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

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

3. 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.

4. 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

5. 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.

6. 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.

7. 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.

8. Facebook Balance Sheet
Assets
Cash ,907
Marketable securities ,546 13,527
Accounts receivable, net , ,259
Prepaid expenses
Total current assets , ,652
Property and equipment, net , ,687
Intangible assets, net , ,246
Goodwill , ,822
Total assets ,961 49,407
Liabilities
Accounts payable
Accrued expenses and other , ,729
Total current liabilities , ,925
Other long-term liabilities , ,264
Total liabilities , ,189
Equity
Contributed capital (additional paid in capital) , ,886
Retained earnings , ,332
Total stockholders’ equity , ,218
Total liabilities + equity , ,407

9. 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

10. 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.

11. 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)

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. Facebook Income Statement
Revenue , ,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 , ,225
Interest expense, net ( ) ( )
Provision for taxes ( 2,119) ( 2,506)
Net income , ,688

18. 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.

19. 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

20. 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?

21. 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

22. 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.

23. 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.

24. 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

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

26. 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?

27. 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

28. Facebook Statement of Cash Flows
Cash flow from operations , ,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 ( ) ( )
Cash flow from investing ( 11,739) ( 9,434)
Financing activities
Proceeds from stock issuance
Repayment of long-term debt ( ) ( )
Cash flow from financing ( ) ( )
Effect of exchange rate fluctuations ( 63) (155)
Change in cash ,
Beginning balance, cash , ,315
Ending balance, cash , ,907

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