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Review of Accounting

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
Income Statement Price-earnings Ratio Balance Sheet Statement of Cash Flows Tax-free Investments (Deprecation)


Basic Financial Statements

Income Statement Balance Sheet Statement of Cash Flows


Income Statement
Device to measure the profitability of a firm over a period of time
It covers a defined period of time It is presented in a stair-step or progressive fashion to examine profit or loss after each type of expense item is deducted


Income Statement (contd)

Sales Cost of Goods Sold (COGS) = Gross Profit (GP) GP Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI) EBIT Interest = Earnings Before Taxes (EBT) EBT Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Income Statement (contd)


Return to Capital
Three primary sources of capital:
Bondholders Preferred stockholders Common stockholders

Earnings per share

Interpreted in terms of number of outstanding shares May be paid out in dividends or retained by company for subsequent reinvestment

Statement of retained earnings

Indicates disposition of earnings

Statement of Retained Earnings


Price-Earnings (P/E) Ratio

Multiplier applied to earnings per share to determine current value of common stock Some factors that influence P/E:
Earnings and sales growth of the firm Risk (volatility in performance) Debt-equity structure of the firm Dividend payment policy Quality of management

Price-Earnings (P/E) Ratio (contd)

Allows comparison of the relative market value of many companies based on $1 of earnings per share
Indicates expectations about the future of a company

Price-earnings ratios can be confusing


Price-earnings Ratios for Selected US Companies


Limitations of the Income Statement

Income gained/lost during a given period is a function of verifiable transactions
Stockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operations

Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

Balance Sheet
Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest
Delineates the firms holdings and obligations Items are stated on an original cost basis rather than at current market value


Balance Sheet Items

Liquidity: Asset accounts are listed in order of liquidity
Current assets
Items that can be converted to cash within 12 months

Marketable securities
Temporary investments of excess cash

Accounts receivable
Allowance for bad debts to determine their anticipated collection value

Includes raw materials, goods in progress, or finished goods

Balance Sheet Items (contd)

Prepaid expenses
Represent future expense items that are already paid for

Long-term commitment of funds Includes stocks, bonds, or investments in other companies

Plant and equipment

Carried at original cost minus accumulated depreciation Accumulated depreciation
Sum of past and present depreciation charges on currently owned assets

Balance Sheet Items (contd)

Depreciation expense is the current years charge

Total assets: Financed through liabilities or stockholders equity

Short-term obligations
Accounts payable Notes payable Accrued expense


Stockholders Equity
Represents total contribution and ownership interest of preferred and common stockholders
Preferred stock Common stock Capital paid in excess of par Retained earnings


Statement of Financial Position (Balance Sheet)


Concept of Net Worth

Net worth/book value = Stockholders equity preferred stock component Market value is of primary concern to the:
Financial manager Security analyst Stockholders


Limitations of the Balance Sheet

Most of the values are based on historical/original cost price
Troublesome when it comes to plant and equipment inventory

FASB ruling on disclosure of inflation adjustments no longer in force

It is purely a voluntary act on the part of the company


Limitations of the Balance Sheet (contd)

Differences between per share values may be due to:
Asset valuation Industry outlook Growth prospects Quality of management Risk-return expectations


Comparison of Market Value to Book Value per Share


Statement of Cash Flows

Emphasizes critical nature of cash flow to the operations of the firm
It represents cash/cash equivalents items easily convertible to cash within 90 days

Cash flow analysis helps in combating discrepancies faced through accrual method of accounting


Statement of Cash Flows (contd)

Advantage of accrual method
Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits

Disadvantage of accrual method

Adequate attention not directed to actual cash flow position of firm


Concepts Behind the Statement of Cash Flows


Determining Cash Flows from Operating Activities

Translation of income from operations from an accrual to a cash basis Direct method
Every item on the income statement is adjusted from accrual to cash accounting

Indirect method
Net income represents the starting point Required adjustments are made to convert net income to cash flows from operations

Indirect Method


Comparative Balance Sheets


Cash Flows from Operating Activities


Determining Cash Flows from Investing Activities

Investing activities:
Long-term investment activities in mainly plant and equipment
Increasing investments represent a use of funds Decreasing investments represent a source of funds


Determining Cash Flows from Financing Activities

Financial activities apply to the sale/retirement of:
Bonds Common stock Preferred stock Other corporate securities Payment of cash dividends
Sale of firms securities is a source of funds Payment of dividends and repurchase of securities is a use of funds

Overall Statement Combining the Three Sections


Analysis of the Overall Statement

How are increases in long-term assets being financed? Preferably, adequate long-term financing and profits should exist Short-term funds may be used to carry longterm needs could be a potential high-risk situation
Example: trade credit and bank loans

Depreciation and Funds Flow

Attempt to allocate the initial cost of an asset over its useful life

Charging of depreciation does not directly influence the movement of funds


Comparison of Accounting and Cash Flows


Free Cash Flow

Free Cash Flow = Cash flow from operating activities Capital expenditures Dividends
Capital expenditures
Maintain productive capacity of firm

Maintain necessary payout on common stock and to cover any preferred stock obligations

Free cash flow is used for special financing activities

Example: leveraged buyouts

Income Tax Considerations

Corporate tax rates
Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 1520%

Cost of a tax-deductible expense


Depreciation as a Tax Shield

Not a new source of fund Provides tax shield benefits measurable as depreciation times the tax rate
Corporation A
Earnings before depreciation and taxes Depreciation Earnings before taxed Taxes (40%) $400,000 100,000 _________ 300,000 120,000 _________ 180,000 100,000 _________ $280,000 $40,000

Corporation B
$400,000 0 _________ 400,000 160,000 _________ 240,000 0 _________ $240,000

Earnings after taxes +Depreciation charged without cash outlay

Cash flow Difference


13th Edition: #27 Crosby Corporation