Module 1:

Introducing Financial

Accounting for MBAs

Buffet’s Acquisition Criteria Large purchases (at least $50 million of before-tax

earnings), Demonstrated consistent earning power (future

projections are of no interest to us, nor are “turnaround” situations),

Businesses earning good returns on equity while employing little or no debt,

Management in place (we can’t supply it), Simple businesses (if there’s lots of technology,

we won’t understand it), An offering price (we don’t want to waste our time

or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

Financial performance is an important factor

in Buffet’s criteria

Buffet’s Concept of “Intrinsic Value”

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

Buffet’s Three Suggestions for Investors:

1. Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

2. Unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.

3. Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Business Activities

Planning Activities

A company exists to implement specific goals and objectives.

A company’s goals and objectives are captured in a business plan.

Information on planning activities is often obtained through: The Letter to Shareholders The Management Discussion and

Analysis (MD&A)

Financing Activities

A company requires financing to carry out its business plans.

Financing activities refer to methods that companies use to raise the funds to pay for resources such as land, buildings, and equipment

There are two main sources of financing: Equity financing Creditor (or debt) financing

Examples of Company Financing

Types of Creditor Financing

Investing creditors—those who primarily finance investing activities (such as bank lenders).

Operating creditors—those who primarily finance operating activities (such as suppliers).

Breakdown of Creditor Financing

Investing Activities

Investing activities are the acquisition and disposition of resources (assets) that a company uses to produce and sell its products and services.

The investing resources, or assets, are of two types Operating assets—resources devoted to

operating activities Nonoperating (financial) assets—resources

devoted to nonoperating activities

Breakdown of Operating and Financial Assets

The Accounting Equation

Operating Activities Operating activities are the use of

company resources to produce, promote, and sell its products and services.

Operating Revenues (or sales) - the inflow of assets from selling products and services.

Operating Expenses (or costs) - the outflow of assets to support operating revenues

Operating Income = Operating Revenues – Operating Expenses

Defining Company Value

Most owners and nonowners formalize their claims on a company in the form of a contract or a security.

Equity securities are common for owners and bonds (notes) are common for nonowners.

These securities are traded in capital markets.

Value of Company = Value of Nonowner Claims + Value of Owner Claims

The Financial Statements Balance Sheet – assets, liabilities and equity at

one point in time

Income Statement – revenues, expenses, and profit over a period of time

Statement of Equity – changes in contributed and earned capital

Statement of Cash Flows – net cash inflows (outflows) form operating, investing and financing activities

Financial Statements

Balance Sheet

A balance sheet reports on investing and financing activities.

It lists amounts for assets, liabilities, and equity as of a point in time.

The accounting equation (also called the balance sheet equation) is the basis of the balance sheet:

Assets = Liabilities + Equity

Berkshire Hathaway’s Balance Sheet

Income Statement An income statement reports on

operating activities. It lists amounts for sales (and

revenues) less all expenses (and costs) over a period of time.

Sales less expenses yield the “bottom-line” net income amount.

Berkshire Hathaway’s Income Statement

Statement of Equity

The statement of equity reports on changes in the accounts that makeup equity Contributed capital Earned capital (retained earnings and

accumulated other comprehensive income) This statement is useful in identifying

and analyzing reasons for changes in owners’ claims on a company’s assets.

Berkshire Hathaway’s Statement of Stockholders’

Equity

Statement of Cash Flows

The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time.

Financial

Statement

Linkages

Information Beyond Financial Statements

Management Discussion and Analysis (MD&A)

Independent Auditor Report Financial Statement Footnotes Regulatory Filings and Proxy

Statements

Buffet on MD&A

Economics of Accounting Information: Demand &

Supply Demand for financial accounting

information extends to numerous users that include: Managers and employees Creditors and suppliers Shareholders and directors Customers Regulators Voters and their representatives

Supply of Accounting Information

Determined by a company’s estimates of the benefits and costs of disclosure.

Regulation and bargaining power also play roles in determining the supply of financial accounting information.

The SEC requires financial statements, various note disclosures, and other reports on a regular basis.

Supply of Accounting Information

Benefits of disclosure lower capital cost from improved

transparency reputation effects enhance labor recruiting

Costs of disclosure Information gathering costs More information to competitors Potential litigation costs Potential political costs

Market Efficiency

Profitability Analysis

Return on Assets (ROA):ROA = Net Income / Average

Assets

For example, if we invest $100 in a savings account yielding $3 at year-end, the return on assets is 3%.

Disaggregating Return on Assets

Profit Margin, Asset Turnover, and Return on Assets for Selected

Industries

Competitive Analysis

Bargaining Power of Buyers – Buyers with strong bargaining power can exact price concessions and demand a higher level of service and delayed payment terms

Bargaining Power of Suppliers – Suppliers with strong bargaining power can demand a higher price for their goods and early payments.

Threat of Substitution – When the number of product substitutes increases, sellers lose their ability to raise prices and/or pass on cost increases to buyers

Threat of Entry – New entrants to a market increase competition. To mitigate that threat, companies expend money to erect barriers to entry. These include R&D, advertising, management hires with special expertise, and mergers to create economies of scale.

Five Forces of Competitive Intensity

Business Context for Financial Statements

Accounting Principles and Governance Structures

Information in financial statements enables company valuation and, by extension, the valuation of its debt and equity securities.

The importance of financial statements means that their accuracy is of paramount importance .

To the extent that financial performance and condition are accurately communicated to business decision makers, debt and equity securities will be more accurately priced.

Oversight of Financial Accounting

Oversight of Financial Accounting SEC oversees all publicly traded companies EDGAR database (www.sec.gov)

Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles

(GAAP) Board of Directors

Audit Committee Courts

Audit Report Financial statements present fairly and in all

material respects company financial condition. Financial statements are prepared in conformity

with GAAP Financial statements are management’s

responsibility. Auditor responsibility is to express an opinion on those statements

Auditing involves a sampling of transactions, not investigation of each transaction

Audit opinion provides reasonable assurance that the statements are free of material misstatements

Auditors review accounting policies used by management and estimates used in preparing the statements

Sarbanes-Oxley Act The SEC requires the CEO and CFO of a company to

personally sign a statement attesting to the accuracy and completeness of the company’s financial statements.

The statements signed by both the CEO and CFO contain the following commitments: The CEO and CFO have personally reviewed the annual

report There are no untrue statements of a material fact or failure

to state a material fact necessary to make the statements not misleading

The financial statements fairly present in all material respects the financial condition of the company

All material facts are disclosed to the company’s auditors and Board of Directors

No changes to the company’s system of internal controls are made unless properly communicated

Financial Accounting: not an exact science

GAAP allows companies choices in preparing financial statements (inventories, property, and equipment).

Companies must choose among the alternatives that are acceptable under GAAP.

Financial statements also depend on countless estimates.

Financial Accounting in Context

A company’s financial statements only tell part of the story.

You must continually keep in mind the world in which the company operates.

Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance.