2

Review of
Accounting

Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Outline
• Income Statement
• Price-earnings Ratio
• Balance Sheet
• Statement of Cash Flows
• Tax-free Investments (Deprecation)

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 Basic Financial Statements
• Income Statement
• Balance Sheet
• Statement of Cash Flows

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 Income Statement
• Device to measure the profitability of a firm
over a period of time.
– It covers a defined period of time.
– It is presented in a stair-step or progressive
fashion
• To examine the profit or loss after each type of
expense item is deducted.

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 Income Statement (cont’d)
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)

GP – Expenses = Earnings Before Interest and

Taxes (EBIT) or Operating Income (OI)

EBIT – Interest = Earnings Before Taxes (EBT)

EBT – Taxes = Earnings After Taxes (EAT) or Net

Income (NI)

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Income Statement (cont’d)

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 Return to Capital
• Three primary sources of capital:
– Bondholders
– Preferred stockholders
– Common stockholders
• Earnings per share
– Interpreted in terms of number of outstanding
shares.
– May be paid out in dividends or retained by
company for subsequent reinvestment.
• Statement of retained earnings
– Indicates the disposition of earnings.
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Statement of Retained Earnings

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 Price-Earnings (P/E) Ratio
• Refers to the multiplier applied to earnings
per share to determine current value of the
common stock.
P/E Ratio = Market Price of Stock / Earnings per
share (EPS).
• Some factors that influence P/E:
– Earnings and the sales growth of the firm.
– Risk (volatility in performance).
– Debt-equity structure of the firm.
– Dividend payment scheme.
– Quality of management.
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 Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market
value of many companies based on $1 of
earnings per share.
– Indicates expectations about the future of the
company.
• Price-earnings ratios can be confusing.

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Price-earnings Ratios for Selected U.S.
Companies

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Limitations of the Income Statement
• Income that is gained or lost during a given
period is a function of verifiable transactions.
– Stockholders, hence may perceive only a much
smaller gain or loss from actual day-to-day
operations.
• Flexibility in the reporting of transactions
might result in differing measurements of
income gained from similar events at the
end of a time period.
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 Balance Sheet
• Indicates what the firm owns and how these
assets are financed in the form of liabilities
and ownership interest.
– Delineates the firm’s holdings and obligations.
– A cumulative chronicle of all transactions that
have affected the corporation since its inception.
– Items are stated on an original cost basis rather
than at current market value.

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 Balance Sheet Items
• Liquidity: Asset accounts are listed in order
of liquidity.
– Current assets: items that can be converted to
cash within 12 months or within the normal
operating cycle of the firm.
– Marketable securities: temporary investment of
excess cash.
– Accounts receivable: allowance for bad debts, to
determine their anticipated collection value.

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 Balance Sheet Items (cont’d)
– Inventory: includes raw materials, goods in
progress or finished goods.
– Prepaid expenses: represents future expense
items, that are already paid for.
• Example: insurance premiums or rent
– Investments: long-term commitment of funds (at
least one year).
• Includes stocks, bonds or investments in other
companies.

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 Balance Sheet Items (cont’d)
– Plant and equipment: carried at original cost
minus accumulated depreciation.
• Accumulated depreciation: sum of all past and
present depreciation charges on currently owned
assets.
• Depreciation expense is the current year’s charge.

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 Balance Sheet Items (cont’d)
– Total assets: Financed through liabilities or
stockholders’ equity.
• Short-term obligations
– Accounts payable: amounts owed on open
accounts to suppliers.
– Notes payable: short-term signed obligations to
bankers and other creditors.
– Accrued expense: payment yet to be made
towards - service already provided or an
obligation incurred.

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 Stockholder’s Equity
• Represents total contribution and ownership
interest of preferred and common
stockholder’s.
– Preferred stock.
– Common stock.
– Capital paid in excess of par.
– Retained earnings.

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Statement of Financial Position
(Balance Sheet)

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 Concept of Net Worth

Net value/ book value = Stockholder’s equity –

preferred stock component

• Market value is of primary concern to the:

– Financial manager
– Security analyst
– Stockholders

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 Limitations of the Balance Sheet
• Most of the values are based on historical or
original cost price.
– Troublesome when it comes to plant and
equipment inventory.
• FASB ruling on disclosure of inflation
adjustments no longer in force.
– It is purely a voluntary act on the part of the
company.

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 Limitations of the Balance Sheet
(cont’d)
• Differences between per share values may
be due to:
– Asset valuation
– Industry outlook
– Growth prospects
– Quality of management
– Risk-return expectations.

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Comparison of Market Value to
Book Value per Share

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 Statement of Cash Flows
• Emphasizes the critical nature of cash flow
to the operations of the firm.
– It represents cash or cash equivalents items
easily convertible to cash within 90 days.
• Cash flow analysis helps in combating the
discrepancies faced through the accrual
method of accounting.

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 Statement of Cash Flows (cont’d)
• Advantage of accrual method:
– Allows the matching of revenues and expenses
in the period in which they occur to appropriately
measure profits.

• Disadvantage of accrual method :

– Adequate attention is not directed to the actual
cash flow position of the firm.

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Concepts Behind the Statement of
cash Flows

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 Determining Cash Flows from
Operating Activities
• Translation of income from operations from
an accrual to a cash basis.
• Direct method
– Every item on the income statement is adjusted
from accrual to cash accounting.
• Indirect method
– Net income represents the starting point.
– Required adjustments are made to convert net
income to cash flows from operations.
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Indirect Method

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Comparative Balance Sheets

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Cash Flows from Operating
Activities

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 Determining Cash Flows from
Investing Activities
• Investing activities:
– Long-term investment activities in mainly plant
and equipment.
• Increasing investment is a use of funds.
• Decreasing investments is a a source of funds.

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 Determining Cash Flows from
Financing Activities
• Financial activities apply to the sale or
retirement of:
– Bonds
– Common stock
– Preferred stock
– Other corporate securities
– Payment of cash dividends.
• Sale of firm’s securities is a source of funds.
• Payment of dividend and the repurchase of securities
is a use of funds.
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Overall Statement Combining the
Three Sections

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 Analysis of the Overall Statement
• How are increases in long-term assets being
financed?
• Preferably, adequate long-term financing
and profits should exist.
• Short-term funds may be used to carry long-
term needs – could be a potential high-risk
situation.
– Example: trade credit and bank loans

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 Depreciation and Fund Flows
• Depreciation attempts to allocate the initial
cost of an asset over its useful life.
• Charging of depreciation does not directly
influence the movement of funds.

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Comparison of Accounting and Cash
Flows

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 Free Cash Flow
Free Cash Flow = Cash flow from operating activities
– Capital expenditures – Dividends.
– Capital expenditures: Maintains the productive
capacity of firm.
– Dividends: Maintains the necessary payout on
common stock and to cover any preferred stock
obligations.
• Free cash flow is used for special financing
activities.
– Example: leveraged buyouts
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 Income Tax Considerations
• Corporate tax rates
– Progressive: the top rate is 40% including state
and foreign taxes if applicable. The lower
bracket is 15-20%.
• Cost of tax-deductible expense

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 Depreciation as a Tax Shield
• Not a new source of fund.
• Provides tax shield benefits measurable as
depreciation times the tax rate.
Corporation A Corporation B
Earnings before depreciation and taxes…….. $400,000 $400,000
Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxed………………………….. 300,000 400,000
Taxes (40%)………………………………………. 120,000 160,000
_________ _________
Earnings after taxes……………………………... 180,000 240,000
+Depreciation charged without cash outlay…. 100,000 0
_________ _________
Cash flow…………………………………………... $280,000 $240,000
Difference…………………………………………... $40,000

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