1. 2 Chapter Review of Accounting McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Income Statement Price-earnings Ratio Balance Sheet
Statement of Cash Flows
Tax-free Investments (Depreciation)

3. Basic Financial Statements
Income Statement
Statement of Retained Earnings (a short supplement to the income statement)
Balance Sheet
Statement of Cash Flows

4. Income Statement
Device to measure the profitability of a firm over a period of time
It covers a defined period of time
It is presented in a stair-step or progressive fashion to examine profit or loss after each type of expense item is deducted

5. Income Statement (cont’d)
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)
GP – Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)
EBIT – Interest = Earnings Before Taxes (EBT)
EBT – Taxes = Earnings After Taxes (EAT) or Net Income (NI)

6. Income Statement (cont’d)
Table 2–1

7. Return to Capital Three primary sources of capital: Earnings per share
Bondholders (receive interest)
Preferred stockholders (receive dividends)
Common stockholders (receive dividends after preferred stockholders)
Earnings per share
Interpreted in terms of number of outstanding shares
May be paid out in dividends or retained by company for subsequent reinvestment

8. Statement of Retained Earnings
Indicates disposition of earnings with:
any adjustments to previously reported income
any restrictions on cash dividends

9. Price-Earnings (P/E) Ratio
Multiplier applied to earnings per share to determine current value of common stock
Indicates expectations about the future of a company
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

10. Price-Earnings (P/E) Ratio (cont’d)
Allows comparison of the relative market value of many companies
Firms with higher expected returns will have higher P/E ratio
Price-earnings ratios can be confusing
Drop in earnings may not match the magnitude of the falloff in earnings, which causes increase in P/E ratio

11. Price-earnings Ratios for Selected U.S. Companies
Expectations of returns and P/E ratios do change over time

12. Limitations of the Income Statement
Income gained/lost during a given period is a function of verifiable transactions
Stockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operations
Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

13. Balance Sheet
Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest
Delineates the firm’s holdings and obligations
A picture of the firm at a point in time
Items are stated on an original cost basis rather than at current market value

14. Balance Sheet Items
Liquidity: Asset accounts are listed in order of liquidity
Current assets
Items that can be converted to cash within one year
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 finished goods

15. Balance Sheet Items (cont’d)
Prepaid expenses
Represent future expense items that are already paid for
Investments
Long-term commitment of funds (at least one year)
Includes stocks, bonds, or investments in other corporations
Plant and equipment
Carried at original cost minus accumulated depreciation
Accumulated depreciation: Sum of past and present depreciation charges on currently owned assets

16. Balance Sheet Items (cont’d)
Total assets: Financed through liabilities or stockholders’ equity
Liabilities are financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations
Short-term obligations
Accounts payable (amount owed on open account to suppliers)
Notes payable (short-term signed obligations
to the banker or other creditors)
Accrued expense (payment not made for the obligation incurred on the services received)

17. Stockholder’s Equity
Represents total contribution and ownership interest of preferred and common stockholders
Preferred stock
Common stock
Capital paid in excess of par
Retained earnings

18. Statement of Financial Position (Balance Sheet)

19. Concept of Net Worth
Net worth/book value = Stockholders’ equity – preferred stock component
Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

20. Limitations of the Balance Sheet
Most of the values are based on historical/original cost price
Troublesome when it comes to plant and equipment and inventory
FASB ruling on disclosure of inflation adjustments no longer in force
It is purely a voluntary act on the part of the company

21. Limitations of the Balance Sheet (cont’d)
Differences between per share values may be due to:
Asset valuation
Industry outlook
Growth prospects
Quality of management
Risk-return expectations

22. Comparison of Market Value to Book Value per Share

23. Statement of Cash Flows
Emphasizes critical nature of cash flow to the operations of the firm
It represents cash/cash equivalents items easily convertible to cash within 90 days
Advantage of accrual method
Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits

24. Statement of Cash Flows (cont’d)
Disadvantage of accrual method
Adequate attention not directed to actual cash flow position of firm
Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

25. Sections of a Statement of Cash Flows
Three primary sections of the statement of cash flows:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The results of three sections are added together to compute the net increase or decrease in cash flow

26. Concepts Behind the Statement of Cash Flows

27. Determining Cash Flows from Operating Activities
Translation of income from operations from an accrual to a cash basis
Direct method
Every item on the income statement is adjusted from accrual to cash accounting
Indirect method
Net income represents the starting point
Required adjustments are made to convert net income to cash flows from operations

28. Net Cash Flows from Operating Activities (Indirect Method)

29. Comparative Balance Sheets
Table 2–6

30. Cash Flows from Operating Activities

31. Determining Cash Flows from Investing Activities
Long-term investment activities in mainly plant and equipment
Increasing investments represent a use of funds
Decreasing investments represent a source of funds

32. Determining Cash Flows from Financing Activities
Financial activities apply to the sale/retirement of:
Bonds
Common stock
Preferred stock
Other corporate securities
Payment of cash dividends
Sale of firm’s securities is a source of funds
Payment of dividends and repurchase of securities is a use of funds

33. Overall Statement Combining the Three Sections

34. Analysis of the Overall Statement
How are increases in current assets being financed?
Is there an associated buildup in current liabilities?
How are increases in long-term assets being financed?
Preferably, adequate long-term financing and profits should exist to finance long-term assets
Short-term funds may be used to carry long-term needs – could be a potential high-risk situation as short-term sources of funds may dry up while long-term needs continue to demand funding

35. Depreciation and Funds Flow
A noncash expense
Not a ‘new’ source of funds
Added back to net income to determine amount of actual funds on hand
Attempt to allocate the initial cost of an asset over its useful life
Charging of depreciation does not directly influence the movement of funds

36. Comparison of Accounting and Cash Flows

37. Free Cash Flow
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends
Capital expenditures
Maintain productive capacity of firm
Dividends
Maintain necessary payout on common stock and to cover any preferred stock obligations
Free cash flow is used for special financing activities
Example: leveraged buyouts

38. Income Tax Considerations
Corporate tax rates
Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15–20%
Cost of a tax-deductible expense - Interest, Travel expenditures, Salaries, etc.
Corporation A Corporation B
Earnings before interest and taxes…………. $400,000 $400,000
Interest…………………………………………… 100,
_________ _________
Earnings before taxes (taxable income)…… 300, ,000
Taxes (40%)……………………………………… 120, ,000
Earnings after taxes…………………………… $180, $240,000
Difference in earnings after taxes…………… $60,000

39. Depreciation as a Tax Shield
Not a new source of fund
Provides tax shield benefits measurable as depreciation times the tax rate
Corporation A Corporation B
Earnings before depreciation and taxes…… $400,000 $400,000
Depreciation……………………………………… 100,
_________ _________
Earnings before taxes………………………… 300, ,000
Taxes (40%)……………………………………… 120, ,000
Earnings after taxes…………………………… 180, ,000
+Depreciation charged without cash outlay… 100,
Cash flow………………………………………… $280,000 $240,000
Difference………………………………………… $40,000