Review of

2 Accounting

Chapter
McGraw-Hill/Irwin
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)

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

2-3
 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

2-4
 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)

2-5
Income Statement (cont’d)

2-6
 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
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Statement of Retained Earnings

2-8
 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

2-9
 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 a
company

• Price-earnings ratios can be confusing

2-10
 Price-earnings Ratios
for Selected US Companies

2-11
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
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 Balance Sheet
• Indicates what the firm owns and how these
assets are financed in the form of liabilities
or ownership interest
– Delineates the firm’s holdings and obligations
– Items are stated on an original cost basis rather
than at current market value

2-13
 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
– Inventory
• Includes raw materials, goods in progress, or finished
goods

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 Balance Sheet Items (cont’d)
– Prepaid expenses
• Represent future expense items that are already paid
for
– Investments
• 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
2-15
 Balance Sheet Items (cont’d)
• Depreciation expense is the current year’s charge
– Total assets: Financed through liabilities or
stockholders’ equity
• Short-term obligations
– Accounts payable
– Notes payable
– Accrued expense

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 Stockholder’s Equity
• Represents total contribution and ownership
interest of preferred and common
stockholders
– Preferred stock
– Common stock
– Capital paid in excess of par
– Retained earnings

2-17
Statement of Financial Position
(Balance Sheet)

2-18
 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

2-19
 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

2-20
 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

2-21
Comparison of Market Value
to Book Value per Share

2-22
 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

2-23
 Statement of Cash Flows (cont’d)
• 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

2-24
Concepts Behind the Statement of
Cash Flows

2-25
 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

2-27
Comparative Balance Sheets

2-28
Cash Flows from Operating
Activities

2-29
 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

2-30
 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 firm’s securities is a source of funds
• Payment of dividends and repurchase of securities is
a use of funds
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 Overall Statement
Combining the Three Sections

2-32
 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 long-
term needs – could be a potential high-risk
situation
– Example: trade credit and bank loans

2-33
 Depreciation and Funds Flow
• Depreciation
– Attempt to allocate the initial cost of an asset
over its useful life
• Charging of depreciation does not directly
influence the movement of funds

2-34
Comparison of Accounting
and Cash Flows

2-35
 Free Cash Flow
Free Cash Flow = Cash flow from operating
activities – Capital expenditures – Dividends
– Capital expenditures
• Maintain productive capacity of firm
– Dividends
• 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
2-36
 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 a tax-deductible expense

2-37
 Depreciation as a Tax Shield
• Not a new source of fund
• Provides tax shield benefits measurable as
depreciation times the tax rate
Corporation A Corporation B
Earnings before depreciation and taxes…… $400,000 $400,000
Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxed………………………… 300,000 400,000
Taxes (40%)……………………………………… 120,000 160,000
_________ _________
Earnings after taxes…………………………… 180,000 240,000
+Depreciation charged without cash outlay… 100,000 0
_________ _________
Cash flow………………………………………… $280,000 $240,000
Difference………………………………………… $40,000

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