Accounting – a way in which biz activities are recorded. Why?
· Shareholders need it for biz/investing decisions
· Mgr’s for incentive pay and gauge of performance
· Creditors for ensuring they get paid, and their loan will hold
· Regulators for tax/gov’t considerations
GAAP- Generally Accepted Accounting Principles aka “book” (want big “book income”/low tax income)
GAAS- Generally Accepted Auditing Standards
Three Key Financial statements:
Balance Sheet – one-day snapshot of assets and liabilities
Income/earning Statement – yearly revenue and expenses
Cash Flow – yearly flow of cash within the firm
Additionally a statement of Shareholder Equity (four sheets total)
Annual report – Most public companies give an annual report to S/h with more detail than four sheets
Required SEC filings
10-K (annual Statement) and 10-Q (quarterly statement). These regulatory required statements can get lengthy and can include:
MD&A (Management Discussion & Analysis) – firms operations, ability to pay short-term obligations and fund operations
Notes to financial statements- detailed info on accounting policies used. (look here for below the line explanations or expenses)
Auditor’s report- speaks to the auditor’s opinion on the fairness of the presentations of the biz. If satisfied will give unqualified opinion. A qualified report shows auditor has reservations about something in report (usually noted specifically).
Limitations: BACKWARD LOOKING Shows only past and doesn’t include goodwill.
Market value and Book value are often different b/c:
1) Historical costs: the balance sheet uses the original costs, so not adjusted to present fair market value. PP&E are often purchased years ago, the building and real estate prices have chaged
2) Limitations of accounting: accounting misses goodwill and human capital (no brand value)
3) Different valuation methods: Accountants value equity as the assets net of liabilities, The Market values equity based on how much future income the firm will generate.
Shareholder Equity = book value – NOT actual value (no taxes, historical cost, etc.) instead of equity use an appraiser. Book value changes by date
Francis v. United Jersey Bank – father dies, sons take over and loot family firm by taking out loans. Mother is a director and is uninformed of the state of the biz. Gets sued, is found liable. Dirs need basic accounting knowledge of firm.
Balance sheet must balance (can have negative Equity (think underwater mortgage. Asset is less valuable than the liability of the amount of debt owed to bank)
Balance sheet: Assets = Liabilities + Equity ( so Liabilities = Assets – Equity, and Equity = Assets – Liability)
Tangible and intangible
Tangible assets: building, equipment, inventory, raw material
Intangible assets: Cash, stocks, bonds, patents, trademark (accounts receivable)
Current (short term) and non-current (long term) these match to current/non-current liability
Current assets the firm expects to sell or exchange within the normal operating cycle, current liability is an obligation expected to be paid in normal operating cycle.
Working capital (accurate cash inventory) = Current assets – current liabilities (shows liquidity(ability to pay short-term obligations))
Capital Assets = longterm assets financed by longterm liabilities & equity(long term assets are used to generate earnings (Think PP& E, property, plant and equipment) and should be funded by longterm liability (debt) or equity)
Asset line item:
prepaid expenses (leases, or insurance) count as assets
Purchased goodwill (advertising, or exception for buying another corp (their goodwill could be asset))
Depreciation and Amortization decrease in asset value is measured in asset column. Depreciation affects tangible assets, amortization affects intangible assets.
Liabilities: obligation to pay a debt
Current liabilities and Accounts payable
Deferred income taxes
Equity: synonyms are Net Worth, Net Assets (b/c = to assets – liability)
P’ship, E = partner’s capital
LLC, E = Member’s Interest
Corp, E = shareholder’s equity
*Private Co’s worth? Look to (1) transaction to purchase corp or % or corp, or (2) get appraiser
Book Value = equity stated in the balance sheet
Market Capitalization = total stock price (stock price X s/h outstanding)
Price to Book ratio (P/B) is the ratio of Market Cap/Book value (McDonald’s Ex is 5 to 1, makes sense b/c fair market value is looking to future growth or earnings and has goodwill included)
Equity Line items that can appear in Balance sheet:
Retained Earnings = Cash saved, could go towards more assets, or distributed to s/holders in div)
Common stock or capital = is the par value or minimum amt saved from stock sale to protect against creditors
APIC = Additional Paid In Capital = amt of capital raised from selling stock (net of par value)
Treasury stock = recorded as negative number (an offset against equity), this is amt paid in buying back stock from S/H.
Negative Equity (when L > A) means you are insolvent
US v. Simon – Chain of loans with big receivables on t
= Pretax Profit (taxable income)
Pretax Profit – Taxes = Net Profit (if negative #, then it is “net operating loss”)
Equity: is Net Profit, the residual income after deducting ALL expenses from revenue
EBIT = Operating Profit: Earnings Before Interest and Tax (though EBIT could include non-recurring, non-operations special expense or revenue)
EBITDA = (Good Estimate of Cash Flow from Operations) Earnings Before Interest, Tax, Depreciation, and Amortization. This gives approx. cash flow generated by operations (b/c Dep. And Amort. Are non-cash expenses that lower income)
Claimants and relation to Income Sheet
Revenue ——————————All Claimants
– COGS & SG&A ————————Suppliers/venders/employees (direct)
– Interest Expense ———————-Creditors
– Tax Expense ——————————Government
=Net Profit ————————————Equity Holders (last in line, Residual claimants)
Income Sheet relation to Balance Sheet
Net income must balance, so Net income of $20,000 is counted as cash in the Asset column, AND simultaneously counted as retained earnings on the Equity side.
Depreciation and Amortization:
Depreciation (for hard/tangible assets), Amortization (for soft/intangible assets)
Depending on method under GAAP, these can change the profits and tax burdens of a corp.
Straight line = Pro-rated, the same annual rate of expense
Accelerated Depreciation method (like declining balance method) = different D/A methods can front load the expense into one “bad” quarter. Makes success of corp hard to measure. THIS IS WHY EBITDA carves out D/A, otherwise no true estimate of cashflow from operations.
D/A on the balance sheet is recorded as a deduction from value of an asset.
Acquiring another corp, means you buy their assets and GOODWILL.
The Acquired Goodwill, is recorded as a capitalized cost in the asset column on balance sheet. It is the difference in purchase price exceeding the fair market value of a target corp.
GOODWILL is not depreciated, but can be “written down” or expensed if it is impaired (facts & circumstances)