ACCTG 371 MODULE 1: FRAMEWORK FOR FINANCIAL
STATEMENT ANALYSIS & VALUATION
Valuing assets & equity securities (ordinary shares)
LO: Users & suppliers of F/S info; 4 F/S & acctg equation; business analysis in context of competitive environment; profitability analysis; acctg principles & regulations framing F/S
Berkshire Hathaway’s Acquisition Criteria (investment company)
1. large purchases (& pretax earnings)
2. consistent earning power (future projection irrelevant, neither are ‘turnarounds’); good cash flows (affects SPrice = net worth of firm for investors)
3. business earning good returns on equity while employing little/no debt 4. management in place (we cannot supply)
5. simple businesses (not many technologies) 6. an offering price
Financial Statement Analysis & Valuation
1. F/S Analysis: process of extracting info from F/S to better understand company’s current & future performance & financial condition
2. Valuation: process of drawing on results of analysis to estimate company’s value/worth (of debt or equity securities = value of firm’s total assets)
Step 2: fin. performance & resultant financial position/condition.
Step 3: future predicted performance
Step 4: present value total assets (debt + equity securities) or net worth (value of equity securities/shares) = decision of investing
Step 1: Business Environment & Accounting Information
Firm’s business activities: financing, investing, operating
Business forces impact how well firm performs activities: market constraints & competitive pressures impacting firm. To reduce their adverse effects, firms prepare business plans to achieve goals & identify when corrective actions needed.
Source of info for bus. plans arise from prior & current F/S.
Understanding BP helps analyst focus F/S analysis by placing analysis in proper context: appropriately assess fin. perf. & position given env. firm operates in. In order to understand bus. env. & acctg info business operates in, demand for fin. acctg. info. is created,
Financial Accounting Information: Demand & Supply
- managers & employees
- investment analysts & info intermediaries - shareholders, directors
- customers, strategic partners - regulators, tax agencies
- voters & their representatives
Demand due to variety of reasons (amount of dividends firm pays, make policies/regulations, lending decisions). Firms present general purpose F/S to satisfy demand from users.
Supply of Acctg Info (quantity & quality provided):
- determined by managers & regulators (setting minimum disclosures) - primary SEC (security & exchange) annual report filing requirements (form
10-K annual, 10-Q quarterly). NZ: annual reports to companies office - benefits of disclosure: lower costs of funds (good prospects reflected by
acctg info; investors more willing to invest at decreased cost of capital; lower interest charged by creditors due to perceived lower risk) & labour,
economic benefits form reliable disclosures (unqualified opinion from auditors; users place higher value on firm as info verified; reduces info uncertainty)
- costs of disclosure: preparation & dissemination (production costs), competitive disadvantages (due to disclosure, info is proprietary), litigation potential (info used against firm; financial expectations not upheld, potential civil lawsuits), adverse political costs (affects value)
International Acctg Standards & Convergence
International Acctg Standards Board (IASB) oversees development of acctg standards for countries outside US & regulates supply fin. info.
FASB (USA) & IASB: development high-quality, compatible acctg standards used for both domestic & cross-border financial reporting (GAAP to converge with IFRS)
a) make existing financial reporting standards fully compatible
b) coordinate future work programs to ensure compatibility maintained.
GAAP vs IFRS
Both accrual acctg & similar conceptual frameworks.
Both same set F/S (SOFP, SOCI, SOCF, statement of stockholders’ equity & explanatory footnotes)
Differences technical in nature, do not differ on broad principles.
Investing & Financing Activities
Debt: implications on riskiness
Balance Sheet
- Investment-type companies (Berkshire Hathaway) & high-tech (Cisco Systems) carry high levels cash (costs of holding cash)
- Relative proportion short & long-term assets dictated by business models (composition of assets on SOFP in same industry similar; can deviate from industry norm by small degree)
- Trade-offs in financing company by owner vs. non-owner financing (non-owner financing less costly)
- Shareholders & long-term creditors influence strategic direction of company
- A & L reported on SOFP at acquisition price (historical cost instead of fair value)
Income Statement
Operating activities: lists amounts of sales (revenues) less expenses (costs) over period of time.
Sales – expenses = net income
Trends; net income as percentage of sales; factors driving success (competitive threat)
- When company purchases long-term asset (buildings), cost reported on SOFP as asset (not expense on SOCI). Report cost of asset over course of useful life as depreciation.
- Manufacturers & merchandisers report cost of product as expense when sale recorded.
- Using cash as base of measurement problematic for financial reporting. - If asset increase in value, increase not reported as income until building
sold (if record increases in asset values as part of income when measurement based on appraised value, issues arise)
- employees earn wages yet to be paid at end of particular period (ie. wages are accrued). Recognised as expense in period work performed, not when paid
- companies are not allowed to report profit on transactions relating to own stock (don’t report income when stock sold, or expense when dividends paid to shareholders)
Statement of Equity
Changes in accounts that make equity: contributed & earned capital (RE + accumulated OCI); other (accumulated OCI & minority/non-controlling interest) Owner may prefer money reinvested, not received as dividends: reinvestment can drive further profit & growth.
Statement of Cash Flows
- provides cash flow info not reflected in SOCI & SOFP
- report net cash inflows relating to operating activities over the longer term (implications if negative for extended period of time)
- composition of investment activities (positive may not be favourable) - sources of financing
- composition operating, investing, financing CF changes over firm’s life cycle
- bottom line increase in CF may not be key number (composition changes)
Financial Statement Linkages
- SOCI & SOFP linked via RE
Berkshire: 13213mil increase in RE (SOFP) = net income (SOCI) + 28mil adjustment relating to adoption new acctg standard. No dividends paid.
- RE, contributed capital & other equity balances appear on both statement of stockholders’ equity & SOFP
- SOCF linked to SOCI as net income is component of operating cash flow. SOCF also linked to SOFP as change in SOFP cash account reflects net cash inflows & outflows for period.
Information Beyond F/S
- management discussion & analysis - independent auditor’s report
- F/S footnotes
- regulatory filings & proxy statements
Value Chain Model
Primary Support
Inbound logistics Firm infrastructure
Operations HR management
Outbound logistics Technology/product development
Servicing Procurement
Competitive Analysis
- industry competition - bargaining power buyers - bargaining power suppliers - threat substitution
- threat entry
Step 2: Adjusting & Assessing Financial Info
GAAP allows acceptable alternatives in preparing F/S (inventories, property, equipment)
F/S depend on estimates
Acctg choices make info difficult to compare companies
Sarbanes-Oxley Act
SEC requires CEO & CFO of company to sign statement attesting to accuracy & completeness of company’s F/S
Commitments:
- no untrue statements of material fact that would made statements misleading
- F/S fairly present in all material respects the financial condition of company
- all material facts disclosed to auditors & board of directors
- no changes to its system of internal controls are made unless properly communicated
Profitability Analysis
Profit Margin, Asset Turnover & ROA
High A turnover = high profit margin
Step 3: Forecasting Financial Numbers
Theoretical linkage between earnings & stock prices: - current earnings predict future
- future earnings may determine expected future dividends
- future dividends, when discounted, determine current stock price
Future Earnings & Excess Returns
- excess annual returns 10-25% for earnings increases - 10-25% negative returns for earnings decreases
Step 4: Company Valuation
Worth of company = current value of expected payoffs (Modules 12-14: compute value using dividends, CF, earnings as payoffs)
Module 15: market-based valuation
Appendix 1B: Oversight of Financial Accounting
SEC oversees all publicly-traded companies FASB (Finacnial acctg standards board)
PCAOB (public company acctg oversight board)
Audit Report
F/S = management’s responsibility. Auditor responsibility: express opinion on statements
Involves sampling transactions, not investigating each trans.
Audit opinion provides reasonable assurance statements free of material misstatements, NOT guarantee
Auditors review acctg policies used by management & estimates used in preparing statements
F/S present fairly, in all material respects, a company’s financial condition, in conformity w/GAAP (unqualified opinion)
MODULE 2: BUSINESS ACTIVITIES & FINANCIAL
STATEMENTS
1. balance sheet 2. income statement
3. statement of SHolder’s equity 4. statement of cash flows
BALANCE SHEET
A = L + E
Uses of funds = sources of funds - assets listed in order liquidity - liabilities listed in order maturity
- equity = contributed capital & retained earnings
Assets
Converted into cash or used up to generate revenues To be reported on SOFP, asset:
1. owned (controlled) by company
2. possess expected future economic benefits Current assets: converted into cash within a year
- cash: currency, bank deposits, investments w/original maturity <90 days (cash equivalents)
- marketable securities: short term investments quickly sold to raise cash - (net) accounts receivable: amounts due to company, from customers;
arise from sale products/services on credit (net of uncollectible accounts, module 6)
- inventory: goods purchased/produced for sale
- prepaid expenses: costs paid in advance (rent, insurance, advertising) Long-term assets:
- PPE, net: land, factory buildings, machinery, motor vehicles, office equipment & items used in operating activities (net of accumulated depreciation—portion of assets’ cost transferred from balance sheet to SOCI, module 6)
- long-term investments: does not intend to sell in near future
- intangible & other assets: assets without physical substance (patents, trademarks, franchise rights, goodwill, other costs incurred to provide future benefits)
Cisco Systems
Assets = reported at historical cost - objective & verifiable
- relevance (market value) vs reliability - only include items reliably measured
considerable amount ‘assets’ may not be reflected on SOFP: strong management, well-designed supply chain, superior technology Knowledge-based assets NOT on SOFP:
- while resources expended for research & development reflect economic assets, generally expensed as incurred
- Pharmaceutical firms do not have assets reflecting full amount money spent developing drugs. These amounts mostly expensed in past & serve to reduce retained earnings. Internally developed trademarks also
economic assets, but not on SOFP (but PURCHASE of externally developed trademarks treated as assets)
Apple’s liabilities & equity:
Liabilities
Current Liabilities
Used to operate/finance business
- accounts payable: amounts owed to suppliers for goods/services purchased on credit
- accrued liabilities: obligations for expenses incurred but unpaid (accrued wages payable earned by employees, accrued interest payable, accrued income taxes)
- unearned revenues: obligations created when firm accepts pmt in advance for G/S delivered in future (advances from customers, customer deposits, deferred revenues)
- current maturities of long-term debt: principal portion of LTDebt due to be paid within 1 yr
Cisco:
Net Working Capital = CA – CL
Measures short-term liquidity (paying bills in short run)
Non-current liabilities
- long-term debt: amounts borrowed from creditors, scheduled for repmt 1 yr+ in future (any portion LTDebt due within 1 yr reclassified as current liabilities = current maturities of LTDebt; includes bonds, mortgages, loans)
- other LT liabilities: obligations (pension & LT tax liabilities, settled 1 yr + into future)
Equity
- contributed capital: cash raised from issuance shares - earned capital/retained earnings
RE updated per period:
beginning RE + net income (- net loss) – dividends = ending RE Choices for owner once profits made: reinvestment (drives growth) or dividend distribution
Equity accounts:
- common stock: par value received from original sale of common stock to investors
- preferred stock: value received from original sale of preferred stock (fewer ownership rights than common)
- additional paid-in capital: amounts received from original sale stock to investors in addition to par value of common stock
- treasury stock: amount firm paid to reacquire common stock from SHolders
- retained earnings: accumulated net income (profit) not distributed to SHolders as dividends
- accumulated other comprehensive income/loss: accumulated changes in equity not reported in SOCI (module 9)
Cisco Shareholders’ Equity:
Most important line item for analysts to determine valuation for corporation = net income
Profit margin = net income / net sales Cisco:
Matching principle: recognise expenses when INCURRED
Long-run profitability: measure revenue against expenses; better predictive value for valuation
Profit vs Cash
- net income does not correspond to net cash flow. Firm could have good income but poor cash flow (& vice versa). Hence 2 dimensions to consider - Balance sheet = expanded acctg equation
Operating vs Non-operating
- operating expenses = usual, customary costs incurred to support main business activities
- non-operating expenses = financing & investing activities Transitory Items in SOCI
- discontinued operations: gains/losses (& net income/loss) from
business segments sold/have been sold in current period
- extraordinary items: gains/losses from unusual & infrequent events
Accrual Accounting
Recognition revenue when earned (even if not received in cash) & matching of expenses when incurred (even if unpaid in cash)
Reconciliation of beg. & ending balances of stockholders’ equity accounts - contributed capital
- RE (including OCI) - treasury stock
STATEMENT OF CASH FLOWS
Reports cash inflows & outflows. Reported based on 3 business activities:
1. cash flows from operating activities: firm’s transactions & events relating to its operations
2. investing: acquisitions & divestitures of investments & long-term assets 3. financing: issuances of & payment toward borrowings & equity
General Coding of Balance Sheet Changes
Working Capital Accounts
Articulation of F/S
- F/S linked within & across time = they articulate - balance sheet & income statement linked via RE
Recording Transactions
Pay $100 wages in cash
- cash assets -100, wage expense 100 reflected in SOCI, reducing income & RE
- all transactions incurred by company during acctg period recorded similarly
Adjusting Accounts
Prepaid rent:
Wage accrual:
Revenue accrual:
Exercise: The Ice Cream Store, Inc. incurred the following start-up costs (1-5). Prepare transaction analysis 1-5 using F/S effects template
Balance Sheet:
Additional transactions:
6. On October 4, purchased merchandise inventory (i.e., ice cream) at a cost of $15,000 by paying $5,000 cash and receiving short-term credit for the remainder from the supplier.
7. Immediately returned some of the ice cream because some of the flavors delivered were not ordered. The cost of the inventory returned was $3,000.
8. Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries earned/paid were $3,000.
10.As of the end of October, one month's depreciation on the equipment and building was recognized -- $383 for the building and $167 for the
equipment.
11.$450 interest expense on the note and mortgage was due and paid on October 31. Assume that the principal amounts ($35,000 + $60,000) of the note and mortgage remain unchanged.
Prepare transaction analysis 6-11, using balance sheet/income statement template
Prepare updated balance sheet as of Oct 31, 20XX & income statement for month of October 20XX. Ignore income taxes
Preparing F/S
Additional Sources of Info: form 8-K
- entry into/termination of material definitive agreement (includes petition for bankruptsy)
- exit from line of business/impairment of assets - change in company’s certified public acctg firm - change in company control
- departure of company’s executive officers
- changes in company’s articles of incorporation or bylaws
- balance sheet: largest difference = typical IFRS-based SOFP presented in reverse order liquidity
- income statement: GAAP requires 3 years’ data on SOCI, IFRS req. 2 - SOCF: GAAP-based SOCF classifies interest expense/revenue & dividend
revenue as operating, and dividends paid as financing. IFRS allows firm choice between 2 options:
i) classify interest expense/revenue, dividends paid, dividend revenue as operating, OR
ii) classify interest expense & dividends paid as financing; interest & dividend revenue as
investing Analyst Reports
Credit & Data Services
Credit analysis:
- Standard & Poor’s
- Moody’s Investor Service - Fitch Ratings
Data services:
- Thomson Corporation
First call = summary of analysts’ earnings forecasts
Compustat database = individual data items for all publicly traded companies or for any specified subset of companies.
