Chapter 2 Accounting Information, Regression Analysis By Cheng Few Lee Joseph Finnerty John Lee Alice C Lee Donald Wort

Chapter Outline 2.1 Introduction 2.2 Financial Statement: A Brief Review Balance Sheet Statement of Earnings Statement of Equity Statement of Cash Flows Interrelationship Among Four Financial Statements Annual vs. Quarterly Financial Data 2.3 Critique of Accounting Information Criticism Methods for Improvement 2.4 Static ratio analysis and its extension Static Determination of Financial Ratios Dynamic Analysis of Financial Ratios Statistical Distribution of Financial Ratios 2.5 Cost-Volume-Profit Analysis and its Applications Deterministic Analysis Stochastic Analysis 2.6 Accounting Income vs. Economic Income 2

2.2Financial statement: A brief review Balance sheet Income statement Cash flow statement Equity statement Annual vs. quarterly financial data 3

2.2.1 Balance Sheet Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009) (Dollars in Millions) Assets Current Assets Cash and Cash Equivalent ($)9,20316,0554,0837,77010,76815,810 Marketable Securities3, ,5452,0413,615 Account Receivable6,8317,0108,7129,4449,7199,646 Inventory3,7443,9594,8895,1105,0525,180 Deferred Taxes on Income1,7371,8452,0942,6093,4302,793 Prepaid Expenses and Other Receivable2,1242,4423,1963,4673,3672,497 Total Current Assets27,32031,39422,97529,94534,37739,541 Marketable Securities — Non-current Property, Plant and Equipment, Net10,43610,83013,04414,18514,36514,759 Intangible Assets, Net11,84212,17528,68828,76327,69531,185 Deferred Taxes on Income ,2104,8895,8415,507 Other Assets3,1223,2212,6233,1702,6343,690 Total Assets53,31758,02570,55680,95484,91294,682 Liabilities and Shareholder’s Equity Current Liabilities Loans and Notes Payable ,5792,4633,7326,318 Account Payable5,2274,3155,6916,9097,5035,541 Accrued Liabilities3,5233,5294,5876,4125,5315,796 Accrued Rebates, Returns, and Promotion2,2972,0172,1892,3182,2372,028 Accrued Salaries, Wages, and Commissions1,0941,1661,3911,5121,4321,606 Taxes on Income1, Total Current Liabilities13,92712,63519,16119,83720,85221,731 Long-term Debt2,5652,0172,0147,0748,1208,223 Deferred Tax liability ,3191,4931,4321,424 Employee Related Obligations2,6313,0655,5845,4027,7916,769 Other Liabilities1,9782,2263,1603,8294,2065,947 4

2.2.1 Balance Sheet Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009) (continued) Shareowners’ Equity Preferred Stock-without Par Value —————— Common Stock-Par Value $1.003,120 Net Receivable from Employee Stock Plan−11 ————— Accumulated Other Comprehensive Income−515−755−2,118−693−4,955−3,058 Retained Earnings35,22341,47149,29055,28063,37970,306 Less: Common Stock Held in Treasury6,0045,96510,97414,38819,03319,780 Total Shareowners’ Equity31,81337,87139,31843,31942,51150,588 Total Liabilities and Shareholders’ Equity53,31758,

2.2.2 Income Statement Table 2-2 Consolidated Statements of Earnings of JNJ Inc. & Subsidiaries ( ) (dollars in millions) (Dollars in Millions Except Per Share Figures) Sales to Customers ($)47,34850,51453,32461,09563,74761,897 Cost of Products Sold13,42213,95415,05717,75118,51118,447 Gross Profit33,92636,56038,26743,34445,23643,450 Selling, Marketing and administrative expenses 15,86016,87717,43320,45121,49019,801 Research Expense5,2036,3127,1257,6807,5776,986 Purchased in-process research and development — Interest Income−195−487−829−452−36190 Interest Expense, net of portion capitalized Other (income) expense, Net 15−214−6711,279−1, ,08822,90423,68030,06126,30727,695 Earnings before Provision for Taxes on Income 12,83813,65614,58713,28316,92915,755 Provision for Taxes on Income 4,3293,2453,5342,7073,9803,489 Net Earnings8,50910,41111,05310,57612,94912,266 Basic Net Earnings per Share ($) Diluted Net Earnings per Share ($)

2.2.3 Statement of Equity 7

8

9

2.2.4 Statement of Cash Flows 10

2.2.4 Statement of Cash Flows 11

2.3Critique of accounting information Criticism Methods for improvement a) Use of Alternative Information b) Statistical Adjustments c) Application of Finance and Economic Theories 12

2.4Static ratio analysis and its extension Static determination of financial ratios Dynamic analysis of financial ratios Statistical distribution of financial ratios 13

Static determination of financial ratios Table 2.5: Company ratios period Ratio ClassificationFormulaJ&JIndustry Liquidity Ratio Current Ratio Quick Ratio Leverage Ratio Debt-to-Asset Debt-to-Equity Equity Multiplier Times Interest Paid

Static determination of financial ratios Table 2.5: Company ratios period (Continued) Ratio ClassificationFormulaJ&JIndustry Activity Ratios Average collection period Accounts receivable Turnover Inventory Turnover Fixed Asset Turnover Total Asset Turnover Profitability Ratios Profit margin 20.30%19.80% 19.47% 19.43% Return on assets 15.25%12.95% 12.41% 12.38% Return on equity 30.20%26.40% 25.07% 24.51% Market value Price/earnings Price-to-book-value

Y j,t =Y j,t -1+δ j (Y j,t *-Y j,t-1 ) (2.1) where 0≤ δ j ≤1, and δ j = A partial adjustment coefficient; Y j,t = Firm’s jth financial ratio period t; Y j,t-1 = Firm’s jth financial ratio period t-1; and Y* j,t = Firm’s jth financial ratio target in period t, Basic Model Dynamic Analysis of Financial Ratios 16

Y* j,t = CX j,t-1 + τ j,t, (2.2) Y j,t -Y j,t-1 =δ j [X j,t-1 -Y j,t-1 ] (2.3) Z j,t =A j +B j W j,t-1 +ε j,t (2.4) where Z j,t = Y j,t - Y j,t-1 ; W j,t-1 = X j,t-1 - Y j,t-1 ; A j and B j = Regression parameters, and ε jj,t = The error term. Basic Model Dynamic Analysis of Financial Ratios 17

Z′ j,t = A′ j + B′ j W′ j,t-1 + ε j ′ j,t,(2.5) where Z′ j,t = log (Y j,t ) - log (Y j,t-1 ); W′ j,t-1 = log (X j,t-1 ) - log (Y j,t-1 ); and ε j ′ j,t = The Error term. Extensions of Basic Model Dynamic Analysis of Financial Ratios 18

Extension of Basic Model Dynamic Analysis of Financial Ratios 19

Table 2.6: Dynamic adjustment ratio regression results VariableCurrent RatioLeverage Ratio Mean Z Mean W Var(Z) Cov(Z,W) Bj`Bj` 0.810*0.259 t-Statistics [3.53][1.06] Aj`Aj` * Partial adjustment coefficient significant at 95% level Empirical Data Dynamic Analysis of Financial Ratios 20

Table 2.7: Ratio correlation coefficient matrix CRATGPMLR CR 1.0 AT GPM LR Empirical Data Dynamic Analysis of Financial Ratios 21

Z 1,t = A 0 +A 1 Z 2,t + A 2 W 1 + ε j 1,t, (2.9a) Z 2,t = B 0 + B 1 Z 1,t + B 2 W 2 + ε j 2,t. (2.9b) where A i, B i (i = 0, 1, 2) are coefficients, ε j 1 and ε j 2 are error terms, and Z 1,t = Individual firm’s current ratio in period t - individual firm’s current ratio in period t-1; Z 2,t = Individual firm’s leverage ratio in period t - individual firm’s leverage ratio period t-1; W 1,t = Industry average current ratio in period t-1 - individual firm’s current ratio period t-1; W 2,t = Industry average leverage ratio in period t-1 - individual firm’s leverage ratio in period t-1. Empirical Data Dynamic Analysis of Financial Ratios 22

Table 2.8: Johnson & Johnson empirical results for the simultaneous equation system A 0 (B 0 )A 1 (B 1 )A 2 (B 2 ) (2.9a) [-1.80] [-5.52] [1.20] (2.9b) [-1.59] [-6.07] [0.91] Empirical Data Dynamic Analysis of Financial Ratios 23

Statistical Distribution of Financial Ratios where μ and σ 2 are the population mean and variance, respectively, and e and π are given constants; that is, π= and e =

Statistical Distribution of Financial Ratios There is a direct relationship between the normal distribution and the log-normal distribution. If Y is log-normally distributed, then X = log Y is normally distributed. Following this definition, the mean and the variance of Y can be defined as: where exp represents an exponential with base e. 25

Deterministic Analysis 26

2.5 COST-VOLUME-PROFIT ANALYSIS AND ITS APPLICATIONS Deterministic analysis Stochastic analysis 27

Deterministic Analysis Operating Profit = EBIT = Q(P － V) － F, (2.12) where Q = Quantity of goods sold; P = Price per unit sold; V = Variable cost per unit sold; F = Total amount of fixed costs; and P - V = Contribution margin. 28

Deterministic Analysis Operating profit = EBIT = Q π (P π － V π ) － F. (2.16) 29

Deterministic Analysis 30

2.6 ACCOUNTING INCOME VS. ECONOMIC INCOME E t = A t + P t, (2.17) where E t = Economic income, A t = Accounting earnings, and P t = Proxy errors. 31

2.7 SUMMARY In this chapter, the usefulness of accounting information in financial analysis is conceptually and analytically evaluated. Both statistical methods and regression analysis techniques are used to show how accounting information can be used to perform active financial analysis for the pharmaceutical industry. In these analyses, static ratio analysis is generalized to dynamic ratio analysis. The necessity of using simultaneous-equation technique in conducting dynamic financial ratio analysis is also demonstrated in detail. In addition, both deterministic and stochastic CVP analyses are examined. The potential applications of CVP analysis in financial analysis and planning are discussed in some detail. Overall, this chapter gives readers a good understanding of basic accounting information and econometric methods, which are needed for financial analysis and planning. 32