HAME513: Understanding Financial Statements

Transcription

1 HAME513: Understanding Financial Statements Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 1

2 This course includes Four self-check quizzes Two discussions Two tools to download and use on the job One course project Completing all of the coursework should take about five to seven hours. What you'll learn How to understand the structure of the three principal financial statements: the income statement, the balance sheet, and the cash flow statement, and interpret the information found in these statements How to identify online sources of financial information that can be used to conduct research on other publicly traded firms and industries Course Description Every company's finance function keeps detailed records of the daily transactions involved in the running of the organization. Periodically, they create reports that allow management, stakeholders, and regulating authorities to have insight into the financial health of the firm. As a manager, you need to understand both the metrics that are reported in income statements, balance sheets, and cash flow statements and how they relate to each other. You also need to understand how comparing numbers across your company, the industry, and from year to year can help you assess the overall financial performance of the firm. The in-depth review of sample case studies in this course will provide you with the tools you need to examine your own Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 2

3 organization's reports. As you make budgeting and investment decisions, your knowledge of how vital financial markers indicate relative health in the organization will help drive initiatives to meet your company's financial goals. Steven Carvell Professor and Associate Dean for Academic Affairs, School of Hotel Administration, Cornell University Steven Carvell has taught finance courses at Cornell University since Professor Carvell is the co-author of In the Shadows of Wall Street (Prentice-Hall, Inc. Strebel, Paul and Steven Carvell, 1988). Carvell has worked for professional money managers in applied strategy in the equity market and served as a consultant to the Presidential Commission on the 1987 stock market crash. Professor Carvell has conducted numerous specialized Executive Education seminars for some of the largest hotel companies in the world. Carvell holds a Ph.D. from the State University of New York, Binghamton. Scott Gibson Zollinger Professor of Finance, Mason School of Business, College of William and Mary Scott Gibson is the Zollinger Professor of Finance at the College of William and Mary Mason School of Business and previously held academic appointments at Cornell University and the University of Minnesota. He holds a B.S. and Ph.D. in Finance from Boston College. Prior to his academic career, he worked as an analyst with Fidelity Investments and as a credit team leader serving Fortune 500 clientele with HSBC Bank. He's won outstanding teaching awards on numerous occasions including being named an outstanding faculty member in BusinessWeek Guide to the Best Business Schools. His finance research has appeared in top academic journals and has been featured in the financial press, including the Wall Street Journal, Financial Times, New York Times, Barron's, BusinessWeek, and Bloomberg. Start Your Course Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 3

4 Module Introduction: Reading the Income Statement In this module, you will examine a critical financial statement known as the income statement, which is sometimes called the profit and loss statement. It's a useful document as it reports the organization's net income. The details of the income statement and how it is put together can tell you a lot about an organization. In this module, you will examine what each of the lines can tell you about the operations of a business. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 4

5 Read: Meet the Companies Click here to download all statements for the three companies in one easy-to-print document, or click the links below to download the statements individually. Note that you will need a printout of the third company's statements to answer some assessment questions. How do companies keep track of all revenues generated and expenses incurred during a period of time? How is this information organized, and what do you need to know in order to be able to make sense of it? To answer these questions, you will turn to the income statement. But first, you must meet the companies that will be used as case studies throughout this course. The Companies In order to get hands-on experience working with financial statements, we have created three fictional companies, each with its own set of financial data. Although the companies are fictitious, the statements and the numbers are realistic representations of what you would encounter in the real world. Notice that although each company is unique, all three of them belong to the same industry sector. This will make for interesting comparisons across companies, as you will see later. Read a brief description of each company and access its financial statements below. Astrobucks Coffeehouse White Mountain Coffee Krunchy Krust Donuts Astrobucks is a high-quality coffee bean roaster and brewer that offers delicious coffee beverages and products. Astrobucks specializes in the sale of coffee, pastries, and accessories through its retail stores, as well as bottled coffee drinks and ice cream through White Mountain Coffee started as a small café nestled in the beautiful mountains of New Hampshire. Since its conception in 1982, the company has grown to become a leading wholesale provider of rich, aromatic specialty coffee blends, available Herschel Watrobsky founded Krunchy Krust Donuts in Today, the company operates more than 360 retail locations in 44 states and 5 countries. The company specializes in serving 33 different kinds of donuts and pastries, including its famous Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 5

6 supermarkets. Founded in 1978, Astrobucks is the world's leading retailer and specialty coffeehouse. originally through mail-order catalogs and now also through the Internet and retail stores. Krunchy Krust Supreme donut, as well as an assortment of specialty coffee beverages. Income Statement Balance Sheet Cash Flow Statement Income Statement Balance Sheet Cash Flow Statement Income Statement Balance Sheet Cash Flow Statement Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 6

7 Watch: Picture the Income Statement How do companies keep track of all revenues generated and expenses incurred during a period of time? How is this information organized, and what do you need to know in order to be able to make sense of this information? Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 7

8 Activity: The Income Statement Line by Line Download the line-by-line item descriptions in PDF format. In this activity, you will be able to examine all of the accounts contained in the income statement. Click any line in the statement below to learn more about that account. INCOME STATEMENT Year 2 Year 1 Jan. 1 - Dec. 31 Jan. 1 - Dec. 31 (in thousands) Net Sales $4,075,522 $3,288,908 The first item on the income statement is called net sales. Net sales represents the primary source of money received by the company from its customers for goods sold or services rendered by the company. Net sales represents the amount received by the company as revenues less deductions from returned goods and the reduction of prices from early payment discounts. By comparing Year One and Year Two, we can see that Astrobucks had a better year in Year Two than in Year One. Specifically, the company had net sales of $4,075,522,000 in Year Two compared to $3,288,908,000 in Year One. In total, net sales for Astrobucks increased by $786,614,000 between Year One and Year Two. Cost of Goods Sold 1,685,928 1,350,011 Cost of goods sold (COGS) represents all the costs incurred by the company in order to convert raw materials into finished products or to deliver the goods and services that created the net sales above. For example, in the case of Astrobucks, the food and beverages sold in the store would be a direct material cost and the wages of the stores' food preparation staff and cashiers would be a direct labor cost. As we can see from its income statement, Astrobucks' cost of goods sold increased between Year One and Year Two. In Year One, its COGS was $1,350,011,000, which increased to $1,685,928,000 in Year Two. In total, cost of goods sold increased by $335,917,000. By comparing this to the increase in net sales of $786,614,000 over the same period, we can see that Astrobucks' net sales are increasing at a much faster pace than its cost of goods sold. This will mean that its gross profit, which we turn to next, will be rising over that period. Gross Profit 2,389,594 1,938,897 Gross profit is the amount that net sales exceeds cost of sales. It represents the residual profit from sales after considering the direct and indirect cost of sales discussed above. We can see that the gross profit for Astrobucks went from $1,938,897,000 in Year One (which is equal to the Year One net sales of $3,288,908,000 minus the Year One cost of sales of $1,350,011,000) to $2,389,594,000 in Year Two (which is equal to the Year Two net sales of $4,075,522,000 minus the Year Two cost of sales of $1,685,928,000). This amounts to a total increase in gross profit of $450,697,000 between Year One and Year Two. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 8

9 Selling, General & Administrative Expenses 1,765,470 1,450,447 Selling, general, and administrative (SG&A) expenses are generally grouped separately from the cost of goods sold so that the reader of an income statement may distinguish between selling and administrative costs and those costs incurred as a direct part of the goods creation process. SG&A expenses include advertising and promotion expenses, travel and entertainment of people who work for the company, executives' salaries, office payroll, and office expenses. Operating expenses also include direct overhead costs associated with operating the Astrobucks store itself (rent, operating lease payments, utilities, supplies, maintenance and repairs, and store manager salaries). It is valuable to separate these costs from the cost of goods sold since the evaluation of income creation and cost control requires that we understand which expenses are directly related to revenue creation and which support the process of revenue creation. In Year One, Astrobucks incurred $1,450,447,000 in SG&A expenses, compared with $1,765,470,000 in Year Two, creating an increase of $315,023,000 in SG&A expenses between the end of Year One and the end of Year Two. Depreciation & Amortization Expenses 237, ,557 As determined by the IRS and published in the Modified Accelerated Cost Recovery System (MARCS), depreciation is the allowance provided to represent the reduction in the value of an asset due to wear and tear over the course of the year. Each year's decline in the value of the company's assets would be captured here. Amortization is the decline in useful value of an intangible asset, such as an Astrobucks store or an espresso machine, over the course of the year. It is important to note that these values are only representations of the actual reduction in the value of the assets. The government determines these numbers. Types of assets are grouped together within the MARCS, such as computers and cash registers, or delivery trucks and forklifts. A useful life is established for assets within the group, and an annual depreciation amount is determined that will fully depreciate the asset over its assumed useful life. While an espresso machine's assumed useful life might be 3 years, it may actually last 5 years. In this case, we would have no allowance for depreciation after the third year. Or, it may break down in 2 years, in which case we would need to make an allowance after the second year to write off the full cost of the asset. Real estate can be even trickier since an Astrobucks store or the company's office building may get more valuable over time. The government still allows the company to depreciate it each year and will tax any gains when the company sells the asset in the future. Finally, land, while costly and valuable, is not depreciated. Its value is maintained on the books at the purchase price until it is sold in the future. Operating Income 386, ,893 Operating income is the amount that gross profits exceed the sum of sales, general, and administrative expenses, and depreciation and amortization expenses. It represents the residual operating profit from sales after considering the expenses discussed above. We can see that the operating income for Astrobucks went from $282,893,000 in Year One (which is equal to the Year One gross profit of $1,983,897,000 minus the Year One SG&A of $1,450,477,000 and the Year One depreciation and amortization expenses of $205,557,000) to $386,317,000 in Year Two (gross profit of $2,389,594,000 minus the SG&A of 1,765,470,000 and the depreciation and amortization expenses of $237,807,000). Between the end of Year One and the end of Year Two, operating income increased from $282,893,000 to $386,317,000 for a total increase of $103,424,000. Interest Income (Expense) 0 0 Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 9

10 Interest expense is the interest paid to banks (as a result of taking out a loan) and bondholders (as a result of selling bonds to the public) for the use of their money. It is also referred to as a fixed financing charge because the interest must be paid year after year, whether the company is earning a profit or losing money. Interest differs from dividends on common stock (a financing charge associated with equity), which is payable only if the board of directors decides to declare them. Interest paid is another cost of doing business and is deductible from earnings in order to arrive at taxable income, which is used as a base for the payment of income taxes. Astrobucks has no interest expenses in either Year One or Year Two. Other Non-Operating Income (Expense) 50,018 56,106 The primary sources of non-operating income (expense) are dividend income from the company's investments in other companies (minority stakes in other businesses), interest income from investments in marketable securities (which will be discussed in the balance sheet section), and the gains or losses (expense) earned or incurred when the company sells off fixed assets and other investments. Astrobucks' non-operating income was $56,106,000 in Year One and declined to $50,018,000 in Year Two. Income before Income Taxes 436, ,999 Income before income taxes is the amount that operating income exceeds the sum of interest expenses and non-operating income. It represents the residual profit from sales after deducting all of the operating and non-operating expenses (and income) discussed above. Between the end of Year One and the end of Year Two, income before income taxes increased from $338,999,000 to $436,335,000, for a total increase of $97,336,000. Income Tax Expense 167, ,313 Every company has a basic tax rate that depends on the level and nature of its income before income taxes. Large corporations such as Astrobucks are subject to the top corporate income tax rate, but tax credits can lower the overall tax rate. Astrobucks' income before income taxes is $338,999,000 in Year One and $436,335,000 in Year Two. The income tax expense on these amounts of income comes to $126,313,000 in Year One and $167,989,000 in Year Two, leaving net income after tax for Year One of $212,686,000 and of $268,346,000 for Year Two. The tax rate applied to the average level of income for the two years would then be 37.26% ($126,313,000 $338,999,000) and 38.5% ($167,989,000 $436,335,000), respectively. Net Income after Taxes 268, ,686 Once all income and costs are added and deducted but before accounting for discontinuing operations and extraordinary items, we arrive at net income after taxes. Gain (Loss) from Non-Recurring Activities 0 0 Under ordinary conditions, the net income after taxes would be the end of the story. However, there are years in which companies may experience unusual and infrequent events called discontinuing operations and extraordinary items. Discontinuing operations occur when, for example, a business sells off one of its divisions and must recognize the gain or loss from that sale. Extraordinary items, on the other hand, could include pension plan terminations, Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 10

11 litigation settlements, or tax loss carry-forwards. These events are isolated on a separate line, net of their tax effect, so that the reader of the income statement can distinguish between reductions in income that resulted from normal operations and those that are not likely to recur in the future. This way the reader can discriminate idiosyncratic or one-time losses from systemic or "normal" operating losses. Net Income 268, ,686 Once all income and costs -- including discontinuing operations and extraordinary items -- are added and deducted, we arrive at net income. As there are no gains or losses from discontinuing operations or extraordinary items in either year, the net income is exactly the same as the net income after income taxes. However, if any of these accounts has a positive or negative amount, we would have added or deducted accordingly. Astrobucks' net income is then $212,686,000 for Year One and $268,346,000 for Year Two, showing that the company improved its "bottom line," or net income, by $55,660,000 between Year One and Year Two. We can also look at this as a very reasonable growth in earnings of 26.17% between Year One and Year Two ($55,660,000 $212,686,000). Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 11

12 Watch: A Second Look at Income Statements Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 12

13 Watch: How to Think about Income Statements When you think about income statements, it is important to focus on the essential information they provide. While you watch this video, consider the income statements for your organization and how they relate to other financial statements. What have you focused on in the past? Will you do anything different now? Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 13

14 Module Wrap-up: Reading the Income Statement It's critical for non-financial managers to understand the information that's conveyed by income statements. In this module, you defined the purpose and general structure of an income statement. You determined how to read an income statement, and you determined the meaning and significance of the elements conveyed in each part of the statement. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 14

15 Module Introduction: Reading the Balance Sheet In this module, you will look at how the balance sheet is put together and what it can tell you about an organization. You will examine the assets, liabilities, and owners' equity of a business at a specific point in time, as well as the net worth of a business, or what it owns and owes at a particular point. Finally, you will explore the relationship of the balance sheet to the income statement. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 15

16 Watch: Picture the Balance Sheet How do companies know at any specific moment in time how much they have in terms of assets, liabilities, and owners' equity? In what ways is this information displayed and communicated, and what do you need to know in order to be able to make sense of it? Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 16

17 Listen: Accrual Accounting Steven Carvell Professor Cornell University How is the difference handled between the time a transaction is recorded and payment is processed? Click play to listen. What is meant by the term accrual and deferral account? When Astrobucks sells a shipment of coffee to a supermarket, how is that transaction recognized? Click play to listen. Click play to listen. When Astrobucks purchases the coffee that it sells, how is that transaction recognized? How are expenses, such as insurance premiums, that are not directly associated with a sale recognized? Click play to listen. Click play to listen. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 17

18 Activity: Balance Sheet Line by Line: Assets Download the line-by-line item descriptions in PDF format. In this activity, you will explore the assets section of the balance sheet and learn what each line, or account, represents. Click any line on the balance sheet to learn more about that item. Please note: The "Assets" section of the balance sheet is typically listed either above the "Liabilities and Equity" section or to the left of the "Liabilities and Equity" section. BALANCE SHEET Year 2 Year 1 Jan. 1 - Dec. 31 Jan. 1 - Dec. 31 ASSETS (in thousands) Assets are used by the company to generate revenue and otherwise facilitate the business's operations. There are physical assets like buildings and delivery trucks, and intangible assets like goodwill and patents. The balance sheet breaks down these assets in two ways: first, by short-term and long-term assets, and then by types of assets, such as cash, accounts receivable, and net fixed assets. Current Assets This item generally includes all assets that will be used by a company within 12 months. The most common current asset accounts found in a company's balance sheet are cash and cash equivalents, accounts receivable, inventories, and other current assets. Cash & Cash Equivalents $200,907 $99,677 Cash: Cash includes money on deposit in the company's checking account. Retail and service firms with stores that deal with the public, like Astrobucks, also have bills and coins in the tills of their stores' cash registers, and most firms keep a petty cash fund. Cash equivalents (also known as marketable securities): In the United States, corporations do not earn any interest on money held in checking accounts. Companies will therefore move all funds not immediately necessary for transactions out of non-interest-earning checking accounts and into interest-earning investments. Because these funds may be needed on short notice, it is essential that the securities be readily marketable and subject to minimal price fluctuation. In addition, these investments typically mature in 90 days or less, which minimizes their loss potential. Examples of these short-term marketable securities include certificates of deposit (CDs), short-term US Treasury bills, and money market mutual funds. The generally accepted accounting practice is to show the value of these marketable securities on the books of the company at purchase cost or current market value, whichever is lower. Astrobucks had $99,677,000 of cash and cash equivalents at the end of Year One and $200,907,000 at the Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 18

19 end of Year Two. This increase of $101,230,000 represents a significant increase in the amount of cash and cash equivalents held by Astrobucks and is a reflection both of the increase in the number of operating units of Astrobucks as well as the increase level of same-store sales at existing Astrobucks stores. Accounts Receivable, Net 114,448 97,573 It would be straightforward if sales were booked onto the income statement at the time the sales occurred. However, companies usually do not receive cash when they make a sale. Instead, they will offer trade credit or an account receivable (A/R) to their customer and allow the customer to pay later. This creates an accrual account for the selling company, and as we will see later, this also creates an accounts payable (A/P) for the company buying the goods and services. In most cases, companies request that full payment be made within 30 days, although there are some companies that allow for longer payment due dates, depending on the industry and the credit period allowed by competing companies. Also, the customer may take longer to pay than the company originally allowed. The accounts receivable account represents the amount due from customers for services provided and booked as sales but not yet collected. A company like Astrobucks recognizes accounts receivable not from its customers buying coffee but from its franchisees that owe money to Astrobucks from franchise fees and from corporate accounts that purchase their coffee. This amount is shown on the balance sheet net of an allowance for uncollectible accounts. Experience shows that some customers fail to pay their bills, either because of financial difficulties or some catastrophe, such as a hurricane or a flood befalling their business. The dollar amount that a company deducts from its accounts receivable each year for this allowance depends upon its historical experience with its clients and the age and amount of each account that is owed to the company. The amount due from Astrobucks' customers and franchisees (net of the allowance for uncollectible accounts) is $97,573,000 in Year One and $114,448,000 in Year Two. Inventories 342, ,174 Inventory is the dollar amount of goods held by the company that the company plans to eventually sell. For a restaurant and coffee distributor like Astrobucks, it represents the food and beverage items in its coffee shops and warehouses that will be sold to customers. For a retail company, this figure represents the goods for sale on the shelves of the store. The inventory of a manufacturer is a little more complex, as it is composed of three groups: raw materials that will be used in the production of the product, partially finished goods or work-in-process inventory, and finished goods, which represent goods ready for shipment to customers. The generally accepted accounting method of valuation of the inventory is to use the purchase cost or the current market value, whichever is lower. This method gives a conservative valuation to the inventory, thus avoiding the likelihood of overvaluing a company's inventory and inflating the value of its assets. The amount of inventory held by Astrobucks went from $263,174,000 in Year One to $342,944,000. This increase is due both to the fact that there were more Astrobucks stores in Year Two than in Year One and the value of the inventory in each store increased as prices for coffee and other food and beverage items held as inventory in these stores increased due to inflation. Other Current Assets 265, ,219 The most common account included in the other current assets account is prepaid expenses: During the year Astrobucks pays bills for insurance coverage or for lease payments on an Astrobucks store or the Astrobucks Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 19

20 corporate office. It is often the case, though, that a billing cycle does not quite match up with a company's accounting cycle. Assume, for example, that Astrobucks pays insurance every three months on the 15th of the month. A payment is made on September 15, and the premium will be due again on January 15. If Astrobucks closes its books out on December 31, it will still have 15 days of insurance prepaid. Those insurance premiums are as yet unused at the balance sheet close date (December 31), so the company has an unexpended item, which will be used up during the next year. Considered another way, if the advance payment had not been made, the company would have had more cash in the bank, so this item reflects the fact that the company has an asset in the form of a prepaid expense. The dollar value of the other current assets account of Astrobucks actually declined from Year One to Year Two, going from $312,219,000 to $265,730,000. Total Current Assets 924, ,643 Total current assets sums up all of the items listed in the current assets section of the balance sheet and includes cash and cash equivalents (marketable securities), accounts receivable, inventories, and other current assets (prepaid expenses). Astrobucks' total current assets went from $772,643,000 in Year One to $924,029,000 in Year Two, an increase of $151,386,000, or 19.59%. Long-Term Assets: This item generally includes all assets used in the production of income for the company that will be held by the company for more than 12 months. The most common long-term asset accounts found in a company's balance sheet are net fixed assets and other long-term assets such as intangibles and goodwill. Property, Plant & Equipment 2,434,712 2,077,759 "Property, plant, and equipment" represents those fixed assets held by the company that are used on an ongoing basis in the course of the business's operations and that are not intended for sale. For a restaurant and coffee shop like Astrobucks, it would include all of the coffee-making equipment, kitchen and dining equipment, the furniture and fixtures in each of its stores, as well as the stores, office buildings, and land owned by Astrobucks. The value of the equipment such as computers, printers, and copying machines in its corporate office would also be included. For a manufacturing company, property, plant, and equipment includes all the assets involved in the manufacturing, warehousing, sale, and transportation of the product. For a retail business, it includes the stores, fixtures, and delivery and maintenance equipment. Overall, this category will include land, buildings, machinery, equipment, furniture, automobiles, and trucks. The generally accepted and approved method for valuation is to use the purchase cost of the asset. Astrobucks' property, plant, and equipment for Year One was $2,077,759, which grew to $2,434,712 for Year Two. Less Accumulated Depreciation & Amortization (1,049,810) (812,003) This amount represent the sum of all the depreciation expenses shown on the company's income statement. The difference in the accumulated depreciation account between Year One and Year Two ($812,003 and $1,049,810) equals the annual depreciation expense from the Year Two income statement of $237,807. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 20

21 Net Property, Plant & Equipment 1,384,902 1,265,756 The fixed assets of Astrobucks, net of depreciation, went from $1,265,756,000 to $1,384,902,000. This $119,146,000 increase is directly attributable to Astrobucks' increase in the number of stores and the equipment and fixtures associated with those new outlets. Other Long-Term Assets 420, ,993 Other long-term assets include items like intangible assets. These may be defined assets having no physical existence, yet having substantial value to the company. Examples most often include goodwill, franchise rights to a restaurant company allowing exclusive rights to open new stores in certain areas, a patent for exclusive manufacture of a specific item like a pharmaceutical drug, trademarks, copyrights, and brand names (like Astrobucks Coffee). Perhaps the most important of the other long-term assets listed above is goodwill, since this asset often has the most material impact on a company's balance sheet when they are involved in an acquisition of another company. Goodwill represents the amount by which the price of an acquired company exceeds the related values of the net assets of the company acquired. For example, if Company X purchases Company Y for $100 million and Company Y at the time of the purchase only had $85 million of net assets on its books, Company X would allocate the $85 million to the respective accounts (current assets and property, plant, and equipment) and allocate the remaining $15 million to goodwill. Astrobucks' other long-term assets went from $175,993,000 to $420,815,000. This represents a whopping $244,822,000, or %, increase in other long-term assets. The majority of this increase is attributable to the acquisition of the Portland Coffee Company. Total Long-Term Assets 1,805,717 1,441,749 The total long-term assets item sums up all of the items listed in the long-term asset section of the balance sheet and includes net fixed assets and other long-term assets. Astrobucks' total long-term assets went from $1,441,749,000 in Year One to $1,805,717,000 in Year Two, an increase of $363,968,000, or 25.24%. Total Assets $2,729,746 $2,214,392 The total assets item sums up all of the items listed in the assets section of the balance sheet and includes all current assets and long-term assets. Astrobucks' total assets went from $2,214,392,000 in Year One to $2,729,746,000 in Year Two, an increase of $515,354,000, or 23.27%. LIABILITIES & STOCKHOLDER'S EQUITY Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 21

22 Activity: Balance Sheet Line by Line: Liabilities and Equity Download the line-by-line item descriptions in PDF format. In this activity, you will explore the liabilities & equity section of the balance sheet and learn what each line, or account, represents. Click any line on the balance sheet to learn more about that item. Please note: The "Liabilities and Equity" section of the balance sheet is typically listed either below the "Assets" section or to the right of the "Assets" section. LIABILITIES & STOCKHOLDERS' EQUITY A liability represents a claim against the company's assets and future cash flows. Some liabilities represent general claims against the company and have no collateral pledged against them. An example of a short-term general liability is accounts payable, and an example of a long-term general liability is debenture bonds. Other liabilities carry collateral claims; a common example of such a liability is a commercial mortgage. The most common liability accounts found in a company's balance sheet are current liabilities and long-term liabilities. Current Liabilities: This item generally includes all debts that will come due within 12 months. These short-term liabilities include accounts payable, notes payable, accrued expenses, income tax payable, and other liabilities. The current liabilities item is a companion to current assets because current assets can be viewed as the source of funds from which payments on current liabilities will be made. The relationship between the two accounts is one of the most revealing things to be learned from an analysis of the balance sheet. Accounts Payable $168,984 $135,994 The accounts payable (A/P) item represents the amount that a company owes to its regular business creditors from whom it has purchased goods or services on a trade credit account. In fact, accounts payable represents the flip side of the accounts receivable relationship that was discussed earlier. One company's account receivable is another company's account payable. Accounts payable is another of a company's accrual accounts, created by the fact that the purchase and receipt of a good or service is not timed perfectly with the payment of the expense incurred by the purchase. Typically, companies are given 30 days to pay a bill for the purchase of a good or service from another company. Any accounts payable, or trade credit, not paid in the current year will be carried on the books into the next fiscal year as an accounts payable. For a company like Astrobucks, the accounts payable account represents money owed to suppliers of coffee, sugar and dairy products, and to other food purveyors that sell goods to the company on trade credit. In Year One, Astrobucks' A/P was $135,994,000 and in Year Two this account grew to $168,984,000. The $32,990,000 increase can be attributed to a rise in the prices of goods and services sold to each store, as well as to Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 22

23 an increase in the number of stores operated by Astrobucks. Short-Term Debt Where the company has written a promissory note to borrow money and it is due in the coming year to a bank, individual, corporation, or other lender, it appears on the balance sheet under notes payable. Notes payable are most commonly short-term bank loans, but this account also includes any payments to long-term loans that are due in the next fiscal year. Finally, this account also includes any lease payments due in the coming fiscal year on leases that are capitalized on the company's balance sheet. Astrobucks has a very modest amount of short-term debt given the dollar amount of assets under their control. In Year One, Astrobucks' short-term debt was only $710,000, and this account grew a modest $12,000 between Year One and Year Two to $722,000. Other Current Liabilities 438, ,891 Other current liabilities include liabilities such as salaries and wages due to employees, fees to attorneys, insurance premiums owed but unpaid, and income taxes payable. As in the case of accounts payable, these accounts are all accrual accounts and are recognitions of the fact that an expense has occurred without the transfer of any funds. As such, there are a number of other payable accounts that will be paid in the coming year. For Astrobucks, other current liabilities went from $325,891,000 in Year One to $438,997,000 in Year Two. Total Current Liabilities 608, ,595 The total current liabilities item is equal to the sum of all of the items listed under the Current Liabilities section of the balance sheet and includes accounts payable, notes payable, and other current liabilities. Long-Term Liabilities When we discussed current liabilities, we included all debts of the company due within one year from the balance sheet date. These debts that are due more than one year from the closing date of the balance sheet are reported as long-term liabilities. Long-Term Debt (Notes & Debentures): 4,354 22,496 These items represent long-term loans to the company and involve commitments where the money owed will not be paid off during the coming year. A note typically represents a long-term loan received from a bank or other lending institution. In the case of a debenture, the money was received by the company as a loan from bondholders, who in turn were given a certificate called a bond (or debenture) as evidence of the loan. The bond is a formal promissory note issued by a company that agrees to repay the debt at maturity. Bonds that are backed by the general credit of the corporation rather than by the company's assets are known as debenture bonds. Debentures are the most common type of bond issued by large, well-established corporations. There are also long-term debts that carry a specific claim against an asset; these include mortgages and asset-backed bonds. Astrobucks had a relatively modest amount of long-term debt in Year One of $5,076,000, which declined to $4,354,000 in Year Two. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 23

24 Deferred Income Taxes 33,217 22,496 Deferred income taxes are one of the long-term liabilities on Astrobucks' balance sheet. This liability results from differences in the income already earned and recognized, the expenses for taxable income according to the Financial Accounting Standards Board (FASB), and income reported to the IRS. We will discuss this issue again in the "Who Makes the Rules?" section later in the course. Companies like Astrobucks include a charge for deferred taxes in their tax calculations on the income statement and show what taxes would be without the differential. This differential was substantial for Astrobucks and amounted to $22,496,000 in Year One and $33,217,000 in Year Two. Other Long-Term Liabilities 1,045 1,036 Other long-term liabilities include all long-term debt other than what is already reported in the balance sheet for the two accounts already discussed. This account can include long-term liabilities such as pension fund obligations and obligations arising from capitalized leases. Astrobucks had $1,036,000 in other long-term liabilities in Year One and $1,045,000 in Year Two. Total Long-Term Liabilities 38,616 28,608 The total long-term liabilities item is equal to the sum of all of the items listed under the Long-Term Liabilities section of the balance sheet and includes notes and debentures, deferred income taxes, and other long-term liabilities. Total liabilities for Astrobucks increased from $28,608,000 in Year One to $38,616,000 in Year Two. Total Liabilities 647, ,203 Current and long-term debt are summed together to produce the figure listed on the balance sheet as total liabilities. Total liabilities for Astrobucks went from $491,203,000 to $647,319,000. This increase of $156,116,000, or 31.78%, was substantially higher than the 25.24% increase in total assets shown by Astrobucks over the same period. This implies that after considering the growth in their assets, Astrobucks is showing a disproportionate increase in its use of liabilities as a funding tool. We will further explore the implications of this in the next course, Using Ratio Analysis to Evaluate Financial Performance. Stockholders' Equity: Companies can raise money either by incurring debt (either short-term in the form of a note payable to a bank, long-term in the form of a mortgage note payable to a bank or a long-term bond payable to investors in the bonds) or by selling shares of equity in the company. The two types of equity sold to investors by companies to raise capital include shares of preferred stock and shares of common stock. Also, the company may reinvest some of the common shareholders' money each year; this is the amount by which net income exceeds the dividends paid out to the shareholders and appears on the balance sheet as retained earnings. Preferred Stock 0 0 Preferred stock shares have a priority over common stock shares with respect to dividends, and in distribution of assets in the event of liquidation under bankruptcy. In the case of dividend payments, preferred stock normally carries a cumulative dividend provision. A cumulative dividend provision means that if in any year the total amount of Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 24

25 the dividend payment due to the preferred shareholder is not paid, it accumulates and must be paid in full to the preferred shareholders before any dividends are distributed to the common stock shareholders. Most often, preferred shareholders get little or no voting rights and therefore have no voice in company affairs unless the company fails to pay them dividends at the promised rate. Specific provisions relating to preferred stock can be obtained from a corporation's charter. Astrobucks had no preferred stock in either Year One or Year Two. Common Stock (shares: 393,692,536 in Year 2; 388,328,592 in Year 1) 973, ,459 Common stock shares represent a proprietary interest in the company. These shares are represented by stock certificates issued by the corporation to its common stock shareholders. These shareholders are considered to be the "owners" of the company, and voting rights are assigned to each share of common stock. Usually, each share of common stock is assigned one vote, so an investor who owns 10,000 shares of common stock is assigned 10,000 votes. Votes are cast at annual meetings where the company's board of directors is selected. The board of directors and the chair of the board will hire the chief executive officer, chief financial officer, and the chief operating officer (the latter positions may or may not exist, depending on the size and structure of the company). The CEO, CFO, and COO are responsible for the daily activities of the company. If there were to be a takeover bid for the company, the common shareholders would vote on the proposal. If a majority of votes to accept the tender offer for the takeover (the exact size of this majority will vary by company charter), then the takeover would be approved. A corporation may issue several different classes of common stock shares, where each class would have different attributes. For example, some corporations issue a Class A Common Stock and a Class B Common Stock, where the Class A Common Stock has 1000 votes per share compared to one vote per share for the Class B Common Stock. In Year One, Astrobucks had $882,459,000 of Common Stocks on their books, and this amount increased to $973,351,000 in Year Two. The value shown on a company's books for common stock is the dollar amount paid for the shares when they were originally sold to the investors when the stock was issued. This amount will most likely be quite different from the market value of the stock if it were to be traded on a public exchange like the New York Stock Exchange. If your company is publicly traded, you can check the value of its common stock through sites like Yahoo Finance. Additional Paid-In Capital 39,393 39,393 This is the amount paid in by shareholders above the par or face value of each share. Common stock typically has a par value of $0.01 per share. When a company sells shares of its own stock to the public, the amount that the sales price exceeds the par value is placed on the balance sheet as additional paid-in capital. Retained Earnings 1,069, ,337 When a company first starts in business, it has no retained earnings. Retained earnings accumulate as the company earns a positive net income and reinvests or "retains" the income. Retained earnings increase each year by the Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 25

26 amount of net income less the dividends declared to shareholders. Retained earnings do not represent some pile of cash that is sitting in a corporate account somewhere. Retained earnings simply represent the sum of the amount of money reinvested in the company by the company's stockholders. This money has probably already been invested in long-term assets or has been used to pay off liabilities long ago. Since its inception, Astrobucks accumulated $801,337,000 of retained earnings at the end of Year One, and this amount grew an additional $268,346,000 to $1,069,683,000 in Year Two. Total Stockholders' Equity 2,082,427 1,723,189 Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 26

27 Watch: A Second Look at Balance Sheets Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 27

28 Watch: How to Think about Balance Sheets The balance sheet, like the other financial statements under consideration, can't be taken in isolation; you want to be able to look at the information it gives you in concert with its relationship to the information on other financial statements, as Professor Carvell and Professor Gibson explain in this video. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 28

29 Module Wrap-up: Reading the Balance Sheet In this module, you examined the purpose of the balance sheet and its general structure. You identified the salient information it contains and the relevance of that information to critical business decisions. You also identified ways to use the balance sheet for assessing the financial health of the organization. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 29

30 Module Introduction: Reading the Cash Flow Statement In this module, you will identify ways to read a cash flow statement. You will examine the way a company's receipts and expenditures are tracked over a given period of time and explore the way financial professionals use these statements to report a firm's sources and uses of cash. In this module, apart from taking a closer look at the cash flow statement and the kind of information it can provide about the financial performance of a business, you will also examine how a financial transaction makes its way across different statements. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 30

31 Watch: Picture the Cash Flow Statement What form do the financial records of a company's receipts and expenditures during a specific period take? In what ways is this information organized, and what do you need to know in order to be able to make sense of it? Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 31

32 Read: Calculating Cash Flow The cash flow statement integrates changes in the company's balance sheet with the income generated to reveal how much cash was generated or used up by the company over the past year. As we've seen in the presentation, "Picture the Cash Flow Statement," the cash flows of the company are separated into three distinct categories: Cash flow from operations Cash flow from investing activities Cash flow from financing activities Cash flow can be calculated using two methods: the direct method and the indirect method. Direct Method: The direct method involves calculating the cash inflows and outflows from each business activity separately. For example: cash collections from customers, cash paid to suppliers and employees, net cash from interest (both paid and earned), net cash from dividends (both paid and earned), and cash paid for income taxes. Indirect Method: The indirect method takes as its starting point net income and adjusts it to calculate the cash flow from operations by adding back non-cash expenses (such as depreciation and amortization and deferred tax liability). Next, the cash provided or consumed by changes in the company's current assets and liabilities are considered, yielding the company's net cash flow from operations. Since the indirect method is the one most often used by companies in their public reporting, we will next review each entry in the cash flow statement using the indirect method, paying special attention to understanding why each entry is made and how it is calculated. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 32

33 Calculating Cash Flow from Operating Activities We begin with Astrobucks' net income, as reported on the bottom line of its income statement, making adjustments to obtain the company's cash flow from operations. We will adjust this figure by adding back the non-cash expenses that were deducted to arrive at the net income figure. The non-cash expense of depreciation and amortization (deducted to arrive at the net income figure) are added back, as they did not represent cash expenditures. The only impact of depreciation and amortization on the cash flows of the company is that it reduces the company's tax liability to the government, as it is deductible from taxable income. The other non-cash item is the deferred tax liability on the company's balance sheet that was created by the difference between income reported for tax purposes to the IRS and income reported according to FASB. We next adjust for the changes in current assets and current liabilities that affect the level of cash created and used by the company's operations. An increase in any of the current asset accounts, such as inventory, represents a use of cash. A decrease in any of the current asset accounts, like accounts receivable, represents a source of cash. Likewise, an increase in any of the current liability accounts, such as accounts payable, represents a source of cash. And a decrease in any of the current liability accounts, like short-term debt, represents a use of cash. Calculating Cash Flow from Investing Activities To calculate the cash flows from investing activities, we take any addition to property, plant, and equipment (which would be a use of cash) and net it out against any purchase of property, plant, and equipment (which would be a use of cash). We make the same adjustment for purchases of other long-term assets, which are uses of cash and therefore represent a cash outflow from investing activities. Likewise, any sale of other long-term assets are sources of cash and therefore represent a cash inflow from investing activities. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 33

34 Calculating Cash Flow from Financing Activities To calculate cash flow from financing activities, we calculate all of the sources of cash from financing activities and deduct them from all of the uses of cash from financing activities. Any proceeds from the sale of stocks or the addition of long-term debt represent a source of cash and therefore represent a cash inflow from financing activities. Any distributions from the repurchasing of stock, the distribution of dividends, or the repayment of long-term debt represent a use of cash and therefore represent a cash outflow from financing activities. Calculating the Net Increase (or Decrease) in Cash and Cash Equivalents (Net Cash Flow) The next part of the cash flow statement calculates the sum of the cash flow from operating activities, the cash flow from investing activities, and the cash flow from financing activities. By adding together the cash flows from these three activities, we find the company's net cash flow for the year or the net increase (decrease) in cash and cash equivalents for the company for the year. Calculating Cash and Cash Equivalents, End of Period The final calculation in the cash flow statement takes the net increase (or decrease) in cash and cash equivalents (net cash flow) and adds to it the cash and cash equivalents from the beginning of the year. (This number is the same as the end of year cash and cash equivalents found in the company's Year One balance sheet.) From this calculation, we obtain the amount of cash and cash equivalents that the company is holding at the end of the Year Two. The chart shown here illustrates the cash inflows and outflows for Astrobucks and whether the amount comes from the income statement (orange) or the balance sheet (blue). Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 34

35 Tool: Cash Flow Statement Analysis Download the Tool Excel Cash Flow Tool Download this cash flow tool to further explore how changes in the balance sheet and income statement affect the cash position of the firm. Then use the tool to create your own cash flow statement. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 35

36 Watch: A Second Look at Cash Flow Statements Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 36

37 Watch: The Life of a Transaction In this presentation, Professor Scott Gibson describes what happens to an average transaction as it is tracked through the statements you have learned about in this course. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 37

38 Watch: How to Think about Cash Flow The cash flow statement is very significant, and as a non-financial manager, you need to be able to identify what it's telling you about the overall health of the organization, its operations, and its financing activities, as Professors Carvell and Gibson explain. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 38

39 Module Wrap-up: Reading the Cash Flow Statement In this module, you defined the purpose of the cash flow statement and examined its general structure. You also examined a sample cash flow statement to determine the sources and uses of cash within an organization. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 39

40 Module Introduction: Other Elements of Financial Reporting In this module, you will examine other questions that affect financial reporting, such as, Who decides how information should be reported? What are some of the limitations of the financial statements covered in this course? What type of financial information is commonly found in an annual report? You will explore online research as a means of finding financial information about public companies as well as important information about agencies, commissions, and organizations related to the financial world. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 40

41 Read: Who Makes the Rules? Key Points There are numerous agencies and associations that have set up regulations and guidelines that accountants must either follow or are expected to follow based on convention: The American Institute of Certified Public Accountants (AICPA) The Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP) The Securities and Exchange Commission (SEC) There are numerous agencies and associations that have set up regulations and guidelines that accountants must either follow or are expected to follow based on convention. We provide a brief description of the most significant of the associations and agencies so that you can become familiar with their structure, their mission, their statutory authority, if any, and what impact they have on accounting practice. Each of these associations and agencies have public websites that provide other information in addition to what we will discuss. You are encouraged to visit any or all of them so that you may gain further insight into each. Below is information about each agency or organization from their websites. The American Institute of Certified Public Accountants (AICPA) From the AICPA website ( Committed to member service and the public interest, the American Institute of Certified Public Accountants and its predecessors have been serving the accounting profession since The AICPA sets Accounting Standards through its accounting standards team and its accounting standards Executive committee. The Accounting Standards Team's principal objective is to determine the AICPA's technical policies regarding financial accounting and reporting standards. The Accounting Standards Executive Committee (AcSEC) is the senior technical committee of the AICPA authorized to set accounting standards and to speak for the Institute on accounting matters. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 41

42 The Financial Accounting Standards Board (FASB) From the FASB website ( Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports. They are officially recognized as authoritative by the Securities and Exchange Commission (Financial Reporting Release No. 1, Section 101) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information. The Mission of the Financial Accounting Standards Board The mission of the Financial Accounting Standards Board (FASB) is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent, and understandable financial information. Financial information about the operations and financial position of individual entities also is used by the public in making various other kinds of decisions. To accomplish its mission, the FASB acts to: Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability and on the qualities of comparability and consistency Keep standards current to reflect changes in methods of doing business and changes in the economic environment Consider promptly any significant areas of deficiency in financial reporting that might be improved through the standard-setting process Promote the international convergence of accounting standards concurrent with improving the quality of financial reporting Improve the common understanding of the nature and purposes of information contained in financial reports The FASB publishes GAAP (see below). Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 42