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CHAPTER TWO

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2007 All rights reserved.

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What you will learn in this chapter


The broad picture of the firm that is painted by the financial statements The component parts of each financial statement How the financial statements fit together (or articulate). The accounting relations that govern the financial statements The stocks and flow equation that dictates how shareholders equity is updated The concept of dirty-surplus accounting The accounting principles that dictate how the balance sheet is measured How price-to-book ratios are affected by accounting principles The accounting principles that dictate how earnings are measured How price-earnings ratios are affected by accounting principles The difference between market value added and earnings Why fundamental analysts want accountants to enforce the reliability criterion How financial statements anchor investors

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Distinguishing Form from Content in Financial Statements Form is the way in which the statements and their components parts fit together. Content is the measurement of the line items that are reported within the component parts of financial statements. The form gives the overall story that the statements are telling.

The content puts numbers into the story.

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The Four Financial Statements


1. Balance Sheet

2. Income Statement
3. Cash Flow Statement

4. Statement of Shareholders Equity

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The Balance Sheet: Dell Computer Corporation

February 1, 2002 ------------ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Investments Other non-current assets $ 3,641 273 2,269 278 1,416 -----7,877 826

February 2, 2001 ------------$ 4,910 525 2,424 400 1,467 -----9,726 996

4,373 459 -----Total assets $ 13,535 -----LIABILITIES AND STOCKHOLDERS EQUITY

2,418 530 -----$ 13,670 ------

Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities (Note 7) Total liabilities Stockholders equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares authorized: 7,000; shares issued: 2,654 and 2,601, respectively Treasury stock, at cost; 52 shares and no shares, respectively Retained earnings Other comprehensive income Other Total stockholders equity

5,075 2,444 -----7,519 520 802 -----8,841 ------

4,286 2,492 -----6,778 509 761 -----8,048 ------

5,605

4,795

(2,249) 1,364 38 (64) -----4,694 -----$ 13,535 ------

839 62 (74) -----5,622 -----$ 13,670 ------

Total liabilities and stockholders equity

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The Form of the Balance Sheet


Assets = Liabilities + Shareholders Equity or Shareholders Equity = Assets Liabilities

Compare to: Value of Equity = Value of Firm Value of Debt

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The Income Statement: Dell Computer Corporation

Net revenue Cost of revenue Gross margin Operating expenses: Selling, general and administrative Research, development and engineering Special charges Total operating expenses Operating income Investment and other income (loss), net Income before income taxes and cumulative effect of change in accounting principle Provision for income taxes Income before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net Net income Earnings per common share: Before cumulative effect of change in accounting principle: Basic Diluted After cumulative effect of change in accounting principle: Basic Diluted Weighted average shares outstanding: Basic Diluted

Fiscal Year Ended ------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------$ 31,168 $ 31,888 $ 25,265 25,661 25,445 20,047 ---------------5,507 6,443 5,218 ---------------2,784 452 482 -----3,718 -----1,789 (58) -----1,731 485 -----1,246 $ -----1,246 -----$ 3,193 482 105 -----3,780 -----2,663 531 -----3,194 958 -----2,236 59 -----2,177 -----$ 2,387 374 194 -----2,955 -----2,263 188 -----2,451 785 -----1,666 -----1,666 ------

0.48 -----$ 0.46 ------

0.87 -----$ 0.81 ------

0.66 -----$ 0.61 ------

0.48 -----$ 0.46 -----2,602 2,726

0.84 -----$ 0.79 -----2,582 2,746

0.66 -----$ 0.61 -----2,536 2,728

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The Form of the Income Statement


Net Revenue Cost of Goods Sold = Gross Margin Gross Margin Operating Expenses = Earnings before Interest and Tax (ebit) Earning Before Interest and Tax Interest Expense + Interest Income = Income before Taxes Income before Taxes Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income Preferred Dividends = Net Income Available to Common

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The Statement of Cash Flows : Dell Computer Corporation

Fiscal Year Ended ------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Tax benefits of employee stock plans Special charges (Gains)/losses on investments Other Changes in: Operating working capital Non-current assets and liabilities Net cash provided by operating activities Cash flows from investing activities: Investments: Purchases Maturities and sales Capital expenditures Net cash used in investing activities Cash flows from financing activities: Purchase of common stock Issuance of common stock under employee plans Other Net cash used in financing activities Effect of exchange rate changes on cash Net (decrease) increase in cash $ 1,246 $ 2,177 $ 1,666

239 487 742 17 178 826 62 -----3,797 ------

240 929 105 (307) 135 642 274 -----4,195 ------

156 1,040 194 (80) 56 812 82 -----3,926 ------

(5,382) 3,425 (303) -----(2,260) -----(3,000) 295 3 -----(2,702) -----(104) -----(1,269)

(2,606) 2,331 (482) -----(757) -----(2,700) 404 (9) -----(2,305) -----(32) -----1,101

(3,101) 2,319 (401) -----(1,183) -----(1,061) 289 77 -----(695) -----35 -----2,083

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The Form of the Cash Flow Statement


Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

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The Statement of Stockholders Equity: Dell Computer Corporation


Common stock And Capital in Excess of Par Value Treasury Stock Retained Earnings 839 1,246 Other Comprehensive Income 62 (65) 2

Shares Balances at February 2, 2001 Net income Change in unrealized gain on investments, net of taxes Foreign currency translation adjustments Net unrealized gain on derivative instruments, net of taxes Total comprehensive income for fiscal 2002 Stock issuances under employee plans, including tax benefits Purchases and retirements Others Balances at February 1,2002 2,601 -

Amount 4,795 -

Shares -

Amount -

Other (74) -

Total 5,622 1,246 (65) 2

39 -

__39 1,222

69 (16) ____ 2,654

843 (30) (3) ____ $5,605

52 __ 52

(2,249) _______ $(2,249)

(721) ______ $1,364

___ $38

10 ___ $(64)

853 (3,000) (3) _____ $4,694

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The Stocks and Flow Equation Ending equity = Beginning equity + Total (comprehensive) income Net payout to shareholders Comprehensive income = Net income + Other comprehensive income Net payout to shareholders = Dividends + Share repurchases -Share issues

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The Articulation of the Financial Statements


Beginning stocks Flows Ending stocks

Cash Flow Statement


Cash from operations

Beginning Balance Sheet


Cash

Cash from investing Cash from financing Net change in cash

Ending Balance Sheet


Cash + Other Assets

Other Assets +

Statement of Shareholders Equity


Total Assets Investment and disinvestment by owners - Liabilities Net income and other earnings Owners equity Net change in owners equity Owners equity - Liabilities Total Assets

Income Statement
Revenues Expenses Net income

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Form is Given by Accounting Relations


A Summary of Accounting Relations How Parts of the Financial Statements Fit Together The Balance Sheet Assets Liabilities = Shareholders' Equity The Income Statement Net Revenue Cost of Goods Sold = Gross Margin Operating Expenses = Operating Income before Taxes (EBIT) Interest Expense = Income Before Taxes Income Taxes = Income After Tax and before Extraordinary Items + Extraordinary Items = Net Income Preferred Dividends = Net Income Available to Common Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) Dividends
Net Income + Beginning Equity + Other Comprehensive Income = + Comprehensive Income = Comprehensive Income Net Payout to Shareholders = = Ending Equity Share Repurchases Total Payout Share Issues Net Payout

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Accounting for a Savings Account


Amount invested: $100 Earnings rate: 5%
BALANCE SHEET Assets $100 Owners equity $100 INCOME STATEMENT Revenue Expenses Earnings $5 0 $5

STATEMENT OF CASH FLOWS Cash from operations Cash investment Cash in financing activities: Dividends Change in cash (5) $0 $5 0

STATEMENT OF OWNERS EQUITY Balance, end of Year 0 Earnings, Year 1 $100 5

Dividends (withdrawals), Year 1 (5) Balance, end of Year 1 $100

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Intrinsic Value and Book Value


Intrinsic Premium:
Intrinsic Value of Equity Book Value of Equity

Market Premium:
Market Value of Equity Book Value of Equity

Intrinsic Price-to-Book Ratio:


Intrinsic Value of Equity Book Value of Equity

Price-to-Book Ratio:
Market Value of Equity Book Value of Equity

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Percentiles of P/B Ratios for U.S. Firms, 1963-2003


8 p10 7 p25 median p75 p90

Price-to-book ratio

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Source: Calculated from Standard & Poors COMPUSTAT data.


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2003

Measurement in the Balance Sheet


Historical Cost Accounting

Fair Value Accounting


See Box 2.3

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Measuring Value Added


Value added = Ending Value Beginning Value + Dividend Stock Return = Pt Pt 1 d t Accounting value added = Ending book value Beginning book value + Net dividend = Comprehensive earnings

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Principles of Earnings Measurement


Recognize only value added from sales to customers
Revenue recognition principles
Add value when it has been earned (usually when a sale is made)

Matching principle
Match expenses against revenue for which they are incurred

Accounting value added (earnings) = Revenue Expenses

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Good Matching
Only costs of good sold are matched to sales revenue, not the full costs of producing or buying inventory during the period. Thus gross margin (Revenue Cost of good sold) measures value added from trading with customers. Costs for goods not sold are reported in the balance sheet, as inventory, to be matched with revenue in future periods when the inventory is sold. Costs of buying plant are not expensed when incurred. Rather, the cost is capitalized on the balance sheet and depreciated over years when the plant produces revenues. Depreciation is a method of matching the cost of plant to the revenues the plant generates. Employee pension costs are recorded as an expense in the period that employees generate revenues, not when they are paid (in retirement).

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Poor Matching
Research and development expenditures are expensed when incurred, rather than matched to (subsequent) revenues they generate Advertising and promotion costs are expensed when incurred, rather than matched to (subsequent) revenues they generate Estimating useful lives for plant assets that are too long: Depreciation is understated

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Percentiles of P/E Ratios for U.S. Firms, 1963-2003


70
p10 p25 median p75 p90

60

Price-to-earnings ratio

50

40

30

20

10

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Source: Calculated from Standard & Poors COMPUSTAT data.

Numerator: Price forecasts future earnings Denominator: Current earnings

2003

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Guiding Principles for Recognizing Accounting Value Added The fundamentalist creed: Dont mix what you know with speculation The accountants restatement of the creed (the reliability criterion): Accounting numbers should be based on objective evidence, free of opinion and bias. Go to Accounting Clinic I

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