UNDERSTANDING FINANCIAL STATEMENTS N I N T H E D I T I O N Lyn M. Fraser Aileen Ormiston Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
CONTENTS Preface xi Organization of the Ninth Edition xii Uses for the Ninth Edition xiv Features of the Ninth Edition xv Acknowledgments xvii About the Authors xviii Chapter 1 Financial Statements: An Overview 1 Map or Maze 1 Usefulness 3 Volume of Information 3 Where to Find a Company's Financial Statements The Financial Statements 7 Notes to the Financial Statements 7 Auditor's Report 10 Sarbanes-Oxley Act of 2002 16 Management Discussion and Analysis 17 Five-Year Summary of Selected Financial Data and Market Data 19 Pandora (A.K.A. "PR Fluff") 19 Proxy Statement 19 Missing and Hard-to-Find Information 20 Complexities 21 Accounting Choices 21 The Future of Financial Statements 22 Quality of Financial Reporting 22 Timing of Revenue and Expense Recognition 22 Discretionary Items 23 The Journey Through the Maze Continues 23 Self-Test 24 Study Questions, Problems, and Cases 27 Chapter 2 The Balance Sheet 36 Financial Condition 36 Consolidation 37
vi Contents Balance Sheet Date 37 Comparative Data 37 Common-Size Balance Sheet 37 Assets 40 Current Assets 40 Cash and Marketable Securities 41 Accounts Receivable 42 Inventories 44 Inventory Accounting Methods 45 Prepaid Expenses 48 Property, Plant, and Equipment 49 Other Assets 52 Liabilities 52 Current Liabilities 52 Accounts Payable 52 Notes Payable 53 Current Maturities of Long-Term Debt 54 Accrued Liabilities 54 Unearned Revenue or Deferred Credits 55 Deferred Federal Income Taxes 55 Long-Term Debt 59 Capital Lease Obligations 60 Postretirement Benefits Other Than Pensions 60 Commitments and Contingencies 61 Hybrid Securities 61 Stockholders' Equity 62 Common Stock 62 Additional Paid-in Capital 62 Retained Earnings 62 Other Equity Accounts 63 Other Balance Sheet Items 64 Self-Test 65 Study Questions, Problems, and Cases 70 Chapter 3 Income Statement and Statement of Stockholders' Equity 78 The Income Statement 79 Common-Size Income Statement 81 Net Sales 81
Contents vii Cost of Goods Sold 83 Gross Profit 83 Operating Expense 85 Depreciation and Amortization 86 Operating Profit 87 Other Income (Expense) 88 Equity Earnings 88 Earnings Before Income Taxes/Effective Tax Rate 90 Special Items 91 Accounting Changes 92 Net Earnings 92 Earnings Per Common Share 92 Comprehensive Income 93 The Statement of Stockholders' Equity 94 Earnings Quality and Cash Flow 96 Self-Test 96 Study Questions, Problems, and Cases 101 Chapter 4 Statement of Cash Flows 107 Preparing a Statement of Cash Flows 108 Calculating Cash Flow from Operating Activities 113 Indirect Method 114 Cash Flow from Investing Activities 116 Cash Flow from Financing Activities 117 Change in Cash 118 Analyzing the Statement of Cash Flows 119 Cash Flow from Operations 119 Nocash Corporation 120 R.E.C. Inc.: Analysis of the Statement of Cash Flows 122 R.E.C. Inc. Analysis: Cash Flow from Operating Activities 122 Summary Analysis of the Statement of Cash Flows 124 Analysis of Cash Inflows 125 Analysis of Cash Outflows 126 Are We There Yet? 126 Self-Test 127 Study Questions, Problems, and Cases 131 APPENDIX 4A Statement of Cash Flows Direct Method 144 Direct Method 144
viii Contents Chapter 5 A Guide to Earnings and Financial Reporting Quality 148 Using the Checklist 150 I. Sales or Revenues 150 II. Cost of Goods Sold 156 III. Operating Expenses 159 IV. Nonoperating Revenue and Expense 166 V. Other Issues 169 What Are the Real Earnings? 171 Quality of Financial Reporting The Balance Sheet 171 Quality of Financial Reporting The Statement of Cash Flows 172 Self-Test 173 Study Questions, Problems, and Cases 178 Chapter 6 The Analysis of Financial Statements 180 Objectives of Analysis 180 Sources of Information 182 Proxy Statement 182 Auditor's Report 182 Management Discussion and Analysis 182 Supplementary Schedules 182 Form 10-K and Form 10-Q 183 Other Sources 183 Tools and Techniques 185 Common-Size Financial Statements 185 Key Financial Ratios 186 Liquidity Ratios: Short-Term Solvency 188 Cash Conversion Cycle or Net Trade Cycle 191 Activity Ratios: Asset Liquidity, Asset Management Efficiency 192 Leverage Ratios: Debt Financing and Coverage 194 Profitability Ratios: Overall Efficiency and Performance 197 Market Ratios 199 Analyzing the Data 200 Background: Economy, Industry, and Firm 202 Short-Term Liquidity 203 Operating Efficiency 205
Contents ix Capital Structure and Long-Term Solvency 205 Profitability 209 Relating the Ratios The Du Pont System 211 Projections and Pro Forma Statements 212 Summary of Analysis 213 Self-Test 215 Study Questions, Problems, and Cases 221 Appendix A Summary of Financial Ratios 251 Appendix B Solutions to Self-Tests 254 Appendix C Glossary 256 Index 265