Week 1: Financial Statements, Equities and Bonds

1. Week 1: Financial Statements, Equities and Bonds Sep. 8, 2011

2. Schedule

3. For today… • Introduction to accounting • Three financial statements • Balance Sheet • Income Statement • Cash Flow Statement • Financial Reports • 10-K • 10-Q

4. What is Financial Accounting? • Accounting is a system for recording financial information about a business and reporting it to decision makers • Financial accounting refers specifically to accounting for external decision makers: creditors, investors, suppliers, etc. • This is what we care about.

5. The Balance Sheet • A list of the assets and liabilities of the firm at a particular time. • Can be thought of as a “snapshot” of the business at one point in time. • Three major components • Assets: resources of the firm • Liabilities: things the firm owes to others • Stockholder’s equity: Everything else • Money investors put in or have reinvested from earnings.

6. Balance Sheet: XOM

7. The details • Current Assets are those that will be used up or can be sold within one year. • Current Liabilities have a maturity of less than one year. • Assets • Investments: Money the firm has invested in other companies (usually when it is sitting on a pile of cash) • Receivables: Money owed to the firm by others (usually customers)

8. The details • Liabilities • Accounts payable: money owed by the firm to suppliers, usually • Deferred Long-term liability charges: a collection of future liabilities of the firm.’ • Stockholder’s equity • Common stock: money that investors have invested in the business. • Retained earnings: money that has been reinvested in the business from its profits.

9. Things to Notice • The Accounting Equation always holds • Assets = Liabilities + Stockholder’s Equity • Why? • Balance sheet items are recorded at the cost to acquire them, not at market value (for now). • The balance sheet is valid for a single date. • Note: All financial statements have notes accompanying them that explain some numbers.

10. The Income Statement • Statement showing revenues and expenses over a period. • Can be thought of as a continuous video of the firm over time. • Revenue is NOT the same as cash inflow and expenses are NOT the same as cash outflow. • More on that soon •  Income Statement: XOM

11. Amount paid for goods sold over the period (aka Cost of Goods Sold) Op. expenses are those incurred in the normal operations of the business. Calculating operating income or loss is important for determining income tax Interest expense is not considered an operating expense: it does not relate to the normal operations of the business.

12. Why distinguish operating income/loss? • When examining a business, we want to be able to determine how much profit it can make from the business itself. • Interest expense adds noise: it reflects how the firm is financed, not how it operates. If we bought the business, we might radically change its capital structure, so we want to see a picture of the business that is independent of that.

13. Profit ≠ Cash Flow: example 1 • The firm sells some inventory to a customer on credit, due next month. • Is that profit? Yes (assuming the customer will pay). • Is that cash flow? No. • In accounting, revenue is recorded when earned, not when cash is received.

14. Profit ≠ Cash Flow: example 2 • A firm uses its cash reserves of $10,000,000 to buy a plant, and uses the plant to generate $2,000,000 of cash per year for 10 years. • It would not be very useful to say the firm had a loss of $10 m in the first year, and $2 m profit thereafter, even though that is our cash flow. • Instead, we can classify the purchase as an investing activity and include the cost of the plant as an expense over time as it is used • This is a process called “depreciation.”

15. The Cash Flow Statement • Provides a summary of cash inflows and outflows over a specified period of time. • Like the income statement, it can be thought of as a continuous video over time. • This is the statement we care most about, as predicting future cash flows is the most important aspect of investing in stocks.

16. Cash Flow Statement: XOM Operating Cash Flow (OCF) is calculated by making adjustments to Net Income for non-cash items on the income statement and balance sheet. Not that important exactly how this is done, but just know that OCF is calculated indirectly from Net Income ICF includes purchase and sale of plant, equipment, land, etc. and other investments. FCF includes inflows and outflows related to financing the business. Inflows from investors and loans, outflows from paying dividends and paying debt. Net Change in cash balances

17. Why distinguish O, I, and F? • As before, we are interested in seeing how much cash the business is capable of generating through its normal (operating) activities. • Cash flows from investing and financing activities are typically unrelated to this; that is, they generate noise around what we are really looking for. • By looking at operating activities, we get a feel for what kind of cash the business can generate even if we change its financing and investing cash flows

18. Another word on Depreciation • Suppose a business spends $10 m on a plant that is used to generate $2 m in profit per year for 10 years. • The company might “depreciate” the plant by $1 m per year for 10 years. • This depreciation will count as an expense on the income statement, so the firm will show $1 m in profit per year. • In this way we spread the cost out over the useful life of the plant.

19. Accounting Red Flags • Revenue recognition • Switching accounting methods • Disclosures only seen in footnotes • Banks transferred liabilities to shadow corporations to meet liquidity standards • Excessive accounts receivable growth • Counting current expenses as prepaid assets • Amortizing over several years to increase income

20. Reports • Released annually and quarterly • Mandated by the Securities & Exchange Commission (SEC).

21. Reports • Annual report includes: • Non-financial section • Discusses the company and its operations • Financial section • The main financial statements • Financial history for 5 or 10 years • Management’s discussion • Other minor things • Quarterly report • Less rigorous than annual report • Unaudited

22. SEC Filings • Form 10-K: annual • Everything in the annual report • More detailed description of the business • Etc. • Form 10-Q: Quarterly • Everything in the quarterly report • More detailed description of the business • Etc.

23. Why do reports and filings matter? • They are an excellent first source when evaluating a company. • They contain detailed information about the company’s financial and non-financial history, operations, management, etc. • If you want to learn more about a company, pull up its annual report and see what you find.

24. Questions?

25. Further Information • Books • Financial Accounting by Libby, Libby & Short • Courses at Cornell • AEM 2210 • HADM 2210 • ORIE 3150