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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-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
revenues
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–
–
–
–
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

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