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Module 1:
Introducing FinancialAccounting for MBAs
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Buffets Acquisition Criteria
Large purchases (at least $50 million of before-tax earnings),
Demonstrated consistent earning power (future projectionsare of no interest to us, nor are turnaround situations),
Businesses earning good returns on equity while employinglittle or no debt,
Management in place (we cant supply it), Simple businesses (if theres lots of technology, we wont
understand it), An offering price (we dont want to waste our time or that
of the seller by talking, even preliminarily, about atransaction when price is unknown).
Financial performance is an important factor
in Buffets criteria
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Buffets Concept of Intrinsic Value
Intrinsic valueis an all-important concept that
offers the only logical approach to evaluating therelative attractiveness of investments andbusinesses. Intrinsic value can be defined simply:It is the discounted value of the cash that can betaken out of a business during its remaining life.
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Buffets Three Suggestions for
Investors:1. Beware of companies displaying weak accounting. If a
company still does not expense options, or if its pensionassumptions are fanciful, watch out. When managementstake the low road in aspects that are visible, it is likely theyare following a similar path behind the scenes. There is
seldom just one cockroach in the kitchen.2. Unintelligible footnotes usually indicate untrustworthy
management. If you cant understand a footnote or othermanagerial explanation, its usually because the CEOdoesnt want you to. Enrons descriptions of certain
transactions still baffle me.3. Be suspicious of companies that trumpet earnings
projections and growth expectations. Businesses seldomoperate in a tranquil, no-surprise environment, andearnings simply dont advance smoothly (except, of course,
in the offering books of investment bankers).
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Business Activities
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Planning Activities
A company exists to implement specific goalsand objectives.
A companys goals and objectives are captured
in a business plan.
Information on planning activities is oftenobtained through:
The Letter to Shareholders
The Management Discussion and Analysis (MD&A)
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Financing Activities
A company requires financing to carry out itsbusiness plans.
Financing activities refer to methods thatcompanies use to raise the funds to pay forresources such as land, buildings, and equipment
There are two main sources of financing:
Equity financing
Creditor (or debt) financing
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Examples of Company Financing
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Types of Creditor Financing
Investing creditorsthose who primarilyfinance investing activities (such as banklenders).
Operating creditorsthose who primarilyfinance operating activities (such as suppliers).
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Breakdown of Creditor Financing
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Investing Activities
Investing activities are the acquisition anddisposition of resources (assets) that a companyuses to produce and sell its products and
services.The investing resources, or assets, are of two
types
Operating assetsresources devoted to operatingactivities
Nonoperating (financial) assetsresources devotedto nonoperating activities
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Breakdown of Operating and
Financial Assets
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The Accounting Equation
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Operating Activities
Operating activities are the use of companyresources to produce, promote, and sell itsproducts and services.
Operating Revenues (or sales) - the inflow ofassets from selling products and services.
Operating Expenses (or costs) - the outflow of
assets to support operating revenues Operating Income = Operating Revenues
Operating Expenses
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Defining Company Value
Most owners and nonowners formalize theirclaims on a company in the form of a contractor asecurity.
Equity securities are common for owners andbonds (notes) are common for nonowners.
These securities are traded in capital markets.
Value of Company =
Value of Nonowner Claims + Value of Owner Claims
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The Financial Statements
Balance Sheetassets, liabilities and equity at one point in time
Income Statementrevenues, expenses, and profit over aperiod of time
Statement of Equitychanges in contributed and earnedcapital
Statement of Cash Flowsnet cash inflows (outflows) formoperating, investing and financing activities
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Financial Statements
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Balance Sheet
A balance sheet reports on investing andfinancing activities.
It lists amounts for assets, liabilities, and equityas of a point in time.
The accounting equation (also called the balancesheet equation) is the basis of the balance sheet:
Assets = Liabilities + Equity
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Berkshire Hathaways Balance Sheet
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Income Statement
An income statement reports on operatingactivities.
It lists amounts for sales (and revenues) less all
expenses (and costs) over a period of time. Sales less expenses yield the bottom-line net
income amount.
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Berkshire Hathaways
Income Statement
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Statement of Equity
The statement of equity reports on changes inthe accounts that makeup equity
Contributed capital
Earned capital (retained earnings and accumulatedother comprehensive income)
This statement is useful in identifying and
analyzing reasons for changes in owners claimson a companys assets.
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Berkshire Hathaways
Statement of Stockholders Equity
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Statement of Cash Flows
The statement of cash flows reports on cash flows foroperating, investing, and financing activities over a periodof time.
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FinancialStatement
Linkages
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Information Beyond Financial
Statements
Management Discussion and Analysis
(MD&A)
Independent Auditor Report
Financial Statement Footnotes
Regulatory Filings and Proxy Statements
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Buffet on MD&A
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Economics of Accounting
Information: Demand & Supply
Demand for financial accounting informationextends to numerous users that include:
Managers and employees
Creditors and suppliers
Shareholders and directors
Customers
Regulators
Voters and their representatives
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Supply of Accounting Information
Determined by a companys estimates of the
benefits and costs of disclosure.
Regulation and bargaining power also play rolesin determining the supply of financialaccounting information.
The SEC requires financial statements, various
note disclosures, and other reports on a regularbasis.
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Supply of Accounting Information
Benefits of disclosure
lower capital cost from improved transparency
reputation effects enhance labor recruiting
Costs of disclosure
Information gathering costs
More information to competitors
Potential litigation costs
Potential political costs
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Market Efficiency
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Profitability Analysis
Return on Assets (ROA):
ROA = Net Income / Average Assets
For example, if we invest $100 in a savingsaccount yielding $3 at year-end, the return onassets is 3%.
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Disaggregating Return on Assets
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Profit Margin, Asset Turnover, and Return on
Assets for Selected Industries
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Competitive Analysis
Bargaining Power of BuyersBuyers with strong bargainingpower can exact price concessions and demand a higher level ofservice and delayed payment terms
Bargaining Power of SuppliersSuppliers with strong
bargaining power can demand a higher price for their goods andearly payments.
Threat of SubstitutionWhen the number of productsubstitutes increases, sellers lose their ability to raise pricesand/or pass on cost increases to buyers
Threat of EntryNew entrants to a market increasecompetition. To mitigate that threat, companies expend moneyto erect barriers to entry. These include R&D, advertising,management hires with special expertise, and mergers to createeconomies of scale.
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Five Forces of Competitive Intensity
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Business Context for Financial
Statements
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Accounting Principles and
Governance Structures
Information in financial statements enablescompany valuation and, by extension, thevaluation of its debt and equity securities.
The importance of financial statements meansthat their accuracy is of paramount importance .
To the extent that financial performance and
condition are accurately communicated tobusiness decision makers, debt and equitysecurities will be more accurately priced.
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Oversight of Financial Accounting
Oversight of Financial Accounting
SEC oversees all publicly traded companies
EDGAR database (www.sec.gov)
Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP)
Board of Directors
Audit Committee
Courts
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Audit Report
Financial statementspresent fairlyand in all material respectscompany financial condition.
Financial statements are prepared in conformity with GAAP
Financial statements are managements responsibility. Auditor
responsibility is to express an opinion on those statements Auditing involves a sampling of transactions, not investigation
of each transaction
Audit opinion provides reasonable assurancethat the statements
are free ofmaterialmisstatements Auditors review accounting policies used by management and
estimates used in preparing the statements
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Sarbanes-Oxley Act
The SEC requires the CEO and CFO of a company topersonally sign a statement attesting to the accuracy andcompleteness of the companys financial statements.
The statements signed by both the CEO and CFO contain thefollowing commitments: The CEO and CFO have personally reviewed the annual report There are no untrue statements of a material fact or failure to state a
material fact necessary to make the statements not misleading The financial statements fairly present in all material respects the financial
condition of the company All material facts are disclosed to the companys auditors and Board of
Directors No changes to the companys system of internal controls are made unless
properly communicated
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Financial Accounting:
not an exact science
GAAP allows companies choices in preparingfinancial statements (inventories, property, andequipment).
Companies must choose among the alternativesthat are acceptable under GAAP.
Financial statements also depend on countless
estimates.
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Financial Accounting in Context
A companys financial statements only tell part
of the story.
You must continually keep in mind the world inwhich the company operates.
Financial statement analysis must be conductedwithin the framework of a thorough
understanding of the broader forces whichimpact company performance.
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