Financial Statements Are Designed to Report Performance Consistently

Financial Analysis

95-711

Fall 2002

Lecture Notes

Session One

Prof. L. A. Pastor

Financial Statements

Interpretation

Managers’ decisions affect financial statements

Financial Statements are designed to report performance consistently

External users need financial statements to evaluate management decisions

Generally Accepted Accounting Principles (GAAP)

Guidelines and rules, that govern the preparation financial statements

Accrual (vs. Cash) Basis of Accounting

“Promulgated” by FASB

Required by the SEC

Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Changes in Owner Equity

Book vs. Market

Accrual vs. Cash

GAAP Preferred

Not for Taxes

Matches Revenues with Expenses

Accrual Basis

Simultaneous

Cash flows and revenue and expense recognition (Same for Cash Basis)

Accruals

Revenues and expense recognition preceding cash in flow and out flow

Deferrals

Cash flows precedes revenue and expense recognition

Examples

John began working at XYZ Co. in December and got paid $5,000 on the first of January for the preceding month. What is the salary expense for John in the month of December using:

the accrual basis of accounting?

the cash basis of accounting?

Example

In December ABC Co. purchased and received $20,000 worth of XYZ’s services on 30 day terms. What is the revenue related to this sale for XYZ in December using

the accrual basis of accounting?

the cash basis of accounting?

Example

If John was the only cost related to the services received by ABC in December what was the profits related to this job for XYZ in December and January using

the accrual basis of accounting?

the cash basis of accounting?

Example

XYZ received a deposit of $10,000 in December from ABC for a new project which is to start in the new year? What is the Revenue for December using

the accrual basis of accounting?

the cash basis of accounting?

Accounting Conventions

Conservatism

Although accuracy is paramount, it is preferable to err on the side of conservatism

Measurement

Consistent Currency Unit

Consistent Time Periods

Going Concern

Reliability

Objective

Cost

Cost

Historical cost

Amount originally paid for the asset

Net realizable value (NRV)

Amount expected to be realized

Replacement cost

Current cost to replace (e.g., certain marketable securities).

Present value

Amount of estimated future cash flows (e.g., monetary assets and liabilities)

Fair Market value (or FMV)

What the market will bear

Types of Business Organizations

Sole Proprietorships

Partnerships

Corporations

Hybrids

Limited Partnerships

LLP

LLC

PC

Organizing a Business

Goals of The Corporation

Shareholders desire wealth maximization

Do managers maximize shareholder wealth?

Managers have many constituencies “stakeholders”

“Agency Problems” represent the conflict of interest between management and owners

Managing Corporations

Shareholder

Elects Board of Directors

Shareholder Votes vs. Proxy

Board of Directors

Hires Management

Oversight of Management

Management makes decision

Authorizes Dividends to Shareholders

Usually Approved by the Board

Balance Sheet

Balance Sheet Format

Value of Assets

Record the asset at either the FMV of what is received or the FMV of what is given up, whichever is more clearly determinable.

Cash, value of services, other assets

If unclear, emphasize the asset received

Acquisition of Assets

Paying cash

Issuing debt

Notes payable, leases

Issuing equity

Common stock, preferred stock

By self-construction

Current Assets (Short Term)

Cash and equivalents

Short-term investments

Receivables (net of allowance for doubtful accounts)

Inventories

Prepaid expenses

Notes receivable

Deferred income taxes

Non Current Assets ( Long Term Assets)

Property, plant and equipment

Natural resources

Intangible assets

Fixed Assets

Property, plant and equipment (PP&E)

Land

Buildings

Furniture, vehicles and equipment

Leasehold improvements

Less: allowance for accumulated depreciation

Property Plant & Equipment

Tangible

Used in the operations of the business

Relatively long-lived

Not intended for resale

“Costs” Capitalized

Transportation

Installation

Additions

Maintenance is not Capitalized

Natural Resources

Acquisition costs (capitalized)

Exploration costs – two methods

Successful efforts (capitalize costs related only to successful completion)

Full costing (capitalize costs related to all exploration)

Intangible Assets

Patents

Copyrights

Trademarks and Trade names

Organization costs

Goodwill

Capitalized R&D

Cost Allocation through “Amortization”

Research & Development

Expensed as incurred until feasibility is established

Capitalized as an Asset after feasibility point

Cost Allocation

Method is Management’s Decision

Depreciation & Amortization

Long Term Assets

Matches Use of Asset to related Revenue

Depletion

Natural Resources

Cost of Resources Extracted

Related Depreciation Expense

Reduce the Value of the asset on the Balance Sheet

Accumulated Depreciation is a “contra asset” account

Increase in Accumulated Depreciation results in a corresponding increase in Depreciation Expense on the Income Statement

Liabilities

Current liabilities

Accounts payable

Accrued expenses payable

Short term Notes

Current portion of long-term debt

Long-term liabilities

Long Term Notes and Bonds Payable

Capital Leases

Mortgages

Liabilities (Obligations) Arise From:

Using or taking possession of resources in the course of operations before paying for them

Receive payment in advance of delivery of service or products

Raise Cash from Financial Institutions or Other Debt holders

Promises that obligate the company in the future like warranties

Requirement of Liabilities

An obligation has been incurred

Amount of obligation can be measured with reasonable certainty

Determine when the debt will be due and payable with reasonable certainty

Time value of money

Is this a Liability

ABC Company has placed an order for 200 units to be delivered in 30 days

Is this a liability?

Why or why not?

Is this a Liability

All of ABC Company’s products come with a one year warranty. Costs are incurred when repairs are made under the warranty.

Is this a Liability?

Why or why not?

Is this a Liability

ABC Company has been notified that it is being sued for discrimination.

Is this a liability?

What do you need to know?

Would a shareholder want to know about this?

Is this a Liability

Hilton Hotels has a frequent visitor program which award points and allows redemption for free stays.

Is this a liability?

What do you need to know?

Would a shareholder want to know about this?

Short Term or Current Liabilities

Expected to be paid within 1 year (or business cycle)

May also incur Interest Expense

Include:

Accounts Payable

Short Term Portion of Long Term Debt

Accrued Expenses

•Payroll not yet paid out

•Utilities

Long Term or Non Current Liabilities

Do not expect to pay off within the next year

Include

Long Term Loans

Bonds

Mortgages

Long Term Debt

Obligation to Repay

Unlike Stocks

Interest Rate

Even if not stated

Gives Rise to Interest Expense

Security

Claims against specific asset (secured)

General claims against all assets (unsecured)

Maturity

Have a definite maturity date

May be callable earlier at the borrower’s discretion

Interest

Principal x Interest Rate x Time

Interest Rate always stated on an annual basis

Ex. On a 10% loan the monthly interest equals

Principal x 10% x 1/12

Leases

Operating leases

Like renting an apartment

Risks and benefits of ownership is not transferred to Lessee (renter)

Payments are recorded as an Expense only

Leased Asset is not recorded on the Balance Sheet

Leases

Capital Lease

Economic Benefits and Risks are transferred to Lessee

Lease is for 75% of assets useful life or

Present value of the lease payments equals 90% of the value of the Asset or

Lease has a bargain purchase option

Asset must be recorded on the books

Lease is recorded as a Liability

Interest has to be calculated for each payment on the lease

Is this a Liability

ABC Company takes a 4 year lease on a vehicle that has a useful life of 5 years

Is this a Liability

ABC Company takes a 2 year lease on a vehicle that has a useful life of 5 years. At the end of the second year, ABC can purchase the car for less than its Fair Market Value.

Is this a Liability

ABC Company takes a 3 year lease on a vehicle that has a useful life of 5 years. The sticker price on the car is $20,000. The present value of all the lease is $19,000.

How will this affect the financial statements?

Answer

Increase in Assets

Increase in Liabilities

Must Depreciate Asset

Must “break out” Interest Expense when lease payment is made

Capital Lease

ABC makes an annual payment on the lease of $7,911 on this 3 year Capital Lease.

What is the effect on the Financial Statements?

Calculate Interest Expense and Principal Payment

Interest Expense

$19,000 x 12% = $2,280

Principal Pay Down

$7,911 - $2,280 = $5,631

Principal Balance

$19,000 - $5,631 = $13,369

Amortization Table

To get Payment amount, use the Excel Function: =PMT(.12, 3, 19000)

Calculate Depreciation

Use Straight line Depreciation

Historical Cost = $19,000

Lease (proxy for useful life) = 3

Annual Depreciation Expense

•$19,000/3 = $6,333

Corresponding Accumulated Depreciation

Stockholders’ Equity

Contributed capital

Common stock

Preferred stock

Additional contributed capital

Retained earnings

Equity

Residual Rights

Assets = Liabilities + Equity

Difference between Assets and Liabilities

Sources of Equity

Sales of Stock

Stock = Par Value x Shares sold

Additional Paid in Capital

Retention of Profits (earnings)

Types of Stock

Common

Voting rights

Last to get anything in a liquidation

Preferred

No voting rights

Has preference over Common Shareholders if dividends are declared

Has preference over Common Shareholder in a liquidation

May include a Preferred Stock Dividend which is based on the Par Value of the Preferred Stock

Common Stock

Authorized

In the Charter

Issued

Sold to Investors

Outstanding

Still in Investors hands

Treasury

Bought back by the Company for future Reissue

Retired

Bought back by the Company and “disposed” of

Issue Stock for Cash

ABC Company is authorized to issue 1,000,000 shares of $2 par value common stock. The company issues, 100,000 shares at $10 per share.

 If it costs ABC $50,000 to issue the shares how are the financial statements affected

Answer

Assets

Cash $950,000

Total Effect on Assets$950,000

Stockholders’ Equity

Common stock, $2 par$200,000

Additional paid-in capital 750,000

Total Effect on Equity$950,000

Issue Stock for Service

ABC Company issues 5,000 shares of $2 par common stock, in exchange for services quoted at $20,000.

How are the financial statements affected?

Answer (not including the earlier transaction)

Income Statement

Professional Services $20,000

Balance Sheet

Stockholders’ Equity

Common stock $2 par $10,000

Additional paid-in capital 10,000

$20,000

Dividends

Management is under no obligation to declare dividends on Common Stock

Management can declare dividends but not pay them out right away (in arrears)

Not included in calculating profit

Deducted from profit to calculate Retained Earnings

Declaring Dividends

At the end of the fiscal year, ABC Company had a profit of $2 million. Management with consent of the Board of Directors declares a $.50 dividend per share. Remember, ABC has 105,000 shares outstanding.

How are the financial statements affected?

Answer

Income Statement

Profit $2,000,000

Statement of Shareholder Equity

Dividends $52,500

Balance Sheet (Equity)

Retained Earnings $1,947,500

Dilution

When more shares are issued, the % of the company that existing stockholder own is reduced.

In public companies shareholders may not care

In closely held companies shareholders may care a whole lot!

Stock rights for common stock

Gives shareholder preemptive right to buy new share

Allows shareholders to maintain a proportional ownership in the corporation when additional shares are issued

Rights are usually for a few weeks

Like a warrant which can be for years

Stock Dividends

A company may declare a stock dividend to reward shareholders without paying out cash

Shareholders do not pay anything for these shares

Total Value of Equity Section does not change

Stock Split

Doubles the number of shares each stockholder owns

Reduces Par Value by half

Does not affect Additional Paid in Capital or Retained Earnings

Total Equity stays the same

Does not increase the number of shares not yet issued by the company

Asset?

Since Advertising should result in future sales and therefore future benefits, is advertising an Asset?

Been on Pets.com lately?

Seventeen dot-coms, as Internet companies are known, were among about three dozen advertisers who paid a record average of $2.2 million for a 30-second commercial on the ABC telecast which saw the St. Louis Rams beat the Tennessee Titans, 23-16.

Pets.com: "Don't Go" (30 Seconds)The company's sock puppet dog sings a woeful tale of a pet's life when his or her owner leaves home to buy pet food.

Pets.com is gone

Still think it’s a good idea to capitalize advertising and marketing cost?