ACCT 5301Summer 2013

Part I: Financial Accounting for Executives

Discussion Case

» Creighton Family Medical Practice˃ Three doctors˃ New medical practice˃ Informal accounting system˃ After one year, one doctor decides to leave the

practice to become a Medical School professor

» How much “should” the practice pay the departing doctor to liquidate his investment?

» Might one of the other investors be willing to pay more?

I. What is the Purpose of Financial Statements?

» Different Statements—Different Purposes˃ Annual Report issued by a publicly traded company?˃ Income tax return?˃ Statements prepared for a lender?˃ Reports issued to, say, partners in an oil & gas venture?˃ Managerial reports?˃ Governmental Financial Reports?

» To What Extent Does the Purpose Influence Measurement?˃ Rules are largely driven by the underlying purpose of the statement

Rule-Making and Enforcement Bodies are Crucial

» Who Makes the Rules for Tax Reporting?˃ Internal Revenue Code Implemented by Congress˃ Enforcement, but also Interpretation, largely the

responsibility of the Treasury Department and the Internal Revenue Service

» How About Financial Reporting?˃ Generally Accepted Accounting Principles (GAAP), issued by

Financial Accounting Standards Board (FASB) in U.S. ˃ International Financial Reporting Standards issued by

International Accounting Standards Board (IASB) internationally

˃ Securities & Exchange Commission (SEC) is primary U.S. entity with responsibility for enforcement

Conceptual Framework for Accounting

» Objective of Financial Statements is to provide information useful to capital markets to make decisions about whether or not to provide capital (decision usefulness)

» Key attributes of such statements are: Relevance Faithful representation (reliability)

» When these are in conflict, rules must weigh relative costs and benefits of competing approaches

» In other reporting settings, some rules of GAAP may be waived to accomplish specific objectives of reporting process

General Concepts Underlying Financial Reporting » Financial statements report to providers of

capital:˃ Shareholders, other equity owners (e.g. partners)˃ Creditors

» Report about the business entity˃ Assumption is that the entity is a going concern

» Financial statements designed to address separate purposes, but are interconnected:˃ Balance Sheet provides a picture of the business entity’s

financial position at a specific point in time˃ Income Statement summarizes the results of the entity’s

operations over an identified period of time˃ Statement of Cash Flow reconciles reported income from

Income Statement with net change in cash on Balance Sheet˃ Statement of Shareholders’ Equity reconciles changes in

equity accounts

“Interconnectedness” of Financial Statements (“Articulation”)

Key Concepts» Accrual vs. Cash Method of Accounting:

˃ Cash Flow Income˃ Taxable Income Financial (“Book” or “GAAP”) Income

» Assets vs. Expenses˃ One goes on Balance Sheet, the other on Income Statement˃ Current period benefit vs. multi-period benefit˃ Cost vs. FMV

» “Matching” Principle˃ Revenues must be recorded in the period in which they are

earned˃ Expenses must be matched with Revenues they generate˃ Requires use of estimates

» Liabilities vs. Revenues˃ Has company earned the money or may it have to be repaid?˃ To which period should the revenue be attributed?

Balance Sheet» Elements of the Balance Sheet

˃ Assets˃ Liabilities˃ Owners’ Equity

» Balance Sheet Equation˃ Assets = Liabilities + Owners’ Equity

Double-entry accounting system˃ For investors, how does equity grow?

Profitability Issuing new shares

˃ How does it shrink? Payouts Losses

˃ How do acquisitions affect owners’ equity?

Balance Sheet (cont)

» What is an Asset?˃ Economic resource that is expected to generate future benefits for a

business˃ May be “tangible” or “intangible”˃ Proper valuation on Balance Sheet?˃ Current vs. “Long term”

» What is a Liability?˃ Obligation to make future payments˃ “Fixed” vs. “Contingent” ˃ “Off-balance sheet” liabilities (e.g., operating leases)˃ Current vs. “Long term”

» What is Owners’ Equity?˃ Residual balance, Assets in excess of Liabilities

Income Statement

» Elements of the Income Statement ˃ Revenues˃ Expenses

» Classified Income Statement˃ Income/expenses from operations

Gross Profit (for manufacturing companies) less selling & administrative expenses˃ Non-operating income and expenses˃ Income tax expense˃ Discontinued operations & Extraordinary items (2 separate sections)˃ Earnings per share

» What is a Revenue?˃ Increases in shareholders’ equity resulting from the provision of goods and/or services to customers

or other activities that constitute the entity’s ongoing major or central operations˃ Not recognized until they are earned, the selling price is fixed or determinable, and cash collection is

reasonably assured˃ Distinguished from gains, which arise from peripheral or incidental transactions

» What is an Expense?˃ Reductions in assets or increases in liabilities during a period from delivering or producing goods,

rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations

˃ Where possible, expenses must be “matched” with related revenues˃ Distinguishable from losses, which are triggered from peripheral, nonrecurring, or incidental

investing or operating activities.

Discussion Case

Ford Motor Company» Motley Fool recommends Ford …

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» Let’s use the company’s Income Statements & Balance Sheets to analyze the turnaround˃ 2004, 2008, 2012

» Begin with 2004 and 2008 Financials

» Compare 2008 and 2012:˃ Were sales higher in 2008 or 2012? ˃ What about net income?˃ What happened to gross profit margin?˃ What about Selling & Administrative expenses?˃ Total debt? How did that affect interest expense? What else affected interest expense?˃ What did Ford do financially & operationally between 2008 and 2012?

Debt-to-Assets? Gross-Profit Margin?Shareholders’ Equity? Net Income?Why do you suppose 2008 income tax expense was positive?

Discussion Case

Ford Motor Company (cont)» Analysis of 2004 v. 2012 Financial Statements» Profitability:

˃ Gross Profit Margin˃ Return on Sales˃ Return on Assets˃ Return on Equity˃ Component analysis of ROE

» Asset Management:˃ Inventory Turnover˃ Inventory-on-hand Period˃ Asset Turnover

» Financial Risk:˃ Long-term debt to equity and assets˃ Interest coverage

Statement of Cash Flow

» Reconciles Net Income to change in Cash balance on Balance Sheet » Changes in cash balance arise from three different types of

activities:˃ Operating Activities

Cash sales + collection of receivables— Cash expenses & payment of accounts payable

˃ Investing Activities Asset purchases and dispositions (physical assets, securities, intangibles, etc.) Acquisition or disposition of affiliated companies

˃ Financing Activities Issuance or repayment of debt Issuance of stock, acquisition of Treasury stock Payment of dividends

» The cash flow statement can be used to evaluate the “strength” of a company’s income

» Keys to analysis:˃ What are implications of increases in receivables?˃ Is the company delaying payment of obligations?˃ What are the company’s “non-cash” expenses?˃ What is the company’s free cash flow?˃ What is the company’s discretionary cash flow?

Discussion Case

Ford Motor Company» Income Statement & Balance Sheets˃ 2011, 2012

» Review 2011, 2012 Cash Flow Statements:˃ What is the relation between income and cash flows for

the 2 years?˃ What items stand out to you in reviewing these

statements?˃ What was “free” cash flow in each year?˃ What were the company’s “discretionary” cash flows in

each year?˃ What does the cash flow statement add to the other two

primary financial statements for Ford?

Limitations of Financial Statement Analysis

» Many of the largest numbers in the financial statements are estimates

Depreciation expense Inventory Cost of Goods Sold Allowance for Bad Debts, Warranty Expenses, etc. Option compensation Contingent liabilities

» Other reported figures may be manipulable Income tax expense Revenue recognition

» Data is not always current» Hidden and/or incomplete financial data

What are Management’s Incentives to Manipulate Financial Data?

» Pressure from Wall Street» Compensation tied to stock price

Options Restricted stock Company loans used to purchase shares Phantom stock and Stock Appreciation Rights (SARs)

» Optimism about the future» Insider knowledge» Attempts to “control” expectations» Combining these incentives with flexibility in

GAAP can be dangerous

Revenue Recognition» Revenues are realized when a company exchanges

goods &/or services for cash or claims to cash (receivables)

» Revenues are realizable when assets a company receives in exchange are convertible to known amounts of cash

» Revenues are earned when a company has substantially accomplished what is must do to be entitled to payment˃ Sale of products – revenue recognized at date of sale.˃ Sale of services – revenue recognized when services have been performed and are

billable.˃ Use of assets (e.g., rent, interest, royalties, etc.) – revenue recognized as time

passes or as assets used.

» Amount to be received must be reasonably determinable and collectability must be reasonably assured

Revenue Recognition—Common Situations

» AvalonBay, the nation’s no. 2 publicly traded apartment management firm – advance deposits

» Lowe’s – gift cards» American Airlines – airline mileage awards» Southwest Airlines – travel point awards» Best Buy – extended warranties» Sam’s Club – membership fees» Lehman Bros – repurchase agreements

Discussion Case

Priceline Restatement» In the 4th quarter, 2000, the company

collected $152 million from its customers for airline tickets, hotel rooms & rental cars

» It paid $134 to airlines, hotels, and rental car companies, and kept $18 million How should it report this activity?

Sales of $152 million and cost of goods sold of $134? or Commission revenues of $18 million?

(Note that the company reported a net loss of $102 million for that quarter)

Discussion Case

Lucent — “Channel Stuffing”» In the 4th quarter, 2000, the company shipped

goods to customers with a generous return policy allowing customers to return those goods if not sold within “normal” time period

» Company subsequently “restated” its financial results reducing revenues by $679 million and converting its operating profit into a loss What signals might you expect to see in its financial statements?

In quarterly data? In Sales vs. Accounts Receivable? In footnotes to financial statements? In bad debt reserves?

Receivable Valuation» Sales on account bring the risk that some

customers will not pay their account» This risk is influenced by firm’s credit policies» Bad debts need to be matched to the period in

which the credit sale occurred, not when the account is charged off

» How? Establishment of an “Allowance Account”˃ Company estimates portion of receivables that will not be collected.˃ Records an expense and establishes a reserve for uncollectible

accounts.˃ Subsequent period charge-offs do not directly affect Income

Statement because expense has already been recorded.

Allowance vs. Expense Accounts» Key Point—Understanding the Relationship

Between Allowance Account (“contra-asset” on Balance Sheet) and the Bad Debt Expense reported on Income StatementBeginning balance in allowance account+ Plus bad debt expense—Minus charge-offs= Equals balance in allowance account

» Can normally calculate charge-offs if you have beginning, ending and expense figures

Allowable Measurement Approaches» How do we estimate uncollectibles?

Percentage of credit sales Aging of outstanding receivables

» Estimates are based on experience Company experience vs. industry experience

» How might an investor discern earnings management through the bad debt reserve? EXAMPLE: In 1996, HealthSouth reported the following:

What were the company’s “charge-offs” in 1996? What does that suggest with respect to the amount recorded as bad debt

expense?

Beginning Balance, Allowance Account

Bad Debt Expense on Income Statement

Ending Balance, Allowance Account

$213 $59 $75

Inventory & Cost of Goods Sold» Valuation—several approaches allowed by GAAP:

FIFO LIFO Weighted Average Specific Identification

» Cannot use LIFO for tax unless also used for book» Question: if a valuation method increases value

of inventory on balance sheet, what does it do to reported income? (trick question) Example – gasoline sales at a truck stop

» Bigger issue arises when inventory becomes obsolete (or begins to diminish in value)

Long-lived AssetsValuation & Depreciation

» Historical Cost vs. FMV – is FMV relevant? Why or why not? When?

» Allowable depreciation methods Straight-line Accelerated (most companies use accelerated methods for tax)

» Other measurement issues that affect earnings Depreciable “life” Salvage value

» Following 9/11, American took an “impairment charge” against its plane fleet of $1.24 billion Good time for “big bath”? Effect on subsequent years’ reported income?

Example: Waste Management» Lawsuit filed in 2002 against founder and 5

former top officers of company» Accounting Issues:

Depreciable lives of garbage trucks Salvage values Depreciation of landfills Unwarranted “environmental reserves” associated with acquisitions

» How would these practices affect the company’s financial statements?

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Accounting for Investments in Other Companies

» Valuation—depends on size and nature of investment:

» Gains and losses from mark-to-market for trading securities included in income

» Gains and losses from “available for sale” securities or 20/50 investments flow into “Other Comprehensive Income”

Size of Investment

< 20% (voting shares) 20% - 50% > 50%

Trading Available for Sale

Active but no control Active, with control

Mark-to-market Elect equity method or “Fair Value”

Consolidation with Acquirer

Bonds Payable» Bonds are publicly traded debt instruments» Usually pay interest at stated rate on face value

over specified period» Stated rate may differ from market rates:

If lower, bond will be sold at a discount If higher, bond will be sold at premium Occasionally, stated rate is zero

» Premium or discount must be amortized into interest expense

» Early retirement will generally trigger reported gain or loss

Leases» Lease arrangement must be capitalized if any of

following is true: Agreement transfers ownership to lessee by end of lease term Agreement contains a bargain purchase option Term of lease is 75 percent or more of economic life of leased asset Present value of minimum contractual lease payments is 90 percent

or more of FMV of leased asset

» Capital lease has same effect on income statement as an “operating” lease during each year of lease agreement

» However, assets and liabilities on Balance Sheet are lower May significantly impact financial ratios

Accounting for Taxes» Book Income will generally not equal Tax

Income » Tax Income determines amount of tax to be

paid this year» Book Income determines amount of tax to be

paid eventually “Permanent” differences vs. “temporary” differences Difference between amount paid this year and amount deferred is

tax on temporary differences

» Examples of Permanent Differences: Foreign earnings permanently reinvested abroad Tax-exempt earnings Stock option differences

Stock Options» GAAP—estimate value of options when issued

and expense over vesting period» Tax—calculate actual value when exercised and

deduct that amount in year of exercise» Amounts deemed compensation often differ

dramatically» Companies often acquire “Treasury Stock” to

satisfy option exercises» Loss on Treasury stock flows through Retained

Earnings» Example

Summary» Analysis of financial statements often based on ratio

analysis, growth, and similar calculations based on reported financial information

» Managers know how valuation models are used» Managers often (generally) have “target” levels for

reported earnings, leverage ratios, etc.» Measurement is often influenced by these

management incentives» It is important to know how key concepts in

measurement impact reported financial information» Measurement incentives may impact structure of

transactions, which may be ok, or may impact choice of measurement methods, which is often not ok