1. Introduction to the Financial Statements
Chapter 2
Introduction
to the
Financial Statements

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

3. 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

4. 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.

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

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

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

8. 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

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

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

11. 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

12. 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

13. Form is Given by Accounting Relations

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

15. 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

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

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

18. 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

19. 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

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

21. 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