ACCOUNTING FOR WALL STREET AND

BEYOND

INCLUDES ANALYSIS OF MICROSOFT FINANCIAL STATEMENTS

AND TECHNICAL QUESTIONS AND ANSWERS FOR INTERVIEWS

ASHISH KOHLI

Investment Banker; Visiting Professor, Indian School of Business and NYU Tandon
School of Engineering; Director, Corporate Relations and Career Management,
Simon Business School, University of Rochester

MBA, Kellogg Graduate School of Management; Chartered Accountant

Second Edition
This publication contains the opinions and ideas of its author. All information is subject to change without notice.
The author cannot guarantee the accuracy of the information contained herein. The advice and strategies contained
herein may not be suitable for your situation. The author specifically disclaims any responsibility for any liability,
loss, or risk, professional or otherwise, which is incurred as a consequence, direct or indirect, of the use and
application of any part of this book.

No part of this book may be reproduced or transmitted in any form or by any means, electronic, mechanical,
photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the United States
Copyright Act, for any purpose, without the express written permission of the author. Please address requests for
permission to use the content of this book to the author.

The author requests that you send any suggestions including but not limited to any errors you have noticed in the book,
content to be added or deleted, and suggestions on how to improve the book to him directly at
trainingakohli@gmail.com.

To order additional copies of the book please contact us at trainingakohli@gmail.com.

Copyright 2019 by Ashish Kohli. All rights reserved.

Published by AshishKohli, Inc.
Printed in the United States
 Table of Contents
INTRODUCTION .................................................................................................................................... 1

CHAPTER 1: INTRODUCTION TO ACCOUNTING ......................................................................... 3

CHAPTER 2: HOW TO READ A FORM 10-K ANNUAL REPORT ................................................ 9

CHAPTER 3: INCOME STATEMENT ............................................................................................... 18

CHAPTER 4: BALANCE SHEET ......................................................................................................... 34

CHAPTER 5: CASH FLOW STATEMENT ........................................................................................ 51

CHAPTER 6: STATEMENT OF SHAREHOLDERS’ EQUITY ....................................................... 59

CHAPTER 7: RATIO ANALYSIS ........................................................................................................ 65

CHAPTER 8: LAST TWELVE MONTHS AND CALENDARIZATION ......................................... 74

CHAPTER 9: ACCOUNTING QUESTIONS & ANSWERS .............................................................. 80

iii
About the Author
Ashish Kohli is a seasoned investment banker, private equity and accounting
professional with over 20 years of transaction experience across various product
groups of accounting, valuation, investment banking and private equity. Ashish
has extensive deal experience in mergers and acquisitions, leveraged buyouts,
private placements, initial public offerings, high-yield debt offerings and
corporate restructurings.

Ashish has extensive teaching experience and has led training seminars globally
in North America, Europe and Asia in various schools including Cambridge,
London School of Economics and Oxford in Europe, and Kellogg, Columbia, NYU, Richard Ivey,
Schulich and Rotman in North America. He is a Managing Director with the Wall Street Global
Institute in New York. He is a Visiting Professor in the PGP program at the Indian School of
Business, Hyderabad and is an Adjunct Professor at NYU Tandon School of Engineering in New
York. He was formerly Director of Corporate Relations and Career Management with the Simon
Business School, University of Rochester. He was also a Career Advisor for Financial Services
and Instructor with the Richard Ivey School of Business, University of Western Ontario where he
taught financial modeling and valuation. He has conducted training programs for many Fortune
500 companies including leading the investment banking training program in New York and
London while he worked for HSBC as well as other corporations and banks including China
Merchants Securities, Deutsche Bank, Al Rajhi Bank and United Nations.

Ashish’s banking career began in the Investment Banking Division of Credit Suisse/Donaldson,
Lufkin & Jenrette in New York where he worked in the M&A, Generalist and Technology Industry
Group. The technology group was the largest technology investment banking franchise in the
world. He also worked with DLJ's private equity group, one of the largest private equity groups in
the world at that time. After Credit Suisse, Ashish worked for the Investment Banking Division of
Jefferies & Company in New York as a Generalist and in the Technology and Media Group where
he focused on capital raising, M&A advisory and restructuring and recapitalizations. One notable
deal he worked on was advising Samsonite Corporation on its recapitalization which was awarded
the 2003 U.S. Middle Market Deal of the Year by Mergers and Acquisitions Advisor.

After Jefferies, Ashish joined the Investment Banking Group of HSBC Securities (USA) Inc. in
New York where he executed M&A and capital raising transactions in industries such as Consumer
& Retail, Real Estate, Technology and Oil and Gas. He then joined ThinkPanmure in New York
as a Principal in the Investment Banking and Private Equity Division working on transactions
across various industries. Prior to investment banking, Ashish worked for Arthur Andersen in their
business advisory, audit and tax groups. Ashish earned his MBA from the Kellogg Graduate
School of Management and a Bachelor of Commerce (Honors) from Shri Ram College of
Commerce, the University of Delhi. He is a Chartered Accountant.

iv
Introduction
“Accounting is the language of business.”
– Warren Buffett

Like many others, I was drawn into the world of finance and accounting by the allure of an exciting,
fast-paced and intellectually stimulating work environment. It was a career where an individual
had the potential to be rich and powerful while still being young. I had just finished high school
when the movie Wall Street was released. Men and women, dressed impeccably in designer suits
had meetings in upscale restaurants. They flew on private jets, worked in offices with unparalleled
views and completed landmark deals that made headlines in prominent newspapers. It seemed to
be one of the few jobs where you could earn enormous professional respect and limitless
compensation at a young age. I was determined to become one of “them”, but I didn’t fully
understand what these people actually did for a living and how I could land one of those jobs.

Investment banking, trading, asset management, private equity, and hedge funds have attracted
and continue to attract some of the best and brightest talent in the world. While these are often
among the most competitive and sought-after jobs, many other excellent positions in finance and
accounting are often overlooked. Finance and accounting positions in corporations, public
accounting firms and consulting firms can be tremendously stimulating, challenging and ultimately
rewarding. Most of these roles require skills in accounting and the ability to have an in-depth
understanding of financial statements.

I teach at some of the leading undergraduate and MBA programs around the world, and I coach a
number of executives at prominent companies globally. Whether they seek their first jobs or look
to transition into a different role in finance and accounting, many of the students and professionals
I work with have similar questions when it comes to finance and accounting careers. Some of those
questions include:

• What kind of technical skills are required to get the finance and accounting positions at
these firms including banks, private equity and corporations?
• What technical skills are needed as I progress my career in these positions?
• What is the typical format for interviews at these positions?
• What academic qualifications do recruiters look for at these jobs?
• What kinds of accounting questions can be expected for the various finance and accounting
jobs, i.e., investment banking vs. equity research, vs. rotational corporate finance programs
at a corporation?

Accounting skills are one area most commonly tested for at most finance and accounting
interviews. In retrospect, as I embarked on a career path, I wish there had been a resource to provide
me with an accounting refresher and technical questions asked for various positions in finance and
accounting and how to best prepare for them. This book is that resource! It offers a comprehensive
overview of the important accounting concepts as well as a guide to help you prepare for
accounting questions asked in interviews for those jobs. This book provides many sought-after
answers to the questions described above and includes a comprehensive list of common technical
interview questions asked, and answers sought, by hiring managers and industry experts.

1
Structure of the Book

This book is meant to give you an accounting refresher, highlight the importance of understanding
the key financial statements and to prepare you for jobs on Wall Street as well as other
opportunities outside of Wall Street in finance and accounting. It is divided into two parts
summarized below:

Part One – Chapters 1-7: Overview of Accounting Concepts Required for Careers in Finance
and Accounting

Part One will assist you in understanding how to read an annual report for a public company in the
U.S. We also review the income statement, balance sheet and cash flow statement as well as look
at ratio analysis and other accounting concepts required for obtaining a career in finance and
accounting. We have provided a detailed analysis of the financial statements for Microsoft
Corporation for the fiscal year ended June 30, 2015.

Part Two – Chapters 8-9: How to Prepare for Your Dream Finance and Accounting Job

Part Two focuses on understanding concepts such as last twelve months and calendarization as
well as the various types of accounting questions asked in various finance and accounting
interviews. It concludes by giving you a comprehensive set of accounting technical questions and
answers that recruiters will ask while you are interviewing for these jobs.

I want you to benefit from my many years of working as an investment banker at some of the
leading global banks. I have led the accounting, financial modeling, valuation, mergers and
acquisition, leveraged buyouts, and other technical training programs for analysts, associates and
senior executives at some of the largest banks and corporations in the world. I have had the
opportunity to lead the recruiting efforts for these banks at some of the most prestigious schools
in North America, Europe and Asia. I have also coached thousands of individuals from various
educational and professional backgrounds. Working with them, I have discovered similarities in
what the recruiters seek and the mistakes candidates make in their interviews. My experiences
motivated me to prepare this guide to enable you to break into the finance and accounting career
of your dreams.

I believe this book will serve as a valuable resource for undergraduate and graduate students as
well as experienced professionals looking for positions in finance and accounting. I wish you luck
and the very best in the finance and accounting careers you would like to pursue.

2
Chapter 1: Introduction to Accounting
“The globalization of the economy, the explosion of technology, the complexity of
business transactions and other forces have thrust the financial system into a new
age. As the pace of economic change accelerates, so does the need for reliable and
relevant information…..”
– American Institute of Certified Public Accountants (AICPA)

AICPA defines accounting as “the art of recording, classifying, and summarizing in a significant
manner and in terms of money, transactions and events which are, in part at least of financial
character, and interpreting the results thereof.”

Importance of accounting Accounting is useful to a number of stakeholders. Shareholders and

investors use accounting information to predict future cash flows of a company and make
investment decisions. Commercial lenders such as banks use financial statement information to
see liquidity, risk and profitability of a firm and based on that decide the loan amount, interest rate
and the security that is needed for a business loan. Management uses accounting in making
operational and financial decisions as well as executive compensation contracts that are sometimes
tied to financial statement results.

Employees use accounting to help gauge the current and potential future profitability and solvency
of the company as well as to see the value of the stock options they get from the company as part
of their compensation. Customers use accounting to see whether the firm has the financial strength
to cover the warranty period of the product they are purchasing. Governments and regulators use
accounting to monitor the health of the company since governments can be a big customer of the
company. Regulators use financial information to regulate businesses such as gas and electric
companies in terms of how much these companies can charge their customers.

Generally accepted accounting principles (GAAP) Financial statements must be presented in

accordance with GAAP. In the U.S., the U.S. Congress delegates the making of the rules to the
Securities and Exchange Commission (SEC), a federal agency whose mission is “to protect
investors, maintain fair, orderly, and efficient markets; and facilitate capital formation.” The SEC
authorizes the Financial Accounting Standards Board (FASB) to determine accounting rules. The
FASB is a private-sector, not-for-profit organization based in Connecticut that establishes financial
accounting and reporting standards for public and private companies, and not-for-profit
organizations that follow GAAP in the U.S.

IFRS and U.S. GAAP There are two main standards in the world, i.e., U.S. GAAP and
International Financial Reporting Standards (IFRS) and there is a very high degree of overlap
between them. IFRS is established by the International Accounting Standards Board (IASB) which
is based in London and is used in more than 100 countries worldwide.

One of the goals of FASB is to ensure that GAAP enables standardization of preparation of
financial statements across companies. GAAP is based on certain accounting assumptions,
principles and constraints.

Accounting assumptions state how a business is organized and operates and how transactions

3
should be recorded. The key accounting assumptions are described below:

Economic entity Business transactions are kept separate from the personal transactions of the
business owner. For example, for legal purposes, sole proprietor and owner are considered one
entity while for accounting purposes, they are considered separate entities.

Accrual basis of accounting Transactions are recorded based on the accrual basis of accounting.
Revenues and expenses are recognized when earned or used and not when cash went in or out.

Going concern Company will continue to exist long enough or for an indefinite period to meet its
objectives and commitments and will not liquidate for the foreseeable future. Examples of
companies or their predecessor companies which have existed for a long period include Cigna
Corporation since 1792, Colgate-Palmolive Company since 1806, Citigroup Inc. since 1812, The
Goldman Sachs Group, Inc. since 1869 and Tata Steel Limited since 1907.

Time period or periodicity Activities of a business are reported in short intervals of time. For
example, public companies in the U.S. report quarterly and annual results.

Monetary unit Financial statements should have one monetary unit. In the U.S., the FASB accepts
the U.S. dollar as the monetary unit, unadjusted for inflation.

Accounting principles form the basis of accounting and have been developed over time. They
include:

Historical cost Assets and liabilities are recorded at cost at which they were acquired and generally
not restated for changes in value.

Revenue recognition Under accrual accounting, revenue should be recorded when earned and
measurable and not when cash is received.

Matching principle Costs should be matched to revenues. Hence, costs should be recorded in the
same period revenue is recorded. Expenses are recorded in the period they were incurred and not
when cash was paid.

Full disclosure Company should provide the necessary information to stakeholders who generally
read financial information so they can make informed decisions.

Constraints of accounting (CA) allow some variation to GAAP and these variations do not
violate GAAP in light of recognized CA.

Materiality Depending on the size of the transaction and the company, it addresses the question
if the inclusion of the financial information makes a difference to the user of the financial
statement. For example, a $1,000 expense may be immaterial to a large company with $5 billion
in revenues but material to a small company with $20,000 in revenues.

Conservatism Assets and revenues should not be overstated while liabilities and expenses should
not be understated. For example, inventory is shown at the lower of cost or market value.

Costs and benefits Companies should not require particular accounting measurements if the costs
4
of implementing them exceed the benefits accrued to users of the information.

Estimates and judgments Certain measurements cannot be performed completely accurately and
hence require estimates.

Most public companies would keep three sets of books, i.e., financial, tax and managerial
accounting books to satisfy the different users of the financial statements.

Financial accounting is the standardized set of financial statements geared towards external users
such as investors, shareholders, customers, creditors, lenders, suppliers and governmental and
regulatory authorities.

Tax accounting is the second set of books which are used to determine how much taxes the
company needs to pay. These tax rules are determined by the Internal Revenue Services (IRS), the
tax collection agency in the U.S. which administers the Internal Revenue Code enacted by the
Congress. Tax returns, to a large extent are based on financial accounting information adjusted to
conform with income tax reporting requirements.

Managerial accounting focuses on development and interpretation of accounting information for

the purpose of assisting management help operate the business. It deals with measurement and
communication of information for internal users. It provides customized reports so managers
within the organization can make informed decisions.

Managerial accounting includes margin analysis to determine profit on a particular product,

customer or store; capital budgeting to decide whether to invest or not in a particular project;
determining trends and forecast financial information as well as product costing to determine
actual costs for products and services.

Financial accounting is what we will be discussing in detail in this book and deals with providing
financial statements to external users. The four basic financial statements are:

The balance sheet is a summary of a company’s assets, liabilities and shareholders’ equity, that
is, its financial position at a specific point in time. More broadly, the balance sheet gives us the
value of a company’s resources, i.e., assets, and the value of the claims on those resources, i.e.,
liabilities and shareholders’ equity.

The income statement tells us how much money the company has earned and shows its operating
results over a given period of time, e.g. a fiscal year or a quarter using accrual method of
accounting. For example, the income statement answers the question, “How much profit has the
company made for the last three-month or 12-month period?”

The cash flow statement tells us how much cash has flowed in and out of the business over a
given period of time. It tells us opening cash, ending cash and change in cash for the specified
period. The change in cash is classified under one of three sections, namely, cash flow from
operating activities, cash flow from investing activities and cash flow from financing activities.

The statement of shareholders’ equity presents changes in equity during the reporting period. It
includes sale and repurchase of common stock, changes in retained earnings due to profits and
losses and dividend payments.
5
Notes to the financial statements accompany the financial statements and are detailed disclosures
that provide additional information to the items on the financial statements. For example, the
balance sheet will provide us with the total amount of debt but the notes to the financial statements
will give us information on the types of debt, amount and the interest rate on each type of debt.

Financial reporting requirements and responsibility Management is responsible for preparing

the financial statements. The audit committee of the board of directors provides oversight to the
management. Further, the board of directors hires an audit firm to express an opinion as to whether
the financial statements are in accordance with GAAP.

In the U.S., a public company is required by the SEC to file an annual filing called Form 10-K and
a quarterly filing called Form 10-Q. The companies are also required to file a Form 8-K if any
materially significant event happens. These events include an acquisition, board and management
changes, bank financing agreements and customer contracts. For a public company in the U.S.,
these filings are available on SEC’s EDGAR system under the “Filing and Forms” tab at
http://www.sec.gov/. Also, the filings can be found on the company website under the section
called investor relations. We will be discussing the Form 10-K and 10-Q in detail in Chapter 2.

6
Quiz for Chapter 1
Q1: Which constraints of accounting details that companies should not require particular
accounting measurements if the costs of implementing them exceed the benefits accrued to users
of the information?

• Costs and benefits

• Materiality
• Conservatism

Q2: Which statement tells us how much money the company has earned and shows its operating
results over a given period of time?

• Cash flow statement

• Statement of retained earnings
• Income statement

Q3: What are the detailed disclosures called that accompany the financial statements and provide
additional information to the items on the financial statements?

• Statement of retained earnings

• Notes to the financial statements
• Cash flow statement

Q4: Which accounting assumption details that the company will continue to exist long enough or
for an indefinite period to meet its objectives and commitments and will not liquidate for the
foreseeable future?

• Economic entity
• Time period
• Going concern

Q5: Which accounting principal details that assets and liabilities are recorded at the cost at which
they were acquired and generally not restated for changes in value?

• Historical cost
• Matching
• Revenue recognition

Q6: The International Financial Reporting Standards (IFRS) are established by which agency?

• Financial Accounting Standards Board (FASB)

• International Accounting Standards Board (IASB)
• Securities and Exchange Commission (SEC)

7
Answers to Quiz for Chapter 1
Q1: Which constraints of accounting details that companies should not require particular
accounting measurements if the costs of implementing them exceed the benefits accrued to users
of the information?

A1: Costs and benefits.

Q2: Which statement tells us how much money the company has earned and shows its operating
results over a given period of time?

A2: Income statement.

Q3: What are the detailed disclosures called that accompany the financial statements and provide
additional information to the items on the financial statements?

A3: Notes to the financial statements.

Q4: Which accounting assumption details that the company will continue to exist long enough or
for an indefinite period to meet its objectives and commitments and will not liquidate for the
foreseeable future?

A4: Going concern.

Q5: Which accounting principal details that assets and liabilities are recorded at the cost at which
they were acquired and generally not restated for changes in value?

A5: Historical cost

Q6: The International Financial Reporting Standards (IFRS) are established by which agency?

A6: International Accounting Standards Board (IASB)

8
Chapter 2: How to Read a Form 10-K
Annual Report
“We read hundreds and hundreds of annual reports every year”
– Warren Buffett answered when
asked how he became so successful in investing

A Form 10-K (10-K) annual report is required to be filed annually by publicly traded companies
with the U.S. Securities and Exchange Commission (SEC). Companies are required to file the 10-
K within 60 days1 after the close of their fiscal year. The 10-K provides valuable qualitative and
quantitative information to a number of parties including current and potential shareholders,
creditors, research analysts, suppliers and customers.

Annual reports to shareholders vs. 10-K filing SEC requires that an annual report is sent to
company shareholders before its annual shareholder’s meeting to elect members of its board of
directors. It is a marketing document with colorful pages with artwork and photographs and is
professionally prepared for the shareholders. It consists of key sections including highlights of the
company’s operations, financial performance and other things management deems appropriate. It
contains a letter to shareholders from the chairman of the board of directors as well as a section on
management discussion and analysis where management discusses and analyzes the performance
of the company. It contains a report required by Sarbanes-Oxley Act containing management’s
objective assessment of the effectiveness of the company’s internal control over financial
reporting. It also contains the opinion of the auditors, financial statements and notes to the financial
statements.

A 10-K filing contains the information found in an annual report but in more detail. Certain
companies can send the 10-K as their annual report to the shareholders and in those instances, the
annual report to shareholders and the 10-K filed with the SEC will be the same document. SEC
determines what information should be presented in the 10-K and it consists of four parts. We will
discuss the information presented in the 10-K using the 10-K filed by Microsoft Corporation
(Microsoft) for the fiscal year ended June 30, 2015, in the book.

10-K vs. 10-Q filings Companies need to also file quarterly reports with the SEC in the form of a
10-Q filing. Information filed under Form 10-Q (10-Q) is similar to a 10-K, though it is less
detailed and the financial statements are unaudited. A company needs to file only three 10-Q filings
as the information for the last quarter is included in the 10-K. 10-Q needs to be filed within 40
days after the close of the quarter.2 First quarter 10-Q consists of results of the first fiscal quarter
and also gives prior year’s quarter numbers. Second quarter 10-Q gives the quarterly numbers for
the second quarter of the fiscal year and the prior year but will also give numbers for the six months

1
Large accelerated filers, i.e. companies with a public float greater than $700 million need to file 10-K within 60 days
of close of the fiscal year. Accelerated filers, i.e., companies with public float between $75 million and $700 million
have 75 days and non-accelerated filers, i.e., companies with less than $75 million public float need to file 10-K within
90 days.
2
Large accelerated filers, i.e. companies with a public float greater than $700 million need to file 10-Q within 40 days
of close of the quarter. Accelerated filers, i.e., companies with public float between $75 million and $700 million also
have 40 days and non-accelerated filers, i.e., companies with less than $75 million public float need to file 10-Q within
45 days.
9
from the beginning of the fiscal year as well as prior year six-month numbers. Third quarter 10-Q
will give quarterly numbers for the third quarter of the fiscal year and the prior year as well as
nine-month numbers from the start of the fiscal year as well as nine-month numbers of the prior
year.

Since a public company does not file a fourth quarter 10-Q, we can refer to the 8-K which contains
the fourth quarter earnings press release for detailed information on a company’s final quarter of
the fiscal year. The 8-K is generally filed prior to the filing of the 10-K.

We describe below the important sections of the 10-K and review Microsoft 10-K for the fiscal
year ended June 30, 2015. Microsoft 10-K can be found on the investor relations section on the
website of Microsoft or can be downloaded from the SEC website.

Cover page or page 1 of the 10-K includes the fiscal year end of the company, state or other
jurisdiction of incorporation, title of each class of securities and the number of shares outstanding
of the issuer’s each class of securities.

Fiscal year end of the company can be different than the calendar year of the company though a
majority of the companies in the U.S. use the calendar year end of December 31 as their fiscal year
end. Some companies adopt a different fiscal year end than the calendar year end depending on
the nature of their business or the time they started their business. Universities generally choose a
fiscal year end of summer to align their fiscal year with the academic school year and also schools
are less busy in summer months. Retailers have their fiscal year end at the end of January or
February since at the end of December they are busy with sales. Inventories, receivables and
payables will be higher and more complex and time consuming to measure at the end of December.
For example, Facebook and General Electric Company have a fiscal year end of December 31
while Macy’s Inc has a fiscal year end of January 31.

On cover page 1 of the 10-K (page 1)3, we see that Microsoft has a fiscal year end of June 30 and
their fiscal year is July 1, 2014 to June 30, 2015.

State of incorporation More than 50% of public companies in the U.S. and 60% of Fortune 500
companies are incorporated in Delaware. Facebook, Walmart and JP Morgan are examples of
companies incorporated in Delaware. Delaware has a business friendly legal framework and has
the Delaware Court of Chancery which is speedy and inexpensive for resolving disputes for
Delaware corporations with trials by judge and not jury. Many other states are also trying to have
business friendly legal frameworks.

On page 1, we see that Microsoft is incorporated in the state of Washington. Microsoft was
incorporated in the state of Washington on June 25, 1981 and then reincorporated in the state of
Delaware on September 19, 1986 because of concerns over Washington’s business incorporation
law, especially provisions concerning the limits on liability that corporate directors can face.
Washington state updated its law allowing companies to indemnify officers and Microsoft
reincorporated in Washington on November 1, 1993.

Par value and exchange stock is listed Par value has no relation to the market value of the stock.

3
Unless specified, page numbers highlighted in the book refer to page numbers from the Form 10-K for Microsoft
Corporation for the fiscal year ended June 30, 2015.
10
It is the lowest possible price at which a company could issue stock. Some U.S. states do not allow
corporations incorporated in the state to issue no-par stock. In these states, stock’s par values are
often extremely low relative to the trading value of the shares and it can be .001, .01 or .1 cents.
In the U.S., the two main stock exchanges are the New York Stock Exchange (NYSE) and Nasdaq.
NYSE is larger than Nasdaq in terms of market capitalization of all companies listed on the
exchange but Nasdaq has more technology companies listed on the exchange including the top 5
companies by market capitalization in the U.S. as of October 24, 2017, 4 i.e., Apple,
Alphabet/Google, Microsoft, Facebook and Amazon.

On page 1, we see that Microsoft has a par value of $0.00000625 per share. Microsoft is listed on
the Nasdaq stock exchange.

Classes of shares and shares outstanding Cover of the 10-K provides details on the various
classes of shares outstanding. Most companies have one class of common shares but some
companies may have more than one class of common shares with different voting shares. For
example, Facebook has two classes of common shares, i.e., class A shares that have one vote and
class B shares which are owned by insiders including founder Mark Zuckerberg and have ten votes.
Having two classes enables the founder and investors holding the shares with ten votes to control
the company even if their ownership is less than investors holding shares with one vote.

Microsoft has one class of common shares and on page 1, it details “As of July 27, 2015, there
were 7,997,980,969 shares of common stock outstanding.” It should be noted that the shares
outstanding on the cover page are the shares as of the latest practicable date which is the filing
date and not the fiscal year end date of June 30, 2015.

Part 1 of the 10-K The 10-K is divided into four parts and each part is further subdivided into
individual items. Part 1 describes the business of the company, its risk factors as well as a
description of the company’s property and legal proceedings.

Item 1: Business This section describes the business of the company, including its main products
and services. It provides details on segments, if any, the business operates in, subsidiaries, if any
the company has and markets the company operates in. It provides details on customers of the
company and customers accounting for over 10% of revenue need to be highlighted. It includes
details on competition the company faces as well as regulations that apply to it.

Microsoft operates in six segments and the competitors in each segment are mentioned in the
business section. On page 16 it says “No sales to an individual customer accounted for more than
10% of fiscal year 2015, 2014, or 2013 revenue”

Item 1A: Risk factors Information about the most significant risks faced by the company or its
securities are highlighted in this section. This section focuses on the risk itself and not on how the
company is addressing those risks. Some risks may focus on the economy, while others may apply
to the company’s industry sector or geographic region and some may be unique to the company.

Microsoft has listed a number of risk factors in pages 18 to 26. These include risk from competition
across its products and services which may lead to lower revenue or margins, execution and
competitive risk from increased focus on cloud-based and other services, risk from acquisitions,

4
Source: https://www.cnbc.com/2017/03/08/the-top-10-us-companies-by-market-capitalization.html
11
joint ventures and strategic alliances as well as possible additional tax liabilities.

Item 1B: Unresolved staff comments If the company receives written comments from the SEC
staff regarding its periodic or current reports not less than 180 days before the end of its fiscal year
and these comments remain unresolved, the company needs to disclose any comments it deems
material.

Microsoft has no unresolved comments for that period. On page 26, Microsoft mentions “We have
received no written comments regarding our periodic or current reports from the staff of the SEC
that were issued 180 days or more preceding the end of our fiscal year 2015 that remain
unresolved.”

Item 2: Properties This section provides details on the company’s properties including plants,
mines and other material physical assets.

On page 26 and 27, Microsoft provides details of its owned and leased properties in the U.S. and
internationally in various countries.

Item 3: Legal proceedings This section requires the company to provide information on
significant pending lawsuits or other legal proceedings, other than ordinary litigation.

Microsoft provides details on these legal proceedings under Note 18 of its notes to financial
statements in the 10-K on page 27.

Item 4: Mine safety disclosures Companies need to include a brief statement that the information
concerning mine safety violations is included in an exhibit to 10-K.

For Microsoft, on page 27, it says that it is “Not applicable.”

Part II of the 10-K includes selected financial data for the last five fiscal years, management’s
discussion and analysis of company’s operating results and its liquidity and the audited
consolidated financial statements of the company.

Item 5: Market for registrant’s common equity, related stockholder matters and issuer
purchases of equity securities The company is required to disclose the U.S. markets on which its
common stock is traded, approximate number of shareholders on record, high and low share prices
for each quarter for the last two years, frequency of cash dividend declared over the last two fiscal
years and restrictions on dividends in the future. Share repurchased by the company also need to
be disclosed.

On page 28, Microsoft details “Our common stock is traded on the NASDAQ Stock Market under
the symbol MSFT. On July 27, 2015, there were 109,479 registered holders of record of our
common stock.” Its 52-week high and low stock price for fiscal 2015 was $50.05 and $40.12
respectively and for fiscal year 2014 it was $42.29 and $30.84. Detailed information on dividends
and share repurchases is given in Note 19 on page 88 and 89 and Microsoft repurchased
93,640,226 shares in the last quarter of fiscal 2015.

Item 6: Selected financial data The company should provide certain financial information for the
last five fiscal years. Data includes net sales, income (loss) from continuing operations, income
12
(loss) from continuing operations per common share, total assets, long-term obligations (such as
long-term debt, capital leases and redeemable preferred stock) and cash dividend declared per
common share. The company should identify and disclose items that might affect comparability
among the years.

Microsoft provides the above data for the last five fiscal years from 2011 to 2015 on pages 28 and
29. In the notes to financial statements, it also provides items such as goodwill and asset
impairment, purchase of NDS and fine imposed by European Commission which affected results
of certain fiscal years.

Item 7: Management’s discussion and analysis of financial condition and results of

operations (MD&A) allows company management to tell its story in its own words. It is a very
important section and should be read in conjunction with the financial statements and notes to
financial statements. It provides management’s assessment of the company’s financial and
operational results including reportable segments and sub-divisions of the business, as appropriate.
Management discusses material changes in line items of the consolidated financial statements from
prior-period amounts. The discussion usually covers the recent three fiscal years with year-to-year
comparisons, i.e., 20Y2 vs. 20Y1 and 20Y1 vs. 20Y0. It also provides non-recurring charges or
gain that are one time in nature. It has a section on liquidity and capital resources where the
company discusses its ability to meet its cash requirements on a short-term, i.e., 12 months or less
or long-term, i.e., more than 12-months basis. Management should highlight the key business risks
and what they are doing to mitigate them as well as highlight off-balance sheet arrangements and
contractual arrangements.

On pages 29 onwards, Microsoft provides highlights of the fiscal year 2015. It discusses each of
its business segments results and provides a discussion of comparison of fiscal year 2015 to fiscal
year 2014 and then fiscal year 2014 to fiscal year 2013 for these segments. It provides details on
its off-balance sheet commitments and contractual obligations on page 45.

Item 7A: Quantitative and qualitative disclosures about market risk The company should
provide information about its exposure to market risk, such as interest rate risk, foreign currency
exchange risk, commodity risk or equity price risk. It may discuss how it manages its market risk
exposures.

Microsoft provides information on page 51 about these various risks and also discusses how it
uses value-at-risk (VaR) to estimate and quantify its market risks.

Item 8: Financial statements and supplementary data The company must include audited
balance sheets for two years and statements of income, comprehensive income and cash flows for
three years of the registrant and its predecessors. It must also include disclosures of changes in
shareholders’ equity and noncontrolling interests for each period an income statement is required,
which may be included as a financial statement or in the notes. The financial statements are
followed by the notes to the financial statements that explain the information presented in the
financial statements. Sarbanes-Oxley Act of 2002 requires the company’s CEO and CFO to certify
that the 10-K is both accurate and complete.

Microsoft provides income statements, comprehensive income and cash flow statements for the
fiscal year ended 2013, 2014 and 2015 on page 53, 54 and 56. It also provides balance sheet for
fiscal year ended June 30, 2015 and June 30, 2014 on page 55. Notes to financial statements start
13
from page 58.

Item 9: Changes in and disagreements with accountants on accounting and financial

disclosure If the company had changed accountants and had any disagreements with them, that
needs to be discussed in this section.

It is not applicable to Microsoft and it says “Not applicable” on page 99.

Item 9A: Controls and procedures section includes information about the company’s disclosure
controls and procedures and its internal control over financial reporting.

Microsoft mentions that it has evaluated the effectiveness of its disclosure controls and procedures.
It details on page 99 that “Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer have concluded that these disclosure controls and procedures are effective.”

Item 9B: Other information includes any information during the fourth quarter of the year
covered by the 10-K that was required to be reported on a different form, but was not yet reported.

For Microsoft, it mentions on page 101 that it is “Not applicable.”

Part III consists of disclosures regarding directors, executive officers, corporate governance,
executive compensation, the beneficial ownership of management and certain large shareholders.
It also provides disclosures on related parties transactions, director independence and accounting
fees and services.

Item 10: Directors, executive officers and corporate governance includes information on the
experience and background of the company’s directors and executive officers. Disclosure about
committees of the board of directors including audit committee and the company’s code of ethics
should also be made here or incorporated by reference if they were made in a proxy statement filed
within 120 days of the fiscal year-end.

On page 101, Microsoft details “A list of our executive officers and biographical information
appears in Part 1, Item 1 of this Form 10-K. Information about our directors may be found under
the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of
Shareholders to be held on December 2, 2015….That information is incorporated herein by
reference. It also has adopted the Microsoft finance code of professional conduct (finance code of
ethics) and is publicly available on its website at www.microsoft.com/investor/msfinancecode.

Item 11: Executive compensation includes detailed disclosure about the compensation policies
and programs of the company. It also needs to disclose how much compensation was paid to the
top executive officers of the company in the past or incorporated by reference.

On page 101, Microsoft details that the information is presented in the proxy statement and
incorporated by reference in the 10-K.

Item 12: Security ownership of certain beneficial owners and management and related
stockholder matters Shares owned by the company’s directors, officers and certain large
shareholders and shares covered by equity compensation plans are required to be disclosed.

14
On page 101, Microsoft discloses the information in the proxy statement and incorporates that by
reference in the 10-K.

Item 13: Certain relationships and related transactions, and director independence includes
information about the relationships and transactions between the company and its directors,
officers and their family members. It also includes information about whether each director of the
company is independent. Independent director is a director that does not have a material
relationship with the company or related persons, except the director sitting fee they get from the
company.

On page 101, Microsoft provides this information in the proxy statement and incorporates that by
reference in 10-K.

Item 14: Principal accountant fees and services includes fees paid to the accounting firm for the
various types of services for the year.

On page 101, Microsoft provides this information in the proxy statement and incorporates that by
reference in 10-K.

Part IV of the 10-K lists the financial statements and schedules required to be filed in Part II,
along with exhibits required to be filed with the SEC.

Item 15: Exhibits, financial statement schedules includes exhibit index that will list all
agreements and documents that have been filed with the SEC. Many exhibits are required,
including documents such as the company’s bylaws, copies of its material contracts, and a list of
the company’s subsidiaries.

On page 102, Microsoft provides a list of exhibits and also highlights that the financial statements
filed under Item 8 of the 10-K are indexed in this section.

We see that this is the last component of the 10-K and the report is signed by the key officers of
Microsoft on page 106 including Satya Nadella, Director and Chief Executive Officer; Amy
Hood, Executive Vice President and Chief Financial Officer (Principal Financial Officer); and
Frank Brod, Corporate Vice President, Finance and Administration; Chief Accounting Officer
(Principal Accounting Officer).

15
Quiz for Chapter 2
Q1: A public company files a 10-K annually and a 10-Q quarterly. How many total numbers of
10-K and 10-Q’s does a company file in a year?

• 4
• 5
• 6

Q2: Large accelerated filers i.e., companies with a float greater than $700 million need to file the
10-K within how many days?

• 30
• 45
• 60

Q3: Risk factors are included in which part of the 10-K?

• Part 1
• Part II
• Part III

Q4: MD&A section will not generally talk about

• Material changes in line items of the consolidated financial statements from prior-period
amounts. Discussion usually covers the recent three fiscal years with year-to-year
comparisons, i.e., 20Y2 vs. 20Y1 and 20Y1 vs. 20Y0
• Non-recurring charges or gain that are one time in nature
• Bios of the management team of the company

Q5: Basic shares outstanding of a public company can be found generally from the

• Front page of the 10-K or 10-Q whichever is more recent

• MD&A section of 10-K
• Part III of the 10-K

Q6: Second quarter of the 10-Q will generally give income statement numbers for which
period(s)?

• Six months of the fiscal year only

• Second quarter three month numbers only
• Second quarter three month numbers as well as first six months of the fiscal year numbers
as well as second quarter of the prior year and first six months of the prior year numbers

16
Answers to Quiz for Chapter 2
Q1: A public company files a 10-K annually and a 10-Q quarterly. How many total numbers of
10-K and 10-Q’s does a company file in a year?

A1: 4. A company needs to file only three 10-Q filings as the information for the last quarter is
included in the 10-K, so a company will file 3 10-Q’s and 1 10-K.

Q2: Large accelerated filers i.e., companies with a float greater than $700 million need to file the
10-K within how many days?

A2: 60. Accelerated filers, i.e., companies with public float between $75 million and $700 million
have 75 days and non-accelerated filers, i.e., companies with less than $75 million public float
need to file 10-K within 90 days.

Q3: Risk factors are included in which part of the 10-K?

A3: Part 1

Q4: MD&A section will not generally talk about

A4: Bios of the management team of the company.

Q5: Basic shares outstanding of a public company can be found generally from the

A5: Front page of the 10-K or 10-Q, whichever is more recent.

Q6: Second quarter of the 10-Q will generally give income statement numbers for which
period(s)?

A6: Second quarter three month numbers as well as first six months of the fiscal year numbers as
well as second quarter of the prior year and first six months of of the prior year numbers.

For example, for a company whose fiscal year end is December 31, 2016, second quarter ended
June 30, 2016 10-Q will give income statement numbers for the 3-month period April 1, 2016 to
June 30, 2016, 6-month period January 1, 2016 to June 30, 2016, 3-month period April 1, 2015 to
June 30, 2015 and 6-month period January 1, 2015 to June 30, 2015.

17
Chapter 3: Income Statement
“The buyer is entitled to a bargain. The seller is entitled to a profit. So there is a fine
margin between where the price is right. I have found this to be true to this day
whether dealing in paper hats, winter underwear or hotels”
– Conrad Hilton

The income statement measures a company’s profit or loss for a specific period of time. The time
period can be a year, quarter or any other period chosen by the business. The income statement is
also called the profit and loss statement, statement of operations or statement of earnings. A simple
income statement and its major components are described below.

We will also analyze the income statement of Microsoft in its 10-K for the fiscal year ended June
30, 2015. The income statement for Microsoft is given at the end of this Chapter 3.

Revenues are the proceeds from the sale of goods produced and services rendered by a company
in the normal course of its business for a specific period. The period a public company reports
revenues to its shareholders’ is 3, 6, 9 and 12 months but the company will also make monthly and
other reports for internal use. Revenues are also called sales and revenues adjusted for merchandise
returns and discounts or allowances on sales is called net revenues or net sales.

Not all income earned by a company is revenues, for example, for a car manufacturing company
sales of cars would be shown as revenues but income earned from investments or a legal settlement
will be shown as other income and not as revenues. Revenue is different from when cash was
received, for example, a company may have sold products to customers on credit and not yet
received the cash and hence, it will show the revenues from the sale even though cash has not yet
been received. It is recognized when it is realized and earned which is typically when products
18
sold have been transferred or service has been rendered.

Microsoft has revenues of $93,580, $86,833 and $77,849 million for the years 2015, 2014 and
2013 respectively. Revenue recognition policy of Microsoft is given in pages 58 to 60 where
Microsoft outlines how it recognizes revenues for the various products and services it sells. It says
on page 58 that “Revenue is recognized when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed and determinable, and collectability is probable. Revenue
generally is recognized net of allowances for returns and any taxes from customers and
subsequently remitted to government authorities.”

A company could have a lot of revenues but still may not be making a profit if its expenses are
high and hence we will discuss expenses including cost of goods sold, selling general and
marketing expenses below. We need to deduct the expenses and taxes to determine net profit of
the company.

Cost of goods sold (COGS) are the direct costs attributable to the production of the products sold
or service rendered by the company. They are also referred to as cost of sales for a manufacturing
company or cost of revenues for a service company. They include costs directly associated with
the revenues and include direct labor costs for workers who produce the goods, material and
product costs and allocated factory overheads.

In a service business, cost of revenue includes labor, payroll taxes and benefits of the employees
who generate the revenues. For a retailer or wholesaler, COGS would include cost of the
merchandise bought from a manufacturer. COGS includes both variable costs like direct material
costs as well as fixed costs such as factory overhead and part of direct labor costs since some staff
is required in the plant irrespective of the amount of goods sold. Fixed costs include rent, insurance
expense, depreciation and salaries and do not vary with the output. Variable costs include direct
material costs and sales commission and vary directly with output, i.e., for example, if material
cost is $5 for making one product, then it will be $20 for making four products.

Microsoft has cost of revenues of $33,038, $27,078 and $20,385 million for the years 2015, 2014
and 2013 respectively. It details out its cost of revenues on page 60. “Cost of revenues includes:
manufacturing and distribution costs for products sold and programs licensed; operating costs
related to product support service centers; costs incurred to include software on PCs sold by
OEMs, to drive traffic to our websites, and to acquire online advertising space; incurred to support
and maintain Internet-based products and services, including data center costs and royalties;
warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting
services; and the amortization of capitalized software development costs. Capitalized software
development costs are amortized over the estimated lives of the products.”

Gross profit is the difference between revenues or net revenues minus cost of goods sold. Some
companies call gross profit as gross margin, though gross margin generally refers to gross profit
margin expressed in percentage terms, i.e., gross profit divided by revenues.

Microsoft labels gross profit as gross margin in its income statement and had gross margin of
$60,542, $59,755 and $57,464 million for the years 2015, 2014 and 2013 respectively.

Operating expenses are expenses incurred by a company as a result of performing its normal
business activities. These include selling, general and administrative expenses, research and
19
development expenses, depreciation and amortization of long-lived assets, amortization of
goodwill and impairment of goodwill, impairment of long-lived assets as well as restructuring
expenses. Companies will typically report the line items separately which are material, i.e., they
could influence the economic decisions of the users. We have discussed these operating expenses
below.

Selling, general and administrative expenses (SG&A) includes the sum of all direct and indirect
selling expenses as well as all general and administrative expenses of the company. Direct selling
expenses include salespeople commission and delivery charges and occur only when the product
is sold. Indirect selling expenses occur throughout the manufacturing process when the product is
completed and include salaries of salespeople and product advertising and promotion expenses.
Selling expenses are both variable and fixed with salesman commission as an example of variable
cost and manager’s salary an example of fixed selling costs.

General and administrative expenses are more fixed costs and include salaries of employees, rent
of buildings, utilities and depreciation expense. All these will exclude expenses related to product
manufacturing or sales. Some companies like Microsoft will show sales and marketing expenses
separately from general and administrative expenses in its income statement while other
companies will combine all expenses under SG&A.

Microsoft has sales and marketing expenses of $15,713, $15,811 and $15,276 for the years 2015,
2014 and 2013 respectively. Microsoft details its sales and marketing expenses on page 60. “Sales
and marketing expenses include payroll, employee benefits, stock-based compensation expense,
and other headcount-related expenses associated with sales and marketing personnel and the costs
of advertising, promotions, trade shows, seminars and other programs. Advertising costs are
expensed as incurred. Advertising expense was $1.9, $2.3, and $2.6 billion in fiscal years 2015,
2014 and 2013, respectively.”

Microsoft has general and administrative expenses of $4,611, $4,677, and $5,013 million for the
years 2015, 2014 and 2013 respectively. Microsoft details its general and administrative expenses
on page 40. “General and administrative expenses include payroll, employee benefits, stock-based
compensation expense, severance expense and other headcount-related expenses associated with
finance, legal, facilities, certain human resources and other administrative personnel, certain
taxes, and legal and other administrative fees.”

Depreciation and amortization (D&A) Companies are required to disclose the total depreciation
and amortization expense in their income statements either as a separate line item, if material or
part of COGS and/or SG&A in the income statement.

Depreciation is the allocation of costs of the fixed asset purchased over the useful life of an asset.
Since assets such as plant and machinery, buildings and furniture are used for more than one year,
all their cost should not be allocated to the income statement for the year they were purchased.
Land is not depreciated since it is assumed to have an infinite useful life.

Amortization is the allocation of the costs of acquiring an intangible asset over its useful life.
Most companies use the straight line method for amortizing intangible assets with a finite life
which is similar to the straight line method of depreciation explained below. Examples of
intangible assets with finite life that are amortized are franchise fees and customer lists.

20
Depreciation is calculated using two main methods, i.e., straight line method and accelerated
depreciation method.

Straight line depreciation method allocates an equal amount of depreciation expense each period
over the useful life of the asset. It is calculated as

Straight line depreciation = Cost – Residual value

Useful life

Cost is the actual historical cost or purchase price of the fixed asset purchased including any initial
costs related to asset acquisition or use, for example, import duties on equipment purchased will
be included in the cost. Residual value or salvage value is the estimated amount a company can
sell the asset for when it disposes of the asset. Useful life is the time period the company expects
the asset purchased will be productive.

Accelerated depreciation method can be double-declining balance (DDB) (200%) method which
is the most common as well as DDB (150%) method and sum-of-the years’ digits method.
Accelerated depreciation methods recognize more depreciation in the earlier years rather than the
later years though the total depreciation expense is the same for both accelerated and straight line
methods over the useful life of the asset. DDB does not use the residual value of the asset in the
calculation but depreciation ends when the residual value has been reached.

Double-declining method uses two times the straight line rate to the declining balance.

DDB = 2 * (Cost – Accumulated depreciation)

Useful life

Some companies will disclose D&A expense as a separate line item under operating expenses if it
is a material expense and also have D&A expense included in the COGS. Certain companies
include D&A expense under SG&A and/or COGS expense and not show as a separate line item in
the income statement. D&A will be disclosed separately in the cash flow statement. If a company
excludes D&A relating to manufacturing of products or the services provided in COGS, then they
will not show gross profit unless D&A is presented as a separate line item before gross margin.

Microsoft does not detail D&A expense as a separate line item in its income statement. Microsoft
shows the total depreciation, amortization and other expenses in its cash flow statement on page
56 and the expense is $5,957, $5,212 and $3,755 million for the years 2015, 2014 and 2013
respectively. We assume D&A is included in COGS since Microsoft shows gross margin separately
as per note above and it does not detail depreciation in its notes on selling, general and
administrative expenses. In its note on property and equipment on page 63, it outlines the way it
depreciates its assets and mentions it uses the straight line method. “Property and equipment is
stated at cost and depreciated using the straight-line method over the shorter of the estimated
useful life of the asset or the lease term. The estimated useful lives of our property and equipment
are generally as follows: computer software developed or acquired for internal use, three to seven
years; computer equipment, two to three years; buildings and improvements, five to 15 years;
leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is
not depreciated.”

For amortization, on page 63, Microsoft outlines its policy on intangible assets. “All of our
21
intangible assets are subject to amortization and are amortized using the straight-line method over
their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of
intangible assets periodically by taking into account events or circumstances that may warrant
revised estimates of useful lives or that indicate the asset may be impaired.”

Earnings before interest and taxes (EBIT) is also called operating income or operating profit
is gross profit minus operating expenses of a company.

Microsoft has operating income of $18,161, $27,759, $26,764 million for the years 2015, 2014
and 2013 respectively shown in its income statement on page 53.

Interest expense is the cost of borrowing money for a specific period from banks and other lenders
such as bond investors.

Microsoft does not show interest expense separately in its income statement but combines interest
expense, dividends and interest income, net recognized gains on investments, net losses on
derivatives and net gains (losses) on foreign currency remeasurements and others as other income,
net on its income statement. On page 64, it provides a breakdown of the various components of
other income, net and also shows interest expense separately. Microsoft had interest expense of
$781, $597 and $429 million for the years 2015, 2014 and 2013 respectively.

Earnings before tax (EBT) is also called pre-tax income is calculated by subtracting all
expenses including COGS, SG&A and interest expense (net) from revenues or can be calculated
by subtracting interest expense from EBIT and adding interest income.

Microsoft calls earnings before income tax as income before income tax on its income statement
on page 53 and has income before income tax of $18,507, $27,820 and $27,052 million for the
years 2015, 2014 and 2013 respectively.

Provision for income taxes is the amount of income tax expense that a company recognizes for a
period to be paid to the government for taxes on its profits. This is calculated by taking the income
of a company and adjusting it for a variety of permanent and temporary differences and then
multiplying by the applicable income tax rate. The amount of income tax expense will generally
not match up with the standard tax rate on business income due to differences between income
reported under GAAP and income reported for tax purpose. For example, companies can use
straight line depreciation for GAAP reporting but use accelerated depreciation for government tax
purposes hence taxable income will be less than the one reported under GAAP.

Microsoft has provision for income tax of $6,314, $5,746 and $5,189 million for years 2015, 2014
and 2013 respectively on page 53 in its income statement. On page 80, Microsoft details the
components of various taxes that include U.S. federal taxes, U.S. state and local taxes, foreign
taxes and deferred taxes.

Net income is calculated by subtracting the income tax expense from EBT.

Microsoft has net income of $12,193, $22,074 and $21,863 million for the years 2015, 2014 and
2013 respectively on page 53 of its income statement.

22
We will now add a few more line items to the income statement shown above and explain those
line items below.

We explain some of the other line items we added to the table above.

Research and development expenses (R&D) Companies in certain industries such as

biotechnology, technology and industrials have high R&D expenses. R&D costs are expensed as
they are incurred. If the amount of R&D expense is not material, the expense is shown under
SG&A expense in the financial statement and if it is material, it is shown as a separate line item

23
on the income statement.

Microsoft shows research and development expenses separately on its income statement on page
53 of $12,046, $11,381 and $10,411 million for the years 2015, 2014 and 2013 respectively. On
page 60, Microsoft explains what constitutes the R&D expense. “Research and development
expenses include payroll, employee benefits, stock-based compensation expense, and other
headcount-related expenses associated with product development. Research and development
expenses also include third-party development and programming costs, localization of purchased
software code and services content. Such costs related to software development are included in
research and development expenses until the point that technological feasibility is reached, which
for our software products, is generally shortly before the products are released to manufacturing.
Once technological feasibility is reached, such costs are capitalized and amortized to cost of
revenue over the estimated lives of the products.”

Other expenses can be shown separately if material or shown under SG&A. Some items which
are unusual in nature or infrequent in occurrence but not both can include gains or losses from
disposal of a portion of a business segment, impairment of long-lived assets and restructuring
charges. These are shown pre-tax as a single line item and are a component of income from
continuing operations.

Impairment of long-lived assets is included in SG&A or presented separately on the income

statement, if material. Long-lived assets are non-current assets that provide a company with a
future economic benefit more than a year. They include property, plant and equipment,
investments in securities of another company and goodwill. An impairment loss happens when the
carrying amount of a long-lived asset is not recoverable and is more than the fair value of the asset.
The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the
undiscounted cash flows expected to result from the use of the asset over its remaining useful life.

Restructuring charges and related asset impairment charges are required to be shown as a
component of income from continuing operations and separately disclosed, if material.
Restructuring charges are non-recurring one-time charges and include employee severance pay
during layoffs, write-down of assets, integration of acquired companies and closure of
manufacturing facilities.

Microsoft shows impairment, integration, and restructuring expenses of $10,011, $127 and $0
million for years 2015, 2014 and 2013 respectively in its income statement on page 53. On page
77, Microsoft explains its goodwill impairment. “We test goodwill for impairment annually on
May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-
based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow
approach is the most reliable indicator of the fair values of the businesses. Upon completion of
the annual testing on May 1, 2015, Phone Hardware goodwill was determined to be impaired…...
No other instances of impairment were identified in our May 1, 2015 test. No impairment of
goodwill was identified as of May 1, 2014.”

On page 82 and 83, Microsoft details the restructuring charges and asset impairment charges. “In
connection with the Phone Hardware Integration Plan, we incurred restructuring charges of $1.3
billion during fiscal year 2015, including severance expenses and other reorganization costs,
primarily associated with our facilities consolidation and write-down of certain assets…… In
connection with the Phone Hardware Restructuring Plan, we recorded restructuring charges of
24
$780 million during fiscal year 2015, including severance expenses and other reorganization
costs, primarily related to contractual obligations.”

“Asset impairment and Other primarily reflects activities associated with the consolidation of our
facilities and manufacturing operations, including asset write-downs of $372 million during fiscal
year 2015, as well as contract termination costs.”

Interest income is the interest a company earns from certificate of deposits, money market and
savings accounts. Sometimes, interest expense is shown net of interest income in the income
statements as interest expense (net).

Microsoft does not show interest income separately in its income statement but combines dividends
and interest income, interest expense, net recognized gains on investments, net losses on
derivatives, net gains (losses) on foreign currency remeasurements and others as other income,
net on its income statement. On page 64, it provides a breakdown of the various components of
other income, net and also shows dividends and interest income separately. Microsoft had dividend
and interest income of $766, $883 and $677 million for years 2015, 2014 and 2013 respectively.

Income from continuing operations shows the earnings after-tax a business has generated from
its operational activities and is expected to continue for several years in the future. It does not
include discontinued operations and other one-time events.

Microsoft does not show income from continuing operations since it does not have any
discontinued operations and other one-time events, net of tax.

Earnings (losses) from discontinued operations, net of tax is shown after income from
continuing operations and is reported net of tax. Discontinued operations are physically and
operationally distinct divisions of the business that the company has decided to but not yet disposed
of or has disposed of in the current year. Companies need to restate past income statements also
which included the discontinued operations to exclude the discontinued operations for
comparability with current year financials.

Microsoft does not have any discontinued operations.

Noncontrolling interest is the part of a company’s subsidiary that is not owned by the parent
company, but is owned by other investors. It is shown on the balance sheet as a separate line item
under the liabilities and equity section of the consolidated balance sheet. In the income statement,
it is subtracted from the consolidated net income and shown separately as part of the profit
attributable to noncontrolling interest shareholders. We have provided a detailed explanation of
noncontrolling interest in Chapter 9 on pages 88-90.

Microsoft does not have any noncontrolling interest in its income statement.

Basic earnings per share represents the amount of net income earned by each common share
outstanding. It is calculated by dividing the net income minus preferred share dividend, if any, by
the weighted average shares outstanding during the period.

Microsoft has basic earnings per share of $1.49, $2.66 and $2.61 for years ended 2015, 2014 and
2013 respectively as shown on page 53 of the income statement.
25
Diluted earnings per share takes into account the effect of any dilutive securities such as options
and convertible debt that could be issued by the company. It is calculated by dividing the net
income minus preferred share dividend, if any by the weighted average diluted shares outstanding
during the period.

Microsoft has diluted earnings per share of $1.48, $2.63 and $2.58 for years 2015, 2014 and 2013
respectively as shown on page 53 of the income statement.

Basic and diluted weighted shares outstanding are used to determine the company’s earnings
per share and incorporates the number of shares outstanding at the beginning plus additional shares
issued or sold during the period minus any shares which were bought back during the period.
Hence, they are the number of shares outstanding during the year, weighted by the portion of the
year they were outstanding. Dilutive shares outstanding will include common shares plus the
potential shares that may result from the conversion of other securities such as stock options,
warrants, convertible preferred stock and convertible debt to common shares.

Microsoft has basic weighted average shares outstanding of 8,177, 8,299 and 8,375 for years
2015, 2014 and 2013 respectively. Microsoft has diluted weighted average shares outstanding of
8,254, 8,399 and 8,470 for years 2015, 2014 and 2013 respectively as shown on page 53 of the
income statement.

Cash dividend declared per common share is the total dividend per share a company has
declared during the fiscal year. Generally, companies declare dividends on a quarterly basis.

Microsoft has cash dividend per common share of $1.24, $1.12 and $0.92 for years 2015, 2014
and 2013 respectively as shown on page 53 of the income statement. On page 89, Microsoft details
the quarterly dividend declared for years 2015 and 2014. We see that Microsoft declared quarterly
dividends of $0.31 quarterly adding up to an annual dividend of $1.24 for fiscal year 2015.

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is an indicator of a

company’s financial performance and cash flow. It is a non-GAAP measure. Hence, you will not
see EBITDA on the income statement of a public company, rather, you will have to calculate it.
We have explained EBITDA in detail in Chapter 9 on pages 81-82.

EBITDA is defined as:

EBITDA = Revenue
Less: Expenses (excluding taxes, interest, depreciation
and amortization)

Or

EBITDA = Operating Income or EBIT (from the income statement)

Add: Depreciation and Amortization (from the cash
flow statement)
We take depreciation and amortization from the cash flow statement because sometimes in the
income statement, depreciation and amortization may be included in COGS or SG&A or in both

26
of them and may not be broken out separately. However, D&A is always shown separately and
added back in the cash flow statement.

Microsoft has operating income of $18,161, $27,759, $26,764 million for the years 2015, 2014
and 2013 respectively shown in its income statement on page 53. Microsoft shows the total
depreciation, amortization and other expenses in its cash flow statement on page 56 and the
expense is $5,957, $5,212 and $3,755 million for the years 2015, 2014 and 2013 respectively. We
will add the D&A expense to the EBIT to get EBITDA and hence we get EBITDA of $24,118,
$32,971 and $30,519 million for the years 2015, 2014 and 2013 respectively.

Statement of comprehensive income includes net income and all the other items that have
bypassed the income statement since they have not yet realized. Net income includes changes from
business operations and sometimes companies, primarily large companies, have gains and losses
from change in the value of their assets. These changes are not shown in the net income but in
other comprehensive income statement in the income statement. Other comprehensive income /
(loss) adjustments are shown net of tax in the statement of comprehensive income.

There are four items which are included in comprehensive income and are also found in
accumulated other comprehensive income section of the statement of shareholders’ equity. They
are i) unrealized gains and losses on marketable securities under available for sale treatment from
marking marketable securities to fair value, ii) the difference between the actual pension gains and
losses and the expected pension gains and losses, iii) for derivatives and specifically cash flow
hedges, the unrealized gains and losses from marking derivatives to fair value and iv) foreign
subsidiaries assets and liabilities converted from foreign currency to domestic currency leads to
unrealized gains and losses.

Microsoft shows net income of $12,193 million for 2015 and then shows other comprehensive
income adjustments to get to comprehensive income. For 2015, these include net unrealized gains
on derivatives of $559 million, net unrealized losses on investments of $362 million and losses
from translation adjustments and others of $1,383 million for a total comprehensive loss of $1,186.

27
Microsoft Income Statement

28
Microsoft Comprehensive Income Statements

29
Quiz for Chapter 3
Q1: A company buys a machine for $60,000 and the machine has a useful life of five years and
the residual value of the machine at the end of the five years is $10,000. What would be the
depreciation expense if the company uses straight line depreciation method?

• $60,000
• $10,000
• $12,000

Q2: A company buys a machine for $60,000 and the machine has a useful life of five years and
the residual value of the machine at the end of the five years is $10,000. What would be the
depreciation expense in year two if the company uses double declining method of depreciation
expense?

• $14,400
• $20,000
• $28,800

Q3: A company’s operating income or EBIT is $10,000, depreciation and amortization which was
included in selling, general and administrative expenses are $2,000 and interest expense is $1,000.
The tax rate is 35%. What would be the EBITDA of the company?

• $8,000
• $12,000
• $7,000

Q4: On January 1, 2017, Company A purchases a franchise license for 10 years from a fast-food
restaurant chain and pays upfront franchise fees of $100,000 to the fast-food chain for the license.
How much can Company A show as an expense in their income statement for the year ended
December 31, 2017?

• $100,000
• $10,000
• $0

Q5: Which of the following below is the most appropriate classification for profit on the sale of
discontinued operations for a manufacturing firm?

• Revenue considered as part of operating activities

• Gain reported after income from continuing operations
• Gain reported before income from continuing operations

Q6: Company A has a net income of $12,000 and pays a preferred dividend of $1,000 to its
preferred shareholders. At the beginning of the year there were 10,000 shares outstanding and
2,000 more shares were issued on July 1. What be the EPS of Company A?

30
 • $11,000/11,000 or $1.00 per share
• $12,000/10,000 or $1.2 per share
• $11,000/12,000 or $0.92 per share

Q7: Company A has a net income of $12,000 and has a tax rate of 40%. Its interest expense is
$4,000 and interest income is $2,000. The company has depreciation and amortization which is
included in COGS and SG&A of $3,000. Please calculate EBITDA of Company A.

• $19,000
• $20,000
• $25,000

Q8: For a public company, should the actual amount of depreciation and amortization expense
(please note we are talking about the dollar amount of D&A and not the line item called
depreciation and amortization on the income statement)
• Always be included in the income statement
• Sometimes be included in the income statement
• Never be part of the income statement since it is shown separately in the cash flow
statement

31
Answers to Quiz for Chapter 3
Q1: A company buys a machine for $60,000 and the machine has a useful life of five years and
the residual value of the machine at the end of the five years is $10,000. What would be the
depreciation expense if the company uses straight line depreciation method?

A1: $10,000. Depreciation is purchase price of $60,000 – residual value = $10,000 divided by the
useful life of 5 years. So the answer is $50,000/5 = $10,000

Q2: A company buys a machine for $60,000 and the machine has a useful life of five years and
the residual value of the machine at the end of the five years is $10,000. What would be the
depreciation expense in year two if the company uses double declining method of depreciation
expense?

A2: $14,400

• Year 1 depreciation will be 2/5 * ($60,000 - $0) = $24,000

• Year 2 depreciation will be 2/5 * ($60,000 - $24,000) = $14,400
• Year 3 depreciation will be 2/5 * ($60,000 - $24,000 - $14,400) = $8,640
• Year 4 depreciation will be 2/5 * ($60,000 - $24,000 – $14,400 - $8,640) = $5,184 or since
depreciation is limited to when the residual value is reached of $10,000, it will be limited
to $50,000 so maximum depreciation in year 4 will be $50,000 - $24,000 - $14,400 - $8,640
or $2,960
• Year 5 depreciation will be 0 and the total depreciation will be same as straight line method
of $50,000

So in year 2 depreciation will be $14,400.

Q3: A company’s operating income or EBIT is $10,000, depreciation and amortization which was
included in selling, general and administrative expenses are $2,000 and interest expense is $1,000.
The tax rate is 35%. What would be the EBITDA of the company?

A3: $12,000. EBITDA is operating income or EBIT plus depreciation and amortization so $10,000
plus $2,000 or $12,000. Interest expense and taxes do not affect EBITDA

Q4: On January 1, 2017, Company A purchases a franchise license for 10 years from a fast-food
restaurant chain and pays upfront franchise fees of $100,000 to the fast-food chain for the license.
How much can Company A show as an expense in their income statement for the year ended
December 31, 2017?

A4: $10,000. Franchise fees are generally paid to the company you take the franchise from in
exchange for the right to use the franchise name for a certain number of years. Franchise fees are
an intangible asset and the fees paid can be expensed over the life of the franchise agreement i.e.,
10 years in this case. Hence, $100,000/10 = $10,000 can be expensed every year.

Q5: Which of the following below is the most appropriate classification for profit on the sale of
discontinued operations for a manufacturing firm?

32
A5: Gain reported after income from continuing operations. Gain/(loss) on discontinued
operations is shown net of tax, after income from continuing operations.

Q6: Company A has a net income of $12,000 and pays a preferred dividend of $1,000 to its
preferred shareholders. At the beginning of the year there were 10,000 shares outstanding and
2,000 more shares were issued on July 1. What be the basic EPS of Company A?

A6: $11,000/11,000 or $1.00 per share. Basic EPS would be net income minus preferred dividends
divided by weighted average basic shares outstanding. Weighted average shares outstanding can
be calculated as: 10,000 shares for 12 months = 120,000 plus 2,000 shares for 6 months or 12,000
divided by 12 months which is 11,000 shares. Hence, Basic EPS = ($12,000 - $1,000)/11,000 =
$1.00.

Q7: Company A has a net income of $12,000 and has a tax rate of 40%. Its interest expense is
$4,000 and interest income is $2,000. The company has depreciation and amortization which is
included in COGS and SG&A of $3,000. Please calculate EBITDA of Company A.

A7: $25,000. We will need to calculate EBIT starting from net income which will be net income
plus taxes which gives us earnings before taxes plus interest expense minus interest income. We
will add depreciation and amortization to EBIT to get EBITDA. So EBITDA will be $12,000 plus
$8,000 of taxes plus $4,000 minus $2,000 plus $3,000 equal to $25,000.

Q8: For a public company, should the actual amount of depreciation and amortization expense
(please note we are talking about the dollar amount of D&A and not the line item called
depreciation and amortization on the income statement)

A8: Always be included in the income statement. Depreciation is an expense and is always
included in the income statement. Sometimes it is shown separately in the income statement if the
amount is material and sometimes it is shown as part of either COGS or SG&A. It is always added
back in the cash flow statement since it is a non-cash charge.

33
Chapter 4: Balance Sheet
“The liabilities are always 100% good. It’s the assets you have to worry about”
– Charlie Munger

A balance sheet measures a summary of a company’s assets, liabilities and shareholder’s equity,
i.e., its financial position at a specific period of time. It gives us the value of a company’s resources,
i.e., assets, and the value of the claims on those resources, i.e., liabilities and shareholder’s equity.
In a balance sheet, assets equal to liabilities plus shareholder equity.

Assets are the company’s economic resources and include current assets and long-term assets. The
dollar amount listed for many assets do not indicate the prices at which the assets can be sold or
replaced. The balance sheet does not show how much the business currently is worth, although it
contains valuable information in being able to calculate the value of a business.

The assets are shown on the balance sheet in the order of liquidity with the most liquid assets first.
Liquidity refers to the amount of time it would usually take to convert the assets into cash. Hence,
cash would come first followed by marketable securities, accounts receivable, inventory, fixed
assets and then goodwill. We have shown below a simple balance sheet of a company highlighting
its total assets.

34
Current assets are an item on a company’s balance sheet that can be converted to cash within one
year. If the company has an operating cycle lasting more than one year, it can be a current asset if
it can be converted into cash within the operating cycle. Current assets include cash and cash
equivalents, accounts receivable, inventory and prepaid expenses and are described below.

Cash and cash equivalents include cash which is currency, coins, checks received but not
deposited, petty cash, checking and savings accounts in banks. Cash equivalents are short-term
highly liquid investments that are readily convertible to cash and they are so near their maturity
that they present insignificant risk of changes in value because of changes in interest rates.

They have a maturity period of three months or less at the time of purchase and need to be
unrestricted and available for immediate use. Examples include money market funds, U.S.
Treasury bills and commercial bills. For example, a three-month U.S. Treasury bill and a three-
year U.S. Treasury note purchased three months from maturity qualify as cash equivalents.
However, a Treasury note purchased three years ago does not become a cash equivalent when its
remaining maturity is three months.

Microsoft has cash and cash equivalents of $5,595 and $8,669 million as of June 30, 2015 and
2014 respectively on its balance sheet on page 55. On page 62, Microsoft details “We consider all
highly liquid interest-earning investments with a maturity of three months or less at the date of
purchase to be cash equivalents. The fair values of these investments approximate their carrying
values.” On pages 65 and 66, under note 4, Microsoft details the components of cash and cash
equivalent for 2015 and 2014 which includes cash, mutual funds, commercial paper, certificates
of deposit and U.S. government and agency securities.

Marketable securities are liquid and unrestricted financial instruments that are traded in a public
market and their value can be easily determined. Marketable equity and debt securities include
common shares, preferred shares, corporate and government bonds that are traded on a stock or
bond exchange and have quoted prices.

Short-term investments consist of marketable securities intended to be sold within one year or
the normal operating cycle of the company, whichever is longer. These amounts are exclusive of
amounts shown in cash equivalents. Operating cycle for a business is the average period of time it
takes the company to make an initial outlay for the cash to produce a good, make a sale and receive
cash from customers for the goods sold. Short-term investments will include short-term marketable
debt and equity securities and short-term paper. Short-term paper comprises of investments that
possess a maturity of less than 270 days such as commercial paper and U.S. Treasury bills.

Microsoft has short-term investments of $90,931 and $77,040 million as of June 30, 2015 and
2014 respectively on the balance sheet on page 55. On page 62, Microsoft details short-term
investments. “In general, investments with original maturities of greater than three months and
remaining maturities of less than one year are classified as short-term investments. Investments
with maturities beyond one year may be classified as short-term based on their highly liquid nature
and because such marketable securities represent the investment of cash that is available for
current operations.” On pages 65 and 66, under note 4, Microsoft details the components of short-
term investments for 2015 and 2014 which includes commercial paper, certificates of deposit, U.S.
government and agency securities, foreign government bonds, mortgage- and asset-backed
securities, corporate notes and bonds, municipal securities and other investments.
35
Accounts receivable are credit sales for which cash has not yet been collected. For example, a
manufacturer will have accounts receivable at its balance sheet on December 31, if it delivered
and sold a product to a customer on December 25, but not collected cash from the customer by
December 31, since the customer may be allowed 45 days to pay for the goods sold to them.

Accounts receivable are also called trade receivables since they arise in the company’s normal
trade. Nontrade receivables are loans and advances by a company to individuals and other entities.
Accounts receivable are generally due in 30 to 60 days depending on the terms offered to customers
and hence are shown as current assets. Accounts receivable are shown on the balance sheet net of
allowance for doubtful accounts. When sales are made for credit, some of the customers may not
be able to pay for the goods or services. The company that made the sale would need to account
for this expense of uncollectible money on an estimated basis in its balance sheet. For example, if
company A made a sale for $1,000 to three customers and believed that one of the customers it
made the sale to for $200 will not be able to pay for the goods it received, company A would show
net accounts receivable of $800 on its balance sheet.

Gross accounts receivable $1,000

Less: allowance for doubtful accounts 200
Net accounts receivable 800

Microsoft has accounts receivable of $17,908 and $19,544 million, net of allowance for doubtful
accounts of $335 and $301 million as of June 30, 2015 and 2014 respectively on the balance sheet
on page 55. On page 63, Microsoft details “The allowance for doubtful accounts reflects our best
estimate of probable losses inherent in the accounts receivable balance. We determine the
allowance based on known troubled accounts, historical experience and other currently available
evidence.”

Notes receivable are receivables that are supported by a formal agreement or note that specifies
payment terms. A note receivable usually carries a specific interest rate or interest rate tied to
another rate such as LIBOR and is a written promise to receive a specific amount of cash payment
from another party on one or more particular future dates. Notes payable can arise from various
circumstances such as when credit is extended to a new customer with no formal prior credit
history. Sometimes, accounts receivable that are overdue are converted into notes receivable
giving the debtor more time to make the payment and would also include a personal guarantee
from the debtor.

Microsoft does not disclose notes receivable separately and discloses notes receivable, if any
under other assets on the balance sheet on page 55.

Inventories would include three components for a manufacturing firm namely, i) raw materials
which are the goods which are consumed directly or indirectly in production, ii) work-in-process
that includes goods in the course of production and are not ready yet for sale, and iii) finished
goods which are goods that are awaiting sale. Inventory for a retailer would include only finished
goods. Inventory is shown as current assets since it is usually liquidated in a year.

Inventories can be calculated based on first-in, first out (FIFO), last-in, first out (LIFO) or weighted
average cost method. The FIFO method assumes that the oldest units available in inventory are the
first units that are sold. This means that ending inventory on the FIFO basis always consists of the
36
cost of the most recently acquired units. The LIFO method assumes that sales were made from the
most recently acquired units, therefore the ending inventory on the LIFO basis consists of the cost
of the oldest acquired units.

Under the weighted average method, we divide the cost of goods available for sale by the number
of units available for sale. Cost of goods available for sale is the sum of beginning inventory plus
net purchases. This weighted average number is used to put a cost on both ending inventory and
cost of goods sold. The weighted average method makes no assumption about the physical flow
of inventory and the cost using weighted average method comes between LIFO and FIFO if we
use this method.

Microsoft has inventories of $2,902 and $2,660 million as of June 30, 2015 and 2014 respectively
on the balance sheet on page 55. On page 63, Microsoft provides details “Inventories are stated
at average cost, subject to the lower of cost or market. Cost includes materials, labor and
manufacturing overhead related to the purchase and production of inventories. We regularly
review inventory quantities on hand, future purchase commitments with our suppliers, and the
estimated utility of our inventory. If our review indicates a reduction in utility below carrying
value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The
determination of market value and the estimated volume of demand used in the lower of cost or
market analysis requires significant judgment.” Further, note 7 on page 73 details the various
components of inventory, i.e., raw materials, work in process and finished goods.

Prepaid expenses arise when an expense is paid in advance. Examples of prepaid expense would
be prepaid insurance and prepaid rent. For example, if insurance expenses of $1,200 were paid for
twelve-month period December 1, 2016 to November 30, 2017 in advance on December 1, 2016,
and the company closes its books on December 31, 2016, it would show an asset of $1,100 as
prepaid expense, i.e., for the 11 months of insurance expense it has paid in advance.

Microsoft does not disclose prepaid expenses separately and discloses prepaid expenses, if any
under other assets on the balance sheet on page 55.

Deferred income taxes arise because of temporary differences between the timing of revenues
and expenses we recognize for tax purposes compared to financial reporting purposes. Deferred
income tax assets would arise if the company has paid taxes in advance or overpaid taxes in its
balance sheet or more income was recognized for tax purposes in the current or prior period and
will not be recognized for financial reporting purpose until some future period. For example,
allowance for doubtful debt may not be allowed to be tax deductible until the specific receivables
are declared bad debts so the taxable income and taxes paid would be more than the income
reported for financial statement purposes.

Deferred income taxes assets or liabilities will only arise due to temporary differences. There are
some permanent differences between tax and financial reporting which will never be eliminated in
the future. For example, municipal bond interest is recognized as income for financial reporting
purpose but is not taxable for tax purpose. Also, meals and entertainment expenses are only
partially allowed to be expensed for tax purposes.

Microsoft has deferred income tax asset of $1,915 and $1,941 million as of June 30, 2015 and
2014 respectively on the balance sheet on page 55. On page 81, Microsoft provides details on
deferred income taxes.
37
Other current assets are all current assets that do not include cash, marketable securities, short-
term investments, accounts receivable, inventory and prepaid expenses. Examples include cash
advances to employees and cash advances to suppliers. Sometimes, nontrade receivables and
prepaid expenses may be small and shown together under other current assets.

Microsoft has other current assets of $5,461 and $4,392 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55.

Total current assets is the sum of all the current assets such as cash and cash equivalents, accounts
receivable, inventory, prepaid expenses and deferred income tax.

Microsoft has total current assets of $124,712 and $114,246 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55.

Long-term assets are an item on a company’s balance sheet that will not turn into cash within a
year or an operating cycle of the company, whichever is longer. They include property, plant and
equipment, investment in affiliates, deferred tax assets and intangible assets. We have described
some of the key long-term assets below.

Investments are assets acquired by the company that are not directly used in the operations of the
business. They include investments in equity and debt securities of other corporations, land held
for speculation and noncurrent receivables. They are shown under noncurrent assets since the
company does not intend to convert the assets into cash in the next year or the operating cycle of
the company, whichever is longer.

Microsoft has equity and other investments of $12,053 and $14,597 million as of June 30, 2015
and 2014 respectively on the balance sheet on page 55.

Property, plant and equipment (PP&E) include land, buildings, equipment, machinery,
furniture, motor vehicles and also natural resources like mineral mines, timber tracts and oil wells.
These assets are tangible, used in the operation of the business and are long-lived, i.e., expected to
be used in more than one period. The original cost of the asset includes the purchase price of the
asset and related taxes and also the import duties, construction costs, freight and handling, site
preparation and installation costs.

Accumulated depreciation is the total depreciation expense for a fixed asset that has been charged
to the income statement since the asset was acquired and made available for use. The accumulated
depreciation of each fixed asset cannot exceed its original cost and if the asset remains in use after
its cost has been fully depreciated, its accumulated depreciation remains in the books and no more
depreciation expense is charged. If the asset is sold, the cost of the and accumulated depreciation
is removed from the accounts. PP&E is shown on the balance sheet at the original cost less
accumulated depreciation or depletion for natural resources to date. For example, if a company
had $1,000 of assets purchased and the accumulated depreciation on those assets was $200, the
PP&E would be shown as

Gross property, plant & equipment $1,000

Less: accumulated depreciation 200
Property, plant and equipment, net 800
38
Microsoft shows property, plant and equipment of $14,731 and $13,011 million, net of
accumulated depreciation of $17,606 and $14,793 as of June 30, 2015 and 2014 respectively on
the balance sheet on page 55. On page 73, Microsoft provides details of PP&E on note 8. We see
that PP&E consists of land, buildings and improvements, leasehold improvements, computer
equipment and software and furniture and equipment.

Intangible assets are assets that lack physical substance and are used in the operations of the
business with a useful life of more than one year. Intangible assets are either identifiable or
unidentifiable. Identifiable intangibles include patents, trademarks or copyrights and can be
acquired separately or are the result of rights or privileges conveyed by the owner. Unidentifiable
intangibles include goodwill and cannot be acquired separately and may have an unlimited useful
life.

Microsoft shows intangible assets of $4,835 and $6,981 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55. On page 63, Microsoft provides details on intangible
assets “All of our intangible assets are subject to amortization and are amortized using the
straight-line method over their estimated period of benefit, ranging from one to 15 years. We
evaluate the recoverability of intangible assets periodically by taking into account events or
circumstances that may warrant revised estimates of useful lives or that indicate the asset may be
impaired.”

Goodwill is the excess of the purchase price over the fair value of the identifiable net assets, i.e.,
assets minus liabilities acquired in a business combination. Goodwill is no longer amortized but
must be tested for impairment, at least annually. If there is an impairment loss, goodwill is reduced
and the loss is recognized in the income statement though there is no effect on the cash flow. If
goodwill is not impaired, it can remain on the balance sheet indefinitely.

Microsoft shows goodwill of $16,939 and $20,127 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55. Note 10 on page 76 details the changes in the
carrying amount of goodwill.

Other long-term assets would include long-term prepaid expenses and any noncurrent assets not
included in the classifications above. For example, if the company has noncurrent investments
which are small and do not warrant a separate classification, they can be grouped into other assets.

Microsoft shows other long-term assets of $2,953 and $3,422 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55.

Liabilities are obligations to other entities due to past events that are expected to require an outflow
of economic resources. Liabilities are usually listed in the order in which they are expected to be
repaid. Liabilities are classified as current liabilities and long-term liabilities. Current liabilities
are those obligations that are expected to be satisfied through the use of current assets or within
one year or the operating cycle, whichever is longer. Current liabilities include short-term debt,
current portion of long-term debt, accounts payable, notes payable, unearned revenues and accrued
liabilities.

39
We have shown below a sample balance sheet with the total liabilities and shareholders’ equity.

40
Accounts payable are obligations to suppliers of merchandise or services purchased on credit. It
is also called trade payables and includes invoices which have been approved but not yet paid.

Microsoft shows accounts payable of $6,591 and $7,432 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55.

Short-term debt is the amount of debt payable to the lender within a year or operating cycle,
whichever is longer.

Microsoft shows short-term debt $4,985 and $2,000 million as of June 30, 2015 and 2014
respectively on the balance sheet on page 55. Note 12 on page 78 explains short-term debt. “As of
June 30, 2015, we had $5.0 billion of commercial paper issued and outstanding, with a weighted-
average interest rate of 0.11% and maturities ranging from 8 days to 63 days. As of June 30, 2014,
we had $2.0 billion of commercial paper issued and outstanding, with a weighted-average interest
rate of 0.12% and maturities ranging from 86 to 91 days. The estimated fair value of this
commercial paper approximates its carrying value.”
Microsoft also details the credit facilities it has in note 12 on page 78. “We have two $5.0 billion
credit facilities that expire on November 4, 2015 and November 14, 2018, respectively. These
credit facilities serve as a back-up for our commercial paper program. As of June 30, 2015, we
were in compliance with the only financial covenant in both credit agreements, which requires us
to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation,
and amortization to interest expense, as defined in the credit agreements. No amounts were drawn
against these credit facilities during any of the periods presented.”

Current portion of long-term debt includes the principal amount of the debt that is due within a
year or operating cycle, whichever is longer. For example, if a company has a $10 million loan
outstanding which is repayable in 10 equal annual installments of $1 million for 10 years, $1
million is a current liability and shown under current portion of long-term debt and $9 million will
be shown as long-term debt.

Microsoft shows current portion of long-term debt of $2,499 and $0 million as of June 30, 2015
and 2014 respectively on the balance sheet on page 55. Note 12 on pages 78 and 79 details the
long-term debt of Microsoft including the current portion of long-term debt. It also shows the
amount of debt maturing in the next five years and thereafter.

Notes payable are written promises to pay cash at some future date and require the payment of
interest in addition to the original obligation amount. Notes payable maturing in the next year or
operating cycle, whichever is longer are shown as current liabilities and notes payable maturing
more than one year will be shown under long-term liabilities.

Unearned revenues consist of cash collected in advance prior to providing the goods and services.
It is also called unearned income, deferred revenues or deferred income. Examples of unearned
revenue would be a magazine publisher receiving subscription dues for a year in advance of
making deliveries to the customers, prepaid insurance and retainer advance paid to a lawyer prior
to starting the case.

Microsoft has short-term unearned revenues of $23,223 and $23,150 million as of June 30, 2015
and 2014 respectively on the balance sheet on page 55.

41
Accrued liabilities are obligations when expenses have been incurred but will not be paid until a
subsequent reporting period. Examples of accrued liabilities include accrued wages of employees
who have worked for certain days but only get paid at the end of the month and accrued interest
expense on loan outstanding for which interest has accrued for a month but is payable only semi-
annually.

Long-term liabilities are those obligations that are not expected to be satisfied within the next
twelve months or operating cycle whichever is longer. They include long-term notes and bonds,
lease obligations, pension obligations and deferred compensation.

Shareholders’ equity comprises of amounts invested by shareholders in a company as well as the

amounts earned by the company on behalf of the shareholders. It comprises of paid-in capital,
retained earnings, treasury stock and accumulated other comprehensive income.

Authorized, issued and outstanding shares Authorized shares are the number of shares that a
company is legally allowed to issue and is set initially by the company’s article of incorporation.
A company can increase its authorized shares at a shareholders meeting, as long as a majority of
the shareholder’s vote for an increase in shares. Issued shares are the shares that the company has
distributed to shareholders in a company and include shares sold to investors for cash as well as
shares given to employees as compensation.

Outstanding shares are the shares issued by the company that are currently held by shareholders.
It does not include treasury stock, which is the shares repurchased by the company. Outstanding
shares are used to calculate the earnings per share of a company.

Microsoft has 24 billion common shares authorized and 8.027 billion and 8.239 billion shares
outstanding as of June 30, 2015 and 2014 as given in stockholders’ equity on the balance sheet on
page 55. Microsoft details on note 19 on page 88 the shares outstanding at the beginning of the
year, issued during the year, repurchased during the year and also shares outstanding at the end
of the year. It also details the share repurchase program. “On September 16, 2013, our Board of
Directors approved a share repurchase program authorizing up to $40.0 billion in share
repurchases. The share repurchase program became effective on October 1, 2013, has no
expiration date, and may be suspended or discontinued at any time without notice. This share
repurchase program replaced the share repurchase program that was announced on September
22, 2008 and expired on September 30, 2013. As of June 30, 2015, $21.9 billion remained of our
$40.0 billion share repurchase program. All repurchases were made using cash resources.”

Paid-in capital or contributed capital reports the amount the corporation received when it issued
the stock. Capital stock includes both preferred and common stock. State laws often require that a
corporation is to record and report separately the par amount of issued shares from the amount
received that was greater than the par amount. The par value amount is credited to common stock.
The actual amount received for the stock minus the par value is credited to paid-in capital in excess
of par value.

Par value is a nominal amount such as $.01 or $.10 per share and it has no relation to the market
value of the shares. Some states still require that a company cannot sell shares in the market below
par value, hence by setting a very low amount, the company does not have issues while making
future sales. Some states have no par value also.
42
On page 1 of 10-K, we see that Microsoft has a par value of $0.00000625 per share.

Preferred stock also called preference shares or preferred shares, is a hybrid instrument having
some features or debt and equity. In the event of liquidation, they are senior in ranking to common
stock but junior to debt such as bonds, so they would get paid before common stock. Preferred
stock pay a dividend and have preference over common stock in dividend, i.e., the company must
pay the preferred dividend before paying dividend to the common shareholders though the
dividend to the preferred stockholders is not guaranteed.

Microsoft does not have preferred stock else we would have seen it on page 55 on the balance
sheet under stockholders’ equity.

Retained earnings is the accumulation of a company’s net income and losses from the date of
incorporation to the current balance sheet date minus the cumulative amount of dividends declared.

Microsoft has retained earnings of $9,096 and $17,710 million under stockholders’ equity as of
June 30, 2015 and 2014 as given in the balance sheet on page 55.

Treasury stock is stock that has been repurchased by the company and not retired. Management
may permanently retire these shares or hold them for future reissuance at a later date or a resale.
Treasury shares allow companies to raise capital quickly as they do not have to seek approval from
the company’s shareholders before selling them. They also can have the option to sell shares in
the open market through brokers when prices are high. If the company was allowed to hold shares
in treasury, those shares could be used to facilitate employee share schemes as no trust
arrangements will be necessary.

Microsoft does not show treasury stock separately under stockholders’ equity in its balance sheet
on page 55. Microsoft details on note 19 on page 88 the shares repurchased during the year and
the outstanding shares incorporate the shares repurchased already.

Accumulated other comprehensive income is not common among most companies and is a
separate line within stockholder’s equity that reports the company’s cumulative income that has
not been reported as part of net income on the income statement of the company. The items that
would be included in this line involve the income or loss involving foreign currency transactions,
hedges, pension liabilities, and the unrealized gains and losses on certain investments.

Microsoft has accumulated other comprehensive income of $2,522 and $3,708 million as of June
30, 2015 and 2014 under stockholders’ equity as given in the balance sheet on page 55. Note 20
on page 90 provides details on the accumulated other comprehensive income by different
components including derivatives, investment, translation adjustments and other.

We can discuss a few more advanced accounting items found on the balance sheet below:

Accounting for leases A lease is an agreement conveying the right to use property, plant and
equipment by the owner or lessor to the lessee usually for a stated period of time. The lease can be
a capital lease which is considered equivalent to a purchase or an operating lease which covers the
use of an asset for a period of time and is treated by the lessee as a periodic expense. FASB defines
a capital lease as a lease that transfers substantially all the benefits and risks of ownership to the
43
lessee. A lease is also considered a capital lease if it meets any of the four criteria namely i) the
lease transfers ownership of the property to the lessee by the end of the lease term, ii) the lease
contains an option to purchase the leased property at a bargain price, iii) lease term is equal to or
greater than 75 percent of the estimated economic life of the leased property, and iv) the present
value of the rental and other minimum lease payments, excluding the portion of the payments
representing executory costs, equals or exceeds 90 per cent of the fair value of the leased property.

Capital leases are also called financial leases and are shown on the balance sheet as an asset under
PP&E and also as a liability such as capital lease liability. The leased asset is shown at the
acquisition cost when there is an agreement between lessor and lessee. The amount recorded by
the lessee as an asset and an obligation under a capital lease is the present value of minimum lease
payments during the lease term. If this amount exceeds the fair value of the leased asset at the
inception of the lease, the amount recorded should be the fair value of the asset. The liability will
be treated as debt to calculate the enterprise value of the company. In the income statement, the
company is allowed to claim depreciation on the asset and an imputed interest payment on the
lease as tax deduction rather than the lease payment itself. The imputed interest payment is
computed by assuming that the lease payment is a debt payment and by apportioning it between
interest and principal.

Operating leases are not shown on the balance sheet and are a source of off-balance sheet
financing. On the income statement, the lease expense is treated as an operating expense. We can
reclassify the operating leases as capital leases and this will increase the debt shown on the balance
sheet. The operating lease payments for future years which are found in the footnotes to the
financial statements can be discounted back at a rate that reflects their status as unsecured debt.
We generally take the current pre-tax cost of debt of the company as the discount rate. This is
similar to how we discount capital leases with the difference being that the rate we use for capital
leases is at the inception of lease versus the current market rate for operating leases.

Microsoft operating lease commitments are shown on page 44 under the section off-balance sheet
arrangements. Microsoft has operating lease commitments of $863 million for 2016, $1,538
million for 2017 and 2018, $1,135 million for 2019 and 2020 and $1,617 million thereafter for a
total of $5,153 million. The note mentions “these amounts represent undiscounted future minimum
rental commitments under noncancellable facilities leases.”

On February 25, 2016, FASB issued a new accounting standard whereby all operating leases will
need to recognize the assets and liabilities for the rights and obligations created by those leases on
the balance sheet. This standard will be effective for public companies for fiscal years beginning
after December 15, 2018.

Accounting for Pensions A pension plan is when an employer makes regular payments into a
pool of funds for the benefit of its employees to plan for their retirement. Pension funds can be
defined contribution (DC) plan which are more common today and defined benefit (DB) plans that
had been more popular with larger companies earlier as well as government jobs today. Some
employers will offer both of these plans also. Between 1998 and 2015, among Fortune 500
companies, traditional DB plans offered to new employees fell from 246 companies or almost half
to approximately 5% of companies or 24 companies5.

5
“A Continuing Shift to Retirement Offerings in the Fortune 500” by Willis Towers Watson dated January 16,
2016.
44
In a defined contribution plan, the employer matches a certain amount of the contribution made
by the employee and the amount is invested as per the plan. The liability of the employer is limited
to the contribution made and the employee takes the risk of the investments made and receives the
final amount of amount invested and investment returns on retirement. 401(k) plans in companies
and their equivalent 403(b) plans in non-profits are good examples of DC plans. The amount of
contribution made by the employer is treated as compensation expense in the income statement.
Microsoft has a DC plan for their employees as described below:

On page 92, Microsoft describes their savings plan“We have a savings plan in the U.S. that
qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in
international locations. Participating U.S. employees may contribute up to 75% of their salary,
but not more than statutory limits. We contribute fifty cents for each dollar of the first 6% a
participant contributes in this plan, with a maximum contribution of the lesser of 3% of a
participant’s earnings or 3% of the IRS compensation limit for the given year. Matching
contributions for all plans were $454 million, $420 million, and $393 million in fiscal years 2015,
2014, and 2013, respectively, and were expensed as contributed. Matching contributions in the
U.S. plan are invested proportionate to each participant’s voluntary contributions in the
investment options provided under the plan.”

In January 2016, Microsoft increased their contribution to 50% of employees regular pre-tax and
Roth deferrals, up to a maximum of $9,000 from 50% of the first 6% employees deferred, to a
maximum of 3% of pay described above.

In a defined benefit plan, the employer guarantees the employee a certain amount at retirement as
an annuity based on a formula linked to pay and number of years of service. The employer takes
the risk on the investments it makes on behalf of the employee and has to make a number of
assumptions such as on the expected return on the investments it makes, increase in salaries in the
future, the life expectancy of employees and how long are they going to stay in the company.

Unfunded pension liability is a big concern in U.S. government and companies. For example,
according to data from Bloomberg, out of the 200 largest DC plans in the S&P 500 based on assets,
186 were not fully funded at the end of 2016. This led to a $382 billion funding gap for the top
200 plans with unfunded pension liability at companies such as General Electric of $31.1 billion,
Lockheed Martin at $14.8 billion, Delta Air Lines at $10.6 billion and DuPont at $8.2 billion at
the end of 2016. Unfunded pension liability is added to total enterprise value since similar to debt,
it is a claim on the company’s assets.

45
Microsoft Balance Sheet

46
Quiz for Chapter 4
Q1: A company issued shares in the market at $12.00 and recorded $0.10 par value and $11.90 as
additional paid in capital on December 31, 2015 in its balance sheet. On December 31, 2016, the
market value of the shares went up to $15.00. How will the par value and additional paid in capital
change?

• No change to par value and additional paid in capital will be up by $3.00

• No change to both par value and additional capital
• Par value and additional capital will go up by same proportion so par value will go up to
$.125 and additional paid in capital will go up to $14.875.

Q2: A company has an authorized share capital of 1,000,000 shares. It issued 500,000 shares in
an initial public offering and then issues another 200,000 shares in a follow-on offering. The
company buys back 100,000 shares as treasury stock and does not retire the stock. What will be
the issued and outstanding shares of the company?

• 1,000,000 issued and $700,000 outstanding shares

• 700,000 issued and 700,000 outstanding shares
• 700,000 issued and 600,000 outstanding shares

Q3: A company has a $10,000,000 loan from a bank which is payable in 10 years and has a
payment of $1,000,000 out of the $10,000,000 million total due payable in six months from the
date of the balance sheet. How will the debt be shown on the balance sheet?

• $1,000,000 as current portion of long-term debt in current liabilities and $9,000,000 as

long-term debt in the balance sheet under long-term liabilities
• $10,000,000 as long-term debt in balance sheet under long-term liabilities
• $1,000,000 as current portion of long-term debt in current liabilities and $10,000,000 as
long-term debt in the balance sheet under long-term liabilities

Q4: If a company receives cash before it recognizes the associated revenue, it results in what in
the balance sheet?

• Unearned revenue
• Accounts receivable
• Prepaid expense

Q5: If the company pays cash before it recognizes the expense, it is called what on the balance
sheet?

• Unearned revenue liability

• Accounts receivable
• Prepaid expense

Q6: What would be the cost of goods sold and ending inventory under FIFO method using the
data below?
47
 January 1 – Beginning inventory is 2 units @$3 = $6
January 20 – Purchase of 4 units @$4 = $16
January 25 – Purchase of 5 units @$5 = $25
Cost of goods sold available – 11 units @47
Units sold during month of January = 8 units

• $34.18 for COGS and $12.82 for ending inventory

• $37 for COGS and $10 for ending inventory
• $32 for COGS and $15 for ending inventory

Q7: What would be the cost of goods sold and ending inventory under LIFO method using the
data given in Q6 above?

• $34.18 for COGS and $12.82 for ending inventory

• $37 for COGS and $10 for ending inventory
• $32 for COGS and $15 for ending inventory

Q8: What would be the cost of goods sold and ending inventory under the weighted average
method using the data given in Q6 above?

• $34.18 for COGS and $12.82 for ending inventory

• $37 for COGS and $10 for ending inventory
• $32 for COGS and $15 for ending inventory

48
Answers to Quiz for Chapter 4
Q1: A company issued shares in the market at $12.00 and recorded $0.10 par value and $11.90 as
additional paid in capital on December 31, 2015 in its balance sheet. On December 31, 2016, the
market value of the shares went up to $15.00. How will the par value and additional paid in capital
change?

A1: No change to both par value and additional capital. Balance sheet represents the cash the
company gets. When the market value of the company stock goes up, the investors get the profits
and not the company. The balance sheet par value and additional paid-in capital do not change.

Q2: A company has an authorized share capital of 1,000,000 shares. It issued 500,000 shares in
an initial public offering and then issues another 200,000 shares in a follow-on offering. The
company buys back 100,000 shares as treasury stock and does not retire the stock. What will be
the issued and outstanding shares of the company?

A2: 700,000 issued and 600,000 outstanding shares. Outstanding shares are the shares which the
company has issued minus the shares repurchased as treasury stock by the company or the shares
that are currently held by shareholders of the company. The company originally issued 500,000
shares and then issued 200,000 more shares so total issued shares are 700,000.

Q3: A company has a $10,000,000 loan from a bank which is payable in 10 years and has a
payment of $1,000,000 out of the $10,000,000 million total due payable in six months from the
date of the balance sheet. How will the debt be shown on the balance sheet?

A3: $1,000,000 as current portion of long-term debt in current liabilities and $9,000,000 as long-
term debt in the balance sheet under long-term liabilities. The total debt of $10,000,000 is split
between current portion of long-term debt which is a current liability and $9,000,000 as long-term
debt which is a long-term liability.

Q4: If a company receives cash before it recognizes the associated revenue, it results in what in
the balance sheet?

A4: Unearned revenue liability.

Q5: If the company pays cash before it recognizes the expense, it is called what on the balance
sheet?

A5: Prepaid expense.

Q6: What would be the cost of goods sold and ending inventory under FIFO method using the
data below?

January 1 – Beginning inventory is 2 units @ $3 = $6

January 20 – Purchase of 4 units @ $4 = $16
January 25 – Purchase of 5 units @ $5 = $25
Cost of goods sold available – 11 units @ 47
Units sold during month of January = 8 units
49
A6: $32 for COGS and $15 for ending inventory. For FIFO COGS, the 8 units sold will be valued
using the units purchased first. Hence it will be 2 units @ $3 = $6 plus 4 units @ $4 = $16 plus 2
units @ $5 = $10 so it will be 8 units @ $32. Ending inventory will be 3 units @ $5 per unit = $15

Q7: What would be the cost of goods sold and ending inventory under LIFO method using the
data given in Q6 above?

A7: $37 for COGS and $10 for ending inventory. For LIFO COGS, the 8 units sold will be valued
using the units purchased last. Hence it will be 5 units @ $5 = $25 plus 3 units @ $4 = $12, so it
will be 8 units @ $37. Ending inventory will be 1 units @ $4 per unit = $4 plus 2 units @ $3 = $6
so it will be $10.

Q8: What would be the cost of goods sold and ending inventory under the weighted average
method using the data given in Q6 above?

A8: $34.18 for COGS and $12.82 for ending inventory. For weighted average method COGS, we
will value the 8 units sold at the average unit COGS available. Average unit cost = 47 divided by
11 or $4.27 per unit. Hence, COGS will be 8 units @ $4.27 = $34.18 and ending inventory will be
4 units @ $4.27 = $12.82.

50
Chapter 5: Cash Flow Statement
“Cash is king. Get every drop of cash you can get and hold onto it”
– Jack Welsh

A cash flow statement is a measure of how much cash a company has produced or spent over a
period of time. The cash flow statement summarizes the cash inflows and outflows of a company
broken down into three primary activities. We have shown below a simple cash flow statement.

51
Cash from operating activities (CFO) also called cash flow from operations or operating cash
flow results from the cash effects of transactions and events that affect net income, i.e., both
production and delivery of goods and services to customers. Operating cash flows are the cash
basis revenues and expenses for a company.

Cash from investing activities (CFI) include purchase or sale of long-term assets that are used in
the production of goods or services by a company like plant and machinery. They also include the
purchase of and sale of marketable securities, i.e., government bonds, stocks and bonds issued by
other companies, and from the acquisition and divestiture of other companies.

Cash from financing activities (CFF) results from inflows and outflows of cash resulting from
transactions affecting the firm’s capital structure. These include obtaining cash from new issues of
shares or bonds, paying dividends or buying back company’s own shares, borrowing money or
repaying amounts borrowed.

Cash flow statement can be presented in two ways, i.e., direct method or indirect method. Most
companies in the U.S. use the indirect method to present cash flow statement. Under the indirect
method, the starting point of the cash flow statement is net income and the cash flow statement
ends with closing cash balance. In cash from operating activities, net income is converted to cash
from operations by making certain adjustments to net income that affect net income but not cash.

Cash flow from operating activity (CFO) starts with net income and then we make adjustments
including for noncash charges. High growth companies such as technology start-ups will show
negative operating and investing cash flows in their early years which will most likely be financed
by stock sales shown in the financing cash flow section. As the company matures, it will have
positive operating cash flow which will help finance the investing cash flows such as acquisitions
and financing cash flows such as dividends paid to common shareholders and share repurchases.

Net income in the cash flow statement will come from the income statement.

Microsoft has net income of $12,193, $22,074 and $21,863 million as of June 30, 2015, 2014 and
2013 as given in the cash flow statement on page 56 which is similar to the net income in the
income statement on page 53.

Gains due to financing or investing cash flows such as a gain on disposal of a fixed asset such
as machinery will be accounted for in investing cash flow and needs to be taken out from operating
cash flow. Similarly, loss from disposal of a fixed asset will be added to the net income to come
to the operating cash flow and the loss will be taken into account in the investing cash flow.

For example, a company bought a machinery six years ago for $100,000 and depreciated it over
ten years using straight line method. The value of the machinery on the books at the end of year
six would be $100,000 minus accumulated depreciation of $60,000 equal to $40,000. The company
sells the machinery for $50,000 in cash and hence has a gain of $10,000. The gain is shown on the
income statement as other income and not revenues since it is not part of the core business of the
company.

The sale of machinery is an investing activity since it is not a core business activity so we need to
remove the gain from the operating cash flow and put it in the investing activity section in the cash
flow statement. Hence, we will remove the gain of $10,000 or subtract this from cash flow from
52
operations and show the total cash received of $50,000 which includes the gain in the cash flow
from investing.

Noncash charges such as depreciation and amortization are added to the net income to get to CFO
since no cash was spent on depreciation and amortization expense. In the income statement,
depreciation has been subtracted to get to net income but no cash was spent so we add it back in
cash flow statement to get to CFO.

Depreciation and amortization is added back to the cash flow statement since it is a non-cash
charge. We add it back since in the income statement it has already been subtracted to get to net
income and since no cash went out, our net income will be lower than our cash in hand.

Microsoft shows the total depreciation, amortization and other expenses in its cash flow statement
on page 56 and the expense is $5,957, $5,212 and $3,755 million for the years 2015, 2014 and
2013 respectively. Microsoft does not detail D&A expense as a separate line item in its income
statement. We assume D&A is included in COGS since Microsoft shows gross margin separately
and it does not detail depreciation in its notes on selling, general and administrative expenses.

Goodwill and asset impairment is added back to the cash flow statement since it is a non-cash
charge. In the income statement, it will be shown as a separate line item or under impairment,
integration and restructuring expenses. We have explained goodwill in detail on pages 82-83 in
Chapter 8 of the book.

Microsoft shows goodwill and asset impairment of $7,498, $0 and $0 million for the years 2015,
2014 and 2013 in its cash flow from operations and has included this amount in its impairment,
integration and restructuring expenses in its income statement. Microsoft shows impairment,
integration, and restructuring expenses of $10,011, $127 and $0 million for the years 2015, 2014
and 2013 respectively shown in its income statement on page 53 and a part of that expenses
includes goodwill and asset impairment.

Note 10 on page 76 details the changes in the carrying amount of goodwill as well as the goodwill
impairment charge. “For fiscal year 2015, a $5.1 billion goodwill impairment charge was
included in “Other”….This goodwill impairment charge was included in impairment, integration
and restructuring expenses in our consolidated income statement…..Our accumulated goodwill
impairment as of June 30, 2015 and 2014 was $11.3 billion and $6.2 billion, respectively.” It
seems that the $5.1 billion is the only goodwill impairment charge since the difference between
$11.3 billion and $6.2 billion is equal to $5.1 billion.

The asset impairment charges would be $7.5 billion minus $5.1 billion which would be
approximately $2.4 billion. Note 11 on page 77 describes certain impairment of intangible assets.
“During fiscal year 2015, we recorded impairment charges of $2.2 billion related to our Phone
Hardware intangible assets….These intangible assets impairment charges were included in
impairment, integration and restructuring expenses in our consolidated income statement.”

Stock-based compensation expense is added back to the cash flow statement since it is a non-
cash charge. Microsoft shows the expense under R&D and SG&A expenses in its income
statement.

53
Microsoft details how it measures stock-based compensation on page 60. “We measure stock-
based compensation cost at the grant date based on the fair value of the award and recognize it
as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the
stock award (generally four to five years) using the straight-line method.” On page 56, Microsoft
adds the stock-based compensation expense of $2,574, $2,446 and $2,406 million for the years
2015, 2014 and 2013 respectively to its net income in the cash flow from operations.

Changes to balance sheet operating accounts are made in CFO. Increase in operating asset
accounts or use of cash is subtracted while a decrease in operating asset accounts or sources of
cash is added. For example, if the accounts receivable balance decreases from one period to the
other, cash has been collected from customers so a decrease in accounts receivable represents an
increase in cash. If inventory increases from one period to another, cash is assumed to have been
paid for the inventory and hence cash decreases. For liabilities, if accounts payable decreases from
one period to another, it means cash has been paid to the suppliers, and hence cash will decrease
also.

We will see that the change in balance sheet numbers for current assets and liabilities often do not
equal the number in the cash flow statement. This could be due to a number of reasons. For
example, when company A acquires company B, it also acquired working capital assets and
liabilities of company B including accounts receivable. The cash paid by company A would be an
investing cash flow since all acquisitions are considered investing cash flow. The accounts
receivable acquired by company A will be shown on the balance sheet of company A but will not
show in the operating cash flow but in investing cash flow section since we would not want to
double count it.

Another example would be the effect of foreign currency translation on accounts receivable for a
multinational company with a number of subsidiaries. Foreign exchange movements will effect
the accounts receivable on the balance sheet but will not affect the operating cash flow. All the
effects of exchange rate movements on the cash flow statements are broken down in a one-line
item at the bottom of the cash flow statement. In the cash flow from operations, we see the changes
in the actual activity of the accounts receivable balances and not the effects of exchange rate
movements.

On page 55, Microsoft shows the changes in operating assets and liabilities including accounts
receivable, inventories and other current assets and liabilities. We see the accounts receivable
goes down $1,636 million from $19,544 million in 2014 to $17,908 million in 2015. If accounts
receivable goes down from one period to the other, cash should go up and we see that cash is
going up in the cash flow section under accounts receivable by $1,456 million and not $1,636
million, i.e., the change in the balance sheet. This could be due to a number of reasons described
above including foreign currency translation.

Interest and dividends received on investments and interest paid on debt Under U.S. GAAP
all of these are shown as cash from operations to maintain comparability between income
statement and cash flow statement. Under the IFRS, they can be shown as operating, investing or
financing cash flow as long as the company is consistent in how it shows them. Some analysts and
investors reclassify interest received under investing cash flows and interest on debt paid as
financing cash flow.

Cash flow from investing activities is the second section in the statement of cash flows after CFO
54
and details the cash flow related to the acquisition and disposal of company’s long-term
investments such as PP&E, investments in subsidiaries and associates. It includes cash payments
to acquire or construct long-term fixed assets such as PP&E and purchases of bonds and stock of
other companies as subsidiaries, associates or joint ventures. It also includes cash received from
the sale of fixed assets such as PP&E and intangible assets such as copyrights and trademarks as
well as cash received from the sale of bonds and stocks of other companies.

Cash flow from financing activities is the third section in the statement of cash flows after CFI
and details the cash inflow and outflow related to the company’s capital structure. Cash inflows
relate to cash received by the company by issuing stock or bonds while cash outflows include cash
used to repurchase shares, pay down principal amount of debt and interest payments on the debt
as well as dividends paid to shareholders.

Interest and dividends paid Under U.S. GAAP, interest paid on the debt will be shown under
cash from operating activity to maintain comparability between income statement and cash flow
statement. Dividends paid will be shown under cash flow from financing activity. Under the IFRS,
both of these can be shown as operating, investing or financing cash flow as long as the company
is consistent in how it shows them. Some analysts and investors reclassify interest paid under
financing cash flows and can find that information since companies need to disclose cash paid for
interest on the financial statements.

On page 64, Microsoft provides a breakdown of the various components of other income, net and
also shows interest expense separately. Microsoft had interest expense of $781, $597 and $429
million for the years 2015, 2014 and 2013 respectively.

55
Microsoft Cash Flow Statement

56
Quiz for Chapter 5
Q1: Which of the following is most likely a source of cash for the company?

• An increase in inventory
• A decrease in accounts payable
• An increase in wages payable

Q2: Which of the following is most likely a use of cash for the company?

• An increase in inventory
• An increase in accounts payable
• A decrease in accounts receivable

Q3: Sale of land would be classified as

• Operating cash flow

• Investing cash flow
• Financing cash flow

Q4: A company issuing bonds would be classified as

• Operating cash flow

• Investing cash flow
• Financing cash flow

Q5: Under U.S. GAAP, interest paid on debt and interest received on investments would be shown
under which section of the cash flow statement?

• Operating cash flow

• Investing cash flow
• Financing cash flow and investing cash flow

Q6: A technology start-up company would most likely have which cash flows negative?

• Financing cash flow and operating cash flow

• Operating cash flow and investing cash flow
• Investing cash flow and financing cash flow

57
Answers to Quiz for Chapter 5
Q1: Which of the following is most likely a source of cash for the company?

A1: An increase in wages payable is a source of cash. An increase in inventory and decrease in
accounts payable is a use of cash.

Q2: Which of the following is most likely a use of cash for the company?

A2: An increase in inventory is a use of cash. An increase in accounts payable and a decrease in
accounts receivable is a source of cash.

Q3: Sale of land would be classified as

A3: Investing cash flow.

Q4: A company issuing bonds would be classified as

A4: Financing cash flow.

Q5: Under U.S. GAAP, interest paid on debt and interest received on investments would be shown
under which section of the cash flow statement?

A5: Operating cash flow to maintain comparability of income statement with cash flow statement.
Some analysts and investors will reclassify interest paid on debt as financing cash flow and interest
received on investments as investing cash flows.

Q6: A technology start-up company would most likely have which cash flows negative?

A6: Operating cash flow and investing cash flow. A start-up would most likely not be making
money from operations in the early stages but would need to spend on equipment and other capital
expenditures. It will finance both it’s operating and investing cash flow from the sale of shares
which would be part of financing cash flow.

58
Chapter 6: Statement of Shareholders’
Equity
“I believe non-dividend stocks aren’t much more than baseball cards. They are worth
what you can convince someone to pay for it”
– Mark Cuban

Statement of shareholders’ equity provides details on the changes within the equity section of the
balance sheet over a period of time. The report includes changes to the common stock, retained
earnings, treasury stock and accumulated other comprehensive income.

The report can be set up in two ways. One way would be to show at the top the beginning balance
for each component of equity followed in the middle by the addition and subtractions from the
beginning balances. In the bottom, the balance at the end would be showing affected by the
additions and subtractions. Another way to show will be to show total shareholders’ equity at the
top from all the sources and then in the middle showing all the adjustments including additions
and subtractions. It will end with total shareholders’ equity at the bottom.

Common stock, additional paid-in capital and treasury stock would start with the opening
balance from the balance sheet of the prior period, and will be adjusted for the common stock
issued for the period, common stock repurchased and stock-based compensation expense to get
the closing balance at the end of the period.

Retained earnings beginning balance will come from the balance sheet of the prior period and
the net income will be added and losses subtracted from retained earnings. Dividends paid will be
subtracted and some effects of stock-based compensation will be included as well as the common
stock repurchased by the company to get the closing retained earnings.

Dividends are not mandatorily required to be paid by companies but once a company declares a
dividend, it is legally required to pay it to its shareholders as of the record date. There are four
main dates with respect to the dividend paid. Declaration date is the date the company declares
that it will pay a dividend to all the shareholders as of the record date which could be, for example,
20 days or 15 days from the declaration date. Record date is the date on which the shareholders
must have held the shares to be entitled to receive the dividend. If the shareholder sells their shares
after the record date, they will still be entitled to receive the dividend.

Payment date is the date the dividend is paid by the company. The ex-dividend date is usually one
to three business days before the date of record based on stock exchange rules. Generally, it takes
three days for the company to record the transaction in their ledger so if a stock is bought two days
before the record date, it may not be reflected in the company ledger. Hence, if you bought the
shares after the ex-dividend date, you will not receive the dividend. The dividend will come out of
the retained earnings of the company on the date of declaration of the dividend.

Dividend yield is calculated by dividing the annual dividend per share by the price of the share.
Dividend payout ratio is the amount of dividends paid to shareholders compared to the total net
income of the company. It can be calculated by dividing the dividends paid to net income or on a

59
per share basis by dividing the dividends per share by the earnings per share. Many investors, buy
dividend paying shares to take advantage of the steady payments as well as the opportunity to
reinvest the dividends. There are a number of companies in the S&P 500 called dividend aristocrats
that have consistently raised their dividends over the last 25 years. As of January 25, 2018, there
were 53 companies in the list including AT&T, Coca-Cola Co, Exxon Mobil Corp, Johnson &
Johnson, McDonald’s, Pepsi, Proctor & Gamble and Walmart. At the same time, there are a
number of large companies, especially in the technology sector that do not pay a dividend including
Facebook and Google.

For 2015, on page 57, Microsoft has a beginning balance of retained earnings of $17,710 million
and then adds net income of 12,193 million to the retained earnings and subtracts dividends paid
of $10,063 and common stock repurchased of $10,744 million and from the retained earnings to
get the ending retained earnings. We see that the beginning and ending balance of retained
earnings can be seen on the balance sheet under stockholders’ equity on page 55. Dividends paid
is shown in detail on page 89 and dividend is recorded on the date it is declared. Since Microsoft
has not paid the dividend for the fourth quarter before the filing date, the dividend payable is
recorded under other current liabilities and on page 55 it says “The dividend declared on June 9,
2015 will be paid after the filing date of this Form 10-K and was included in other current
liabilities as of June 30, 2015”.

Microsoft share price was $87.18 on March 23, 2018 and the last four quarters dividend was $1.68
so the dividend yield was $1.68 divided by $87.18 or 1.93%.

Share repurchases are when a company purchases their own shares back from their shareholders.
Similar to a dividend, a share repurchase is a way for a company to return funds to shareholders
or an alternate form of shareholder distribution. The company buys back its own stock from
shareholders, effectively reducing the number of outstanding shares and increasing the
proportional rights of any single shares. Companies participate in share repurchase when they are
carrying cash on the balance sheet in excel of what may be needed to fund operations and growth
opportunities. Certain companies carry debt on their balance sheet choose to repurchase shares by
borrowing more money when the cost of financing is attractive compared to the accretion
generated through the buyback.

Share buybacks can result in reducing the number of shares and can increase earnings per share
and make it more attractive for investors. It can offset dilution from employee compensation
awards and also make investors happy who want excess capital returned to them. It also enables
companies to manage their debt-equity ratio.

For 2015, on page 45, Microsoft talks about its share repurchase program and the buybacks made
during fiscal year 2015, 2014 and 2013 “On September 16, 2013, our Board of Directors
approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The
share repurchase program became effective on October 1, 2013, has no expiration date, and may
be suspended or discontinued at any time without notice. While the program has no expiration
date, we intend to complete it by December 31, 2016. As of June 30, 2015, $21.9 billion remained
of our $40.0 billion share repurchase program.”

“During fiscal year 2015, we repurchased 295 million shares of Microsoft common stock for $13.2
billion under the share repurchase program approved by our Board of Directors on September 16,
2013. During fiscal year 2014, we repurchased 175 million shares for $6.4 billion; 128 million
60
shares were repurchased for $4.9 billion under the share repurchase program approved by our
Board of Directors on September 16, 2013, and 47 million shares were repurchased for $1.5
billion under the share repurchase program that was announced on September 22, 2008 and
expired September 30, 2013. During fiscal year 2013, we repurchased 158 million shares for $4.6
billion, under the share repurchase program announced on September 22, 2008. All repurchases
were made using cash resources.”

On page 88 Microsoft breaks down the shares repurchased quarterly for years 2015, 2014 and
2013 and mentions that “The share repurchase program became effective on October 1, 2013, has
no expiration date, and may be suspended or discontinued at any time without notice.”

Accumulated other comprehensive income (AOCI) will begin with the opening balance
adjusted for certain transactions that effect AOCI to get the ending AOCI. AOCI are income and
expenses that are not shown in the income statement or pass through the income statement but
directly shown in the shareholder equity section of the balance sheet. There are four items that go
into AOCI. Firstly, unrealized gains and losses on marketable securities under available for sale
treatment from marking marketable securities to fair value are shown in AOCI. Secondly, for
pensions, the difference between the actual pension gains and losses and the expected pension
gains and losses go into AOCI. Thirdly, for derivatives and specifically cash flow hedges, the
unrealized gains and losses from marking derivatives to fair value are shown in AOCI. Lastly,
foreign subsidiaries assets and liabilities converted from foreign currency to domestic currency
leads to unrealized gains and losses which go to AOCI.

For 2015, on page 57, Microsoft has beginning balance of AOCI of $3,708 million and then
subtracts other comprehensive loss of $1,186 million to get the ending AOCI of $2,522 million.
The details of the other comprehensive loss of $1,186 million can be seen on the comprehensive
income statements on page 54. The opening and ending AOCI balance can be seen on the balance
sheet on page 55 under stockholders’ equity.

61
Microsoft Statement of Shareholders’
Equity

62
Quiz for Chapter 6
Q1: Company A declares a quarterly dividend of $1 per share on April 10, 2017 to be paid to
shareholders on record on April 25, 2017 with the dividend payment scheduled on May 7, 2017.
Company A has 120,000 shares issued and $100,000 shares outstanding. What is the total dividend
to be paid for the quarter and when is the journal entry for dividends recorded by Company A?

• $120,000 and when the dividend is recorded

• $100,000 and when the dividend is declared
• $100,000 and on the record date

Q2: For derivatives and specifically cash flow hedges, the unrealized gains and losses from
marking derivatives to fair value are shown where?

• Income statement before net income

• Accumulated other comprehensive income
• Not shown anywhere

Q3: AT&T stock price was $34.70 on March 23, 2018 and it paid a divided of $2.00 for the last
four quarters. Its earnings per share for the last four quarters was $3.48. What is the dividend yield
and payout ratio for AT&T?

• Dividend yield of 5.76% and dividend payout ratio of 57.5%

• Dividend yield of 5.76% and dividend payout ratio of 173.5%
• Dividend yield of 57.5% and dividend payout ratio of 5.76%

Q4: A company declares divided on June 20, 2017 to shareholders on record at July 12, 2017 and
the ex-dividend date of July 9, 2017. The dividend will be paid on July 25, 2017. Who will receive
the dividend on the shares (if more than one choice, please highlight all of them)?

• Shareholder who purchased the shares on July 10, 2017

• Shareholder who purchased the shares on June 18, 2017 but sold on July 1, 2017
• Shareholder who purchased the shares on July 8, 2017 but sold on July 23, 2017

Q5: If a company goes bankrupt, what is the order in which stakeholders are paid?

• Debt holders, preferred stockholders and common equity shareholders

• Preferred stockholders, Debt holders and common equity shareholders
• Debt holders, common equity shareholders and preferred stockholders

63
Answers to Quiz for Chapter 6
Q1: Company A declares a quarterly dividend of $1 per share on April 10, 2017 to be paid to
shareholders on record on April 25, 2017 with the dividend payment scheduled on May 7, 2017.
Company A has 120,000 shares issued and $100,000 shares outstanding. What is the total dividend
to be paid for the quarter and when is the journal entry for dividends recorded by Company A?

A1: $100,000 and when the dividend is declared and it will be debit retained earnings and credit
dividends payable.

Q2: For derivatives and specifically cash flow hedges, the unrealized gains and losses from
marking derivatives to fair value are shown where?

A2: Accumulated other comprehensive income

Q3: AT&T stock price was $34.70 on March 23, 2018 and it paid a divided of $2.00 for the last
four quarters. Its earnings per share for the last four quarters was $3.48. What is the dividend yield
and payout ratio for AT&T?

A3: Dividend yield of 5.76% and dividend payout ratio of 57.5%

Q4: A company declares divided on June 20, 2017 to shareholders on record at July 12, 2017 and
the ex-dividend date of July 9, 2017. The dividend will be paid on July 25, 2017. Who will receive
the dividend on the shares (if more than one choice please highlight all)?

A4: Shareholder who purchased the shares on July 8, 2017 but sold on July 23, 2017 since dividend
is paid to shareholders on the record date, i.e., July 12, 2017

Q5: If a company goes bankrupt, what is the order in which stakeholders are paid?

• Debt holders, preferred stockholders and common equity shareholders

• Preferred stockholders, Debt holders and common equity shareholders
• Debt holders, common equity shareholders and preferred stockholders

A5: Debt holders, preferred stockholders and common equity shareholders

64
Chapter 7: Ratio Analysis
“One common way of judging whether housing’s price is in line with its fundamental
value is to consider the ratio of housing prices to rent. This is analogous to the ratio
of prices to dividends for stocks”
– Janet Yellen

Ratio analysis is used to evaluate a number of factors within a business including profitability,
liquidity and solvency of a business. Ratios are compared to a benchmark. This analysis is useful
to see a trend line where each ratio is calculated for a company over a number of reporting periods
to see the trend in the information. Ratio analysis is also used for industry comparison purposes
where we calculate the ratios for companies in the same industry and then compare the results
across all companies.

There are no standards for defining basic ratios and hence we need to make sure that we are using
the same definitions or formulas while making comparisons across companies. We have described
below a few profitability ratios.

Profitability ratios show a company’s overall efficiency and returns to investors. Profitability
ratios can be of two types, i.e., margins and returns. Margin ratios include gross profit margin,
operating profit margin, pre-tax margin and net income margin ratios.

Gross profit margin is also called gross profit percentage or gross margin and is calculated by
dividing the company’s gross profit by its net sales.

Gross profit margin = Gross profit

Net Revenues

The higher the gross margin, the more the company retains each dollar of sales for operating
expenses, expansion, debt repayment, interest obligations as well as distributions to shareholders.
Gross margins will vary by industry, for example, legal and accounting service providers and
software companies will have high gross margins compared to car dealerships where the cost of
goods sold is high.

Microsoft’s gross profit margin for each year can be found by dividing its gross profit (in the
Microsoft 10-K, the gross profit is referred to as the gross margin) by its revenues. Microsoft’s
gross profit margin has been decreasing over the past 3 years and was 64.7% in 2015, 68.8% in
2014, and 73.8% in 2013.

Cost of revenues as a % of revenue increased over the three-year period from 26.19% in 2013, to
31.18% in 2014, to 35.30% in 2015. In the MD&A section on page 32, Microsoft mentions that in
2015, “Cost of revenue increased, mainly due to Phone Hardware, as well as increasing costs in
support of our Commercial Cloud, including $396 million of higher datacenter expenses.” On
page 33, Microsoft says that in 2014, “Cost of revenue increased mainly due to higher volumes of
Xbox consoles and Surface devices sold, and $575 million of higher datacenter expenses, primarily
in support of Commercial Cloud revenue growth. Cost of revenue also increased due to the
acquisition of NDS.” As a result of an increase in cost of revenues both in absolute numbers as

65
well as a percentage of revenues due to more hardware revenues which typically have lower
margins than software sales, the gross profit margin went down.

Operating profit margin is also called EBIT margin, operating margin or operating income
margin is calculated by dividing the company’s operating profit by its net sales. It shows how
much money is left over to pay for taxes and the stakeholders of the company including debt
holders and common shareholders.

Operating profit margin = Operating profit

Net Revenues

Microsoft’s operating profit margin for each year can be found by dividing its operating income
by its revenues. Microsoft’s operating profit margin was 19.4% in 2015, 32.0% in 2014, and 34.4%
in 2013. Excluding impairment, integration and restructuring charges, the operating margin was
30.1%, 32.1% and 34.4% for the years 2015, 2014 and 2013 respectively. Like gross profit margin,
Microsoft’s operating profit margin has been decreasing each year.

EBITDA margin is calculated by dividing the company’s earnings before interest, tax,
depreciation and amortization by its net sales.

EBITDA margin = EBITDA

Net Revenues

Microsoft’s EBITDA is calculated by taking the operating income from the income statement and
adding back depreciation and amortization from the cash flow statement. The EBITDA margin
was found by dividing the EBITDA by Microsoft’s revenues for each year. Microsoft’s EBITDA
margin is 25.8% in 2015, 38.0% in 2014 and 39.2% in 2013. Excluding impairment, integration,
and restructuring charges, Microsoft’s EBITDA margin is 36.5% in 2015, 38.1% in 2014 and
39.2% in 2013.

Pretax margin is calculated by dividing the company’s pretax earnings or earnings before taxes
(EBT) by its net sales.

Pretax margin = EBT

Net revenues

The pretax margin was found by dividing the EBT by Microsoft’s revenues for that year.
Microsoft’s pretax margin is 19.8% in 2015, 32.0% in 2014, and 37.4% in 2013. Excluding
impairment, integration, and restructuring charges, the pretax margin is 30.5% in 2015, 32.2% in
2014, and 37.4% in 2013. This ratio is decreasing over the three years.

Net profit margin is also called net margin or net income margin is calculated by dividing the
company’s net income by its net sales. It shows the percentage of the revenues remaining after
paying all operating expenses, interest, taxes and preferred share dividends from net revenues.
Analysts base the net income margin on net income from continuing operations since they want to
focus on the future performance and items below the line such as discontinued operations are not
taken into account since they will not impact future results.

Net profit margin = Net profit

66
 Net revenues

The net profit margin is calculated by dividing the net income by Microsoft’s revenues for the year.
Microsoft’s net profit margin is 13.0% in 2015, 25.2% in 2014, and 28.1% in 2013. Excluding
impairment, integration, and restructuring charges, the net profit margin is 23.7% in 2015, 25.6%
in 2014, and 28.1% in 2013. We have not tax adjusted the impairment, integration and
restructuring charges since it seems that Microsoft did not get a tax benefit for those charges as
its MD&A section says on page 41 “Our effective tax rate for fiscal years 2015 and 2014 was
approximately 34% and 21%, respectively. The fiscal year 2015 effective rate increased by 13%,
primarily due to goodwill and asset impairments and restructuring charges recorded in fiscal year
2015, most of which did not generate a tax benefit.”

Return ratios include return on equity. Return on equity (ROE) measures the return the investors
get on the amount of capital they put into the company or the amount of investment required to
produce the net income of the company.

Return on equity = Net income

Average shareholders’ equity

Net income is generated throughout the year but shareholders’ equity is at a point of time. We
hence take an average shareholders’ equity to approximate its level during the time the net income
is generated. It is calculated by adding the shareholder’s equity at the beginning and end of the
period and then dividing the total by two. ROE should increase with the increase in risk of the
company.

Return on equity was found by dividing the net income by Microsoft’s average shareholders’
equity. Microsoft’s return on equity is 14.4% for 2015. Excluding impairment, integration, and
restructuring charges, the return on equity is 26.1% for 2015.

Another measure to see return on equity could be for common shareholders only and for that we
subtract preferred dividends. It is calculated as

Return on common equity = Net income – preferred dividends

Average common shareholder’s equity

Since Microsoft does not have any preferred shares, its return on common equity is the same as
above for 2015.

Liquidity ratios tells us about the company’s ability to pay off its short-term liabilities. The
liquidity ratios include current ratio and quick ratio.

Current ratio measures that the company has adequate resources to pay its current liabilities from
its current assets.
Current ratio = Current assets
Current liabilities

Current ratio was found by dividing Microsoft’s current assets by Microsoft’s current liabilities.
Current ratio was 2.50 in 2015 and 2.50 in 2014.

67
Quick ratio also called as acid test ratio, measures the ability of the company to use its near cash
or quick assets to pay off its current liabilities. It is calculated by dividing the quick assets, i.e.,
cash and cash equivalents, marketable securities and accounts receivable by current liabilities.
Inventories are not included in the numerator while computing quick assets since it can take time
to liquidate the inventory held by a company.

Quick ratio = Quick assets

Current liabilities

– Or –

Quick ratio = Cash and cash equivalents, marketable securities and accounts receivable
Current liabilities

Quick ratio was found by dividing Microsoft’s quick assets by Microsoft’s current liabilities. Quick
ratio was 2.30 in 2015 and 2.31 in 2014.

Solvency ratios measures a company’s financial leverage and ability to pay off its long-term
obligations including principal payment and interest on the debt.

Debt to equity ratio shows the reliance on debt as a source of financing. It is closely monitored
by lenders since too high a ratio could be a warning sign that the company may not be able to pay
its principal and interest payments. Too low a ratio may suggest that the company is not using the
benefits of leverage to maximize return to common shareholders. It is calculated by dividing the
total debt of the company by the shareholders’ equity of the company. Total debt is calculated
differently by analysts and we have taken short-term debt, current portion of long-term debt and
long-term debt in our calculations. Some analysts use long-term debt or total liabilities for total
debt calculations.

Debt to equity ratio = Total debt

Shareholders’ equity

Debt to equity ratio was found by dividing Microsoft’s total debt by Microsoft’s shareholder’s
equity. Debt to equity ratio was 0.44 in 2015 and 0.25 in 2014.

Debt to capital ratio measures the company’s financial leverage and reliance on debt as source
of financing. It is calculated by dividing the total debt of the company by the debt and shareholders’
equity of the company which includes common equity, preferred equity and noncontrolling
interest.

Debt to capital ratio = Total debt

Total debt + shareholders’ equity

Debt to capital ratio was found by dividing Microsoft’s total debt by Microsoft’s shareholder’s
equity and total debt. Debt to capital ratio was 0.31 in 2015 and 0.20 in 2014.

Interest coverage ratio measures the ability of the company to pay its interest on its outstanding
debt. It is calculated by dividing the earnings before interest and taxes or EBIT by interest expense.

68
 Interest coverage ratio = EBIT
Interest expense

The interest coverage ratio for Microsoft was found by dividing operating income by interest
expense. Interest coverage ratio was 23.3 in 2015, 46.5 in 2014, and 62.4 in 2013. Excluding
impairment, integration, and restructuring charges, interest coverage ratio was 36.1 in 2015, 46.7
in 2014, and 62.4 in 2013.

Debt to EBITDA ratio measures how many periods a company will have to operate at the same
level of earnings in order to pay off the current levels of debt. It is calculated by dividing the total
debt by earnings before interest, taxes depreciation and amortization.

Total Debt to EBITDA ratio = Total Debt

EBITDA

The total debt to EBITDA ratio for Microsoft was 1.46 in 2015 and 0.69 in 2014. Excluding
impairment, integration, and restructuring charges, total debt to EBITDA ratio was 1.03 in 2015
and .68 in 2014.

Activity ratios measure a company’s ability to convert its assets, liability and capital accounts in
its balance sheet to cash or sales. Activity ratios include accounts receivable turnover ratio,
inventory turnover ratio and accounts payable turnover ratio.

Accounts receivable turnover ratio measures how quickly a company can collect cash for credit
sales to its customers. It is calculated by dividing total credit sales by average accounts receivables.

Accounts receivables turnover = Sales

Average accounts receivable

Microsoft has accounts receivables turnover of 4.64 in 2015 and 4.20 in 2014.

Days of sales outstanding or average collection period measures how many days does it take for
a company’s customers to pay their bills. It is calculated by dividing the total number of days in a
year by the accounts receivables turnover.

Days of sales outstanding = 365

Accounts receivable turnover

Days of sales outstanding was found by dividing 365 by Microsoft’s accounts receivable turnover
ratio. Days of sales outstanding was 78.7 in 2015 and 86.8 in 2014.

Inventory turnover measures the number of times inventory is sold or used in a particular time
period such as a year. It is calculated by dividing the cost of goods sold by the average inventory.

Inventory turnover = Cost of goods sold

Average inventory

For Microsoft, inventory turnover was 11.88 in 2015 and 11.78 in 2014.

69
Days of inventory on hand measures the number of days of inventory in hand.

Days of inventory on hand = 365

Inventory turnover

Days of inventory on hand is calculated by dividing 365 by Microsoft’s inventory turnover ratio.
Days of inventory on hand was 30.7 in 2015 and 31.0 in 2014.

Accounts payable turnover measures the rate at which the company pays its suppliers. It shows
how many times per period the company pays its average payable amount. It is calculated by
dividing the cost of goods sold by the average payables.

Accounts payable turnover = COGS

Average trade payable

For Microsoft, accounts payable turnover was 4.71 in 2015 and 4.42 in 2014.

Number of days payable measures the speed at which the company pays its suppliers. It is
calculated by dividing 365 by the accounts payable turnover ratio.

Days of Accounts payable = 365

Accounts Payable Turnover

Days of accounts payable is calculated by dividing 365 by Microsoft’s accounts payable turnover
ratio. Days of accounts payable was 77.46 in 2015 and 82.63 in 2014.

Valuation ratios are used by investors to determine valuation and analyze the attractiveness of an
investment in the equity of a company. The commonly used ratios are price to earnings ratio and
price to book ratio.

Price-to-earning ratio is also called P/E ratio or PER is calculated by dividing the share price by
the earnings per share of the company.

P/E ratio = Share price

Earnings per share

Microsoft share price was $44.15 on June 30, 2015 so we will use that value for this ratio.
According to the page 53 of 10-K, diluted EPS was $1.48 in 2015 which means the P/E ratio is
29.8 in 2015.

Microsoft’s share price was $41.70 on June 30, 2014 so we will use that value for this ratio.
According to page 53 of the 10-K, diluted EPS was $2.63 in 2014 which means the P/E ratio is
15.9.

Price-to-book ratio is used to compare the current market price of the company to its book value.
It is calculated by dividing the market capitalization of the company to its book value from the
balance sheet, i.e., shareholders’ equity on the balance sheet.

70
 P/book ratio = Market capitalization
Book value

Microsoft’s share price was $44.15 on June 30, 2015 so we will use that value for this ratio. The
number of basic shares outstanding on page 88 of 10-K on June 30, 2015 was 8,027 million. These
were multiplied by the share price to give the market capitalization, and the result was divided by
shareholder’s equity in 2015 to give the P/B ratio of 4.43 in 2015. Microsoft’s share price was
$41.70 on June 30, 2014 and shares outstanding were 8,239 million on page 88 of 10- K. These
were multiplied by the share price to give the market capitalization, and the result was divided by
shareholder’s equity in 2014 to give the P/B ratio of 3.83 in 2014.

71
Quiz for Chapter 7
Q1: A company’s quick ratio is 1.5. If the company purchases $10,000 worth of inventory from
its cash what would happen?

• Denominator would decrease more than the numerator leading to a higher current ratio
• Numerator would decrease more than the denominator, resulting in a lower quick ratio
• Numerator and denominator would decrease proportionally, leading to no change in current
ratio

Q2: A company’s current ratio is 1.2. If the company pays its accounts payable with the cash in
hand, what would happen to the current ratio?

• Denominator would decrease more than the numerator leading to a higher current ratio
• Numerator would decrease more than the denominator, resulting in a lower current ratio
• Numerator and denominator would decrease proportionally, leading to no change in current
ratio

Q3: A company has net revenues of $10,000, cost of goods sold of $5,000, SG&A and other
operating expenses of $3,000 and interest expense of $1,000. What would be the company’s
interest coverage ratio?

• 0.5
• 5.0
• 2.0

Q4: A company has a share price of $50 and has 10 million shares outstanding and has
shareholders’ equity of 250 million on its balance sheet. What is the price to book value per share?

• 0.5
• 2.0
• 5.0

Q5: A company has a market capitalization of $500 million, shares outstanding of 10 million and
net income of $25 million. What is the price to earnings ratio for the company?

• 20
• 50
• 200

72
Answers to Quiz for Chapter 7
Q1: A company’s quick ratio is 1.5. If the company purchases $10,000 worth of inventory from
its cash what would happen?

A1: Numerator would decrease more than the denominator, resulting in a lower quick ratio.
Quick ratio is equal to cash and cash equivalents plus accounts receivable divided by current
liabilities. The numerator will decrease since cash will be reduced and no change in the
denominator, so quick ratio will decrease.

Q2: A company’s current ratio is 1.6. If the company pays its accounts payable with the cash in
hand, what would happen to the current ratio?

A2: Denominator would decrease more than the numerator leading to higher current ratio. Current
ratio is equal to current assets divided by current liabilities. Let us say current assets were $16,000
and current liabilities were $10,000, so current ratio was 1.2. If cash reduces by $4,000 and
accounts payable reduces by $4,000, current ratio will be $12,000/$6,000 = 2.0. Hence, if current
ratio was more than 1.0 and both numerator and denominator reduce by the same amount, current
ratio will go up.

Q3: A company has net revenues of $10,000, cost of goods sold of $5,000, SG&A and other
operating expenses of $3,000 and interest expense of $1,000. What would be the company’s
interest coverage ratio?

A3: 2.0. Interest coverage ratio is calculated as EBIT divided by interest expense. EBIT would be
$10,000 minus $5,000 minus $3,000 which is $2,000. Interest coverage ratio would be $2,000
divided by $1,000 equal to 2.0x.

Q4: A company has a share price of $50 and has 10 million shares outstanding and has
shareholders’ equity of 250 million on its balance sheet. What is the price to book value per share?

A4: 2.0. Price to book value per share is defined as market capitalization divided by shareholders’
equity. Market capitalization will be $50 multiplied by $10 equal to $500 million and shareholders’
equity is 250 million so book value equals 2.0.

Q5: A company has a market capitalization of $500 million, shares outstanding of 10 million and
net income of $25 million. What is the price to earnings ratio for the company?

A5: 20. Price to earnings ratio can be defined as market capitalization divided by net income also.
Since market capitalization is share price multiplied by shares outstanding and net income is shares
outstanding multiplied by earnings per share, the net result is share price divided by earnings per
share. Hence P/E ratio will be $500 million divided by $25 million or 20.

73
Chapter 8: Last Twelve Months and
Calendarization
“Numbers have life; they’re not just symbols on paper”
– Shakuntala Devi

Last twelve months (LTM) also referred to as trailing twelve months (TTM) data shows the most
recent twelve months’ data for a company that is available. LTM data is more current than the
fiscal year end data for companies and hence is useful in assessing the most recent business
performance of the company.

LTM numbers help compare the performance of similar companies in an industry that might have
different fiscal year ends. For example, if one company has a fiscal year end of December 31 and
another has a fiscal year end of June 30, then their fiscal year ends would provide data for January
1 to December 31 and July 1 to June 30 respectively, which would not be the same periods for
both companies. By taking LTM data we can better compare numbers for the same time period.

Calculation of LTM data A public company in the U.S. files a quarterly report every three months
called 10-Q and an annual report called 10-K with the SEC. Companies are required to file their
10-K within 60 days after the close of their fiscal year and 10-Q within 40 days of the end of the
quarter.

A company needs to file only three 10-Q filings as the information for the last quarter is included
in the 10-K. First quarter 10-Q consists of results of the first fiscal quarter and also gives prior
year’s quarter numbers. Second quarter 10-Q would give the quarterly numbers for the second
quarter of the fiscal year and the prior year but will also give numbers for the six months from the
beginning of the fiscal year as well as prior year six-month numbers. Third quarter 10-Q will give
quarterly numbers for the third quarter and prior years third quarter numbers as well as nine-month
numbers from the start of the fiscal year as well as nine month’s numbers of the prior year.

In order to calculate LTM data the company’s financial results from the most recent four quarters
are added. Since the company does not file fourth quarter 10-Q, LTM numbers can be calculated
by either taking the information from the 10-K or a combination of 10-K and 10-Q’s depending
on the time when we are calculating the numbers. We have provided a few examples below to
explain how to calculate LTM.

Example 1: We need to find the LTM numbers on February 20, 2016 for a company with a fiscal
year end of December 31.

Step 1: Determine the quarters and the dates by when the company needs to file their 10-Q and 10-
K by. For this example, the data would be as follows:

74
 Quarters Period Date filed by Document to be filed
Q1 January 1, 2015 to March 31, 2015 May 10, 2015 10-Q
Q2 April 1, 2015 to June 30, 2015 August 9, 2015 10-Q
Q3 July 1, 2015 to September 30, 2015 November 10, 2015 10-Q
Q4 October 1, 2015 to December 31, 2015 March 1, 2016 10-K6

Step 2: Determine if the company has filed 10-K/10-Q. We know that the company would need to
file its 10-K within 60 days of the year end, i.e., by March 1, 2016. The first thing we would need
to determine is if the company had filed its 10-K by February 20, 2016, i.e., the date when we are
calculating the LTM data. We found from company filings that the company had filed its 10-K on
January 25, 2016, before the date we are calculating the LTM data for.

Step 3: Determine 12-month period. The next thing we would need to determine is the twelve-
month period for the company for which they have filed their numbers with the SEC. In this case,
it would be January 1, 2015 to December 31, 2015 since the data for the period January 1, 2016 to
February 20, 2016 would not be available and will only be available after the company files its 10-
Q for the quarter ended March 31, 2016.

Step 4: Find the appropriate documents to get the period. In this case the 10-K would give us the
period January 1, 2015 to December 31, 2015 and hence the 10-K would only be required to find
LTM data.

Example 2: We need to find the LTM numbers on September 20, 2015 for a company with a
fiscal year end of December 31.

Step 1: Determine the quarters and the dates by when the company needs to file their 10-Q and 10-
K by. For this example, the data would be as follows:

Quarters Period Date filed by Document to be filed

Q1 January 1, 2015 to March 31, 2015 May 10, 2015 10-Q
Q2 April 1, 2015 to June 30, 2015 August 9, 2015 10-Q
Q3 July 1, 2015 to September 30, 2015 November 10, 2015 10-Q
Q4 October 1, 2015 to December 31, 2015 March 1, 2016 10-K

Step 2: Determine if the company has filed 10-K/10-Q. We know that the company would need to
file its 10-Q within 40 days of the quarter end. We see that the company would have filed its second
quarter 10-Q by August 9, 2015.

Step 3: Determine 12-month period. The next thing we would need to determine is the twelve-
month period for the company for which they have filed their numbers with the SEC. In this case,
it would be July 1, 2014 to June 30, 2015 since the data for the period July 1, 2015 to September
20, 2015 would not be available and will only be available after the company files its 10-Q for the
quarter ended September 30, 2015.

6
10-K would give the data for the period January 1, 2015 to December 31, 2015 and not for the three months. The
company does not file the fourth quarter 10-Q.
75
Step 4: Find the appropriate documents to get the period. In this case, we would need a combination
of 10-K and 10-Q’s to get the period July 1, 2014 to June 30, 2015.

Period Number of months Document filed

January 1, 2014 to December 31, 2014 12 10-K
Add: January 1, 2015 to June 30, 2015 6 10-Q
Less: January 1, 2014 to June 30, 2014 (6) 10-Q

This would give us the period July 1, 2014 to June 30, 2015. We would need only the 10-K and
the second quarter 10-Q since the second quarter 10-Q gives us 6-months data for the current year
and the prior year also.

Hence, for a public company there can be four scenarios to calculate LTM depending on the time
period we are calculating the LTM data. The data can be found

• through the 12-month period from the 10-K

• by taking the 12-month data from the 10-K and adding the most recent 3-month data
from the 10-Q and subtracting the prior year 3-month data from the prior year 10-Q
• by taking the 12-month data from the 10-K and adding the most recent 6-month data
from the 10-Q and subtracting the prior year 6-month data from the prior year 10-Q
• by taking the 12-month data from the 10-K and adding the most recent 9-month data
from the 10-Q and subtracting the prior year 9-month data from the prior year 10-Q

Calendarization In the U.S., most public companies report their financial performance according
to their fiscal year ending December 31, which also is same as the calendar year end. Certain
companies in retail and other industries can have a different fiscal year end than the calendar year,
for example, January 31 or April 30. In order to compare comparable companies in the same
industry, this variance in fiscal year ends needs to be addressed otherwise the data we will compare
would be for different periods.

LTM helps in obtaining most recent data for comparing companies in the same industry but the
months may not be same for the companies. For example, if company A has a fiscal year end of
December 31 and company B has a fiscal year end of April 30, their fiscal year periods would be
January 1 to December 31 and May 1 to April 30 respectively and hence the data would not be for
the same period. LTM data as of May 15 would be April 1 to March 31 for company A and May
1 to April 30 for company B assuming that both companies have filed their 10-Q’s which would
also not be the same months. To get the exact months for both companies, we can calendarize the
data of company B to make it similar to company A.

Example 1: We need to find the calendar year numbers for 2015 for a company with a fiscal year
end of April 30.

Step 1: Determine the quarters depending on the fiscal year end of the company. For this example,
the data would be as follows

76
Fiscal Year Ended April 30, 2015
Quarters Period Document filed
Q1 May 1, 2014 to July 31, 2014 10-Q
Q2 August 1, 2014 to October 31, 2014 10-Q
Q3 November 1, 2014 to January 31, 2015 10-Q
Q4 February 1, 2015 to April 30, 2015 10-K

Fiscal Year Ended April 30, 2016

Quarters Period Document filed
Q1 May 1, 2015 to July 31, 2015 10-Q
Q2 August 1, 2015 to October 31, 2015 10-Q
Q3 November 1, 2015 to January 31, 2016 10-Q
Q4 February 1, 2016 to April 30, 2016 10-K

Step 2: Determine the period for calendar year data for 2015. We would need the data for the
period January 1, 2015 to December 31, 2015.

Step 3: Find the appropriate documents to get the period. In this case, we would need a combination
of 10-K and 10-Q’s to get the period January 1, 2015 to December 31, 2015.

Period Number of months

January 1, 2015 to January 31, 2015 1
February 1, 2015 to April 30, 2015 3
May 1, 2015 to July 31, 2015 3
August 1, 2015 to October 31, 2015 3
November 1, 2015 to December 31, 2015 2
January 1, 2015 to December 31, 2015 12

To get the data for January 1, 2015 to January 31, 2015 we can take the 3-month data from the 10-
Q for period November 1, 2014 to January 31, 2015 and multiply it by 1/3 to get the one-month
data. Similarly, to get the data for the period November 1, 2015 to December 31, 2015, we can
take the data for the 3-month period November 1, 2015 to January 31, 2016 and multiply that by
2/3.

77
Quiz for Chapter 8
Q1: A company has a fiscal year end of December 31. The current date is June 15, 2017 and you
need to find the LTM data. What document would you need to find the data?

• 10-K and first quarter 10-Q filing

• 10-K and second quarter 10-Q filing
• 10-K and third quarter 10-Q filing

Q2: A company has a fiscal year end of December 31. The current date is October 22, 2017 and
the company has not yet filed its 10-Q for the period ending September 30, 2017. What document
would you need to find the LTM data?

• 10-K and first quarter 10-Q filing

• 10-K and second quarter 10-Q filing
• 10-K and third quarter 10-Q filing

Q3: How would you find the calendar year 2016 data for a company with a fiscal year end of May
31?

• 2 quarters data from June 1 to November 30, 2016 + 1 quarter from March 1 to May 31,
2016 + 1/3 data from the period December 1, 2016 to February 28, 2017 + 2/3 data for the
period December 1, 2015 to Feb 28, 2016
• 2 quarters data from June 1 to November 30, 2016 + 1 quarter from March 1 to May 31,
2016 + 2/3 data from the period December 1, 2016 to February 28, 2017 + 1/3 data for the
period December 1, 2015 to Feb 28, 2016
• 2 quarters data from May 1 to October 30, 2016 + 1 quarter from Feb 1 to April 30, 2016
+ 2/3 data from the period November 1, 2016 to January 31, 2017 + 1/3 data for the period
November 1, 2015 to January 31, 2016

Q4. A company filed its 10-K for the period January 1, 2015 to December 31, 2015 on January
20, 2016. The current date is January 27, 2016 and we need to calculate LTM and calendar year
data. Please see which statement below is true?

• Fiscal year, calendar year and LTM data will be the same
• LTM and calendar year will be the same but fiscal year will be different
• Calendar year and fiscal year will be the same but LTM data will be different

Q5. A company has its fiscal year end of December 31. The company has not yet filed its 10-K
and the current date is January 26, 2016. What will be the LTM period and how will we calculate
it?

• January 1, 2015 to December 31, 2015 and we will use the 10-K to get LTM data
• October 1, 2014 to September 30, 2015 and we will use 10-K plus 9-month data from 10-
Q minus 9-month data from prior year 10-Q
• None of the above and we will need to calculate it differently. Please explain how.

78
Answers to Quiz for Chapter 8
Q1: A company has a fiscal year end of December 31. The current date is June 15, 2017 and you
need to find the LTM data. What document would you need to find the data?

A1: 10-K and first quarter 10-Q filing. Since the first quarter 10-Q would have been filed within
40 days of the quarter ending March 31, 2017 i.e., by May 10 and the second quarter 10-Q has still
not been filed because the second quarter has not ended yet. The LTM period will be April 1, 2016
to March 31, 2017.

We will need the 12-months number from the 10-K for the period January 1, 2016-Decemeber 31,
2016 and add the 3-month data from the first quarter 10-Q for 2017, i.e., the period from January
1, 2017 to March 31, 2017 and subtract the first quarter data from the prior year i.e., January 1,
2016 to March 31, 2016.

Q2: A company has a fiscal year end of December 31. The current date is October 22, 2017 and
the company has not yet filed its 10-Q for the period ending September 30, 2017. What document
would you need to find the LTM data?

A2: 10-K and second quarter 10-Q filing. Since the third quarter 10-Q has not been filed, the most
recent 10-Q filed would be second quarter 10-Q ending June 30, 2017. The LTM period will be
July 1, 2016 to June 30, 2017. We will need the 12-months number from the 10-K for the period
January 1, 2016-Decemeber 31, 2016 and add the six-month data from the second quarter 10-Q
for 2017, i.e., the period from January 1, 2017 to June 30, 2017 and subtract the second quarter
data from the prior year i.e., January 1, 2016 to June 30, 2016.

Q3: How would you find the calendar year 2016 data for a company with a fiscal year end of May
31?

A3: 2 quarters data from June 1 to November 30, 2016 + 1 quarter from March 1 to May 31, 2016
+ 1/3 data from the period December 1, 2016 to February 28, 2017 + 2/3 data for the period
December 1, 2015 to Feb 28, 2016 would give us the calendar year data Jan 1, 2016 to December
31, 2016.

Q4: A company filed its 10-K for the period January 1, 2015 to December 31, 2015 on January
20, 2016. The current date is January 27, 2016 and we need to calculate LTM and calendar year
data. Please see which statement below is true?

A4: Fiscal year, calendar year and LTM data will be the same. In this case the fiscal year, calendar
year and LTM will all be January 1, 2015 to December 31, 2015.

Q5: A company has its fiscal year end of December 31. The company has not yet filed its 10-K
and the current date is January 26, 2016. What will be the LTM period and how will we calculate
it?

A5: LTM period will be October 1, 2014 to September 30, 2015. We will use 10-K plus 9-month
data from 10-Q minus 9-month data from prior year 10-Q.

79
Chapter 9: Accounting Questions &
Answers
“You have to understand accounting and you have to understand the nuances of
accounting. It’s the language of business and it’s an imperfect language, but unless
you are willing to put in the effort to learn accounting – how to read and interpret
financial statements – you really shouldn’t select stocks yourself”
– Warren Buffet
Accounting technical skills are very important not only for accounting positions in corporations
and accounting firms, but also for almost all types of finance positions, including investment
banking, equity research, financial planning and analysis, asset management and private equity.
The ability to read and interpret financial statements is a critical technical skill for a successful
career in accounting and finance. In a finance interview, accounting questions test the candidate’s:

• Familiarity with all the individual components of the three financial statements, namely,
the income statement, balance sheet and cash flow statement
• Ability to link the three financial statements together. When you build a financial model,
you need to understand how the three financial statements interact with each other
• Knowledge of advanced accounting concepts, including goodwill and deferred taxes assets
and liabilities, especially for students with business and accounting majors
• Insight into the unique characteristics of the industry for which the candidate is
interviewing. For example, the income statement of a bank and a manufacturing company
are quite different. While interviewing for the financial institutions group at an investment
bank, the candidate must be able to walk the interviewer through the major line items of
the income statement for that sector

The questions below are related to the three financial statements as well as certain basic terms
including EBITDA and working capital.

Briefly describe the three financial statements.

The balance sheet is a summary of a company’s assets, liabilities and shareholders’ equity, that
is, its financial position at a specific point in time. More broadly, the balance sheet gives us the
value of a company’s resources, i.e., assets, and the value of the claims on those resources, i.e.,
liabilities and shareholders’ equity.

The income statement tells us how much money the company has earned and shows its operating
results over a given period of time, e.g., a fiscal year or a quarter. For example, the income
statement answers the question, “How much profit has the company made for the last three-month
or 12-month period?”

The cash flow statement tells us:

• how much cash has flowed in and out of the business over a given period of time
• the difference between the company’s opening cash balance and its closing cash balance.
The cash flow statement tells us opening cash, ending cash and change in cash for the
specified period
80
 • the change in cash, classifying each line item under one of three sections, namely, cash
flow from operating activities, cash flow from investing activities and cash flow from
financing activities
• how the balance sheet and the income statement are linked. The cash flow statement can
be derived from the income statement and the balance sheet
• how the company’s net income reconciles to its ending cash balance. The cash flow
statement starts with net income and ends with the ending cash balance of the company for
that period. For example, it helps answer the question, “Why is it that the company has
$1,000 in net income on the income statement but $2,000 in cash in the cash flow
statement?”

If you could pick one financial statement to determine the financial health of a company,
what would it be? If you had to select two financial statements, which ones would you choose?

None of the three financial statements taken alone will give us a complete picture of a company’s
health. In the interview, you can justify your choice of any of the three financial statements as long
as you have a good, logical explanation for it. If asked to select one, it is best to pick the cash flow
statement. The cash flow statement is constructed from the income statement and balance sheet
and shows the sources and uses of cash for a particular period. It also tells investors how much
cash the company is generating and whether it is enough to pay its debt service and interest
obligations.

If asked to pick two financial statements, you should choose the income statement and the balance
sheet since the cash flow statement can be constructed from these two financial statements.
However, you would need the balance sheet for both the period in question and the prior period to
construct the cash flow statement.

What is EBITDA?
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is an indicator of a
company’s financial performance and cash flow. It is a non-generally accepted accounting
principles (GAAP) measure. Hence, you will not see EBITDA on the income statement of a public
company, rather, you would have to calculate it. EBITDA is defined as:

EBITDA = Revenue
Less: Expenses (excluding taxes, interest, depreciation
and amortization)

Or

EBITDA = Operating Income or EBIT (from the income statement)

Add: Depreciation and Amortization (from the cash
flow statement)

We should take depreciation and amortization from the cash flow statement because sometimes in
the income statement, depreciation and amortization may be included in the cost of goods sold
(COGS) or in the selling, general and administrative expenses (SG&A) or in both of them and may
not be broken out separately. However, they are always added back in the cash flow statement and
shown separately. In an interview, it is easier to use the above definition as there are fewer factors
81
to take into account. EBITDA can also be defined as:

EBITDA = Net Income

Add: Taxes
Add: Interest Expense
Less: Interest Income
Add: Depreciation and Amortization (from the cash
flow statement)

EBITDA can be used to analyze and compare profitability between companies and industries
because it eliminates the effects of financing decisions, e.g., interest expense, and accounting
decisions, e.g., depreciation of assets. It is widely used as a measure of a company’s cash flow and
is also used in leverage covenants to analyze credit ratios, e.g., total debt to EBITDA and EBITDA
to interest expense.

Though EBITDA is widely used by the investment community, it has several drawbacks:

• It leaves out the cash required to replace old equipment, which can be significant. It
assumes that fixed assets don’t require capital replenishment, which is probably not the
case for fast-growing firms
• It ignores a company’s tax obligations, which are a cash-absorbing expense
• It may exclude certain expenses, for example, some companies may reclassify certain
operating expenses as extraordinary charges in the income statement below EBIT to
enhance EBITDA

What is working capital and net working capital?

Working capital can be used as a measure of both a company’s efficiency and its short-term
financial health. Working capital is calculated as:

Working Capital = Current Assets

Less: Current Liabilities

Current assets include cash and other assets expected to be turned into cash within one year, such
as marketable securities, accounts receivable, short-term notes receivable, inventory and prepaid
expenses. Current liabilities are obligations that the company is expected to settle in cash within
one year and include accounts payable, short-term debt including line of credit, the short-term
portion of long-term debt and accrued expenses.

Some industries, such as manufacturing, require a high level of working capital. This is a result of
the relatively long period of time between when the manufacturing firm pays suppliers for products
that will eventually be sold and when it receives cash for the sale. Other industries, such as retail
for instance, require little working capital because, in most cases, retailers sell products for cash
before they are required to pay suppliers for the products, making profits readily available for
reinvestment in the business.

Positive working capital means that the company is able to fund its short-term liabilities with its

82
short-term assets. Negative working capital means that a company is currently unable to meet its
short-term liabilities with its current assets including accounts receivable and inventory. If a
company’s working capital is negative, it may have trouble paying back creditors in the short term.

When calculating the free cash flow for discounted cash flow (DCF) analysis purposes, we
calculate net working capital, which highlights the cash a company requires to finance its on-going
operations. It is defined as:

Net Working Capital = Current assets (excluding cash and marketable securities)
Less: Current liabilities excluding all
short term interest bearing debt

Short-term debt includes short-term debt and the short-term portion of long-term debt.

The questions below illustrate how the three financial statements are related to each other.

What are some of the links between the income statement, balance
sheet and cash flow statement?

The three financial statements are linked to each other in various ways. For example, if
we have a company’s income statement and balance sheet, we can create a cash flow
statement. Below are examples of some of the connections between the three statements:

• Net income after dividends from the income statement goes to the top of the cash
flow statement. Additionally, net income after dividends flows from the income
statement to the retained earnings section under shareholders’ equity in the
balance sheet
• In the income statement, depreciation is an expense that is calculated on the basis
of property, plant and equipment (PP&E) shown on the balance sheet.
Depreciation expense is added back in the cash flow statement because it is a
non-cash expense. It is also added to the accumulated depreciation section of the
balance sheet, which reduces net PP&E
• If the company takes on additional debt, it affects the financing activities section
of the cash flow statement, increases the debt on the balance sheet and increases
the interest expense in the income statement

If you add $100 of depreciation expense with a 40% tax rate in the
income statement, how does it affect the income statement? Based on
that change, how does the balance sheet balance?

You are likely to be asked some version of this question to test your understanding of how the
three financial statements are related to each other. In the above scenario, the impact on the three
statements is as follows:

Income statement. Depreciation is an expense, therefore, operating income or EBIT declines by

$100. Assuming a tax rate of 40%, net income declines by $60.
83
Cash flow statement. Net income decreases by $60, therefore, cash flow, which starts with net
income, decreases by $60. $100 of depreciation expense is a non-cash expense, and it is added
back to the cash flow statement, thus, cash flow from operations increases by $40. As a result of
this, the ending cash balance increases by $40. This $40 then flows to the balance sheet as cash
under current assets.

Balance sheet. The $60 reduction in net income causes retained earnings to decrease by $60.
Accumulated depreciation increases by $100, thus, net PP&E decreases by $100 and cash goes up
by $40, as described earlier from the cash flow statement, therefore, assets decrease by $60. Since
assets = liabilities + shareholders’ equity, the balance sheet balances as assets decrease by $60 and
liabilities + shareholders’ equity decreases by $60.

Table 1.1: Effect of $100 Increase in Depreciation Expense on the Financial

Statements
(in $)
XYZCo Summary Financial Statement for the fiscal year ended December 31, 2015
$100 INCREASE IN DEPRECIATION
CURRENT SCENARIO EXPENSE
INCOME STATEMENT INCOME STATEMENT
Revenue $1,000 Revenue $1,000

COGS 200 COGS 200

Gross Profit $800 Gross Profit $800

SG&A 250 SG&A 250

Depreciation 100 Depreciation 200

EBIT decreases by
Operating Income / EBIT $450 Operating Income / EBIT $350 $100

Tax Expense 180 Tax Expense 140 Tax decreases by $40

Net Income $270 Net Income $210 Net income decreases by $60

BALANCE SHEET BALANCE SHEET

ASSETS ASSETS
Cash increases by
Cash $1,370 Cash $1,410 $40

Accounts Receivable - Accounts Receivable -

Inventory - Inventory -
Total Current Assets $1,370 Total Current Assets $1,410 Current assets increase by $40

Gross PP&E 300 Gross PP&E 300

Less: Accumulated Less: Accumulated Accumulated depreciation increases by
Depreciation 100 Depreciation 200 $100
Net PP&E $200 Net PP&E $100 Net PP&E decreases by $100

Total Assets $1,570 Total Assets $1,510 Total assets decrease by $60

LIABILITIES LIABILITIES

Accounts Payable - Accounts Payable -

Accrued Expenses - Accrued Expenses -

Total Current Liabilities $0 Total Current Liabilities $0

Long Term Debt 1,300 Long Term Debt 1,300

84
 SHAREHOLDERS' SHAREHOLDERS'
EQUITY EQUITY
Retained earnings decreases by $60 since net
Retained Earnings 270 Retained Earnings 210 income
goes to retained
Other - Other - earnings
Total Shareholders' Total Shareholders'
Equity $270 Equity $210 Shareholders' equity decreases by $60

Total liabilities & equity decrease by

Total Liabilities & Equity $1,570 Total Liabilities & Equity $1,510 $60

CASH FLOW STATEMENT CASH FLOW STATEMENT

Net Income $270 Net Income $210 Net income decreases by $60
Depreciation & Depreciation &
Amortization 100 Amortization 200 Depreciation & amortization increases by $100
Cash Flow from Cash Flow from Cash flow from operations increases by
Operations $370 Operations $410 $40

Cash Flow from Investing - Cash Flow from Investing -

Cash Flow from Financing - Cash Flow from Financing -

Total Cash Flow $370 Total Cash Flow $410 Ending cash flow increases by $40

Beginning Cash 1,000 Beginning Cash 1,000

Change in Cash 370 Change in Cash 410 Change in cash increases by $40
Ending cash increases by $40 and goes to
Ending Cash $1,370 Ending Cash $1,410 balance sheet

A company buys a car for $1,000 on January 1, 2008. How will this
affect its income statement, cash flow and balance sheet for the period
January 1, 2008 to December 31, 2008? Assume that the depreciation
method used for the car is straight-line over five years and that the tax
rate is 40% OR

How does an increase of $1,000 in capital expenditures affect the three

financial statements?

Sometimes the interviewer will withhold certain information, such as the tax rate or the
method of depreciation, and will expect you to ask for this information or make
assumptions when answering the question.

Income statement. Depreciation expense for the period January 1, 2008 to December
31, 2008 will be $1,000 / 5 = $200. Net income will be reduced by $120 as you would
get a tax benefit of $80 (40% of $200).

Cash flow statement. The company spent $1,000 to buy the car, therefore, its capex
will increase by $1,000 and there will be a $1,000 use of cash in cash flow from investing
activities. The cash flow statement starts with net income, which comes down by $120
in the cash flow statement as net income from the income statement will go to the top of
the cash flow statement. Depreciation expense is added back to the cash flow statement,
i.e., $200 is added back and the net change in cash is −$1000 − $120 + $200 = −$920.

Balance sheet. Cash goes down by $920 in the balance sheet because it has gone down
85
by $920 in the cash flow statement which flows to the balance sheet. Gross PP&E goes
up by $1,000 since a new car was bought. Accumulated depreciation increases by $200,
therefore net PP&E goes up by $800 ($1,000 − $200). Net income decreases by $120,
which causes shareholders’ equity to decrease by $120. Therefore, assets come down by
$120 (−$920 + $800) and shareholders’ equity decreases by $120. Thus, assets =
liabilities + shareholders’ equity and the balance sheet balances.

Table 1.2: Effect of $1,000 Purchase of a Car on the Financial Statements

(in $)
XYZCo Summary Financial Statement for the fiscal year ended December 31, 2015
CURRENT SCENARIO $1,000 CAPEX/ PURCHASE OF A CAR
INCOME STATEMENT INCOME STATEMENT
Revenue $1,000 Revenue $1,000
COGS 200 COGS 200
Gross Profit $800 Gross Profit $800
SG&A 250 SG&A 250
Depreciation 100 Depreciation 300 Depreciation increases by $200
Operating Income / EBIT $450 Operating Income / EBIT $250 EBIT decreases by $200
Tax Expense 180 Tax Expense 100 Tax decreases by $80
Net Income $270 Net Income $150 Net income decreases by $120

BALANCE SHEET BALANCE SHEET

ASSETS ASSETS
Cash $1,370 Cash $450 Cash decreases by $920
Accounts Receivable - Accounts Receivable -
Inventory - Inventory -
Total Current Assets $1,370 Total Current Assets $450 Current assets decrease by $920

Gross PP&E 300 Gross PP&E 1,300 Gross PP&E increases by $1,000
Less: Accumulated Depreciation 100 Less: Accumulated Depreciation 300 Accumulated depreciation increases by $200
Net PP&E $200 Net PP&E $1,000 Net PP&E increases by $800

Total Assets $1,570 Total Assets $1,450 Total assets decrease by $120

LIABILITIES LIABILITIES
Accounts Payable - Accounts Payable -
Accrued Expenses - Accrued Expenses -
Total Current Liabilities $0 Total Current Liabilities $0

Long Term Debt 1,300 Long Term Debt 1,300

SHAREHOLDERS' EQUITY SHAREHOLDERS' EQUITY

Retained Earnings 270 Retained Earnings 150 Retained earnings decreases by $120 since net income
Other - Other - goes to retained earnings
Total Shareholders' Equity $270 Total Shareholders' Equity $150 Shareholders' equity decreases by $120

Total Liabilities & Equity $1,570 Total Liabilities & Equity $1,450 Total liabilities & equity decrease by $120

CASH FLOW STATEMENT CASH FLOW STATEMENT

Net Income $270 Net Income $150 Net income decreases by $120
Depreciation & amortization increases by
Depreciation & Amortization 100 Depreciation & Amortization 300 $200
Cash Flow from Operations $370 Cash Flow from Operations $450 Cash flow from operations increases by $80

86
 Purchase of Car - Purchase of Car (1,000) Capex increases by $1,000 because of purchase of car
Cash Flow from Investing $0 Cash Flow from Investing ($1,000) Cash Flow from investing decreases by $1,000
Cash Flow from Financing - Cash Flow from Financing -

Total Cash Flow $370 Total Cash Flow ($550) Ending cash flow decreases by $920

Beginning Cash 1,000 Beginning Cash 1,000

Change in Cash 370 Change in Cash (550) Change in cash decreases by $920
Ending Cash $1,370 Ending Cash $450 Ending cash decreases by $920 and goes to balance sheet

The questions below relate to more advanced accounting terms including goodwill and
noncontrolling interest.

What is goodwill and how is it calculated?

Goodwill is the excess of equity purchase price over the fair value of the identifiable net assets
acquired in a business combination. Goodwill can be defined as:

Goodwill = Equity Purchase Price Paid for the Company Including Premium
Less: Fair Market Value of Identifiable Net Assets
(Assets – Liabilities) of the Target

Goodwill = Equity Purchase Price Paid for the Company Including Premium – Fair Market Value
of Identifiable Net Assets (Assets – Liabilities) of the Target or Fair Market Value of Equity of
the Target

Acquirers generally pay more than the fair market value of a company’s identifiable net assets for
many reasons, including: i) synergies they might get from buying the target, ii) unreported assets
the target may have on the balance sheet including customer loyalty, and iii) assets off-balance
sheet due to accounting standards.

Let us explain some of the key terms described above. In accounting, the book value of equity is
the original cost of the company’s common stock adjusted for inflows and outflows such as
retained earnings, dividends and stock buybacks. It appears as shareholders’ equity on a company’s
balance sheet in its annual reports, Form 10-K and Form 10-Q. It is defined as:

Book Value of Equity = Book value of assets

Less: Book value of liabilities

The fair market value of equity is the book value of assets and liabilities revalued to fair market
value, generally at the time of a business combination. For example, land, which is generally
shown on the books at cost and is not depreciated or appreciated, may undergo a significant
adjustment from its book value to its fair market value.

Fair Market Value of Equity = Fair Market Value of Assets

Less: Fair Market Value of Liabilities

The market value of equity is the total market value of all the company’s outstanding shares. It
includes the premium paid to buy the shares of the company acquired. It can be defined as:
87
 Market Value of Equity = Fully Diluted Shares Outstanding
Times Share Price (including premium if any)
for a public company or Equity Value for
a private company

Please note that in calculating goodwill, we take the equity purchase price paid for the company
and not its enterprise value, which is the total value of the company. Intangible assets can be
identifiable or unidentifiable assets. Identifiable assets include patents, copyrights and trademarks,
which have a limited life and can be acquired separately. Unidentifiable assets include goodwill,
which has an unlimited life and cannot be acquired separately.
What is the accounting treatment of goodwill?

US GAAP and Canadian GAAP no longer allow goodwill to be amortized as an operating expense.
Goodwill is shown as an intangible asset on the balance sheet and is tested once a
year for impairment. If it is found impaired, it is written down to its impaired value and a loss is
shown on the income statement. The loss does not affect the cash flow of the company. If no
impairment is found, goodwill can remain on a company’s balance sheet indefinitely. Goodwill
cannot be written up on the balance sheet.

Although a write-down of goodwill does not affect cash flow, it could indicate that the acquirer
overpaid for the acquisition. An article in the Wall Street Journal observed that, in 2012, “U.S.
companies slashed the value of their past acquisitions by $51 billion because the deals didn’t pan
out as expected … Hewlett-Packard Co. took a $13.7 billion write-down due to the diminishing
value of its 2011 acquisition of software firm Autonomy … Microsoft Corp. took a $6.2 billion
write-down largely on its 2007 purchase of online-advertising company aQuantive.”7

What is negative goodwill? How is it accounted for?

Negative goodwill arises when the price paid for equity is less than the fair value of a company’s
identifiable net assets. Negative goodwill generally occurs after a distressed sale. Under current
U.S. and Canadian GAAP, negative goodwill is recorded as income. The gains are not supported
by any current cash inflow, therefore, they are both nonrecurring and non-cash in nature. On the
balance sheet side, the acquired net assets under the current standards will be carried at fair value.

What is noncontrolling or minority interest and why is it added to

calculate total enterprise value? What is redeemable noncontrolling
interest?

Noncontrolling interest, sometimes referred to as minority interest,8 is the part of a company’s

subsidiary that is not owned by the parent company, but is owned by other investors. It is shown

7
Chasan, Emily and Murphy, Maxwell. “Companies Get More Wiggle Room on Soured Deals,” Wall Street Journal, Nov. 11,
2013, http://www.wsj.com/articles/SB10001424052702304868404579191940788875848.

8
In December 2007, FASB Statement No. 160 suggested changing name from minority interest to noncontrolling
interest.
88
in the balance sheet as a separate line item under the liabilities and equity section of the
consolidated balance sheet. In the income statement, it is subtracted from the consolidated net
income and shown separately as part of the profit attributable to minority shareholders.

When a company owns more than 50% but less than 100% of another company, the parent
company has to consolidate the other company in its books and reflect 100% of the subsidiary’s
assets and liabilities and 100% of its income in its books. For example, if Company A owns 80%
of company B, it will consolidate all of Company B’s financials in its books. It will show 100%
of Company B’s assets, liabilities and income in its books. The 20% of Company B that Company
A does not own is shown separately as noncontrolling interest in the equity section of the
consolidated balance sheet. It is also shown separately as noncontrolling interest in the
consolidated income statement.

Balance Sheet presentation Let’s say Company A acquires Company B and their
balance sheets are as follows:
(in $) (in $)
Company A Company B
Assets $20,000.0 Assets $10,000.0
Liabilities $10,000.0 Liabilities $5,000.0
Shareholders Shareholders
Equity $10,000.0 Equity $5,000.0

The combined balance sheet will be:

(in $)
Company Combined
Assets $30,000.0
Liabilities $15,000.0
Shareholders Equity $14,000.0
Noncontrolling Interest $1,000.0

Noncontrolling interest is the 20% of Company B not owned by Company A. Assets = Liabilities
+ Shareholders equity + Noncontrolling interest. In the balance sheet of A we will show under
equity

Total Company A shareholders’ equity $14,000

Noncontrolling interest $1,000
Total equity $15,000

Income statement presentation In the income statement, Company A’s net income is $10,000
and Company B’s net income is $5,000, thus, the consolidated net income will be $15,000. The
noncontrolling interest of 20% in Company B, which is $1,000, will be shown as a separate line
item and net income after noncontrolling interest will be $14,000. In the income statement of A,
we will show

89
Net income $15,000
Less: Net income attributable to noncontrolling interest $1,000
Net income attributable to Company A $14,000

Cash flow presentation Unless a transaction is specifically with a noncontrolling interest holder,
it is generally not possible to identify the portion of an individual asset such as cash that is
attributable to noncontrolling interest. Hence, the statement of cash flows does not require
differentiation between cash flows attributable to controlling and noncontrolling interests. Hence,
consolidated net income is the starting point for net income in the cash flow statement and in our
example above Net income would be $15,000 in the cash flow statement.

Why is it added to total enterprise value (TEV) To calculate TEV, we add the balance sheet
noncontrolling interest in the enterprise value formula as it represents a claim on the assets of the
company—it is a liability, like debt. For example, if someone were to acquire the company, they
would also need to pay off this liability.

We can also see why noncontrolling interest is added back while doing comparable company
metrics such as TEV/EBITDA. For example, if Company A owns 80% of Company B, when we
take EBITDA from the consolidated income statement, it accounts for 100% of the consolidated
companies due to the accounting rule described above. The market value of the equity value
included in TEV accounts for the fact that Company A owns 80% of Company B. Hence, the
numerator, which is TEV, is accounting for 80% of Company B and the denominator, which is
EBITDA, is accounting for 100% of Company B. To make an apples-to-apples comparison of this
valuation multiple to account for either 100% or 80% of TEV and EBITDA of Company B in both
numerator and denominator, we need to adjust either the EBITDA or the TEV.

Rather than adjusting the consolidated EBITDA to show 80% of Company B since sometimes
EBITDA for Company B is not broken out in the consolidated financial statements, we can add
the noncontrolling interest to the TEV. By doing so, we will be showing 100% of the Company B
in both the numerator, which is TEV, and the denominator, which is EBITDA.

Redeemable noncontrolling interest A noncontrolling shareholder may hold redemption rights,

for example, a put option or a forward contingent purchase or sale agreement on the common and
preferred shares of a consolidated subsidiary. Redeemable noncontrolling interest is a result of the
combination of a noncontrolling interest and a redemption feature. These redemption features are
important to the noncontrolling interest holder since it can enable the holder to liquidate their
holding when there is no active market for the security.

Example of redeemable noncontrolling interest can be when Company A is the parent of

Subsidiary B, and Entity C purchases a 20 percent noncontrolling interest in B from A. Company
A and Entity C agree that C can sell its 20 percent interest in B back to A for a fixed amount of
$10 million at any time during the next three years.

Balance sheet and income statement presentation Redeemable noncontrolling interest is shown
outside or permanent equity in a separate component of equity referred to as “temporary equity”
or mezzanine equity. It is shown between equity and total liabilities as redeemable noncontrolling
interest. In the income statement, we do not separate redeemable and nonredeemable
noncontrolling interest.

90
Key Terms
Page No. Term
7 AICPA American Institute of Certified Public Accountants
8 CA Constraints of accounting
56 CFF Cash flow from financing
56 CFI Cash flow from investing
56 CFO Cash flow from operations
23 COGS Cost of goods sold
24 D&A Depreciation and amortization
87 DCF Discounted cash flow
25 DDB Double declining balance
26 EBIT Earnings before interest and tax
30 EBITDA Earnings before interest, tax, depreciation and amortization
26 EBT Earnings before tax
7 FASB Financial Accounting Standards Board
41 FIFO First in first out
7 GAAP Generally accepted accounting principles
7 IFRS International Financial Reporting Standards
9 IRS Internal Revenue Services
7 IASB International Accounting Standards Board
78 LTM Last twelve months
41 LIFO Last in first out
17 MD&A Management discussion and analysis
15 NYSE New York Stock Exchange
75 P/B Price/book
74 P/E Price/earnings
42 PP&E Property, plant and equipment
28 R&D Research and development
71 ROE Return on equity
24 SG&A Selling, general and administrative expenses
7 SEC Securities and Exchange Commission
94 TEV Total enterprise value
78 TTM Trailing twelve months
17 VaR Value at risk

91