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CHAPTER 3
UNDERSTANDING FINANCIAL STATEMENTS
Financial statements provide the fundamental information that we use to analyze and answer valuation questions. It is important, therefore, that we understand the principles governing these statements by looking at four questions:
- How valuable are the assets of a firm? The assets of a firm can come in several forms – assets with long lives such as land and buildings, assets with shorter lives such inventory, and intangible assets that still produce revenues for the firm such as patents and trademarks.
- How did the firm raise the funds to finance these assets? In acquiring these assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age.
- How profitable are these assets? A good investment, we argued, is one that makes a return greater than the hurdle rate. To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns we are making on these investments.
- How much uncertainty (or risk) is embedded in these assets? While we have not directly confronted the issue of risk yet, estimating how much uncertainty there is in existing investments and the implications for a firm is clearly a first step. We will look at the way accountants would answer these questions, and why the answers might be different when doing valuation. Some of these differences can be traced to the differences in objectives – accountants try to measure the current standing and immediate past performance of a firm, whereas valuation is much more forward looking.
The Basic Accounting Statements
There are three basic accounting statements that summarize information about a firm. The first is the balance sheet , shown in Figure 3.1, which summarizes the assets owned by a firm, the value of these assets and the mix of financing, debt and equity, used to finance these assets at a point in time.
Assets Liabilities
Fixed Assets Debt
Equity
Short-term liabilities of the firm
Intangible Assets
Long Lived Real Assets
Assets which are not physical, like patents & trademarks
Current Assets Investments in securities & Financial Investments assets of other firms
Short-lived Assets
Equity investment in firm
Debt obligations of firm
Current Liabilties
Other Liabilities Other long-term obligations
Figure 3.1: The Balance Sheet
The next is the income statement , shown in Figure 3.2, which provides information on the revenues and expenses of the firm, and the resulting income made by the firm, during a period. The period can be a quarter (if it is a quarterly income statement) or a year (if it is an annual report).
Cash Flows From Operations
+ Cash Flows From Investing
+ Cash Flows from Financing
Net cash flow from operations, after taxes and interest expenses
Includes divestiture and acquisition of real assets (capital expenditures) and disposal and purchase of financial assets. Also includes acquisitions of other firms.
Net cash flow from the issue and repurchase of equity, from the issue and repayment of debt and after dividend payments
= Net Change in Cash Balance
Figure 3.3: Statement of Cash Flows
The statement of cash flows can be viewed as an attempt to explain how much the cash flows during a period were, and why the cash balance changed during the period.
Asset Measurement and Valuation
When analyzing any firm, we would like to know the types of assets that it owns, the values of these assets and the degree of uncertainty about these values. Accounting statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the values of these assets and a poor job of reporting uncertainty about asset values. In this section, we will begin by looking at the accounting principles underlying asset categorization and measurement, and the limitations of financial statements in providing relevant information about assets.
Accounting Principles Underlying Asset Measurement An asset is any resource that has the potential to either generate future cash inflows or reduce future cash outflows. While that is a general definition broad enough to cover almost any kind of asset, accountants add a caveat that for a resource to be an asset. A firm has to have acquired it in a prior transaction and be able to quantify future benefits with reasonable precision. The accounting view of asset value is to a great extent grounded in the notion of historical cost , which is the original cost of the asset, adjusted upwards for improvements made to the asset since purchase and downwards for the loss in value associated with the aging of the asset. This historical cost is called the book value. While
the generally accepted accounting principles for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements.
- An Abiding Belief in Book Value as the Best Estimate of Value : Accounting estimates of asset value begin with the book value. Unless a substantial reason is given to do otherwise, accountants view the historical cost as the best estimate of the value of an asset.
- A Distrust of Market or Estimated Value: When a current market value exists for an asset that is different from the book value, accounting convention seems to view this market value with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when values are is estimated for an asset based upon expected future cash flows.
- A Preference for under estimating value rather than over estimating it : When there is more than one approach to valuing an asset, accounting convention takes the view that the more conservative (lower) estimate of value should be used rather than the less conservative (higher) estimate of value. Thus, when both market and book value are available for an asset, accounting rules often require that you use the lesser of the two numbers.
Measuring Asset Value The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balance sheet. First, there are the fixed assets , which include the long- term assets of the firm, such as plant, equipment, land and buildings. Next, we have the short-term assets of the firm, including inventory (including raw materials, work in progress and finished goods), receivables (summarizing moneys owed to the firm) and cash; these are categorized as current assets. We then have investments in the assets and securities of other firms, which are generally categorized as financial investments. Finally, we have what is loosely categorized as intangible assets. These include assets, such as patents and trademarks that presumably will create future earnings and cash flows, and also uniquely accounting assets such as goodwill that arise because of acquisitions made by the firm.
Fixed Assets Generally accepted accounting principles (GAAP) in the United States require the valuation of fixed assets at historical cost, adjusted for any estimated gain and loss in value from improvements and the aging, respectively, of these assets. While in theory the adjustments for aging should reflect the loss of earning power of the asset as it ages, in
however, that absent a decisive declaration of a bad debt, firms may continue to show as accounts receivable amounts that they know are unlikely to be ever collected.
Cash Cash is one of the few assets for which accountants and financial analysts should agree on value. The value of a cash balance should not be open to estimation error. Having said this, we should note that fewer and fewer companies actually hold cash in the conventional sense (as currency or as demand deposits in banks). Firms often invest the cash in interest-bearing accounts or in treasuries, so as to earn a return on their investments. In either case, market value can deviate from book value, especially if the investments are long term. While there is no real default risk in either of these investments, interest rate movements can affect their value. We will examine the valuation of marketable securities later in this section.
Inventory Three basis approaches to valuing inventory are allowed by GAAP: FIFO, LIFO and Weighted Average. (a) First-in, First-out (FIFO): Under FIFO , the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought latest in the year. This results in inventory being valued close to the current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three valuation approaches, and the highest net income. (b) Last-in, First-out (LIFO): Under LIFO , the cost of goods sold is based upon the cost of material bought latest in the period, while the cost of inventory is based upon the cost of material bought earliest in the year. This results in finished goods being valued close to the current production cost. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three valuation approaches, and the lowest net income. (c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all materials bought during the period. When inventory turns over rapidly, this approach will more closely resemble FIFO than LIFO. Firms often adopt the LIFO approach for its tax benefits during periods of high inflation. The cost of goods sold is then higher because it is based upon prices paid towards to the end of the accounting period. This, in turn, will reduce the reported taxable income and net income, while increasing cash flows. Studies indicate that larger firms with rising
prices for raw materials and labor, more variable inventory growth and an absence of other tax loss carry forwards are much more likely to adopt the LIFO approach. Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare the inventory values of firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. It can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.
Investments (Financial) and Marketable Securities In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms, and other marketable securities including treasury bills or bonds. The way in which these assets are valued depends upon the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment ; a minority, active investment ; or a majority, active investment. The accounting rules vary depending upon the categorization.
Minority, Passive Investments If the securities or assets owned in another firm represent less than 20% of the overall ownership of that firm, an investment is treated as a minority, passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities and often a market value. Accounting principles require that these assets be sub-categorized into one of three groups: investments that will be held to maturity, investments that are available for sale and trading investments. The valuation principles vary for each.
- For investments that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement under net interest expenses
- For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm, and unrealized gains increase the book value of equity.
- For trading investments, the valuation is at market value and the unrealized gains and losses are shown in the income statement.
Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period.
Intangible Assets Intangible assets include a wide array of assets ranging from patents and trademarks to goodwill. The accounting standards vary across intangible assets.
1. Patents and Trademarks Patents and trademarks are valued differently depending on whether they are generated internally or acquired. When patents and trademarks are generated from internal sources, such as research, the costs incurred in developing the asset are expensed in that period even though the asset might have a life of several accounting periods. Thus, the intangible asset is not usually valued in the balance sheet of the firm. In contrast, when an intangible asset is acquired from an external party, it is treated as an asset. Intangible assets have to be amortized over their expected lives, with a maximum amortization period of 40 years. The standard practice is to use straight-line amortization. For tax purposes, however, firms are not allowed to amortize goodwill or other intangible assets with no specific lifetime. 2. Goodwill Intangible assets are sometimes the by-products of acquisitions. When a firm acquires another firm, the purchase price is first allocated to tangible assets and then allocated to any intangible assets such as patents or trade names. Any residual becomes goodwill. While accounting principles suggest that goodwill captures the value of any intangibles that are not specifically identifiable, it is really a reflection of the difference between the market value of the firm owning the assets and the book value of assets. This approach is called purchase accounting and it creates an intangible asset (goodwill) which has to be amortized over 40 years. Firms, which do not want to see this charge against their earnings, often use an alternative approach called pooling accounting , in which the purchase price never shows up in the balance sheet. Instead, the book values of the two companies involved in the merger are aggregated to create the consolidated balance of the combined firm.^3
(^3) The Financial Accounting Standards Board (FASB) was considering eliminating the use of pooling and reducing the amortization period for goodwill in purchase accounting to 20 years at the time this book went to print.
Illustration 3.1: Asset Values for Boeing and the Home Depot Table 3.1 summarizes asset values, as measured in the balance sheets of Boeing, the aerospace giant, and The Home Depot, a building suppliers retailer, at the end of the 1998 financial year: Table 3.1: Assets: Boeing and the Home Depot Boeing Home Depot Net Fixed Assets $8,589 $8, Goodwill $2,312 $ Investments and Notes Receivable $0 $ Deferred Income Taxes $411 $ Prepaid Pension Expense $3,513 $ Customer Financing $4,930 $ Other Assets $542 $ Current Assets Cash $2,183 $ Short-term Marketable Investments $279 $ Accounts Receivables $3,288 $ Current Portion of Customer Financing $781 $ Deferred Income Taxes $1,495 $ Inventories $8,349 $4, Other Current Assets $0 $ Total Current Assets $16,375 $4, Total Assets $36,672 $13, There are a number of points worth noting about these asset values.
- Goodwill : Boeing, which acquired Rockwell in 1996 and McDonnell Douglas in 1997, used purchase accounting for the Rockwell acquisition and pooling for McDonnell Douglas. The goodwill on the balance sheet reflects the excess of acquisition value over book value for Rockwell and is being amortized over 30 years. With McDonnell Douglas, there is no recording of the premium paid on the acquisition among the assets.
- Customer Financing and Accounts Receivable : Boeing often either provides financing to its customers to acquire its planes or acts as the lessor on the planes. Since these contracts tend to run over several years, the present value of the payments due in future years on the financing and the lease payments is shown as customer financing. The current portion of these payments is shown as accounts receivable. The Home Depot provides credit to its customers as well, but all these payments due are shown as accounts receivable, since they are all short term.
measured primarily at book value. In the section that follows, we will examine the accounting measurement of both liabilities and equity.
Measuring the Value of Liabilities and Equities Accountants categorize liabilities into current liabilities, long term debt and long term liabilities that are neither debt nor equity. Next, we will examine the way they measure each of these.
Current Liabilities Current liabilities categorizes all obligations that the firm has coming due in the next accounting period. These generally include:
- Accounts Payable – representing credit received from suppliers and other vendors to the firm. The value of accounts payable represents the amounts due to these creditors. For this item, book and market value should be similar.
- Short term borrowing – representing short term loans (due in less than a year) taken to finance the operations or current asset needs of the business. Here again, the value shown represents the amounts due on such loans, and the book and market value should be similar, unless the default risk of the firm has changed dramatically since it borrowed the money.
- Short term portion of long term borrowing – representing the portion of the long term debt or bonds that is coming due in the next year. Here again, the value shown is the actual amount due on these loans, and market and book value should converge as the due date approaches.
- Other short term liabilities – which is a catch-all component for any other short term liabilities that the firm might have, including wages due to its employees and taxes due to the government. Of all the items on the liability side of the balance sheet, absent outright fraud, current liabilities should be the one for which the accounting estimates of book value and financial estimates of market value are the closest.
Long Term Debt Long term debt for firms can take one of two forms. It can be a long-term loan from a bank or other financial institution or it can be a long-term bond issued to financial markets, in which case the creditors are the investors in the bond. Accountants measure the value of long term debt by looking at the present value of payments due on the loan or bond at the time of the borrowing. For bank loans, this will be equal to the nominal value of the loan. With bonds, however, there are three possibilities: When bonds are issued at par value,
for instance, the value of the long-term debt is generally measured in terms of the nominal obligation created, in terms of principal (face value) due on the borrowing. When bonds are issued at a premium or a discount on par value, the bonds are recorded at the issue price, but the premium or discount to the face value is amortized over the life of the bond. As an extreme example, companies that issue zero coupon debt have to record the debt at the issue price, which will be significantly below the principal (face value) due at maturity. The difference between the issue price and the face value is amortized each period and is treated as a non-cash interest expense that is tax deductible. In all these cases, the book value of debt is unaffected by changes in interest rates during the life of the loan or bond. Note that as market interest rates rise (fall), the present value of the loan obligations should decrease (increase). This updated market value for debt is not shown on the balance sheet. If debt is retired prior to maturity, the difference between book value and the amount paid at retirement is treated as an extraordinary gain or loss in the income statement. Finally, companies which have long term debt denominated in non-domestic currencies have to adjust the book value of debt for changes in exchange rates. Since exchange rate changes reflect underlying changes in interest rates, it does imply that this debt is likely to be valued much nearer to market value than is debt in the home currency.
Other Long Term Liabilities Firms often have long term obligations that are not captured in the long term debt item. These include obligations to lessors on assets that firms have leased, to employees in the form of pension fund and health care benefits yet to be paid, and to the government in the form of taxes deferred. In the last two decades, accountants have increasingly moved towards quantifying these liabilities and showing them as long term liabilities.
1. Leases Firms often choose to lease long-term assets rather than buy them. Lease payments create the same kind of obligation that interest payments on debt create, and they must be viewed in a similar light. If a firm is allowed to lease a significant portion of its assets and keep it off its financial statements, a perusal of the statements will give a very misleading view of the company's financial strength. Consequently, accounting rules have been devised to force firms to reveal the extent of their lease obligations on their books. There are two ways of accounting for leases. In an operating lease , the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income
plan) or a 'defined benefit' (wherein the employer promises to pay a certain benefit to the employee). In the latter case, the employer has to put sufficient money into the plan each period to meet the defined benefits. Under a defined contribution plan, the firm meets its obligation once it has made the pre-specified contribution to the plan. Under a defined-benefit plan, the firm's obligations are much more difficult to estimate, since they will be determined by a number of variables including the benefits that employees are entitled to, the prior contributions made by the employer, the returns the plan have earned, and the rate of return that the employer expects to make on current contributions. As these variables change, the value of the pension fund assets can be greater than, less than or equal to pension fund liabilities (which is the present value of promised benefits). A pension fund whose assets exceed its liabilities is an over- funded plan, whereas one whose assets are less than its liabilities is an under-funded plan and disclosures to that effect have to be included in financial statements, generally in the footnotes. When a pension fund is over-funded, the firm has several options. It can withdraw the excess assets from the fund, it can discontinue contributions to the plan, or it can continue to make contributions on the assumption that the over-funding is a transitory phenomenon that could well disappear by the next period. When a fund is under-funded, the firm has a liability, though accounting standards require that firms reveal only the excess of accumulated^5 pension fund liabilities over pension fund assets on the balance sheet.
b. Health Care Benefits A firm can provide health care benefits in one of two ways: by making a fixed contribution to a health care plan, without promising specific benefits (analogous to a defined contribution plan), or by promising specific health benefits and setting aside the funds to provide these benefits (analogous to a defined benefit plan). The accounting for health care benefits is very similar to the accounting for pension obligations. The key difference between the two is that firms do not have to report^6 the excess of their health care obligations over the health care fund assets as a liability on the balance sheet, though a footnote to that effect has to be added to the financial statement.
lease. 5 The accumulated pension fund liability does not take into account the projected benefit obligation, where actuarial estimates of future benefits are made. Consequently, it is much smaller than the total pension liabilities. 6 While companies might not have to report the excess of their health care obligations over assets as a liability, some firms choose to do so anyway.
3. Deferred Taxes Firms often use different methods of accounting for tax and financial reporting purposes, leading to a question of how tax liabilities should be reported. Since accelerated depreciation and favorable inventory valuation methods for tax accounting purposes lead to a deferral of taxes, the taxes on the income reported in the financial statements will generally be much greater than the actual tax paid. The same principles of matching expenses to income that underlie accrual accounting suggest that the 'deferred income tax' be recognized in the financial statements. Thus a company which pays taxes of $55,000 on its taxable income based upon its tax accounting, and which would have paid taxes of $75,000 on the income reported in its financial statements, will be forced to recognize the difference ($20,000) as deferred taxes in liabilities. Since the deferred taxes will be paid in later years, they will be recognized as paid. It is worth noting that companies that actually pay more in taxes than the taxes they report in the financial statements create an asset on the balance sheet called a deferred tax asset. This reflects the fact that the firm's earnings in future periods will be greater as the firm is given credit for the deferred taxes. The question of whether the deferred tax liability is really a liability is an interesting one. Firms do not owe the amount categorized as deferred taxes to any entity, and treating it as a liability makes the firm look more risky than it really is. On the other hand, the firm will eventually have to pay its deferred taxes, and treating it as a liability seems to be the conservative thing to do.
Preferred Stock When a company issues preferred stock, it generally creates an obligation to pay a fixed dividend on the stock. Accounting rules have conventionally not viewed preferred stock as debt because the failure to meet preferred dividends does not result in bankruptcy. At the same time, the fact the preferred dividends are cumulative makes them more onerous than common equity. Thus, preferred stock is viewed in accounting as a hybrid security, sharing some characteristics with equity and some with debt. Preferred stock is valued on the balance sheet at its original issue price, with any cumulated unpaid dividends added on. Convertible preferred stock is treated similarly, but it is treated as equity on conversion.
Equity The accounting measure of equity is a historical cost measure. The value of equity shown on the balance sheet reflects the original proceeds received by the firm when it issued the equity, augmented by any earnings made since (or reduced by losses, if any) and
preferred stock shares almost as many characteristics with unsecured debt as it does with equity.
Illustration 3.2: Measuring Liabilities and Equity: Boeing and the Home Depot Table 3.2 summarizes the accounting estimates of liabilities and equity at Boeing and The Home Depot for the 1998 financial year: Table 3.2: Liabilities – Boeing and Home Depot Boeing Home Depot Current Liabilities Accounts Payable & other liabilities $10,733 $1, Accrued Salaries and Expenses $0 $1, Advances in excess of costs $1,251 $ Taxes payable $569 $ Short term debt and Current LT debt $869 $ Total Current Liabilities $13,422 $2, Accrued Health Care Benefits $4,831 $ Other Long Term Liabilities $0 $ Deferred Income Taxes $0 $ Long-term Debt $6,103 $1,
Minority Interests $0 $
Shareholder's Equity Par Value $5,059 $ Additional Paid-in Capital $0 $2, Retained Earnings $7,257 $5, Total Shareholder's Equity $12,316 $8, Total Liabilities $36,672 $13, The most significant difference between the companies is the accrued health care liability, representing the present value of expected health care obligations promised to employees in excess of health care assets. The shareholders’ equity for both firms represents the book value of equity and is significantly different from the market value of equity. Table 3. summarizes the difference at the end of the 1998. Table 3.3: Book and Market Value of Equity Comparison Boeing Home Depot Book Value of Equity $12,316 $8,
Market Value of Equity $32,595 $85, One final point needs to be made about the Home Depot’s liabilities. The Home Depot has substantial operating leases. Because these leases are treated as operating expenses, they do not show up in the balance sheet. Since they represent commitments to make payments in the future, we would argue that operating leases should be capitalized and treated as part of the liabilities of the firm. We will consider how best to do this later in this book.
Measuring Earnings and Profitability
How profitable is a firm? What did it earn on the assets that it invested in? These are the fundamental questions we would like financial statements to answer. Accountants use the income statement to provide information about a firm's operating activities over a specific time period. In terms of our description of the firm, the income statement is designed to measure the earnings from assets in place. In this section, we will examine the principles underlying earnings and return measurement in accounting, and the methods that they are put into practice.
Accounting Principles Underlying Measurement of Earnings and Profitability Two primary principles underlie the measurement of accounting earnings and profitability. The first is the principle of accrual accounting. In accrual accounting, the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed (in whole or substantially). A corresponding effort is made on the expense side to match^7 expenses to revenues. This is in contrast to cash accounting , where revenues are recognized when payment is received and expenses are recorded when they are paid. The second principle is the categorization of expenses into operating, financing and capital expenses. Operating expenses are expenses that, at least in theory, provide benefits only for the current period; the cost of labor and materials expended to create products that are sold in the current period is a good example. Financing expenses are expenses arising from the non-equity financing used to raise capital for the business; the most common example is interest expenses. Capital expenses are expenses that are expected to generate benefits over multiple periods; for instance, the cost of buying land and buildings is treated as a capital expense.
(^7) If a cost (such as an administrative cost) cannot be easily linked with a particular revenues, it is usually recognized as an expense in the period in which it is consumed.
