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Chapter2: Reviewing Financial Statements

Cautions in Interpreting Financial Statements

As we mentioned earlier in the chapter, firms must prepare their financial statements according to GAAP. GAAP provides a common set of standards intended to produce objective and precise financial statements. But recall also that managers have significant discretion over their reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed, within the GAAP framework, firms can “smooth” earnings. That is, firms often take steps to over- or understate earnings at various times. Managers may choose to smooth earnings to show investors that firm assets are growing steadily. Similarly, one firm may be using straight-line depreciation for its fixed assets, while another is using a modified accelerated cost recovery method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS accounting methods, they write fixed asset values down quickly; assets will thus have lower book value than if the firm used straight-line depreciation methods.

  

          time out!

2-7

  

What is a statement of retained earnings?

2-8

  

If, during a given period, a firm pays out more in dividends than it has net income, what happens to the firm's retained earnings?

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p. 36

finance at work //: markets

Coldwater Creek Receives Automatic Delisting Notice from Nasdaq as a Result of Incomplete 10-Q Filing

Coldwater Creek Inc. announced today that it received a Nasdaq Staff Determination on June 14, 2006, stating that Coldwater Creek (the “Company”) failed to comply with Marketplace Rule 4310(c)(14) because its Quarterly Report on Form 10-Q for the quarter ended April 29, 2006 (the “Form 10-Q”) filed on June 8, 2006, was incomplete. NASDAQ Staff Determination notices are generated automatically in these circumstances and indicate that, due to such noncompliance, Coldwater Creek's common stock will be subject to delisting.

   As indicated in the Form 10-Q, the Company's independently registered public accounting firm had not completed its review of the financial information included in the Form 10-Q when it made the filing due to the Company's pending restatement of certain historical financial information. As a result, the Company was unable to provide the officer certifications required by […] the Sarbanes-Oxley Act of 2002 with the Form 10-Q.

   In the interim, the Company is working diligently to complete the amendment to its Form 10-K for the fiscal year ended January 28, 2006, to reflect the restated financial information so that the Company's independently registered public accounting firm can complete its review of the financial information in the Form 10-Q. Once this review is completed, the Company intends to file as soon as possible a fully compliant amended Form 10-Q/A, including the certifications required under […]the Sarbanes-Oxley Act. It is currently expected that the Company's amended Form 10-K filing will be finalized prior to the Nasdaq hearing date, which will enable the Company to file its amended Form 10-Q and return to compliance with Nasdaq's Marketplace Rules.

   

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Want to know more?
Key Words to Search for Updates: Sarbanes-Oxley Act of 2002, financial statements, 10Q filing, 10K filing.
Source: The Wall Street Journal, June 20, 2006, p. A3.


This process of controlling a firm's earnings is called earnings management The process of controlling a firm's earnings.. At the extreme, earnings management has resulted in some widely reported accounting scandals involving Enron, Merck, WorldCom, and other major U.S. corporations that tried to artificially influence their earnings by manipulating accounting rules. Congress responded to the spate of corporate scandals that emerged after 2001 with the Sarbanes-Oxley Act of 2002 Requires that any firm's senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm's financial condition during the period covered., passed in June 2002. Sarbanes-Oxley requires public companies to ensure that their corporate boards' audit committees have considerable experience applying generally accepted accounting principles (GAAP) for financial statements. The act also requires that any firm's senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm's financial condition during the period covered. If a firm's board of directors or senior managers fail to comply with Sarbanes-Oxley (often referred to as SOX), the firm may be delisted from stock exchanges.

p. 37

   As illustrated in the Finance at Work reading, Coldwater Creek's accounting firm had not completed its review of the firm's financial statements when they were released to the public. As a result, the firm's common stock became subject to delisting. Congress's goal in passing SOX was to prevent deceptive accounting and management practices and to bring stability to jittery stock markets battered in 2002 by accounting and managerial scandals that cost employees their life savings and harmed many innocent shareholders as well.   <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077443438/student/bull.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

  

          time out!

2-9

  

What is earnings management?

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