Accounting process and financial statements review

Financial Statements

Part I.A. The Generally Accepted Accounting Principles (GAAP) refer to the standards used in the production and audit of financial accounting statements. There are variations of the standards that are applied to government entities as well as publicly traded entities. Private corporations do not need to adhere to GAAP as they are not required to answer to public shareholders and securities regulators.

The GAAP is the predominant standard in the U.S., and runs in parallel to the global International Financial Reporting Standard. GAAP was developed to provide consistency to financial statements, allowing for ease of interpretation by investors, regulators and financial analysts alike. The standards outline who financial statements must be prepared and presented.

The Financial Accounting Standards Board is responsible for writing and implementing the GAAP. They are guided by the Securities Exchange Commission (SEC). The FASB issues a variety of interpretations, standards, concepts and technical bulletins. These proclamations are used by accountants and auditors to help create the statements.

B. One of the most important measures of a company's health it its liquidity. Liquidity refers to a corporation's ability to meet its short-term debt and interest obligations. Thus, when analyzing financial statements, it is critical to study liquidity ratios. These ratios relate to various current asset accounts in relation to the amount of current liabilities.

Understanding a firm's liquidity is crucial. Many financial measures relate to overall firm performance, or long-term capital structure. But it is liquidity that is important to the immediate survival of the firm. For example, when WorldCom declared bankruptcy, they had assets far in excess of liabilities. But their liquidity was poor -- they had substantial pending debt obligations and no means by which to cover those. Thus, liquidity is an essential component of any financial statement analysis. Therefore, accountants need to pay particular attention to the liquidity figures of their company in order to ensure its immediate survival.

Part II. With respect to Kraft, the income statement is just as useful if not more than the statement of operating cash flows. Kraft has few non-cash items on its income statement. The depreciation is minimal compared with the revenues. Overall, the trends for operating cash flows and net income share similar trajectories. Given that, the income statement is more useful, because that is the statement that is used for taxation purposes and is used as the benchmark against which the firms financial performance and stock price is measured.

For Unilever, cash from operating activities is the more useful of the two. What we see is that net income has increased steadily over the past five years. Yet, the cash flow from operating activities has decreased steadily over that period. Part of this can be attributed to declines in the amount of depreciation, but in part this is due to increases in the amount of working capital reduction. Working capital reduction is not always a bad thing -- tightening receivables and inventory turns is often considered to be good financial policy.

In the case of Unilever, it is important to synthesize the two statements. We can see, for example, that "unusual expense" is the category most responsible for the change in working capital. At this point, it would be advisable to delve deeper into the comments in the annual report to discern the precise nature of these unusual items, as they will reveal the cause for the steady decrease in "unusual items" that has fueled the widening gulf between net income and cash flow from operations in the past five years.

I would predict that Kraft will work in the next few years to reduce costs. Their revenues have experienced steady increase, but their net income has not. They will focus their efforts on reducing the selling/general/administrative expenses. The other prediction I will make about Kraft is that they work to reduce their liabilities. They have experienced a sharp jump in liabilities over the past couple of years, which has had adverse impact on their capital structure. They will attempt to bring their debtload down over the next couple of years.