2-1 Review of Accounting Chapter 2 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights...
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Transcript of 2-1 Review of Accounting Chapter 2 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights...
2-1
Review of Accounting
Chapter 2
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
1
2-2
Chapter Outline
• Income Statement
• Price-earnings Ratio
• Balance Sheet
• Statement of Cash Flows
• Tax-free Investments (Depreciation) 2
2-3
Basic Financial Statements
• Income Statement
• Statement of Retained Earnings (a short supplement to the income statement)
• Balance Sheet
• Statement of Cash Flows3
2-4
Income Statement
• Device to measure the profitability of a firm over a 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
4
2-5
Income Statement (cont’d)Table 2–1
2-6
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)
Earnings per share (EPS)= Earrings to common stockholders/common shares outstanding
6
2-7
Return to Capital• Three primary sources of capital:
• Bondholders (receive interest)
• Preferred stockholders (receive dividends)
• Common stockholders (receive dividends after preferred 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
7
2-8
Statement of Retained Earnings• Indicates disposition of earnings with:
• any adjustments to previously reported income
• any restrictions on cash dividends
8
2-9
Price-Earnings (P/E) Ratio• Multiplier applied to earnings per share to determine
current value of common stock
• Indicates expectations about the future of a company• Firms with higher expected returns often will have higher
P/E ratio
• 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
9
2-10
Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market value of many companies
• Price-earnings ratios can be confusing
• Drop in earnings means drop in price as well; it may not match the magnitude of the falloff in earnings, which causes increase in P/E ratio.
10
2-11
Price-earnings Ratios for Selected U.S. Companies
• Expectations of returns and P/E ratios do change over time
11
2-12
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
12
2-13
Balance Sheet
• Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest
• Delineates the firm’s holdings and obligations
• A picture of the firm at a point in time
• Items are stated on an original cost basis rather than at current market value
13
2-14
Balance Sheet Items• Liquidity: Asset accounts are listed in order of
liquidity• Current assets
• Items that can be converted to cash within one year
• 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 14
2-15
Balance Sheet Items (cont’d)• Prepaid expenses
• Represent future expense items that are already paid for
• Investments• Long-term commitment of funds (at least one year) • Includes stocks, bonds, or investments in other
corporations• Plant and equipment
• Carried at original cost minus accumulated depreciation
• Accumulated depreciation: Sum of past and present depreciation charges on currently owned assets 15
2-16
Balance Sheet Items (cont’d)• Total assets: Financed through liabilities or
stockholders’ equity
• Liabilities are financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations
• Short-term obligations
• Accounts payable (amount owed on open account to suppliers)
• Notes payable (short-term signed obligations
• to the banker or other creditors)
• Accrued expense (payment not made for the obligation incurred on the services received)
16
2-17
Stockholder’s Equity• Represents total contribution and ownership
interest of preferred and common stockholders
• Preferred stock
• Common stock
• Capital paid in excess of par (common stock)
• Retained earnings
17
2-18
Statement of Financial Position (Balance Sheet)
18
2-19
Concept of Net Worth
• Net worth (book value) = Stockholders’ equity – preferred stock component
• Market value is a primary concern to the:
• Financial manager
• Security analyst
• Stockholders
19
2-20
Limitations of the Balance Sheet
• Most of the values are based on historical/original cost price
• Troublesome when it comes to plant and equipment and inventory
• FASB ruling on disclosure of inflation adjustments no longer in force
• It is purely a voluntary act on the part of the company
20
2-21
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
21
2-22
Comparison of Market Valueto Book Value per Share
22
2-23
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
• Advantage of accrual method
• Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits
23
2-24
Statement of Cash Flows (cont’d)
• Disadvantage of accrual method
• Sufficient attention not directed to actual cash flow position of firm
• Cash flow analysis helps in combating discrepancies faced through accrual method of accounting
24
2-25
Sections of a Statement of Cash Flows
• Three primary sections of the statement of cash flows:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
• The results of three sections are added together to compute the net increase or decrease in cash flow
25
2-26
Concepts Behind the Statement of Cash Flows
26
2-27
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 27
2-28
Net Cash Flows fromOperating Activities (Indirect
Method)
28
2-29
Comparative Balance Sheets
Table 2–6
29
2-30
Cash Flows from Operating Activities
30
2-31
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
31
2-32
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 firm’s securities is a source of funds• Payment of dividends and repurchase of
securities is a use of funds 32
2-33
Overall Statement Combining the Three Sections
33
2-34
Analysis of the Overall Statement
• How are increases in current assets being financed?
• Is there an associated buildup in current liabilities?
• How are increases in long-term assets being financed?
• Preferably, adequate long-term financing and profits should exist to finance long-term assets
• Short-term funds may be used to carry long-term needs – could be a potential high-risk situation as short-term sources of funds may dry up while long-term needs continue to demand funding
34
2-35
Depreciation and Funds Flow
• Depreciation
• A noncash expense
• Not a ‘new’ source of funds
• Added back to net income to determine amount of actual funds on hand
• Attempt to allocate the initial cost of an asset over its useful life
• Charging of depreciation does not directly influence the movement of funds 35
2-36
Comparison of Accounting and Cash Flows
36
2-37
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 37
2-38
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 a tax-deductible expense - Interest, Travel expenditures, Salaries, etc.
Corporation A Corporation BEarnings before interest and taxes…………. $400,000 $400,000Interest…………………………………………… 100,000 0
_________ _________ Earnings before taxes (taxable income)…… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000
_________ _________ Earnings after taxes…………………………… $180,000 $240,000Difference in earnings after taxes…………… $60,000
2-39
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 BEarnings before depreciation and taxes…… $400,000 $400,000Depreciation……………………………………… 100,000 0
_________ _________ Earnings before taxes………………………… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000
_________ _________ Earnings after taxes…………………………… 180,000 240,000+Depreciation charged without cash outlay… 100,000 0
_________ _________ Cash flow………………………………………… $280,000 $240,000Difference………………………………………… $40,000