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Chapter Three: The Balance Sheet and Financial Disclosures

The Balance Sheet shows a company's financial statement at a moment in time, does not portray the market value of the entity, does not show all of a company's assets (e.g. key employees, reputation, client lists, etc.), and does not show the liquidation value of an entity. It does describe many of the resources a company has available to generate cash flow.

- Liquidity refers to the length of time before an asset is converted to cash or until a liability is paid.

- Long-Term Solvency refers to the riskiness of the amount of liabilities in the capital structure (riskiness to investors and creditors increases as the proportion of Debt to Equity increases).
   * Financial Leverage refers to the use of debt (fixed financing) to increase the investor's return.
       - If Profit Margin > Interest Rate, Financial Leverage will increase Return on Investment (ROI) and riskiness
    * Operating Leverage refers to the use of fixed asset in a company's structure as opposed to variable costs (such as outsourcing production, paying commission, etc).  Using a variable cost structure is less risky, but using fixed assets allow significant leverage of profits after reaching a certain quantity.  (Example of Jamaal selling ties on commission versus salaries).

The Balance Sheet distinguishes between current and long-term assets and current and long-term liability (remember how these category titles are named on typical company balance sheet?)

Current Assets:
    - Cash and Cash Equivalent
      > Cash include bank deposits, money orders, cashier checks, etc.
      > Cash Equivalents include commercial paper, money market, and treasury bills
       * Investments that have a maturity date of 3 months or less from date of purchase
       * Commercial paper is short-term (<270 days), unsecured loans, from high credit corporations
    - Short-Term Investments
       * Holds short-term marketable securities
       * Current asset if company has ability and intent to sell these securities within twelve months or business cycle, whichever is longer.
       * Classified as:
          1) Trading Securities - Short-term trading, will trade soon (stocks or bonds)
          2) Held to Maturity - You intend to hold on to investment until it matures (only bonds)
          3) Securities Available for Sale - All other investments not classified above (stocks or bonds)
    - Receivables
       * Accounts Receivable - Sale of goods on credit, no interest charges
       * Nontrade Receivable - Money owed to company for reason other than a sale
       * Notes Receivable - Any receivable that has a formal agreement
       * If receivable is not expected to be collected within a year or business cycle, it should be classified in the long-term asset, "Investments and Funds"
    - Inventory
       * Includes raw materials, work-in-process, and finished goods
       * Can only be current because the sale of inventory defines the length of the business cycle
    - Prepaid Expenses
       * Could be current or long-term
    - Other Current Assets
       * Short-term Investments and Nontrade investments

Noncurrent\Long-Term Assets (Not specified on Balance Sheet)
    - Investments and Funds
      * Hold long-term assets not used in operations, such as stocks and bonds of other companies
    - Property, Plant and Equipment
      * Tangible, long-lived assets used in operations
      * "Operating Asset" classified as (PPE and Intangibles
      * Land, Buildings, Equipment, Furniture, and natural resources are examples
      * Often presented as a net figure, book value (Historical cost less accumulated depreciation)
    - Intangible Assets:
      * No physical substance
      * Represent ownership of an exclusive right to a product, process, or name
      * Examples are patents, copyrights, and franchise agreements
      * Reported net of accumulated amortization
    - Other Assets:
      * Long-term prepaid (deferred charges)
      * Goodwill, prepaid pension costs

Current Liabilities
    - Accounts Payable - Obligations to suppliers (no interest)
    - Notes Payable - An I.O.U. (interest)
    - Current Maturities of Long-Term Debt
      * Notes maturing within one year are marked as current liabilities
    - Unearned revenue
    - Accrued Liability
      * Represents obligations created when expenses have been accrued but not paid yet
      * Examples - Salary Payable, Interest Payable

Long-Term Liabilities:
    - Long-Term Debt
    - Other Long-Term Liabilities
      * Deferred Income Taxes\Pension Costs\Employee Benefits
      * Deferred Lease Obligations, Deferred Gains

Shareholder's Equity:
    - Paid In Capital - Money invested by owners in return for common stock
    - Retained Earnings - Money that the company has earned since inception and not paid out to investors (dividends)
    - Other Comprehensive Income
    - Deferred Compensation - Money owed to an owner or executive
    - Treasury Stock - Company stock which the company has purchased back on the stock market

Treasury Stock (Pros and Con)
    * Increases Earnings per Share
    * Increases demand for stock
    * Provides stock for pension plan/executive compensation
    * Indicates company does not have anything else to spend money on

Examples of Disclosure Notes on Financial Statements
    - Required to include a Summary of Significant Accounting Policies
       * Depreciation Method
       * Inventory Methods
       * Defines Cash and Cash Equivalents
       * Defines Policies for Revenue Recognition
    - Required to include Subsequent Events
       * Events with a material effect on financial position occurring after end of financial reporting period but before issuance of the financial statements
    - Required to include Related Party Transactions (not arms-length transaction)
       * Nature of the Relationship
       * Description of Transaction
       * Dollar Amount of Transaction
       * Any Amount Still Owed
    - Other Required Disclosures:
       * Errors (Unintentional)
       * Irregularities (Intentional)
           > Similar - Illegal Acts - such as Bribes, Kickbacks, Illegal Political Contributions, etc.)

Staff Accounting Bulletin no. 99:
    - Expressed the view that more than a quantitative benchmark is necessary for determining materiality (e.g. fraud)

Management Discussion and Analysis (MD&A):
    - Management provides views on significant events, trends, and uncertainties for operations, liquidity, and resources

Management's Responsibilities:
    - Management prepares and is responsible for the financial statements and other information in the report
    - Management is also responsible for assessment of the company's internal control procedures
    - Sarbanes-Oxley requires corporate executives to personally certify financial statements

Auditor's Responsibilities:
    - Examine financial statements
    - Examine internal control procedures related to supporting content of the financial statements
    - Attest to fairness of the financial statements

Auditor's Report:
    - Issued by CPAs
    - Commonly used terms: "Present fairly", "In conformity with GAAP", and "Reasonable assurance"

Types of Auditor's Opinions:
    - Unqualified:
       * Clean Opinion - Do not have to qualify their opinion, everything looks good
       * NYSE requires companies to have an auditor express an unqualified opinion to be listed
       * May still issue unqualified opinion even with a few comments (an auditor can add an explanation to unqualified opinion)
          > Lack of Consistency - due to change in accounting principles, but auditor agrees with change.
          > Uncertainty Surrounding the Resolution of a Material Event - The event could have a material impact on the financial position is it is not estimatable or probable.
          > Emphasize a Certain Point - Often relates to a significant event or interpretation, but does not affect overall unqualified opinion.

    - Qualified Opinion - An exception to the standard unqualified opinion, but not sufficient to warrant invalidating financial statements as a whole
      * Not Conforming with Generally Accepted Accounting Principles
      * Inadequate Disclosures
      * Restriction on Scope of Examination by Management (e.g. "Only look at these stores")

    - Adverse Opinion - Serious exception - Very Rare

    - Disclaimer - Insufficient information has been obtained to express an opinion

Current Ratio:  Current Assets / Current Liabilities

Quick (Acid-Test) Ratio: (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities

Debt-to-Equity: Total Liabilities / Shareholder's Equity





Chapter Four – The Income Statement and Statement of Cash Flows

 

Income Statement (aka Statement of Operations, Statement of Earnings, Profit & Loss)

·         Summarizes the profit-generating activities that occurred during the reporting period.

·         Earnings Quality – The ability of the reported earnings to predict the company’s future earnings.  Analysts try to separate a company’s transitory earnings and permanent earnings.

o       Transitory earnings represent transactions which are unlikely to occur again in the near future.

o       Some categories to examine:

o       Restructuring Costs – Not uncommon to declare, shows costs of a restructuring or reengineering program.  Prior to 2003 would expense anticipated costs in current period and record a liability, but the SEC became wary of how regular these expenditures were being declared (could have negative expenses). SFAS No. 146 prohibits management from recognizing a liability before a cost associated with an exit or disposal activity unless a liability has actually been incurred.  The Standard also stated the objective should be to record the fair value of the liability (the present value: time value of money)

o       Goodwill Impairment/Long-Lived Asset Impairment – Any operational asset should be written down when there has been a significant impairment in value (tangible or intangible)

o       Pro Forma Earnings – Management will often present an assessment of earnings which they view as permanent, which normally excludes expenses, such as restructuring, acquisition charges, and certain intangible amortization.  Sarbanes-Oxley requires that if pro forma statements are provided with any SEC or public report that the company reconcile the earnings to those determined through GAAP.

·         Earnings Smoothing

o       Debate about how GAAP allows for the flexibility for management to manipulate earnings to make them appear less volatile, meet earnings, etc.

o       This is a common practice used to meet wall street expectations

o       Managers may accelerate or delay the recognition of revenues or expenses (example – channel stuffing to raise sales)

o       Managers may also reclassify certain expenses – for example from operating to nonoperating or from continuing operations to a special charge (restructuring is big – AT&T)

o       Big Bath – If you are going to miss earnings, you might as well miss big.

o        

 

Income from Continuing Operations

·         Revenues, expenses (including income tax), gains, and losses

o       These are distinguished and exclude from those of discontinued operations

·         Recall the definition of revenues and expenses.  Additionally, recall the matching principle which explains the relationship between revenues and expenses.

o       If a relationship cannot be established, then we expense in current period, allocate over multiple periods, or relate it to another future period.

·         Gains and Losses result from peripheral activities (sale of equipment, building, and other items which are not part of normal operations).

·         Distinguishing between Operating and Nonoperating

o       Operating includes revenues and expenses directly related to the principal revenue-generating activities

o       Nonoperating includes revenues, expenses, gains, and losses from peripheral activities (e.g. gains on investments, sale of long-term assets, interest revenue/expense

o       Other Income is often used to classify nonoperating activities

·         No specific standards indicate how income from continued operations must be displayed.  Two main types with many variations:

o       Single-Step (Simple) – Revenues and Gains are grouped and Expenses and Losses are grouped, then subtracted from each other (i.e. no separation between operating and nonoperating)

o       Multiple-Step (Useful for Analysis) – Operating and Nonoperating are distinguished, plus various subtotals are calculated (gross profit, operating income, and earnings before taxes)

 

Specifically Reported Items

·         Only two items are allowed and mandated to be reported below income from continuing operations: Discontinued Operations and Extraordinary Operations.

·         Discontinued Operations must be listed first, followed by Extraordinary Operations.  Both are normally reported net of tax.

·         There used to be a third item: Cumulative Effect of a Change in Accounting Principle, where an accounting change would be shown as one lump sum effect in the current year.  In 2005, it was determined that changes in accounting principles would be handled retrospectively (i.e. restate the numbers as if it had been the new way all along).

·         Discontinued Operations:

o       If a component of an entity has been disposed of or is classified as held for sale, we report the results of its operation separately in discontinued operations, IF:

o       1) Operations and cash flows of the component have been/will be eliminated from ongoing operations

o       2) The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction

·         Extraordinary Items:

o       An unusual event which materially affects the current period’s income, but it highly unlikely to occur again

o       Reported separately, net of tax

o       Unusual in nature and infrequent in occurrence.

o       Use professional judgment for this subjective category

o       The loss of a major client/death of CEO/strikes/competition are not extraordinary items as they are usual risks of operations

o       Also, the definition may vary (e.g. hurricane damage in Florida vs. hurricane damage in Maine)

·         Unusual or Infrequent Items

o       Material events which are unusual in nature OR infrequent, but not both as defined by extraordinary items, should be listed in continuing operations, but be separated out

 

Income Tax Expense

·         Always reported separately due to size and significance.

·         When tax rules and GAAP differ regarding the timing of revenue or expense recognition, the actual payment of taxes may occur in a period different from when income tax expense is reported in the income statement.  You would record a differed tax asset or liability as appropriate.

 

Comprehensive Income

·         Debate over what should be included in Net Income

·         FASB decided to maintain traditional view of net income calculation, but also expand to show Comprehensive Income.  Four Categories:

o       Net unrealized holding gains (unrealized gains/losses on investments marked to the market)

o       Minimum Pension Liability Adjustments

o       Deferred gains/losses from derivatives

o       Currency Translation Adjustments

·         May be reported net of tax or before tax with a separate tax line.

·         May be reported in (Income Statement, Changes in Shareholder’s Equity <Majority>, as a separate statement, or even a disclosure statement)

·         Accumulated comprehensive income is recorded in the equity section of the Balance Sheet as Accumulated Other Comprehensive Income

 

Accounting Changes:

·         Changes in Accounting Principle

o       Example – Change from LIFO to FIFO or revenue recognition

o       Retrospectively restate prior year financial statements to allow for comparability and consistency

·         Change in Accounting Estimate

o       When changing an estimate, do not revise prior year financial statements

o       Change is treated prospectively

·         Change in Depreciation, Amortization or Depletion Methods

o       Viewed as a change in accounting estimate

o       Treat this prospectively

o       Example of Equipment half way through

 

Correction of Accounting Errors:

·         Errors discovered in the same year

o       Original erroneous journal entry should be reversed and the correct entry be recorded.

·         Errors discovered in a subsequent year

o       Depends on materiality

o       If minor (which is the majority) then correct in current year

o       If major, then have a Prior Period Adjustment – an adjustment to retained earnings to account for error.  Additionally, financial statements affected by the error are retrospectively restated.  Finally, it should all be defined in a disclosure note

 

Earnings Per Share Disclosure:

·         Basic EPS – Divide net income by the weighted average number of common shares outstanding during the period

·         Diluted EPS – Factors in for the potential dilution for stock option and other compensation packages

 

Statement of Cash Flows

·         Covers the change in Cash and Cash Equivalents over a period of time.

·         Direct vs. Indirect Method

o       Affects only the operating activities section

o       Direct Method – the cash effect of each operating activity is reported directly in the statement

o       Indirect Method – starts with net income and works backward to the cash basis.  Two types of adjustments – the reversal of non-cash items figured in net income and the adjustment to factor for increases of decreases in assets and liabilities.

·         Three Categories:

·         1) Operating Activities

o       Cash inflows and outflows from activities reported in the income statement

o       Example – cash received from customers for sales and cash expended to purchase inventory

o       Accrual revenues will typically not equal cash inflows and accrual expenditure will typically not equal cash outflows

o       The difference between inflows and outflows of this category are called ‘net operating cash flow’ or ‘net cash flows from operating activities’

·         2) Investing Activities           

o       Cash flows related to the acquisition and disposition of long-term operating assets and investment assets.

·         3) Financing Activities

o       Cash flows related to external financing of the company

o       Includes the sale of our company’s stock and bonds and their repurchase

o       What about interest?

o       Also includes dividends


 
 
 
 
 
     
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