FIN Chapter 3 - The Balance Sheet and Financial Disclosures...

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Unformatted text preview: The Balance Sheet and Financial Disclosures The Balance Sheet Illustrative Example on p. 112 in textbook Purpose: To report a company’s financial Purpose: position on a particular date. position From this point forward, all balance sheets From must be classified balance sheets. classified Apple’s Balance Sheet Usefulness of the Balance Sheet Balance Sheet provides information useful Balance for assessing future cash flows, liquidity, and long-term solvency and – Liquidity measures how quickly assets are Liquidity converted to cash converted – Solvency measures the degree of liabilities in Solvency a firm’s capital structure firm’s Financial Flexibility Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. An enterprise with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater the financial flexibility, the lower the risk of enterprise failure. Limitations of Balance Sheets Reports most assets at their historical cost Reports rather than current market values. rather Judgments and estimates are used in Judgments determining many values on the balance sheet. sheet. Balance sheet omits many items that are Balance of financial value (both assets and liabilities) liabilities) Use of Estimates Some situations in which estimates affect amounts reported in the balance sheet include: – allowance for loan losses or bad debts – depreciable lives and estimated salvage values for plant and equipment – warranty returns – determining the amount of revenues that should be recorded as unearned – Impairment of assets When estimates are required, there is subjectivity in determining the amounts. – Such subjectivity can impact the usefulness of the information by reducing the reliability of the measures, either because of bias or lack of verifiability. Market to Book Market-to-Book ratio > 1.0 where Market-to-Book – Market = Share Price * Number of Shares Outstanding – Book Value = Net Assets = Assets minus Liabilities – GAAP generally reports assets and liabilities at historical costs, whereas GAAP the market attempts to estimate fair market values. the – GAAP excludes resources that cannot be reliably measured such as GAAP talented management, employee morale, recent innovations and successful marketing, whereas the market attempts to value these. successful – GAAP does not consider market differences in which companies GAAP operate such as competitive conditions and expected changes, whereas the market attempts to factor in these differences in determining value. the – GAAP does not usually report expected future performance, whereas GAAP the market attempts to predict and value future performance. the For U.S. companies, book value is on average two-thirds of market For value. value. Apple’s Market to Book Stock price at 9/26/08: $128.24 Shares O/S at 9/27/08: 888,325,973 Market value = $128.24 x 888,325,973 = $113,918,922,800 Book value = Asset minus liabilities = $21,030,000,000 M/B Ratio = 5.42 Assets Probable future economic benefits obtained or controlled Probable by a particular entity as a result of past transactions or events events – The first requirement, owning or controlling an asset, implies that The a company has legal title to the asset, such as the title to property, or has the unrestricted right to use the asset, such as a lease on the property. lease – The second requirement implies that a company expected to The realize a benefit from the asset. Cash inflows from the sale of the asset or from sales of products Cash produced by the asset. produced Receipt of other assets in exchange for the original asset (i.e., A/R Receipt becomes cash) becomes Future services the company will receive (i.e., insurance coverage) Liabilities Probable future sacrifices of economic benefits arising Probable from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events as Creditors have the first claim on the assets of the Creditors business business – Means positions of creditors are less risky than those of Means shareholders, which suggests they should earn a lower rate of return than shareholders return Interest is tax-deductible whereas dividends paid are not. – Makes debt less expensive than equity – but also less flexible Makes since interest payments are contractual obligations fixed in amount and timing. amount Equity Equity (also referred to as net assets, Equity shareholders’ equity, stockholders’ equity) shareholders’ The residual interest in the assets of an The entity that remains after deducting liabilities. liabilities. Asset Classifications Current Assets Investments Property, Plant and Equipment Intangible Assets Other Assets Current Assets Assets that are reasonably expected to be Assets converted to cash or consumed within the coming year, or within the normal operating cycle, whichever is longer. operating Operating cycle is the period of time Operating necessary to convert cash to raw materials to finished product to receivables to cash. receivables Normal Operating Cycle Cash Collections Purchases Receivables Inventories Sales Operating Cycle Companies strive to decrease their Companies operating cycle by: operating – Decrease accounts receivable balances by Decrease better collection procedures better – Reduce inventory levels by improved Reduce production systems and management production – Increase trade credit to minimize cash Increase invested in inventories invested Current Assets Presented in order of decreasing liquidity – – – – – Cash and Equivalents Short-term Investments Accounts Receivable Inventories Prepaid Expenses Current assets are expensive to hold (they must be Current stored, insured, monitored, financed, etc.) and they typically generate returns that are less than noncurrent assets. – As a result, companies seek to maintain just enough to satisfy As liquidity needs, but not so much as to reduce income. liquidity Cash and Cash Equivalents Cash on hand (total of all bank accounts Cash including checking account) and cash equivalents equivalents Cash Equivalents are highly liquid investments Cash that can be quickly converted to cash such as commercial paper, money market funds, and U.S. treasury bills. U.S. – Must have a maturity < 3 months from the date of Must purchase purchase Restricted cash is not available for operations Restricted and should NOT be classified as cash. NOT – Instead is listed under Investments Short­Term Investments (Marketable Securities) Classified as current if management has Classified the ability and intent to liquidate them within one year (or the operating cycle, whichever is longer). whichever These are investments in other These companies’ stock or bonds. companies’ Most are reported at current market value. Short­Term Investments (Marketable Securities) – Trading -- Debt and equity securities held primarily for sale in the near future. Reported at market value. market – Available-for-Sale -- Debt and equity securities not classified as trading or Held-tosecurities Maturity. Reported at market value. Maturity. market – Held-to-Maturity -- Debt securities that the firm has the positive intent and ability to hold to maturity. May be current or non-current depending on circumstances. Reported at historical cost. historical cost Apple’s Financia l Instru­ ments Receivables Result from amounts owed to the company from Result other parties. other All receivables must be expected to be collected All within one year, or the operating cycle, whichever is longer or they must be classified as Investments (noncurrent). Investments Valued at net realizable value (amount of cash Valued expected to be collected). expected – Reported at net which means that the Allowance for Reported Doubtful accounts is deducted from the gross amount of A/R of Receivables Trade receivables – arise in the course of Trade the company’s normal business. the Nontrade receivables – result from loans Nontrade or advances made to individuals or other entities. entities. Notes receivable – interest bearing and Notes use a formal document called a promissory note. promissory Apple’s Receivables Inventories Consist of assets that a retail or wholesale Consist company acquires for resale or goods that manufacturers produce for sale. manufacturers Consists or raw materials, work in process, and Consists finished goods finished Impaired if value declines (involves reducing the Impaired asset’s value and recording a loss) – Lower of Cost or Market (example of conservatism) Cost Pure service companies have no inventories Prepaid Expenses An asset that is recorded when an An expense is paid in advance. expense Current asset if the benefits will be Current realized within one year (or the operating cycle, whichever is longer); otherwise noncurrent (Other Asset). noncurrent Apple’s Other Current Assets Noncurrent Assets Expected to provide economic benefits beyond Expected the next year, or operating cycle, whichever if longer. longer. – – – – Investments Property, Plant and Equipment Intangible Assets Other Assets Impaired if value declines (involves reducing the Impaired asset’s value and recording a loss) asset’s Investments Nonoperating (financial) assets not used Nonoperating directly in operating. directly – Investments in stock or debt (bonds) of other Investments companies (some reported at market value) companies – Land held for speculation – Noncurrent receivables – Restricted cash (cash set aside for special Restricted purposes) purposes) Property, Plant and Equipment Tangible, long-lived assets used in the operations of the Tangible, business (operational assets) business Primary revenue-generating assets of the company Land, buildings, warehouses, equipment, machinery, Land, vehicles, furniture and natural resources (minerals, timber, oil, etc.) timber, Reported at historical cost less accumulated depreciation Reported (a contra-asset account) (a – Exception: Land is not depreciated – Natural Resources – depletion instead of depreciation – Book value (net) = Historical Cost less accumulated depreciation Apple’s PPE Intangible Assets Represent exclusive rights that a company can use to Represent generate future revenues (operational assets) generate – Patents, copyrights, franchises, goodwill, trademarks Only reflects intangible assets purchased from others – Internally-generated intangible assets are expensed as incurred Internally-generated (assets are understated) (assets – Other knowledge-based assets such as a strong management Other team, a well-designed supply chain, or superior technology are not included on the balance sheet. not – Can use an Accumulated Amortization account (a contra-asset Can account) or remove amortization from the Intangible Asset directly directly – Book value (net) = Historical cost less accumulated amortization Intangible assets with definite useful lives are amortized Apple’s Intan­ gibles Other Assets Long-term prepaid expenses (deferred Long-term charges), and all other noncurrent assets. charges), Apple’s Other Assets Liabilities Current Liabilities Long-Term Liabilities Current Liabilities Expected to be satisfied within one year or Expected the operating cycle, whichever is longer the – Exception: if management intends to Exception: refinance a current liability, and has the ability to do so, then a current liability can be reclassified as long-term. reclassified Current Liabilities Accounts Payable – obligations to suppliers of Accounts merchandise or providers of services (due within 30 to 60 days) 60 Notes payable (short-term borrowings) – interest Notes bearing, promissory notes bearing, Unearned revenues – cash received for services not yet Unearned performed or goods not yet delivered performed Accrued liabilities – obligations created when expenses Accrued have been incurred but cash is not yet paid have Current portion of long-term debt – the amount of Current payments on long-term debt (i.e., long-term notes, loans, mortgages, bonds payable) that are due to be paid in cash within the next year or operating cycle, whichever is longer. longer. Apple’s Current Liabilities Long­Term Liabilities Liabilities that are payable beyond the Liabilities current year or operating cycle, whichever is longer. is Notes, bonds payable, pension Notes, obligations, lease obligations, etc. obligations, Apple’s Long­Term Liabilities Equity Composed of paid-in capital (invested capital) and Composed retained earnings (earned capital) retained Paid-in capital – amounts paid by shareholders for Paid-in common and preferred stock common Retained earnings – the accumulated net income since Retained the company’s inception that has not been paid out to shareholders (dividends) shareholders – Called Accumulated Deficit if negative (more net losses and/or Called dividends paid out than net income over time) dividends Accumulated other comprehensive income or loss – Accumulated accumulated changes in equity that are not reported on the income statement. the Apple’s Comprehensive Income Contributed Capital The capital that has been invested by shareholders directly via the The purchase of stock (net of any company repurchases of stock from its shareholders, called treasury stock) shareholders, – Common stock – par value of stock received from the original sale of Common common stock to investors multiplied by the number of shares issued. common – Preferred stock – value of stock received from original sale of preferred Preferred stock to investors; preferred stock has fewer ownership rights compared to common stock to – Additional paid-in capital – amounts received from the original sale of Additional stock to investors in addition to the par value of common and preferred stock stock – Treasury stock – amount the company paid to reacquire its common Treasury stock from shareholders stock For each class of stock, must disclose the par value, number of For shares authorized, issued, and outstanding shares Apple’s Preferred Stock E3­8, p. 145 Work together in class. Financial Disclosures Financial statements are only part of the Financial annual report annual – Face of the financial statements Face (parenthetically) Examples, Allowance for Doubtful Accounts, Examples, Accumulated Depreciation, Share information Accumulated – Disclosure Notes (Footnotes) Disclosure Notes Summary of Significant Accounting Policies Supplementary Schedules and Explanations Description of Subsequent Events Related Third-Party transactions Any other items necessary to achieve full disclosure – Contingencies – existing situations involving uncertainty as to Contingencies possible outcome. possible – Contractual Situations – examples are the essential provisions of Contractual lease contracts, pension obligations, stock option plans, debt covenants, preferred dividends-in arrears, purchase commitments, etc. commitments, – Fair value disclosures of financial instruments Summary of Significant Accounting Policies Conveys valuable information about the Conveys company’s choices from among various alternative accounting methods. alternative Type of depreciation method, inventory Type valuation method (FIFO, LIFO, etc), revenue recognition policies, etc. revenue Apple’s Summary of SAP Subsequent Events A significant development that takes place after significant the company’s fiscal year-end but before the financial statements are issued. financial Two types of events: – Events that provide additional evidence about the Events conditions that existed at the B/S date, affect the estimates used in preparing the F/S, and therefore result in needed adjustments in the F/S. result – Events that provide evidence about conditions that did Events not exist at the B/S date but arise subsequent to that date and do not require adjustment of the F/S: date Subsequent Events Balance Sheet Date Date Statements Issued Financial Statement Period Subsequent Period Events in this period may affect the reporting of events in this period. Subsequent Events Disclosure should take form of notes, Disclosure supplemental schedules, or even pro forma (“as if”) if”) – Examples: issuance of debt or equity, business Examples: combinations, divestiture of a business segment, settlement of litigation, loss of property to disaster, losses on major receivables, losses on marketable securities, etc. securities, Many events need no adjustment or disclosure Many (i.e., legislation, product changes, management changes, strikes, unionization, marketing agreements, loss of important customers – note that these are all non-accounting events). that IBM 2006 Subsequent Events On January 25, 2007, the company and Ricoh Company announced an agreement to On form a joint venture, the InfoPrint Solutions Company (joint venture), which will be based on the company’s Printing Systems Division (a division of the Systems and Technology Group segment). The company will transfer its printer business to the joint venture and initially receive 49 percent ownership of the joint venture. The company will divest its 49 percent ownership to Ricoh over a three-year period from the closing as the joint venture evolves into a fully owned subsidiary of Ricoh. At closing, the company will receive cash from Ricoh as consideration for the initial 51 percent acquisition of the joint venture by Ricoh as well as a prepayment for the remaining 49 percent to be acquired and certain royalty and services that the company will provide the joint venture. The company will provide maintenance services for one year and other IT and business process services to the joint venture for up to five years. The royalty agreement is up to 10 years. The company will provide financing to the joint venture’s clients and business partners. This transaction is expected to close in the second quarter of 2007. On February 5, 2007, the company sold approximately 300 millon shares of Lenovo On common stock with proceeds approximating $120 million. As a result of this transaction, the company’s equity in Lenovo at February 5, 2007 represented 9.9 percent of ordinary voting shares and 11.31 percent of total ownership. On January 30, 2007, the company announced that the Board of Directors approved On a quarterly dividend of $0.30 per common share. The dividend is payable March 10, 2007 to shareholders of record on February 9, 2007. 2007 Noteworthy Events and Transactions Related-party transactions – Transactions with owners, management, families of Transactions owners or management, affiliated companies, and other parties that can influence or be influenced by the company the – Not an arm’s length transaction (transaction between Not two independent parties in the normal course of business). business). Using interest rates that differ from market rates, or prices Using that are different from normal market prices that – Description of the transaction must be disclosed along Description with dollar amounts involved (including amounts due to or from related parties) to Noteworthy Events and Transactions Errors – unintentional mistakes Irregularities – intentional distortions of Irregularities financial statements financial Illegal acts – bribes, kickbacks, illegal Illegal contributions to political candidates, and other violations of the law other – Foreign Corrupt Practices Act of 1977 – Foreign mandates disclosure of illegalities mandates E3­11, p. 146 Work in class Management Discussion and Analysis Provides a biased, but informed, Provides perspective of a company’s operations, liquidity, and capital resources. liquidity, Management’s Responsibilities The preparation of financial statements and all The related disclosure is management’s responsibility. responsibility. Management is responsible for assessing the Management company’s internal control procedures. company’s Sarbanes-Oxley requires the CEO and CFO to Sarbanes-Oxley personally certify financial statements and disclosures. disclosures. – Submission of false statements carries a penalty of up Submission to 20 years in jail. to Auditor’s Report Provides the analyst with an independent and Provides professional opinion about the fairness of the representations in the financial statements and about the effectiveness of internal controls. about Even unqualified “clean” reports can include an Even explanatory paragraph that discusses: explanatory – Lack of consistency – consistency and/or Lack comparability is impaired due to change in accounting principle principle – Uncertainty – future potential losses are not Uncertainty reasonably estimable reasonably – Emphasis – highlight significant events Auditor’s Report Non-“clean” opinions include – Qualified opinion – contains an exception to Qualified unqualified opinion, but the exception is not serious enough to abstain from opining on entire set of financial statements financial – Adverse opinion – exceptions are so serious that a Adverse qualified opinion is not justified qualified – Disclaimer – insufficient information is gathered to Disclaimer express an opinion express – Going concern – auditor is responsible for assessing Going firm’s ability to continue as a going concern. If in doubt, must be disclosed in the auditor’s report. What does Apple pay for accounting fees? For fiscal 2008: – Auditing $8 million – Tax $600,000 Compensation of Directors and Top Executives SEC requires firms to disclose information SEC about compensation to directors and top executives in its annual proxy statement. executives Using Financial Statement Information Comparative financial statements – the current year’s financial Comparative statements are presented along with at least one previous year for comparison. comparison. – Horizontal analysis – comparison across years – Vertical analysis – comparison of amounts within a single year to a base Vertical amount amount Expressing all income statement amounts as a percentage of sales Expressing all balance sheet amounts as a percentage of total assets Ratio analysis – evaluating information in ratio form allows analysts Ratio to control for size differences over time and among firms. to – Default risk – ability of a company to pay their obligations as they come Default due due – Operational risk – how adept a company is at withstanding various Operational events and circumstances that may impair its ability to earn profits events – Operational risk leads to default risk – Useful to compare ratios to competitors and/or industry averages Liquidity Ratios Liquidity refers to the readiness of assets Liquidity to be converted to cash to – Current Ratio – Acid Test Ratio Current Ratio Working capital = current assets minus Working current liabilities current – Disadvantage – can’t compare working capital Disadvantage across different companies across Current Ratio = Current Assets/Current Current Liabilities Liabilities Note: Current assets can be generated by Note: long-term borrowing long-term Apple’s Current Ratio Current Ratio = Current Assets / Current Current Liabilities Liabilities 2008: 2.46 2007: 2.37 Acid Test Ratio (or Quick Ratio) Includes only cash, short-term Includes investments, and accounts receivable (quick assets) in numerator of current ratio. ratio. – Inventories may be quickly saleable – Prepaid assets cannot be converted to cash Should be smaller than current ratio Apple’s Quick Ratio Acid Test Ratio = Quick Assets / Current Acid Liabilities Liabilities 2008: 1.91 2007: 1.83 Financing Ratios Provide indication of firm’s ability to pay Provide long-term debts long-term – Debt to Equity Ratio – Times Interest Earned Ratio Debt to Equity Ratio Indicates the extent of creditors, rather than owners, in Indicates providing resources providing Debt to Equity = Total Liabilities/Shareholders’ Equity – The higher the ratio, the higher the risk – Higher debt-to-equity ratios are likely accompanied by higher Higher interest rates interest – Higher debt-to equity ratios represent more risk for shareholders Higher since debt has preference over owners’ claims since Financial leverage – achieving higher profits through Financial borrowing borrowing – Occurs when rate of return earned is greater than borrowing rate Apple’s Debt to Equity Debt/Equity = Total Liabilities / Stockholders’ Debt/Equity Equity Equity 2008: 0.88 2007: 0.74 Note: main LT liabilities are customer Note: deposits (no debt) deposits Times Interest Earned Ratio Indicates the margin of safety provided to Indicates creditors creditors Times Interest Earned Ratio = Income Times before Interest and Taxes/Interest Expense Expense – The more times income covers interest The expense, the greater protection creditors have. have. Apple’s Times Interest Earned Not applicable because they have zero Not interest expense. interest Reporting Segment Information Many companies operate in several Many business segments as a strategy to achieve growth and to reduce operating risk through diversification. risk Segmentation leads to better forecasting Segmentation and analysis of risks; but also leads to disclosure of proprietary information. disclosure Reporting by Operating Segment Segment reporting facilitates the financial Segment statement analysis of diversified companies. statement Two famous reporting failures: – IBM used to report their entire operations as a single IBM segment. segment. – Caterpillar, Inc. – cited in 1989 by SEC for not Caterpillar, disclosing that nearly 25 percent of its revenue came from nonrecurring income in Brazil. A change in Brazilian economics in the following year wiped out this income which left investors with substantial losses. losses. What is a Reportable Operating Segment SFAS No. 131 – segments should be reported based on the way SFAS management views segments for operating decisions and performance evaluation performance – Can be based on line of business, geography, or both An operating segment is a component of an enterprise: – That engages in business activities from which is may earn revenues That and incur expenses and – Whose operating results are regularly reviewed by management to Whose make decisions about resources to be allocated to the segment and to assess its performance assess – For which discrete financial information is available Only segments that comprise ≥ 10 percent of total company Only revenues, assets or net income need be reported separately. revenues, A company must account for ≥ 75 percent of its total consolidated company revenue through segment reporting. revenue What Amounts are Reported by an Operating Segment The following disclosures are required: – – General information about the segment Information about reported segment profit or loss, Information including certain revenues and expenses, segment assets, and the basis of measurement assets, – IFRS (No. 8) also requires that companies disclose IFRS total liabilities of its reportable segments. total – Reconciliations of the totals of segments revenues, Reconciliations reported profit and loss, assets, and other significant items to corresponding total company amounts. items – Interim period information. Reporting by Geographic Area Political and economic environments vary by Political country which affects that country’s risks and rewards. rewards. SFAS131 requires: – Revenues from external customers (1) attributed to Revenues domestic sales; and (2) attributed to all foreign countries in total countries – Long-lived assets other than financial instruments, Long-lived long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets by (1) domestic amounts and (2) located in all foreign countries in total. foreign Information About Major Customers If 10% or more of consolidated revenue is If generated by a single customer, the company must disclose that fact, and the identity of the operating segment or segments earning the revenue. segments – Note that the identity of the customer need Note not be disclosed. not E3­17 and E3­18, p. 148 Work in class ...
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This note was uploaded on 04/08/2009 for the course ACG 3481 taught by Professor Dickinson during the Fall '08 term at University of Florida.

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