Fourth Edition Financial Accounting for MBAs PETER D. EASTON JOHN J. WILD ROBERT F. HALSEY MARY LEA McANALLY 0 Cambridge ‘BUSINESS PUBLISHERS‘To my daughters, Joanne and Stacey “Poe ‘To my wife Gail and children, Kimberly, Jonathan, Stephanie, and Trevor, and my parents, Leonard and Mary = ‘To my wife Ellie and children, Grace and Chaistian aH ‘To my husband Brttan and my children Loic, Maclean, Quinn and Kay. =MUK Cambridge Business Publishers COPYRIGHT © 200% Cambie nes Phen LLC aby Cantar smn Pann LL: ce pry Cnt Baas Pater 1 atc msn, open pein may ert rd ‘Coie sos Pb Caan, ttn iio ty nay rk or sm 978 9849-865 Bookstores & Faculty to ode his book, cll 800-619-6478 or mai castomerserviedeambridgepub.com. Students to ord this book, peas vis the book's Website and order iret online‘new Finacial accountng textbook for MBAs in more than a generation. Their collective experience in award T: combined sil and expertise of Easton, Wild, Haley, and McAnally create the ideal team to author the fist winning teaching, costing and research in he area of nancial accounting and analysis provides a powertal foun ation fr his innovative ethook PETERD.EASTON isso ‘xpi accounting avalon Sods th Nowe Dane Alam FAM Senso Cotspec Buss fi Profesor Eons experts YM since ct set ty the leg communi Profesor ston sa Principal in Chicago a consultant on acountng and valuation sts. Profesor Eaton hos underradate de procs from the University of Adelaide andthe Univesity of South Ausvalia. He hold a radote degree fom the University of New England and a PRD in Bus. ance) fom the University of California, Berkely Professor Easton's research on corpse valation has ben poblised inthe Journal of Accounting and Exo- mis, Journal of Accounting Research The Accuoeig Review: Contemporary Accounting Research Review of ‘Accounting States, a Journal of Business Finance and Accounting Profesor Eason has served san ssociste ‘tr fr 1 eading accounting journal and bei cu tently an asocnte editor forthe Journal of Accounting Research, Journal of Business Finance and Account ‘ng and Joural of Accounting, Auting, and Finance [He iean editor of the Review of Accounting Stas, Professor Easton has held appointment tthe Unive: sity of Chicago, the University of Calfomia a Berkley, Ohio State University, Macquarie Univesity. the Aus tralian Graduate School of Management tbe Universi of Meboume, Tilburg University, National University ‘of Singapore, Seoul National Universi and Nyenrode University. He i the recipient of aumerous awards for Financial Accounting for MBAS Introducing Financial Statements and Transaction Analysis ‘Accounting Adjustments and Constructing Financial Statements ‘Analyzing and interpreting Financial Statements Reporting and Analyzing Operating Income, Reporting and Analyzing Operating Assets Reporting and Analyzing intercorporate Investments Reporting and Analyzing Nonowner Financing. Reporting and Analyzing Owner Financing. Reporting and Analyzing Off-Balance-Sheet Financing Forecasting Financial Statements Analyzing and Valuing Equity Securities. Compound interest Tables. Constructing the Statement of Cash Flows, ‘Chart of Accounts with Acronyms Expanded Coverage of Intemational Financial Reporting Standards Glossary Index. 24 4 at 54 4 7MODULE One Financial Accounting for MBAs 1-1 ‘rancal Statement Dera and Spe ‘ya rar Sater 30 Zevon 1A Acorn SE0 Fung ung EA 125 ipenaie 1B: ascowreng Proapiee an gy areas 129 Mnagerant Apptions +39 [MODULE Two: Introducing Financial Statements and Transaction Analysis 2-1 oct Gompany: Ape 2-1 ater of oes uty 216 ‘earner 270 ‘NayangareRocordngrrareacone 22 ‘obra 3X AdGtons oman cee 292 boaysttenore 2.99[MODULE Three | Accounting Adjustments | and Constructing Financial Statements 3-1 ‘orig arr ace 8 (siamese tes) 910 ‘ral Barco Preparation snGUSE 9-12 Prana ar reprnon 3:30 StsrantctStocroten’Equty 317 ‘Asters an Oosrg rocees Using Jour Ent 3-24 Management Applesions 298 [MoouLe Four | Analyzing and Interpreting | Financial Statements 4-1 Return on east OS) fe ‘Sparing Remar PNA Spe hsrein nce Staterent-NOPAT 45 Spcattatamsin the Bence Sheet —NOA 4.8 WOR eaggrogaton mo Merge ana Turover Nat Gperang ett Mera Neier ure) Content x ‘Repand ab: Nonoperting Ren Component of ROE 4-20 [Ronepersng Petar Wo Dect Frarcig, Wirt Nenaoaratng Petrtrout Debt Franch, but Wh Comaten ot Nnoparhg Pur Fons 4-24 ‘Spec Tapes 628 ‘open 4: Too of cuity and SavencyAralsle 428 Cesc Anayoe +28 Schwan 7 operate 4 bint Dagargaton Arye 429 Reuarmertan he Bose Oot Meck 431 Inroton of DuPont Decasregaion <2 Managemen Appestions 450 [Mooute Five | Reporting and Analyzing | Operating Income 5-1 Focus Company: Picer 5-1 Spat moore Someonerts 5-5 Toverusartis ace Wn 8 mech eed mrt PD) apes "hose ax trea ert ANowancee 8:17 eragn curency taritonCfets 6-26 oma Spenser tee 52s eprint fOr Tes 5:29 Management Appfoatons 5-61[mooute sux Reporting and Analyzing Operating Assets 6-1 coos Company Cn Byers 6 Seine ss ‘suena oe eterna 8 right nt én ore 98 Sooae een Management Applesters 6-49 MODULE Reporting and Analyzing Intercorporate Investments 7-1 Iesmerte ny Sra sy 7) enagoment Aptestons MODULE Eight Reporting and Analyzing Nonowner Financing 8-1 roous Company: Yrsah Conmuneatons 64 AosaataPayane Tamever APT 8S Management Appieabons 8-43MODULE Nine Reporting and Analyzing Owner Financing 9-1 Prec capia a6 Dosa egy Cre Ose Hanagomert Applatons 8 MODULE Ten Reporting and Analyzing Off- Balance-Sheet Financing 10-1 Catster Operations 1-7 Sher tonttracyer nets 10-21 Spar 0, harsntin argonet Peso opus 10: Sc ne tes (SEs) 1028 ‘Appensx 100: Lease Captatzation | nga cata aagemert Appeations 10-48 MODULE Eleven Forecasting Financial Statements 11-1 Focus Company: Proctor & Gable 1-1 evecusng Spenng boone 18 rose Nerope'tirg xoeracs ‘Stop 3: Forecasting Assets, Labiias and Equity 17 icy St ah Ron 25 sep (ona): Forecast Pu Statement for castro Oe Yeu Anaad vans Cas aot 1190pependt 18 Qpparbaiers Forecast Report on Procter Ceahetenget Ache Tat ‘etstons 1.6 MODULE Twelve ‘Analyzing and Valuing Equity Securities 12-1 ele eS cum Company: rma GJobacn 25 Resanl Opera ere 8 Seperate os Mod 12 Stpoin Aira POP Markt 129 NecsSrentsttaumen ada 8 oper 2h lon oraon Pn Stamos 2+ ‘Appendix A: Compound intrest Tables A APPENDIX & Constructing the Statement ‘of Cash Flows B-1 rene tn 8 tga to copete Ne ach Po on Obert rave rang Laotes an ea B12 SlonredOaconreneremvtired 24 scsi aah ow teraton BS Fata Arann aah Rs 816 ‘eras Dre ato Reporting forthe Satara ot cers rom Gperaing Actes a ‘Appendix ©: Chart of Aocount with Acroryme O-1 ‘Appendix: D: Expanded Coverage of tera! ‘Rrancial Reportna Standards O-1Financial Accounting for MBAs Leannine Ooseorives {LO ay nd ace he wis and spp of ari sntanontiomatn. 1.5 {LO dey neni to fou tac strani, rd dnt acount aquton (3 {L04 este busines rahe win conn of» compere ervormet 1-20) {LO esc ne scxunin pclae rein at aetna tate 1-25) eres nd Berkshire Hathaway ows numerous businesses that pursue dverae acts, The lgendary Waren Butt, the "Sage of Oma,” manages the company. Butts vest rent philosopy is to acqure and Pod compares over {he long un. His acqulston err, aken tom Barashre Hathaway's anal report, flow 1 tae paces 2 Deen et ig oe ee ‘tons Basins aig ges on ety we enpoye tl 0 te 4 angumern ace fe cats, 5. Simple bsreses e's bis hag. vse (flog pce dt wart a wai tn or that sete by th, en pein tt a tensa ones une, toast tee of Bets 2k ota alate to financial pero ‘manoa, Fst he seeks businesees wih ge are onaistont fearing power. Butt i not ony looking for consistent fering, but eanings that are measured according to ‘ocourtng pats that closely minor the underig eco rome prtomance of the bates ‘Secon, Bue focus on “businoseasearing good retuera on equi defied ae income divided by average ‘stockholder’ exit Ourprefererce woud bet each our ‘90 by dec omning 2 dvertied group of bunesses {hat genersta cash and consstort warn above-average rctura” (Berkshire Hathaway annus report). For manage mont to ean a good return on equity, t must fous on Bot income ffeancal perfomance) and equly (inane cexnation, “Third, Buffet values companies based on their abit to generate constant earings and cash, He focuses Intnl vais, which he dees In each srnual report as folows: nein va an apr conc at es te ay lel apeach evating ers aracteress of armen ar tues. kee vue cn be detsings te dscsuted ee bea aan beaker ‘uta esas ig remaniog ‘The counted valve Bufltt descrbos is the prosent tod) vale ofthe cash flava te company expect 12 ‘Grerat fn thefts. Cath fs gaeratod when companice {se wellmananed and operate profitably and ster. Waren fet provides come eapecally use invest ‘ment guidanes in he Chalman's letter from th Berkhre ‘oe soitosrieste: Fet beveeo ampane ‘tin weak sccm a compar st oes mot wlth When mjunes tk elo et a spe etn he snes Ta elon at re cosa in treat, ‘Sind, wigs fe uly inet us ter meet ett, 8 usualy eeu th CED do nt ou Ean espns of crn tans Fray be suis compan a taps sings po- ele sd gow pets Suse stom pone fra tena r-aepse evict reais a dart tance ery ce of cose, Pe erg This book wll explain Butts reerences to stock ‘option aocouning and pension assumetions as wall 5 @ host of other eacountng lssuea that floc Interpretation and valuston of comoanias’francal performance. We i fnayee and interpret the footnotes, which Butt vows fe cruci o quay frarea reporting and anayis. Ou ‘hiowophy sgl: we must understand the ineacion land nuances of frarcialvepring to bocome eral ead fs and uses of franc rports for company all andMODULE ORGANIZATION * crore 1 Sipay ot tarsiost J Mesa | cone | me we cummenct | fewmonsaces |" hrayne = ste ay = sSanoe Fincial accounting information serves many porpoes. To understand tis, imagine that we are 3 Specific user of ccouning information, Forexampe, imagine we ae tock investor—how might We {he accountng information fo Meni sock to by? Imagine we area bond wader—ow might we the accountng infomation to aress whether a company i able o repay is debt? Imagine e are 3 Ianager—how might we use sccomting information o decide whether acquire another company ot {Tvest of acumen visio? nage we ae an egy or ced anays+—-how might We use acounting to sess and commniate a vestentaprasal or ret report? “This book explains the concepts preprton, sh application of financial scouting information snd, moran, how decison makers se such information, Accounting information lors any {eesiors beyond the few sted above In genera, managers use financial accounting infomation ‘make opening. investing, and financing Scions. Investors and analysts wse financial scountng information to help decide wbotert hy or sell stock. Lenders and rating agencies use seeounting Information to help decide on 2 company’s cediworhiness and lending terns. Regulators Use ae ‘Counting informatio tense soc ahd economic pbces an wo moniter compliance wit avs Le {al institu use accountng information to assess ines andepazations in itigatin, Other deision ‘hers ely on accounting information fr proses ranging from determining demands in labor union sitions to levying damages fc environmental abuses “This module hepis with an overview ofthe information envionment that companies fae and it icuses the demand for and suppl of Banca information. We then review financial statements tnd explain what they convey abou company, Profiabliyf described next ands used as a fous mach of our aplication of accounting information, We conlude the module witha introduction to business analysts, whichis an importa pt of drawing inferences fom finan sstemens. We include (i the appendix diseussion of the regulatory envionment that defines curent nancial re Poting for companies. "The remainder of the book can be broken into four passe figure at top of next pape. Past const of Madles 1,2 an 3 and fer a induction of accountng fundamentals and the basins Evironmcn. Pst’? consss of Module, which nodes analy of Financial statements. Although faim ofthis bok sto lp us understand the pplication of fnancal statements, itis impertn hat ‘we understand their preparation. Ths, Pr 3, which consists of Modes through 10, describes the accounting frases, Hie, and equity, Prt consist of Modules 11 and 1, which explain the forecasting of accountng number andthe valation of common stock.REPORTING ON BUSINESS ACTIVITIES “To-fectively manage a company or infer wheter ts well managed, must understand the com: pany’s basins sctiities. Facil statements elp ws understand these business atts. Those ements report ona company’s performance an inca condition, and revel executive manage men's privilege formation and esas. Financia statment satiety the neds of diferent ers, The fnctining of he scouting ior imation system involves application of coating standards to prodoce financial statment Aectively ‘sng thi infomation sem ivolves making judameas, sumptions and estimates based on Jala cnn in the financial pot, The retest vale we drive fom this information syst 38 Wer of ‘nancial pots ithe ist we gin nto the busines aetves of the company unde nals "To ffecively analyze and wee acountngsformatio, we must conser the business conext in hich the information is eeated-see Exhib 1. Without exception, all companies pian business {tvs fiance those aves, inet in those stv, and then engage i operating actives. ‘Companis conc all hese activites while confronting busines fores,mluding marks constant an competitive presres. Financ statements provides cul inp or states planning They aso Jrovide information about the relative succes of thor plans, which ca be wet take corrective thon o make new operating, investing, an nancing decisions Exhibit 1 depicts the busines activites or typical company. The ote (greening sth plan ring proces that else the overarching goal and Objectives ofthe company within which sategic ‘evistns are made, Tose strategie decisions involve company inancing asst managment, ad dally ‘pentions Appl, In, the fests company in Modules nd 3, provides the following description of itunes strategy ints anual pa Business Strategy The Company is commited to begin the best prsenel computing. po {abe spt muse snd male communal exponen a studeis eascaters, oan les Sonal, bushasses,govrmort agence and consurars tou treet hava, a ‘nate, pepraral, sanicss, and weet ofengs. The Companys business sey verges Uinque sty to dergn an develope on oparting estan hardware application software od ices to provide eastoras naw products end slur wih super ease--s, sar ite agraton and noua na eng Tne Comes tallow contra recent ‘eee and devlomert sete othe development and esha of nota prod ot and tocol in ation o ering spool conus and felted soitone ne Company cortnss to captaze onthe comvrgece of te poraora como pl cone Secteics and moble cormancctore by crating ag ening irovatons, sch as be Pod IPhonsTonos Strand Aol. The Conary’ sraeg also neues expriing ts toon ater eect rch mar of gated customer and pois them aha quay als Sed pos-assappor expen,Lor eenty ana A company's strate (eBusiness) planrefccts how it plan o achieve it goals and objectives. A plan's success depends onan effsiveanaynis of market demand and supp Specifically company {ust assess demand ors prot an services, and ssess the supply ofits np (bth Labor and pita, The plan must aso cade competitive analyses, oppor asessment and consideration "stv financial statements provide insight ito the succes of a company’s sei plan, an re an impor int othe planning poess. These taerens highlight prions ofthe state plan that, [proved profile and ths, wart ton cpt invetment They ao eval acas that ares Festive, and provide infomation tp anager develo remedial action ‘Once stategc adsense planed nd implemente, teresting Gn atmens provide input ino the planing roses fr the following yar and this proces exis again. Understanding a ‘impasse plan help focus obra of Srna seme by placing tem in pope cone, FINANCIAL STATEMENTS: DEMAND AND SUPPLY Demand for nail statements as cise fr centres a a means 1 facilitate efficent contac ing and rik-shaing. Decision makers and other stakeholders demand information ona company’s past and prospective returns and sks. Supply of financial statement is diven by companies that trish o lower their costs of financing and less obvious costs such as political, contacting and Tabor. Manages decide how mich financial infomation 10 supply by weighing the costs of dslosure gant the benefits of ictosare Regulatory agencies interven inthis process with various dnlosere reuiremens tha xablsh minimum supply of information, Demand for Information “The following broad classes of users possess demand fr financial accounting information Managers and employees Investment analysand information intermediaries Creditors and supers Sharcholders ad retry‘= Customers and strate paiers 1m Regulators and as agencies fm Veer and their representatives Managers and Employees For their own webring and future earings pteaal, managers and employees demand account ing infomation onthe fst eondion, pola, and prospects oftheir companies ae wel 6 ‘comparative fnatcl information on competing companies abd tines opportunites. This permis ‘hemo benchmark their company's performance ab conto. Managers and employees ls demand Financial accounting information for ase in compensation an horas cena hs re ed to sch numbers. The popalarty of employee pote sharing and stock overship plans has further nceased ‘mand for financial informtion Otc soars of demand include unin contacts tht link wage = _otations to secouning numbers and pension and ene plans whore solvency depends on company evformance Investment Analysts and Information Intermediaries. Investment analysts nd cfr information intermedi, such asfnanll press writer and business ‘commentators, ae interested in predicting companies” fre performance. Expectations about futwe profitably and the ability o generate es mp! the price of secures and company’ bility 0 bonow money at favorable terms. Financial reports ree information about pst performance and ‘arent resources valle to companies. These reports also provide information about elas on those rescuree, inca cams by suppis creditors, lenders, and shareholders. This information allows faults to make lnfeemed atesments out ftre financial performance an conten s0 they can Dovid stock recommendations or write commentais. Creditors and Suppliers ‘Banks and he lenders demand financial accounting iafemation to help determine loan tens, oan amounts, interest rates, and required eoluteral, Loan agreements often inelude contac require ‘ment, called eovenans, tat restric the borower’s Behavior in some fashion, Fo example, loan covenants might equi the loan pint maintain minimum levels of working capita, retained faring, intrest coverage, and so forth to safegund lenders. Covenant violations can yield techni al deft enabling the err to deman early payment or eter compensation. Supliers demand ‘inane infrmation oes credit ems ao determine hee ong term comment wo supply ‘hin lations. Boh cet and suppliers use nancial information to monitor and adjust hi on fret and commitment with empany. Shareholders and Directors Shareholders and directors demand financial accountng information to asses the profitability and ‘sks of companies. Shareholders and ters Such as iavesiment analts, trkers and psa nes tors) search for information wl in thir investment decisions. Fundamental analyse uses ian ‘ial inlormaton to estimate company valve and to frm buy-sell stock strategies. Hoth dirctors and Sharcholers se accounting information to evalate managerial performance, Manager simily use ‘uch infomation fo equst an increase in compensation an managerial poster fom dizer. Outside ‘rectors are crcia to determining Who uns the compony. and thse directors use accounting informa tio lp make leadership decisions, Customers and Strategic Partners ‘Customers (bth current and potent demand ecounting information to assess company’s ability 0 provide product or sevices ts agreed and oases the company's saving power an lability. ts tegic pres wish estimate the company’s potato asses the flmess of returns on mut transtions and strategic alliances,Module | FanlAesours rita Regulators and Tax Agencies Regulators (such a the SEC, the Federal Trade Commision, andthe Federal Reserve Dank) nd 3x fgsncies demand accounting information for ana astexsment, public protection pice etn iiportespore amas, and soft tax pices. Timely and ell information Is rial effective ‘eplatory plc) nd acountng information i ofen cea o soil and economic poy. Fore “inpl, government often grant onopoly rights o eerie and gas companies serving specific ares inexchange for egulstion ovr prices charged to consumes. These prices ae manly determined from Accounting esses. Voters and their Representatives ‘Voters and ther epresenatves 0 mtinal, ate, apd loa governments demand accounting informa tin for policy dceisons, The decisions can involve economic, social taxation, and ces initiatives, ‘oters ants epesentatives ls we accounting infomation ooonitor goverment spensing, We Inve eu of he $1,000 hamner ype srs hat government Wateiog groups uncover whi sit {ng though aceouning data, Contos o nonprofit organizations also demand accounting informa ton oases the impact heir nations. "Te accounng standards expainedin this book are consent with generally accepted account ing ines (GAAP) acoopted by the Fnancal Accounting Standards Board FASB). A siniar ‘Suanizaton, known as the lntenatioal Accounting Standards Board (ASB), develops a global ctofirtomatenal Pancial poring Standarés (FAS) for preparation of financial statements {oincrease comparably of foal tslements and reduce reporting complet, the Seouties Enchange Gormission SEC), the FAS, andthe ASB ae commited a proces of convergence tone eat of ors accounting standards. As we progress trough the book, we wl provi IFAS Insight bones eth to ety citerencesbateen GAAP and FR. ‘Supply of Information In gener the quay and uty of counting information that companies supply ae determine by ‘mangges" assessment ofthe Bnei and costs of dsclosue. Manages release information provided {he banc of disclosing tht information outweigh the cot of ing 0. Bot egularion and argaln- Ing perfect disclosure costs and benefits a thas ply oes in deermining the supply of account ing information, Mos sess ofthe wor regulate the minimum levels of accounting discloses. In {he US. pully ade fms mst le fisncial accountng information Wi the Securities Exchange Commission (SEC), The to mai compulsory SEC filings ar: ‘Form I0-K he audited ann epot that includes the Four Financial atemens diseased below, ‘wth explanatory notes andthe managements discussion and nays of nancial resus, ‘a Form 10-Q: the unsuited quarry report hat ineluds summary versions of the four nancial ‘Sateen a ined additonal dela Forms 10K and 0-Q are avilable electronically from the SEC Website (ee Appendix 1A) The mini ‘mur, regulated level of nfrmation st te standard. oth che quantity and quality of information fie cross companies and overtime, We need oly lok at several anual pot to sce considenble Sarianee inthe amount and ype of sccouning infomation pple. Far example, dterences abound tn dclsuts for segment operations, rodt performance repos, and nancng actives, Further, Some stakcoder posses ample Drgining power to obtain accountng information fr themselves “These piily ince private lenders and major supplies and customers Benefits of Disclosure “The benefits of supplying accounting information extend toa. companys capital bar, input, nd at ‘pumarkes Companies mst compete in these markets, For example capital markets provide deb and au Financing: te beter a company's prospects, the lower isis ost of epi as eflctedin lowerMoaule | Parc scouting er te sierest rats or higher stock rice), The same holds for company’s retingeffos in abor markets fds silty to crash sopenorspplier aster elatins in the input and output makes ‘Ncompony’s performance nthese markets depends on success with its busines activities andthe masters aareese of ta uscess, Companies reap the fenefits of disclosure with good news about thei reducts, processes, management, and so rth, Thai thee are real economic incentives for Companies to disclose relible(auied) accounting information enabling them w bec compete in ‘ia, Inor input and ouput marks. ‘What inte companics from providing fle or misleading good news? There ae several con strains, Animportant ons imposed by stakeholders shat of ut requirements and legal reper ‘cussion assotted wih inaccurate accounting infomation. Another retest reptatin eet rom ‘iscouues a subsequent events either supporto refue cai news. Costs of Disclosure “The ost of eppying accounting information inlets preparation and dissemination, competitive di sdvenages litigation potent and pial oss. Preparation and dsemination cos can be susan tial, but companies have of ale incur those cons Dosis managers need sina information {or ther own business decisions. The potential fr information wo yield compestivecsadvanapes is high Companies are concered hat dlosres of thee activites Sich as pedo or segment success, i tegic alliances purus, technological or stem innovations, an product proces quality improve ‘ment wilharn hei compeitive advantages. Alo, companies are Hequenly sted whea scosies r= st expectations tat reno mt. Highly vise companis fe fae poial and public res, which ‘eae “politcal costs" These connie ofen ty to appete mf they dono neat excess mois For ‘ample, government defense contr, age software conlomeres, and ol companies ae favorite {args of public scrutiny, Disclomre costae hie foe compares acing politcal eos “The SEC adopted Regulation FD or Reg FD for short to carb the pratce of selective disclosure by public companies (ale ters by the SEC) to cern shareholders sd rancal analysts, Inthe ast many companies dscloced important information in ecings and conference cals tht excluded Individel shareholders. The goal ofthis ules to even the playing Fel oral investors. Reg FD reads asfollows:" Whenever aa sue discloses any material nonpublic information regarding tha sss, he issuer shal ake public dsclosire of that information simultaneously, in the case of an intentional disclosure; and. promptly i he case ofa non-national disclosure” Reg FD increased the cox ‘of voluntary financial ielosure and le sone companies to curtilthesoply of rane informaton toallucen. International Accounting Standards and Convergence “The Intemational Accounting Standards Board IASB) oversees the development of accounting stan aus for avast umber of counres outside te U.S. Moce than 100 cous, including those in the European Union reqie use of lntnatonl Financial Reporting Standards (IFRS) developed by the TASB, For many years, IASB and the FASB operated a independent standard-seting bodies. In the ‘ly 2000s, presure mounted for these two stndard-seting organizations to collaborate and ees ‘one wat of inemationally acceptable standards. Ata join mecing in September 2002, the FASB and the IASB each acknowledged tee commitment tothe development of high-quality, compatible ‘outing standards that could be wed for bth domestic and cross-border financial reporting. At at, towing, both the FASB and IASB pledged to use thelr best effos (a) make ther existing financial reporting standards fally compatibles s00n a practicable and (bo coordinate thi fue work pro- {ams to enue that once achieved, compat i maintained. T2008, he SEC issed a oad map forthe use of IFRS by U.S. companies. The SEC envisions that al companies wil report under TFRS by 2014. Larger companies have bepun i sue TFRS com pliant financial stterents, and frcign private issuers on US, tok exchanges are cute peri ted ile financial statment in accordance with IFRS without econlatio 9 US. GAAP as was previously equred. As remaining diflerencs are cimiaaed, te convergence of acounting standards Isbecoming a rai. ‘Ae finan ements issued under IFRS satay diferent fom those sed under US, GAAP? Ata broad level the answer iso Bodh re pepe using acral accouning and uilize ini 10Loe sey ant stan ov ‘conceptual frameworks. Both equ the same set of ail statements balance sheet, icone state ment statement of cash ows, tate of stockholders’ ogy, and a set of explanatory foros. ‘Tha doe aot mean that diferenoes emai, Hosever the remaining differences re fypiall teh In natr and do df on boa pincples discussed inthis book. Indeed ces acount andar ison ty the FAST andthe IASB, sh asthe acountng for auistons of companies, were developed {july and sed smuanecly to ninimizedifleences as the two standard sting has Woek ord ‘meniaton of iteration standart “Apex Dear the end ofthis book, summasizes dieences brwoen U.S.GAAP andthe IFRS. ‘Also there area variety of sources ha provide more dea and technical nals of sims and Aitferenes between US. GAAP and TFRS, The FASD, the IASB, and each of the "Big 4” acount ing firms also maintain Websites devoted wo this sue (Search under IFRS and PC, KPMG, EY and Delo: he two stndar- sting odes also provide useful information, sec FASB (ww. fasborgl in) and 1ASB (ww ash org/Homeim Inte bar market hat folowedtne bursting of te dot.com bubble, and amid a seis of ovperate scandals uch as Enron, Teo, and WorldGor, Congress passed the Sarbanes-Onley Act, often ‘eteedto ax SOX, SOX sought Yo ety persived problems in accounting, cng wesk uct Commies and deficient neal conto Increased scrtiny of ancl eporing and internal ‘Contos hes had some sucoses A report by Gls, Lewis and Coa covprate-govorance r- {earch frm, shows that the nanber a inci estatements by pubcly waded companies sued toa recor 1.295 n2005 whic one restatement foreach 12 pubic companies, and move thant tiple the 2002 tl, the year SOX pass, The Glas, Lewis and Co. eport concluded that “whan 29 many companies produce inaccurate narca statements, it srl cals to question the ‘uaity of normation hat ivestorereld upon to make captal-alortion decisions” (CFO.Com) Bottom ine: we must be erial readers of rancial repos. FINANCIAL STATEMENTS ‘Companies ws our Finan statements peroclly report on business seve. Those statements ‘nee lance sec, income saement,stement of oceldes egy, and statement of cash Now Exhibit 2 shows how thes amen ae linked across tine. balance shoe reports ona companys Financial poston tpn In dine, Te income statment, statement of stockholders equ and the statement cash ows eporton performance over apriod fine The thc taterents nthe mile ‘of Exhibit 12 (periadof time sttement) lnk the Balance sect from th besnning tthe end of Psi‘Aone-year or anna, rpoting period is common and is called the accounting, o fiscal. sear OF Couns, fms prepare fatcal sistent more frequen. semiannual, quarter, pd monthly nan fin satements are common. Cafendar-yea companies have reporting periods beginning on Janay 1 tnd ending on December 31. Berkshire Hathaway is + ealendaryear company. Some companies ‘hose a sal year ending on ada cher han December 1, sch when sales and inventory ar ow Foccxample, Best Huy’s seal yearend is always near Fetroary 1, arte busy holiday season, Balance Sheet Atalance set reports a company’s ini postion ata point in ime. The alae shee epost the company's resources (ase), rely, wha! the company owns. The blaice soe also repo the Sources of asst financing Tete ae two wae # company can nance ts aes, It an raise money ‘rom shareholders: this is over ancing, Ht can also raise money fom banks or ater eeditrs and supplies: this is nomowner financing. This means thal bob owners and nosowaets Hold lains oa Company assets Ovaer claims on ast ae feferred 0 as equi) and nonowner clas are refered 10 ‘Table (or eb), Since ll fnncing most be invested in somthing, we obtain the Following bane ‘elation: esting equal fnancing Tis equality inealed the accounting equation, which follows: Investing Nonowner Financing + Owner Financing “The scouting equation works fr ll companies al ots in ine ‘Te tlance sheet for Berksbire Hathaway isn Exhibit 1.3 (eondensed, Refer to this lance sheet to verify the follwing amounts assets ~ $273,160 milion; Hablites ~ $149,799 millon: and ‘quiy ~ 5123401 milion. Asses equal labilits pls equity, which fees the accounting equation: investing equals financing Investing Activities Balance shoes ae orzanized ike the accounting equation, Investing stivies are epreseated bythe ‘company's asst, These assets at ianced by 8 combination of nonoer financing (aii) 25d ‘owner financing (ety) Reper aroun et pore mene, vena | cats a ed abies areca — ‘ot pie suore0 Franca uy ‘Conia cots 28960 Nero ner et Bae etl eat ja) | owrecamon ‘tain an uty. w7sne0For simplicity, Betahite Hathaway’ lace shet in Exit 3 categorizes assets ino cash nt roneash aes, Noncash ase consist of several ase categories (Module? explains the composition ‘of noncsh assets), These categories are sed in ender of {hei eames o ash Fr example, companies vn a et tory of astts called inventories, These re goods tat th ‘Company intend ol os estomers. Inventories are con ‘ered into cash when they ave sold witin shor period of tie, Hence, they ate cls as shor erm ass’. Comp ics also report category of sss called property planc and ‘auipment This eatery icles a company's fice bul ings or manufacturing fails, Proper, plat sod equip [meat assets wl be held for an extended period of time and tne therefore, generally clase as longterm aes, The relative properion of sorter and long-term as: [sti largely determined by a company’s business mode. “Thisisevidem inthe praphtothesde that depes the elaine J proportion of sow and longterm assets or several compa estat we featur inthis book, Companies suchas Apple som and Gong egret investment i long-term asics. On the other hand, Comeast and Procter & Gamble require lage investment in long-term asses. Aug manages san infcnce the relative amounts ad po poton of eset, thei eit is somewhat ited by the nate of ther indus. Financing Activities Assets mst be pi fo, ad Funding is provided by, a combination of owner and noaowne rancng. ‘nme (or equity) financing incidesresourescontbued to de company By its owners along with ‘ay pot retained bythe company. Nonovnee (realtor of et) financing is borowed mene. We distinguish beeen aie rope of Lhe nd ty these two financing sures fora reason: Borowed money 1 @ eaty tals legal coigton to repay armours owed, sale Utes | tod so can eu n severe consequeces forthe Boros Euity financing etalle no such legal obligation repay [en The eltive proportion of nonowner (abilities) and [Foner (eis) fnaneing i largely determined bya co py’s business model. Tis i evident im the graph tothe Tid, ein cing many ofthe companies we etueas focus Companies in this book, Google a reltvely new company thats eapanding ito new masks. Hs business mde! is [therefore mone sky than that of amore exalishod company fopeaing in elatvely stable market. Google cannot lord to take on additonal risk of higher teoowner financing lev tls On the tera Caterpilr'scash om relatively tlt can operate with more nonowner financing (ur discussion of ivesting and financing activities es man terms and concepts hat We explain later in the book, Our deste here isto provige a sneak preview into the ikerpay armen frail Sotemeats, manager behavior, and Seonamics. Some questions that we might have at his ey stage regarding the balance shet follow SERS RTRI ETE 1m Berks Hathaway reports $4,329 milion of cash o its 207 balance sheet, whichis 165 oft talases, Many investent type somapanis suchas Berkshire Hathaway and high-ech companies och as Cisco Systems cary high evel of cash, Why sha? Is there a cast to lding too much fh Ts eco tcary too litle cas? 15 The relative proportion of short-term and long-term assets largely dictated by companies bs ress mess Why i this he case? Why i he composition of sts on balance sets ar copanies inthe same indus similar? By what degre ea a company’s asset composition safely {eva from ndosry om? sm What are he radeon inancing company by owner versus nonownes financing? nonow ner financing eles coy, why dont we se companies naned entire with horowed money? ‘= How do shareholders influence the sateic direction ofa company’? How ca loogtem eredions nluence suategiedetion? ‘Most assets and abies ae reported onthe lance sett heir acquisition price, called itor ‘al ease Would reporting asset and liabilities at fair values be more sformatve? What problems Init faie-valuereponig cause? Review the Berkshire Hathaway lane shee summarized in Exhibit 1.3 and hin about these ques tions. We provide answers foreach of thse questions a we roses ough the Book. Balance shes prepared under FPS tend to last accounts in evrse order of qu (ack of neamees to cash). For oxarpie rtangible asset are ycay Isa ft ar cashed ast mong assets, Als, ext) i ypiclyInted bar abies, whe idiites ae asi ste in order of decreasing guy. Income Statement Anincome statement reprs ona company’s ptformance over a pei of time and iss amounts for reventcs (lo called sales) and expenses Revenes less expenses yield the balonine net income "mnount. Rerkhire Hathawaysinome statment en Exhibit Ut, Refer ot income saement 2 ‘eri the following: revenues = $118,248 milion; expenses = $105,032 milion: and net income 13213 milion, Net income refit the profit alo elle easings) wo overs for that specific peri Fepateraiis owr = sti62is {Goods arsavese Mansfacturing and merchangisng companies typically include atonal expense account called costo god sold (or est of sales), nthe income samen following revenues. Its also comman © ‘pot a sutotl called gross profit or goss margin) which is revenues less cost of goods Sold. The compat ening eee we hen po low BT sone anes yet - Bea ane a Operating Activities (Operating activities use company esources to produce, promot, and slits prodocts and services ‘These activities extend fom int markets involving sopher of materials nd labo 10 company’s ‘utp markets involving customer of products and services. Input markets generat most expensesga55038 {er cots) such a inventory salaries, material, alo piste, Output markets generate revenues (or sales) to ‘istomers. Out markets aso generate some expenses Such as marketing and distributing products and se oes to eusmers, Net income arises wea feveaues cxceed expenses, A Tons occurs when expenses exceed Dilfreaces exist in the relative profitability of ‘companies arms ineties. Although effective man fgement ean increase the profitably of company. a business models play lange prt i determining com 7} pany profitability, These ferences ae illstated in iff ea fata sen cee ems on oa nmin ih ie cumarereseememnsmsall iy Alcona pics since ae ne pete Sted ise er hey amon epoca epg ene Polar epee as a coe ng pe gy Senet gene Cotten cp Sa ne rast ‘= Assume that company sels a product customer who promises to pay in 30 days. Should the feller recognize th ale whea tis made or when cass collected? {8 When company purchases sfmg-term asset sich a a building, is eos is repoed om the balance sect at an ase. Should 4 ompaay, instead, record the cost of tht building 36 an Expense when ts acute? IF ot, Bow shoul a company report the cst ofthat aset over the course of suse ife? ‘mt Manuacturers and merchandiser repo the cost of product as an expense whe the product ae fs reorded How might we measur the costs ofa prodt that is sold by a merchandise? By a nutter? ‘man asic, sucha silting, increases in valu, tha increase in valu is mt reported income ‘nti the bldng sol, ever What concems aise if we record increases in asst vals spat fof income, when measurement of tat nese is ase on appraised values? | Employees commonly eam wages that are yet to be pid a the end ofa particular pero. Should thelr wages be ecopized ars expense inthe period hat the work x peformed, ov whe the wages are pi | Conpanis aren llowed to repr profit on tansctons lating to their own stock. That ey don't report income when stock sod, ado they report an expense when dividends are pl to shrcholers. Why is this he case? Review the Resse Hathaway’ income statement summarized in Exhibit 1 and think abou these {gcntions, We provide answers for cach of these questions as we progres through the book. When Ghar and rea reports, we have no interest in pictures of parsonnal, plats or prog cs, References to EBITDA earings belo meres, taxes, depreclabon and anorizato] make Us shudcer—does management tink te toot fay pays fr capital expends’? We're very Scoploous of accounting mahadology that e vague or uncea, sice toa tn hat means mar- ‘gomont wishes to hide sorting, we dont want t ead messages that a publ rations ‘epartment or consutant hs tuned out Istee, we expect company’s CEO to explains or het oun worde wna happening,”—su ravay mnweot