Lecture 2 (Jan.15)Lecture Notes Chapter 2 – Introduction to Financial Statement AnalysisChapter OverviewFinancial statements are the tools financial managers use to assess the success of a firm and to compare it to competitors. It is also the tool they use to make the correct decisions that maximize stockholder wealth. Therefore, it is absolutely imperative that students have a thorough grasp of the story each statement tells about the company and how it fits in with the other statements. Chapter 2 covers both national and international accounting standards, as well as the different types of financial statements. Most students are familiar with balance sheets and income statements, but the statement of cash flows is often overlooked. Its importance, implications, and use to the financial manager are explored thoroughly. This discussion is followed by an introduction to other sources of financial statement information that are rarely discussed in an introductory text: the management discussion and analysis, statement of stockholders’ equity, and the notes to financial statements. The chapter concludes with a look at the realities of financial reporting, including the Enron and WorldCom scandals and ensuing legislation, and a look at the role of the auditor.Accounting Regulations:Generally Accepted Accounting Principles (GAAP):Provide a common set of rules and a standard format for public companies’ financial reportsRequires that financial statements are audited by an independent auditor. This aids with Trust & Comparability.International Financing Reporting Standards (IFRS):Adopted by over 120 jurisdictions internationallyAn attempt at international convergence of accounting standardsCriticisms include the lack of clear guidance and the vast customizable nature of IFRSArent very clear, have a lot of lee-waySarbanes-Oxley (SOX) 2002:In response to the Enron scandal of 2001Limits non-audit fees to auditorRequires rotation of audit partners every 5 years;Audit committees must be dominated by outside directors and at least one of theseOutside directors must have a financial backgroundInstitutes larger penalties for providing false info to shareholders: $5 million and 20 years imprisonmentCEO & CFO must personally attest to accuracy of financial statementsCEOs & CFOs must return bonuses and/or profits from the sale of stock or the exerciseof stock options during any period covered by restated statementsSection 404 - Senior management and boards must attest to the validity of its entirefinancial control systemCostly to implement especially for small firms, up to 3% of revenuesDodd Frank (2010):Exempted smallest companies from Section 404 of SOXBroadened whistleblower provisions – an individual who provides information related toa possible violation of the federal securities laws that results in penalties by the SEC is eligible to receive from 10 to 30% of that penalty.Financial StatementsThe purpose of financial statements is to provide a means for interested outside parties, such as creditors and investors, to obtain information about a firm with an overview of the short- and long-term financial condition of a business.1. The Balance Sheet___: provides a snapshot of a firm’s financial position (assets and liabilities) at a given point in timeAssets: include cash, inventory, Property, Plant & Equipment (PP&E), and other investments a company has made. (Assets= Liabilities + Stockholder Equity)Current Assets are cash or assets that can be converted into cash within one year. (I.e. cash, inventory, short-term marketable securities, accounts receivable, and prepaid expenses)Long-Term Assets produce tangible benefits for more than one year. (I.e. PP&E and long-term investments)Depreciation is the yearly deduction made from the value of a fixed asset over time according to its life span.Book Value of Asset is the acquisition cost less the accumulated depreciation for that asset.Liabilities are a firm’s obligations to its creditors.Current Liabilities will be satisfied within one year. (I.e. accounts payable, short-term debt, current maturities of long-term debt, accrued salaries, and unearned revenue)Long-Term Liabilities extend beyond one year. (I.e. long-term loans)Stockholder’s Equity____ is a firm’s net worth from an accounting perspective.SE = Assets - LiabilitiesThis is why the left and right sides of the BS must be equal. The assets must equal liabilities plus stockholders’ equity because stockholders’ equity is the difference between assets and liabilities.SE = Common Stock + Retained EarningsStockholders’ equity is also called the Book Value of Equity or the Book Value of the Firm.Because assets are listed at book value (historical cost) rather than at market value, this measure generally isn’t likely to provide an accurate assessment of the true value of the firm’s equity. Also, many valuable, intangible assets aren’t included. These include items like the potential for growth, employee expertise, firm reputation, relationships with clients & suppliers, and the quality of management. Sometimes, stockholders’ equity is used as an estimate of Liquidation Value, the value of the firm after all its assets are sold and liabilities are paid.Recall, the Market Value of Equity is what investors are willing to pay for the firm.MVE = Number of Shares x Price/Share = market capitalizationRather than being based on the historical cost of the firm’s assets, MVE is dependent on what investors expect those assets to produce in the future.2. Income Statement: provides details about a firm’s revenues and expenses over a period of time (generated by the assets and liabilities covered in the balance statement).SalesCost of SalesGross ProfitOperating ExpensesOperating Income + Other IncomeEarnings Before Interest & Taxes (EBIT) - Interest ExpenseEarnings Before Taxes (EBT) - Pretax Income – TaxesNet IncomeNet Income is “the bottom line” of the income statement. It is a measure of profitability during the period.Operating Expenses are expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold.EPS = Net Income/ Shares Outstanding Note: Shares outstanding may be affected by outstanding stock options and convertible bonds.Diluted EPS is reported to include these effects:Diluted EPS = Net Income/ (Shares Outstanding + Stock Options + Convertible Bonds)Earnings Before Interest, Taxes,