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APPENDIX 2

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.
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.




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Figure 1: The Balance Sheet
Assets Liabilities
Current Short-term liabilities of the firm
Long Lived Real Assets Fixed Assets Liabilties
Short-lived Assets Current Assets Debt Debt obligations of firm

Investments in securities & Financial Investments Other
Other long-term obligations
assets of other firms Liabilities

Assets which are not physical, Intangible Assets
Equity Equity investment in firm
like patents & trademarks


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).
Figure 2: Income Statement


Gross revenues from sale
Revenues
of products or services
Expenses associates with
- Operating Expenses
generating revenues

Operating income for the = Operating Income
period

Expenses associated with - Financial Expenses
borrowing and other financing

Taxes due on taxable income - Taxes

Earnings to Common &
= Net Income before extraordinary items
Preferred Equity for
Current Period

- (+) Extraordinary Losses (Profits)
Profits and Losses not
associated with operations
Profits or losses associated - Income Changes Associated with Accounting Changes
with changes in accounting
rules
Dividends paid to preferred - Preferred Dividends
stockholders

= Net Income to Common Stockholders


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Finally, there is the statement of cash flows, shown in figure 3.3, which specifies the
sources and uses of cash of the firm from operating, investing and financing activities,
during a period.
Figure 3: Statement of Cash Flows

Net cash flow from operations,
Cash Flows From Operations
after taxes and interest expenses



Includes divestiture and acquisition
of real assets (capital expenditures)
+ Cash Flows From Investing
and disposal and purchase of
financial assets. Also include
acquisition of other firms.

Net cash flow from the issue and
+ Cash Flows from Financing
repurchase of equity, from the
issue and repayment of debt and after
dividend payments


= Net Change in Cash Balance
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.


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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



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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
practice they are much more a product of accounting rules and convention, and these
adjustments are called depreciation. Depreciation methods can very broadly be
categorized into straight line (where the loss in asset value is assumed to be the same
every year over its lifetime) and accelerated (where the asset loses more value in the
earlier years and less in the later years). [While tax rules, at least in the United States,
have restricted the freedom that firms have on their choice of asset life and depreciation
methods, firms continue to have a significant amount of flexibility on these decisions for
reporting purposes. Thus, the depreciation that is reported in the annual reports may not,
and generally is not, the same depreciation that is used in the tax statements.

Current Assets
Current assets include inventory, cash and accounts receivables. It is in this
category that accountants are most amenable to the use of market value, especially in
valuing marketable securities.
Accounts receivable represent money owed by entities to the firm on the sale of

products on credit. The accounting convention is for accounts receivable to be
recorded as the amount owed to the firm, based upon the billing at the time of the
credit sale. The only major valuation and accounting issue is when the firm has to
recognize accounts receivable that are not collectible. Firms can set aside a portion of



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their income to cover expected bad debts from credit sales, and accounts receivable
will be reduced by this reserve. Alternatively, the bad debts can be recognized as they
occur and the firm can reduce the accounts receivable accordingly. There is the
danger, 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 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.
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.
(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.
(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


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taxable income and net income, while increasing cash flows. 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




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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.
Firms are allowed an element of discretion in the way they classify investments and,
subsequently, in the way they value these assets. This classification ensures that firms
such as investment banks, whose assets are primarily securities held in other firms for
purposes of trading, revalue the bulk of these assets at market levels each period. This is
called marking-to-market and provides one of the few instances in which market value
trumps book value in accounting statements.

Minority, Active Investments
If the securities or assets owned in another firm represent between 20% and 50%
of the overall ownership of that firm, an investment is treated as a minority, active
investment. While these investments have an initial acquisition value, a proportional
share (based upon ownership proportion) of the net income and losses made by the firm
in which the investment was made, is used to adjust the acquisition cost. In addition, the
dividends received from the investment reduce the acquisition cost. This approach to
valuing investments is called the equity approach. The market value of these
investments is not considered until the investment is liquidated, at which point the gain or
loss from the sale, relative to the adjusted acquisition cost is shown as part of the earnings
under extraordinary items in that period.

Majority, Active Investments
If the securities or assets owned in another firm represent more than 50% of the
overall ownership of that firm, an investment is treated as a majority active investment1.
In this case, the investment is no longer shown as a financial investment but is instead
replaced by the assets and liabilities of the firm in which the investment was made. This
approach leads to a consolidation of the balance sheets of the two firms, where the assets
and liabilities of the two firms are merged and presented as one balance sheet. The share




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of the firm that is owned by other investors is shown as a minority interest on the
liability side of the balance sheet. A similar consolidation occurs in the financial
statements of the other firm as well. The statement of cash flows reflects the cumulated
cash inflows and outflows of the combined firm. This is in contrast to the equity
approach, used for minority active investments, in which only the dividends received on
the investment are shown as a cash inflow in the cash flow 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



1 Firms have evaded the requirements of consolidation by keeping their share of ownership in other firms
below 50%.


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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.2

Measuring Financing Mix
The second set of questions that we would like to answer and accounting
statements to shed some light on relates to the current value and subsequently the mixture
of debt and equity used by the firm. The bulk of the information about these questions is
provided on the liability side of the balance sheet and the footnotes.

Accounting Principles Underlying Liability and Equity Measurement
Just as with the measurement of asset value, the accounting categorization of
liabilities and equity is governed by a set of fairly rigid principles. The first is a strict
categorization of financing into either a liability or equity based upon the nature of the
obligation. For an obligation to be recognized as a liability, it must meet three
requirements:
It must be expected to lead to a future cash outflow or the loss of a future cash inflow

at some specified or determinable date,
The firm cannot avoid the obligation.

The transaction giving rise to the obligation has happened already.

In keeping with the earlier principle of conservatism in estimating asset value,
accountants recognize as liabilities only cash flow obligations that cannot be avoided.




2 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.


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The second principle is that the value of both liabilities and equity in a firm are
better estimated using historical costs with accounting adjustments, rather than with
expected future cash flows or market value. The process by which accountants measure
the value of liabilities and equities is inextricably linked to the way they value assets.
Since assets are primarily valued at historical cost or at book value, both debt and equity
also get 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 include 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.




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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.




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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
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
statement and the lease does not affect the balance sheet. In a capital lease, the lessee
assumes some of the risks of ownership and enjoys some of the benefits. Consequently,
the lease, when signed, is recognized both as an asset and as a liability (for the lease
payments) on the balance sheet. The firm gets to claim depreciation each year on the
asset and also deducts the interest expense component of the lease payment each year. In
general, capital leases recognize expenses sooner than equivalent operating leases.
Since firms prefer to keep leases off the books and sometimes to defer expenses
they have a strong incentive to report all leases as operating leases. Consequently the
Financial Accounting Standards Board has ruled that a lease should be treated as a capital
lease if it meets any one of the following four conditions.
(a) The lease life exceeds 75% of the life of the asset.
(b) There is a transfer of ownership to the lessee at the end of the lease term.
(c) There is an option to purchase the asset at a "bargain price" at the end of the lease
term.
(d) The present value of the lease payments, discounted at an appropriate discount rate,
exceeds 90% of the fair market value of the asset.
The lessor uses the same criteria for determining whether the lease is a capital or
operating lease and accounts for it accordingly. If it is a capital lease, the lessor records
the present value of future cash flows as revenue and recognizes expenses. The lease



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receivable is also shown as an asset on the balance sheet and the interest revenue is
recognized over the term of the lease as paid.
From a tax standpoint, the lessor can claim the tax benefits of the leased asset
only if it is an operating lease, though the revenue code uses slightly different criteria3 for
determining whether the lease is an operating lease.

2. Employee Benefits
Employers provide pension and health care benefits to their employees. In many
cases, the obligations created by these benefits are extensive and a failure by the firm to
adequately fund these obligations needs to be revealed in financial statements.

a. Pension Plans
In a pension plan, the firm agrees to provide certain benefits to its employees,
either by specifying a 'defined contribution' (wherein a fixed contribution is made to the
plan each year by the employer, without any promises as to the benefits which will be
delivered in the 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




3 The requirements for an operating lease in the revenue code are as follows - (a) the property can be used
by someone other than the lessee at the end of the lease term, (b) the lessee cannot buy the asset using a
bargain purchase option, (c) the lessor has at least 20% of its capital at risk, (d) the lessor has a positive
cash flow from the lease independent of tax benefits and (e) the lessee does not have an investment in the
lease.


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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 accumulated4 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 report5 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.

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


4 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.
5 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.


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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 reduced by any dividends paid out during the period. While these three items go into
what we can call the book value of equity, a few other items also end up in this estimate.




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1. When companies buy back stock for short periods, with the intent of reissuing the
stock or using it to cover option exercises, they are allowed to show the repurchased
stock as treasury stock, which reduces the book value of equity. Firms are not allowed
to keep treasury stock on the books for extended periods and have to reduce their
book value of equity by the value of repurchased stock in the case of actions such as
stock buybacks. Since these buybacks occur at the current market price, they can
result in significant reductions in the book value of equity.
2. Firms that have significant losses over extended periods or carry out massive stock
buybacks can end up with negative book values of equity.
3. Relating back to our discussion of marketable securities, any unrealized gain or loss
in marketable securities that are classified as available-for-sale is shown as an
increase or decrease in the book value of equity in the balance sheet.
As part of their financial statements, firms provide a summary of changes in shareholders
equity during the period, where all the changes that occurred to the accounting (book
value) measure of equity value are summarized.
Accounting rules still do not seem to have come to grips with the effect of
warrants and equity options (such as those granted by many firms to management) on the
book value of equity. If warrants are issued to financial markets, the proceeds from this
issue will show up as part of the book value of equity. In the far more prevalent case
where options are given or granted to management, there is no effect on the book value of
equity. When the options are exercised, the cash inflows from the exercise do ultimately
show up in the book value of equity and there is a corresponding increase in the number
of shares outstanding. The same point can be made about convertible bonds, which are
treated as debt until conversion, at which point they become part of equity. In partial
defense of accountants, we must note that the effect of options outstanding is often
revealed when earnings and book value are computed on a per share basis. Here, the
computation is made on two bases, the first on the current number of shares outstanding
(primary shares outstanding) and the second on the number of shares outstanding after all
options have been exercised (fully diluted shares outstanding).
As a final point on equity, accounting rules still seem to consider preferred stock,
with its fixed dividend, as equity or near-equity, largely because of the fact that preferred


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dividends can be deferred or cumulated without the risk of default. To the extent that
there can still be a loss of control in the firm (as opposed to bankruptcy), we would argue
that preferred stock shares almost as many characteristics with unsecured debt as it does
with equity.

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 match6 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




6 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.


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expected to generate benefits over multiple periods; for instance, the cost of buying land
and buildings is treated as a capital expense.
Operating expenses are subtracted from revenues in the current period to arrive at
a measure of operating earnings from the firm. Financing expenses are subtracted from
operating earnings to estimate earnings to equity investors or net income. Capital
expenses are written off over their useful life (in terms of generating benefits) as
depreciation or amortization.

Measuring Accounting Earnings and Profitability
Since income can be generated from a number of different sources, generally
accepted accounting principles (GAAP) require that income statements be classified into
four sections: income from continuing operations, income from discontinued operations,
extraordinary gains or losses and adjustments for changes in accounting principles.
Generally accepted accounting principles require the recognition of revenues
when the service for which the firm is getting paid has been performed in full or
substantially and for which it has received in return either cash or a receivable that is both
observable and measurable. Expenses linked directly to the production of revenues (like
labor and materials) are recognized in the same period in which revenues are recognized.
Any expenses that are not directly linked to the production of revenues are recognized in
the period in which the firm consumes the services.
While accrual accounting is straightforward in firms that produce goods and sell
them, there are special cases where accrual accounting can be complicated by the nature
of the product or service being offered. For instance, firms that enter into long term
contracts with their customers, for instance, are allowed to recognize revenue on the basis
of the percentage of the contract that is completed. As the revenue is recognized on a
percentage of completion basis, a corresponding proportion of the expense is also
recognized. When there is considerable uncertainty about the capacity of the buyer of a
good or service to pay for a service, the firm providing the good or service may recognize
the income only when it collects portions of the selling price under the installment
method.




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Reverting back to our discussion of the difference between capital and operating
expenses, operating expenses should reflect only those expenses that create revenues in
the current period. In practice, however, a number of expenses are classified as operating
expenses that do not seem to meet this test. The first is depreciation and amortization.
While the notion that capital expenditures should be written off over multiple periods is
reasonable, the accounting depreciation that is computed on the original historical cost
often bears little resemblance to the actual economical depreciation. The second expense
is research and development expenses, which accounting standards in the United States
classify as operating expenses, but which clearly provide benefits over multiple periods.
The rationale used for this classification is that the benefits cannot be counted on or
easily quantified.
Much of financial analysis is built around the expected future earnings of a firm, and
many of these forecasts start with the current earnings. It is therefore important that we
know how much of these earnings come from the ongoing operations of the firm, and
how much can be attributed to unusual or extraordinary events that are unlikely to recur
on a regular basis. From that standpoint, it is useful that firms categorize expenses into
operating and nonrecurring expenses, since it is the earnings prior to extraordinary items
that should be used in forecasting. Nonrecurring items include the following:
1. Unusual or Infrequent items, such as gains or losses from the divestiture of an asset or
division and write-offs or restructuring costs. Companies sometimes include such
items as part of operating expenses. As an example, Boeing in 1997 took a write-off
of $1,400 million to adjust the value of assets it acquired in its acquisition of
McDonnell Douglas, and it showed this as part of operating expenses.
2. Extraordinary items, which are defined as events that are unusual in nature,
infrequent in occurrence and material in impact. Examples include the accounting
gain associated with refinancing high coupon debt with lower coupon debt, and gains
or losses from marketable securities that are held by the firm.
3. Losses associated with discontinued operations, which measure both the loss from the
phase out period and the estimated loss on the sale of the operations. To qualify,
however, the operations have to be separable separated from the firm.




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4. Gains or losses associated with accounting changes, which measure earnings changes
created by accounting changes made voluntarily by the firm (such as a change in
inventory valuation and change in reporting period) and accounting changes
mandated by new accounting standards.

Measures of Profitability
While the income statement allows us to estimate how profitable a firm is in
absolute terms, it is just as important that we gauge the profitability of the firm in
comparison terms or percentage returns. Two basic gauges measure profitability. One
examines the profitability relative to the capital employed to get a rate of return on
investment. This can be done either from the viewpoint of just the equity investors, or by
looking at the entire firm. Another examines profitability relative to sales, by estimating a
profit margin.

I. Return on Assets (ROA) & Return on Capital (ROC)
The return on assets (ROA) of a firm measures its operating efficiency in
generating profits from its assets, prior to the effects of financing.
EBIT ( - tax rate )
1
ROA =
Total Assets
Earnings before interest and taxes (EBIT) is the accounting measure of operating income
from the income statement and total assets refers to the assets as measured using
accounting rules, i.e., using book value for most assets. Alternatively, return on assets can
be written as:
Net Income + Interest Expenses ( - tax rate )
1
ROA =
Total Assets
By separating the financing effects from the operating effects, the return on assets
provides a cleaner measure of the true return on these assets.
ROA can also be computed on a pre-tax basis with no loss of generality, by using
the earnings before interest and taxes (EBIT), and not adjusting for taxes -


EBIT
Pre - tax ROA =
Total Assets




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This measure is useful if the firm or division is being evaluated for purchase by an
acquirer with a different tax rate or structure.
A more useful measure of return relates the operating income to the capital
invested in the firm, where capital is defined as the sum of the book value of debt and
equity. This is the return on capital (ROC). When a substantial portion of the liabilities is
either current (such as accounts payable) or non-interest bearing, this approach provides a
better measure of the true return earned on capital employed in the business.


EBIT ( - t )
1
After - Tax ROC =
BV of Debt + BV of Equity
EBIT
Pre - Tax ROC =
BV of Debt + BV of Equity

Decomposing Return on Capital
The return on capital of a firm can be written as a function of its operating profit
margin and its capital turnover ratio.
EBIT (1- t ) EBIT (1- t ) Sales
After - Tax ROC = X
=
BV of Capital Sales BV of Capital
= After - Tax Operating Margin * Capital Turnover Ratio
Pre - Tax ROC = Pre - Tax Operating Margin * Capital Turnover Ratio
Thus, a firm can arrive at a high ROC by either increasing its profit margin or more
efficiently utilizing its capital to increase sales. There are likely to be competitive
constraints and technological constraints on increasing sales, but firms still have some
freedom within these constraints to choose the mix of profit margin and capital turnover
that maximizes their ROC. The return on capital varies widely across firms in different
businesses, largely as a consequence of differences in profit margins and capital turnover
ratios.

II. Return on Equity
While the return on capital measures the profitability of the overall firm, the
return on equity (ROE) examines profitability from the perspective of the equity investor
by relating profits to the equity investor (net profit after taxes and interest expenses) to
the book value of the equity investment.


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Net Income
ROE =
Book Value of Common Equity
Since preferred stockholders have a different type of claim on the firm than do common
stockholders, the net income should be estimated after preferred dividends and the book
value of common equity should not include the book value of preferred stock. This can be
accomplished by using net income after preferred dividends in the numerator and the
book value of common equity in the denominator.

Summary
Financial statements remain the primary source of information for most investors
and analysts. There are differences, however, in how accounting and financial analysis
approach answering a number of key questions about the firm. We examine these
differences in this chapter.
The first question that we examined related to the nature and the value of the
assets owned by a firm. Categorizing assets into investments already made (assets in
place) and investments yet to be made (growth assets), we argued that accounting
statements provide a substantial amount of historical information about the former and
very little about the latter. The focus on the original price of assets in place (book value)
in accounting statements can lead to significant differences between the stated value of
these assets and their market value. With growth assets, accounting rules result in low or
no values for assets generated by internal research.
The second issue that we examined was the measurement of profitability. The two
principles that seem to govern how profits are measured are accrual accounting “
revenues and expenses are shown in the period where transactions occur rather than when
the cash is received or paid “ and the categorization of expenses into operating, financing
and capital expenses. Operating and financing expenses are shown in income statements.
Capital expenditures take the form of depreciation and amortization and are spread over
several time periods. Accounting standards miscategorize operating leases and research
and development expenses as operating expenses (when the former should be categorized
as financing expenses and the latter as capital expenses).



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