Valuation of the Corporation
Two fundamental aspects of accounting that matter crucially to law and policy
· There is no such thing as objective truth in accounting
· People naturally will want to present financial information that suits their interests.
o fraudulently inflated values on financial statements result in liability (RMBCA § 8.31)
Financial statements are produced through a three-stage process.
“recording and controls” stage
· company records! ‘in its books information concerning every transaction in which it is, ‘involved.
· company (optionally w/ assistance of public accountants) verifies accuracy of information it has recorded
· company classifies and analyzes the audited information and presents it in a set of financial statements
Cash accounting vs. Accrual accounting
· All public firms, and most others, use accrual accounting rather than cash accounting. The goal is to prevent the firms from massaging their financial statements.
· cash accounting: a method of accounting that describes the movement of cash: account for sales when you get paid, account for expenses when you write the check
· accrual accounting: a method of accounting that uses the realization and matching principles:
o recognize revenue when goods shipped even when payment not yet received
o allocate expenses incurred in generating revenues in the period in which the revenues are recognized
· cookie jar accounting: a method of manipulating accrual accounting that WorldCom used.
· mark to market accounting: Set the value of assets to their current market value. For example, value the right to receive natural gas at the market value of that right. If the asset increases in market value, you show an income even though you didn’t sell the asset. Enron used this technique.
Balance Sheet – analogous to a “snapshot”
· Right side of the balance sheet: where firm’s money came from
· Left side of balance sheet: where firm’s money went
Assets=Liabilities + Equity
o tangible and intangible property owned by the firm
· cash, inventory, fixed assets (buildings, equipment), intangibles (patents, goodwill), accounts receivable, securities
· current assets-assets that are likely to be converted to cash within one year
o Assets generally reflect historical costs (objective & verifiable) [Cost principle] · Assets not reflection of market value, liquidation value, nor replacement value.
o Debt, whether pursuant to written evidence of indebtedness or otherwise
· current liabilities – due within the year
· long-term liabilities – due in greater than one year
î depreciation of assets represents future expense (assets are depreciated over useful life vs. in year of purchase)
î whether company uses straight line or accelerated affects apparent growth – more accelerated means more growth and lower current taxes
î intangibles are “amortized” over their useful life (similar to depreciation)
o represents the accounting value of the interest of the firm’s owners
o two sources
· shareholder (SH) investment
î “legal capital account” or “capital account” or “capital surplus”: where SH investment is tracked
î initially includes value of property (including money) the owners contribute when they organize the firm
î “earned surplus” or “retained earnings”: where earnings are tracked
o Shareholder’s equity = net assets = book value of corporation.
· paid-in capital: a legal fiction, based on the par value of the shares: how much is deemed to have been paid in as an equity cushion for the company.
· PP&E: (“P. P. and E.”): property, plant, and equipment. Fixed assets under GAAP: record them at their historic costs.
· accumulated depreciation:
or assets where we haven’t yet gotten cash in hand, and liabilities where we haven’t yet paid them.
· Total from Operating Activities: a.k.a. “cash flow from operations”. Reflects something closer to the truth.
· Net changes in cash flow show up on the balance sheet as differences in the “cash” account.
Off balance sheet financing
· Beware off balance sheet financing. Much of Enron is about this stuff. It involves incurring liabilities that the accountants say is not officially a liability, so it doesn’t appear on the balance sheet but may appear in the footnotes.
· Profit Margin – equals Net Income over Net Sales (is it increasing or decreasing)
· Operating Margin – equals Operating Expenses over Net Income (is it costing more or less to make money from year to year)
· Current Ratio – “Quick Test” equals current assets over current liabilities (ability to cover current debts as they become due)
o Working Capital – equals current assets MINUS current liabilities (how much extra cash is available for new things)
· Debt Ratio – equals total debt over total assets (how much does the company have to show for its debts)
· Debt to Equity Ratio – equals total debt over total equity (how much is the company leveraged)
· Price to Earnings Ratio – equals market price over net income (earnings) per share
Inventory Turnover Ratio – equals net sales over Inventory (how many times per year care you able to turn over you entire inventory – more is better – is the company holding too much inventory)