 Assist you in becoming more sophisticated in your understanding and use of financial statements
– what’s the link to opportunity assessment?
» financial accounting provides much of the information by which prospects are measured
 Complex area
– focus of a semester long course

 Provides information for many financial decisions
– internal users (managerial accounting)
» planning
» control
– external users (financial accounting)
» investing
» lending
» customer/supplier negotiations
» labor negotiations

 Balance Sheet
– statement of financial position (moment in time)
» assets --the valuable resources of a company
 subject to GAAP measurement conditions
» liabilities --the claims of outsiders to the resources
 subject to GAAP measurement conditions
» equity --the residual that belongs to the owners
Fundamental asset characteristics:
• a future benefit
• controlled by the company
• flowing from a past transaction

Google, Inc.’s
Balance Sheet
All numbers in thousands
2009 2008
Assets
Current Assets
Cash and cash equivalents
Short term investments
Net receivables
Other current assets
Total Current Assets
Long term investments
Property, plant and equipment
Intangible assets
Other long term assets
Total Assets
$10,198 $ 8,657
14,287 7,189
3,846 2,928
836 1,404
29,167 20,178
129 85
4,845 5,234
5,677 5,837
679 434
$40,497 $31,768
Liabilities
Current Liabilities
Accounts payable
Other current liabilities
Total Current Liabilities
Long-term liabilities
Total Liabilities
$2,463 $ 2,002
285 300
2,748 2,302
1,745
4,493
1,227
3,529
Stockholders' Equity
Common stock
Retained earnings
15,922 14,677
20,082 13,562
Total Stockholders' Equity 36,004 28,239
Total Liab. & Stockholders' Equity $40,497 $31,768

 Income Statement (P&L)
– summarizes performance for a past period
» revenues --asset inflows from operations
» expenses --asset outflows for operations
» gains --net inflows from nonoperating items
» losses --net outflows for nonoperating items

Google, Inc.’s
Income Statement
All numbers in thousands
Years Ending December 31 2009 2008
Total Revenue
Cost of Revenue
$23,650 $21,796
8,844 8,622
Gross Profit
Operating Expenses
14,806
Research Development 2,843
Selling General and Administrative 3,651
Total Operating Expenses 6,494
13,174
2,793
3,749
6,542
Income from Continuing Operations 8,312 6,632
Total Other Income/(Expense)
Earnings Before Interest and Taxes
Interest Income
Income Before Tax
Income Tax Expense
Net income
8,312
69
8,381
1,861
5,538
316
5,854
1,627
$ 6,520 $ 4,227

 Statement of Cash Flows
– summarizes flows for the period by type
» operating
 typically prepared indirectly
» investing
 purchases and sale of ‘capital’ investments
» financing
 transactions with creditors and owners

Google, Inc.’s
Statement of Cash Flow
Years Ending December 31
Operating Activities
Net Income
Depreciation
Adjustments To Net Income
Changes In Accounts Receivables
Changes In Liabilities
Changes In Other Operating Activities
Net Cash Flow From Operating Activities
Investing Activities
Capital Expenditures
Investments
Other Cashflows from Investing Activities
Net Cash Flow From Investing Activities
Financing Activities
Sale/(Purchase) of Stock
Other Cash Flows from Financing Activities
Net Cash Flow From Financing Activities
Effect Of Exchange Rate Changes
Change In Cash and Cash Equivalents
All numbers in thousands
2009 2008
$6,520 $4,227
1,524 1,500
785
(504)
511
480
9,316
(810)
(7,101)
(108) (3,320)
(8,019) (5,319)
143
90
233
11
1,799
(335)
183
479
7,853
(2,358)
359
(72)
159
87
(46)
$ 1,541 $2,575

 Financial statements are built from a company’s transactions
– record assets and liabilities
» revenues and expenses from the changes in them
 The ever present accounting equation
A = L + SE

 Can dramatically impact reported results
– inventory
– depreciation
– research and development
– consolidations


ABC Company’s inventory transactions:
– 1/01/x1--buys 1 unit @ $10
– 1/12/x1--buys 1 unit @ $12
1/21/x1--sells 1 unit @ $20

ABC Company’s Performance: inventory (B/S) CGS(I/S)
FIFO 1 @ $12 = $12 $10
LIFO 1 @ $10 = $10 $12

Method
FIFO
LIFO
Inventory(B/S) current prices old prices
Cost of Goods Sold(I/S) old prices current prices
Financial Statement Impact (assuming rising prices)
Balance Sheet
Inventory
Income Statement
FIFO > LIFO
Cost of Goods Sold
Net Income
FIFO < LIFO
FIFO > LIFO

 Process of allocation, not valuation
» charge a portion of the cost to expense during each year of an asset’s useful life
 income statement shows depreciation expense
 balance sheet shows accumulated depreciation
 Amount of depreciation taken depends on:
» cost
» method (straight-line, accelerated)
» salvage value
» life

 Method differences
– most U.S. firms use SL
» can convert SL to accelerated (MACRS) using income tax footnote
 Life differences (for companies using SL) average life = gross PP&E ÷ annual depr. exp.
 Age differences (for companies using SL) average age = accumulated depreciation ÷ annual depr. exp.

 Activity directed at developing new knowledge
– translate into
» products
» services
» processes
 Sometimes successful, often not
– tangible evidence of success
» patents
» trademarks
» profits!

 When money is spent up front, how do we evaluate it’s future success?
 Necessary in order to
– capitalize (record as asset) the successful
– expense (write off) the rest

GAAP’s solution
– expense all R&D
» conservatism

Assume:
1. R&D spending is constant @ $10,000/year
2. Creates benefits lasting 5 years
3. Company has $100,000 of assets and $25,000 of income, both before considering R&D
Required:
– Evaluate the impact of expensing R&D on
Return on Assets (ROA)

 Need to exercise care in interpreting profitability
– especially when level of R&D expenditures is changing

 Consolidate holdings in excess of 50% of voting shares
– financial statements of affiliates combined as though a single legal entity
– tax reporting--may be separate or combined tax returns

 Two methods
– pooling of interests
» commingling of existing interests
 Book value (BV) basis of both affiliates maintained in consolidated statements
– purchase
» acquisition of one company by another
 subsidiary’s assets and liabilities remeasured at fair value at date of combination
– goodwill

 Change in GAAP in 2001 (SFAS 141)
– prohibits new poolings
» prior poolings left unchanged
– subsequent action modified the purchase accounting rules
» goodwill is no longer amortized
 still recorded as an asset
– written down (off) only if impaired

 Income Statement
– Net income pooling > purchase
 Balance Sheet
– Total assets---------purchase > pooling
– Total liabilities-----purchase = pooling
– Total equity---------purchase > pooling

 Noncontrolling interest (minority interest)
– stock of subsidiary owned by outsiders
– creates outside claims on
» assets
 minority interest in net assets (liability/equity)
» income
 minority interest in income (pseudo expense)

 Consolidation of unconsolidated subsidiaries (those just below 50%)
– happens occasionally but not common
» very suspicious
– reported using equity method
» would like them to be consolidated (controlled)
 income statement--net income is o.k.
 balance sheet--subsidiaries debts are left off the books
– can adjust data using footnote disclosures
» very involved adjustments

 For what purpose?
– price arbitrage
– lending
– customer/vendor evaluation
– labor negotiations
– government regulation
– litigation support

 What are we looking for?
Where P t
D t
P t-1
= Share price at end of period,
= Dividends received during the period,
= Share price at beginning of period
 What are we worried about?

 Factors affecting corporate performance
– industry characteristics (Porter’s five forces)
» buyer power (price sensitivity)
 costliness, competing products
» supplier power
 scarcity, quantity
» rivalry among firms
» threat of new entrants
 capital intensity, government regulation, rate technological change
» threat from substitute products

 Factors affecting corporate performance
– industry characteristics (Porter’s five forces)
– corporate strategy
» product focus
 differentiation, low cost leadership, niche ●
» location in the value chain
 manufacturing, distribution, integration
» diversification (geographic or industry)
» leverage
 use of financial and/or operating leverage

35%
30%
25%
20%
15%
10%
5%
0%
0 1 2 3 4 5 6 7 8 9 10 11
Turnover
ROE=10%
ROE=20%

 Factors affecting corporate performance
– industry characteristics (Porter’s five forces)
– corporate strategy
» product focus
 differentiation, low cost leadership, niche
» location in the value chain
 manufacturing, distribution, integration
» diversification (geographic or industry)
» leverage
 use of financial and/or operating leverage

ABC Company plans to sell a new product this year that can be sourced two ways:
1. subcontract to Asia for a cost of $1.50 each.
2. produce in a refurbished company owned facility at a variable production cost of $1 and facility operating costs of $275,000/year
What is product cost?
• at 500,000 units
• at 800,000 units
Option 1
$750K
($1.50/unit)
$1,200K
($1.50/unit)
Option 2
$775K
($1.55/unit)
$1,075K
($1.34/unit)
39

 Company has $1,000 asset earning $150
(15%) before financing
 asset financed as follows:
» $300 by long-term debt (10% interest cost)
» $700 by equity
ROA = (150 ÷ 1,000) = 15%
ROCE = (120 ÷ 700) = 17%
Assets provided by creditors:
Return generated $300 x .15 = $45
Financing cost $300 x .10 = $30
$15 excess to equity
40

 Ratios are popular
– performance measurement
» ROA, ROCE
– risk assessment
» extent to which current profits may be different that those in the future
 liquidity
 solvency
 turnover
 leverage (operating, financial)


Financial Statements tell us…
– only part of the story
» hard to predict the future
 fundamental challenge of analysis
» limitations in GAAP
 substantial latitude in preparing information
– discretionary accounting choices
 important information left off the statements
– ‘off-balance-sheet” financing


Management’s natural desire to cast things in a favorable light
– management vs. manipulation
» why we have
 GAAP
 audits
– millennium scandals
» why we now have
 Sarbanes/Oxley Act
– 404
 PCAOB

 Performance measurement framework
– profitability (Dupont Model—see p. 125)
» ROA
 profit margin
 asset turnover
» ROE
 ROA
 financial leverage
– risk
» solvency risk
» operating leverage
» financial leverage see ratio list

 Our focus is on the future
– to predict well we need to consider
» current economic conditions and forecasts
» industry characteristics
» company strategy

 Need to evaluate the components of GAAP income
– permanent earnings (recurring, persistent)
– transitory earnings

Sales
-Cost of goods sold
Gross profit
Operating expenses
Income from operations
+ Other revenues/gains
- Other expenses/losses
Income before taxes
- Income tax expense
Net Income

 Other Revenue/Gains
– gains from peripheral activities (e.g., the sale of
PP&E, investments)
 Other Expenses/Losses
– losses from peripheral activities (e.g., the sale of PP&E, investments)
– restructuring charges
– impairment losses

Sales
-Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+ Other revenues/gains
- Other expenses/losses
Income before taxes
- Income tax expense
Income before …

 Discontinued Operations
 Extraordinary Items

 Results from disposal of segment
– a sizable component of operations
 Reported in two separate components
– income/loss on operations
– gain/loss on disposal
 Both components reported net of related tax effects

 Manufacturer of flexible vinyl sheeting
– automotive, industrial, medical
– sold consumer products business in 2005
Income b/4 Disc. Operations
Loss from operations (net of
2005
8,813,858
$428,489 in tax benefits)
Loss from disposal (net of
- 593,593
$1,825,954 in tax benefits) -3,674,046
Net Income 4,546,219

 Both unusual in nature and nonrecurring
– fire, flood and other casualties
 Reported net of related tax effects flood loss 1,000,000 tax effect (400,000) net loss 600,000

 Restatements
– change amounts in financial statements for prior years (comparative statements)
– Used for
» correcting errors
 on prior years’ income statements
» reporting changes in accounting principles
 retrospective method
» changes in the entity (acquisitions, divestitures)

 XYZ Co. began operations in 2002
– in 2002 recorded cost of a $100,000 building as a purchase of land.
– error not detected until this year (2006)
– building has a 20 year life and $0 salvage value.
– company uses straight-line depreciation.
– tax rate = 40%

Income Statement 2002 2003 2004 2005 2006 depreciation taken 0 0 0 0 0 correct depreciation 5 5 5 5 5 gross effect on inc.
- 5 - 5 - 5 - 5 - 5 taxes (40%) +2 +2 +2 +2 +2 net effect on inc. - 3 - 3 - 3 - 3 - 3
Corrections on Income Statement:
NI (as previously reported) error
NI (corrected)
41 45
-3 -3
--
--
38 42 47
Corrections on Statement of Retained Earnings:
-6


XYZ’s 2006 Financial Statements
– Income Statement: depreciation expense
Net Income
2004 2005 2006
5.0
5.0
5.0
38* 42* 47
*restated
– Statement of Retained Earnings: beg. balance prior period adjustment adjusted beg. balance
+ net income
- dividends ending balance
2004 2005 2006 xxxx xxxx xxxx
-6.0
0.0
0.0 xxxx xxxx xxxx
38.0
42.0
47.0
xxxx xxxx xxxx xxxx xxxx xxxx

 Many accounting standards provide opportunities for
– managing income
– off-balance sheet financing (OBSF)
Q1.13
 Why would managers want to do this?
– basic economics
» we are all self interested agents
Q3.6
 agency costs
 Why would GAAP permit managers do this this?
PEAP, POOP, WYWAP

 Politically Expedient Accounting Principles
– Concessions, concessions, concessions!
» Footnote reporting of option expense
» Pensions (triple smoothing of volatility)
 Whatever You Want Accounting Principles
– GAAP allow lots of choices
» FIFO/LIFO
» Accelerated/St. line

 Pitifully Old and Obsolete Principles
– Many old standards still around:
– Treasury stock (1934) – Stock splits (1941)
– Depreciation (1946) – Inventory (1947)
– LT contracts (1955) – Quarterly reporting (1934)

 Major problem areas
– investments (smoothing)
– leases (OBSF)
– retirement benefits (smoothing, OBSF)
Details forthcoming in our next session
(Saturday, February 16, 2013)