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Chapter 2

Chapter 2. 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

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Chapter 2

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  1. Chapter 2

  2. 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

  3. Distinguishing Form fromContent 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.

  4. The Four Financial Statements • Balance Sheet • Income Statement • Cash Flow Statement • Statement of Shareholders’ Equity

  5. The Balance Sheet: Dell Computer Corporation

  6. 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

  7. The Income Statement: Dell Computer Corporation

  8. The Form of theIncome Statement Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax – Interest Expense = 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

  9. The Statement of Cash Flows : Dell Computer Corporation

  10. The Form of theCash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

  11. The Statement of Stockholders’ Equity: Dell Computer Corporation

  12. 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

  13. OtherAssets + Expenses Ending stocks Beginning stocks Flows Cash Flow Statement Cash from operations Beginning Balance Sheet Ending Balance Sheet Cash from investing Cash from financing Cash Cash Net change in cash + Other Assets Statement of Shareholders’ Equity Total Assets Total Assets Investment and disinvestment by owners - Liabilities - Liabilities Net income and other earnings Owners’ equity Owners’ equity Net change in owners’ equity Income Statement Revenues Net income The Articulation of the Financial Statements

  14. Form is Given by Accounting Relations

  15. Accounting for a Savings Account • Amount invested: $100 • Earnings rate: 5%

  16. 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: • Price-to-Book Ratio:

  17. Percentiles of P/B Ratios for U.S. Firms, 1963-2001 Source: Calculated from Standard & Poors’ COMPUSTAT data.

  18. Measurement in the Balance Sheet • Historical Cost Accounting • Fair Value Accounting See Box 2.3

  19. Measuring Value Added Value added = Ending Value – Beginning Value + Dividend Stock Return = Accounting value added = Ending book value – Beginning book value + Net dividend = Comprehensive earnings

  20. 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 See Box 2.4 for examples of good and bad matching

  21. Percentiles of P/E Ratios for U.S. Firms, 1963-2001 Numerator: Price forecasts future earnings Denominator: Current earnings Source: Calculated from Standard & Poors’ COMPUSTAT data.

  22. 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. Go to Accounting Clinic I

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