly filings of condensed financial information. Detailed filings occur annually after an examination by independent third parties (auditors).

NAIC investors primarily use the annual Form 10-K and the quarterly Form 10-Q SEC filings. These and other required filings are available through the SEC Electronic Data Gathering and Retrieval(EDGAR) system. The URL for the SEC Web site is: www.sec.gov

EDGAR filings are also available from other Internet sites that use a friendly format. FreeEdgar.com is an example.

MD&A - Management Discussion and Analysis

Financial Condition and Results of Operations

The SEC recently added the Management Discussion and Analysis as a required disclosure in annual Form 10-K filings. Management must write a narrative discussing the results of operations and the financial condition of the company from the perspective of liquidity and capital resources.

Management is also expected to make disclosure of significant changes which might occur in the future. There may be indications of the need for future debt or stock offerings. Significant future capital expenditures should also be mentioned. There are some safe-harbor rules which prevent management from being sued over these forward-looking statements.

Clearly, management's insights into the future are worth reading.

A Brief Discussion of GAAP

There is no single source for Generally Accepted Accounting Principles (GAAP). What has become Generally Accepted has evolved over time and continues to change.

Since 1939, various groups of accountants have issued bulletins, opinions, standards and interpretations that deal with accounting principles and practices.

Collectively, these and other authoritative literature comprise GAAP.

An Accounting Framework

Accounting principles attempt to create uniformity of practice. They rely on concepts which assume a business will continue to operate in the future.

The more complex concepts involve measurement, classification, and recognition. They include:

• Can a value be calculated?
• Is an expenditure an investment that is recorded as an asset on the balance sheet or an expense that is recorded in the income statement?
• When is revenue earned or when is a liability incurred?

The answers aren't always easy. Various users of financial statements may view the answers differently.

Financial statements are attempts to present pictures. They are meant to be reliable and relevant. They may not present reality as you view it. But, they are often a reasonable representation.

We will explore some of the limitations of current accounting in Sessions #2 and #3.

Session #1 - Questions and Answers

Ellis Traub: I don't intend to take away anything from this wonderful workshop. It's a real keeper and I intend to download the whole thing, including the great questions and answers, and use it for reference. However, I'd like to put in one of my traditional "newbie advocacy" comments at this point. For those of you who are new to the NAIC investing methodology, please don't get frightened by the host of terms, the myriad of issues, and the nuances that are being discussed in this workshop. These are of considerable interest to many NAIC investors. However, in order to do a successful job of investing you don't need to have all this stuff under your belt.

Income Statement: Basically, you need to know that an Income Statement (a measure of a company's performance over time) deals with:

• Revenues/Sales (which are "good")
• Expenses (which are "bad")
• Sales less the Expenses produce Profits ("good")

If you divide the profits by the number of shares outstanding, you come up with Earnings per Share (also "good"). And if you divide the price of the stock by the Earnings per Share, you get the P/E (Price/Earnings ratio.)

Balance Sheet: You also need to know about the Balance Sheet (a measure of the status of a company at a point in time.)

• Assets are what the company owns ("good")
• Liabilities are what the company owes ("bad")
• Equity ("good") is what is left when you subtract the Liabilities from the Assets.

When Equity is divided by the shares outstanding, you have the Book Value (or Equity per share - "good"). All of the stuff in the workshop fits into one or another of those categories. That's about all you need to know for starters. The rest will come as you become curious about it and feel the need or desire to look into it deeper.

Diane: I wholeheartedly agree. I have tried to avoid the technical side of accounting and point out how to use financial statements to understand the business. Throw out the specific numbers and all the ratio analysis (for the moment.) UNDERSTAND how the company makes money. How will the business make more money in the future? Do they have the resources (both financial and non-financial) to make it happen? Read what management has to say about the business. Skip the numbers and technical terms. Management should tell you how they plan to grow the business: More stores? New products? New selling territories? Cost reductions to improve profitability? Now go back and look at the trend of the numbers. Make your projections. Don't let really good looking numbers on an SSG make you forget to take a final step back and ask some simple questions. That's why Peter Lynch and FOOLS keep reminding us to look first at investing in businesses that we understand. Having a simple-minded yet disciplined approach to investing can actually be quite successful. I'm living proof. I truly have one of the simplest minds around.

Judith Russ Leon: The SEC requires quarterly filings of condensed financial information. Detailed filings occur annually after an examination by independent third parties (auditors). Does the SEC also set standards for ADRs (American Depository Receipts) of companies in foreign countries that trade on US exchanges? If so, are the standards different than those for US stocks?

Diane: I am not specifically familiar with all the rules related to ADRs, although I know the stock exchanges have listing requirements and regulations which involve financial reporting requirements. Your question brings up another interesting point. Foreign corporations are not required to prepare financial statements in accordance with U.S. GAAP. Most prepare financial statements according to the rules of their country. Nokia's 1997 annual report has two sets of financial statements. One is prepared using International Accounting Standards (IAS). The other is prepared using Finnish Accounting Standards. Nokia also provides a table reconciling IAS numbers to U.S. GAAP numbers. I have no idea which set of figures are used in Value Line. Here is another good reason to verify summarized financial data with the figures reported in an annual report.

Valsa: When reading the MD&A, how do you know what is important? What exactly are looking for in this section of the report? Are there clues you look for to tell you how the management is functioning and how well it will do in the next year?

Diane: In MD&A, management discusses the results of operations. Why were revenues up or down? Why were gross margins up or down? What unusual items are included in net income? They must also discuss the financial condition of the company. As to Liquidity, does the company have enough cash to operate or resources to obtain funds in the future? As to Capital Resources, what is the condition of the company's plant and equipment? Does the company have enough capacity to produce more product in the future? There are definitely clues to management's expectations for the future. How well they will execute their plans is always a question. It is one reason we look at the company's history. What is management's track record in the past? Good management can usually execute their plans. We will explore some of these questions for Diebold in the following sessions. The highlights in the illustration for MD&A will show some of the comments I felt were useful.

Candis King: How does FASB (Financial Accounting Standards Board) fit into the picture?

Deb Kearney: FASB (Financial Accounting Standards Board) works to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. FASB is one part of the standard setting structure. Financial Standards issued by FASB are considered GAAP (Generally Accepted Accounting Principles.) There is a system of due process through which all standards and interpretations pass. When a CPA audits a firms financial statements, there is a 'guarantee' that those statements follow GAAP. In other words that those statements have been derived using the same 'formula' as used by other companies. This assures us that when we read and compare Balance Sheets or Income Statements, we are comparing like entities -- apples to apples and not apples to oranges. FAF - FASB - GASB - the holy trinity to accountants!

Diane: The FASB is the current predominant accounting rule-making authority. It is made up of seven people from the accounting profession and industry. It is funded by contributions from public accounting firms, accounting organizations, industry and other private sources. The FASB works closely with the SEC to identify accounting issues. Its mission: "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors and users of the financial information." More information (and the current text of FASB accounting pronouncements) is available at www.fasb.org.

Continue to Session #2 - Balance Sheet

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.