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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
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.
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Annotated Outline and Strategy
I. The Income Statement
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.
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.
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.
PPT Price-earnings ratios for selected U.S. companies (Table 2-3)
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.
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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,
II. Balance Sheet
PPT Kramer Corporation—Balance Sheet (Table 2-4)
A. Whereas the income statement provides a summary of financial transactions for a
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
4. Inventory
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.
1. Accounts payable
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3. Accrued expenses: an obligation to pay is incurred but payment has not
been made
5. Preferred stock
6. Common stock accounts:
a. Common stock (par value)
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
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
F. Limitations 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
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 in January 2018
(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.
PPT Illustration of concepts behind the 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.
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,
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)
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PPT Kramer Corporation—Comparative Balance Sheets (Table 2-6)
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
PPT Cash Flows from Investing Activities (Table 2-8)
PPT Cash Flows from Financing Activities (Table 2-9)
Perspective 2–4: The three sections of the statement of cash flows are brought together in
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.
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income to arrive at cash flow.
Finance in Action: International Accounting Standards vs. U.S. GAAP
Economies and capital markets have moved to a global platform, creating the need for a uniform
reporting standard. This led to the formation of International Financial Reporting Standards
(IFRS) by the International Accounting Standards Board (IASB), which was adopted by many
countries except the United States. In the U.S., the Financial Accounting Standards Board
(FASB) developed reporting standards know as Generally Accepted Accounting Principles
(GAAP). Many standards have been aligned; however, significant differences remain between
IFRS and U.S. GAAP.
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.
PPT Comparison of accounting and cash flows (Table 2-11)
Finance in Action Ethics: Switzerland, a Beautiful Place to Pay Your Taxes
Switzerland is only one example of a European country with lower tax rates than the U.S., and it
demonstrates why some corporations have moved their headquarters out of the United States. In
response to this exodus, Congress lowered the federal corporate tax rate from 35 percent to 21
percent beginning in 2018, substantially reducing incentives to relocate overseas.
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)
VI. Income Tax Considerations
A. Personal taxes at varying rates apply to the earnings of proprietors and partners.
B. Starting December 2017, a major tax bill passed by Congress changed the
corporate tax rate from as high as 35 percent to a flat rate of 21 percent. Some
state and foreign taxes may still apply to increase the overall rate higher than 21
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percent.