Financial Statement Analysis & Valuation [6 ed.] 9781618533609

Table of contents :
Financial Statement Analysis and Valuation, 6th Edition [Easton, McAnally]
Title Page
Copyright
About the Authors
Preface
Brief Contents
Contents
Module 1 Framework for Analysis and Valuation
Module 2 Review of Business Activities and Financial Statemen
Module 3 ProfitabiIity Analysis and Interpretation
Module 4 Credit Risk Analysis and Interpretation
Module 5 Revenue Recognition and Operating Income
Module 6 Asset Recognition and Operating Assets
Module 7 Liability Recognition and Nonowner Financing
Module 8 Equity Recognition and Owner Financing
Module 9 lntercorporateI nvestments
Module 10 Analyzing Leases, Pensions, and Taxes
Module 11 Financial Statement
Module 12 Cost of Capital and Valuation Basics
Module 13 Cash-Flow-Based Valuation3
Module 14 Operating-IncomeBased Valuation
Module 15 Market-Based Valuation
Appendix A Compound Interest Tables
Appendix B Computing and Analyzing Cash Flows
Appendix C Comprehensive Case
Appendix D Chart of Accounts (with Acronyms)
Glossary
Index

Citation preview

Financial Statement Analysis & Valuation Sixth Edition

Peter D. Easton University of Notre Dame

Mary Lea McAnally Texas A&M University

Gregory A. Sommers Southern Methodist University

Cambridge BUSINESS PUBLISHERS

'

To my daughters, Joanne and Stacey - PDE

To my husband Brittan, and my children Loic, Cindy, Maclean, Lacey, Quinn, and Kay - MLM

To my wife Susan, and my children Christian, Peter, and Philip - GAS

Financial Statement Analysis & Valuation, Sixth Edition, by Pe te r D. Easton, Mary Lea McAnally, and Gregory A. Sommers. CO PYRIGHT © 202 1 by Cambridge Business Publishers, LLC . Published by Cambridge Business Publishers, LLC. Exclusive rights by Cambridge Business Publishers, LLC for manufacture and export. ALL RIGHTS RES ERVED. No part of this publication may be reproduced, distributed, or stored in a database or retrieval system in any form or by any means, without prior written consent of Cambridge Business Publishe rs, LLC, including, but not limited to, in a ny network or other electronic storage or transmission, or broadcast for distance learning.

Student Edition ISBN 978-1-61853-360-9

Bookstores & Faculty: to order this book, call 800-619-6473 or email [email protected].

Students: to order this book, please visit the book' s website and order directly online. Printed in Canada. 10 9 8 7 6 5 4 3 2

About the Authors

is an expert in accounting and val- MARY LEA MCANALLY is the PwC Professor of uation and holds the Notre Dame Alumni Chair in Accoun- Accounting at Mays Business School at Texas A&M Unitancy in the Mendoza College of Business. Professor versity. She obtained her PhD from Stanford University Easton's expertise is widely recognized by the academic and B. Comm. from the Un ivers ity of Alberta. She worked research community and by the legal community. Professor as a Chartered Accountant (in Canada) and is a Certified Easton frequently serves as a consultant on accounting and Internal Auditor. Prior to arriving at Texas A&M in 2002, Professor McAnally held positions at University of Texas valuation issues in federal and state courts. Professor Easton holds undergraduate degrees from at Austin, Canadian National Railways, and Dunwoody the University of Adelaide and the University of South and Company. Australia. He holds a graduate degree from the University Professor McAnally teaches financial re porting, analyof New England and a PhD in Business Administratio n s is, and valuation in the full -time, Professional, and (majoring in accounting and finance) from the University Executive MBA programs. Through the Mays Center for Executive Development, she works with a wide range of California, Berkeley. Professor Easton 's research on corporate valuation of corporate clients. As a Certified Appreciative Inquiry has been published in the Journal of Accounting and Eco- Facilitator, Professor McAnally helps academic units nomics, Journal of Accounting Research, The Accounting (departments, colleges, and institutes) develop and impleReview, Contemporary Accounting Research, Review of ment strategic plans . She has also taught at the University Accounting Studies, and Journal of Business Finance and of A lberta, University of Calgary, IMADEC (in Austri a), Accounting. Professor Easton has served as an associate and at the Indian School of Business at the Hyderabad and editor for 11 leading accounting journals and he is cur- Mohali campuses. She has received numerous fac ultyrently an associate editor for the Journal of Accounting determined and student-initiated teaching awards at the Research, Journal of Business Finance and Accounting, MBA and executive levels. and Journal of Accounting, Auditing, and Finance. He is Professor McAnall y's research interests include an editor of the Review of Accounting Studies. accounting and disclosure in regulated environments, Professor Easton has held appointments at the Univer- executive compensation, and accounting for risk. She sity of Chicago, the University of California at Berkeley, has published articles in the leading academic journals Ohio State University, Macquarie University, the Aus- including Journal of Accounting and Economics, Journal tral ian Graduate School of Management, the University of Accounting Research, The Accounting Review, Review of Melbourne, Tilburg Uni versity, National University of Accounting Studies, and Contemporary Accounting of S ingapore, Seoul National University, and Nyenrode Research. She was Associate Editor at Accounting HoriUniversity. He is the recipient of numerous awards for zons, served on the editorial board of Contemporary excellence in teaching and in research. Professor Easton Accounting Research, and was G uest Editor for the regularly teaches accounting analysis and security valu- MBA-teaching volume of Issues in Accounting Education. ation to MBAs. In addition, Professor Easton has taught managerial accounting at the graduate level. PETER D. EASTON

© Cambridge Business Publishers

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About the Authors

GREGORY A. SOMMERS is Director of the Master of Science in Accounting program and Professor of Practice in Accounting in the Edwin L. Cox School of Business at Southern Methodist University. He holds an undergraduate degree in accounting from Fresno Pacific University and a PhD in Accounting and Management Information Systems from The Ohio State University. Professor Sommers is a Certified Public Accountant who practiced in and continues to be licensed in Californ ia. Professor Sommers' research focuses on market-based empirical studies of the relations between currently available accounting data, expectations of future accounting data, expected cost of capital and valuation. His research has been published in Journal of A ccounting Research, Journal of Business, Finance, and Accounting, and Journal of Applied Corporate Finance. Professor Sommers serves on the editorial board of Review of Accounting Studies. Professor Sommers teaches financial accounting in the undergraduate

and graduate programs as well as in executive education at Southern Methodist University. He has taught financial statement analysis and valuation for over 15 years at the graduate level. In addition to being an author on another textbook in financial Statement Analysis, his teaching materials were previously utili zed as resources for another author's textbook in this area. Professor Sommers' teaching has earned him numerous awards including Outstanding MBA Teaching as well as recognition from student organizations. Professor Sommers is an active member of the American Accounting Association and its Financial Accounting and Re porting and Accounting Program Leaders Group Sections. He has served as chairman of the Trueblood Seminar for Professors sponsored by Deloitte. Professor Sommers is recognized as an expert in the areas of financial reporting, financial analysis, estimation of cost of capital, and business valuation.

Preface

Welcome to the Sixth Edition of Financial Statement Analysis & Valuation. Our main goal in writing this book was to address the needs of today's instructors and students interested in financial analysis and valuation by providing the most contemporary, engaging, and user-oriented textbook avai lable. This book is the product of extensive market research including focus groups, market surveys, class tests, manuscript reviews, and interviews with faculty from across the country. We are grateful to students and faculty whose insights, suggestions and feedback greatly benefited this edition.

TARGET AUDIENCE Financial Statement Analysis & Valuation is intended for use in a financial statement analysis and/or valuation course in which profitability analysis and security valuation are emphas ized. This book accommodates mini-courses lasting only a few days as well as extended courses lasting a full semester.

INNOVATIVE APPROACH Financial Statement Analysis & Valuation is applications oriented and focuses on the most salient aspects of accounting, analysis, and valuation. It teaches students how to read, analyze, and interpret financ ial statement data to make informed business decisions. This textbook makes financial statement analysis and valuation engaging, relevant, and contemporary. To that end, it consistently incorporates real company data, both in the body of each modu le and throughout the assignment material.

FLEXIBLE STRUCTURE The curricula, instructor preferences, and course lengths vary across colleges. Accordingly and to the extent possible, the 15 modules that make up Financial Statement Analysis & Valuation were designed independently of one another. This modular presentation enables each college and instructor to "customize" the book to best fit their needs. Our introduction and discussion of financial statements constitute Modules I and 2. Module 3 presents the analysis of financial statements with an emphasis on analysis of operating profitability. Module 4 introduces credit risk analysis. Modules 5 through 10 offer an analysis of accounting numbers and disclosures. The aim of those modules is to help us better interpret financial statements and to adjust those statements as necessary to improve our financial statement analysis. Modules 11 through 15 describe forecasting, cost of capital estimation, and company valuation.

©Cambrid ge Business Publishers

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Preface

Flexibility for Courses of Varying Lengths Many instructors have approached us to ask about suggested class structures based on courses of varying length. To that end, we provide the following table of possible course designs. For instructors desiring greater emphasis on accounting analysis, additional time can be spent on Modules 1 through 10. For instructors des iring greater emphasis on analysis and valuation, additional time can be spent on Modules 11 through 15. 15 Week Semester-Course MODULE 1 Framework for Analysis and Valuation

10 Week Quarter-Course

MODULE 3 Profitability Analysis and Interpretation

MODULE 4 Credit Risk Analysis and Interpretation

MODULE 5 Revenue Recognition and Operating Income

MODULE 6 Asset Recognition and Operating Assets

1 Week Intensive-Course

Week 1 (Modules 1 and 2)

Week 1 (Modules 1 and 2)

Day 1 (Modules 1 and 2)

Week2

Week2

L

Week 1

MODULE 2 Review of Business Activities and Financial Statements

6Week Mini-Course

Week 2

Week3

Day 2

--Week4

Week3

Optional

Weeks

Week4

Week 3

Optional

Day 3 (Modules 5 and 6 ) Week 6

Weeks

Skim

Week?

Optional

Optional

MODULE 7 Liability Recognition and Nonowner Financing

MODULE 8 Equity Recognition and Owner Financing

MODULE 9 lntercorporate Investments

MODULE 10 Analyzing Leases, Pensions, and Taxes

Optional

--Week8

Optional

Optional

Optional

Week9

Week6

Optional

Optional

Week 10

Week 7

Skim

Optional

Week8

Week4

-

--MODULE 11 Forecasting Financial Statements

MODULE 12 Cost of Capital and Valuation Basics

MODULE 13 Cash-Flow-Based Valuation

MODULE 14 Operating-Income-Based Valuation

MODULE 15 Market-Based Valuation

Week 11

Day 4 (Modules 11 and 12)

--Week 12

Week9

Weeks

Week 13

Weeks 9 and 10

Weeks Sand 6 Day S (Modules 13 and 14)

Week 14

Week 10

Week 6

Week 1S

Optional

Optional

Optional

Preface

THE ONLy FSA TEXT WITH

AN ONLINE LEARNING AND HOMEWORK SYSTEM

~ is an online learning and assessment program intended to complement your textbook and faculty instruction. Access to myBusinessCourse is FREE ONLY with the purchase of a new textbook, but access can be purchased separately. MBC is ideal for faculty seeking opportunities to augment their course with an online component. MBC is also a turnkey solution for online and hybrid courses. The following are some of the features ofMBC.

Increase Student Readiness •

eLecture videos cover each module's learning objectives and concepts. Consistent w ith the text, and created by the authors, these videos are ideal for online learning and review, as well as online instruction.

•

Reviews are narrated video demonstrations created by

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the authors that show students how to solve the Review problems from the textbook. Immediate feedback with auto-graded homework.

•

Test Bank questions that can be incorporated into your

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Identify where your students are struggling and customize your instruction to address their needs. Gauge how your entire class or individual students are performing by viewing the easy-to-use gradebook. Ensure your students are getting the additional reinforcement and direction they need between class meetings.

86o/o of students said they would encourage their professor to continue using MBC in future terms.*

Provide Instruction and Practice 24/7 •

Assign homework from your Cambridge Business Publishers' textbook and have MBC grade it for you automatically.

•

With our Videos, your students can revisit accounting topics as often as they like or until they master the topic.

•

Make homework due before class to ensure students enter your classroom prepared.

Integrate with LMS ~ integrates with many learning management systems, including Canvas, Blackboard, Moodie, D2L, Schoology, and Sakai. Your gradebooks sync automatically.

' These statistics are based on the results of two surveys in which 2,330 students participated.

vii

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Preface

INNOVATIVE PEDAGOGY Financial Statement Analysis & Valuation includes special features specifically designed for the student with a keen interest in analysis and valuation.

Focus Companies for Each Module Each module's content is explained thro ugh the reporting activities of real companies. To that end, each module incorporates a "focus company" for special emphasis and demonstration. T he enhanced instructional value of focus companies comes from the way they engage students in real analys is and interpretation. Focus companies were selected based on the industries that business students typically enter upon graduation.

Focus Company by Module MODULE 1

Apple

MODULE 10

Microsoft , Deere, and HP

MODULE 2

Apple

MODULE 11

Procter & Gamble

MODULE 3

Apple

MODULE 4

Home Depot

MODULE 12 -- MODULE13 -- -

MODULE 5

Pfizer

MODULE 6

Home Depot

MODULE 7

Verizon

MODULE 8

Johnson & Johnson

MODULE 9

Google

-

-

-

NextEra Energy, Inc. Procter & Gamble

MODULE 14

Procter & Gamble

MODULE 15

Dollar General

APPENDIX B

Starbucks

APPENDIX C

Harley-Davidson

Real Company Data Throughout Market research and reviewer feedback tell us that one of instructors' greatest frustrations with other financial statement analysis and valuatio n textbooks is their lack of real, contemporary company data. We have gone to great lengths to incorporate real company data throughout each module to reinforce important concepts and engage students. We engage nonaccounting students specializing in finance, marketing, management, real estate, operations, and so forth, with companies and scenarios that are relevant to them. For representative examples, SEE PAGES 3-17, 5-17, 6-22.

Analyst Adjustments Analyst Adjustments are incorporated throughout most of the modules. These boxed elements ex plain and illustrate the types of adjustments analysts make to accounting information to make it more useful in their assessment of a firm. For representative examples, SEE PAGES 5-14, 6-28, 7-7. ANALYST ADJUSTMENTS 5.2

Adjusting for Allowances on Accounts Recelvable

As we analyze allowances, we know managers have latitude in the amount of allowance they record within GAAP. Allowances such as those tor sales returns and discounts (discussed in a prior section) and that for doubtful accounts (dscussed here) are susceptible to managerial latitude. For example, if a manager records an allowance for doubtful accounts that is too small, bad debt expense is too lo w fo r that period. This overstates net income for that period as well as accounts receivable and total assets. Conversely, an allowance that is too large is consistent with an inflated bad debt expense. Under either scenario, income and total assets are misstated for that period. Returning to Pfizer, we observe that the company's allowance has been decreasing over the past three years as shown below and that a more reasonable estimate might be to keep the allowance at the same proportion of accounts receivable, gross, for those years. W e can adjust the relevant balance sheet and income statement accounts and then use the adjusted numbers (instead of the numbers as reported by the company) in subsequent analyses. The following Pfizer financial statement data , a long with adjustments, are used for a reform.Jlation. We determine the average percentage o f the allowance amount to t he gross accounts receivable as follows.

L; Allowance for doubttul accounts

I Accounts rece;vable, gross

$609+ $584 + $541

6 61713

= $8,834 + $8,805 + $8,566 = ·

We then estimate the allowance for doubtful accounts using the average percent for each of the past 3 years.

Preface

Data Analytics and Data Visualization New technologies are changing the landscape of accounting and financial reporting. Companies are increasingly using data analytics and visualization (charts, pictures, and graphs) to more effectively convey financial information. To familiarize students with data visualization, each module opens with a data dashboard and it uses real-world data analytics and applications fo r student learning. Analytics and visualizations are reinforced with assignments in each module that present data graphically and require students to analyze and interpret the data visualizations. We prov ide students with online access to author-created PowerBI dashboards where they can interact with the data and learn how to create their own data visualizations. These discussions and assignments are identified by the data analytics icon in the margin. SEE PAGES 1-35, 4-35, 5-56. Data Analytics Data analytics is an umbrella term for diverse ac1ivi1ies that gather, organize, and analyzc raw data. Fuclcd by

fa

advances in computing power, mass storage. and machine learning. we have seen data analytics applications sky-

rocket in the past decade. Business has benefited greatly-consider the following:

Data Analytlcs

t

•

throughout the text

•

Data ana/ytrcs and visua#zat10ns are discussed where appropnate and reinforced with

Data analytics can be applied to any type of infonnation including structured data (such as spreadsheets and databases) and unstructured data (such as 10-K footnotes and transcripts of earnings calls). In the business realm, leaders use data analytics techniques to belier understand and manage data related to customers, input costs, production, employees, operations, risks, prices, and other aspects. Data analytics provide the business intelligence that infonns critical fim1·level decisions such as lending at banks, production optimization at manufacturing plants, new product development at biotech finns. and corn· modity sales by agriculture cooperatives, and many additional applications.

DATA ANAL YTICS INSIGHT

Using Big Data to Predict Bankruptcy for Private Companies

Moody's KMV RiskCalc™ uses extensive data from 1,500 credit defaults in the private sector. The model provides an example of how credit rating agencies assess the likelihood of default and bankruptcy. Most notably, Moody's model differs in a two-pronged assessment of solvency: financial· statement-only mode and a credit·cycle·adjusted mode. The latter adjusts for a company's stage of the credit cycle and is assessed on an industry-wide and country-wide basis that is updated monthly. The financial·statement·only risk evaluation is quite similar in spirit to Altman's original Z·score model, applying slightly different variables to capture leverage, profitability, liquidity, size, and growth. (Sou10e: https://www.moodysanalytics.com/product-i stlriskcalc)

pg.51.

Calculating Ratios for Firms with Negative Equity Using Data Analytics Access the Excel file of Compustat data available at the MBC website and use data visualization software such as Power BI or Tableau, to answer the requirements.

L01

Required

a. In the Excel file. define return on assets. return on equity. market capi1aliza1ion. and return on market value of equity for all firms in the dataset (use year end balances in the denominators for all of the ratios). For ROE. define Net income attributable to common as Net income minus Noncontrolling interest l/S. b. Use a line chan to depict the median ROA. ROE, and return on market value for all G IC sectors in 2019. Explain the relative magnitude of the three lines. c. Use a Scatterplot diagram of firms in 2019. Display Net income on the horizontal (X) axis and Equity Attributable to Company Shareholders on the vertical (Y) axis. Set fi lters to display firms with Net income between $(4.000) million and $4.000 million and Equity between $(10.000) million and SI 0.000 million. Identify Boeing on the scatterpl ot. d. Refer 10 the scatterplot from part c. Display the fim1s in 1he scatterplot that have a negative ROE. What distinction would analysts make between negative ROE for Apache Corporation (-105%) ver· sus HCA Healthcare (- 102%)? How would analysts interpret the 7.4% ROE of for Boeing (shown in

Business Insights & Analysis Insights Updated Business Insight boxes throughout each module showcase real-world business scenarios through the lens of financial statement analysis. For representative examples, SEE PAGES 2-11, 3-23, 5-10. Analysis Insight boxes, in select modules, highlight the importance of analysts' professional judgment in financial analysis as well as with the reformulation of financial statements. For representative examples, SEE PAGES 3-33, 4-32, 13-5.

Research Insights Academic research plays an important role in the way business is conducted, accounting and analys is are performed, and students are taught. It is important for students to recognize how

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Data Analytics

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Preface

modern research and modern business practice interact. Therefore, we periodically incorporate relevant research to help students understand the important relation between research and modern business. For representative examples, SEE PAGES 3-26, 5-37, 7-19.

Decision Orientation One primary goal of a fi nancial statement analysis and va luation course is to teach students the skills needed to apply their accounting knowledge to so lvi ng real business problems and making informed business decisions. With that goal in mind, Analysis Decision boxes in each module encourage students to apply the material presented to solving actual business scenarios. ANALYSIS DECISION

You Are the Vice President of Rnance

Your company is currently rated 81 /B+ by the Moody's and S&P Global Ratings credit rating agencies, respectively. You are considering restructuring to increase your company's credit rating. What types of restructurings might you consider? What benefits will your company receive from those restructurings? What costs will your company incur to implement such restructurings? [Answer. p. 7-31)

Financial Statement Effects Template As instructors, we recognize that the financial statement analysis and valuation course is not directed solely toward accounting majors. Financial Statement Analysis & Valuation embraces this reality. This book highlights financial reporting, analysis, valuation, interpretation, applications and decision making. We incorporate the following financial statement effects template to train students in understanding the economic ramifications of transactions and their impacts on financial statements. This analytical tool is a great resource for students in learning analysis and applying it to their future courses and careers. Each transaction is identified in the "Transaction" column. Then, the dollar amounts (positive or negative) of the fi nancial statement effects are recorded in the appropriate balance sheet or income statement columns. The template also reflects the statement of cash flow effects (via the cash column) and the statement of stockholders' equity effects (via the contributed capital and earned capital columns). The earned capital account is immediately updated to reflect any income or loss arising from each transaction (denoted by the arrow line from net income to earned capital). This template is instructive as it reveals the financial impacts of transactions, and it provides insights into the effects of accounting cho ices. For those desiring a more traditional analysis, journal entries and T-accounts are shown in the margin. Balance Sheet

Transaction

Cash Asset

+

Noncash Assets =

Liabillties

+

Income Statement Revenues

Contrib. Capital +

Expen-......._ Net = Income ses

Or. Acct

Cr Acct

'

Account

'

Account

t In the margin next to the financial statement effects template are shown the related journal entry and T-account effects.

The statement of cash flow effects are reflected via the Cash Asset column.

The statement of stockholders' equity effects are reflected via the Contributed Capital and Earned Capital columns.

Mid-Module and Module-End Reviews Financial statement analysis and valuation can be challenging-especially for students lacking business experience or previous exposure to finance, management, and other business courses. To reinforce concepts presented in each module and to ensure student comprehension, we include multiple mid-module and module-end reviews that require students to recall and apply the

Preface

financial statement analysis and valuation techniques and concepts described in each module. To aid students in developing their comparative analysis skills, most of those review problems center on a company or companies that compete with the focus company of that module. For representative examples, SEE PAGES 3-4, 8-14, 11-19.

Experiential Learning Students retain information longer if they can apply the lessons learned from the module content. To meet this need for experiential learning, we conclude each module with a hands-on analysis project. A series of questions guides students' inquiry and helps students synthesize the material in the module and integrate material across modules. For representative examples, SEE PAGES 1-48, 3-57, 11-51.

Excellent, Class-Tested Assignment Materials Excellent assignment material is a must-have component of any successful textbook (and class). We went to great lengths to create the best assignments possible from contemporary financial statements. In keeping with the rest of the book, we used real company data extensively. We also ensured that assignments reflect our belief that students should be trained in analyzing accounting information to make business decisions, as opposed to working on mechanical tasks. Assignments encourage students to analyze accounting information, interpret it, and apply the knowl edge gained to a business decision or in a valuation context. There are six categories of assignments: Questions, Mini Exercises, Exercises, Problems, IFRS Applications, and Analysis Discussion Points.

SIXTH EDITION CHANGES Based on classroom use and reviewer feedback, a number of substantive changes have been made in the new edition to further enhance the students' experiences. •

Digital delivery enhanced To serve the expanding delivery modes of higher education, we updated and expanded our in-module Reviews and Guided Example videos for all modules (each Leaming Objective has a Review/Guided Example, as well as a corresponding eLecture). In addition, all objective assignments are available in MBC.

•

Data visualizations and analytics Companies are increasingly using data visualizations (charts, pictures, and graphs) to more effectively convey financial information. To support student learning, each module opens with a data dashboard and includes end-of-module assig nments that present data graphically and require students to analyze and interpret the data visualizations. We provide students with online access (via MBC) to author-created PowerBI dashboards where they can interact with the data and learn how to create their own data visualizations.

•

Content reflects new standards This edition covers new standards on Revenue Recognition, Leases, and Marketable Securities. It also includes in-depth discussion of the Tax Cuts and Jobs Act and how new tax law impacts financial analysis.

•

Redundancies have been reduced In response to adopter feedback, we have eliminated redundant discussions spanning Modules 3, 4, and 7 related to credit ratings and liquidity/ solvency ratios.

•

Revenue, operating expenses, and receivables We expanded the discussion of revenue recognition following the new standard and included an illustration and analysis of Microsoft's revenue recognition. We also discuss sales returns and allowances and the effects of foreign currency exchange rates. Our operating expenses discussion introduces the effects of the Tax Cuts and Jobs Act, with a deeper discussion in Module l 0.

•

Inventories Our discussion of cash conversion cycle includes an illustration of management actions undertaken by Home Depot to streamline its supply chain to reduce days inventory outstanding.

ftJ

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•

Bond rating A new section in Module 7 discusses Credit Analysis, including how bond ratings are detennined. We provide an example of S&P Global's ratings for Verizon, following its purchase of Vodafone's interest in Verizon Wireless. We also simpl ify our discussion of bond pricing.

•

Share-based compensation Module 8 includes an expanded discussion of share-based compensation and Tesla's use of convertible de bt.

•

Investments We include a deeper discussion of the determination of fair value, including an expanded discussion of Level 3 inputs to value securities with limited markets and the accounting for those securities. Module 6 includes a new, expanded discussion of the new goodwill impairment standard.

•

Derivatives We markedly revised our discussion of derivatives to simplify the exposition while maintaining the analysis coverage.

•

Equity carve-outs The discussion of equity carve-outs is simplified and we provide examples of the accounting for sell-offs, IPOs, spin-offs, and split-offs. We also discuss the deconsolidation of a subsidiary.

•

Leasing Module JO reflects the new lease standard including the analysis of right-of-use assets and differences between operating and financial leases. We discuss retrospective and prospective adoption, using Microsoft and Delta Airlines.

•

Pension disclosures We markedly revised our discussion of pension accounting with a detailed illustration of the pension footnote disclosures. We include a section on fair valuation of pension obligations and the accounting for plan settlements.

•

Taxes We provide an in-depth, completely revised, discussion of income tax expense, including the effects of the Tax Cuts and Jobs Act and the analysis implications during the transition period.

•

Updated assignments We updated all data and financial statements throughout the book to reflect each company's latest available financial statement filings and disclosures. Assignments include current financial statement excerpts and reflect new standards for Revenue Recognition, Leases, and Marketable Securities and the Tax Cuts and Jobs Act.

For Instructors o>!!...

~ : A web-based learning and assessment program intended to complement your textbook and instruction. This easy-to-use course management system grades homework automatically and provides students with additional help when you are not available. Further, detailed diagnostic tools assess class and individual perfonnance. myBusinessCourse is ideal for online courses, hybrid courses, or traditional face-to-face courses for which you want to offer students more resources to succeed. Assignments with the iJ in the margin are available in myBusinessCourse. eLecture videos · are available for the module Leaming Objectives, and Guided Examples for the in-module Reviews are available for you to assign students. Solutions Manual: Created by the authors, the Solutions Manual contains complete solutions to all assignments. PowerPoint: Created by the authors, the PowerPoint slides outline key elements of each module. Test Bank: The test bank includes multiple-choice items, exercises, short essay questions, and problems. Website: All instructor materials are accessible via the book's website (password protected) along with other useful links and information. www.cambridi:epub.com

For Students eLectures: Each module's Leaming Objectives include an eLecture video available in o ur online learning management system, myBusinessCourse (see be low fo r more infonnation).

Preface

Guided Examples: Guided Example videos are available for each Review, also in myBusinessCourse (see below for more informati on).

~ is a web-based learning and assessment program intended to complement your textbook and faculty instruction. This easy-to-use program provides you with additional help when your instructor is not available. Guided Example videos are available for all in-module Reviews, and eLecture videos are available for each Leaming Objective, aligned with the topics presented in the text. With Instructor-Led MBC courses, assignments with the • in the marg in are also available and are automatically graded. Access is free with new copies of this textbook (look for the page containing the access code towards the front of the book). If you buy a used copy of the book, you can purchase access at www.mybusinesscourse.com. Website: Useful links are available to students free of charge on the book's website.

ACKNOWLEDGMENTS All six editions of this book benefited greatly from the valuable feed back of focus group attendees, reviewers, students, and colleagues. We are extremely grateful to them for their help in making this project a success. Khaled Abdou, Penn State University Kristian Allee, University of Wisconsin Teri Allen, Southwest Oklahoma State University Rihab Alzubaidi, Westfield State College Paul Bahnson, Boise State University Gerhard Barone, Gonzaga University Jan Banon, Emory University Progyan Basu, University of Maryland Sudipta Basu, Temple University Hilary Becke r, Carlton University Laura Beal, University of Nebraska at Ohama Frank Be il, University of Minnesota Joy Begley, University of British Columbia Richard Bernste in, University of Toledo William Black, Case Western Reserw University Massimil iano Bonacchi, New York University Bryan Bouc hard, So111hern New Hampshire University Kelsey Brasel, University ofAlabama-Tuscaloosa James Briley, Northeastern State University Philip Brown, Harding University Megan Burke, Texas A&M University Jeffrey Byrne, Indiana University So111heast Michael Calegari, Sa111a Clara University Charles Caliendo, Unh>ersity of Minnesota Shelly Cante rbury, George Mason University Ji an Cao, Florida Atlantic University Dan Carraher, Dominican University David Canw right, Johnson & Wales University Judson Caskey, University of Texas-Austin Cory Cassell, University ofArkansas Jack Cathey, Un iversity of North Carolina-Clwrlotte Eric Chen, University of Hartford Agnes Cheng, Louisiana State University Me i Cheng, University of Arizona Bob Churchman, Harding Uni 1•ersity Michael Cle ment, University of Texas-Austin Thomas Coe, Quinnipiac University Daniel Cohe n, University a/Texas-Dallas Scott Colvin, Fairfield University John Copley, Uni1•ersity of Texas-Dallas Erin Corne lsen, University of South Dakota Roger Crane, Indiana University East Steve Crawford, Rice University Akash Dania, Alcorn State University Seb Dem irkan, University of Maryland Hemang Desai, Southern Methodist University Erik Devos, University of Texas- El Paso Timo thy Dimond, Northern Illinois University Burak Do lar, Western Washington University Michael Drake, Brigham Young Uni1•ersity

James Edwards, University of South Carolina Ellen Engel, University of Chicago Stephan Fafatas, Washington & Lee University Patricia Fairfield, Georgetown University Jianing Fang, Marist College Luc ille Faure!, University o/California--lrvine Caitlin Finning-Go lde n, Bridgewater State University Mary Fischer, University o/Texas-Tyler Kare n Foust, Tulane University Joe Foy, CUNY-Brooklyn College Ed Funicella, Purdue University Carl Gabrini, College o/Coasral Georgia Margaret Gagne, Marist College Ke lly Gamble, University of Alabama-Hu111sville Maclean Gaulin, University of Utah Waqar Ghani, Saint Joseph's University Don Giacomino, Marquette University John Giles, North Carolina State University Alan Glazer, Franklin & Marshall College Jianxin Gong, University of Illinois Maurice Gosselin, University of Laa/ Lise Graham, University of Wisconsin-La Crosse Jeffrey G ramlich, University of Solllhern Maine Marina Grau, University of St. Thomas To ny Gre ig, University of Wisconsin Umit Gurun, University o/Texas-Dallas Robert Ha lsey, Babson College John Hand, University of North Carolina Trevor S. Harris, Columbia University Charles Harter, Georgia Solllhern University Allen Hartt, University of New Hampshire Robert Ho ltfreter, Ce111ral Washington University James A Howard, University of Maryland Paul Hribar, University of Iowa Paul Hutc hison, Unil•ersity of North Texas Ade l Ibrahim, University of Illinois James Irving, Clemson University Pawan Jain, Central Michigan University Rona ld Jastrzebski, Purdue University Kurt Jesswein, Sam Houston State University Gun Joh, San Diego State University Stephen John, Kean University Janee Johnson, University of Ari:ona Marilyn Johnson, Michigan State University Rick Johnston, Purdue University Christopher Jones, George Washington University Kevin Jones, Drexel University William K arnas, University o/Texas- Dallas Jocelyn Kauffunger, University of Pittsburgh Elizabeth Keating, Harvard University

xiii

xiv

Preface Marve Keene, Coastal Carolina University Myung-Sun Kim, SUNY University of Buffalo Sungsoo Kim, Rutgers University-{;amden Bonnie Klamm, North Dakota State University John Kostolansky, Loyola University Gopal Krishnan, George Mason University Cynthia Krom, Franklin & Marshall University Lisa Kutcher, Colorado State Unil>ersity Ron Lazer, University of North Carolina Seung Won Lee, Purdue University Northwest Reuven Lehavy, University of Michigan Matt Lenzen, KPMG Siyi Li, University of Illinois-Chicago Steve Lim, Texas Christian University Haijin Lin, University of Houston Philip Little, Coastal Carolina Universiry Dennis Lopez, University a/Texas-San Antonio Yoshie Lord, Eastern Illinois University Barbara Lougee, University of San Diego Henock Louis, Penn State University James Lukawitz, University of Memphis Ron Mano, Westminster College Stanimir Markov, Southern Methodist University Maureen Mascha, University of Wisconsin-Oshkosh C hristophe r Maxwell, Univeriry o/Colorado--Boulder Karen McDougal, St. Joseph University Michael Mclain, Hampton University Krishnagopal Menon, Boston University Norman Meonske, Kent State University Bill Mesa, Colorado Christian University Birendra Mishra, California State University- Riverside Debra Moore, Dallas Baptist University Eri n Moore, Westfield State University Mark Moore, Texas Tech University Haim Mozes, Fordham University Belinda Mucklow, University of Wisconsin Matt Munson, Chapman University Ken Nagy, Salem State R.D. Nair, University a/Wisconsin Alex Nekrasov, University of California--lrvine Michael Neugent, University of Cincinnati Christopher Noe, Massachusetts Institllfe o/Teclmology Emeka Nwaeze, University a/Texas-San Antonio Frank O' Hara, University of San Francisco Collins Okafor, North Carolina A& T State University Donald Pagach, North Carolina State University Shailendra Pandit, University of Illinois-Chicago Aaron Pennington, York College of Pennsylvania Ray Pfeiffer, Texas Christian University Brandis Phillips, North Carolina A& T University C hris Prestigiacomo, University of Missouri Stephan Poplaski, Johnson & Wales University Richard Price, Utah State Universiry Larry Prober, Rider University Rama Ramamurthy, College of William & Mary KK Raman, University of Texas-San Antonio Sue Redman, Texas A&M University Ken Reichelt, Louisiana State University

Fred Repetti, Catholic University ofAmerica Jay Rich, Illinois State University Edward Riedl, Harvard University Byung Ro, Purdue University Andrea Roberts, University of Virginia Tom Rosengarth, Bridgewater College Darren Roulstone, Ohio State University Marc Rubin, Miami University Anwar Salimi, CSU Pomona Monica Salomon, University of West Florida Janet Samue ls, Ari:ona State University Carol Sargent, Georgia State University James Scalise, NC State University Bill Schwartz, Oklahoma State University Dan Segersin, Metropolitan State University Kaustav Sen, Pace University Galen Sevcik, Georgia State Unil'ersity Nicholas Seybert, University of Maryland Andreas S imon, Cal Poly-san Luis Obispo James S inclair, University of Connecticut Praveen Sinha, Cal State-Long Beach Nancy Snow, University of Toledo Xiafei Song, St. Mary's University Victor Stanton, University o/California--Berkeley Jialin Sun, University of St. John's John J. Surdick, Xavier University Eric Sussman, UCLA Wallace Tang, St. Mary's College ofCalifornia Diane Tanner, University of North Florida Gary Taylor, University of Alabama Teresa Thamer, Brenau University Randy Thomas, Upper Iowa University Dorothy Thompson, University of North Texas Russell Tietz, Kent State University Jack Trifts, Bryant Uni1•ersity Mark Trombley, University of Arizona Carmelita Troy, Andrews University Andrew Van Buskirk, Ohio State University Michael Vasilou, Loyola University-{;hicago William Walsh, Syracuse University Hongxia Wang, Ashland University Xiaoli Wang, Marist College Charles Wasley, University of Rochester Gary Waters, Auburn University Ralph Welton, Clemson University Clark Wheatley, Florida International University Donna Whitten, Purdue University Northwest Billy Wi, Wesleyan College Matt Wieland, University of Georgia Paula Wilson, University of Puget Sound Jeffrey Wong, University of Nel'ada--Reno Lee Yao, Loyola University-New Orleans Susan Young, Fordham University Jiewei Yu, University of Ari:ona Yong Yu, University o/Texas--Austin Lin Zheng, Mercer Unil'ersity Luo Zuo, Cornell Unil'ersity

Very special thanks are extended to Susan Hamlen and Paul Hutchison for their thorough accuracy checking of the text and solutions manual. In addition, we are extremely grateful to George Werthman, Lorraine Gleeson, Dana Zieman, Jocelyn Mousel, Jill Fischer, Debbie McQuade, Terry McQuade, and the entire team at Cambridge Business Publishers for their encouragement, enthusiasm, and guidance.

~ June 2020

Brief Contents 1

Framework for Analysis and Valuation .. . . . ...... . .. . ............. . .. . .. 1-1

2

Review of Business Activities and Financial Statements ...... . ........ .. ... 2-1

3

Profitability Analysis and Interpretation .......... . . ..................... 3-1

4

Credit Risk Analysis and Interpretation ...... .. .. . .. . . .. ........ . . . .. . . . 4-1

5

Revenue Recognition and Operating Income ............................ 5-1

6

Asset Recognition and Operating Assets ................................ 6-1

7

Liability Recognition and Nonowner Financing ................ . .. .... . . .. 7-1

8

Equity Recognition and Owner Financing ............................... 8-1

9

lntercorporate Investments .. . ........... . ............................ 9-1

1o

Analyzing Leases, Pensions, and Taxes ........................ .. ..... 10-1

11

Financial Statement Forecasting ... . ................................. 11-1

12

Cost of Capital and Valuation Basics ...... . ........................... 12-1

13

Cash-Flow-Based Valuation ......................................... 13-1

14

Operating-Income-Based Valuation ................................... 14-1

15

Market-Based Valuation ... . ...... . .... . ........................... 15-1 APPENDIX A: Compound Interest Tables ............................... A-1 APPENDIX B: Computing and Analyzing Cash Flows ..................... B-1 APPENDIX C: Comprehensive Case .................................. C-1 APPENDIX D: Chart of Accounts (with Acronyms) . .. . ... . .. . . . .. . ........ D-1

Glossary . . . .. ..... . .. . . . .................. . .... .. ... . . . .. . . .. . .. . G-1 Index .................................... . ..................... . .. 1-1

©Cambridge Business Publishers

xv

Contents About the Authors

Questions

Ill

Module

1-36

Mini Exercises

Preface v

1

IFRS Applications

Framework for Analysis and Valuation Step 1 Business Environment and Accounting Review 1-1

1-37

Exercises 1-39 Problems 1-41

1-1

Ongoing Analysis Project Solutions to Reviews

1-5

1-6

Financial Statements: Demand and Supply Hi Demand for Information 1-6 Supply of Information

Module

1-48 1-48

1-49

2

Review of Business Activities and Financial Statements 2-1

1-9

International Accounting Standards

1-47

Analysis Decision Points

1-10

Review 1-2 1-11

Review of Financial Statements Balance Sheet

Interpreting a Balance Sheet 2-3

1-12

Assets

1-12

Review 2-1 2-12

Statement of Stockholders' Equity 1-17 Statement of Cash Flows

Interpreting an Income Statement

2-12 Recognizing Revenues and Expenses 2-13 Reporting of Transitory Items 2-14 Analyzing the Income Statement 2-16

1-18

Information Beyond Financial Statements 1-19 Review 1-3 1-19

Analyzing the Business Environment 1-20 Analyzing the Value-Chain 1-20

Review 2-2 2-16

Five-Forces Analysis of Business Environment 1-20 SWOT Analysis of Business Environment 1-21 Analyzing Competitive Advantage 1-22 Review 1-4

1-23

Step 2 Adjusting and Analyzing Financial Data 1-24 Managerial Choices in Financial Reporting 1-24 Analysis of Return on Assets

1-25

Components of Return on Assets

1-25

2-18

Articulation of Financial Statements

2-19

Retained Earnings Reconciliation

2-20

2-20

Four-Step Accounting Cycle 2-22 Financial Statement Effects Template

2-22 Accounting Cycle Step 1-Analyze Transactions

1-29

Valuation Models 1-29 Are Financial Data Relevant?

and Prepare Entries 2-24 Applying the Financial Statement Effects Template Applying the Journal Entry and T-Account 2-24

1-29

Financial Statement Analysis in an Efficient Capital Market

Accounting Cycle Step 2-Prepare Accounting Adjustments 2-27

1-31

Appendix 1A: Financial Statement Data and Analytics

2-24

Review 2-6 2-26

1-30

Review 1-7 1-32

xvi

2-18

Statement Format and Data Sources

Analyzing Transactions and Adjustments 2-22

Review 1-6 1-28

1-36

Interpreting a Statement of Cash Flows

Financial Statement Linkages

Review 1-5 1-27

Guidance Answer

2-17

Review 2-3 2-18

Review 2-5 2-21

Step 3 Forecasting Financial Numbers 1-27

Analyzing Global Reports

Interpreting a Statement of Stockholders' Equity

Review 2-4 2-19

Analysis of Return on Equity 1-26

Step 4 Business Valuation

2-3

Liabilities and Equity 2-5

Income Statement 1-15

1-32

Prepaid (Deferred) Expenses 2-28 Unearned (Deferred) Revenues 2-28 © Cambridge Business Publishers

Contents Accrued Expenses

2-29

Analyzing Global Reports

Accrued Revenues

2-29

Appendix 3A: Operating versus Nonoperating Classification

Accounting Adjustments for Apple

2-30

3-30 3-31

Appendix 3B: Nonoperating Return Component of ROE 3-32

Review 2-7 2-31

Review 3-8 3-36

Accounting Cycle Step 3-Prepare Financial Statements

2-31

Review 2-8 2-31

Appendix 3C: Vertical and Horizontal Analysis 3-36 Review 3-9 3-39

Accounting Cycle Step 4-Close the Books

2-32

Guidance Answer

Review 2-9 2-32

Additional Information Sources Form 10-K 2-32 Form 20-F and Form 40-F Form 8-K

xvii

3-40

Questions 3-40 Mini Exercises 3-40

2-32

Exercises 3-44 Problems

2-34

3-49

IFRS Application 3-56 Analysis Discussion Points

2-35

Analyst Reports 2-35 Credit Services 2-36

3-56

Ongoing Analysis Project Solutions to Reviews

Data Services 2-36

3-57

3-58

Review 2-10 2-36

Analyzing Global Reports Guidance Answers Questions

2-36

2-37

Module

2-37

Mini Exercises

4

Credit Risk Analysis and Interpretation

2-38

Exercises

2-40

Market for Credit 4-3

Problems

2-46

Demand for Credit

IFRS Application 2-51 Analysis Discussion Points

Supply of Credit 2-52

Review 4-1

Ongoing Analysis Project 2-53

4-3 4-4

4-7

Credit Risk Analysis Process

Solutions to Reviews 2-53

4-8

Information for Credit Risk Analysis

4-8

Chance of Default 4-9 Module

3

Loss Given Default

4-11

Review 4-2 4-13

Profitability Analysis and Interpretation

3-1

Measuring Credit Risk 4-13 Adjusting Financial Information

Return on Equity (ROE) Review 3-1

3-3

3-4

Coverage Analysis

ROE Disaggregation: DuPont Analysis Review 3-2 3-6

Review 4-3 4-24

3-6

Credit Ratings 4-25

Analysis of Profitability and Productivity 3-7

Importance of Credit Ratings 4-27

Analysis of Profitability 3-8 Analysis of Productivity 3-9

How Credit Ratings Are Determined

Analysis of Financial Leverage

Review 4-4 4-33

3-12

Review 3-3 3-14

Balance Sheet Analysis with an Operating Focus

3-15

4-33 4-34

Bankruptcy Prediction Errors 4-34

3-17

Review 4-5 4-35

Review 3-4 3-19

Income Statement Analysis with an Operating Focus

3-19

Guidance Answers Questions

Review 3-5 3-23

Return on Net Operating Assets (RNOA)

4-35

4-35

Mini Exercises 4-36

3-24

Exercises 4-38

Review 3-6 3-26

RNOA Disaggregation into Margin and Turnover 3-27

Net Operating Asset Turnover 3-27 Trade-Off between Margin and Turnover 3-28 Review 3-7 3-30

Predicting Bankruptcy Risk Altman Z-Score 4-33 Application of Z-Score

3-16

Net Nonoperating Obligations (NNO)

Net Operating Profit Margin

4-17

Liquidity Analysis 4-20 Solvency Analysis 4-21

3-4

Return on Assets and Its Disaggregation

Net Operating Assets (NOA)

4-14

Profitability Analysis 4-15

3-26

Problems 4-41 IFRS Applications

4-46

Analysis Discussion Point 4-49 Ongoing Analysis Project 4-49 Solutions to Reviews 4-50

4-28

4-1

Contents

xviii

Module

5

Module

Asset Recognition and Operating Assets

Revenue Recognition and Operating Income 5-1 Analyzing Revenue

Average Cost (AC)

5-6

Performance Obligations Satisfied Over Time

5-7

Analyzing Inventory-Tools 6-14 Gross Profit Analysis 6-14

5-16

Analyzing Unearned (Deferred) Revenue Review 5-3 5-17

Foreign Currency Effects on Revenue, Expenses, and Cash Flow 5-18

Foreign Currency and Future Results

Review 6-3 6-19

5-20

Research and Development Facilities and Equipment Review 6-4 6-22

5-21

Accounting for Accounts Receivable

Analyzing PPE Assets-Sales, Impairments, and

5-22

Analysis of Accounts Receivable-Magnitude Analysis of Accounts Receivable-Quality

5-23

5-25

5-27

Analyze Research and Development Expense 5-28 Provision (Benefit) for Taxes on Income 5-31 Analyze Discontinued Operations

Analyzing Global Reports

5-35

SEC Warnings about Pro Forma Numbers 5-35 Disclosures and Market Assessments

6-31

PPE Turnover 6-31

Review 6-6 6-33

5-34

Regulation G Reconciliation

Review 6-5 6-30

Analyzing PPE Assets-Tools PPE Useful Life 6-32 PPE Percent Used Up 6-33

5-31

Review 5-6 5-33

Pro Forma Income Reporting

6-24

Restructuring Costs 6-25

Analyze Deductions from Income 5-27

5-36

6-33

6-34

Guidance Answers Questions 6-35

Mini Exercises 6-36

Review 5-7 5-38

5-39

Analyzing Global Reports

Exercises

6-38

Problems 6-45

5-39

IFRS Applications

5-39

6-48

Analysis Discussion Points

5-40

6-49

Ongoing Analysis Project 6-50

Exercises 5-45 Problems 5-52 IFRS Applications

Restructuring 6-23 Asset Sales 6-23 Asset Impairments

Review 5-5 5-27

Analyzing Expenses and Losses

6-18

Analyzing PPE Assets-Capitalization and Depreciation Plant and Equipment 6-20

5-19

Analyzing Accounts Receivable 5-21 Aging Analysis of Receivables

Days Inventory Outstanding and Inventory Turnover 6-15 Days Payable Outstanding 6-17 Cash Conversion Cycle

Foreign Currency and Cash Flows 5-18 Foreign Currency and Income 5-19

Mini Exercises

Solutions to Reviews

6-50

5-58 5-59

Analysis Discussion Points Ongoing Analysis Project

6-10

Review 6-2 6-13

Review 5-2 5-15

Questions

6-9

LIFO Reserve Adjustments to Financial Statements LIFO Liquidations 6-11

Reporting Sales Allowances 5-13 Analysis of Sales Allowances 5-13

Guidance Answer

6-9

Lower of Cost or Market (LCM)

5-12

6-7

6-8

Analyzing Inventory-Reporting

5-12

Accounting for Sales Allowances

Review 5-4

6-5

Financial Statement Effects of Inventory Costing Review 6-1

5-11

Review 5-1

6-5

Last-In, First-Out (LIFO)

5-4

Complications of Revenue Recognition

Analyzing Sales Allowances

6-1

Analyzing Inventory-Costing Methods 6-3 First-In, First-Out (FIFO) 6-5

5-3

Revenue Recognition Rules

6

5-59

Solutions to Reviews 5-60

Module

7

Liability Recognition and Nonowner Financing 7-1 Analyzing Accrued Liabilities

7-3

Accrued Liabilities Defined

7-3

6-20 6-22

Contents Stock Issuance

Accruals for Contractual LiabilitiesWages Payable Example

7-4

Analyzing Stock-Based Compensation 7-5

7-8

7-5

Analyzing Dividends and Stock Splits Cash Dividend Disclosures

Review 7-2 7-10

Dividend Payout and Yield

Analyzing Long-Term Debt- Pricing

7-10

8-19 8-20

Stock Split 8-20

Pricing of Bonds Issued at a Discount 7-12 Pricing of Bonds Issued at a Premium 7-12

Review 8-4 8-21

Analyzing Accumulated Other Comprehensive Income

7-13

(AOCI) 8-21

Review 7-3 7-14

AOCI Components

Analyzing Long-Term Debt-Reporting Balance Sheet Reporting

8-19

8-19

Cash Dividends Financial Effects

Pricing of Bonds Issued at Par 7-11

Effective Cost of Debt

8-17

Review 8-3 8-18

Reporting for Short-Term Debt 7-9 Current Maturities of Long-Term Debt 7-10

7-15

8-22

Review 8-5 8-24

7-16

Financial Statement Effects of Bond Repurchase Fair Value Disclosures 7-17

8-21

AOCI Disclosures and Interpretation

7-15

Income Statement Reporting

Analyzing Convertible Securities 8-24 7-16

Review 7-4 7-18

Review 8-6 8-25

Analyzing Earnings per Share (EPS) 8-26 Review 8- 7 8-27

Analyzing Credit Quality 7-18 Credit Analysis 7-18

Analyzing Global Reports

Credit Ratings 7-19 Why Credit Ratings Matter 7-20 Review 7-5 7-23

7-23

8-28

Appendix SA: Stock-Based Compensation: Reporting and Analyzing 8-29 Guidance Answer Questions

Analyzing Global Reports

8-32

8-32

Mini Exercises 8-33

Appendix 7A: Time Value of Money 7-24 Review 7-6 7-30

Exercises 8-36 Problems 8-42

Appendix 78: Amortization of Debt 7-30

IFRS Applications

Guidance Answer

Ongoing Analysis Project

7-31

8-51 8-53

Solutions to Reviews 8-53

7-32

Mini Exercises

8-16

Accounting for Stock-Based Compensation

Footnote Disclosures for Stock-Based Compensation

Analyzing Short-Term Debt 7-9

Exercises

8-14

Analysis of Stock-Based Compensation Plans 8-15

Accruals for Contingent Liabilities-Warranties Example

Questions

8-11

Review 8-2 8-14

Accruals for Contingent Liabilities Defined Review 7-1

8-10

Stock Repurchase (Treasury Stock)

Accruals for Contractual LiabilitiesDeferred Revenue Example 7-5

xix

7-32

7-35

Problems 7-40 IFRS Applications

Module

7-45

Analysis Discussion Points

lntercorporate Investments

7-46

Ongoing Analysis Project 7-46 Solutions to Reviews

9

Analyzing lntercorporate Investments

7-47

9-1 9-3

Passive Investments in Equity Securities 9-4 Investments in Debt Securities 9-8

Module

8

Review 9-1

Equity Recognition and Owner Financing 8-1 Analyzing Stockholders' Equity and Classes of Stock 8-3 Stockholders' Equity Accounts 8-3 Statement of Stockholders' Equity 8-6 Preferred Stock

8-7

Common Stock

8-8

Review 8-1

9-11

Analyzing Equity Investments with Significant Influence Equity Method Accounting and ROE Effects

9-14

Review 9-2 9-19

Analyzing Equity Investments with Control Investments with Control

9-19

9-19

Review 9-3 9-30

Analyzing Global Reports 9-31 Appendix 9A: Analyzing Derivatives

8-9

Analyzing Stock Transactions

Investments with Significant Influence 9-12

9-32

Review 9-4 9-34

8-10

Appendix 98: Analyzing Equity Carve-Outs 9-35

9-12

xx

Contents

Guidance Answer Questions

Mini Exercises Exercises Problems

9-40

Module

9-40

Financial Statement Forecasting

9-40

9-44 9-54

Forecasting Process 9-57

Review 11-1

Analysis Discussion Point

9-58

Ongoing Analysis Project

9-59

Building Forecasts from the Bottom Up Segment Data

Review 11-4 11-19 Appendix 11A: Forecasting the Statement of Cash Flows

10-3

10-6 Summary of Lease Accounting and Reporting Analysis Issues Relating to Leases

Debt Financing

10-4

Appendix 11 C: Parsimonious Method for Forecasting NOPAT and

10-10

Review 11-7 11-24

10-13

Defined Benefit Pension Plans on the Balance Sheet

10-13

Appendix 11 D: Morgan Stanley's Forecast Report on Procter & Gamble 11-24 11-32

Analysis Issue- Sufficiency of Plan Assets to

Questions

10-15 Defined Benefit Pension Plans on the

Mini Exercises

Pay Pension Obligations

10-16

Pension Expense Smoothing

11-38

Problems

11-45

Solutions to Reviews

10-21

Footnote Disclosure-Key Assumptions

10-23 Other Post-Employment Benefits (OPEB)

10-25

Review 10-2 10-26

Steps in Stock Valuation

10-31

Intrinsic Value

10-32

Expanded Explanation of Deferred Taxes

10-33

Appendix 10A: Lease Accounting Example- Finance and Operating Leases 10-40

12-6 12-9

10-39

Estimating Cost of Capital

12-9

12-10

Diversifiable and Non-Diversifiable Risk

Review 12-1

12-11

12-11

Cost of Equity Capital Using the Capital

10-40

Asset Pricing Model

10-45 10-54

IFRS Applications

12-5

Review of Time Value of Money Valuation of an Equity Instrument

10-38

12-4

12-4

Valuation of a Debt Instrument

Review 10-3 10-37

12-12

Cost of Equity Capital Using a Multi-Factor Model

10-64 10-65 10-66

Ongoing Analysis Project Solutions to Reviews

12-1

12-3

Payoffs from Equity and Debt Instruments

10-27

Analysis of Income Tax Disclosures

Problems

12

Basics of Valuation

Timing Differences Create Deferred Tax

Mini Exercises

Module

Cost of Capital and Valuation Basics

10-27

Disclosures for Income Taxes

11-51 11-52

10-23

Analysis Implications

Assets and Liabilities

11-32

Exercises

Ongoing Analysis Project

10-17

Fair Value Accounting for Pensions

Analyzing Global Reports

11-23

NOA

10-11

Review 10-1 10-12

Analyzing Income Taxes

11-21

Review 11-6 11-23

Lease Accounting

Income Statement

11-19

Appendix 11 B: Multiyear Forecasting with Target Cash and New

10-3

Lessee Reporting Example- Microsoft Corporation

Analyzing Pensions

11-17

11-17

Review 11-5 11-21

New Lease Reporting Standard

Exercises

11-13

Review 11-3 11-17

Analyzing Leases, Pensions, and Taxes 10-1

Questions

11-9

Review 11-2 11-12 Forecasting the Balance Sheet

10

Analyzing Leases

11-6

11-7

Forecasting the Income Statement

9-60

Solutions to Reviews

11-1

11-3

Company Guidance

IFRS Applications

Module

11

Review 12-2 12-14 Cost of Debt Capital

12-14

Review 12-3 12-16 Weighted Average Cost of Capital

12-16

Review 12-4 12-18 Dividend Discount Model

12-18

Recursive Process of Valuation

12-18

12-13

Contents Framework of the Dividend Discount Model

12-19

Dividend Discount Model with Constant Perpetuity

Model Equivalency 12-19

Review 12-5 12-20

Dividend Discount Model with Increasing Perpetuity

12-20

12-21

Review 12-6 12-23

14-5

14-6

Residual Operating Income (ROPI) Model ROPI Model Structure 14-6 Steps in Applying the ROPI Model

Appendix 12A: Estimating Cost of Equity Capital

12-23

Guidance Answer 12-28 Questions 12-29 Mini Exercises

14-4

Valuation Model Inputs Review 14-1

Issues in Applying the Dividend Discount Model

Illustrating the ROPI Model

14-8

Extending the ROPI Model

14-10

14-6

14-7

Review 14-2 14-11

12-29

Steady State in Valuation

14-11

Exercises

12-30

Multi-Year Forecast Precision

Problems

12-31

Achieving Steady State 14· 12 Forecasting Steady State-An Illustration

Analysis Discussion Points Ongoing Analysis Project Solutions to Reviews

12-34 12-36

14-12

12-37

Managerial Insights from the ROPI Model

13

Analyzing Global Reports

Cash-Flow-Based Valuation

13-1

13-3

Questions

Residual Operating Income Model Model Equivalency

13-4

13-6

Review 13-1

DCF Model Structure 13-6 Steps in Applying the DCF Model

13-7

Illustrating the DCF Model

13-8

Extending the DCF Model

13-9

Analyzing Global Reports

14-30

Ongoing Analysis Project

14-31

Module

15 15-1

Valuation Model Using Market Multiples

15-3

Application of the Model Using Market Multiples

Appendix 13A: Financial Statements for Procter & Gamble Appendix 138: Derivation of Free Cash Flow Formula

13-16

13-18

Appendix 13C: Deutsche Bank Valuation of Procter & Gamble Guidance Answer 13-29

14-32

Market-Based Valuation

13-15

Review 13-2 13-15

Valuation Using Balance Sheet Multiples

13-18

Valuation Using a Net Operating Asset (NOA) Multiple Review 15-1

15-8

Valuation Using a Net Operating Profit After

13-29

Tax (NOPAT) Multiple

15-9

13-30

Valuation Using a Net Income (NI) Multiple

Problems

13-33

Valuation Using Industry-Based Multiples

Analysis Discussion Point 13-37 Ongoing Analysis Project

Module

15-6

15-6

15-8

Valuation Using Income Statement Multiples

Exercises

Solutions to Reviews

15-4

15-5

Valuation Using a Book Value (BV) Multiple

13-29

Mini Exercises

Analysis Discussion Point Solutions to Reviews 13-6

Questions

14-21

Exercises 14-23 Problems 14-26

13-4

Discounted Cash Flow (DCF) Model

14-18

14-20

14-21

Mini Exercises

13-4

Valuation Model Inputs

14-17

Appendix 14A: P&G Financial Statements Guidance Answer

Dividend Discount Model 13-3 Discounted Cash Flow Model 13-4

14-15

14-16

14-18

Review 14-4

Equity Valuation Models

14-13

Review 14-3 14-15

Assessment of Valuation Models Module

xxi

Combining Estimates from Differing Multiples

13-37

15-11

Review 15-2 15-12

13-38

Selecting Comparables for Market Multiples Deriving Price-to-Book from Residual

14

15-12

Operating Income Model 15-13 PB Ratios in Relation to Profitability, Growth, and Risk

Operating-Income-Based Valuation Equity Valuation Models

15-10 15-11

14-3

Dividend Discount Model

Operating Income Model

15-16

PE Ratios in Relation to Profitability, Growth, and Risk

14-3

Discounted Cash Flow Model

14-1

Review 15-3

14-4

Residual Operating Income Model

15-17

15-18

Interpreting and Reverse Engineering Market Multiples 14-4

15-13

Deriving Price-to-Earnings from Residual

15-19

xxii

Contents Interpreting and Reverse Engineering the PB Ratio

15-19

Cash Flow Patterns

Interpreting and Reverse Engineering the PE Ratio

15-21

Usefulness of the Statement of Cash Flows

Perspective on Valuation Multiples and Fundamental Analysis Guidance Answer

15-21

Ratio Analyses of Cash Flows Free Cash Flow

15-23

15-26

Problems

15-30

Appendix BB: Direct Method Reporting for Statement of Cash Flows Guidance Answer

Ongoing Analysis Project

15-34

Questions

15-37

A

B-42

IFRS Application

B-55

Solutions to Reviews

Compound Interest Tables

A-1 Appendix

Appendix

B-32

B-33

Mini Exercises 8·34 Exercises B-37

15-37

Problems Appendix

B-29

Review 8-8 B-32

Analysis Discussion Points Solutions to Reviews

B-27

B-28

Review 8-7 B-29

Questions 15-23 Mini Exercises 15-24 Exercises

B

B-56

C (Online)

Comprehensive Case (Harley Davidson)

Computing and Analyzing Cash Flows

B-1

Reviewing Financial Statements

C-3

Business Environment for Financial Reporting

Framework for Statement of Cash Flows

B-3

Income Statement Reporting and Analysis

Relation Among Financial Statements

B-3

Balance Sheet Reporting and Analysis C-9

Statement of Cash Flows Structure Investing Activities Preview

B-4

B-8

Financing Activities Preview

Assessing Profitability and Creditworthiness

B-8 B-9

Credit Analysis

8-10

Java House Case Illustration Review 8-2

B-12

Forecasting Financial Statements

8 -15

Valuing Equity Securities

Java House Case Illustration

B-16

Summary Observations

B-18

Review 8-5

Appendix

8-19

Computing Cash Flows from Balance Sheet Accounts Supplemental Disclosures for Indirect Method B-20

8-19

Cash Flow Components

B-21

C-34

C-34

D

Chart of Accounts (with Acronyms)

8 -21

Analysis of Cash Flow Information B-21

C-31

Assessment of the Valuation Estimate

8-16

8-18

Java House Case Illustration

C-28

C-28

Discounted Cash Flow Valuation C-32 Residual Operating Income Valuation C-33

Cash Flows from Financing Activities B-18 Analyze Remaining Liabilities and Equity B-18 Review 8-4

C-27

Summarizing Profitability and Creditworthiness

Computing Cash Flows from Investing Activities Analyze Remaining Noncash Assets B-16 Review 8-3

C-24

Disaggregation of RNOA-Margin and Turnover C-26

Steps to Compute Net Cash Flow from Operating Activities

C-22

ROE Disaggregation- DuPont Analysis C-24 ROE Disaggregation-Operating Focus C-26

8-9

Cash Flow from Operating Activities

C-3

C-4

Statement of Cash Flows Reporting and Analysis Independent Audit Opinion C-23

B-7

Operating Activities Preview

Review 8-1

B-25

Review 8-6 B-27

15-22

Review 15-4

B-23

Glossary Index 1-1

G-1

D-1

C-1

MODULE

Framework for Analysis and Valuation

Analyst Playbook visually organizes the topics, eLecture videos,

Analyst Playbook ...--- Guided Example videos, and assignments by Learning Objective.

Explain and assess the four main business activities. Planning:: Operating:: Investing :: Financing Identify and discuss the users and suppliers of financial statement information.

1-6

e1 - 2

Review 1-2

8, 13, 17,18, 22, 36, 40,62

1-12

e1-3

Review 1-3

3, 4, 5,6, 7,21, 23,24, 25, 26, 27,28, 34,35, 37,44,45,46, 48, 54, 58, 60, 61

1-20

e1-4

Review 1-4

10, 11 ,30,31

1-24

e1-5

Review 1-5

19, 31 , 38,39, 41 ,43, 44, 45, 46,48, 49, 50, 51,53,59,61

1-27

e1-U

Review 1-6

2, 9

1·29

e1-7

Review 1·7

20, 33, 47

1-32

e1-8

Information Demand:: Information Supply:: Global Setting Review the four financial statements. Balance Sheet :: Income Statement of Stockholders' Equity :: Statement of Cash Flows Assess business operations within the context of a competitive environment. Competitive Environment:: Business Environment:: Competitive Advantage Apply basic profitability analysis. Return on Assets:: Return on Equity:: Relevance of Financial Statements Describe the financial statement forecasting process. Factors that Affect Forecasting :: Forecasting Process Explain the role of financial information in business valuation. Information for Business Decisions:: Valuations Models :: Efficient Markets Access and analyze financial datasets.

12,26,27,31, 57

Datasets:: www.SEC.gov :: Data Analytics :: Excel :: Data Visualization

© Cambridge Business Publishers

PREVIEW A Preview introduces each module.

We introduce a four-step framework for analysis and valuation: •

Understand the business environment and accounting information.

•

Adjust and assess financial information.

•

Forecast future payoffs such as earnings, cash flow, or dividends.

•

Use forecasted information to estimate firm value.

We elaborate on each of the four steps and set the stage for the remainder of the book. We explain how each module fits into the process of financial statement analysis, company valuation, and business decisions that arise from both analysis and valuation. Each module lays out Learning Objectives and maps them to the module's eLectures, guided examples, and end-ofchapter problem assignments. Use the Analyst Playbook in each module to track your learning. Consider looping back to the Learning Objectives as we work through each module and ask whether we have learned that content. Apple Inc. is the Module 1 focus company and we refer to its financial statements to illustrate key financial accounting issues. The dashboard here conveys information about Apple's balance sheet, income statement, and statement of cash flows over the past nine years.

Assets

Liabilities

• $3008

Equity

$4008

Net Income •

Revenue -

Market Cap

$1,2008

$2508

•

()pe

z N

)>

-4

Framework for Analysis and Valuation

c r

m

Business Environment and Accounting Information

0

z

Adjusting and Assessing Financial Information

Reporting on Business Activities

Choices in Financial Reporting

Demand for and Supply of Accounting Information

Analysis of Financial Statements

Review of Financial Statements Analyzing the Business Environment

I

Valuation Using Financial Statements

Forecasting Process Forecasting Mechanics

Financial Statement Analysis in an Efficient Capital Market

Profitability and Productivity

Review 1-5

Company Valuation for Business Decisions Valuation Process and Models

Return on Assets Disaggregation

Reviews 1-1, 2, 3, 4

Module Organization visually depicts the key topics and their sequence within the module.

Forecasting Financial Statements

Review 1-7

Review 1-6

Financial statement analysis is the process of extracting information from financial statements to better understand a company's current and future performance and financial condition. Financial statements serve many objectives. Management uses financial statements to raise financing for the company, to meet disclosure requirements, and to serve as a benchmark for executive bonuses. Investors and analysts use financial statements to he lp decide whether to buy or sell stock. Creditors and rating agencies use financial statements to help decide on the creditworthiness of a company's debt and lending terms. Regulatory agencies use financial statements to encourage enactment of social and economic policies and to monitor compliance with laws. Legal institutions use financial statements to assess fines and reparations in litigation. Various other decision makers rely on financ ial statements for purposes ranging from determ ining demands in tabor union negotiations to assessi ng damages fo r environmental abuses. Valuation is the process of draw ing on the results of financial statement analysis to estimate a company's worth (enterprise value). A company's worth can be viewed as a collection of assets, and those assets have claims on them. Owner claims are reflected in equity shares (securities) of a company. Nonowner claims are reflected in obligations and debt shares (securities) of the company. The valuation process seeks to assess the worth of equity shares or debt shares, or both. F inancial statement analysis and valuation is the joint process of scrutinizing a company's financial statements and valuing its eq uity and debt. The relations between the company (its assets) and the market claims on the company are depicted here: Company

.. [j

Market

..-

Owner Claims

Shareholders (equity market)

Non owner Claims

Creditors (debt market)

+ Value of the Company

Claims on the Company

We see that company value equals owner and nonowner claims, where those claims are val ued by the equity and debt markets.

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

This book provides a framework and several tools to help us analyze companies and value their securities. To this end, it is helpful to imagine ourselves as a specific user of financial statements. For example, imagine we are a stock investor- how do we identify a stock to buy or whether to sell a stock we own? Imagine we are a bond trader- how do we identify a bond to acquire or whether to dispose of a bond we own? Imagine we are a manager-how do we decide whether to acquire another company or divest of a current division? Imagine we are an equity or credit analyst- how do we assess and communicate an investment appraisal or credit risk report? This focused perspective will enhance our learn ing process and makes it relevant. This module begins with an overview of the demand for and supply of accounting information. We then review financial statements and explain what they convey about a company. We provide an introduction to analysis of the business environment, which is a crucial part of understanding the context in which we draw inferences from financial statements. Profitability is described next as it frames much of our analysis of financial statements. In concluding the module, we discuss the application of information garnered from fmancial statement analys is and business analysis to produce forecasts that are used in valuation. We include (in the appendix) a discussion of accessing SEC filings, which are required for all companies traded publicly in the U.S. The remainder of the book is organized around four key steps in financial statement analysis and v aluation. These steps are portrayed graphically below. Step 1 consists of Modules 1 and 2 where we develop an understanding of the business environment and company-reported accounting information, including the statement of cash flows in Append ix B. This helps answer the question: What is the setting in which the company operates? Step 2 consists of Modules 3 and 4, which introduce both profitability and credit risk analysis, and Modules 5 through 10, which provide tools for adjusting and assessing financial statement information. T his ste p is the core of financial statement analysis, allowing us to adjust financial statements as necessary to improve our analysis and better reflect business performance and financia l condition. The adjustments and assessments answer the question: What is the company's current financial performance and condition? Step 3 consists of Module 11 , which appl ies our know ledge of the business environment and company's current status to form predictions about future financial performance and condition. Forecasting reflects our beliefs of where the company is heading. Step 4 consists of Modules 12 through 15, which explo res how forecasted information is used in a variety of val uation methods. The valuation estimates based on fo recasted numbers help answer the question: What is the company worth? All bus iness decisions should be informed by an analysis of value or the change in value. This book explains the explicit connections that

Step 1-Understanding the Business Environment and Accounting Information Modules 1 and 2 and Appendix B

Where does the firm operate?

Step 2-Adjusting and Assessing Financial Information and Accounting Information Profitability Analysis- Module 3 Investing- Modules 6, 9, and 10 Credit Analysis- Module 4 Financing- Modules 7 and 8 Operations- Module 5

Where is the firm currently?

Step 3-Forecasting Financial Information Module 11

Where 1s the firm going?

Step 4-Using Information for Valuation Cost of Capital and Valuation Basics- Module 12 Cash-Flow-Based Valuation- Module 13 Operating-Income-Based Valuation- Module 14 Market-Based Valuation- Module 15

What is the firm worth?

1-4

1·5

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

allow us to estimate company value from financial information. All four steps are repeated in Appendix C, which examines Harley-Davidson as a case analysis.

STEP 1 • BUSINESS ENVIRONMENT AND ACCOUNTING The main objective of financial reporting is to provide users with information that supports investment and management decisions. Although there are many users of financial statements provided by companies, there are three main user groups:

I

Explain and assess the four main business

•

Investors and equity analysts who use financial statement information to judge the company's profitability and financial strength and to make reasonable estimates of the value of the company's equity securities.

•

Lenders and credit analysts who use financial statement information to assess the company's ability to repay its debts and to determine how to manage credit risk associated with the company's debt securities. Company managers who use financial statements to inform decisions such as where to invest scarce resources, how to finance those investments, how to maximize the company's profitability, and how much cash to maintain.

act1v1t1es.

electure icons identify topics for which there are instructional videos in myBusinessCourse (MBC). See the Preface for more information on MBC.

•

Business Activities To effectively analyze and use accounting information, we must consider the larger business context-see Exhibit 1.1. The yellow circle at the center of the exhibit captures the three types of ongoing business activities at every firm. 1. Operating activities: companies hire and train employees, manufacture products, deliver services, market and sell their products and services, and manage after-sale customer support. 2. Investing activities: companies acquire land, buildings and equipment, grow the business with new products and services, or acquire other companies to expand into new markets. 3. Financing activities: companies raise cash to fund the operating and investing activities. This includes selling stock to equity investors and borrowing from banks and other lenders. lnfographics are used to convey concepts and procedures. \

EXHIBIT 1.1

., ...

Business Activities

_____ -

___

,.

Business activities occur within a particular bus iness env ironment characterized by a number of business forces, including market conditions, competitive pressures, and regulations. These forces affect the way the company does business and shapes the company's overarching goals and objectives along with the company's strategy and its strategic planning process. Exhibit 1.1 depicts these forces and strategic plans in the outer (purplish) ring.

_____

_.,_ .. __-

. . ._._......

,._,,,.._.,

...... ........... _..

•w . .- . -. - -. . . ...

.,

,..,_,_..

,

,._............ _ .

__

....,_ .........-...... --··- ..... -

'"'"-------·~

~~

'~

are inputs into planning

Current financial statements renect pertormance and condition

Income statement Statement of stockholders' equity Statement of cash nows

Income statement Statement of stockholders' eqLity Statement of cash nows

Prior financial statements

Reports prepared [prior year]

...._~----------------.....~·----------------"""'~ Period of time

Reports prepared [current year]

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

1-6

Business Strategy A company's strategic (or business) plan reflects how it plans to achieve its goals and objectives. A plan's success depends on an effective analysis of market de mand and supply. Specifically, a company must assess de mand for its products and services and assess the supply of its inputs (both labor and capital). The plan must also include competitive analyses, opportunity assessments, and consideration of business threats. We discuss competitive forces later in the module. Past financial statements (depicted on the left of Exhibit 1.1) are an important input into the planning process. They provide information about the relative success of past strategic plans. Managers use that information to take corrective action and make new operating, investing, and financing decisions. These new actions yield the current financial statements (on the right hand side of Exhibit 1.1) and the process starts anew. Understanding a company's strategic plan helps focus our analysis of financial statements by placing them in proper context.

v

!E

1·1

L01

Complete the statements by filling in the blanks. I . Companies engage in the following three types of ongoing business activities: _ _ __ activities, activities, and acti vities. 2. A company's reflects how it plans to achieve its goals and objectives. 3. Investors use financial statement information to make reasonable estimates of the value of Lenders use financial statement information to assess the company's ability to _ _ __ Company managers use financial statements to decide whe re to invest resources. 6. Indicate whether the fo llowing business activities are operating, investing, or financing activities.

4. 5.

• • • • • •

• Constructing new manufacturing faci lities • Hiring and training employees • Gaining control of the voting stock of a supplier to secure the supply chain • Entering into a bank Joan

Manufacturing products Issuing stock to investors Repaying a mortgage Selling services to a client Acquiring land Engaging in after-sales support

Solution on page 1-49.

•FINANCIAL STATEMENTS: DEMAND AND SUPPLY De mand for financi a l state ments has existed for centu ries as a mea ns to faci litate effici ent co ntracting and ri sk-sharing . Decision makers and other stake holde rs dem and information on a company's past and prospecti ve returns and risks. Supply of financ ial state ments is driven by companies' wish to lower financing costs and othe r costs such as political, contracting, and labor. Managers decide how much financial information to supply by weighing the costs of disclosure against the be nefits of disclosure. Regulatory agencies intervene in this process with various di sclosure requirements that establish a minimum supply of information.

Demand for Information The following broad classes of users demand financial accounting information.

• • •

Managers and employees Investment analysts and information intermediaries Creditors and suppliers

• • • •

Stockholders and directors Custome rs a nd strategic partne rs Regulators and tax agencies Voters and their re presentatives

Managers and Employees Managers and employees are interested in the company's current and future financial health. This leads to a demand for accounting information on the financial condition, profitabi lity, and

Identify and discuss the users and suppliers of financial statement information.

t Learning Objectives are highlighted at the start of the section covering that topic.

1-7

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

prospects of their companies as well as comparative financial information on competing companies and business opportunities. This permits them to benchmark their company's performance and condition. Managers and employees also demand financial accounting information for use in compensation and bonus contracts that are tied to such numbers. The popularity of employee profit sharing and stock ownership plans has further increased demand for financial information. Other sources of demand include union contracts that link wage negotiations to accounting numbers and monitor pension and benefit plans whose solvency depends on company performance. Financial statements provide useful information to company managers to address the following types of questions. •

What product lines, geographic areas, or other segments are performing well compared with our peer companies and our own benchmarks?

• •

Should we consider expanding or contracting our business? How will current profit levels impact incentive and share-based compensation?

Investment Analysts and Information Intermediaries Investment analysts and other information intermediaries, such as fmancial press wr iters and business commentators, are interested in predicting companies' future performance. Expectations about future profitability and the ability to generate cash impact stock price and a company's ability to borrow money at favorable terms. Financial reports reflect information about past performance and current resources available to companies. These reports also provide information about claims on those resources, including claims by suppliers, creditors, lenders, and stockholders. This information aUows analysts to make informed assessments about future fmancial performance and condition so they can provide stock recommendations or write commentaries. Financial statements provide useful information to investment analysts to address the following types of questions.

Excerpts of reports from agencies such as Credit Suisse, Moody's, and Deutsche Bank illustrate how accounting information is used by financial services.

•

What are expected future profits, cash flows, and dividends for input into stock-price models?

• •

Is the company financially solvent and able to meet its financial obligations? How do expectations about the economy, interest rates, and the competitive environment affect the company?

Analysts use financial information to prepare research reports s imilar to the one issued in 2019 by Cr edit Suisse on Apple Inc. (below). Analysts use balance sheet numbers, inc luding debt and equity along with income statement numbers, including revenue, earnings per share (EPS), and earnings before interest, tax, depreciation, and amortization (EBITDA) to compute ratios that inform their price target ($209) and their stock rating (Neutral). We will discuss analysts and their activities in more depth later. For now, know that accounting information is a bedrock for equity analysis.

CREDIT

SUISS~

Rating Price (09-Apr-19, USS) Target pnce (US$) 52-week price range (USS) Marl

INITIATION

Services P rote ntia l vs. iPhone Maturation •

Initiate at Neutral, $209 TP: As Apple's iPhone matures, the company is looking to transform nself into a more recurring, higher-growth, and ultimately higher-value business as n pushes to increasingly monetize ns massive 900mm iPhone installed base. We recognize the potential in the shift to Services, which we expect will reach S65bn in revenue by FY21 , but believe will take time for that view to play out. Near-term upside from here likely requires the multiple to re-rate higher, investor perception of Apple as a hardware-centric company will be hard to shake against a backdrop of double-digit iPhone sales declines (CSe -11% y/y in CY19), in our view. 'Mth the s tock up 40% from its Jan low and near a peak multiple (1 Sx CY20 EPS), we remain on the sidelines awaning a better entry point and/or line-of-sight to significant Services-led upside to break out of the historical valuation range.

n

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

1-8

Creditors and Suppliers Banks and other lenders demand financial accounting information to help determine loan terms, loan amounts, interest rates, and required collateral. Loan agreements often include contractual requirements, called covenants, that restrict the borrower's behavior in some fashion. For example, loan covenants might require the loan recipient to maintain minimum levels of working capital, retained earnings, and interest coverage to safeguard lenders. If covenants are violated, the lender can demand early payment or other compensation. Suppliers demand financial information to establish credit tenns and to determine their long-term commitment to supply-chain relations. Both creditors and suppliers use financial information to monitor and adjust their contracts and commitments with a company. Financial statements provide useful information to creditors and suppliers to address the following types of questions. • •

Should we extend credit in the form of a loan or line of credit for inventory purchases? What interest rate is reasonable given the company's current debt load and overall risk profile?

•

Is the company in compliance with the existing loan covenants (loan conditions that restrict the borrower's behavior in some fashion, such as minimum levels of working capital, retained earnings, and cash flow, whi ch safeguard lenders)?

Following is Apple, Inc's disclosure of loan covenants on its credit facility (a line of credit) from a recent annual report.

Credit Facility We are party to a credit agreement that provides revolving commitments for up to $1.25 billion of borrowings, as well as term loan commitments, in each case maturing in January 2021 .... The credit agreement contains negative covenants that, subject to significant exceptions, limit our ability to, among other things, incur additional indebtedness, make restricted payments, pledge our assets as security, make investments, loans, advances, guarantees and acquisitions, undergo fundamental changes and enter into transactions with affiliates. We are also required to maintain a ratio of consolidated EBITDA, as defined in the credit agreement, to consolidated interest expense of not less than 3.50 to 1.00 and are not permitted to allow the ratio of consolidated total indebtedness to consolidated EBITDA to be greater than 3.25 to 1.00.... As of December 31 , 2018, we were in compliance with these ratios.

Stockholders and Directors Stockholders and directors and others (such as investment analysts, brokers, and potential investors) demand financial accounting information to assess the profitability and risks of companies and other information useful in their investment decisions. Fundamental analysis uses financial information to estimate company value and to form buy-sell stock strategies. Both directors and stockholders use accounting information to evaluate managerial performance. Outside directors are crucial to detennining who runs the company, and these directors use accounting information to help make leadership decisions. Financial statements provide useful information to stockholders and directors to address the following questions. • •

Is company management demonstrating good stewardship of the resources that have been entrusted to it? Do we have the information we need to criticall y evaluate strategic initiatives that management proposes?

Customers and Strategic Partners Customer s (both current and potential) demand accounting information to assess a company's abi lity to provide products or services and to assess the company's staying power and reliabi lity. Strategic partners wish to estimate the company's profitability to assess the fairness of returns on mutua l transactions and strategic alliances. Financial statements provide useful information to customers and strategic partners to address the fol lowing questions.

Excerpts from recent financial statements are used to illustrate and reinforce concepts.

/

1-9

© Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

•

Will the company be a reliable supplier?

•

Is the strategic partnership providing reasonable returns to both parties?

Regulators and Tax Agencies Regulators (such as the Securities and Exchange Commission [SEC], the Federal Trade Commission, and the Federal Reserve Bank) and tax agenc ies demand accounting information for antitrust assessments, public protection, setting prices, im port-export analyses, and setting tax po licies. Timely and reliable information is crucial to effective regul atory po licy, and accounting information is often central to social and economic policies. For example, governments often grant monopoly rights to electric and gas companies serving specific areas in exchange for regulation over prices charged to consumers. These prices are mainly determined from accounting measures.

Voters and Their Representatives Voters and their representatives to national, state, and local governments demand accounting information for policy decisions. The decisions can involve economic, social, taxation, and other initiatives. Voters and their representatives also use accounting information to monitor government spending. Contributors to nonprofit organizations also demand accounting information to assess the impact of their donations.

Supply of Information In general, the quantity and quality of accounting information that companies supply are detennined by managers' assessment of the benefi ts and costs of disclosure. Managers release information provided the benefits of disclosing that information outweigh the costs of doing so. Both regulation and bargaining po wer affect disclosure costs and benefits and thus play roles in determ ining the supply of accounting info rmation. Most areas of the world regulate the minimum levels of accounting disclosures. In the United States, publicly traded firms must fi le financial accounting information with the SEC. T here are two main compulsory SEC fi lings. Form 10-K: the audited annual report that includes the four financial statements, discussed below, with explanatory notes and the management's discussion and analysis (MD&A) of financial results. Form 10-Q: the unaudited quarterly report that includes summary versions of the four fi nancial statements and limited additional disclosures.

•

•

Forms 10-K (which must be filed within 60 [90] days of the year-end for larger [smaller] companies) and 10-Q (which must be filed within 40 [45] days of the quarter-end for larger [smaller] companies, except for the fourth quarter, when it is part of the 10-K) are available electronically from the SEC website (see Appendix I A). The mini mum, regulated level of information is prescribed by SEC regulations, but both the quantity and quality of information differ across companies and over ti me. We need only look at several annual reports to see considerable variance in the amount and type of accounting information supplied. For example, differences abound on disclosures for segment operations, product performance reports, and financing activities . Further, some stakeholders possess ample bargaining power to obtain accounting information for themselves. These typically include private lenders and major suppliers and customers. T here are a number of datasets that aggregate financial statement data (includ ing SEC data), to aid access to fi nancial statement information fo r a single fi rm or for large sets of fi rms. Most university libraries have subscriptions to one or more of the following datasets that we can access without charge. •

Compustat

•

Mergent Onl ine

•

EMIS (for emerging-market companies)

Datasets consist of data that are "scrubbed" and formatted. Yet, we can use computer languages such as Python, R, or Java to gather data directly from the SEC website. This makes it possible to perform more-sophisticated textual analyses. For analyses in this text we use existing datasets

©Cambridge Business Publishers

Module 1 I Framework for Analysis and Valuation

and simpler programs such as Excel and Power BI, which are widely available Microsoft tools. We discuss this in more detail in Appendix l A.

Benefits of Disclosure The benefits of supplying accounting information extend to a company's capital, labor, input, and output markets. Companies must compete in these markets. For exam ple, capital markets provide debt and equity financing; the better a company's prospects, the lower is its cost of capital (as reflected in lower interest rates or higher stock prices). The same holds for a company's recrui ting efforts in tabor markets and its ability to establish superior supplier-customer relations in the input and output markets. A company's performance in these markets depends on success w ith its business activities and the market's awareness of that success. Companies reap the benefi ts of disclosure w ith good news about their products, processes, management, and so forth. T hat is, there are real economic incentives for companies to disclose reliable (audited) accounting information, ena bling them to better compete in capital, tabor, input, and output markets. What inhibits companies from providing false or misleading good news? There are several constraints. An important constraint imposed by stakeho lders is that of audit requi rements and legal repercussions associated with inaccurate accounting information. Another relates to reputation effects from disclosures as subsequent events either support or refute earlier news.

Costs of Disclosure Costs of supplying financial information include the following. •

Preparation and dissemination costs. Even though companies might already have gathered info rmation for internal use, the cost of auditing the information and compl ying with the SEC's rules can be time consuming and costly.

•

Competitive disadvantages. Disclosing product or segment successes, strategic alliances or pursuits, technological or system innovations, and product or process quality improvements could reduce or eliminate a company's competitive advantage. Litigation. Risk of litigation increases if companies disclose information that creates expectations that are not met. The cost of defending against customer or investor lawsuits is not inconsequential even for cases that are dismissed.

•

•

Political costs. Highly visible companies can face political and public pressure. For example, government defense contractors, large software cong lomerates, and oil companies are favorite targets of public scrutiny. Extra disclosure can increase this scrutiny.

The SEC adopted Regulation Fair Disclosure (FD), or Reg FD for short, to curb the practice of selective d isclosure by public companies (called issuers by the SEC) to certain stockho lders and financial analysts. In the past, many companies disclosed important info rmation in meetings and conference calls that excluded individual stockholders. T he goal of this rule is to level the playing field for all investors. Reg FD reads as follows: "Whenever an issuer discloses any material nonp ublic information regarding that issuer, the issuer shall make public disclosure of that information .. . simultaneously, in the case of an intentional d isclosure; and . . . promptly, in the case of a non-intentional disclosure." Reg FD increased the cost of voluntary fi nancial disclosure and led some compan ies to curtail the supply of financial information to all users.

International Accounting Standards Companies in more than 120 countries, including the European Union, the Un ited Kingdom, Canada, and Japan use International Financial Reporting Standards (IFRS) for their financial reports. Headquartered in London, the International Accounting Standards Board (IASB) oversees the development of IFRS. While the IASB and the Financial Accounting Standards Board (FASB) operate as independent standard-setting bodies, the two boards work together cooperati vely, often undertaking joint projects. Consequently, IFRS and U.S. GAAP (general ly accepted accounting principles) are generally more ali ke than different for most transactions.

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Module 1 I Framework for Analysis and Valuation

Currently, there is no formal plan for the U.S. to transition to IFRS or for the IASB and FASB to converge; however, both boards believe comparable global accounting standards are desirable because comparability would •

Improve the quality of financial reports .

•

Benefit investors, companies, and other market partic ipants who make global investment decisions.

•

Reduce costs for both users and preparers of financial statements.

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Make worldwide capital markets more efficient.

Evidence of increasing "comparability" of U.S. GAAP and IFRS includes the following.

Reviews are self-study tools that require the application of accounting topics covered in each section. To aid learning, solutions are provided at the end of the module.

•

Since 2007, the SEC has permitted foreign companjes to file IFRS financial statements without requiring reconciliation to U.S. GAAP. Currently, more than 500 companies w ith a cumulative market capitalization of tri llions of dollars report to the SEC using IFRS.

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The FASB participates actively in the development of IFRS, providing input on IASB projects throug h the IASB 's Accounting Standards Advisory Forum (ASAF).

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Recent joint projects between the two boards relate to leases, financial instruments, revenue recognition, and insurance contracts.

We might ask: are financial statements pre pared under IFRS substantially different from those prepared unde r U.S. GAAP? At a broad level, the answer is no. Both are prepared using accrual accounting and utilize somewhat similar conceptual frameworks. Both require the same set of financial statements: a balance sheet, an income statement, a statement of cash flows, a statement of stockholders' equity, and a set of explanatory footnotes. T hat does not mean that no differences ex ist. However, the differences are typically technical in nature, and do not differ on broad principles di scussed in this book. A t the end of each module, we summarize key diffe rences between U.S. GAAP and IFRS. A lso, there are a variety of sources that provide more detailed and technical analysis of similarities and differences between U.S. GAAP and IFRS. The FASB, the IASB, and each of the " Big 4" accounting firms also maintain websites devoted to this issue. Search under IFRS and PwC, KPMG , EY, and Deloitte. The two standard-setting bodies also provide useful information. See: FASB {www.fasb .org/intl/) and IASB {www.ifrs.org).

~··"'·~. ~ REVIEW 1 ·2

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r

L02

Required Match the users of financial statement information with the types of questions they would typically ask and answer using accounting data.

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__ __

I. Managers and employees II. Investment analysts and information intermed iaries III. Creditors and suppliers IV. Stockholders and directors V. Customers and strategic partners VI. Regulators and tax agencies

a. Is company management demonstrating good stewardship of the resources that have been entrusted to it? b. What product lines have performed well compared with competitors?

c. What regulated price is appropriate given the company's financial condition? d. Is the strategic partnership providing reasonable returns to both parties? e. What expectations about the company's future profit and cash flow should we use as input into the pricing of its stock? f. Is the company in compliance with the contractual terms of its existing loan covenants?

Solution on page 1-50.

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Module 1 I Framework for Analysis and Valuation

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•REVIEW OF FINANCIAL STATEMENTS Companies use four financial statements to periodically report on business activities. These statements are the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows. Exhibit 1.2 shows how these statements are linked across time. A balance sheet reports on a company's financial position at a point in time. T he income statement, statement of stockholders' equity, and the statement of cash flows report on performance over a period of time. The three statements in the middle of Exhibit 1.2 (period-of-time statements) lin k the balance sheet from the beginning to the end of a period. A one-year, or annual, reporting period is common and is called the accounting (fiscal) yew: Of course, firms prepare financial statements more frequently; semiannual, quarterly, and monthly financial statements are common. Calendar-year companies have reporting periods beginning on January 1 and ending on December 31. Some companies choose a fiscal year ending on a date other than December 31. Sometimes the fi scal year end coincides with a time when inventory is at a low point or at the end of a natural business cycle. Other times, the fiscal year is an industry standard. Most companies end their fiscal year on the same date each year (such as May 3 1). Other companies select a fiscal year that ends on the same week day each year. For example, many U.S. retailers have a fiscal year ending on the Saturday closest to February 1some years that will be in late January, other years in early February. Apple, Inc. ends its fiscal year on the last Saturday in September. EXHIBITi 1.2

Financial Statement Links across Time Statement of

Cash Rows

Balance Sheet

(beginning-ofperiod)

(end-ofperiod)

~=

Income Statement

--

Balance Sheet A balance sheet reports a company's financial position at a point in time. The balance sheet reports the company's resources (assets), namely, what the company owns. The balance sheet also reports the sources of asset financing. There are two ways a company can fi nance its assets. It can raise money from stockholders; this is owner financing. It can also raise money from banks or other creditors and suppliers; this is nonowner financing. This means both owners and nonowners hold claims on company assets. Owner claims on assets are referred to as equity, and nonowner claims are referred to as liabilities (or debt). Since all financing must be invested in something, we obtain the following basic relation: investing equals financing . This equality is called the accounting equation, which follows. Investing

Assets

= •=

Nonowner Financing

Llabllltles

+

+

Owner Financing

Equity

L03 Review the four financial statements.

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Module 1 I Framework for Analysis and Valuation

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/

The accounting equation works for all companies at all points in time. -----"'~ Apple 's balance sheet (condensed) is in Exhibit 1.3. Its accounting equation follows ($ millions).

Real Companies and Institutions are highlighted in bold, blue font.

Assets

Liabilities

+

Equity

$365 ,725

$258,578

+

$107,147

Investing Activities Balance sheets are prepared at a point in time and are organized like the accounting equation. Investing activities are represented by the company's assets. These assets are financed by a combination of nonowner financing (liabilities) and owner financing (equity). Apple's condensed balance sheet in Exhibit 1.3 categorizes assets into short-term and longterm assets (Module 2 explains the composition of assets in more detail). Assets are listed on the balance sheet in order of their nearness to cash, with short-term assets (also called current assets) expected to generate cash within one year from the balance sheet date. For example, the first shortterm asset listed is cash, then accounts receivable (amounts owed to Apple by its customers that will be collected in cash in the near future), and then inventories (goods available for sale that must first be sold before cash can be collected). Land, buildings, and equipment (often referred to as property, plant, and equipment or just PPE) will generate cash over a long period of time and are, therefore, classified as long-term assets.

Real financial data for focus companies illustrate key concepts of each module.

Balance Sheet ($ millions) APPLE, INC. Consolidated Balance Sheef • September 29, 2018

Report amounts at a point in time

I investing

r

I Total resources

~ Total assets. .. .. .. . ....... . .. .. .. . ...

Assets Short-term assets ....................... • .... • .. • ....... • .. . .......... . ........ Long-term assets .................. . ....•....•..•....... • .......... . ...........

~-----~

$131,339 234,386

. . • .. ..•.. •. . ... ..•.. •.. .. • .. .. . •.. .. • ...

$365,725

Short-term liabilities ... . .. . ... . ... . .. . . ..... .. ......... .. ...... .. . . ....... .. .. . . Long-term liabilities ...................................... . .......... . .......... .

$11 6,866 141 ,712

Total liabilities . .. ...... . ... . .. .. .. . ... . . • .. ..•.. • ....... • .. • .... • . ... . • .. .. • ...

258,578

~------~•., Liabilities

I Financing

Nonowner financing

Stockholders' Equity Contributed capital .... . .. . ... . . .. . .. . ...... .. ........• .. .. . ... .. . . •..... . .. .... Retained earnings ....................................... . .......... . .......... . Other equity ........................... • .... • .. . .......... . .......... . .. ......

~I0-w-ne_r_fi-na_n_c-in-g~I

.

~ Total stockholders' equityt ............... . ..... . .......... . ....... . ..... . ....... .

40,201 70,400 (3,454) 107,147

. - - - - - - - - - , . -+ Total liabilities and equity ......................... . .......... . .... . ..... . ....... . $365,725 Total financing of resources • Financial statement titles often begin with the word consolidated. This means the financial statement includes a parent company and one or more subsidiaries, which are companies the parent company controls. t Components of equity are explained as part of Exhibit 1.5.

The relative proportion of short- and long-term assets is largely determined by a company's industry and business model. This is ev ident in the graph to the side that depicts the relative proportion of short- and long-term assets for a num ber of well-known companies. •

Larger investments in short-term assets occur at companies such as Best Buy, Starbucks, and Nordstrom 's that carry relatively high levels of inventories. High current assets also occur for technology companies like Alpha bet (formerly Google) and Cisco that have high cash balances and large investments in marketable securities that are classified as short-term because they can be sold quickly in financial markets.

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•

•

Man ufacturers such as 3M, Johnson & Johnson, and Colgate-Palmolive require more investment in property, plant, and equipment in addition to large investments in inventories and accounts receivable from customers. At the other end of the spectrum are transportation companies like Southwest Airlines and communications companies like Comcast whose business models require significant investment in long-term equipment, such as planes and telecom infrastructure.

Module 1 I Framework for Analysis and Valuation

Relative Proportion of Short-Term and Long-Term Assets

100% 80% 60% 40% 20% 0%

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