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Review of Accounting
Author's Overview
As already discussed, finance is a blend of accounting, economics, and other disciplines. This
chapter will prove invaluable in establishing the relationship between accounting and finance,
whether the student has already taken accounting or not. Though it is assumed that every student
taking the introductory course in managerial finance has had course work in accounting, many
students are in need of a review. By explicitly covering this review material early in the course,
the student is able to grasp later material more easily and the instructor does not have to
continually close the "accounting gaps" during the course. The instructor must, of course, decide
whether to lecture on this material or merely assign it as reading. Some may choose to forego it
altogether. Our experience as professors is that the introductory accounting curriculum has
changed over the years and does not always cover the relationship between the balance sheet,
income statement, and statement of cash flows. In order to cover the financial analysis material
in the next chapter, understanding Chapter 2 is a necessity. Also cash flow generation is
necessary for understanding capital budgeting decisions.
Chapter Concepts
LO1. The income statement measures profitability.
LO2. The price-earnings ratio indicates the relative valuation of earnings.
LO3. The balance sheet shows assets and the financing of those assets with debt and equity.
LO4. The statement of cash flows indicates the change in the cash position of the firm.
LO5. Depreciation provides a tax reduction benefit that increases cash flow.
Annotated Outline and Strategy
I. The Income Statement
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2
PPT Kramer Corporation-Income Statement (Table 2-1)
A. The income statement begins with the aggregate amount of sales (revenues) that
are generated within a specific period of time.
B. The various expenses that occur in generating the sales are subtracted in stair-step
fashion to arrive at the net income for the defined period.
C. The separation of the expense categories such as cost of goods sold, selling and
administrative expenses, depreciation, interest and taxes enables the management
to assess the relative importance and appropriateness of the expenditures in
producing each level of sales.
D. The "bottom line" value, net income, is the aggregate amount available to the
owners.
E. Net income is converted from an aggregate value to an earnings per share (EPS)
value by dividing net income by the number of shares of outstanding stock.
F. The EPS is a measurement of the return available to providers of equity capital to
the firm. The return to the providers of debt capital, interest, appears earlier in
the income statement as a tax-deductible expense.
PPT Kramer Corporation-Statement of Retained Earnings (Table 2-2)
G. The earnings per share may be converted to a measure of current value through
application of the price/earnings (P/E) ratio.
H. The P/E ratio is best used as a relative measure of value because the numerator,
price, is based on the future and the denominator, earnings, is a current measure.
PPT P/E Ratios for Selected U.S. Companies (Table 2-3)
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Education.
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Perspective 2-1: P/E ratios provide a new concept and can be of benefit to the student.
Students tend to respond enthusiastically to stock market considerations in valuation.
They can get a feel for P/E ratios and how they change over time in Table 2-3.
I. There are limitations associated with the income statement. For example, the
income statement reflects only income occurring to the individual or business firm
from verifiable transactions as opposed to the economists' definition of income,
which reflects changes in real worth. Furthermore, flexibility in the application of
Generally Accepted Accounting Principles may cause similar events to be
recorded and reported differently.
J. The statement of retained earnings, a supplement to the income statement,
indicates the disposition of earnings.
II. Balance Sheet
PPT Kramer Corporation – Balance Sheet (Table 2-4)
A. Whereas the income statement provides a summary of financial transactions for a
period of time, the balance sheet portrays the cumulative results of transactions at
a point in time. The balance sheet may present the position of the firm as a result
of transactions for six months, twenty-five years, or other periods.
B. The balance sheet is divided into two broad categories. The assets employed in
the operations of the firm compose one category while the other, liabilities and net
worth, is composed of the sources of financing for the employed assets.
C. Within the asset category, the assets are listed in their order of liquidity.
1. Cash (including demand deposits)
2. Marketable securities: investments of temporarily excess cash in highly
liquid securities
3. Accounts receivable
4. Inventory
5. Prepaid expenses: future expense items that have already been paid
6. Investments: investments in securities and other assets for longer than one
operating cycle
7. Plant and equipment adjusted for accumulated depreciation
D. The various sources of financing of a firm are listed in their order of maturity.
Those sources that mature earliest, current liabilities, are listed first. The more
permanent debt and equity sources follow.
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1. Accounts payable
2. Notes payable
3. Accrued expenses: an obligation to pay is incurred but payment has not
been made
4. Long-term debt: all or a majority of the principal will be paid beyond the
current period
5. Preferred stock
6. Common stock accounts:
a. Common stock (par value)
b. Capital paid in excess of par
c. Retained earnings
E. Confusing balance-sheet-related terms
1. Retained earnings is the account used to measure the accumulation of
earnings over the life of the firm. It includes “all the income the firm ever
made minus all the dividends the firm ever paid.” It is not a bucket of
money that can be reinvested, but the annual increase in retained earnings
is one of the sources of funds that make up the existing investment level.
2. Net worth or book value of the firm is composed of the various common
equity accounts and represents the net contributions of the owners to the
business plus the earnings retained by the firm (Retained Earnings – see
above).
3 Book value is a historical value and does not necessarily coincide with the
market value of the owner's equity.
F. Limitation of the balance sheet: Values are recorded at cost. Replacement cost of
some assets, particularly plant and equipment, may greatly exceed their recorded
value. The Financial Accounting Standards Board (FASB) issued a ruling in
October 1979 that required many large companies to disclose inflation adjusted
accounting data in their annual reports. However, the standard is no longer in
force and the inclusion of inflation adjusted accounting data in financial reports is
purely a voluntary act.
Perspective 2-2: Illustrate the substantial differences that may exist between market
definitions of value and accounting definitions.
PPT Comparison of Market Value to Book Value per Share (Table 2-5)
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III. Statement of Cash Flows
A. In November 1987, the accounting profession replaced the statement of changes in
financial position (and the sources and uses of funds statement) with the Statement
of Cash Flows as a required financial statement.
B. The new statement emphasizes the critical nature of cash flow to the operations of
the firm.
C. The three primary sections of the statement of cash flows are:
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.
PPT Illustration of Concepts behind Statement of Cash Flows (Figure 2-1)
D. Income from operations may be translated from an accrual basis to a cash basis in
two ways to obtain cash flow from operations.
1. Direct method -- each and every item on the income statement is adjusted
from accrual accounting to cash accounting.
2. Indirect method - a less tedious process than the direct method is usually
preferred. Net income is used as the starting point and adjustments are
made to convert net income to cash flows from operations. Beginning
with net income,
a. Add depreciation for the current period, decreases in individual
current asset accounts (other than cash) and increases in current
liabilities;
b. Subtract increases in current asset accounts (other than cash) and
decreases in current liabilities.
Perspective 2-3: The steps necessary for computing cash flow from operations are illustrated
in Figure 2–2. The actual numerical material can be found in Tables 2-1, 2-6 and 2-7.
PPT Steps in Computing Net Cash Flows from Operating Activities Using
the Indirect Method (Figure 2-2)
PPT Kramer Corporation-Comparative Balance Sheet (Table 2-6)
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PPT Cash Flows from Operating Activities (Table 2-7)
E. Cash flow from investing is found by summing the changes of investment in
securities and plant and equipment. Increases are uses of funds and decreases are
sources of funds.
F. Cash flow from financing activities is found by summing the sale or retirement of
corporate securities and dividends. The sale of securities is a source of funds and
the retirement of securities and payment of dividends are uses of funds.
G. Cash flows from operations, cash flows from investing, and cash flows from
financing are combined to arrive at the net cash flows. The net increase or
decrease shown in the statement of cash flows will be equal to the change in the
cash balance on the balance sheet.
Perspective 2-4: The three sections of the statement of cash flows are brought together in
Table 2-10. In the example, highlight how the cash flows from operating activities are funding
investing and financing activities.
Perspective 2-5: The Finance in Action Box discusses some of the major differences between
international accounting standards (IFRS) and U.S. generally accepted accounting principles
(GAAP) and is a good example of how the global economy is impacting financial reporting.
PPT Kramer Corporation -- Statement of Cash Flows (Table 2-10)
IV. Depreciation and Funds Flow
A. Depreciation is an attempt to allocate an initial asset cost over its life.
B. Depreciation is an accounting entry and does not involve the movement of funds.
C. As indicated in the statement of cash flows, depreciation is added back to net
income to arrive at cash flow.
Perspective 2-6: To illustrate how the initial purchase of an asset and the subsequent write-off
affects cash flow, refer to Table 2-11.
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PPT Comparison of Accounting and Cash Flows (Table 2-11)
Finance in Action: Switzerland, a Beautiful Place to Pay Your Taxes
Switzerland is only one example of European countries with lower tax rates than the U.S. and it
demonstrates why some corporations have moved their headquarters out of the United States.
This is a significant issue for many global companies headquartered in the U.S. because the U.S.
is out of step with the rest of the world on corporate taxation of foreign operations.
V. Free Cash Flow
A. Free cash flow is equal to cash flow from operating activities:
Minus: Capital expenditures required to maintain the productive capacity
of the firm.
Minus: Dividends
B. The amount of free cash flow is often a determining factor as to whether a
leveraged buyout is possible.
VI. Income Tax Considerations
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A. Personal taxes at varying rates apply to the earnings of proprietors and partners.
B. Corporate earnings are subject to taxation at two levels -- at the corporate level
and at the personal level when received as dividends. Since 1980 Congress has
changed corporate tax rates four times.
C. The after-tax cost of a tax-deductible business expense can be calculated by
taking the (expense) (1 – tax rate).
D. Although depreciation is a noncash expense, it does affect cash flow by reducing
taxes. Tax reduction in cash outflow for taxes resulting from depreciation charges
may be computed by multiplying the (depreciation expense) (tax rate).
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