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Chapter

Review of Accounting

McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 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 profit or loss after each type of expense item is deducted

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Income Statement (contd)


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 (contd)

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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 disposition of earnings
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Statement of Retained Earnings

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Price-Earnings (P/E) Ratio


Multiplier applied to earnings per share to determine current value of common stock Some factors that influence P/E:
Earnings and sales growth of the firm Risk (volatility in performance) Debt-equity structure of the firm Dividend payment policy Quality of management
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Price-Earnings (P/E) Ratio (contd)


Allows comparison of the relative market value of many companies based on $1 of earnings per share
Indicates expectations about the future of a company

Price-earnings ratios can be confusing

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Price-earnings Ratios for Selected US Companies

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Limitations of the Income Statement


Income gained/lost during a given period is a function of verifiable transactions
Stockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operations

Flexibility in reporting 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 or ownership interest
Delineates the firms holdings and obligations 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

Marketable securities
Temporary investments of excess cash

Accounts receivable
Allowance for bad debts to determine their anticipated collection value

Inventory
Includes raw materials, goods in progress, or finished goods
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Balance Sheet Items (contd)


Prepaid expenses
Represent future expense items that are already paid for

Investments
Long-term commitment of funds Includes stocks, bonds, or investments in other companies

Plant and equipment


Carried at original cost minus accumulated depreciation Accumulated depreciation
Sum of past and present depreciation charges on currently owned assets
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Balance Sheet Items (contd)


Depreciation expense is the current years charge

Total assets: Financed through liabilities or stockholders equity

Short-term obligations
Accounts payable Notes payable Accrued expense

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Stockholders Equity
Represents total contribution and ownership interest of preferred and common stockholders
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 worth/book value = Stockholders 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/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 (contd)


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 critical nature of cash flow to the operations of the firm
It represents cash/cash equivalents items easily convertible to cash within 90 days

Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

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Statement of Cash Flows (contd)


Advantage of accrual method
Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits

Disadvantage of accrual method


Adequate attention not directed to actual cash flow position of 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 investments represent a use of funds Decreasing investments represent a source of funds

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Determining Cash Flows from Financing Activities


Financial activities apply to the sale/retirement of:
Bonds Common stock Preferred stock Other corporate securities Payment of cash dividends
Sale of firms securities is a source of funds Payment of dividends and 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 longterm needs could be a potential high-risk situation
Example: trade credit and bank loans
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Depreciation and Funds Flow


Depreciation
Attempt 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
Maintain productive capacity of firm

Dividends
Maintain 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 1520%

Cost of a 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
Earnings before depreciation and taxes Depreciation Earnings before taxed Taxes (40%) $400,000 100,000 _________ 300,000 120,000 _________ 180,000 100,000 _________ $280,000 $40,000

Corporation B
$400,000 0 _________ 400,000 160,000 _________ 240,000 0 _________ $240,000

Earnings after taxes +Depreciation charged without cash outlay


Cash flow Difference

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Exercise
13th Edition: #27 Crosby Corporation

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