Financial Statement Analysis

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved.

Clinic 1-1

Accounting Clinic I

Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University


Clinic 1-3

Introduction

Accounting clinic I contains the following:

A brief review of the four financial statements

Examples of how each financial statement is prepared

A summary of the principles of measurement in financial statement


Clinic 1-4

The Financial Statements

1. Balance Sheet

2. Income Statement

3. Cash Flow Statement

4. Statement of Shareholders’ Equity


Clinic 1-5

February 1, February 2, 2002 2001 ------------- ------------- ASSETS Current assets: Cash and cash equivalents $ 3,641 $ 4,910 Short-term investments 273 525 Accounts receivable, net 2,269 2,424 Inventories 278 400 Other 1,416 1,467 ------ ------ Total current assets 7,877 9,726 Property, plant and equipment, 826 996 net Investments 4,373 2,418 Other non-current assets 459 530 ------ ------ Total assets $ 13,535 $ 13,670 ------ ------ LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 5,075 $ 4,286 Accrued and other 2,444 2,492 ------ ------ Total current liabilities 7,519 6,778 Long-term debt 520 509 Other 802 761 Commitments and contingent - - liabilities (Note 7) ------ ------ Total liabilities 8,841 8,048 ------ ------ Stockholders equity: Preferred stock and capital in - - excess of $.01 par value; shares issued and outstanding: none Common stock and capital in 5,605 4,795 excess of $.01 par value; shares authorized: 7,000; shares issued: 2,654 and 2,601, respectively Treasury stock, at cost; 52 (2,249) - shares and no shares, respectively Retained earnings 1,364 839 Other comprehensive income 38 62 Other (64) (74) ------ ------ Total stockholders equity 4,694 5,622 ------ ------ Total liabilities and $ 13,535 $ 13,670 stockholders equity ------ ------

The Balance Sheet: The Balance Sheet: Dell Computer Dell Computer

CorporationCorporation


Clinic 1-6

The balance sheet reports the resources the firm controls at a point in time and the claims against those resources. That is, it is a detailed description of the firm's assets, liabilities and owners' equity.


Clinic 1-7

The Form of the Balance Sheet

Assets = Liabilities + Shareholders’ Equity

or

Shareholders’ Equity = Assets – Liabilities

Assets are economic resources that produce future earnings.

Liabilities are obligations to transfer assets or provide services to parties other than the owners.

Equity is the owners' residual interest in the assets of an entity that remains after deducting the liabilities.


Clinic 1-8

Example - Balance Sheet Preparation

Presented below are selected accounts of Biking Corporation at December 31, 2004:

Patent $150,000 Income taxes payable $93,000 Interest payable 30,000 Notes payable (short-term) 264,000Bonds payable 450,000 Equipment 950,000Common stock, $5 par value 400,000 Discount on bonds payable 25,000Preferred stock, $10 par value 150,000 Refundable federal and state income taxes 97,630Prepaid insurance 89,000 Accumulated depreciation – equipment 232,000Accounts payable 283,000 Inventory 242,000Trading securities 117,000 Cash 360,000Land 520,000 Accumulated depreciation – building 450,000Accounts receivable 143,000 Long-term loan from bank 640,000Rent payable 45,000 Building 1,200,000Retained earnings ?

Required: Prepare a classified balance sheet.


Clinic 1-9

SolutionCurrent assets $ Current liabilities $Cash 360,000 Accounts payable 283,000Trading securities 117,000 Notes payable 264,000Accounts receivable 143,000 Interest payable 30,000Inventory 242,000 Income taxes payable 93,000Prepaid insurance 89,000 Rent payable 45,000Total current assets 951,000 Total current liabilities 715,000

Property, plant and equipment Long-term liabilitiesLand 520,000 Long term loan from bank 640,000Buildings 1,200,000 Bonds payable 450,000Less acc. depreciation (450,000) 750,000 Less discount on bonds payable (25,000) 425,000Equipment 950,000 Total long term liabilities 1,065,000Less acc. depreciation (232,000) 718,000 Total liabilities 1,780,000Total Property, plant and equipment 1,988,000

Stockholders’ equityIntangible assets Capital stockPatent 150,000 Preferred stock, $10 par; 150,000

Common stock, $5 par 400,000 550,000Retained earnings 759,000Total stockholders’ equity

Total assets 3,089,000 Total liabilities and 3,089,000stockholders’ equity

Retained earnings are calculated as a plug number.


Clinic 1-10

The balance sheet reports assets and the claims on those assets at a point in time.

The other three financial statements summarize the effects of transactions and economic events occurring between two balance sheets dates.

The income statement reports revenues less expenses (earnings) that increase owners' equity between two balance sheet dates.


Clinic 1-11

Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Net revenue $ 31,168 $ 31,888 $ 25,265 Cost of revenue 25,661 25,445 20,047 ------ ------ ------ Gross margin 5,507 6,443 5,218 ------ ------ ------ Operating expenses: Selling, general and 2,784 3,193 2,387 administrative Research, development and 452 482 374 engineering Special charges 482 105 194 ------ ------ ------ Total operating expenses 3,718 3,780 2,955 ------ ------ ------ Operating income 1,789 2,663 2,263 Investment and other income (58) 531 188 (loss), net ------ ------ ------ Income before income taxes and 1,731 3,194 2,451 cumulative effect of change in accounting principle Provision for income taxes 485 958 785 ------ ------ ------ Income before cumulative 1,246 2,236 1,666 effect of change in accounting principle Cumulative effect of change in - 59 - accounting principle, net ------ ------ ------ Net income $ 1,246 $ 2,177 $ 1,666 ------ ------ ------ Earnings per common share: Before cumulative effect of change in accounting principle: Basic $ 0.48 $ 0.87 $ 0.66 ------ ------ ------ Diluted $ 0.46 $ 0.81 $ 0.61 ------ ------ ------ After cumulative effect of change in accounting principle: Basic $ 0.48 $ 0.84 $ 0.66 ------ ------ ------ Diluted $ 0.46 $ 0.79 $ 0.61 ------ ------ ------ Weighted average shares outstanding: Basic 2,602 2,582 2,536 Diluted 2,726 2,746 2,728

The Income Statement: The Income Statement: Dell Computer Dell Computer



Clinic 1-12

The Form of the Income Statement

Net Revenue – Cost of Goods Sold = Gross Margin

Gross Margin – Operating Expenses = Operating Income before Tax (EBIT)

Operating Income before Tax – Interest Expense = Income before Taxes

Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items)

Income before Extraordinary Items + Extraordinary Items = Net Income

Net Income – Preferred Dividends = Net Income Available to Common


Clinic 1-13

Example - Income Statement Preparation

below are selected ledger accounts of Grant Corporation at December 31, 2005:

Merchandise Inventory 409,000 Accounting and legal services 24,000Office salaries 282,000 Shipment-in 81,000Sales 5,000,000 Advertising 108,000Purchases 2,548,000 Depreciation of office 62,000Insurance expense 26,000 Depreciation of sales equipment 58,000Sales commission 76,000 Sales salaries 257,000Sales returns 42,000 Extraordinary loss (before tax) 96,000Purchase discounts 31,000 Interest expense 176,000

A physical inventory indicates that the ending inventory is $547,000.

Assume a tax rate of 35%.

Required:Prepare a condensed income statement


Clinic 1-14

Solution

Net Sales (1) 4,958,000Cost of goods sold (2) 2,460,000 Gross profit 2,498,000Selling expense (3) 499,000Administrative expense (4) 394,000 893,000 Income from operations 1,605,000Other expense 176,000Income before taxes 1,429,000 Income taxes (35%) 500,150Income before extraordinary item 928,850Extraordinary loss, net of $33,600 taxes 62,400Net income 866,450

(1) 5,000,000-42,000

(2) 409,000+(2,548,000+81,000-31,000)-547,000

(3) 257,000+76,000+108,000+58,000

(4) 282,000+26,000+24,000+62,000


Clinic 1-15

Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Cash flows from operating activities: Net income $ 1,246 $ 2,177 $ 1,666 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 239 240 156 Tax benefits of employee 487 929 1,040 stock plans Special charges 742 105 194 (Gains)/losses on investments 17 (307) (80) Other 178 135 56 Changes in: Operating working capital 826 642 812 Non-current assets and 62 274 82 liabilities ------ ------ ------ Net cash provided by 3,797 4,195 3,926 operating activities ------ ------ ------ Cash flows from investing activities: Investments: Purchases (5,382) (2,606) (3,101) Maturities and sales 3,425 2,331 2,319 Capital expenditures (303) (482) (401) ------ ------ ------ Net cash used in investing (2,260) (757) (1,183) activities ------ ------ ------ Cash flows from financing activities: Purchase of common stock (3,000) (2,700) (1,061) Issuance of common stock under 295 404 289 employee plans Other 3 (9) 77 ------ ------ ------ Net cash used in financing (2,702) (2,305) (695) activities ------ ------ ------ Effect of exchange rate changes (104) (32) 35 on cash ------ ------ ------ Net (decrease) increase in cash (1,269) 1,101 2,083

The Statement of Cash The Statement of Cash Flows : Dell Computer Flows : Dell Computer



Clinic 1-16

The statement of cash flows explains the change in cash during the period in terms of cash provided by or used for operating, investing and financing activities.


Clinic 1-17

The Form of the Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing


Clinic 1-18


The primary purpose of a statement of cash flows is to provide relevant information about the cash inflows and outflows of an enterprise during a period. The statement has three main sections:Cash Flows from Investing ActivitiesCash Flows from Investing Activities - Investing activities involve acquiring and disposing of debt or equity investments, property, plant and equipment and other productive assets used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory).


Clinic 1-19


Cash Flows from financing ActivitiesCash Flows from financing Activities - Financing activities involve obtaining resources from owners and providing them with a return on their investment; borrowing money and repaying amounts borrowed, and obtaining and paying for other resources obtained from creditors on long-term credit.

Cash Flows from operating ActivitiesCash Flows from operating Activities - Operating activities involve all transactions and other events that are not defined as investing or financing. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.


Clinic 1-20

Example – Preparation of a cash flow statement

Presented below are the balance sheets of Scientific Instruments, Ltd. for December 31, 2005 and 2004

2005 2004Cash 70 110Accounts receivables 170 300Inventories 200 240Loan to company B 1,500 -Land 500 -Equipment 500 550Acc. Depreciation (190) (200)

2,750 1,000

Accounts Payable 120 200Bonds Payable 1,000 -Deferred tax liability 380 300Common Stock 1,220 250Retained Earnings 30 250

2,750 1,000

Scientific Instruments, Ltd.Balance Sheet

December 31, 2005 and 2004


Clinic 1-21

Additional Information:Equipment with original cost of $50 was sold for $35

Dividend declared and paid in cash was $300

Stocks and Bonds were issued for cash

Net income reported was $80.

Required:

Prepare a statement of cash flow for 2005

Note: Cash from operating activities involves adjusting net income for all the non-cash items in net income.


Clinic 1-22

Solution

Cash flows from operating activitiesNet Income 80

Adjustments to reconcile net income to net cash providedby operating activities:Gain on sale of equipment (10)Depreciation 15Increase in deferred tax liability 80Decrease in accounts receivables 130Decrease in inventories 40Decrease in accounts payable (80) 175Net cash provided by operating activities 255

Cash flows from investing activitiesLoan to B (1,500)Purchase of Land (500)Sale of Equipment 35Net cash used by investing activities (1,965)

Cash flows from financing activitiesIssuance of common stock 970Issuance of bonds payable 1,000Payment of cash dividend (300)Net cash provided by financing activities 1,670 Net decrease in cash (40)Cash, December 31, 2004 110Cash, December 31, 2005 70

Statement of Cash FlowFor the year ended December 31, 2005

Scientific Instruments, Ltd.


Clinic 1-23

Common stock And Capital in

Excess of Par Value

Treasury Stock

Shares

Amount

Shares

Amount

Retained Earnings

Other Comprehensive

Income

Other

Total Balances at February 2, 2001

2,601

4,795

-

-

839

62

(74)

5,622

Net income - - - - 1,246 - - 1,246 Change in unrealized gain on investments, net of taxes

-

-

-

-

-

(65)

-

(65)

Foreign currency translation adjustments

-

-

-

-

-

2

-

2

Net unrealized gain on derivative instruments, net of taxes

-

-

-

-

-

39

-

__39 Total comprehensive income for fiscal 2002

-

-

-

-

-

-

-

1,222

Stock issuances under employee plans, including tax benefits

69

843

-

-

-

-

10

853 Purchases and retirements

(16)

(30)

52

(2,249)

(721)

-

-

(3,000)

Others - (3) - - - - - (3) Balances at ____ ____ __ _______ ______ ___ ___ _____ February 1,2002 2,654 $5,605 52 $(2,249) $1,364 $38 $(64) $4,694

The Statement of Stockholders’ Equity: The Statement of Stockholders’ Equity: Dell Computer CorporationDell Computer Corporation


Clinic 1-24

Shareholder’s Equity

has two primary components:contributed capital which represents stockholders’ investment – common stock (par value) and additional paid in capital, and

retained earnings which equals cumulative net income minus cumulative dividends since the formation of the company. (Dividends are distributions of assets to stockholders.)


Clinic 1-25

Comprehensive Income

To avoid earnings fluctuations some of the unrealized gains/losses are reported in “other comprehensive income” and not included in net income.


Clinic 1-26


Clinic 1-27

The Stocks and Flows Equation

Ending equity = Beginning equity + Total (comprehensive) income

– Net payout to shareholders

Comprehensive income = Net income + Other comprehensive income

Net payout to shareholders = Dividends + Share repurchases -Share issues


Clinic 1-28

The Articulation of the Financial Statements

Revenues

Expenses

Net income

Income StatementIncome Statement

Investment and disinvestment

by owners

Net income and other earnings

Net change in owners’ equity

Statement of Shareholders’ EquityStatement of Shareholders’ Equity

Cash from operations

Cash from investing

Cash from financing

Net change in cash

Cash Flow StatementCash Flow Statement

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Beginning Balance SheetBeginning Balance Sheet

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Ending Balance SheetEnding Balance Sheet


Clinic 1-29

Principles of Measurement

Two types of measurement are used in financial statements

Mark-to-market accounting

Assets and liabilities are reported at their “fair value” and gains and losses from revaluing them are reported in the income statement or as part of other comprehensive income in the equity statement. Fair value is either market value or an estimate of value.


Clinic 1-30

Historical cost accounting

Assets and liabilities are reported at their historical cost (the dollar amount paid when they were acquired or incurred). In subsequent periods, those costs are amortized to the income statement as the assets are deemed to have been used up in operations or as liabilities accrue costs.

GAAP accounting uses both types of measurement.


Clinic 1-31

Mark-to Market AccountingUnder U.S. GAAP, the following assets and liabilities are approximately at market value:

Cash and Cash Equivalents Short-term Payables Short-term and Long-term Borrowings Long-term Debt SecuritiesEquity Investments

The following assets and liabilities are measured at an estimate of their fair value rather than their market value:

Net Accounts Receivables (net of estimate of likely bad debt.)Accrued and Estimated Liabilities


Clinic 1-32

Historical Cost Accounting

The following assets and liabilities are at (amortized) historical cost on the balance sheet:

Long-term Tangible Assets

Recorded Intangible Assets

Goodwill

These assets can be written down if their value is deemed to have been impaired, but are never written up (in the U.S.).


Clinic 1-33

Mixed Accounting Measurement

The following assets are sometimes measured at historical cost and sometimes at fair values:

Inventories: Lower of cost or market rule applies

Debt investments• Trading

• Available-for-sale

• Held to maturity

Equity investments• Trading

• Available-for-sale

See Accounting Clinic III


Clinic 1-34

Historical Cost Accounting in The Income Statement

Revenue recognition principle - value added is recognized when:

The earnings process is substantially accomplished

Receipt of cash is reasonably certain

Matching principle -Expenses are recognized in the income statement by their association with revenues for which they are incurred.

The earnings number reflects net value added from revenues, that is, net of matched expenses.

Go to Accounting Clinic II for more on matching


Clinic 1-35

Cost of Goods Sold: An Application of Matching

Cost of goods sold is an accrual concept, calculated in the following way:Inventory, beginning XXX+ Purchases XXXGoods available for sale XXX- Inventory, ending (XXX)Cost of Goods Sold XXX

The beginning balance of inventory and purchases of goods during the year sum up to the total goods that the firm could have sold during the year.The ending balance of inventory (usually available from physical count) is subtracted to get the cost of the goods actually sold.


Clinic 1-36

In the income statement preparation example total purchases were 2,598,000 (after adding shipment and subtracting discounts). The beginning of inventory was 409,000 and the ending of inventory was 547,000. Therefore total cost of goods sold was:

409,000+2,598,000-547,000=2,460,000


Clinic 1-37

The cash outflow equivalent to the cost of goods sold is payment to suppliers. Accrual accounting performs two main adjustments to this amount to arrive at the cost of goods sold:

Accounts Payable adjustment – payment might not reflect the entire expenditure on inventories. Some inventories were purchased on account.

Inventory adjustment – inventory is a pure accrual concept and is recognized in order to match the expense (COGS) with revenue (the amount we received for the goods sold).

More about the matching concept in Accounting Clinic II.


Clinic 1-38

R&D accounts: An Example of Poor Matching

Peabody Co. produces operating income of $30,000 from operations each year. The company invested $20,000 in an R&D project in December 31, 2004. The investment will produce an incremental income of $7,000 in each of the following 5 years.Calculate operating income for the years 2004-20091. if the firm expenses R&D immediately (as GAAP

requires)2. if the firm capitalizes R&D and amortize it using

straight line method.


Clinic 1-39

(1) R&D is expensed immediately 2004 2005 2006 2007 2008 2009 Operating income before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

Incremental income from R&D

__0

7,000

7,000

7,000

7,000

7,000

30,000 37,000 37,000 37,000 37,000 37,000 R&D expense (20,000) __0 __0 __0 __0 __0 Operating income 10,000 37,000 37,000 37,000 37,000 37,000 (2) R&D is capitalized using straight line The total R&D expenditure is 20,000. It is amortized 20,000/5=4,000 per year for 5 years. 2004 2005 2006 2007 2008 2009 Operating income before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

Incremental income from R&D

______

7,000

7,000

7,000

7,000

7,000

30,000 37,000 37,000 37,000 37,000 37,000 R&D expense __0 (4,000) (4,000) (4,000) (4,000) (4,000) Operating income 30,000 33,000 33,000 33,000 33,000 33,000


Clinic 1-40

Fully expensing R&D in the year in which it was incurred results in poor matching in operating income.

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Financial Statement Analysis

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