Accounting & Finance

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 Financial Statements

 The Balance Sheet

 The Income Statement
 The Statement of Cash Flows
 Accounting Practice and Malpractice
 Taxes

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The Financial Statements:

I. THE BALANCE SHEET

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 Balance Sheet Classification and Aggregation

Both GAAP and IFRS require balance sheets separation of current items from
noncurrent items. Separate sections include:

 Current assets represent assets that a firm expects to turn into cash, or sell, or
consume within the firm’s operating cycle or normally one year from the date of the
balance sheet (i.e., accounts receivable and inventory).

 Current liabilities represent obligations a firm expects to pay within one year (i.e.,
accounts payable and salaries payable).

 Noncurrent assets are typically held and used for several years (i.e., land, buildings,
equipment, patents, long-term security investments).

 Noncurrent liabilities and shareholders’ equity are sources of funds where the
supplier of funds does not expect to receive them all back within the next year.

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 Characteristics of a Balance Sheet

A Balance Sheet:
• is also known as a statement of financial position;
• provides information at a point in time;
• lists the firm’s assets, liabilities, and shareholders’
equity and provides totals and subtotals; and
• can be represented as the Basic Accounting
Equation or Identity:

Assets = Liabilities + Shareholders’ Equity

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 Balance Sheet Measurement

Both GAAP and IFRS use two conceptual bases to measure the monetary
amounts on the balance sheet:

 The historical amount reflects the acquisition cost of assets or the

amount of funds originally obtained from creditors or owners, or

 The current amount reflects “fair value” as of the balance sheet date.

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 The Balance Sheet

 Definition
– Financial statement that shows the value of the
firm’s assets and liabilities at a particular time
(from an accounting perspective)

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 The Balance Sheet
The Main Balance Sheet Items

Current Assets Current Liabilities

• Cash & Securities • Payables
• Receivables • Short-term Debt
• Inventories
+
+ = Long-term Liabilities
Fixed Assets
• Tangible Assets +
• Intangible Assets
Shareholders’ Equity

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 The Balance Sheet 3

 TABLE 3.1 Target’s balance sheet (figures in $ millions).

Year Year
Ending Ending Year Ending Year Ending
February 1 February 1 February 1 February 1
Assets 2020 2019 Liabilities and shareholders’ Equity 2020 2019
Current assets

Cash and marketable securities 2,577 1,556 Current liabilities

Receivables 498 632 Debt due for repayment 161 1,052
Inventories 8,992 9,497 Accounts payable 9,920 9,761
Other current assets 835 834 Other current liabilities 4,406 4,201
Total current assets 12,902 12,519 Total current liabilities 14,487 15,014
Fixed Assets Long-term debt 11,338 10,223
Tangible fixed assets Other long-term liabilities 5,121 4,756
Property, plant, and equipment 48,183 46,185
Less accumulated depreciation 19,664 18,687 Total liabilities 30,946 29,993
Net tangible fixed assets 28,519 27,498
Shareholders’ equity
Intangible asset (goodwill) 686 699 Common stock and other paid-in capital 6,268 6,085
Other assets 672 574 Retained earnings 5,565 5,212
Total shareholders’ equity 11,833 11,297
Total Assets 42,779 41,290
Total liabilities and shareholders’ equity 42,779 41,290

 Note: Column sums subject to rounding error.

 Source: Derived from Target annual reports.

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 The Balance Sheet

 Common-Size Balance Sheet

– All items in the balance sheet are expressed as
a percentage of total assets

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 The Balance Sheet
 TABLE 3.2 Target’s common-size balance sheet (all items expressed as a
percentage of total assets).
Year Year Year
Year Ending Ending Ending Ending
February 1 February 1 February February 1
Assets 2020 2019 Liabilities and shareholders’ Equity 1 2020 2019
Current assets Current liabilities
Cash and marketable securities 6.0% 3.8% Debt due for repayment 0.4% 2.5%
Receivables 1.2% 1.5% Accounts payable 23.2% 23.6%
Inventories 21.0% 23.0% Other current liabilities 10.3% 10.2%
Other current assets 2.0% 2.0% Total current liabilities 33.9% 36.4%
Total current assets 30.2% 30.3%
Long-term debt 26.5% 24.8%
Fixed Assets Other long-term liabilities 12.0% 11.5%
Tangible fixed assets
Property, plant, and equipment 112.6% 111.9% Total liabilities 72.3% 72.6%
Less accumulated depreciation 46.0% 45.3%
Net tangible fixed assets 66.7% 66.6% Shareholders’ equity
Common stock and other paid-in capital 14.7% 14.7%
Intangible asset (goodwill) 1.6% 1.7% Retained earnings 13.0% 12.6%
Other assets 1.6% 1.4% Total shareholders’ equity 27.7% 27.4%
Total Assets 100.0% 100.0% Total liabilities and shareholders’ equity 100.0% 100.0%

 Source: Derived from Target annual reports.

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Book Values and Market Values (1 of 3)

 Book Values
– Value of assets or liabilities according to the balance
sheet
 Market Values
– The value of assets or liabilities were they to be resold
in a market
 Generally Accepted Accounting Principles (GAAP)
– Procedures for preparing financial statements
 Equity and asset “market values” are usually
higher than their “book values”

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Book Values and Market Values (2 of 3)
Example
According to GAAP, your firm has equity worth $6
billion, debt worth $4 billion, assets worth $10
billion. The market values your firm’s 100 million
shares at $75 per share and the debt at $4 billion

Q: What is the market value of your assets?

A: Since (Assets = liabilities + equity), your assets
must have a market value of $11.5 billion

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 Book Values and Market Values (3 of 3)
Example (continued)

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil
Equity = $6 bil

Market Value Balance Sheet

Assets = $11.5 bil Debt = $4 bil
Equity = $7.5 bil

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 The Income Statement

 Definition
– Financial statement that shows the revenues,
expenses, and net income of a firm over a
period of time (from an accounting
perspective)

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 The Income Statement
 TABLE 3.3 Target’s income statement, year ending February 1, 2020.
$ Million % of Sales
Net sales 78,112 100.0%
Cost of goods sold 54,864 70.2%
Selling, general & administrative expenses 16,233 20.8%
Depreciation 2,357 3.0%
Earnings before interest and income taxes (EBIT) 4,658 6.0%
Other income 21 0.0%
Interest expense 477 0.6%
Taxable income 4,202 5.4%
Taxes 921 1.2%
Net income 3,281 4.2%
Allocation of net income
Dividends 1,330 1.7%
Addition to retained earnings 1,951 2.5%

 Source: Derived from Target annual reports.

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 The Income Statement
 Earnings Before Interest and Taxes (EBIT), millions
 EBIT = total revenues − costs − depreciation
= 78,112 − (54,864 + 16,233) − 2,357
= $4,658 million

 Source: Target’s Income Statement (February 1, 2020)

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 Profits vs. Cash Flows

 Differences
– “Profits” subtract depreciation (a non-cash
expense)
– “Profits” ignore cash expenditures on new
capital (the expense is capitalized)
– “Profits” record income and expenses at the
time of sales, not when the cash exchanges
actually occur
– “Profits” do not consider changes in working
capital

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 The Statement of Cash Flows
 Statement of Cash Flows
– Financial statement that shows the firm’s cash receipts and cash
payments over a period of time.
– It starts with profits and converts to cash flows.

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 The Statement of Cash Flows
 TABLE 3.4 Target’s statement of cash flows, year ending February 2020 (figures in
millions of dollars).

Cash provided by operations:

Net income 3,281
Depreciation 2,604
Changes in working capital items
Decrease (increase) in accounts receivable 134
Decrease (increase) in inventories 505
Decrease (Increase) In other current assets 229
Increase (decrease) in accounts payable 159
Increase (decrease) in other current liabilities 205
Total decrease (increase) in working capital 1,232
Cash provided by operations 7,117

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 The Statement of Cash Flows
Cash flows from investments:
Capital expenditure (3,027)
Sales (acquisitions) of long-term assets 63
Other investing activities 20
Cash provided by (used for) investments (2,944)
Cash provided for (used by) financing activities:
Increase (decrease) in short-term debt 2,069
Increase (decrease) in long-term debt 1,739
Dividends (1,330)
Issues (repurchases) of stock (1,415)
Other (77)
Cash provided by (used for) financing activities (3,152)
Net increase (decrease) in cash and cash equivalents 1,021

 Source: Calculated from data in Target’s Annual Report.

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 The Statement of Cash Flows
 Target’s Change in Cash Balance (February 1, 2020)
 ($ Millions)

Cash provided by operations $7,117

Cash provided by (used for) investments $(2,944)

Cash provided by (used for) financing activities $(3,152)

Net increase (decrease) in cash and cash equivalents $933

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 Free Cash Flow
 Free Cash Flow (FCF)
– Cash available for distribution to investors after firm pays for
new investments or additions to working capita.
– Free cash flow = interest payments to debt investors +
shareholders’ operating cash flow −  capital expenditures.
– Target’s FCF (millions) = $477 + $7,117 − $2,944 = $4,650.

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 Corporate Tax Rates (2020)
 U.S. Tax Cuts and Jobs Act
• Passed in December 2017.
• Reduced the corporate tax rate from 35% to 21%.
• For every $100 that the company earns, it pays $21 in federal tax.

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 Taxes 1

 Example
 Taxes and cash flows can be changed by the use of debt. Firm A pays
part of its profits as debt interest. Firm B does not.

Firm A Firm B
EBIT $100 $100
Interest 40 0
pretax income 60 100
Tax (21% of pretax income) 12.6 21
Net Income $47.4 $79

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 Personal Tax Rates (2021)
 TABLE 3.6 Personal tax rates, 2021.

Taxable Income (dollars)

Taxable Income (dollars) Single Married Taxpayers Filing Joint Marginal Tax
Taxpayers Returns Rate
0 to 9,950 0 to 19,900 10%
9,950 to 40,525 19,900 to 81,050 12%
40,525 to 86,375 81,050 to 172,750 22%
86,375 to 164,925 172,750 to 329,850 24%
164,925 to 209,425 329,850 to 418,850 32%
209,425 to 523,600 418,850 to 628,300 35%
523,600 and above 628,300 and above 37%

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 Taxes
• Taxes have a major impact on financial decisions.
• Marginal Tax Rate is the tax paid on each extra dollar of
income.
• Average Tax Rate is the total tax bill divided by total
income.

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 Taxes 5

 Example - Taxes paid by single person making $50,000

 Tax = (.10 × 9,875) + (.12 × 30,250) + (.22 × 9,875)

= $6,790

6, 790
Average tax rate   .1358 or 13.58%
50, 000

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 Common Stock

Treasury Stock
Stock that has been repurchased by the company
and held in its treasury

Issued Shares
Shares that have been issued by the company

Outstanding Shares
Shares that have been issued by the company
and held by investors
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 Total U.S. Financing
 Holdings of Corporate and Foreign Bonds (Qtr. 3, 2020).

 Access the text alternative for slide images.

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 Total U.S. Financing
 Holdings of Corporate Equities (Qtr. 3, 2020).

 Access the text alternative for slide images.

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 Common Stock
Authorized Share Capital
Maximum number of shares that the company is
permitted to issue, as specified in the firm’s articles
of incorporation

Par Value Retained Earnings

Value of security shown Earnings not paid out as
on certificate dividends

Additional Paid Up Capital

Difference between issue price and par
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 Common Stock

 Book Value vs. Market Value

– Book value is a backward looking measure
• Tells us how much capital the firm has raised from
shareholders in the past
• Does not measure the value that shareholders place
on those shares today
– The market value of the firm is forward looking
• Depends on the future dividends that shareholders
expect to receive

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 Common Stock

 Majority voting
– Voting system in which each director is voted on
separately
 Cumulative voting
– Voting system in which all votes that one shareholder is
allowed to cast can be cast for one candidate for the
board of directors
 Proxy contest
– Takeover attempt in which outsiders compete with
management for shareholders’ votes

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 Preferred Stock

 Preferred stock
– Stock that takes priority over common stock in
regards to dividends
 Net worth
– Book value of common shareholder’s equity
plus preferred stock

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 The Flow of Savings to Corporations

Financial Markets
Stock markets
Fixed-income markets
Money markets

Corporation
Reinvestment Investors
Investment
in real assets worldwide

Financial Institutions
Banks
Insurance Companies

Financial
Intermediaries
Mutual Funds
Pension Funds

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The Flow of Savings to Corporations

Fixed-
income • Market for debt securities
market
Capital • Market for long-term
market financing

Money • Market for short-term

market financing (less than 1 year)

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 Function of Financial Markets

 Transporting cash
across time
 Risk transfer and A financial market is a market in which
people trade financial securities and
diversification derivatives such as futures and options
 Liquidity at low transaction costs. Securities
include stocks and bonds, and precious
 Payment mechanism metals.
 Provide information

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 Function of Financial Markets

Information Provided by Financial Markets

 Commodity prices
 Interest rates
 Company values
Examples of credit rating Interest rates on long-term corporate bonds

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 Function of Financial Markets
 Market Capitalization ($ millions).
Number of Market
Shares × Stock Price = Capitalization ($
(millions) millions)
Callaway Golf (ELY) 94.2 × 27.30 = $ 2,572
Alaska Air Group (ALK) 123.7 × 50.70 = $ 6,272
Yum! Brands (YUM) 301.7 × 103.07 = $ 31,096
Caterpillar Tractor (CAT) 543.3 × 186.66 = $ 101,427
Microsoft (MSFT) 7,560 × 242.12 = $ 1,830,27

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