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

2-1
 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.

2-2
The Four Financial Statements

1. Balance Sheet

2. Income Statement

3. Cash Flow Statement

4. Statement of Shareholders’ Equity

2-3
The Balance Sheet:
Dell Computer February 1,
2002
February 2,
2001

Corporation Current assets:

ASSETS
------------- -------------

Cash and cash equivalents $ 3,641 $ 4,910

Short-term investments 273 525
Accounts receivable, net 2,269 2,424
Inventories 278 400
Other 1,416 1,467
------ ------
Total current assets 7,877 9,726
Property, plant and equipment, 826 996
net
Investments 4,373 2,418
Other non-current assets 459 530
------ ------
Total assets $ 13,535 $ 13,670
------ ------
LIABILITIES AND STOCKHOLDERS EQUITY

Current liabilities:
Accounts payable $ 5,075 $ 4,286
Accrued and other 2,444 2,492
------ ------
Total current liabilities 7,519 6,778
Long-term debt 520 509
Other 802 761
Commitments and contingent - -
liabilities (Note 7)
------ ------
Total liabilities 8,841 8,048
------ ------
Stockholders equity:
Preferred stock and capital in - -
excess of $.01 par value;
shares issued and outstanding:
none
Common stock and capital in 5,605 4,795
excess of $.01 par value;
shares authorized: 7,000;
shares issued: 2,654 and
2,601, respectively
Treasury stock, at cost; 52 (2,249) -
shares and no shares,
respectively
Retained earnings 1,364 839
Other comprehensive income 38 62
Other (64) (74)
------ ------
Total stockholders equity 4,694 5,622
------ ------
Total liabilities and $ 13,535 $ 13,670
stockholders equity
------ ------

2-4
 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

2-5
The Income Statement: Fiscal Year Ended

Dell Computer
-------------------------------------------
February 1, February 2, January 28,
2002 2001 2000
------------ ------------ -------------
Corporation Net revenue
Cost of revenue
$ 31,168
25,661
$ 31,888
25,445
$ 25,265
20,047
------ ------ ------
Gross margin 5,507 6,443 5,218
------ ------ ------
Operating expenses:
Selling, general and 2,784 3,193 2,387
administrative
Research, development and 452 482 374
engineering
Special charges 482 105 194
------ ------ ------
Total operating expenses 3,718 3,780 2,955
------ ------ ------
Operating income 1,789 2,663 2,263
Investment and other income (58) 531 188
(loss), net
------ ------ ------
Income before income taxes and 1,731 3,194 2,451
cumulative effect of change in
accounting principle
Provision for income taxes 485 958 785
------ ------ ------
Income before cumulative 1,246 2,236 1,666
effect of change in accounting
principle
Cumulative effect of change in - 59 -
accounting principle, net
------ ------ ------
Net income $ 1,246 $ 2,177 $ 1,666
------ ------ ------
Earnings per common share:
Before cumulative effect of
change in accounting
principle:
Basic $ 0.48 $ 0.87 $ 0.66
------ ------ ------
Diluted $ 0.46 $ 0.81 $ 0.61
------ ------ ------
After cumulative effect of
change in accounting
principle:
Basic $ 0.48 $ 0.84 $ 0.66
------ ------ ------
Diluted $ 0.46 $ 0.79 $ 0.61
------ ------ ------
Weighted average shares
outstanding:
Basic 2,602 2,582 2,536
Diluted 2,726 2,746 2,728
2-6
 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

2-7
The Statement of Cash Fiscal Year Ended

Flows : Dell Computer -------------------------------------------

February 1,
2002
February 2,
2001
January 28,
2000

Corporation
------------ ------------ -------------
Cash flows from operating
activities:
Net income $ 1,246 $ 2,177 $ 1,666
Adjustments to reconcile net
income to net cash provided by
operating activities:
Depreciation and amortization 239 240 156
Tax benefits of employee 487 929 1,040
stock plans
Special charges 742 105 194
(Gains)/losses on investments 17 (307) (80)
Other 178 135 56
Changes in:
Operating working capital 826 642 812
Non-current assets and 62 274 82
liabilities
------ ------ ------
Net cash provided by 3,797 4,195 3,926
operating activities
------ ------ ------
Cash flows from investing
activities:
Investments:
Purchases (5,382) (2,606) (3,101)
Maturities and sales 3,425 2,331 2,319
Capital expenditures (303) (482) (401)
------ ------ ------
Net cash used in investing (2,260) (757) (1,183)
activities
------ ------ ------
Cash flows from financing
activities:
Purchase of common stock (3,000) (2,700) (1,061)
Issuance of common stock under 295 404 289
employee plans
Other 3 (9) 77
------ ------ ------
Net cash used in financing (2,702) (2,305) (695)
activities
------ ------ ------
Effect of exchange rate changes (104) (32) 35
on cash
------ ------ ------
Net (decrease) increase in cash (1,269) 1,101 2,083

2-8
 The Form of the
Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

2-9
The Statement of Stockholders’ Equity:
Dell Computer Corporation
Common stock
And Capital in
Excess of Par Value Treasury Stock
Other
Retained Comprehensive
Shares Amount Shares Amount Earnings Income Other Total
Balances at
February 2, 2001 2,601 4,795 - - 839 62 (74) 5,622
Net income - - - - 1,246 - - 1,246
Change in unrealized gain on
investments, net of taxes - - - - - (65) - (65)
Foreign currency translation
adjustments - - - - - 2 - 2
Net unrealized gain on
derivative instruments, net of
taxes - - - - - 39 - __39
Total comprehensive income
for fiscal 2002 - - - - - - - 1,222
Stock issuances under
employee plans, including tax
benefits 69 843 - - - - 10 853
Purchases and
retirements (16) (30) 52 (2,249) (721) - - (3,000)
Others - (3) - - - - - (3)
Balances at ____ ____ __ _______ ______ ___ ___ _____
February 1,2002 2,654 $5,605 52 $(2,249) $1,364 $38 $(64) $4,694

2-10
 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

2-11
The Articulation of the Financial Statements
Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations

Beginning Balance Sheet Cash from investing Ending Balance Sheet
Cash from financing

Cash Net change in cash Cash

Other Assets + + Other Assets

Statement of Shareholders’ Equity
Total Assets Total Assets
Investment and disinvestment by owners
- Liabilities - Liabilities
Net income and other earnings

Owners’ equity Net change in owners’ equity Owners’ equity

Income Statement

Revenues

Expenses

Net income

2-12
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 + Share Repurchases
Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income  = Comprehensive Income  Share Issues
 Net Payout to Shareholders  = Net Payout
= Ending Equity

2-13
 Accounting for a Savings Account

• Amount invested: $100

• Earnings rate: 5%
BALANCE SHEET INCOME STATEMENT

Assets $100 Owners’ equity $100 Revenue $5

Expenses 0

Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY

Cash from operations $5 Balance, end of Year 0 $100

Cash investment 0 Earnings, Year 1 5

Cash in financing activities: Dividends (withdrawals), Year 1 (5)

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

Change in cash $0

2-14
 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

2-15
 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

2-16
 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

2-17
Guiding Principles for Recognizing Accounting
Value Added

• The fundamentalist creed: Don’t mix what you

know with speculation

• The accountant’s restatement of the creed (the

reliability criterion):
Accounting numbers should be based on
objective evidence, free of opinion and bias.

2-18