CHAPTER TWO

McGraw-Hill/I rwin
Copyright 2013 by The McGraw-Hill Companies, I nc. All rights reserved.
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What You Will Learn From This Chapter
The broad picture of the firm that is painted by the financial
statements
The component parts of each financial statement
How the financial statements fit together (or articulate)
The accounting relations that govern the financial statements
The stocks and flow equation that dictates how shareholders equity
is updated
The concept of comprehensive income
The accounting principles that dictate how the balance sheet is
measured
How price-to-book ratios are affected by accounting principles
The accounting principles that dictate how earnings are measured
How price-earnings ratios are affected by accounting principles
The difference between market value added and earnings
Why fundamental analysts want accountants to enforce the
reliability criterion
How financial statements anchor investors
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The Big Picture for This Chapter
The 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
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The Four Financial Statements
1. Balance Sheet

2. Income Statement

3. Cash Flow Statement

4. Statement of Shareholders Equity
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The Balance Sheet:
Nike, Inc., 2010
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How Balance Sheet Components Fit Together
Assets = Liabilities + Shareholders Equity

Or:

Shareholders Equity = Assets Liabilities


Compare to:

Value of Equity = Value of Firm Value of Debt
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The Income
Statement:
Nike, Inc., 2010
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The Components of the
Income Statement
Net 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)
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The Cash Flow
Statement :
Nike, Inc., 2010
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The Components of the
Cash Flow Statement
Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing
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The Statement of
Shareholders
Equity:
Nike, Inc., 2010
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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:
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The Articulation of the Financial Statements:
How They Fit Together
Investment and disinvestment by owners

Net income and other comprehensive income
Net change in owners equity
Statement of Shareholders Equity
Revenues
Net income
Income Statement
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Cash Flow Statement
Cash
- Liabilities
Total Assets
Owners equity
Beginning Balance Sheet
+ Other Assets
- Liabilities
Cash
Total Assets
Owners equity
Ending Balance Sheet
Beginning stocks Flows Ending stocks
Other Assets +
Expenses
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A Summary of the Accounting Relations


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



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

BALANCE SHEET INCOME STATEMENT
Assets $100 Owners equity $100 Revenue $5
Expenses 0
Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS EQUITY
Cash from operations $5 Balance, end of Year 0 $100
Cash investment 0 Earnings, Year 1 5
Cash in financing activities: Dividends (withdrawals), Year 1 (5)
Dividends (5) Balance, end of Year 1 $100
Change in cash $ 0
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Intrinsic Value and Book Value
Intrinsic 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:

Equity of Value Book
Equity of Value Intrinsic
Equity of Value Book
Equity of Value Market
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Percentiles of P/B Ratios for U.S. Firms, 1963-2010
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Measurement in the Balance Sheet
Historical 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 Added
Value 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

t 1 t t
d P P

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Principles of Earnings Measurement
Recognize 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 principle
Match expenses against revenue for which they
are incurred.


Accounting value added (earnings) = Revenue Expenses



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Good Matching: Examples
Only 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).
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Bad Matching: Examples
Research 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, 1963-2010
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Guiding Principles for Recognizing
Accounting Value Added
The 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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