CHAPTER TWO

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
2-2
 What You Will 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 comprehensive income
• 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

2-3
 The Big Picture for This Chapter

• The financial statements are the lens on the

business. They draw a picture in two ways:

1. The way that the component parts of

the statements fit together sketches out the
picture

2. The numbers reported within

each component fills out the sketch

Accounting equations describe how the components fit

together

2-4
 The Four Financial Statements

1. Balance Sheet

2. Income Statement

3. Cash Flow Statement

4. Statement of Shareholders’ Equity

2-5
The Balance Sheet:
Nike, Inc., 2010

2-6
How Balance Sheet Components Fit Together

Assets = Liabilities + Shareholders’ Equity

Or:

Shareholders’ Equity = Assets – Liabilities

Compare to:

Value of Equity = Value of Firm – Value of Debt

2-7
 The Income
Statement:
Nike, Inc., 2010

2-8
 The Components of the
Income Statement

Net Revenue – Cost of Goods Sold = Gross Margin

Gross Margin – Operating Expenses = Operating Income

Operating Income – Interest Expense + Interest Income = Income before

Taxes

Income before Taxes – Income Taxes = Income after Taxes and before
Extraordinary Items

Income before Extraordinary Items + Extraordinary Items = Net Income

Net Income – Preferred Dividends = Net Income Available to Common

Operating income is sometimes called earnings before interest and taxes

(ebit)

2-9
The Cash Flow
Statement :
Nike, Inc., 2010

2-10
 The Components of the
Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

2-11
The Statement of
Shareholders’
Equity:
Nike, Inc., 2010

2-12
 The Components of the Equity Statement
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

2-13
The Articulation of the Financial Statements:
How They Fit Together
Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations

Beginning Balance Sheet Cash from investing Ending Balance Sheet
Cash from financing

Cash Net change in cash Cash

Other Assets + + Other Assets

Statement of Shareholders’ Equity
Total Assets Total Assets
Investment and disinvestment by owners
- Liabilities - Liabilities
Net income and other comprehensive income

Owners’ equity Net change in owners’ equity Owners’ equity

Income Statement

Revenues

Expenses

Net income

2-14
A Summary of the Accounting Relations
How Parts of the Financial Statements Fit Together
The Balance Sheet

Assets
− Liabilities
= Shareholders' Equity

The Income Statement

Net Revenue
− Cost of Goods Sold
= Gross Margin
− Operating Expenses
= Operating Income before Taxes (EBIT)
− Net Interest Expense
= Income Before Taxes
− Income Taxes
= Income After Tax and before Extraordinary Items
+ Extraordinary Items
= Net Income
− Preferred Dividends
= Net Income Available to Common

Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash Flow from Operations

+ Cash Flow from Investing
+ Cash Flow from Financing
= Change in Cash

Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income
Statement)
Dividends
Net Income + Share Repurchases
Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income ← = Comprehensive Income − Share Issues
− Net Payout to Shareholders ← = Net Payout
= Ending Equity

2-15
 Accounting for a Savings Account

• Amount invested: $100

• Earnings rate: 5%
BALANCE SHEET INCOME STATEMENT

Assets $100 Owners’ equity $100 Revenue $5

Expenses 0

Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY

Cash from operations $5 Balance, end of Year 0 $100

Cash investment 0 Earnings, Year 1 5

Cash in financing activities: Dividends (withdrawals), Year 1 (5)

Dividends (5) Balance, end of Year 1 $100

Change in cash $0

2-16
 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
Book Value of Equity

2-17
Percentiles of P/B Ratios for U.S. Firms, 1963-2010

2-18
 Measurement in the Balance Sheet

• Historical Cost Accounting

• Fair Value Accounting

Box 2.3 in text explains how each item of assets

and liabilities is measured.

2-19
 Measuring Value Added

Value added = Ending Value – Beginning Value + Dividend

Stock Return = Pt − Pt −1 + d t

(The stock return is sometimes referred to as Market Value Added)

Accounting value added = Ending book value – Beginning

book value + Net payout
=Comprehensive earnings

2-20
 Principles of Earnings Measurement

• Recognize value added only when you have a customer

 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

2-21
 Good Matching: Examples

• Only costs of good sold are matched to sales revenue, not the full
costs of producing or buying inventory during the period. Thus,
gross margin (Revenue – Cost of good sold) measures value added
from trading with customers. Costs for goods not sold are
reported in the balance sheet, as inventory, to be matched with
revenue in future periods when the inventory is sold.

• Costs of buying plant are not expensed when incurred. Rather,

the cost is “capitalized” on the balance sheet and depreciated over
years when the plant produces revenues. Depreciation is a
method of matching the cost of plant to the revenues the plant
generates.

• Employee pension costs are recorded as an expense in the period

that employees generate revenues, not when they are paid (in
retirement).

2-22
 Bad Matching: Examples

• Research and development expenditures are expensed when

incurred, rather than matched to (subsequent) revenues they
generate.

• Advertising and promotion costs are expensed when incurred,

rather than matched to (subsequent) revenues they generate.

• Estimating useful lives for plant assets that are too long:
Depreciation is understated.

2-23
Percentiles of P/E Ratios for U.S. Firms, 1963-2010

2-24
 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:
Basic Accounting Principles

2-25