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Chapter Two Slides

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The Four Financial Statements
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders’ Equity
2-1
The Form of the Balance Sheet
Assets = Liabilities + Shareholders’ Equity
or
Shareholders’ Equity = Assets – Liabilities
Compare to:
Value of Equity = Value of Firm – Value of Debt
2-2
The Form of the
Income Statement
Net Revenue – Cost of Goods Sold = Gross Margin
Gross Margin – Operating Expenses = Earnings before Interest and Tax (ebit)
Earning Before Interest and Tax – Interest Expense + Interest Income =
Income before Taxes
Income before Taxes – Income Taxes = Income after Taxes (and before
Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items = Net Income
Net Income – Preferred Dividends = Net Income Available to Common
2-3
The Form of the
Cash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing
2-4
The Stocks and Flow Equation
Ending equity = Beginning equity + Total
(comprehensive) income
– Net payout to shareholders
Comprehensive income = Net income + Other
comprehensive income
Net payout to shareholders = Dividends + Share
repurchases
-Share issues
2-5
The Articulation of the Financial Statements
Beginning stocks
Flows
Ending stocks
Cash Flow Statement
Cash from operations
Beginning Balance Sheet
Cash from investing
Ending Balance Sheet
Cash from financing
Cash
Net change in cash
Cash
+ Other Assets
Other Assets +
Statement of Shareholders’ Equity
Total Assets
Total Assets
Investment and disinvestment by owners
- Liabilities
- Liabilities
Net income and other earnings
Owners’ equity
Net change in owners’ equity
Owners’ equity
Income Statement
Revenues
Expenses
Net income
2-6
Intrinsic Value and Book Value
• Intrinsic Premium:
 Intrinsic Value of Equity – Book Value of Equity
• Market Premium:
 Market Value of Equity – Book Value of Equity
• Intrinsic Price-to-Book Ratio:
 Intrinsic Value of Equity
Book Value of Equity
• Price-to-Book Ratio:
 Market Value of Equity
Book Value of Equity
2-7
Percentiles of P/B Ratios for U.S. Firms, 1963-2003
8
p10
p25
median
p75
p90
7
5
4
3
2
1
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
0
1963
Price-to-book ratio
6
Source: Calculated from Standard & Poors’ COMPUSTAT data.
2-8
Measurement in the Balance Sheet
• Historical Cost Accounting
• Fair Value Accounting
Box 2.2 explains how each item of assets and liabilities is
measured
2-9
Measuring Value Added
Value added = Ending Value – Beginning Value + Dividend
Stock Return = Pt  Pt 1  d t
Accounting value added = Ending book value – Beginning
book value + Net dividend = Comprehensive earnings
2-10
Principles of Earnings Measurement
• Recognize only value added from sales to customers
 Revenue recognition principles
Add value when it has been earned (usually
when a sale is made)
 Matching principle
Match expenses against revenue for which they
are incurred
• Accounting value added (earnings) = Revenue – Expenses
2-11
Good Matching
• Only costs of good sold are matched to sales revenue, not the full
costs of producing or buying inventory during the period.
• Costs for goods not sold are reported in the balance sheet, as
inventory, to be matched with revenue in future.
• Costs of buying plant are not expensed when incurred. Rather,
the cost is “capitalized” on the balance sheet and depreciated over
years when the plant produces revenues.
• Employee pension costs are recorded as an expense in the period
that employees generate revenues, not when they are paid (in
retirement).
2-12
Poor Matching
• Research and development expenditures are expensed when
incurred, rather than matched to (subsequent) revenues they
generate
• Advertising and promotion costs are expensed when incurred,
rather than matched to (subsequent) revenues they generate
• Estimating useful lives for plant assets that are too long:
Depreciation is understated
2-13
Percentiles of P/E Ratios for U.S. Firms, 1963-2003
70
p10
p25
median
p75
p90
50
40
30
20
10
Source: Calculated from Standard & Poors’ COMPUSTAT data.
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
0
1963
Price-to-earnings ratio
60
Numerator: Price forecasts future earnings
Denominator: Current earnings
2-14
Guiding Principles for Recognizing Accounting
Value Added
• The fundamentalist creed: Don’t mix what you
know with speculation
• The accountant’s restatement of the creed (the
reliability criterion):
Accounting numbers should be based on
objective evidence, free of opinion and bias.
Go to Accounting Clinic I
2-15
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