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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