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BA 270, Fall 2003
• 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
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
• Actual statements are harder than textbook
– more ambiguous
– more complex underlying economics
– less standardized
• Ability to read actual statements is the most
important skill
• 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
• 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)
• 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
– 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-end
Assets = 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
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
• 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
• 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
– Closer link to taxes
– More limited flexibility--code law system
– E.g., Germany, Japan, France, other European
• 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

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