七 Investment Tools: Financial Statement Analysis: Basic Concepts 1.A: Preliminary Reading Measuring Business Income a: Explain why financial statements are prepared at the end of the regular accounting period, why accounts must be adjusted at the end of each period, and why the accrual basis of accounting produces more useful income statements & balance sheets than the cash basis. To be relevant, information must be reliable. This means information must be consistentand comparable over time and be provided on a timely basis. According to the relevancy principle, a firm needs to identify its activities in a timely fashion within a specific period, such as a quarter or year. Normal accounting procedure is to record during the accounting period those economic events that occurred as the result of external transactions. At the end of the period after all the external transactions have been recorded, several of the accounts in the ledger need to be updated before their balances can be posted to the financial statements. The adjusting process is consistent with two important accounting principles: 1. The revenue recognition principle, which requires that revenue be reported in the income statement only when it is earned, not before and not after. 2. The matching principle reports expenses on the income statement in the same accounting period as the revenues that were earned as a result of the expenses.
Accrual basis accountingassigns revenues to the accounting period in which they are earned and matches expenses with the revenues generated by those expenses. The objective of the accrual basis is to report the economic effects of revenues and expenses when they are earned or incurred, not when cash is received or paid. Cash basis accountingrecognizes revenues when cash is received and expenses when cash is paid. Under the cash basis net income for the period is the difference between revenues received in cash and expenses paid with cash. Accrual accounting generally provides a better indication of performance than information based on the receipt and disbursement of cash. Accrual accounting increases the comparability of income statements and balance sheets from one period to another period. The accrual basis reflects the understanding that the economic effect of revenue generally occurs when it is earned and not when cash is received. The revenue recognition principle is the basis for making adjusting entries that pertain to unearned and accrued revenues. Adjusting entries are necessary to better match revenues and expenses that occurred during the accounting period. Adjusting entries are used to record the effects of internal economic events. 1.B: Preliminary Reading Financial Reporting and Analysis a: Define each asset and liability category on the balance sheet and prepare a classified balance sheet. Assets category on the balance sheet Current assetsare assets which will be sold, collected, or consumed within one year or the firm’s operating cycle, whichever is longer. The operating cycle is the average time between paying for inventory or the employees who perform services and receiving cash payment back from the firm’s customers. 1. Cash is currency or demand deposits. 2. Short-term investments are debt or equity investments for which a ready market exists and management intends to sell within one year or operating cycle. 3. Accounts receivable are amounts owed to the firm by its customers for goods and services delivered. 4. Notes receivable are amounts owed, usually by customers, which will not be collected within the typical collection period. 5. Inventory represents products that will be sold in the normal course of business. 6. Prepaid expenses (e.g., rent) are services paid for but not yet used. Investmentsare land, debt securities, or equity securities which management does not intend to sell within the year. 1. Property, plant, and equipment: Land is the real estate upon which the firm’s buildings sit. 2. Intangible assets are economic resources lacking tangible existence such as patents, copyrights, trademarks, and goodwill.
Liability categories on the balance sheet Liabilitiesare responsibilities (amounts owed) which must be met in the future, usually by the payment of cash. Current liabilities are those liabilities that will be paid within one year or operating cycle. 1. Accounts payable are the amounts owed to suppliers for goods or services received but not yet paid for. 2. Wages, rent, etc. payables are the amounts owed to employees, landlord, etc. for services used but not yet paid for. 3. Notes payable are the amounts owed creditors usually with explicit interest expense. 4. Dividends payable are owed to owners for dividends declared but not yet paid. 5. Current portion of long-term debt is that portion of long-term debt that will be paid within the year. Long-term liabilities are the amounts owed creditors that will not be paid within one year. Stockholders’ equityis the owners' investment and the total earnings retained from the beginning of the business. Contributed capital (paid-in-capital) is the amount of the stockholders' investment in the firm’s equity securities. Common stock is the portion of stockholders' investment valued at par. Other paid-in-capital is the excess of the shareholders’ investment over the stock’s par value. Retained earnings is the total net income less the amount distributed to the owners as dividends from the beginning of business.
A classified balance sheet A balance sheet can be presented in many different ways. A classified balance sheet is one in which the accounts are ordered in some logical manner, such as by liquidity or maturity. In a typical classified balance sheet: 1. Assets are listed in order of liquidity, from most liquid to least liquid. 2. Liabilities are listed in order of when they become due. 3. Equity is generally presented with contributed or paid-in capital first and retained earnings last. b: Define each component of a multistep income statement and prepare a multistep income statement. A multi-step income statement is a statement that provides subtotals along the way to providing net income. The basic structure of the income statement is: sales less cost of goods soldequals gross margin(a.k.a. gross profit) less operating expensesequals Income from operations(a.k.a. operating income) add or subtract other revenues and expensesequals income before income taxesless income taxesequals net income. · Gross salesor revenues are the total sales (cash and credit) during an accounting period. Net sales or net revenues are the gross amount less returns, allowances, and discounts. · Cost of goods soldis the cost of sales for the goods sold during the period; that is, the cost of the merchandise (paid for or the cost to manufacture). · Operating expensesare the costs of operating a business other than the cost of goods sold. Examples include selling expenses and administrative expenses. · Other revenues and expensesare non-operating items. Examples include interest expense and interest income. · Income taxesare the provision for income taxes for reporting purposes. 1.C: Preliminary Reading Short-Term Liquid Assets a: Describe how to choose the appropriate accounting method for investment securities and explain how fair (market) value gains and losses on such investments are reported. Short-term investments (a.k.a. marketable securities) are investments intended to be held only until cash is needed for the operations of the business. It is intended that these investments are to be held for less than one year. Short-term investments are initially recorded at cost (cash price plus any acquisition costs such as brokerage fees). If management intends to hold short-term investments in debt securities to maturity, then they are reported at their original cost. These are called investments in securities held to maturity. If management classifies a short-term investment as a trading investment (trading investments are always considered to be current assets), then the investment is reported on the balance sheet at its fair market value. Any unrealized holding gains or losses due to the appreciation or depreciation of the investment must be listed as a gain or loss on the income statement. b: Describe how to account for transactions with credit customers, including accounting for bad debts under the allowance method and the direct write-off method. Let SSS corporation have $10,000 of credit sales and $2,000 of cash collections in its accounts receivable during the year: Accounts Receivable$10,000 Sales Revenue $10,000 Cash$2,000 Accounts Receivable $2,000 Now assume it is year end. It is estimated that of the $8,000 balance in accounts receivable, $1,000 will ultimately turn out to be uncollectable. Bad Debts Expense$1,000 Allowance for Doubtful Accounts$1,000 The bad debts expense decreases net income under the matching concept. And the allowance for doubtful accounts decreases the accounts receivable on the balance sheet to its net realizable value. Balance Sheet: Accounts Receivable$8,000 less Allowance for Doubtful Accounts( 1,000) Net realizable value$7,000 To continue the example, in the following year, it is learned that customer ZZZ, who owed the firm $100 has declared Chapter 7 bankruptcy. ZZZ's account receivable will be written-off by reducing the allowance and the particular accounts receivable. Allowance for doubtful accounts$100 Accounts Receivable$100 The direct write-off method is used for income tax calculations and by firms with immaterial bad debts. Here the firm does not use an allowance account (accounts receivable on the balance sheet is the amount owed by customers). It recognizes bad debts expense only when a particular account is written-off as uncollectable. The write-off of the $100 of accounts receivable from customer ZZZ declaring bankruptcy is: Bad Debts Expense$100 Accounts Receivable$100 1.D: Preliminary Reading Inventories a: Describe how the choice of inventory system or method affects the financial statements. LIFO results in: Higher COGS Lower taxes Lower net income Lower inventory balances Lower working capital Higher cash flows FIFO results in: Lower COGS Higher taxes Higher net income Higher inventory balances Higher working capital Lower cash flows b: Define inventory cost. The cost of inventory includes invoice price (less discounts), transportation costs, and taxes. Inventory includes not only the inventory on hand, but may include inventory items in transit. Goods are valued according to the assumed cost flow, which may or may not reflect the physical flow of inventory. The cost of ending inventory and, hence, cost of goods sold is determined by choosing one of the four generally accepted accounting principles (GAAP) alternatives. c: Calculate the cost of an invetory based on 1) the specific identification method, 2) the average-cost method, 3) first in, first out (FIFO), and 4) last in, first out (LIFO). Specific identification:The units in ending inventory and listed as sold are valued at the specific invoice price of those units sold. Weighted average:The units held in ending inventory and listed as sold are valued at the average cost of goods available for sale (beginning inventory + purchases)/(number of units in inventory). FIFO:This is the FIRST IN (purchases) FIRST OUT (sales) cost flow assumption. Under FIFO, the unit cost of the one unit in beginning inventory and the first unit purchased are assigned as the Munits sold to calculate the cost of goods sold. LIFO:This is the LAST IN (purchases) FIRST OUT (sales) cost flow assumption. It is the opposite of FIFO. d: Explain the effect of an overstatement or understatement of inventories on the financial statements. In working out the effects of an overstatement (O) or understatement (U), it is necessary to realize that the ending inventory in one period is the beginning inventory of the next period. Then use the following relationships: Ending Inventory = Beginning Inventory + Purchases – Cost of Goods Sold or Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory For example, let ending inventory in year 1 be overstated by $1,000 (e.g., $1,000 of inventory was accidentally or fraudulently double counted at the end of year 1). Therefore, in year 1 cost of goods sold will be understated, net income overstated, and inventory overstated all by $1,000. Later, assuming that inventory is properly accounted for at the end of year 2, beginning inventory (which is ending inventory in year 1) is overstated causing cost of goods sold to be overstated and net income understated by $1,000. Because ending inventory in year 2 is correct, inventory on the balance sheet of year 2 would be correct. Hence, an inventory error washes out in year two. e: Calculate the lower-of-cost-or-market amount of an inventory. After inventory is valued using specific identification, weighted average, FIFO, or LIFO, that value is compared to the current replacement market price of each distinct product in inventory. If the market price is higher than cost, then nothing is done. If the market price is lower than cost, then ending inventory is written-down to the lower replacement market price. Example: Suppose that Company X uses FIFO and that two items remain in inventory at year end. The original cost of these two items is $40 and their market value or replacement cost is $30. In this case, the inventory account would be "written down" to $30 and this $10 "loss" would be reflected on the income statement (i.e., the inventory account would fall and expenses would increase). Alternatively, if the replacement cost of these units were $50, then no write-down or additional expense recognition would occur. 1.E: Preliminary Reading Current Liabilities and the Time Value of Money a: Define liabilities, explain the difference between current and long-term liabilities, and describe the uncertanties about the value of some liabilities. Liabilities are probable future payments of assets (usually cash) or services (prepaid revenue) that a firm is obligated to make as a result of a past transaction. Current liabilities are expected to be paid within one year or operating cycle from the firm’s existing current assets. Long-term liabilities are obligations that will not be paid within the year or operating cycle. There are several uncertainties related to liabilities. Sometimes the payee is unknown. For example, when the board of directors declares a cash dividend (dividends payable) the stockholders at the future date of record are not known with certainty. Also, warranty payables are recognized at the time of sale but the payees are not yet known. Sometimes the due date is uncertain. Examples would be warranty payables and the prepayment for goods and services to be delivered at a future unspecified date. Finally, the amount may be uncertain. An example would be warranty payables. Also, at the end of the year a firm must estimate and recognize some expenses like utilities, pensions, taxes, employee benefits. b: Describe how accountants record and report estimated liabilities (such as warranties and income taxes) and contingent liabilities. In some cases, the precise amount of a liability is not known, but the liability can be reasonably estimated. Warranties are recorded as: During period of sale: Warranty expenseXX Estimated warranty payable XX When repairs made under warranty: Estimated warranty payableXX Parts inventory XX Cash XX Income taxes are recorded as: A company must estimate interim (quarterly) income taxes (say 100): Provision for income taxes (expenses)100 Income taxes payable 100 Then when taxes are determined (assumed to be greater than estimated, 115) and paid: Income taxes payable100 Provision for income taxes15 Cash 115 A contingent liability exists when, as a result of a past event, a firm is obligated to pay only if a future event occurs. The most frequent source of contingent liabilities is lawsuits for which future cash payments depend upon the result of court action. Disclosure depends on the ability to estimate the liability and likelihood of future payment of the liability. · If the future payment is probable and reasonably estimable, then the loss (expense) and liability must be disclosed on the income statement and balance sheet, respectively. · If the future payment is reasonably likely or not reasonably estimable, then only footnote disclosure is required. · If future payment is remote, then no disclosure is required. 1.F: Preliminary Reading Long-Term Assets a: Describe the difference between long-term assets and other kinds of assets. A long-term asset is an asset that has a useful life that is more than one year, is acquired for use in operations, and is not intended for resale to customers. Long-term assets are generally reported at their carrying value or book value. If however, the asset has lost its revenue-generating ability, it may be written down. A plant asset is a tangible asset that is fixed or permanent. Property, plant, and equipment (PP&E) assets are long-lived tangible assets used in the production or sale of other assets. PP&E assets’ long lives distinguish them from prepaid expenses and other current assets. PP&E assets are used and not sold (like inventory) during the business’s regular course of operations. Also, PP&E assets are not ultimately sold as would be done with interest or dividend generating investments. PP&E assets’ tangible physical existence differentiates them from intangible assets. PP&E versus other assets: The primary difference between plant assets and inventory is that plant assets are held to be used in operations, whereas inventory is held to be sold. The primary difference between plant assets and current assets in general is their useful lives. The primary difference between plant assets and long-term investments is that plant assets are used in the operations of the business. b: Calculate the cost, and record the purchase of, property, plant and equipment. The cost of plant assets, as with all assets, is their cash or cash equivalent price plus all necessary expenditures made prior to placing the asset in service. Such expenditures include transportation(in), insurance while being transported, installation cost, initial timing cost, search cost, broker cost, legal fees to transfer title, etc. If the plant is constructed, capitalized costs (added to the purchase cost of the asset) include materials, labor, reasonable amounts of overhead, interest cost during the construction period, architectural fees, etc. Cost of land includes search cost, real estate commissions, title transfer fees, back property taxes paid, surveying and landscaping costs, etc. All these expenditures are made prior to and are necessary for placing the asset in service. The entry to record these capitalized expenditures (assuming they were made in cash) is: LandXX? BuildingXX? EquipmentXX? Cash?XX c: Explain depreciation accounting (including the reasons for depreciation), calculate depreciation using the straight-line and units-of-production methods, and calculate depreciation after revising the estimated usefull life of an asset. Example (Straight Line):