Accounting and Financial Statements Analysis 101 for In-house Counsel Professor Michael Smith Boston University

Session Overview Institutional context Financial statements Balance sheet Income statement Statement of cash flows Format? Purpose? Measurement?

Regulatory Oversight The Financial Accounting Standards Board (FASB) has responsibility for developing Generally Accepted Accounting Principles (GAAP) The Securities and Exchange Commission (SEC) is responsible for enforcement of accounting rules. Independent auditors review financial statements and provide an opinion. The Public Company Accounting Oversight Board (PCAOB) has responsibility for oversight of auditing.

SEC Filings Form 10-K Management’s Discussion and Analysis Financial Statement Footnotes to Financial Statements Form 8-K Prompt notification of significant events Proxy Statement (14-A) Required when soliciting votes Details on executive and board compensation

The Balance Sheet Assets = Liabilities + Owners’ Equity Creditors’ Claims Owners’ Claims Uses of funds Productive capacity Sources of funds (Financing) Capital structure refers to the relative amounts of debt and equity in a firm’s financing.

Purpose of Balance Sheet Provides investors with information about: the nature and amounts of the firm’s productive assets. the firm’s capital structure (relative amounts of debt and equity) and financial risk. the firm’s financial flexibility and liquidity (how quickly assets and liabilities will generate or consume cash). The information is most useful to creditors: Little information about the firm’s earnings potential.

Balance Sheet Vocabulary Asset: resource owned by a firm whose benefits can be measured with a reasonable degree of precision. Liability: a firm’s debts or obligations, settled over time through the provision of cash, goods, or services. Owners’ equity: the residual claim of owners against the net assets of the firm.

Facebook Balance Sheet Assets 2016 2015 Cash 8.903 4,907 Marketable securities 20,546 13,527 Accounts receivable, net 3,993 2,259 Prepaid expenses 959 659 Total current assets 34,301 21,652 Property and equipment, net 8,591 5,687 Intangible assets, net 2,535 3,246 Goodwill 19,434 18,822 Total assets 64,961 49,407 Liabilities Accounts payable 302 196 Accrued expenses and other 2,573 1,729 Total current liabilities 2,875 1,925 Other long-term liabilities 2,892 3,264 Total liabilities 5,767 5,189 Equity Contributed capital (additional paid in capital) 38,227 34,886 Retained earnings 20,967 9,332 Total stockholders’ equity 59,194 44,218 Total liabilities + equity 64,961 49,407

Accounting Assets Resources whose benefits can be precisely measured: Cash, inventory, accounts receivable, property, plant and equipment, investments in other firms, intangible assets purchased from another firm, Reported as assets on the balance sheet Resources whose benefits cannot be precisely measured: Research and development, advertising, brand names, internally generated intangible assets Not reported as assets on the balance sheet

Goodwill Goodwill arises only from merger & acquisition activity. Goodwill is the premium of price paid over the market value of the identifiable assets purchased net of the market value of the identifiable liabilities assumed.

Asset Write-Downs If the market value of a long-term asset is lower than its book value, the company must reduce (write down) the asset on the balance sheet and take a corresponding loss on the income statement. The following terms are synonymous: Asset impairment Write-down Write-off (write-down to 0)

Liabilities Examples of obligations reported as liabilities on balance sheets: Accounts payable, unearned revenue, debt, wages payable, taxes payable, utilities payable, etc. Legal obligations to make payments are not necessarily accounting liabilities: Some lease contracts Losses related to litigation accrued if sufficiently probable and estimable.

Owners’ Equity Additional paid in capital is the cumulative amount of cash generated by primary stock issuances. Retained earnings is the cumulative amount of profits reinvested in the firm. Treasury shares is the cumulative value of shares repurchased by the firm less the value of those shares reissued.

Balance Sheet Caveats Almost all asset and liability accounts are based in part on management’s estimates GAAP does not allow the recognition of internally generated intangible assets on the balance sheet. Some liabilities (and the assets financed by them) may not be on the balance sheet.

Income Statement Report of profitability for a period of time. Based on the accrual method of accounting Income does not necessarily correspond to operating cash flows in a given year; over time these amounts will reconcile.

Purpose of Income Statement Provides investors with information about earnings generated by the firm in the past fiscal year and its ability to generate wealth in the future. the various revenues, expenses, gains and losses of the firm The information is most useful to stock investors.

Facebook Income Statement 2016 2015 Revenue 27,638 17,928 Cost of revenue ( 3,789) ( 2,867) Research and development ( 5,919) ( 4,816) Marketing and sales ( 3,772) ( 2,725) General and administrative ( 1,731) (1,295) Income from operations 12,427 6,225 Interest expense, net ( 91) ( 31) Provision for taxes ( 2,119) ( 2,506) Net income 10,217 3,688

Accrual Accounting: Expenses Matching principle: Expenses are recognized in the period in which the associated revenues (or benefits) are earned, without regard to the timing of cash payments.

Criteria for Revenue Recognition Income is earned i.e., the work is “done” Income is realizable i.e., have received an asset in exchange for the work

Example of Revenue Recognition Product bundle, 5 year contract Copier Extended warranty (for years 2 through 5) Annual maintenance (all 5 years) A single price for all elements of the bundle Customer pays cash upfront When can the company record revenue on the income statement?

When is Revenue Recognized? Allocate price to “buckets” Price Copier Extended warranty Annual maintenance Record revenue immediately Record revenue in years 2 through 5 Record revenue in years 1 through 5

EBIT and EBITDA Managers often believe that bottom-line net income does not capture the real value created by the company. EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Income, Taxes, Depreciation and Amortization) make adjustments to bottom-line net income to represent (presumably) more accurately the profits and/or cash flows generated from operations. Managers are more often compensated based on some variation of EBIT or EBITDA than bottom-line net income.

EBIT and EBITDA What is the explanation for the exclusions? Interest expense Related to financing choices, not operating efficiency Reduces comparability across companies with different capital structures Tax expense Related to the vagaries of tax laws Reduces comparability across companies Depreciation and amortization Non-cash expenses related to transactions that occurred in the past Managers are more often compensated based on some variation of EBIT or EBITDA than bottom-line net income.

Facebook: EBIT and EBITDA GAAP Earnings Add back Interest expense Tax expense Depreciation and amortization Total GAAP 10,217 EBIT 10,217 +91 +2,301 12,609 EBITDA 10,217 +91 +2,301 +2,342 14,951

Statement of Cash Flows Reports cash flows during a period related to the firm’s operating, investing, and financing activities.

Purpose of Statement of Cash Flows Does the firm generate enough cash to make its debt payments in the next period? Does the firm generate enough cash to finance growth with internal funds, or will it have to raise money by issuing stock or debt?

Classification of Activities on SCF Operating activity Cash receipts from sales Cash payments to suppliers Cash payments to employees Investing activity Cash payments for property, plant, equipment, intangible assets, acquisitions. Cash receipts from sales of long-term assets. Financing activity Cash receipts/payments related to debt Cash receipts from stock issuances Cash payments for dividends and stock repurchases

Facebook Statement of Cash Flows 2016 2015 Cash flow from operations 16,108 10,320 Investing activities Purchases of property and equipment ( 4,491) ( 2,523) Sales (purchases) of securities, net ( 7,186) ( 6,700) Acquisitions of businesses, net ( 62) ( 211) Cash flow from investing ( 11,739) ( 9,434) Financing activities Proceeds from stock issuance -- --- Repayment of long-term debt ( 310) ( 139) Cash flow from financing ( 310) ( 139) Effect of exchange rate fluctuations ( 63) (155) Change in cash 3,996 592 Beginning balance, cash 4,907 4,315 Ending balance, cash 8,903 4,907

Main Takeaways Format and purpose of main financial statements Rules underlying measurement of assets, liabilities, revenues and expenses. Alternative definitions of income