Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

Chapter 3 will cover: • Statement of financial condition (balance sheet) • Statement of shareholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Financial Condition Shows: • What a firm owns (assets) • What a firm owes • to outsiders (liabilities) • to owners (shareholders’ equity) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Statement of Financial Condition is: Prepared at a specific point in time: • End of year • End of quarter Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Assets Current assets include: • Cash • Cash equivalents • Other assets expected to be converted into cash within one year or one operating cycle, whichever is longer Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Operating Cycle • Time required to purchase/manufacture goods, sell the goods, and collect the cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Marketable Securities • Short-term investments • Earn a return on cash not needed immediately • Valuation depends upon the intent of investment Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Receivables (Accounts Receivable) • Customer balances outstanding on credit sales • Carried at net realizable value Net realizable value: • Actual amount less allowance for estimated uncollectible accounts Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Allowance Account • Important in assessing earnings quality • There should be a consistent relationship among the changes in sales, accounts receivable, & the allowance account Caution flag raised if sales & accounts receivable are increasing, but allowance account is decreasing Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

A Retail Company • Has only one type of inventory • Merchandise inventories purchased for resale Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

A Manufacturing Company Has three types of inventory: • Raw materials • Work in process • Finished goods Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Cost Flow Assumption for Inventory Determines: • Value on balance sheet • Expense of cost of goods sold on income statement Is important for analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Commonly Used Cost Flow Assumptions • LIFO (last in, first out) • FIFO (first in, first out) • Average cost Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

LIFO • Matches current costs with current revenue on income statement • Undervaluesbalance sheet inventory during inflation • Overvalues balance sheet inventory during deflation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

FIFO • Values balance sheet inventory close to current cost • Understates cost of goods sold during inflation • Overstates cost of goods sold during deflation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

For Taxes & Reporting Purposes: • Companies must use the same method if LIFO is chosen for tax purposes • Many companies have switched to LIFO during inflation to pay lower taxes (with higher cost of goods sold expense) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Accounting Convention of Conservatism If actual value falls below cost: • Inventory written down Inventory never written up in value Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Common Size Balance Sheet • Expresses all items on balance sheet as percent of total assets • Useful in trend & structural analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Deferred Income Taxes Result from temporary differences in recognizing revenue & expense for: • Tax purposes (payments to I.R.S.) • Reporting purposes (preparation of financial statements) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Examples of Temporary Differences Accounting for: • Depreciation expense • Installment sales • Leases • Warranty & service contracts • Pensions & other employee benefits • Subsidiary investment earnings Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Permanent Differences Do not affect deferred taxes Example: • Accounting for municipal bond revenue • Recognized as income for reporting but not tax Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Deferred Taxes Can appear on balance sheet as: • Asset and/or liability • Current and/or noncurrent Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Property, Plant, & Equipment • Tangible, long-lived assets • Also called fixed assets or capital assets • Produce benefit for more than one year Carrying value on balance sheet: • Cost less accumulated depreciation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Land is an Exception • Carried at cost; not depreciated • Assumed to have unlimited useful life Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Goodwill • Results from one company acquiring another • Price paid more than fair market value of net identifiable assets (Identifiable assets less liabilities assumed) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Carrying Value of Goodwill • Company evaluates value • Decreased value requires write-off • Increased value is not recorded Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liabilities • Represent claims against assets Current liabilities: • Payment expected within one year (or one operating cycle, whichever is longer) Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Long-term Borrowings Obligations with maturities beyond one year: • Bonds • Long-term notes payable • Mortgages • Obligations under leases Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Long-term Borrowings Continued: The current portion (amount due within one year) • Is included in current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Postemployment Liabilities Includes certain postemployment obligations For example: • Accrued amount for expected medical bills of retired employees & spouses Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Pension Accounting Two types of plans: 1. Defined benefit: employer specifies amount contributed Example: • 401 (k) Pension expense is amount contributed Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Pension Accounting Continued: 2. Defined benefit: specifies amount that will be paid to employees after retirement Pension expense is estimated based on assumptions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Information About Defined Benefit Plans • Is disclosed in notes • You may need several accounting courses to understand notes Or read this book Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leases Operating lease • Conventional rental agreement Capital lease • Treated as if it were a purchase of asset Requires recognition of asset & liability on balance sheet Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Hybrid Securities Example: • Mandatorily redeemable preferred stock • Have characteristics of debt & equity • Carried between liabilities & equity on balance sheet Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Shareholders’ Equity or Stockholders’ Equity • Ownership interests in company • Residual interest in assets that would remain after satisfying all of the liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Common Stock • Usually does not receive a fixed return (Dividends declared at discretion of company’s directors) • But has voting rights Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Common Stock Continued: • Carried at par or stated value • Number of shares sold multiplied by par or stated value • Bears no relationship to market price Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Retained Earnings • Sum of all company profits less any payments made to shareholders in cash or stock dividends • Are not piles of unused cash Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Accumulated Other Comprehensive Income or Loss • Items “like” a revenue or expense but are not the same • “Unrealized gains & losses” • Not counted as part of earnings • Changes go to equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Accumulated Other Comprehensive Income or Loss Include: • Unrealized gains/losses in marketable securities classified as available for sale • Specific type of pension liability adjustment • Gains & losses on derivative financial instruments • Foreign currency translation adjustments Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws