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    CH 7

    Uploaded by

    Yusef Sobhi

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    © All Rights Reserved
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    me ee Financial Statement Ai Connecting Economic C A quit tasteless joke made the rounds a reutatin to reassure potential cnt tht ae ape peel eectan campaign, Wea pron te eed ss 6 he caedates were Bil Cntr, il young By residential standards, and B0b Dole, who wes tre TO years oda he time to an eppenrene on MTY, clinton was asked whether he wore overs ores, The joke was that when Bo ‘ole was asked that same questo, he repli Depends" Te “hur” came fom the double rearing ter Dole chooses his underwear ase toe some changing preference, rhe refering © the brand name ofan aut incontinence prod tn some industries GAAP accounting ecvatey aptres the ectnomic vues of assets enployed hu ables created that is the account ahi tions Ftd oselyconwey tei economic eles Ip other industries, GAAP accountng 4s not acartelycaptre the types of asses enponed sna ibties crested Either the GAAP elustons fe inaceurat of in Some instances, GAAP fit ecord the aset or ibility onthe bance shes in art of tts book, we sw tha balance sees and income stants ae the two typ fia tal statements define in terms of econo com apts A balance seet shows book val at ‘ur interpretation is that he ment his preference epends on the fats Tat’ going to be the tran thing we find out about how closely 2 punting i connected with economist depend tn Chapter 6 we exleined thatthe accounting adjustment process attempt to bng ase ond Taal valuation in balance shets mre it Ine tit ther economic values. We alo inated how uses can make revenues and emer In the income statement beter measures ofthe fos of economic esauces in ad out f the fi ating the accountng pred Econo vai, 3 teplaned,s best measured by computing preted nt present ves of ture cash Hos ature chapters we wil see many apbatons oF ‘hes present vale teerique inthe acouting treatment of spect catgais of assets and tities, The gost of ths chapters to Msi with two exams, how closely the process a jist acount to econmic ves. AS we wil 86 ‘depends onthe yp of ase ond Hailes ppeating ina particular fs alence sheet point in tne Te cones of ase abies von euites ere central fs contucon. A ome statment shows the lows of rues OFF Sine generated by the earings proces IcOME {earings messued sng the concepts of tues expenses, and income, When te accounts fa fm dose elle econo valis i bal sce sheets ive dea cares ofthe conic Wales fase ar is ot the tle Shee dates, and ts income statemen's ge tres of te fons of econo esac in an tut of the fir oer psd of ine. hen the scours ffm do nt dose capture the E> ric ofthe fits balance sheet ge Souls Tce ofthe economic wales of aes and To pits at the balance seet dates. come statements as fal to eat come the fms of conomie escutcee ove eros fine. ot the met nfrmaton fom ast of nancial sat stand ety yes ry wires nr TRYOUTS vedestand whee they le A re etare sues teers ewe CN) boy wih es | Se ee lid ea ps Oe wo had at \ re ogc earn sens, NAT he acount mbes | (ce andecie athe TaN wT eck fain not \ a ning eqipme vest te esa MEE cong our iy Jeeta od porsreqpred tomate YE \ tm fm mst ae ce Ths ape compares aes \ aon capa eu to deer e0-—_alon of alc sheet rede sates, accounts, determined using GAAP wit theun- 3. intodce sno ratios commonly sed to ethjing econo values thas fou ain goals: facta nan statement anayss—the 1 Te develop on understanding sto why GAAP rmaetobook rato andthe retum on eay ratio. nd economic valuation of eomprie die 2, To show how understanding this ference ovides abasic amewerk forth analysis of financial steers Pol sat Daye ad slr: perfor fncncialstatonet wh (ojo tir teat: The Boing Corporation bas (hou 97 lon shares of Sauget 200 te sack ‘lia sper inex of ion 4 To show you by looking at two parila empanies a deta that fanclstenent nay 2¢ much anata it a eence. Alternative Measures of Value: A Framework for Financial Statement Analysis Thre diferent bc albatons ae import to undntanding he Sarl eh of it We sendy bry dsc te of the oh book, scuning and coma veka of il acts ables Tet ithe ovr vation of pub Thy wade fe provided by tne tock msc, We il now pend some ie ang, ‘rch of thaw thes ineeues, Then we wil show hw these thre messire provide 8 ‘Eamework for financial statement analy The Value Firm in the Stock Mia ‘One way o reso the question, "What ithe total eannomie value of companys 0 ‘et yale ofthe common shareholders equity, which i aso known as th fms market ‘aptalietio is calculated by taking the uber of common shares oustanding tines the price er sha Aetrmine the prices at which shares of stock sll om 2 stock 1 seller sow a fong tres in peting good dea fr ther Selves: The market provides incentive fo he to ste sistion and afl vee tate thei options. Bertse bayer and slr must gue for transaction to take plas, Spd becuse under sy cmpllon to at, Doh anit cone tht the fers [rs aceptable Tuya ashe valton offs an exemalystong inden of the 35° pepe sconoric vale far How do byes and sles determine what pier acceptable to then? They process information sbout the fur ca Bows of company and they frm expectations about ‘wha thee cashflows wl be. GAAP ancl satements fe one source information Used by baer and seller in tc sessment of market value Tey cory rer ‘nether tneument in ight of GAAP balance sheets, income satemens, abd sp. orig dclosres “The main pint is that tock markt peices are prety good messes ofthe aegre- tte economic he ofa company They vale al of he aes ad abies as one bun- fle. The rock market doesnot provide etna of economic vals of iuiidat ‘company suet sd ible GAAP Valuation Financial statements constructed using GAAP serve multiple users. To be useful hey swe constructed sp an ebjectve and vefuble fision. The nusben azcived at BY ossectiv counts and auditors must be capable of plication hy oer assotans a su tea unde te for signed the sane ack The nambers equ some evidence te susan ther. Seat and went ‘Objectivity nd verily crente igi in nancial statements. GAAP statements | Another example would be "GAAP numbers difer from econamic numbers in two main ways recognition and. |) SAGARnare elree cee e te r a | | [tke book vale ofan ast reflects am llocton over ime bat te change Sn ts ox ‘omic ale elo a change in the expected preset vl ofits fare cas Dow. Only In spec ccumsances wil the two eric "Recognising tat GAAP impose objertity and viable a conservative bis ted therfore might not be seal in generating an accurate Banca epor fo every nm, we boul spprouh nec tatment aaj catosh, Reagan problems of restive recogatian and shortamings ofthe ajustet process shuld al concer ‘ken do GAAP acutely capte what happening the Sr? These has m0 cay nsw and awe el ear, ancl sateen ana more of a at an 2 seence Financial Statement Analysis Conceptual Framework for Financial Statement Analysis ‘Te previous concepts nd ides canbe combined as fellows wo forma gener concep tual foundtion for Snancl statement els, Ree to gue 7-1 you read though thes eps opsscrve ‘The information in GAAP Gnanci statements provides input t» many deciions. A lem ht url stneert | banker must decd whether to grant aoan to afm. A portoig manager mst decide | it nd an nee to nves inthe stock of parca company. A board of deers might be i ‘fp econ eos: | teretd in eralting managerial performance A manager might be asesing compet i seo ‘Sona pat of strategie analy. Regless af the conte, the deion maker loos at itm the att ad nities of the Gen ad bow de rn manages and as these assets ‘rinsanc a bok roving spdliltes, Depending on the parle decison the empha might be on flere Sthertom loos tose ste and lai, eer ily i fru on te" mtr what the decision context, the stem shuld says be to place 2c ‘nite of ventory ondo-—_countng number in thet pope economic contest Ino wht Ie scounting 00 i on Sees re cthe it what they men ina economic ese matey decison ate bared erate ‘on atefl snl fea Hows, not necessary accounting numbers. Central good Remember when you gto decion making an underranding of and inition abot whether particular 2 ‘hesret buy alofof counting gumbere eee good srogae for he ecomic value ofthe ses, Hal | Bread you teach thi renee, an expen. fa eononic an eur Vine Cre Bsr esl Sate Aas (Gockel) en een ane oi Seopa N anata anges aa ete ange ett ‘on nea an ‘Bisa pes oes ‘ono res) ‘he get ie ras aR, apie te “hut Dense =| el teinoswihcme nx | ties ers tot ae satan ae Teese ont 924) ninesnensy eso Someta oan Fi honk ae sto wne thom ap Tare re met of he ine we onl sept Erk ceed ba Sistem mae naples hr might be Icey deroped pene, eal bert itrac [oti nd olaton we se chplomentaprecmente onmecrve: ‘afin rand aa of eure for eal vl hea inal ston tbo gay et ob compe the ‘oj have ee ax Creu ct is messing at ‘ncaa ond vel ow gh compar life eens mt of se fil ce ey Items of Fg 7 the eka doo equ {SB vided by BE 1. atmate he economic valu fhe fms sity (EVE) using tok marke valuation, dentinal seta ailties that ve accounting valotions close thelr Economie values (Ay dL) Look tothe Banca statements eves. 2, Went acounting tet and bites or which we can find a msonable economic ‘lebih are not care at that vale inthe nancial stamens (Ayah) Took to individual ast snd lsbity markets for ales. 4 LEtalltheenmining counting ste sd blir ofthe Bem Bx which economic values cannot be resonsbly ested (Ay snd L) Use tedhnignes such sx present {eof expected fur at lows fo estimate vals 5, Search for ante and lables tht arena std om the Blane ses et ate eo omic nets and lable (Ag and 1). Use ecigues sch as resent ve of Dt fate cash Hows etimate as. ‘either ofthe colamns in Figure 7.1 represents sect tth ut comparing and contrasting the thee appronches to ae hlp financial reader to rstand betes the acl stats ofa pruarBe. would bene ial the accourting asst andl tes flint the book value citegries BvA apd BvLy Then we would know th ‘GAAP ace with economic values, If nado, BE were alo hein vale t EXE Swe would know tht we ve nt ily ising ny asses and aie inthe accounting ‘Conceptually, we want to understand company economialy by developing » complet et of asec bles with individu economic wala hat ave atta Set enone value lose to the aus the stock marketplaces on te firm, Ee I we ‘ely sets and abe with ol net economic vue near EXE, thea the wo in {Ependent measures of value agice and we canbe rexonaby certain we didnot omit fnything. If Brdy + Bvdy + Bvhy + EvAy Bvt, ~ Els ~Evl,— Bolg is much pester or lee than EVE, then perhaps the mock market is eling a someting Per fips we left out some sete or abies im an anal: ‘Obey the cle Bray Dia Oy half i BE une nce we am pce con the scouting numbers any Baal anal Moe sets nd Tables EAs, Tidy Evy and Br mak the financial nai more subjective ute chpters ook rote atthe specific for diferent types of sets and ible. Here we we thee important finance satis to gauge the dosenes ofthe connection brtween GAAP book tle and economic vals fra gien fm. The market value of tim common ck umber of shares outstanding times the pi: per sare) divided tpi bok value india ts market-to-book ratio In gener st sone umber {Ivided by another number, Acountats ue ation to menare aiiy (cash flows in Sd ut ofthe fr), profisby, ciency, ed long-ram financal survival lv) Specicaly, the market-to-book ati indeates how closely the bance shet reflects arepte economic alts aa pit fe In tar, his fet ho income statements ‘tc the flows of value The other important statics inl forms of return on =~ Tuts which show rl lows and how they resto shurholder’ reoures employed 0 the busines etn an egy provides 1 measure of he Gm nencome divided by ‘Thneane oft socholoery ey. Return on egy ean be measured ina kas two “ray We could use GAAP mses of nee ned egy to calcul aecounting et ‘regi or we coud ws economic meaner of iuome ad ety to alate c= omic return on eu If the scsnont cond captre the econo, the to returns tm ety wl be cls. the cena do ot closely eptre te economics the 9 = turns qu wil ot be clove "stm wos balance sess clenystlest economic vals will most ily have counting earns on eau ferent fom 3 Bom whose balance thors do not hesly Tee scovomi lute Accounting eeturn on equ is fen Used 6 a esse of Pe Fonmance over a petiod, and we wil wast to compare a rns acoutingeetarn ox tutyapnnstereasonablecxpetation, lee eed to snderstandtheconnection between (hark to book toe sd sconting fears on equ in sessing eds in account Ing ret on equ. Figute 72 shows sujeive schematic gram useing thelr of ean that GAAP numbers merit a 2 function ofthe mathe o-bock tai. Read comps ‘snd savings end loans tend tobe anaieed cht by looking st CAAP seca ‘whereas an ani of «high-tech company pct lacs reliance othe accountng ‘uber Manufacturing fms ll somewhere the idle With tine yo wil deelog ‘tition about wher a particular Bem fon this ine nd how mc locking ys Wl hate todo oui of he nancial statements. en ete Ratlnce on GAAP a Fiance ety sy. ox Baty other ‘This tpi is fy complcted so we use examples to strate wha we mean rocarg Fst Panel Bancorp we stand cnt ables whore ean lcs ste captured wel by GAAP Mlcoso we sects and cents lables whore exo "als ar not cepted wel by GAAP. We export martt-to-ooklaon senting tuna om equity and economic tus ones fo hee two compan, We dee how the proses of rsognition and adusnen aft thete nance Review Questions Fue rs tmnt ol Ue an es eh cas compte Seok rial fhe ama pr Sn ae cera nsec: | . tenes) te eit | Harrodsburg First Financial Bancorp, Inc. Shem tone | sapere Financ Bancorp, ne. here Harrodsburg) ta smal savings and oe Ina in Ke ky ls 998 Frm 108 contained the allowing semen ‘hide of he as ido toning Ine eileen ‘nese there ave 2182,125 Bp be te crpeny bar ‘Poche 2580 thar te tem the compen ‘nip hres pal a 2183125 258897, or 323515 have cans ‘Sone comp Splinmore a Chapa 3) The Bank conducts «general basking busines in central Kentacy which pima- iy canis of atracing depos fro the gneal ui and appbing hse nds {the organ of tan or eet, consume, and nonecentlporpores, ‘The Banks oft sgifcowty pendent on met ners cma hc the iferone etnies nome gerard fom Strong se (.. loons and event) an th cere expence pad x ee ering babies (le tamer depot aed oro fn). Harrodsburg balance sheet as of September 30,198, shown in Exhibit 7-1, As you cans, total stockholder equity ender GAAP wat $2898 00. The pice of atodthurg’ common tock coed at 15.125 per sha on September 30, 199. Wee fon Harrodshorgs ance shet that on September 30, 198, 1923818 share of com thon sock outstanding wee ot held in tbe company. Therefore, the mare value of arodebarg toctholder quty was 29109520 (he economic ale tat the stock tart attaches to Harrodbur 15125/hare 1.923518 shares = $8083.20 (ounded) arodiburg Pt Finan Bnew, ie and Subilny ‘onsletd Bane Sheet. Sentamber 20,3998 (moons i hound) (Cath an de fom bake sma Invert esr epost 7am ‘Stes bh oma ae of 11226782 rey oan ccble ae ss2n9 ‘Accu nee rece ‘wos Pres nd eqipment, et eit Ober ats Sal TOTAL ASSETS suH ‘Hamnires ano srocxmotoens rawr, iGo $7087 ‘Advan poymens by borrower for ae and surance na Delorean tar rl Dried payable Otter aes "TOTAL LIABILITIES stocenouneas rouiry Common soc, $0.10 par valu 50000 shares autor Reine eninge uaa ested ‘Accumulated other comprehen name “restr snc 25847 sare cost ‘Unoctied popes sock ows plan (ES) se "lol ety {TOTAL LIABILITIES AND STOCKHOLDERS EQUITY ee (HAPTER 1 HURNCIALSTATEWLMT ANALISICCOMNECTING ECOKOMIE CONCEFIS TO ACCOUMTINE REPONTS «137 As sal the ook end okey no th Ss for meet capi emenbe te mere il eet $7398 fora 57.3943 for bering Spee “The suply and demand of investors assessing he net present ve of thee ture «ash los rom Farodsburg stock determine the market tle of Herodlnngs ay ‘GAAP that guide the consruton of the nail statements dtermne te a a of Harrodsburg stockholder equity. With Hstrdsbarg, these so diferent meses of au (tock mate nd accounting) yield extremely clove result differ ec, 11100, wheres the book and mark luce are abou $90 milion Market value 829003200 Book le ices of markt oer book ‘common way took at the elation between market and book vse isoform the market-to-book rai, which for Harrodsburg epember 3 1598 sas $29.03 200898, 98640 = 1.008 “The market vate of Harodsbur' qty canbe thought ofa the ack markets ‘timate ofthe economic value oft sets es he econo of ioe, ASSETS economic) ~ LIABILITIES (economi} EQUITY (exomie) The sock musket has no particular need to es the vues of he Harodsburg’s sss and bites separately When you own she of sack you ona lide pte ot the emir sit of assets nus lbs In fy if Harring sunset ae ees in cresting an orguizaton that moc than the sum ots pastes he sear Yalu ofthe individual ses and lbiier wl ot eaptte te was te hoe a So wile the market asses the vale ofthe ety 1 529,093.20 we dnt ely ne how th market would separately ass the ales of Harrodsburg indvidul ee aod Tabi “4-GAAM bales set, however, must provide separate values fer Hezodsug’s 4ases and lables, We an use the stock inaretsascament of Haaeoarts ceo some additonal diclsures Harrodsburg provides, and knowlege of how seating ‘orindvidal sects and lilies works tn pin some insight int tow clue GAAP gh, me to estinatng economic values of individual sets and les What wees 'sczrily not folpoot, swe wil discus, bt does demonstrate cme fae work fo thinking about financial atement sala Exhibit 720m page 118 presents a workset ht wil allow us oes systema ‘ally the economic vl of individual GAAP sets and lables The tea oe tp with an economic valuation as best we can, foreach of the accoustng sets ahd Habis, We wl hen see how close our explinstion comes to jasvng he eet aoe of Harrossburg tock If we come close, ten we can be reasonably sews tal des, stand what the abies and lables of Havodsbig ses what iesnoie ls oe swell we donot come cos, we must ok for move asets and aie o sore {he valuations closer gether or we wil conciadetht the mathe sot tenet assesment ofthe value of Hattoaturg ‘The GAAP column in Exhibit 72 copes the GAAP balance she om Eshiit7. ‘The Economic enum ists or best guest the econo lu ofthe to ably, Finally he Souce column iniates which chapter inthe tex expense fe in dete In esencr it provides roadmap for pat td ate chapters. Chpter ete see of the basic economic argument forall em, Each ase or leblity slated Aor Lo indlate ts category in Figure 7.1 Harrodsburg is inthe stings and lan busin, and most of sas ad Ubi cs are close to being cash or mostly gut We se that GAAP vale ese st lae 1© the economic vats that would be obtuied wing the methods has Chapt & ‘The economic vile of Hartodsburge Cash and Due fm Bans oe Ineres Beating Deposits is seta the amount of eth and money ty hs om dee I fppears onthe GAAP blanc sheet. We would expect GAAP tnd econo ale tobe en for these items 20 + rar 2 vnuuarion easies AnD AceDUNTING MEASURES osahet—staresbarg Pot Fnanal Bn Cth and de om bus (A) Invest earng depos (A) Sees walla ‘Sees lé-so-matry aan resale (A) rs Fit ec ac See ht ne and bay Coated Balance Satember 20,3098 (moans i acca) Smee $78 $0 Cape 2 pases ‘rama | 0 Chae 2 fr vale) Sess Sass) Ghee 0 vac oS1L226762 (As) baa 182268830 Chapa 10 imo tang Gap ) Cremer Guper 3 as) sat 2 Gopi tt TOTAL LABLITIESAND STOCKHOLDERS SQUITY. SIOBS ‘The nex set is Seciies Amable fr Sale. Chapter 10 expan that GAAP for ae a | pies eee ren: | ‘Defeened federal income tax (La) 13982 t Chapter 14 | ‘Dividends payable (L.) 3545 3548 0 Chapter 2 1 ‘Other liabilities (14) urs n73 0 Chapter 12 ae cot EOE es i ‘STOCKHOLDERS EQUITY Common stock, $0.10 par value, 5,000,000 shares. fre ae ormt | “Total stockholders’ equity F249816 $290932 S116 © Chapters 7,16 these tere adjment to bring the Book vals nine with market values at tach Glance sheet date, Therefore, te eonomie vale of thee meine om he ‘GAAP bales shee. The next et Scat Held-o-Matoriy: Chaper 10 ls revs tht GAAP ssquieaccounting for thee secre at cost and do ot requ adjusting them to helt market values. The value oa the GAAP balance sed, therefor, snot equal © ihe economic ar of these scutes, However Harrodsburg’ baance sheet loses {he fr value ofthese secures (8112268 in Exhibit 7.2), which we tke as 2 good | Financial anal ges wel yond ox anderson of thera of counting ro fatal ap has [Fol gral basin lead ice appcosimaton wo ther matket vale. Assesment of ie Yluereqies examination of male price or application ofthe dacounted expected cash Yow echoes ‘sin Chapter 6 So fir ale is an approximation af sconoms moe Chapter § dscuses how receivables re accounted for atthe proc value of tele ‘tar cash Row, wih an alowance fr ancl amouns Ths snout ‘ith te value of thee discounted expe cath Howe So the book tale oe Lege ceiabe shouldbe dost ther exon vale. ‘Accrued interest Receivables jot interest owed to Harrodsburg nd shouldbe cose ‘0 ts economie ale though sine acral method {haoter 1 explains how he book ale of Premises nd Equpmct itd to the his: tml cons ofthese att add forthe pasige of tine. Uner sine cone, GAAP regis sjusiments to ring te bok ale int ine wih mat vane oe ‘he mate value isbelow the book valu and vores not ven then Thecinn se *qetion mark in Eaibit7.2 forthe economic ue of Pema and Eocene ‘A question mark seems appropri for Other Ase oy beens we Jenene Enon eat he are. We know dnt they zen Cash Interest Beatog Deon Seaties ne Recehable, or Premises ad Equipment, but we rea uncer xsl wher a ths category, ‘ears tls uncerin about whee the st of sets on Harrod lnc sheet lacode ll the items that the sock maret counts as Harrosburge eee Ye eed {2a possi in Eubibt 7.2 by inuding the ln for Aste Not Recpaned Sy ake ‘Any ast nt recognized by GAAP havea iplict book value af meee aoe, Ue cconomic vale i grater than eo For example, f Haneda condecee ae le ssuch or devloped valuable gos trough yeas of opening te eee ‘ight hold economic esses not recognized by GAAP How do we ascn whether significant amounts of ast (and Iblis) are noe recognized by GAAP? Wie must combine knowiedge of GAAP with rovlales oF Fie ofthe partial catty meme analy Acetone te + The indastyorindusues in which he entity has operations + The competion i faes The Dsines strategist employ +The inputs it ses, + The histor of the fm + The ouputsit produces + The setae ‘We usally ge information about these factors fom management in its disuse on and ana fom disclosures ia fotnte othe Email stone foe apes, mapains and online information produces ftom indsty goupe ood oo ‘erence wt ile fens. Asessing the gps in GAAP ancl sce et ofthe act of finencl statement analysis ARSough ican be Gutsy aes Set yo gain the requisite experience, it wil often be the mos un aad toed pe oe Bn anal task (ise the basins it iin and the competion ties, Harrodsburg ic elke to hve significant economic asets not reegnied by GAAP Harodsbers Lose tok oe s93i0 _>s9340 hope 2 "TOTAL LABILETES FRM Seas Sox Cups 7 Comer prefered stok—sbues auton 10 hae nue end otnaing 13 so § ins “ol abs pls peered nck sao Camino sod pinata saber 8,00; thu ined an oestndng 270 ein’ eating acai her compere income of $8 “onl eomenn soso egy *TOTAD LIABILITIES AND STOCKHOLDERS BQUITY a Chap 718 Unerind 146 = paar 2 wacuation eases amb ACCOUNTING MEASURES Frese bosk wld ol at 10 et eal ey enti an ct ‘Scatter ce (ote oak ef he fm, "eo vara ue ‘shane fr By nd Ober Compensation dU conomic vale are equal for Cash and Short-Term Ivestnents at S927 inthe Fo ‘omic colton in Ebi 75, "Shaper lcosts why Accounts Recrvable ook vale arco other economic ‘alae. 80, $1,460 entered inthe Bonomi column fr Aesounts ecivable "We ennot ay mich about the econome value ofthe Otber Cet Asses because we dont evn know what they ae. We do kao howe, hat Miso sts hem as ‘utente therfore hey at expect tobe ened within he next operating yes. Some ofthese asta probly inven, described in Chapter 8, which ean hae sn conomie vale that eaceds Book vale. However va the busiest iin Mixosoe ‘Funlly o have iaventore with sublenialylarer economic vale thin bok vale In fc Microsofts unlkt to have inventories wit mach economic value ata We pat ''queion ma in the Enomic column for these sets, but the economic al is Uiily to dif sigafcanty from ter book rau CChape epsis how the economic value af Property and Equipment could be _goster than ite book value Nicos, incorporated in 198, sts rately young frm, It doesnot requie rmuch property to conduct it operation, Mos likey thes, Microw Property and Equipments economic vl i relate tothe market-to-book fat o 17,ony igh higher than ebook vale, Nonetheless we pata gueton mak Inthe Economie conn of Exhibit 75 Equity and Other Investment re dificult give an economic value Some ofthe lavestnet ncded inthis category are marketable secure, which ate ejsted so that book vale eqils marke ae (oe Chptr 10) Ufortanstey this tegry also incdes ober investments recorded at historia cost From Micron 1K: iy and other nett inde debe and equity estrament, Det series ‘publi traded ety rece ore recede mare. Al athe i= ey Neston ling in venture artnet ae recreate Because we dont know what Other Ars represent we ca' ely asin « market value and hence, the question mark he Ezoaami alums ‘sts not regnied by GAAP have a book value of zero. Le’ think about what the economic ale of thos shes might be for Microsoft Mcroso creates sot Inlctaa poopety. Windows the Ofc sate of progrims ba nee Explorer are ‘ome of soot nore viable products The computer programs knowl, andor faeatons hae develop and manta thes produce wl ely generate enormous fi ‘te buneits for Mirooft Micro lo cares substantial brad sane recogni td pesenein the oftware indy These economic sets do ot get on Microsofts GAAP balance shes yet surly they are an seta par ofthe erpomic value of Mi ‘soot egy tinting economia of hte ts ot eognined by GAAP can be pascal tlhe ne wl back ito en ema ar ging through cso habs ‘ecousts apuble Accrasd Compensation, and Unetrnel Revenue ae srsightfor wad obtgtions whore bon ater se slose to tei economic vue We doa now ‘hacly whet the Othe Lies sey but we can sfly asune in tnt css tat the ‘Sonoma ofthese nites iat leas much thei ook vale (ee Chapter ‘Dh: tisexremely dil o put an conoml ae on Income Tes Payable as noted in Chapter 1 hee the question mak inthe Economie colama n Esha 7, We matt concentrate now on Micros ibis: Recounied by GAAP be cause thy a kel fo be sbtanal. One sen of fare saci that appeats oly in ‘ery limted cumstances on GAAP Glace sti potential lowe nition. Mi ‘ovat 1996 10K sates he flowing tigation Litton earn nlc prope rights atm and copyrights (svi inthe PC software indy. nation, thar are goverment regulation ‘nd vestigation ee olong wh oer ene corpo ep ks Anhough it is det o pace an economic value om the Eure scrifce that wi esl fom tigation, we should scknowledge that they coud be substantial. 2 2 il be aldo hs tub when you ar ‘Sow eu i Chapter 3. Enomi clan prefered kine particu, Microsoft lost an anita cae brought by the US. Deparment of asic, End st the time ofthis book's pubeation, i remained unclear what fue cost his Tuling wil impore om Mecano. Microsoft ike mot high-aclogy companies, compensates employs input with sock optons These optons cry the ight to pshare Microsoft tock at Reed Prices (called excise price eatdless of the pice at which the sok scarey se [ipin the mle The oder ofan opon wleece ony the markt pce exceeds the earl pic a thi case, Microvolt mrt deliver a share valued at he art pie In exchange for eeving the carte pri. The diference between the eonomie ae ‘ofthe sate and the amount of the ner price ete epesnts sauces sctied by Microsoft, From it 1998 10K, we Gu that at June 30 1958, Microsoft had oatstnding options on 49 milion shares. The average execs ric for these options was S287 per sare Recall on jane 30,1986 Mirosof sock wa sling for $108.75 per share Therefore, Miso had to eet obliptons under options on Jone 3, 1988, wo ge up a ‘hare wort $108375 and rece $057 in ea foreach option exercise. The mou ‘of Microsofts obligation est $39 lion $39,350 milion tobe more predioe Coxe of sas: 466 milion srs x $108375persare $0508 CGahrecced £66 milion shares» $2387 per share nc of otf shares overeat ec We enter $39,380 inthe Economic calm in the Line for bites not engined by GAAP ‘As dicated ets, Convert referred Stok i sconomiclly, ma ik abi in han eu Thee ate 12 lion shares of referred tock that te ener nto ‘Sinton shares ot cath Repesting theca excerpt rom Micros 198 10 awh pf hres rmsertb int common sare: or an guilt aroun of cach ears ya forma ha provides floor pie of 73.75 ane cp of 102.24 pr prefered sare ‘Sime to management stack options, when Mico snc ris in price, the Hine lising refereed stock face vale fn the balance shee underesinates he amount of the algton In sn economies, nove include he smount of dls that would be forgone by giving prefered stockholders common sock in excss of the face vale of| thei prefersed stock By analysing the ers ofthe conversion Wwe can show tat the fxpeted value ofthe economic obligation is about S180 ein, as tered in the Eamon clan ia END? Lev Rel tat the tock market vale he aggregate company for 287586 milion, which we entered in the Economic column in Fx 7-5 in thet common hareoider equity line Nov total economic lables plus convertible prefred plas fnmmon shareholders equity amount $312931zilian. BY the fundamental balance ‘Sent we nw tht tot economic nets mst be $312931 milion as Weente this "odat in the Econo aun fr the total aset tow. Sabracting the fal GAAP ae et vale of $22,337 lion, wesc that thereat leat $290,574 milion of exonome tee vale that he not Been explain’. “The tinexphined umount so large thatthe bull of mast be Asus not Reng sed by GAAP. Are apparent rom any Inovedge of Microsofts basis anda ur Soy examizaion of i balance sheet, most of Micosos economic asiets we not {corded int GAAP accounts, Cash and Short-Term Investment amotio abot S¢ billion of Microsofts 802 blion in tal sts onthe Balance thet, or at about ‘hind of Microw otal GAAP setae im Cash and Shore Tem nvsanets Surely, (Cah and Short Ter Invent ae not Miro tnain economia ‘Microsofts nn econo set he itll! propery owns In partic, ‘the computer codes for Windows Microsoft Offs, and ote software farms the mcs [Maly sure of Microsofts earings and each Hows fr» ew more yar, These cco akiit 7.6 The rf videns wore Mears 199 assets shou whether ecotded or generate income, GAAP wil enti itcome hat ‘Eom temsctions with castomere In olher words Micros’ GAAF snome tate ‘Rent wll eventually show the fis of these unbooked ss Lit ool a the inane Mierowof eae inthe Ya allowing one 30198. Ex bi he provides Mironts come satenet ford ear beginning 09 Jane 3,198 tnd ening om ane 30,199, icose conortion Ineame Sutement (emoents in allen, except earings per share) ‘Opening expenses: Com of evens esath and deopment Seles and mate ‘Geer and smite Ober expt “pal operating expen perting nome Inneset income Guin on se of ois, Tron ove some tes. Micros enone fr 1999 war $7785 millon. The contrib pete sha see tion in dens n 199, ling 7,757 lion for the com ‘om darcholder: Cormmon sheer szounting run on equ for 1959 ca be ‘alltel a fol snasnsises7 = 0501 = 301% ‘An scouting ate of torn of re han SO shou sk yous xtreme ih ‘but ur ana ims to the sans ee hgh. Miers enormons ool of aes generates income which make te numerator inthe secourtng etn Tae Mg dep ee mot ofthese aves do nt appear on is balance sheet and there: ‘te tc not elected in Microsofts GAAP sarcholsers’ ity. This low number bolls ‘Boone denominator ofthe accounting ern on eau A igh rtio—GAAP income ver GAAP harold quires, suppor that a an investor, you oughta sare of conf common sock st tu cling pe of $108,975 on fue 30, 1996. By fun 30,1989, thi sare re i aoe fo S10037%, Because Microwot pape no dvidends, your economic rate of eur ca be ‘oleate lows: (s19037s —s108.s75ys108375 = a6 = 64% This rest excess the counting rate of eur “This is quite a large amount fo diferencias of eta ‘Nidesoft mus: ily estes good mvs drng Sal 1999 that wos not captured by GAAP beeping ce constant this ator woud be reece in Mizosofts markt paring staitc o bench to-book cto being higher on June 20,199, than twas on Jane 30,1998, Miss dd ca re nage abe constant homevet Ie faled option obligations hat essed aaa ee deed at blow malar pcs, This let overwicimed the good news fa Fre ee como eara on egy and dragod the market-to-book rato ows t0 Te678 on June 30,199. ‘echoes Merogait because we knew ts book and mathe ees were Hk tobe signal dierent. How di we know? We Ee a itl about Microsofts eonomic Sean ec GAAP vere not ily to captae them One look the blacesest ae a Mr intlionthe gestae on Mierosofs balance sheets Cash nl Sb ‘SSte ovement: We song sbspeced that thee were not Microsofts main economic Review Questions 1. hile exit hte tg by GAA 700i ie of {edn ihe? Wha onl be nf agined econ se Det 2, lsh nye of enor Se ice a care at ta any he arena Ein. 3. bo ys nk te sek et ae itn or 3 omy bas oe Vy “oon wa cans you ep 1b 0? Discussion “are book values feet fom matt values? The key sin he proce tha Nera Ri suluce Mase le eat from wansctions between buyers and sel Se MIE adhe kom applying GAAP tothe wansactions ai ecu of te pevod ils anton roc sa the GAAP vlustion proces sve diferent porposes Jay dire roles ine acy ofthe worlds eanomis, apd even ae corducted by {lees peopl Tene ocesss balance soppy and demand. The only blancing proces in te “GAA? Hoenn the ome tequied by ASSETS = LIABILITIES + EQUITIES. ts si Gor mma iaentc oot basncng of eompcting msexents of abe People we PAE onal statements becuse they aze produced by» ven et of rules nd a Gees sted and often bac by the reputation ofa ple szounting fm. These ‘spec ue the srengs of GAAP, Seer Scaepuny such as Mico the GAAP ancl statements an reve impostantinforsation afer all te eunings generated by Mico’ unbooked ses et scl eventual in GAAP income Ir we become avare of Micmsts eo ra colon and now how GAAP work, we cin expect that Microsofts croting vet egy wil sain ry high fr tan years to come, When Micoso ics He ent investors wl be looking sts accounting return om exit and Comparing it tos prety high Denhmask riko geod tenes explain wy GAAP do not show the intel prope purtale the le of the computer cas fe Windows, Mikroxot Of and ot ‘ff dats eros minesnomie ase The Sis the reve and ceelopient ‘Sede required to produce the computer code for Windows, Micosot Office, and cere ta key constves son of th telecta property prexated an eel pote she tine they were made. GAAP test resach and develo Serna capone, aot ase to nt management airy to overstate income By ‘Rellng the recoring of expense The second: any favorable evens edhe vale of SOCRRIE Sipe accede expences required to produce it Mico got Lak GAAP ld not ecognize thes fortante events By recording thet vale: The GAAP Sopot is ole these pod fortunes prove terse in the generation of rovens nvexorin the snc markt ot willing to wat so long for proofrengsad these nes ‘Dy bidding up the price of eros tock ine Penton ice these examples in mind as we sty the deta of GAAP for ee Flies in Pate 3 ofthis book What reireents do GAAP i= hey recgaize om tena anasto Ebi Ae hee recent met Por hel gone fre benefits or all aie eqing a fre tric! Or TTGAAP segnison inked ltv to market vale recognition! Hae eee do GAAP clei the sjustment for diferent ype of ass and sib a they do seognae? Are hese adjosiment nin wih changes mark ‘ee ati be te eects ofthe ferences between GAAP adjustent od mat aloe Wat wtb ure anil statement? These questions must be adres et ceva ofc ype fasts and nis, because no sage answer eect the cont hey bin te tal and hat ceri ae with esoenting Conclusion aking good we ofeccounting data egures understanding what and a no ae ee ling ham. We aploe ths dsincton ate cages ht allow, We ce in any openssh sy reetrable neon longest and Ba et um a move fined insight int accountng ecogsion To unde son ucumtng reprt, we ist Sst understand what is aappening c= ere eine mut hae ome way tous what appropiate scgnton might aa eae het tha eogation to examine the segs and west of Yerousnecoontng techies

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