2

Review of
Accounting

Chapter

Copyright © 2008 by The McGraw-HillMcGraw-Hill/Irwin

Companies, Inc. All
 Chapter Outline
• Income Statement
• Price-earnings Ratio
• Balance Sheet
• Statement of Cash Flows
• Tax-free Investments (Depreciation)

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 Basic Financial Statements
• Income Statement
• Balance Sheet
• Statement of Cash Flows

Two other Statements

• Statement of Retained Earnings
• Statement of Stockholders’ Equity

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 Income Statement
• Device to measure the profitability of a firm
over a period of time
– It covers a defined period of time
– It is presented in a stair-step or progressive
fashion to examine profit or loss after each type
of expense item is deducted.

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 Income Statement (cont’d)
１ . Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)

2. GP – Operating Expenses
= Earnings Before Interest and Taxes (EBIT) or
Operating Income (OI)

3. EBIT – Interest = Earnings Before Taxes (EBT)

4. EBT – Taxes = Earnings After Taxes (EAT)

or Net Income (NI)
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 Cost of Goods Sold (COGS)
• Cost of goods sold includes the direct
costs attributable to the production of the
goods sold by a company. This amount
includes the materials cost used in creating
the goods along with the direct labor costs
used to produce the good. It excludes
indirect expenses such as distribution costs
and sales force costs.
Also referred to as "cost of sales".
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 Cost of Goods Sold

COGS
Inventory (01.01.12) $5,000
Purchases During the 45,000
Year
Direct Labor/Wages 30,000
----------
80,000
Less: Inventory 10,000
(31.12.12) ---------

Net Cost of Good Sold $70,000

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 Operating Expenses
• A category of expenditure that a business incurs as
a result of performing its normal business
operations. Also known as "OPEX“
• For example, the payment of employees' wages,
maintenance and repairs, such as snow removal,
trash removal, janitorial service, pest control, and
lawn care advertising, office expenses, attorney
fees and legal fees, utilities, such as telephone

It does not include depreciation or the cost of

financing or income taxes.
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Table 2-1 Example Income Statement

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 Return to Capital
• Three primary sources of capital:
– Bondholders
– Preferred stockholders
– Common stockholders
• Earnings per share
– Interpreted in terms of number of outstanding
shares
– May be paid out in dividends or retained by
company for subsequent reinvestment
• Statement of retained earnings
– Indicates disposition of earnings
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 Table 2-2 Statement of Retained
Earnings
• Indicates disposition of earnings with
– Adjustments to previously-reported income
– Restrictions on cash dividends

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 Price-Earnings (P/E) Ratio
• Multiplier applied to earnings per share to
determine current value of common stock
• Some factors that influence P/E:
– Earnings and sales growth of the firm
– Risk (volatility in performance)
– Debt-equity structure of the firm
– Dividend payment policy
– Quality of management

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 Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market
value of many companies based on $1 of
earnings per share
– Indicates expectations about the future of a
company
• Price-earnings ratios can be confusing

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 Table 2-3 Price-Earnings Ratios for
Selected U.S. Companies
January January January January January January January
Corporation
3, 1994 2, 1998 2, 2001 3, 2006 4, 2010 2, 2013 2, 2015

Bank of America *dd 16 10 11 35 10 45

Cisco Systems 41 28 58 19 23 8 19

Ford Motor Co. 14 9 5 7 *dd 8 10

Intel Corp. 12 19 19 18 17 11 16

Johnson & Johnson 17 27 31 18 14 13 16

McDonald's Corp. 19 21 23 17 16 15 19

Southwest Air 36 17 28 38 62 10 26

Textron Inc. 14 27 10 17 49 11 22

Walmart Stores 26 27 38 18 15 14 18

S&P 500 Index 23 25 23 17 18 14 19

*dd means the company is operating at a deficit and has no P/E ratio at the time
because there are no positive earnings per share.
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Limitations of the Income Statement
• Income gained/lost during a given period is a
function of verifiable transactions
– Stockholders, hence, may perceive only a much
smaller gain/loss from actual day-to-day
operations
• Flexibility in reporting transactions might
result in differing measurements of income
gained from similar events at the end of a
time period
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 Balance Sheet
Indicates what the firm owns and how these
assets are financed in the form of liabilities
and ownership interest.
Delineates the firm’s holdings and obligations.
A cumulative chronicle of all transactions that
have affected the corporation since its inception.
Items are stated on an original cost basis rather
than at current market value.

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2-17
 Balance Sheet Items - Assets
Rule: Asset accounts are listed in order of
liquidity

1.Current assets
• Items that can be converted to cash within 12 months

– Cash or Cash Equivalents

– Marketable securities
• Temporary investments of excess cash
– Accounts receivable
• Allowance for bad debts to determine their anticipated
collection value

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 Assets
– Inventory
• Includes raw materials, goods in progress, or finished
goods
– Prepaid expenses
• Represent future expense items that are already paid
for.

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 Assets
2. Long Term Assets
– Investments
• Long-term commitment of funds
• Includes stocks, bonds, or investments in other companies
– Plant and equipment
• Carried at original cost minus accumulated depreciation
• Accumulated depreciation
– Sum of past and present depreciation charges on currently owned
assets
• Depreciation expense is the current year’s charge

Total assets: Financed through liabilities or stockholders’

equity

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 Balance Sheet Items - Liabilities
Rule: Liabilities accounts are listed in order of
priority.

1. Short-term obligations:
– Accounts payable
– Notes payable
– Accrued expense

2. Long-Term Obligations
– Bond
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 Stockholder’s Equity
3. Stockholder’s Equity
Represents total contribution and ownership
interest of preferred and common
stockholders
– Preferred stock
– Common stock
– Capital paid in excess of par
– Retained earnings

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Statement of Financial Position (Balance Sheet)

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Concept of Net Worth

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 Market Value of Stocks
• Market value is of primary concern to the:
– Financial manager
– Security analyst
– Stockholders

Market Value = P/E Ratio x EPS x Total

Number of Common Stocks

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 Limitations of the Balance Sheet
• Most of the values are based on
historical/original cost price
– Troublesome when it comes to plant and
equipment inventory
• FASB ruling on disclosure of inflation
adjustments no longer in force
– It is purely a voluntary act on the part of the
company

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 Limitations of the Balance Sheet
(cont’d)
• Differences between per share values may
be due to:
– Asset valuation
– Industry outlook
– Growth prospects
– Quality of management
– Risk-return expectations

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Table 2-5 Comparison of Market Value
to Book Value per Share
Market Price Book Value Ratio of Market Price
Corporation
Per Share Per Share to Book Value
UPS* 103.42 6.19 16.71
Verizon 47.80 4.00 11.95
IBM* 153.90 14.40 10.69
Kellogg* 69.84 9.53 7.33
PepsiCo* 98.90 15.44 6.41
Apple 112.40 19.01 5.91
Adobe 73.48 13.57 5.41
Microsoft 47.13 10.92 4.32
Oracle 44.05 10.81 4.07
Google 534.39 145.68 3.67
eBay 57.15 15.95 3.58
Southern Co. 52.13 22.07 2.36
Kohls 60.19 28.16 2.14
Comstock Resources 4.66 19.63 0.24

* Companies with large stock repurchases over time.

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Statement of Stockholders’ Equity

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 Statement of Cash Flows
• Emphasizes critical nature of cash flow to firm operations
• Represents cash or cash equivalent items easily
convertible to cash within 90 days
• Advantage of accrual method (of Accounting)
– Allows matching of revenues and expenses in period in
which they occur to appropriately measure profits
• Disadvantage of accrual method
– Adequate attention not directed to firm’s actual cash
flow position
• Cash-flow analysis helps in combating discrepancies
faced through accrual method of accounting
 Developing an Actual Statement

• Statement of cash flows

– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
• Results added together to compute net change in
cash flow
 Concepts Behind the
Statement of Cash Flows

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 Figure 2-1 Concepts Behind the
Statement of Cash Flows (1 of 2)

Step 1: Cash flows from operating activities

•Cash Inflows:
– Generation of funds in normal operations
•Cash Outflows:
– Expenditure of funds in normal operations
Step 2: Cash flows from investing activities
•Cash Inflows:
– Sale of plant and equipment
– Liquidation of long-term investment
•Cash Outflows:
– Purchase of plant and equipment
– Long-term investment
Figure 2-1 Concepts Behind the Statement
of Cash Flows (2 of 2)
Step 3: Cash flows from financing activities
•Cash Inflows:
– Sale of bonds, common stock, preferred stock, and other
securities
•Cash Outflows:
– Retirement or repurchase of bonds, common stock,
preferred stock, and other securities
– Payment of cash dividends
Step 4: Add Step 1, 2, and 3 together to arrive at net
increase (decrease) in cash
 Determining Cash Flows from
Operating Activities (1 of 2)

• Translation of income from operations from accrual

to cash basis
• Direct method
– Every item on income statement adjusted
from accrual to cash accounting
• Indirect method (more popular)
– Net income represents starting point
– Adjustments are made to convert net income
to cash flows from operations
 Determining Cash Flows from
Operating Activities (2 of 2)

• Start with net income

• Recognize depreciation is a noncash deduction
• Recognize increases in current assets reduce cash
balance
• Recognize that decreases in current assets increase cash
balance
• Recognize that increases in current liabilities increase
cash balance
• Recognize that decreases in current liabilities decrease
cash balance
Figure 2-2 Steps in Computing Net Cash Flows from
Operating Activities (Indirect Method)

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Table 2-1 Example Income Statement

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Table 2-6 Comparative Balance Sheets

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Table 2-7 Cash Flows from Operating Activities

Net income (earnings after taxes) (Table 2-1) $110,500

Adjustments to determine cash flow from operating activities:

Add back depreciation (Table 2-1) 50,000

Increase in accounts receivable (Table 2-6) (30,000)

Increase in inventory (Table 2-6) (20,000)

Decrease in prepaid expenses(Table 2-6) 10,000

Increase in accounts payable(Table 2-6) 35,000

Decrease in accrued expenses(Table 2-6) (5,000)

Total adjustments 40,000

Net cash flows from operating activities $150,500

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 Determining Cash Flows from
Investing Activities

• Investing activities
– Long-term investment activities in mainly plant
and equipment
• Increasing investments represent use of funds
• Decreasing investments represent source of funds
– Table 2-8 Cash flows from investing activities
 Determining Cash Flows from
Financing Activities
• Financial activities apply to the sale or retirement of
– Bonds
– Common and preferred stock
– Other corporate securities
– Payment of cash dividends
• Sale of firm’s securities is source of funds
• Payment of dividends and repurchase of securities is
use of funds
• Table 2-9 Cash flows from financing activities
 Table 2-10 Combining the
Three Sections of the Statement

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 Combining the
Three Sections of the Statement

• May require further analysis on how buildups in

various accounts were financed
• Adequate long-term financing and profits should exist
to finance long-term needs
• Short-term funds may be utilized to carry long-term
needs
– High-risk situation as short-term sources of
funds may dry up while long-term needs
continue to demand funding
 Depreciation and Funds Flow

• Depreciation
– Non-cash expense
– Not a ‘new’ source of funds
– Added back to net income to determine
amount of actual funds on hand
– Represents an attempt to allocate initial cost of
asset over useful life
• Charging of depreciation does not directly influence
fund movement, but rather serves as an accounting
entry
Table 2-11 Comparison of Accounting
and Cash Flows

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 Free Cash Flow

• Free cash flow = Cash flow from operating activities –

Capital expenditures – Dividends
– Capital expenditures
• Maintains productive capacity of firm
– Dividends
• Maintains necessary payout on common stock and
covers preferred stock obligations
• Free cash flow used for special financing activities
 Income Tax Considerations (1 of 2)

• Corporate Tax Rates

– Progressive rage - top rate is 40% including state and
foreign taxes if applicable, lower bracket is 15–20%
• Cost of Tax-Deductible Expense
– Include interest on business loans, travel expenditures,
salaries, etc.
Corporation A Corporation B

Earnings before Interest and taxes $400,000 $400,000

Interest 100,000 0

Earnings before taxes (taxable Income) $300,000 $400,000

Taxes (40%) 120,000 160,000

Earnings after taxes $160,000 $240,000

Difference In earnings after taxes $60,000

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 Income Tax Considerations (2 of 2)

• Depreciation as a Tax Shield

– Not new source of funds
– Provides tax shield benefits measurable as
depreciation times tax rate

Corporation A Corporation B
Earnings before Interest and taxes $400,000 $400,000
Depreciation 100,000 0
Earnings before taxes $300,000 $400,000
Taxes (40%) 120,000 160,000
Earnings after taxes $180,000 $240,000
+Depreciation charged without cash outlay 100,00 0
Cash flow $280,000 $240,000
Difference $40,000

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