CHAPTER TWOMcGraw-Hill/IrwinCopyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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What You Will Learn From This ChapterThe broad picture of the firm that is painted by the financial statementsThe component parts of each financial statementHow the financial statements fit together (or articulate)The accounting relations that govern the financial statementsThe stocks and flow equation that dictates how shareholders equity is updatedThe concept of comprehensive incomeThe accounting principles that dictate how the balance sheet is measuredHow price-to-book ratios are affected by accounting principlesThe accounting principles that dictate how earnings are measuredHow price-earnings ratios are affected by accounting principlesThe difference between market value added and earningsWhy fundamental analysts want accountants to enforce the reliability criterionHow financial statements anchor investors2-*

The Big Picture for This ChapterThe financial statements are the lens on the business. They draw a picture in two ways:

1. The way that the component parts of the statements fit together sketches out the picture

2. The numbers reported within each component fills out the sketch

Accounting equations describe how the components fit together 2-*

The Four Financial StatementsBalance Sheet

Income Statement

Cash Flow Statement

Statement of Shareholders Equity2-*

The Balance Sheet: Nike, Inc., 20102-*

How Balance Sheet Components Fit TogetherAssets = Liabilities + Shareholders Equity

Or:

Shareholders Equity = Assets Liabilities

Compare to:

Value of Equity = Value of Firm Value of Debt2-*

The Income Statement: Nike, Inc., 20102-*

The Components of theIncome StatementNet Revenue Cost of Goods Sold = Gross Margin

Gross Margin Operating Expenses = Operating Income

Operating Income 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

Operating income is sometimes called earnings before interest and taxes (ebit)2-*

The Cash Flow Statement : Nike, Inc., 20102-*

The Components of theCash Flow StatementChange in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing2-*

The Statement of Shareholders Equity: Nike, Inc., 20102-*

The Components of the Equity Statement

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

The Stocks and Flow Equation:2-*

The Articulation of the Financial Statements:How They Fit Together2-*

A Summary of the Accounting Relations2-*

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)

Net 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

Accounting for a Savings AccountAmount invested: $100Earnings rate:5%

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Intrinsic Value and Book ValueIntrinsic 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: 2-*

Percentiles of P/B Ratios for U.S. Firms, 1963-20102-*

Measurement in the Balance SheetHistorical Cost Accounting

Fair Value Accounting

Box 2.3 in text explains how each item of assets and liabilities is measured.

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Measuring Value AddedValue added = Ending Value Beginning Value + Dividend

Stock Return =

(The stock return is sometimes referred to as Market Value Added)

Accounting value added = Ending book value Beginning book value + Net payout =Comprehensive earnings

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Principles of Earnings MeasurementRecognize value added only when you have a customer

Revenue recognition principles Add value when it has been earned (usually when a sale is made).

Matching principleMatch expenses against revenue for which theyare incurred.

Accounting value added (earnings) = Revenue Expenses

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Good Matching: ExamplesOnly 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).2-*

Bad Matching: ExamplesResearch 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, 1963-20102-*

Guiding Principles for Recognizing Accounting Value AddedThe Fundamentalist Creed Dont mix what you know with speculation

The Accountants 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:Basic Accounting Principles

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