Part I: Financial Accounting for
Executives
» Creighton Family Medical Practice
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Three doctors
Discussion
New medical practice
Case
Informal accounting system
After one year, one doctor decides to leave the
practice to become a Medical School professor
» How much “should” the practice pay
the departing doctor to liquidate his
investment?
» Might one of the other investors be
willing to pay more?
I.
What is the Purpose of Financial Statements?
» Different Statements—Different Purposes
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Annual Report issued by a publicly traded company?
Income tax return?
Statements prepared for a lender?
Reports issued to, say, partners in an oil & gas venture?
Managerial reports?
Governmental Financial Reports?
» To What Extent Does the Purpose Influence
Measurement?
˃ Rules are largely driven by the underlying purpose of the statement
Rule-Making and Enforcement Bodies are
Crucial
» Who Makes the Rules for Tax Reporting?
˃ Internal Revenue Code Implemented by Congress
˃ Enforcement, but also Interpretation, largely the
responsibility of the Treasury Department and the
Internal Revenue Service
» How About Financial Reporting?
˃ Generally Accepted Accounting Principles (GAAP),
issued by Financial Accounting Standards Board (FASB)
in U.S.
˃ International Financial Reporting Standards issued by
International Accounting Standards Board (IASB)
internationally
˃ Securities & Exchange Commission (SEC) is primary U.S.
entity with responsibility for enforcement
Conceptual Framework for Accounting
» Objective of Financial Statements is to provide
information useful to capital markets to make
decisions about whether or not to provide capital
(decision usefulness)
» Key attributes of such statements are:
 Relevance
 Faithful representation (reliability)
» When these are in conflict, rules must weigh
relative costs and benefits of competing
approaches
» In other reporting settings, some rules of GAAP
may be waived to accomplish specific objectives
of reporting process
General Concepts Underlying Financial
Reporting
» Financial statements report to providers of
capital:
˃ Shareholders, other equity owners (e.g. partners)
˃ Creditors
» Report about the business entity
˃ Assumption is that the entity is a going concern
» Financial statements designed to address
separate purposes, but are interconnected:
˃ Balance Sheet provides a picture of the business
entity’s financial position at a specific point in time
˃ Income Statement summarizes the results of the
entity’s operations over an identified period of time
˃ Statement of Cash Flow reconciles reported income
from Income Statement with net change in cash on
Balance Sheet
˃ Statement of Shareholders’ Equity reconciles changes
in equity accounts
“Interconnectedness” of Financial Statements
(“Articulation”)
Key Concepts
» Accrual vs. Cash Method of Accounting:
˃ Cash Flow
Income
˃ Taxable Income
Financial (“Book” or “GAAP”) Income
» Assets vs. Expenses
˃ One goes on Balance Sheet, the other on Income Statement
˃ Current period benefit vs. multi-period benefit
˃ Cost vs. FMV
» “Matching” Principle
˃ Revenues must be recorded in the period in which they are
earned
˃ Expenses must be matched with Revenues they generate
˃ Requires use of estimates
» Liabilities vs. Revenues
˃ Has company earned the money or may it have to be repaid?
˃ To which period should the revenue be attributed?
Balance Sheet
» Elements of the Balance Sheet
˃ Assets
˃ Liabilities
˃ Owners’ Equity
» Balance Sheet Equation
˃ Assets = Liabilities + Owners’ Equity
 Double-entry accounting system
˃ For investors, how does equity grow?
 Profitability
 Issuing new shares
˃ How does it shrink?
 Payouts
 Losses
˃ How do acquisitions affect owners’ equity?
Balance Sheet (cont)
» What is an Asset?
˃ Economic resource that is expected to generate future benefits for a
business
˃ May be “tangible” or “intangible”
˃ Proper valuation on Balance Sheet?
˃ Current vs. “Long term”
» What is a Liability?
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Obligation to make future payments
“Fixed” vs. “Contingent”
“Off-balance sheet” liabilities (e.g., operating leases)
Current vs. “Long term”
» What is Owners’ Equity?
˃ Residual balance, Assets in excess of Liabilities
Income Statement
» Elements of the Income Statement
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Revenues
Expenses
» Classified Income Statement
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Income/expenses from operations
 Gross Profit (for manufacturing companies) less selling & administrative expenses
Non-operating income and expenses
Income tax expense
Discontinued operations & Extraordinary items (2 separate sections)
Earnings per share
» What is a Revenue?
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Increases in shareholders’ equity resulting from the provision of goods and/or services
to customers or other activities that constitute the entity’s ongoing major or central
operations
Not recognized until they are earned, the selling price is fixed or determinable, and cash
collection is reasonably assured
Distinguished from gains, which arise from peripheral or incidental transactions
» What is an Expense?
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Reductions in assets or increases in liabilities during a period from delivering or
producing goods, rendering services, or carrying out other activities that constitute the
entity’s ongoing major or central operations
Where possible, expenses must be “matched” with related revenues
Distinguishable from losses, which are triggered from peripheral, nonrecurring, or
incidental investing or operating activities.
Ford Motor Company
» Motley Fool recommends Ford …
Discussion
Case
http://www.fool.com/investing/general/2013/07/10/2-more-reasons-to-invest-in-fords-turnaround.aspx
» Let’s use the company’s Income Statements & Balance
Sheets to analyze the turnaround
˃ 2004, 2008, 2012
» Begin with 2004 and 2008 Financials
Debt-to-Assets?
Gross-Profit Margin?
Shareholders’ Equity?
Net Income?
Why do you suppose 2008 income tax expense was positive?
» Compare 2008 and 2012:
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Were sales higher in 2008 or 2012?
What about net income?
What happened to gross profit margin?
What about Selling & Administrative expenses?
Total debt? How did that affect interest expense? What else affected interest
expense?
˃ What did Ford do financially & operationally between 2008 and 2012?
Ford Motor Company (cont)
Discussion
Case
» Analysis of 2004 v. 2012 Financial Statements
» Profitability:
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Gross Profit Margin
Return on Sales
Return on Assets
Return on Equity
Component analysis of ROE
» Asset Management:
˃ Inventory Turnover
˃ Inventory-on-hand Period
˃ Asset Turnover
» Financial Risk:
˃ Long-term debt to equity and assets
˃ Interest coverage
Statement of Cash Flow
» Reconciles Net Income to change in Cash balance on
Balance Sheet
» Changes in cash balance arise from three different types of
activities:
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Operating Activities
Cash sales + collection of receivables
— Cash expenses & payment of accounts payable
Investing Activities
 Asset purchases and dispositions (physical assets, securities, intangibles, etc.)
 Acquisition or disposition of affiliated companies
Financing Activities
 Issuance or repayment of debt
 Issuance of stock, acquisition of Treasury stock
 Payment of dividends
» The cash flow statement can be used to evaluate the
“strength” of a company’s income
» Keys to analysis:
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What are implications of increases in receivables?
Is the company delaying payment of obligations?
What are the company’s “non-cash” expenses?
What is the company’s free cash flow?
What is the company’s discretionary cash flow?
Ford Motor Company
Discussion
Case
» Income Statement & Balance Sheets
˃ 2011, 2012
» Review 2011, 2012 Cash Flow Statements:
˃ What is the relation between income and cash flows for
the 2 years?
˃ What items stand out to you in reviewing these
statements?
˃ What was “free” cash flow in each year?
˃ What were the company’s “discretionary” cash flows in
each year?
˃ What does the cash flow statement add to the other two
primary financial statements for Ford?
Limitations of Financial Statement
Analysis
» Many of the largest numbers in the financial
statements are estimates
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Depreciation expense
Inventory
Cost of Goods Sold
Allowance for Bad Debts, Warranty Expenses, etc.
Option compensation
Contingent liabilities
» Other reported figures may be manipulable
 Income tax expense
 Revenue recognition
» Data is not always current
» Hidden and/or incomplete financial data
What are Management’s Incentives to
Manipulate Financial Data?
» Pressure from Wall Street
» Compensation tied to stock price
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Options
Restricted stock
Company loans used to purchase shares
Phantom stock and Stock Appreciation Rights (SARs)
Optimism about the future
Insider knowledge
Attempts to “control” expectations
Combining these incentives with flexibility in
GAAP can be dangerous
Revenue Recognition
» Revenues are realized when a company exchanges
goods &/or services for cash or claims to cash
(receivables)
» Revenues are realizable when assets a company
receives in exchange are convertible to known
amounts of cash
» Revenues are earned when a company has
substantially accomplished what is must do to be
entitled to payment
˃ Sale of products – revenue recognized at date of sale.
˃ Sale of services – revenue recognized when services have been
performed and are billable.
˃ Use of assets (e.g., rent, interest, royalties, etc.) – revenue recognized as
time passes or as assets used.
» Amount to be received must be reasonably
determinable and collectability must be
reasonably assured
Revenue Recognition—Common
Situations
» AvalonBay, the nation’s no. 2 publicly traded
apartment management firm – advance
deposits
» Lowe’s – gift cards
» American Airlines – airline mileage awards
» Southwest Airlines – travel point awards
» Best Buy – extended warranties
» Sam’s Club – membership fees
» Lehman Bros – repurchase agreements
Priceline Restatement
Discussion
Case
» In the 4th quarter, 2000, the company
collected $152 million from its customers
for airline tickets, hotel rooms & rental cars
» It paid $134 to airlines, hotels, and rental
car companies, and kept $18 million
 How should it report this activity?
 Sales of $152 million and cost of goods sold of $134? or
 Commission revenues of $18 million?
(Note that the company reported a net loss of $102 million for that
quarter)
Lucent — “Channel
Discussion
Stuffing” Case
» In the 4th quarter, 2000, the company shipped
goods to customers with a generous return
policy allowing customers to return those
goods if not sold within “normal” time period
» Company subsequently “restated” its
financial results reducing revenues by $679
million and converting its operating profit
into a loss
 What signals might you expect to see in its financial statements?
 In quarterly data?
 In Sales vs. Accounts Receivable?
 In footnotes to financial statements?
 In bad debt reserves?
Receivable Valuation
» Sales on account bring the risk that some
customers will not pay their account
» This risk is influenced by firm’s credit policies
» Bad debts need to be matched to the period in
which the credit sale occurred, not when the
account is charged off
» How? Establishment of an “Allowance
Account”
˃ Company estimates portion of receivables that will not be collected.
˃ Records an expense and establishes a reserve for uncollectible
accounts.
˃ Subsequent period charge-offs do not directly affect Income
Statement because expense has already been recorded.
Allowance vs. Expense Accounts
» Key Point—Understanding the Relationship
Between Allowance Account (“contra-asset”
on Balance Sheet) and the Bad Debt Expense
reported on Income Statement
Beginning balance in allowance account
+ Plus bad debt expense
—Minus charge-offs
= Equals balance in allowance account
» Can normally calculate charge-offs if you have
beginning, ending and expense figures
Allowable Measurement Approaches
» How do we estimate uncollectibles?
 Percentage of credit sales
 Aging of outstanding receivables
» Estimates are based on experience
 Company experience vs. industry experience
» How might an investor discern earnings
management through the bad debt reserve?
 EXAMPLE: In 1996, HealthSouth reported the following:
Beginning Balance,
Allowance Account
$213
Bad Debt Expense on
Income Statement
$59
Ending Balance,
Allowance Account
$75
 What were the company’s “charge-offs” in 1996?
 What does that suggest with respect to the amount recorded as bad
debt expense?
Inventory & Cost of Goods Sold
» Valuation—several approaches allowed by
GAAP:
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FIFO
LIFO
Weighted Average
Specific Identification
» Cannot use LIFO for tax unless also used for
book
» Question: if a valuation method increases value
of inventory on balance sheet, what does it do
to reported income? (trick question)
 Example – gasoline sales at a truck stop
» Bigger issue arises when inventory becomes
obsolete (or begins to diminish in value)
Long-lived Assets
Valuation & Depreciation
» Historical Cost vs. FMV – is FMV relevant?
 Why or why not?
 When?
» Allowable depreciation methods
 Straight-line
 Accelerated (most companies use accelerated methods for tax)
» Other measurement issues that affect earnings
 Depreciable “life”
 Salvage value
» Following 9/11, American took an “impairment
charge” against its plane fleet of $1.24 billion
 Good time for “big bath”?
 Effect on subsequent years’ reported income?
Example: Waste Management
» Lawsuit filed in 2002 against founder and 5
former top officers of company
» Accounting Issues:
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Depreciable lives of garbage trucks
Salvage values
Depreciation of landfills
Unwarranted “environmental reserves” associated with acquisitions
» How would these practices affect the
company’s financial statements?
Accounting for Investments in Other
Companies
» Valuation—depends on size and nature of
investment:
Size of Investment
< 20% (voting shares)
Trading
Available
for Sale
Mark-to-market
20% - 50%
> 50%
Active but no control
Active, with control
Elect equity method
or “Fair Value”
Consolidation with
Acquirer
» Gains and losses from mark-to-market for trading
securities included in income
» Gains and losses from “available for sale” securities
or 20/50 investments flow into “Other
Comprehensive Income”
Bonds Payable
» Bonds are publicly traded debt instruments
» Usually pay interest at stated rate on face value
over specified period
» Stated rate may differ from market rates:
 If lower, bond will be sold at a discount
 If higher, bond will be sold at premium
 Occasionally, stated rate is zero
» Premium or discount must be amortized into
interest expense
» Early retirement will generally trigger reported
gain or loss
Leases
» Lease arrangement must be capitalized if any
of following is true:
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Agreement transfers ownership to lessee by end of lease term
Agreement contains a bargain purchase option
Term of lease is 75 percent or more of economic life of leased asset
Present value of minimum contractual lease payments is 90 percent
or more of FMV of leased asset
» Capital lease has same effect on income
statement as an “operating” lease during each
year of lease agreement
» However, assets and liabilities on Balance Sheet
are lower
 May significantly impact financial ratios
Accounting for Taxes
» Book Income will generally not equal Tax
Income
» Tax Income determines amount of tax to be
paid this year
» Book Income determines amount of tax to be
paid eventually
 “Permanent” differences vs. “temporary” differences
 Difference between amount paid this year and amount deferred is
tax on temporary differences
» Examples of Permanent Differences:
 Foreign earnings permanently reinvested abroad
 Tax-exempt earnings
 Stock option differences
Stock Options
» GAAP—estimate value of options when issued
and expense over vesting period
» Tax—calculate actual value when exercised and
deduct that amount in year of exercise
» Amounts deemed compensation often differ
dramatically
» Companies often acquire “Treasury Stock” to
satisfy option exercises
» Loss on Treasury stock flows through Retained
Earnings
» Example
Summary
» Analysis of financial statements often based on
ratio analysis, growth, and similar calculations
based on reported financial information
» Managers know how valuation models are used
» Managers often (generally) have “target” levels for
reported earnings, leverage ratios, etc.
» Measurement is often influenced by these
management incentives
» It is important to know how key concepts in
measurement impact reported financial
information
» Measurement incentives may impact structure of
transactions, which may be ok, or may impact
choice of measurement methods, which is often
not ok