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CHAPTER TWOCHAPTER TWO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 All rights reserved.
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What you will learn in this chapterWhat 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 fromDistinguishing Form fromContent in Financial StatementsContent 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 StatementsThe Four Financial Statements
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders’ Equity
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February 1, February 2, 2002 2001 ------------- ------------- ASSETS Current 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 ------ ------
The Balance Sheet: The Balance Sheet: Dell Computer Dell Computer
CorporationCorporation
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The Form of the Balance SheetThe 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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Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Net revenue $ 31,168 $ 31,888 $ 25,265 Cost of revenue 25,661 25,445 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
The Income Statement: The Income Statement: Dell Computer Dell Computer
CorporationCorporation
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The Form of theThe Form of theIncome StatementIncome 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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Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- 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
The Statement of Cash The Statement of Cash Flows : Dell Computer Flows : Dell Computer
CorporationCorporation
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The Form of theThe Form of theCash Flow StatementCash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing
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Common stock And Capital in
Excess of Par Value
Treasury Stock
Shares
Amount
Shares
Amount
Retained Earnings
Other Comprehensive
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
The Statement of Stockholders’ Equity: The Statement of Stockholders’ Equity: Dell Computer CorporationDell Computer Corporation
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The Stocks and Flow EquationThe 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 + Sharerepurchases -Share issues
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The Articulation of the Financial StatementsThe Articulation of the Financial Statements
Investment and disinvestment by owners
Net income and other earnings
Net change in owners’ equity
Statement of Shareholders’ EquityStatement of Shareholders’ Equity
Revenues
Net income
Income StatementIncome Statement
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Cash Flow StatementCash Flow Statement
Cash
- Liabilities
Total Assets
Owners’ equity
Beginning Balance SheetBeginning Balance Sheet
+ Other Assets
- Liabilities
Cash
Total Assets
Owners’ equity
Ending Balance SheetEnding Balance Sheet
Beginning stocks Flows Ending stocks
Other Assets +
Expenses
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Form is Given by Accounting RelationsForm 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
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Accounting for a Savings AccountAccounting 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
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Intrinsic Value and Book ValueIntrinsic 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:
• Price-to-Book Ratio:
Equity of ValueBook
Equity of Value Intrinsic
Equity of ValueBook
Equity of ValueMarket
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Percentiles of P/B Ratios for U.S. Firms, 1963-2003Percentiles of P/B Ratios for U.S. Firms, 1963-2003
Source: Calculated from Standard & Poors’ COMPUSTAT data.
0
1
2
3
4
5
6
7
8
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Pri
ce-t
o-bo
ok r
atio
p10 p25 median p75 p90
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Measurement in the Balance SheetMeasurement in the Balance Sheet
• Historical Cost Accounting
• Fair Value Accounting
See Box 2.3
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Measuring Value AddedMeasuring Value Added
Value added = Ending Value – Beginning Value + Dividend
Stock Return =
Accounting value added = Ending book value – Beginning book value + Net dividend = Comprehensive earnings
t1tt dPP
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Principles of Earnings MeasurementPrinciples of Earnings Measurement
• Recognize only value added from sales to customersRevenue recognition principles
Add value when it has been earned (usually
when a sale is made)
Matching principleMatch expenses against revenue for which they
are incurred
• Accounting value added (earnings) = Revenue – Expenses
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Good MatchingGood 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 MatchingPoor 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, 1963-2003Percentiles of P/E Ratios for U.S. Firms, 1963-2003
Source: Calculated from Standard & Poors’ COMPUSTAT data.Numerator: Price forecasts future earnings
Denominator: Current earnings
0
10
20
30
40
50
60
7019
63
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Pric
e-to
-ear
ning
s ra
tio
p10 p25 median p75 p90
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Guiding Principles for Recognizing Accounting Guiding Principles for Recognizing Accounting Value AddedValue 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.
Go to Accounting Clinic I
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