Overview

BA 270, Fall 2003

Overview

• Course objectives– Be able to understand and interpret financial

statements (infer underlying economics)– Be able to understand the implications of

transactions for financial statements– Be able to prepare statements– Understand the role of accounting data in

valuation

Why do we care?

• Financial reporting provides the primary window into the company’s finances– companies tend not to disclose detailed

information unless required– voluntary disclosure is selective

• Disclosure is very aggregated – you need to understand the approach taken and

assumptions made to interpret it

How will you use?

• Outside looking in:– Equity investment decisions– Mergers and acquisitions– Venture capital– Competitive analysis

• Inside looking out:– Assessing market impact of transactions– Pro forma analysis/business plans

Problems

• Actual statements are harder than textbook examples– more ambiguous– more complex underlying economics– less standardized

• Ability to read actual statements is the most important skill

Texts

• Hirst and McAnally (Primary)– business application cases– examples from financial statements– 3rd edition

• Stickney and Weil (Secondary)– mechanics– mostly background reading– 10th edition

Class types

• Mechanics – going from transactions to reporting

• Application – going from published statements to

understanding the firm

My role

• Review the important points

• Focus on application

• Separate the wheat from the chaff

• Explain difficult concepts

• Help assess progress

Class Pattern

• Most topics cover two days

• First day– brief lecture (read recommended reading)

– easier problem/case (work on assigned problem/case)

• Second day– focus on interpretation (review unclear concepts)

– harder cases (work assigned case)

What is accounting?

• Process of condensing complex economic reality in a meaningful way– trades off benefits and costs of completeness

• Underpins liquidity and transparency of capital markets– permits efficient allocation of capital

• Permits separation of ownership and control– diffuse corporate ownership– diversified shareholder portfolios

Introduction to Valuation

• Financial accounting is designed primarily to inform equity investors in valuing the firm

• Any asset can be valued as the present value of expected future cash flows to the owner

Vt = CFt+1/(1+r) + CFt+2/(1+r)2 + CFt+3/(1+r)3 + ...

where Vt is value in period t

CFt+1 is expected cash flow in period t+1

r is the discount rate (cost of capital)

Bond Valuation Example

• Bond value is present value of expected interest and principal payments– 2 yr. bond paying $10 annual interest and $100 at the

end with 10% discount rate is worth:

P0 = $10/(1+.1) + $110/(1.21) = $100

• Works for “junk” bonds– 2 yr. bond promising $15 int. & $150 at end– expected to pay $10 int. & $100 at end:

P0 = $10/(1+.1) + $110/(1.21) = $100

• Works with secondary trading– 2 yr. bond paying $10 annual int. & $100 at end– purchaser expects to sell after 1 year– price today is PV of yr. 1 int. + expected price– expected price at the end of year 1

P1 = $110/(1.1) = $100

– price today

P0 = $10/1.1 + $100/1.1 = $100

Dividend Discount Model• For a stock, future equity cash flows are:

– dividends– repurchases, including acquisitions

• conceptually identical to dividends

Pt = Dt+1/(1+r) + Dt+2/(1+r)2 + Dt+3/(1+r)3 + ...

where Dt+1 is cash flows to equity in period t+1

• Accounting is intended to provide information on future cash flows to equity holders:– Amount (D)

– Timing (t)

– Uncertainty (r)

Paradox

• Accounting provides little direct information on “dividends”– Dividends are discretionary and hard to predict– Dividends reflect value distribution not creation– Really care about ability to pay dividends

• Microsoft examples

Savings Account Example

• A company can be viewed as a savings account or mutual fund

• Like a savings account, what matters is how much you expect to withdraw and when

• If the savings account never paid out, it would be worthless

• You generally don’t worry about expected withdrawal, but how much you have in it

Lessons from a savings account

• In anticipating future withdrawals (dividends) two things matter– what assets you have working for you (balance

sheet)– how profitably those assets are likely to be

employed (income statement)

Annual Report

• Primary document providing information to estimate future dividends

• Two parts– Front-end sales document– Back-end financial statements

• Sales document– Overview– President's letter– General discussion of business

Balance Sheet

• Primary financial statement– all others derive from it

• Snapshot of the firm at year-endAssets = Liabilities + Shareholders' Equity

$24.5B = $12.7B + $11.8B

• Assets–economic resources

• Liabilities–"creditor" claims on resources

• Shareholders's equity–the residual– Contributed capital – Retained earnings– Other

• Equity accumulates two primary ways– invested money (contributed capital)

– income earned and not withdrawn (retained earnings)

• Withdrawals (dividends) reduce assets and equity– withdrawals (dividends) are not bad or good

– they simply mean reallocating from investment to cash

• Ability to pay dividends is affected by assets working for you and creditor claims against assets

• Not all assets have the same expected return & risk– therefore, we disaggregate into asset classes

• Not all liabilities have the same terms– therefore we disaggregate into liability classes

Income Statement

• Derives from the balance sheet– Assets = Liabilities + Contributed Capital +

Retained Earnings + Other$24.5B = $12.7B + $4.7B + $24.5B - $17.4B

– RE2002 = RE2001 + Net Income2002 - Div.2002

$24.5B = $23.4B + $3.1B - $2.0B

• Net Income = Revenues - Expenses

• Revenues and gains--inflow of net assets from selling and providing services– Sales ($19.6B)– Other ($0.2B+$0.4B=$0.6B)

• Expenses and losses--outflow of net assets to generate revenues– Cost of goods sold ($7.1B)– Selling, general and admin. costs ($7.0B)– Income tax expense ($1.5B)– Accounting adjustments ($0.4B+$0.6B=$0.9B)– Other ($0.2B+$0.4B=$0.6B))

Why the Income Statement?

• In addition to assets, dividend paying ability depends on profitability of asset utilization

• Profitability of asset use varies across companies• Past profits are indicative of future profitability

– especially in the short term

• That’s the role of the income statement• Past income is not interesting in its own right

– it is already in assets and equity on the balance sheet

– only interesting as an indication of future profitability

Not all income is created equal

• Income items vary in terms of permanence– sales and cost of goods sold vary with units sold

– SG&A contains some fixed costs, e.g., depreciation

– some items may be nonrecurring, e.g., reorganization costs and gains on sales of divisions

• Income varies by determining factors– operating items are determined by operations

– interest is affected by interest rates

– taxes are affected by tax laws and location choice

Statement of Cash Flows

• Derives from the balance sheet– Change in cash ($2.1B - $1.9B = $0.3B)

• Generally begins at net income and ends with change in cash

• Sections– Operating ($4.7B)– Investing (-$1.2B)– Financing (-$3.3B)

Not all net income is cash

• Accounting is intended to capture economic reality when it occurs– Credit sales booked as sold– Expenses booked as accrued

• Sometimes you care about cash too– Liquidity– Free cash flows are sometimes used in valuation

Free cash flows = Operating + Investing$3.6B = $4.7B - $1.2B

Notes

• Provide detail to interpret main statements

• First note is significant accounting policies– measurement affects interpretation

• Other notes provide details on statements – note with quarterly financial data– note with segmental data– other notes providing detail on balance sheet

and income statement accounts

Mgmt.'s Discussion & Analysis

• Discusses what happened in the financial statements and why

• Generally quite terse, but subject to increasing scrutiny

Auditor's Report

• What was audited (financial statements)• Auditor followed GAAS• Opinion

– Financial statements presented fairly in accordance with GAAP

– Qualifications• Material uncertainty as to going concern• Inconsistency (generally change in accting. method)• Disclaimer or adverse opinion

Other

• Forms 10-Q (quarterly) and 10-K (annual)– filed with Securities & Exchange Commission– include financial statements

• Proxy statement– detail on executives, board of directors and

large owners– includes compensation data

Global Financial Reporting

• British American Model– Equity investor focus– Information about amount, timing and uncertainty

of future cash flows: – Virtually no link to tax– Permits flexibility--common law system– Comparable to UK, Canada, Australia and NZ– Increasingly the model of worldwide through the

effort of the IASC

• Continental European Model– Traditionally more emphasis on debt holders (and

sometimes governments), but changing– More focus on minimum net assets of the firm

(conservatism)– Closer link to taxes– More limited flexibility--code law system– E.g., Germany, Japan, France, other European

countries

• Inflationary Model– Used in countries with high inflation– Restates financial statements for changes in

price levels– Otherwise generally similar to the Continental

European Model– E.g., some South American countries, Israel,

emerging markets