Introduction to the Financial Statements Chapter 2 Introduction to the Financial Statements

Introduction to the Financial Statements How do accounting rules affect price-to-book ratios and price-earnings ratios?

What Will You Learn from this Chapter The broad picture of the firm that is painted by the financial statements The component parts of each financial statement How the financial statements fit together (or “articulate”). The accounting relations that govern the financial statements The stocks and flow equation that dictates how shareholders’ equity is updated The concept of dirty-surplus accounting The accounting principles that dictate how the balance sheet is measured How price-to-book ratios are affected by accounting principles The accounting principles that dictate how earnings are measured How price-earnings ratios are affected by accounting principles The difference between market value added and earnings Why fundamental analysts want accountants to enforce the reliability criterion How financial statements anchor investors

Distinguishing Form from Content in Financial Statements Form is the way in which the statements and their components parts fit together. Content is the measurement of the line items that are reported within the component parts of financial statements. The form gives the overall story that the statements are telling. The content puts numbers into the story.

The Four Financial Statements Balance Sheet Income Statement 3. Cash Flow Statement 4. Statement of Shareholders’ Equity

The Balance Sheet: Dell Computer, 2002 Shareholders’ Equity = Assets - Liabilities

The Income Statement: Dell Computer, 2002 Net Income = Revenue - Expense

Further Structure in 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 New Income – Preferred Dividends = Net Income Available to Common

The Cash Flow Statement: Dell Computer, 2002 Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

The Statement of Shareholder’s Equity: Dell Computer, 2002

The Stocks and Flow 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

The Articulation of the Financial Statements Investment and disinvestment by owners Net income and other earnings Net change in owners’ equity Statement of Shareholders’ Equity Revenues Net income Income Statement Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Cash - Liabilities Total Assets Owners’ equity Beginning Balance Sheet + Other Assets Ending Balance Sheet Beginning stocks Flows Ending stocks Other Assets + Expenses

Form is Given by Accounting Relations

Accounting for a Savings Account Amount invested: $100 Earnings rate: 5%

Intrinsic Value and Book Value Intrinsic Premium: Intrinsic Value of Equity - Book Value of Equity Market Premium: Market Value of Equity - Book Value of Equity Intrinsic Price-to-Book ratio: Intrinsic Value of Equity Book Value of Equity Price-to-Book ratio : Market Value of Equity

Percentiles of P/B Ratios, 1963-2001 U.S. Firms

Measurement in the Balance Sheet Historical Cost Accounting Fair Value Accounting See Box 2.3

Measuring Value Added Value added = Ending Value – Beginning Value + Dividend Stock Return = Accounting value added = Ending book value – Beginning book value + Net dividend = Comprehensive earnings

Principles of Earnings Measurement Recognize only value added from sales to customers Revenue recognition principles Add value when it has been earned (usually when a sale is made) Matching principle Match expenses against revenue for which they are incurred Accounting value added (earnings) = Revenue – Expenses See Box 2.4 for examples of good and bad matching

Percentiles of P/E Ratios, 1963-2001 U.S. Firms Numerator: Price forecasts future earnings Denominator: Current earnings

Guiding Principles for Recognizing Accounting Value Added The fundamentalist creed: Don’t mix what you know with speculation The accountant’s restatement of the creed (the reliability criterion): Accounting numbers should be based on objective evidence, free of opinion and bias. Go to Accounting Clinic I