Third Edition: Peter D. Mary Lea Gregory A. Xiao-Jun Easton Mcanally Sommers Zhang

Cambridge Business Publishers, 2013
FINANCIAL STATEMENT
ANALYSIS & VALUATION
Third Edition
Peter D. Mary Lea Gregory A. Xiao-Jun
Easton McAnally Sommers Zhang
Overview of
Business Activities and
Financial Statements
Module 2:
Four Main Financial Statements
Balance Sheet
Income Statement
Statement of Stockholders Equity
Statement of Cash Flows
Balance Sheet
Mirrors the Accounting Equation
Assets = Liabilities + Equity
Uses of funds = Sources of funds
Assets are listed in order of liquidity
Liabilities are listed in order of maturity
Equity consists of Contributed Capital and
Retained Earnings

Assets
To be reported on a balance sheet, an asset must
1. Be owned (or controlled) by the company
2. Must possess expected future economic benefits

Assets are listed in order of liquidity
Current assets comprise assets that can be
converted to cash within a year
Long-term assets cannot be easily converted to
cash within a year.

Examples of Current Assets
Cashcurrency, bank deposits, and investments with an
original maturity of 90 days or less (called cash equivalents);
Marketable securitiesshort-term investments that can
be quickly sold to raise cash;
Accounts receivable, netamounts due to the company
from customers arising from the sale of products and
services on credit (net refers to uncollectible accounts
explained in Module 6);
Inventorygoods purchased or produced for sale to
customers;
Prepaid expensescosts paid in advance for rent,
insurance, advertising or other services.
Examples of Long-term Assets
Property, plant and equipment (PPE), netland, factory
buildings, warehouses, office buildings, machinery, motor
vehicles, office equipment and other items used in operating
activities (net refers to subtraction of accumulated
depreciation, the portion of the assets cost that has been
transferred from the balance sheet to the income statement,
which is explained in Module 6);
Long-term investmentsinvestments that the company
does not intend to sell in the near future;
Intangible and other assetsassets without physical
substance, including patents, trademarks, franchise rights,
goodwill and other costs the company incurred that provide
future benefits.
Apples Assets
Cisco Systems, Inc. Assets
Assets are Reported at
Historical Cost
Historical Cost is
Objective
Verifiable
Relevance vs. Reliability
Only include items that can be reliably measured.
Considerable amount of assets may not be reflected
on a balance sheet
Strong management team, a well-designed supply chain,
or superior technology
Knowledge Based Assets are not
Reflected on the Balance Sheet
NOTE: While resources expended for research and
development reflect and economic asset, they generally
are expensed as incurred.

INSIGHT: Pharmaceutical firms do not have assets
reflecting the full amount of money that they have
spent developing drugs. These amounts, for the most
part, have been expensed in the past and serve to
reduce retained earnings. Internally developed trade
marks are also economic assets, but may not show up
on the balance sheet. [The purchase of externally
developed trademarks are treated as assets.]
Disneys Assets
Wheres Mickey? The
market value of the
Mickey Mouse
trademark does not
explicitly show up here.
Apples Liabilities and Equity
Examples of Current Liabilities
Accounts payableamounts owed to suppliers for goods and
services purchased on credit.
Accrued liabilitiesobligations for expenses that have been incurred
but not yet paid; examples are accrued wages payable (wages earned by
employees but not yet paid), accrued interest payable (interest that is owing
but has not been paid), and accrued income taxes (taxes due).
Unearned revenuesobligations created when the company accepts
payment in advance for goods or services it will deliver in the future; also
called advances from customers, customer deposits, or deferred revenues.
Short-term notes payableshort-term debt payable to banks or
other creditors.
Current maturities of long-term debtprincipal portion of
long-term debt that is due to be paid within one year.
Cisco systems, Inc. Current Liabilities
Net Working Capital
Net working capital =
Current assets Current liabilities
Operating Cycle
Examples of Noncurrent Liabilities
Long-term debtamounts borrowed from
creditors that are scheduled to be repaid more than one
year in the future; any portion of long-term debt that is
due within one year is reclassified as a current liability
called current maturities of long-term debt. Long-term debt
includes bonds, mortgages, and other long-term loans.

Other long-term liabilitiesvarious obligations,
such as pension liabilities and long-term tax liabilities,
that will be settled a year or more into the future. We
discuss these items in later modules.
Cisco Systems, Inc.
Long-term Liabilities
Equity
Equity consists of:

Contributed Capital (cash raised from the
issuance of shares)
Earned Capital (retained earnings). Retained
Earnings is updated each period as follows:
Examples of Equity Accounts
Common stockpar value received from the original sale of common
stock to investors.
Preferred stockvalue received from the original sale of preferred
stock to investors; preferred stock has fewer ownership rights compared to
common stock.
Additional paid-in capitalamounts received from the original
sale of stock to investors in addition to the par value of common stock.
Treasury stockamount the company paid to reacquire its common
stock from shareholders.
Retained earningsaccumulated net income (profit) that has not
been distributed to stockholders as dividends.
Accumulated other comprehensive income or loss
accumulated changes in equity that are not reported in the income statement
(explained in Module 9).
Cisco Systems, Inc.
Stockholders Equity
Income Statement
Apples Income Statement
Cisco Systems, Inc.
Income Statement
When are Revenues and Expenses
Recognized?
Revenue Recognition Principlerecognize
revenues when earned

Matching Principlerecognize expenses
when incurred
Profit vs. Cash
Net Income does not necessarily correspond to a net cash
flow. A firm could have good income but poor cash
flow or vice versa (i.e., there are two dimensions to
consider).
We have previously summarized the mechanics of the
balance sheet with the expanded accounting equation:
Operating vs. Nonoperating
Operating expenses are the usual and
customary costs that a company incurs to
support its main business activities

Nonoperating expenses relate to the
companys financing and investing activities

Transitory Items in the
Income Statement
Transitory Items
Discontinued operations Gains or losses (and
net income or loss) from business segments that
are being sold or have been sold in the current
period.

Extraordinary items Gains or losses from
events that are both unusual and infrequent.
Accrual Accounting
Accrual accounting refers to the recognition
of revenue when earned (even if not received
in cash) and the matching of expenses when
incurred (even if not paid in cash).
Statement of Equity is a reconciliation of the
beginning and ending balances of stockholders
equity accounts.
Main equity categories are:
Contributed capital
Retained earnings (including Other Comprehensive
Income or OCI)
Treasury stock
Apples
Statement of cash flows (SCF) reports cash inflows
and outflows
Cash flows are reported based on the three
business activities of a company:
Cash flows from operating activities - Cash flows from
the companys transactions and events that relate to its
operations.
Cash flows from investing activities - Cash flows from
acquisitions and divestitures of investments and long-term
assets.
Cash flows from financing activities - Cash flows from
issuances of and payments toward borrowings and equity.
Apples
Statement
of Cash
Flows
Cisco
Systems

Statement
of Cash
Flows
Relation of SCF to Income Statement
and Balance Sheet
General Coding of
Balance sheet Changes
Working Capital Accounts
Articulation of Financial Statements
Financial statements are linked within and across
time they articulate.
Balance sheet and income statement are linked
via retained earnings.

Apples Retained Earnings
Reconciliation
Recording transactions
Pay $100 Wages in Cash
Cash assets are reduced by $100, and wage expense of
$100 is reflected in the income statement, which
reduces income and retained earnings by that amount.
All transactions incurred by the company during the
accounting period are recorded similarly.
Adjusting Accounts
Prepaid Rent
Unearned Revenue
Accrual of Wages
Accrual of Revenue
Exercise: The Ice Cream Store, Inc.
The Ice Cream Store, Inc. incurred the following start-up
costs:

1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with
the investment of $90,000 in cash by the owners.
2. Obtained a bank loan and received the proceeds of $35,000 on
October 2. The cash will be used for operations.
3. Purchased equipment for $25,000 cash on October 2.
4. Acquired a building at a cost of $80,000. It was financed by
making a $20,000 down-payment and obtaining a mortgage for
the balance. The transaction occurred on October 2.
5. On October 2, the President of the United States publicly
declared that she will eat (and plug) our ice cream while
entertaining guests in the White House.

Prepare a transaction analysis of 1. 5. using the financial
statement effects template.
Balance Sheet Income Statement
Transaction Cash Asset +
Noncash
Assets
=
Liabi
-lities
+
Contrib
. capital
+
Retained
Earnings
Revenues Expenses
1. The Ice Cream Store, Inc.
was formed on October 1,
20XX, with the investment of
$90,000 by the owners.
+90 +90
2. Obtained a bank loan and
received the proceeds of
$35,000 on October 2. The cash
will be used for operations.
+35
+35
N/P
3. Purchased equipment for
$25,000 cash on October 2. -25
+25
Equip
4. Acquired a building at a cost
of $80,000. It was financed by
making a $20,000 down-
payment and obtaining a
mortgage for the balance. The
transaction occurred on
October 2.
-20
+80
Bldg.
+60
M/P
5. The President of the United
States agreed to eat (and plug)
our ice cream while
entertaining guests in the White
House on Oct. 2.
ASSETS
Cash $80,000
Equipment 25,000
Building 80,000

Total Assets $185,000

LIABILITY AND STOCKHOLDERS' EQUITY
Liabilities:
Note Payable $35,000
Mortgage Payable 60,000
Total Liabilities 95,000

Stockholders Equity:
Capital Stock 90,000
Total Liabilities and
Stockholders Equity $185,000
Ice Cream Shop
Balance Sheet:
Ice Cream Shop
Additional Transactions
6. On October 4, purchased merchandise inventory (i.e., ice
cream) at a cost of $15,000 by paying $5,000 cash and receiving
short-term credit for the remainder from the supplier.
7. Immediately returned some of the ice cream because some of
the flavors delivered were not ordered. The cost of the
inventory returned was $3,000.
8. Sales of ice cream for the month of October, 20XX, totaled
$8,000. All sales were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries
earned/paid were $3,000.

continued
Ice Cream Shop
Additional Transactions continued
10. As of the end of October, one month's depreciation on the
equipment and building was recognized -- $383 for the building
and $167 for the equipment.
11. $450 interest expense on the note and mortgage was due and
paid on October 31. Assume that the principal amounts ($35,000
+ $60,000) of the note and mortgage remain unchanged.

Prepare a transaction analysis of 6. -11. using the
balance sheet/income statement template
presented above.
Balance Sheet
Income Statement
Transaction
Cash
Asset
+ Noncash Assets =
Liabi-
lities
+
Contrib.
capital
+
Retained
Earnings
Revenues Expenses
6.
-5
+15
Inv.
+10
A/P
7. -3
Inv.
-3
A/P
8.
+8
-3.5
Inv.
+4.5
+8
Sales
-3.5
COGS
9.
-3 . -3
-3
Wage exp.
10.
- .383
Bldg., net
-.167
Equip., net
-.550
-.550
Dep. exp.
11.
-.450 -.450
-.450
Int. Exp.
Prepare the following financial statements (ignore income taxes):
(i) an updated Balance Sheet as of October 31, 20XX; and (ii) an
Income Statement for the month of October 20XX.
Cash ($80,000 -5,000 +8,000 -3,000 -450) $79,550.
Merchandise Inventory ($0 + 15,000 -3,000 -3,500) 8,500.
Equipment ($25,000 ) 25,000.
Less: Accumulated Depreciation (383)
Building ($80,000) 80,000.
Less: Accumulated Depreciation (167)
Total Assets $192,500.
Accounts Payable ($0 + 10,000 3,000) $7,000.
Note Payable ($35,000 principal is unchanged) 35,000.
Mortgage Payable (60,000 principal is unchanged) 60,000.
102,000.
Stockholders' Equity:
Capital Stock 90,000.
Retained Earnings 500.
90,500.
Total Liabilities and Stockholders' Equity $192,500.

REVENUES:
Sales of Ice Cream $8,000
Cost of Sales 3,500
GROSS PROFIT: 4,500
Payroll Expense 3,000
Depreciation Expense 550
INCOME FROM OPERATIONS 950
Interest Expense 450
NET INCOME $500

Note: Assume no income taxes.
Preparing the Financial Statements
Balance Sheet and Income Statement
Additional Sources of Information
Form 10-K
Item 1, Business; Item 1A. Risk Factors;
Item 2, Properties;
Item 3, Legal Proceedings;
Item 4, Submission of Matters to a Vote of Security Holders;
Item 5, Market for Registrants Common Equity and Related Stockholder
Matters;
Item 6, Selected Financial Data;
Item 7, Managements Discussion and Analysis of Financial Condition and
Results of Operations;
Item 7A, Quantitative and Qualitative Disclosures About Market Risk;
Item 8, Financial Statements and Supplementary Data;
Item 9, Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure;
Item 9A, Controls and Procedures.
Additional Sources of Information
Form 8-K
Entry into or termination of a material definitive
agreement (including petition for bankruptcy)
Exit from a line of business or impairment of assets
Change in the companys certified public accounting
firm
Change in control of the company
Departure of the companys executive officers
Changes in the companys articles of incorporation or
bylaws
Global Accounting
Balance Sheet The most visible difference is that the typical IFRS-
based balance sheet is presented in reverse order of liquidity.
Income Statement The most visible difference is that GAAP
requires three years data on the income statement whereas IFRS
requires only two.
Statement of Cash Flows One of the more apparent differences
between GAAP and IFRS is that a GAAP-based statement of cash
flows classifies interest expense, interest revenue, and dividend
revenue as operating cash flows, and dividends paid as financing cash
flows. IFRS allows firms to choose from between the following two
options:
1. Classify interest expense, dividends paid, interest revenue, and dividend revenue
as operating cash flows, or
2. Classify interest expense and dividends paid as financing cash flows, and
interest revenue and dividend revenue as investing cash flows.
Analyst Reports
Credit and Data Services
Credit Analysis
Standard & Poors (StandardAndPoors.com)
Moodys Investors Service (Moodys.com)
Fitch Ratings (FitchRatings.com)
Data Services
Thomson Corporation (Thomson.com)
First Call - summary of analysts earnings forecasts
Compustat database - individual data items for all publicly
traded companies or for any specified subset of
companies.
End Module 2

Third Edition: Peter D. Mary Lea Gregory A. Xiao-Jun Easton Mcanally Sommers Zhang

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Third Edition: Peter D. Mary Lea Gregory A. Xiao-Jun Easton Mcanally Sommers Zhang

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Cambridge Business Publishers, 2013

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