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Chapter

McGraw-Hill/IrwinCopyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of

Accounting2

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Chapter Outline

Income Statement

Price-earnings Ratio

Balance Sheet Statement of Cash Flows

Tax-free Investments (Deprecation)

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Basic Financial Statements

Income Statement

Balance Sheet

Statement of Cash Flows

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Income Statement

Device to measure the profitability of a firmover a period of time

It covers a defined period of time

It is presented in a stair-step or progressivefashion to examine profit or loss after each typeof expense item is deducted

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Income Statement (contd)

Sales Cost of Goods Sold (COGS)

= Gross Profit (GP)

GP Expenses = Earnings Before Interest andTaxes (EBIT) orOperating Income (OI)

EBIT Interest = Earnings Before Taxes (EBT)

EBT Taxes = Earnings After Taxes (EAT) orNetIncome (NI)

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Income Statement (contd)

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Return to Capital

Three primary sources of capital: Bondholders Preferred stockholders

Common stockholders Earnings per share

Interpreted in terms of number of outstandingshares

May be paid out in dividends or retained bycompany for subsequent reinvestment

Statement of retained earnings Indicates disposition of earnings

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Statement of Retained Earnings

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Price-Earnings (P/E) Ratio

Multiplier applied to earnings per share todetermine current value of common stock

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

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Price-Earnings (P/E) Ratio (contd)

Allows comparison of the relative marketvalue of many companies based on $1 ofearnings per share

Indicates expectations about the future of acompany

Price-earnings ratios can be confusing

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Price-earnings Ratios

for Selected US Companies

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Limitations of the Income Statement

Income gained/lost during a given period is afunction of verifiable transactions

Stockholders, hence, may perceive only a much

smaller gain/loss from actual day-to-dayoperations

Flexibility in reporting transactions might

result in differing measurements of incomegained from similar events at the end of atime period

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Balance Sheet

Indicates what the firm owns and how theseassets are financed in the form of liabilitiesor ownership interest

Delineates the firms holdings and obligations

Items are stated on an original cost basis ratherthan at current market value

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Balance Sheet Items

Liquidity: Asset accounts are listed in orderof liquidity Current assets

Items that can be converted to cash within 12 months

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 finishedgoods

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Balance Sheet Items (contd)

Prepaid expenses Represent future expense items that are already paid

for

Investments Long-term commitment of funds

Includes stocks, bonds, or investments in othercompanies

Plant and equipment Carried at original cost minus accumulated

depreciation

Accumulated depreciation Sum of past and present depreciation charges on currently

owned assets

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Balance Sheet Items (contd)

Depreciation expense is the current years charge

Total assets: Financed through liabilities orstockholders equity

Short-term obligationsAccounts payable

Notes payable

Accrued expense

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Stockholders Equity

Represents total contribution and ownershipinterest of preferred and commonstockholders

Preferred stock

Common stock

Capital paid in excess of par

Retained earnings

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Statement of Financial Position

(Balance Sheet)

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Limitations of the Balance Sheet

Most of the values are based onhistorical/original cost price

Troublesome when it comes to plant and

equipment inventory

FASB ruling on disclosure of inflationadjustments no longer in force

It is purely a voluntary act on the part of thecompany

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Limitations of the Balance Sheet

(contd)

Differences between per share values maybe due to:

Asset valuation

Industry outlook

Growth prospects

Quality of management

Risk-return expectations

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Comparison of Market Value

to Book Value per Share

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Statement of Cash Flows

Emphasizes critical nature of cash flow tothe operations of the firm

It represents cash/cash equivalents items easily

convertible to cash within 90 days

Cash flow analysis helps in combatingdiscrepancies faced through accrual method

of accounting

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Statement of Cash Flows (contd)

Advantage of accrual method

Allows matching of revenues and expenses inthe period in which they occur to appropriately

measure profits

Disadvantage of accrual method

Adequate attention not directed to actual cash

flow position of firm

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Concepts Behind the Statement of

Cash Flows

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Determining Cash Flows from

Operating Activities

Translation of income from operations froman accrual to a cash basis

Direct method

Every item on the income statement is adjustedfrom accrual to cash accounting

Indirect method

Net income represents the starting point

Required adjustments are made to convert netincome to cash flows from operations

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Indirect Method

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Comparative Balance Sheets

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Cash Flows from Operating

Activities

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Determining Cash Flows from

Investing Activities

Investing activities:

Long-term investment activities in mainly plantand equipment

Increasing investments represent a use of funds Decreasing investments represent a source of funds

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Determining Cash Flows from

Financing Activities

Financial activities apply to thesale/retirement of:

Bonds

Common stock

Preferred stock

Other corporate securities

Payment of cash dividends Sale of firms securities is a source of funds

Payment of dividends and repurchase of securities isa use of funds

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Overall Statement

Combining the Three Sections

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Analysis of the Overall Statement

How are increases in long-term assets beingfinanced?

Preferably, adequate long-term financingand profits should exist

Short-term funds may be used to carry long-term needs could be a potential high-risk

situation Example: trade credit and bank loans

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Depreciation and Funds Flow

Depreciation

Attempt to allocate the initial cost of an assetover its useful life

Charging of depreciation does not directlyinfluence the movement of funds

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Comparison of Accounting

and Cash Flows

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Income Tax Considerations

Corporate tax rates Progressive: the top rate is 40% including state

and foreign taxes if applicable. The lower

bracket is 1520% Cost of a tax-deductible expense

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Depreciation as a Tax Shield

Not a new source of fund

Provides tax shield benefits measurable asdepreciation times the tax rate

Corporation A Corporation BEarnings before depreciation and taxes $400,000 $400,000

Depreciation 100,000 0

_________ _________

Earnings before taxed 300,000 400,000

Taxes (40%) 120,000 160,000

_________ _________Earnings after taxes 180,000 240,000

+Depreciation charged without cash outlay 100,000 0

_________ _________

Cash flow $280,000 $240,000

Difference $40,000

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Exercise

13th Edition: #27

Crosby Corporation