ACCT 5301 Summer 2013

1. Part I: Financial Accounting for Executives ACCT 5301Summer 2013

2. Creighton Family Medical Practice • Three doctors • New medical practice • Informal accounting system • After one year, one doctor decides to leave the practice to become a Medical School professor • How much “should” the practice pay the departing doctor to liquidate his investment? • Might one of the other investors be willing to pay more? Discussion Case

3. What is the Purpose of Financial Statements? • Different Statements—Different Purposes • Annual Report issued by a publicly traded company? • Income tax return? • Statements prepared for a lender? • Reports issued to, say, partners in an oil & gas venture? • Managerial reports? • Governmental Financial Reports? • To What Extent Does the Purpose Influence Measurement? • Rules are largely driven by the underlying purpose of the statement

4. Rule-Making and Enforcement Bodies are Crucial • Who Makes the Rules for Tax Reporting? • Internal Revenue Code Implemented by Congress • Enforcement, but also Interpretation, largely the responsibility of the Treasury Department and the Internal Revenue Service • How About Financial Reporting? • Generally Accepted Accounting Principles (GAAP), issued by Financial Accounting Standards Board (FASB) in U.S. • International Financial Reporting Standards issued by International Accounting Standards Board (IASB) internationally • Securities & Exchange Commission (SEC) is primary U.S. entity with responsibility for enforcement

5. Conceptual Framework for Accounting • Objective of Financial Statements is to provide information useful to capital markets to make decisions about whether or not to provide capital (decision usefulness) • Key attributes of such statements are: • Relevance • Faithful representation (reliability) • When these are in conflict, rules must weigh relative costs and benefits of competing approaches • In other reporting settings, some rules of GAAP may be waived to accomplish specific objectives of reporting process

6. General Concepts Underlying Financial Reporting • Financial statements report to providersof capital: • Shareholders, other equity owners (e.g. partners) • Creditors • Report about the business entity • Assumption is that the entity is a going concern • Financial statements designed to address separate purposes, but are interconnected: • Balance Sheet provides a picture of the business entity’s financial position at a specific point in time • Income Statement summarizes the results of the entity’s operations over an identified period of time • Statement of Cash Flow reconciles reported income from Income Statement with net change in cash on Balance Sheet • Statement of Shareholders’ Equity reconciles changes in equity accounts

7. “Interconnectedness” of Financial Statements (“Articulation”)

8. Key Concepts • Accrual vs. Cash Method of Accounting: • Cash Flow Income • Taxable Income Financial (“Book” or “GAAP”) Income • Assets vs. Expenses • One goes on Balance Sheet, the other on Income Statement • Current period benefit vs. multi-period benefit • Cost vs. FMV • “Matching” Principle • Revenues must be recorded in the period in which they are earned • Expenses must be matched with Revenues they generate • Requires use of estimates • Liabilities vs. Revenues • Has company earned the money or may it have to be repaid? • To which period should the revenue be attributed?

9. Balance Sheet • Elements of the Balance Sheet • Assets • Liabilities • Owners’ Equity • Balance Sheet Equation • Assets = Liabilities + Owners’ Equity • Double-entry accounting system • For investors, how does equity grow? • Profitability • Issuing new shares • How does it shrink? • Payouts • Losses • How do acquisitions affect owners’ equity?

10. Balance Sheet (cont) • What is an Asset? • Economic resource that is expected to generate future benefits for a business • May be “tangible” or “intangible” • Proper valuation on Balance Sheet? • Current vs. “Long term” • What is aLiability? • Obligation to make future payments • “Fixed” vs. “Contingent” • “Off-balance sheet” liabilities (e.g., operating leases) • Current vs. “Long term” • What is Owners’ Equity? • Residual balance, Assets in excess of Liabilities

11. Income Statement • Elements of the Income Statement • Revenues • Expenses • Classified Income Statement • Income/expenses from operations • Gross Profit (for manufacturing companies) less selling & administrative expenses • Non-operating income and expenses • Income tax expense • Discontinued operations & Extraordinary items (2 separate sections) • Earnings per share • What is a Revenue? • Increases in shareholders’ equity resulting from the provision of goods and/or services to customers or other activities that constitute the entity’s ongoing major or central operations • Not recognized until they are earned, the selling price is fixed or determinable, and cash collection is reasonably assured • Distinguished from gains, which arise from peripheral or incidental transactions • What is an Expense? • Reductions in assets or increases in liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations • Where possible, expenses must be “matched” with related revenues • Distinguishable from losses, which are triggered from peripheral, nonrecurring, or incidental investing or operating activities.

12. Ford Motor Company • Motley Fool recommends Ford … http://www.fool.com/investing/general/2013/07/10/2-more-reasons-to-invest-in-fords-turnaround.aspx • Let’s use the company’s Income Statements & Balance Sheets to analyze the turnaround • 2004, 2008, 2012 • Begin with 2004 and 2008 Financials • Compare 2008 and 2012: • Were sales higher in 2008 or 2012? • What about net income? • What happened to gross profit margin? • What about Selling & Administrative expenses? • Total debt? How did that affect interest expense? What else affected interest expense? • What did Ford do financially & operationally between 2008 and 2012? Discussion Case

13. Ford Motor Company (cont) • Analysis of 2004 v. 2012 Financial Statements • Profitability: • Gross Profit Margin • Return on Sales • Return on Assets • Return on Equity • Component analysis of ROE • Asset Management: • Inventory Turnover • Inventory-on-hand Period • Asset Turnover • Financial Risk: • Long-term debt to equity and assets • Interest coverage Discussion Case

14. Statement of Cash Flow • Reconciles Net Income to change in Cash balance on Balance Sheet • Changes in cash balance arise from three different types of activities: • Operating Activities Cash sales + collection of receivables — Cash expenses & payment of accounts payable • Investing Activities • Asset purchases and dispositions (physical assets, securities, intangibles, etc.) • Acquisition or disposition of affiliated companies • Financing Activities • Issuance or repayment of debt • Issuance of stock, acquisition of Treasury stock • Payment of dividends • The cash flow statement can be used to evaluate the “strength” of a company’s income • Keys to analysis: • What are implications of increases in receivables? • Is the company delaying payment of obligations? • What are the company’s “non-cash” expenses? • What is the company’s free cash flow? • What is the company’s discretionary cash flow?

15. Ford Motor Company • Income Statement & Balance Sheets • 2011, 2012 • Review 2011, 2012 Cash Flow Statements: • What is the relation between income and cash flows for the 2 years? • What items stand out to you in reviewing these statements? • What was “free” cash flow in each year? • What were the company’s “discretionary” cash flows in each year? • What does the cash flow statement add to the other two primary financial statements for Ford? Discussion Case

16. Limitations of Financial Statement Analysis • Many of the largest numbers in the financial statements are estimates • Depreciation expense • Inventory • Cost of Goods Sold • Allowance for Bad Debts, Warranty Expenses, etc. • Option compensation • Contingent liabilities • Other reported figures may be manipulable • Income tax expense • Revenue recognition • Data is not always current • Hidden and/or incomplete financial data

17. What are Management’s Incentives to Manipulate Financial Data? • Pressure from Wall Street • Compensation tied to stock price • Options • Restricted stock • Company loans used to purchase shares • Phantom stock and Stock Appreciation Rights (SARs) • Optimism about the future • Insider knowledge • Attempts to “control” expectations • Combining these incentives with flexibility in GAAP can be dangerous

18. Revenue Recognition • Revenues are realized when a company exchanges goods &/or services for cash or claims to cash (receivables) • Revenues are realizable when assets a company receives in exchange are convertible to known amounts of cash • Revenues are earned when a company has substantially accomplished what is must do to be entitled to payment • Sale of products – revenue recognized at date of sale. • Sale of services – revenue recognized when services have been performed and are billable. • Use of assets (e.g., rent, interest, royalties, etc.) – revenue recognized as time passes or as assets used. • Amount to be received must be reasonably determinable and collectability must be reasonably assured

19. Revenue Recognition—Common Situations • AvalonBay, the nation’s no. 2 publicly traded apartment management firm – advance deposits • Lowe’s – gift cards • American Airlines – airline mileage awards • Southwest Airlines – travel point awards • Best Buy – extended warranties • Sam’s Club – membership fees • Lehman Bros – repurchase agreements

20. Priceline Restatement • In the 4th quarter, 2000, the company collected $152 million from its customers for airline tickets, hotel rooms & rental cars • It paid $134 to airlines, hotels, and rental car companies, and kept $18 million • How should it report this activity? • Sales of $152 million and cost of goods sold of $134? or • Commission revenues of $18 million? (Note that the company reported a net loss of $102 million for that quarter) Discussion Case

21. Lucent — “Channel Stuffing” • In the 4th quarter, 2000, the company shipped goods to customers with a generous return policy allowing customers to return those goods if not sold within “normal” time period • Company subsequently “restated” its financial results reducing revenues by $679 million and converting its operating profit into a loss • What signals might you expect to see in its financial statements? • In quarterly data? • In Sales vs. Accounts Receivable? • In footnotes to financial statements? • In bad debt reserves? Discussion Case

22. Receivable Valuation • Sales on account bring the risk that some customers will not pay their account • This risk is influenced by firm’s credit policies • Bad debts need to be matched to the period in which the credit sale occurred, not when the account is charged off • How? Establishment of an “Allowance Account” • Company estimates portion of receivables that will not be collected. • Records an expense and establishes a reserve for uncollectible accounts. • Subsequent period charge-offs do not directly affect Income Statement because expense has already been recorded.

23. Allowance vs. Expense Accounts • Key Point—Understanding the Relationship Between Allowance Account (“contra-asset” on Balance Sheet) and the Bad Debt Expense reported on Income Statement Beginning balance in allowance account + Plus bad debt expense —Minus charge-offs = Equals balance in allowance account • Can normally calculate charge-offs if you have beginning, ending and expense figures

24. Allowable Measurement Approaches • How do we estimate uncollectibles? • Percentage of credit sales • Aging of outstanding receivables • Estimates are based on experience • Company experience vs. industry experience • How might an investor discern earnings management through the bad debt reserve? • EXAMPLE: In 1996, HealthSouth reported the following: • What were the company’s “charge-offs” in 1996? • What does that suggest with respect to the amount recorded as bad debt expense?

25. Inventory & Cost of Goods Sold • Valuation—several approaches allowed by GAAP: • FIFO • LIFO • Weighted Average • Specific Identification • Cannot use LIFO for tax unless also used for book • Question: if a valuation method increases value of inventory on balance sheet, what does it do to reported income? (trick question) • Example – gasoline sales at a truck stop • Bigger issue arises when inventory becomes obsolete (or begins to diminish in value)

26. Long-lived Assets Valuation & Depreciation • Historical Cost vs. FMV – is FMV relevant? • Why or why not? • When? • Allowable depreciation methods • Straight-line • Accelerated (most companies use accelerated methods for tax) • Other measurement issues that affect earnings • Depreciable “life” • Salvage value • Following 9/11, American took an “impairment charge” against its plane fleet of $1.24 billion • Good time for “big bath”? • Effect on subsequent years’ reported income?

27. Example: Waste Management • Lawsuit filed in 2002 against founder and 5 former top officers of company • Accounting Issues: • Depreciable lives of garbage trucks • Salvage values • Depreciation of landfills • Unwarranted “environmental reserves” associated with acquisitions • How would these practices affect the company’s financial statements?

29. Accounting for Investments in Other Companies • Valuation—depends on size and nature of investment: • Gains and losses from mark-to-market for trading securities included in income • Gains and losses from “available for sale” securities or 20/50 investments flow into “Other Comprehensive Income”

30. Bonds Payable • Bonds are publicly traded debt instruments • Usually pay interest at stated rate on face value over specified period • Stated rate may differ from market rates: • If lower, bond will be sold at a discount • If higher, bond will be sold at premium • Occasionally, stated rate is zero • Premium or discount must be amortized into interest expense • Early retirement will generally trigger reported gain or loss

31. Leases • Lease arrangement must be capitalized if any of following is true: • Agreement transfers ownership to lessee by end of lease term • Agreement contains a bargain purchase option • Term of lease is 75 percent or more of economic life of leased asset • Present value of minimum contractual lease payments is 90 percent or more of FMV of leased asset • Capital lease has same effect on income statement as an “operating” lease during each year of lease agreement • However, assets and liabilities on Balance Sheet are lower • May significantly impact financial ratios

32. Accounting for Taxes • Book Income will generally not equal Tax Income • Tax Income determines amount of tax to be paid this year • Book Income determines amount of tax to be paid eventually • “Permanent” differences vs. “temporary” differences • Difference between amount paid this year and amount deferred is tax on temporary differences • Examples of Permanent Differences: • Foreign earnings permanently reinvested abroad • Tax-exempt earnings • Stock option differences

33. Stock Options • GAAP—estimate value of options when issued and expense over vesting period • Tax—calculate actual value when exercised and deduct that amount in year of exercise • Amounts deemed compensation often differ dramatically • Companies often acquire “Treasury Stock” to satisfy option exercises • Loss on Treasury stock flows through Retained Earnings • Example

34. Summary • Analysis of financial statements often based on ratio analysis, growth, and similar calculations based on reported financial information • Managers know how valuation models are used • Managers often (generally) have “target” levels for reported earnings, leverage ratios, etc. • Measurement is often influenced by these management incentives • It is important to know how key concepts in measurement impact reported financial information • Measurement incentives may impact structure of transactions, which may be ok, or may impact choice of measurement methods, which is often not ok