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Chapter
McGraw-Hill/Irwin

Review of Accounting

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

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Basic Financial Statements
• Income Statement • Balance Sheet • Statement of Cash Flows

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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 the profit or loss after each type of expense item is deducted.

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Income Statement (cont’d)
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)
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Income Statement (cont’d)

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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 the disposition of earnings.
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Statement of Retained Earnings

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Price-Earnings (P/E) Ratio
• Refers to the multiplier applied to earnings per share to determine current value of the common stock.
P/E Ratio = Market Price of Stock / Earnings per share (EPS).

• Some factors that influence P/E:
– Earnings and the sales growth of the firm. – Risk (volatility in performance). – Debt-equity structure of the firm. – Dividend payment scheme. – Quality of management.
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Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market value of many companies based on $1 of earnings per share.
– Indicates expectations about the future of the company.

• Price-earnings ratios can be confusing.

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Price-earnings Ratios for Selected U.S. Companies

2-11

Limitations of the Income Statement
• Income that is gained or lost during a given period is a function of verifiable transactions.
– Stockholders, hence may perceive only a much smaller gain or loss from actual day-to-day operations.

• Flexibility in the reporting of transactions might result in differing measurements of income gained from similar events at the end of a time period.
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Balance Sheet
• Indicates what the firm owns and how these assets are financed in the form of liabilities and ownership interest.
– Delineates the firm’s holdings and obligations. – A cumulative chronicle of all transactions that have affected the corporation since its inception. – Items are stated on an original cost basis rather than at current market value.

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Balance Sheet Items
• Liquidity: Asset accounts are listed in order of liquidity.
– Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm. – Marketable securities: temporary investment of excess cash. – Accounts receivable: allowance for bad debts, to determine their anticipated collection value.
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Balance Sheet Items (cont’d)
– Inventory: includes raw materials, goods in progress or finished goods. – Prepaid expenses: represents future expense items, that are already paid for.
• Example: insurance premiums or rent

– Investments: long-term commitment of funds (at least one year).
• Includes stocks, bonds or investments in other companies.

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Balance Sheet Items (cont’d)
– Plant and equipment: carried at original cost minus accumulated depreciation.
• Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets. • Depreciation expense is the current year’s charge.

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Balance Sheet Items (cont’d)
– Total assets: Financed through liabilities or stockholders’ equity.

• Short-term obligations
– Accounts payable: amounts owed on open accounts to suppliers. – Notes payable: short-term signed obligations to bankers and other creditors. – Accrued expense: payment yet to be made towards - service already provided or an obligation incurred.
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Stockholder’s Equity
• Represents total contribution and ownership interest of preferred and common stockholder’s.
– Preferred stock. – Common stock. – Capital paid in excess of par. – Retained earnings.

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Statement of Financial Position (Balance Sheet)

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Concept of Net Worth
Net value/ book value = Stockholder’s equity – preferred stock component • Market value is of primary concern to the:
– Financial manager – Security analyst – Stockholders
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Limitations of the Balance Sheet
• Most of the values are based on historical or 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.

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Limitations of the Balance Sheet (cont’d)
• Differences between per share values may be due to:
– Asset valuation – Industry outlook – Growth prospects – Quality of management – Risk-return expectations.

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Comparison of Market Value to Book Value per Share

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Statement of Cash Flows
• Emphasizes the critical nature of cash flow to the operations of the firm.
– It represents cash or cash equivalents items easily convertible to cash within 90 days.

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

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Statement of Cash Flows (cont’d)
• Advantage of accrual method:
– Allows the matching of revenues and expenses in the period in which they occur to appropriately measure profits.

• Disadvantage of accrual method :
– Adequate attention is not directed to the actual cash flow position of the firm.

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Concepts Behind the Statement of cash Flows

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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.
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Indirect Method

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Comparative Balance Sheets

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Cash Flows from Operating Activities

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Determining Cash Flows from Investing Activities
• Investing activities:
– Long-term investment activities in mainly plant and equipment.
• Increasing investment is a use of funds. • Decreasing investments is a a source of funds.

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Determining Cash Flows from Financing Activities
• Financial activities apply to the sale or retirement of:
– Bonds – Common stock – Preferred stock – Other corporate securities – Payment of cash dividends.
• Sale of firm’s securities is a source of funds. • Payment of dividend and the repurchase of securities is a use of funds.
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Overall Statement Combining the Three Sections

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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
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Depreciation and Fund Flows
• Depreciation attempts to allocate the initial cost of an asset over its useful life. • Charging of depreciation does not directly influence the movement of funds.

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Comparison of Accounting and Cash Flows

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Free Cash Flow
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends. – Capital expenditures: Maintains the productive capacity of firm. – Dividends: Maintains the necessary payout on common stock and to cover any preferred stock obligations.

• Free cash flow is used for special financing activities.
– Example: leveraged buyouts
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Income Tax Considerations
• Corporate tax rates
– Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15-20%.

• Cost of tax-deductible expense

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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%)………………………………………. Earnings after taxes……………………………... +Depreciation charged without cash outlay…. Cash flow…………………………………………... Difference…………………………………………... $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

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