1、七 Investment Tools: Financial Statement Analysis: Basic Concepts1.A: Preliminary Reading Measuring Business Incomea: Explain why financial statements are prepared at the end of the regular accounting period, why accounts must be adjusted at the end of each period, and why the accrual basis of accoun

2、ting produces more useful income statements & balance sheets than the cash basis.To be relevant , information must be reliable. This means information must beconsistent and comparable over time and be provided on a timely basis. According to the relevancy principle , a firm needs to identify its act

3、ivities in a timely fashion within a specific period, such as a quarter or year.Normal accounting procedure is to record during the accounting period those economic events that occurred as the result of external transactions. At the end of the period after all the external transactions have been rec

4、orded, several of the accounts in the ledger need to be updated before their balances can be posted to the financial statements. The adjusting process is consistent with two important accounting principles:1.Therevenue recognition principle, which requires that revenue be reported in theincome state

5、ment only when it isearned , not before and not after.2.Thematching principlereports expenses on the income statement in the sameaccounting period as the revenues that were earned as a result of the expenses.Accrual basis accountingassigns revenues to the accounting period in which they areearned an

6、d matches expenses with the revenues generated by those expenses. The objectiveof the accrual basis is to report the economic effects of revenues and expenses when they areearned or incurred, not when cash is received or paid.Cash basis accountingrecognizes revenues when cash is received and expense

7、s whencash is paid. Under the cash basis net income for the period is the difference betweenrevenues received in cash and expenses paid with cash.Accrual accounting generally provides a better indication of performance than informationbased on the receipt and disbursement of cash. Accrual accounting

8、 increases thecomparability of income statements and balance sheets from one period to another period.The accrual basis reflects the understanding that the economic effect of revenue generallyoccurs when it is earned and not when cash is received. Therevenue recognition principlethe basis for making

9、adjusting entriesthat pertain to unearned and accrued revenues.isAdjusting entries are necessary to better match revenues and expenses that occurred during the accounting period. Adjusting entries are used to record the effects of internal economic events.1.B: Preliminary Reading Financial Reporting

10、 and Analysisa: Define each asset and liability category on the balance sheet and prepare a classified balance sheet.Assets category on the balance sheetCurrent assetsare assets which will be sold, collected, or consumed within one year or thefirm s operating cycle, whichever is longer. The operatin

11、g cycle is the average time betweenpaying for inventory or the employees who perform services and receiving cash payment back from the firm s customers.1.2.Cash is currency or demand deposits.Short-term investments are debt or equity investments for which a ready market exists and management intends

12、 to sell within one year or operating cycle.3.Accounts receivable are amounts owed to the firm by its customers for goods and services delivered.4.Notes receivable are amounts owed, usually by customers, which will not be collected within the typical collection period.5.6.Inventory represents produc

13、ts that will be sold in the normal course of business.Prepaid expenses (e.g., rent) are services paid for but not yet used.Investments are land, debt securities, or equity securities which management does not intend to sell within the year.1.Property, plant, and equipment: Land is the real estate up

14、on which the firms buildingssit.2.Intangible assets are economic resources lacking tangible existence such as patents,copyrights, trademarks, and goodwill.Liability categories on the balance sheetLiabilities are responsibilities (amounts owed) which must be met in the future, usually by the payment

15、of cash. Current liabilities are those liabilities that will be paid within one year or operating cycle..5.Accounts payable are the amounts owed to suppliers for goods or services received but not yet paid for.Wages, rent, etc. payables are the amounts owed to employees, landlord, etc. for se

16、rvices used but not yet paid for.Notes payable are the amounts owed creditors usually with explicit interest expense.Dividends payable are owed to owners for dividends declared but not yet paid.Current portion of long-term debt is that portion of long-term debt that will be paid within the year. Lon

17、g-term liabilities are the amounts owed creditors that will not be paid within one year.Stockholders equity is the owners investment and the total earnings retained from the beginning of the business. Contributed capital (paid-in-capital) is the amount of thestockhol ders investment in the firm s eq

18、uity securities. Common stock is the portion ofstockholders investment valued at par. Other paid-in-capital is the excess of the shareholdersinvestment over the stock s par value. Retained earnings is the total net income less theamount distributed to the owners as dividends from the beginning of bu

19、siness.A classified balance sheetA balance sheet can be presented in many different ways. Aclassified balance sheetis one inwhich the accounts are ordered in some logical manner, such as by liquidity or maturity. In atypical classified balance sheet:1.2.Assets are listed in order of liquidity, from

20、most liquid to least liquid.Liabilities are listed in order of when they become due.3.Equity is generally presented with contributed or paid-in capital first and retained earnings last.b: Define each component of a multistep income statement and prepare a multistep income statement.A multi-step inco

21、me statementis a statement that provides subtotals along the way toproviding net income. The basic structure of the income statement is:sales less cost of goodssold equals gross margin(a.k.a. gross profit) lessoperating expensesequalsIncome fromoperations(a.k.a. operating income) add or subtractothe

22、r revenues and expensesequalsincome before income taxesless income taxesequalsnet income .Gross salesor revenuesare the total sales (cash and credit) during an accountingperiod. Net sales or net revenues are the gross amount less returns, allowances, anddiscounts.Cost of goods sold is the cost of sa

23、les for the goods sold during the period; that is, the cost of the merchandise (paid for or the cost to manufacture).Operating expenses are the costs of operating a business other than the cost of goods sold. Examples include selling expenses and administrative expenses.Other revenues and expensesar

24、e non-operating items. Examples include interestexpense and interest income.Income taxesare the provision for income taxes for reporting purposes.1.C: Preliminary Reading Short-Term Liquid Assetsa: Describe how to choose the appropriate accounting method for investment securities and explain how fai

25、r (market) value gains and losses on such investments are reported.Short-term investments (a.k.a. marketable securities) are investments intended to be held only until cash is needed for the operations of the business. It is intended that these investments are to be held for less than one year. Shor

26、t-term investments are initially recorded at cost (cash price plus any acquisition costs such as brokerage fees).If management intends to hold short-term investments in debt securities to maturity, then theyare reported at their original cost. These are calledinvestments in securities held to maturi

27、tymanagement classifies a short-term investment as atrading investment (trading investmentsare always considered to be current assets), then the investment is reported on the balancesheet at itsfair market value. Any unrealized holding gains or losses due to the appreciation ordepreciation of the in

28、vestment must be listed as again or loss on the income statement. Ifb: Describe how to account for transactions with credit customers, including accounting for bad debts under the allowance method and the direct write-off method.Let SSS corporation have $10,000 of credit sales and $2,000 of cash col

29、lections in its accounts receivable during the year:AccountsReceivable$10,000Sales Revenue$10,000Cash$2,000Accounts$2,000ReceivableNow assume it is year end. It is estimated that of the $8,000 balance in accounts receivable, $1,000 will ultimately turn out to be uncollectable.Bad Debts Expense$1,000

30、$1,000AccountsThe bad debts expense decreases net income under the matching concept. And the allowancefor doubtful accounts decreases the accounts receivable on the balance sheet to its netrealizable value.Balance Sheet:Accounts Receivable$8,000less Allowance for Doubtful Accounts( 1,000)Net realiza

31、ble value$7,000To continue the example, in the following year, it is learned that customer ZZZ, who owed the firm $100 has declared Chapter 7 bankruptcy. ZZZs account receivable will be written-off byreducing the allowance and the particular accounts receivable.Allowance for doubtful accounts$100Acc

32、ounts Receivable$100The direct write-off method is used for income tax calculations and by firms with immaterial bad debts. Here the firm does not use an allowance account (accounts receivable on the balance sheet is the amount owed by customers). It recognizes bad debts expense only when a particul

33、ar account is written-off as uncollectable. The write-off of the $100 of accountsreceivable from customer ZZZ declaring bankruptcy is:Bad Debts Expense$100Accounts Receivable$1001.D: Preliminary Reading Inventoriesa: Describe how the choice of inventory system or method affects the financial stateme

34、nts.LIFO results in:Higher COGSLower taxesLower net incomeLower inventory balancesLower working capitalHigher cash flowsFIFO results in:Lower COGSHigher taxesHigher net incomeHigher inventory balancesHigher working capitalLower cash flowsb: Define inventory cost.The cost of inventory includes invoic

35、e price (less discounts), transportation costs, and taxes.Inventory includes not only the inventory on hand, but may include inventory items in transit.Goods are valued according to the assumed cost flow, which may or may not reflect the physical flow of inventory.The cost of ending inventory and, h

36、ence, cost of goods sold is determined by choosing one of the four generally accepted accounting principles (GAAP) alternatives.c: Calculate the cost of an invetorybased on 1) the specificidentificationmethod, 2) theaverage-cost method, 3) first in, first out (FIFO), and 4) last in, first out (LIFO)

37、.Specific identification : The units in ending inventory and listed as sold are valued at the specific invoice price of those units sold.Weighted average:The units held in ending inventory and listed as sold are valued at theaverage cost of goods available for sale (beginning inventory + purchases)/

38、(number of units in inventory).FIFO: This is the FIRST IN (purchases) FIRST OUT (sales) cost flow assumption. Under FIFO, the unit cost of the one unit in beginning inventory and the first unit purchased are assigned as the M units sold to calculate the cost of goods sold.LIFO: This is the LAST IN (

39、purchases) FIRST OUT (sales) cost flow assumption. It is the opposite of FIFO.d: Explain the effect of an overstatement or understatement of inventories on the financial statements.In working out the effects of an overstatement (O) or understatement (U), it is necessary to realize that the ending in

40、ventory in one period is the beginning inventory of the next period. Then use the following relationships:Ending Inventory = Beginning Inventory + PurchasesCost of Goods Soldor Cost of Goods Sold = Beginning Inventory + PurchasesEnding InventoryFor example , let ending inventory in year 1 be oversta

41、ted by $1,000 (e.g., $1,000 of inventory was accidentally or fraudulently double counted at the end of year 1). Therefore, in year 1 cost of goods sold will be understated, net income overstated, and inventory overstated all by $1,000. Later, assuming that inventory is properly accounted for at the

42、end of year 2, beginning inventory (which is ending inventory in year 1) is overstated causing cost of goods sold to be overstated and net income understated by $1,000. Because ending inventory in year 2 is correct, inventory on the balance sheet of year 2 would be correct. Hence, an inventory error

43、 washes out in year two.e: Calculate the lower-of-cost-or-market amount of an inventory.After inventory is valued using specific identification, weighted average, FIFO, or LIFO, that value is compared to the current replacement market price of each distinct product in inventory. If the market price

44、is higher than cost, then nothing is done. If the market price is lower than cost, then ending inventory is written-down to the lower replacement market price.Example: Suppose that Company X uses FIFO and that two items remain in inventory at year end. The original cost of these two items is $40 and

45、 their market value or replacement cost is $30. In this case, the inventory account would be written down to $30 and this $10 losswould be reflected on the income statement (i.e., the inventory account would fall and expenses would increase).Alternatively, if the replacement cost of these units were

46、 $50, then no write-down or additional expense recognition would occur.1.E: Preliminary Reading Current Liabilities and the Time Value of Moneya: Define liabilities, explain the difference between current and long-term liabilities, and describe the uncertanties about the value of some liabilities.Li

47、abilities are probable future payments of assets (usually cash) or services (prepaid revenue) that a firm is obligated to make as a result of a past transaction. Current liabilities are expectedto be paid within one year or operating cycle from the firm surrenexistingassetsc. Long-term liabilities a

48、re obligations that will not be paid within the year or operating cycle.There are several uncertainties related to liabilities. Sometimes the payee is unknown. For example, when the board of directors declares a cash dividend (dividends payable) the stockholders at the future date of record are not

49、known with certainty. Also, warranty payables are recognized at the time of sale but the payees are not yet known. Sometimes the due date is uncertain. Examples would be warranty payables and the prepayment for goods and services to be delivered at a future unspecified date. Finally, the amount may

50、be uncertain. An example would be warranty payables. Also, at the end of the year a firm must estimate and recognize some expenses like utilities, pensions, taxes, employee benefits.b: Describe how accountants record and report estimated liabilities (such as warranties and income taxes) and continge

51、nt liabilities.In some cases, the precise amount of a liability is not known, but the liability can be reasonably estimated.Warranties are recorded as:During period of sale:Warranty expenseXXEstimated warranty payableXXWhen repairs made underwarranty:Estimated warranty payableXXParts inventoryXXCash

52、XXIncome taxes are recorded as:A company must estimate interim (quarterly) income taxes (say 100):Provision for income taxes (expenses)100Income taxes payable100Then when taxes are determined (assumed to be greater than estimated, 115) and paid:Income taxes payable100Provision for income taxes15Cash

53、115A contingent liability exists when, as a result of a past event, a firm is obligated to pay only if a future event occurs. The most frequent source of contingent liabilities is lawsuits for which future cash payments depend upon the result of court action. Disclosure depends on the ability to est

54、imate the liability and likelihood of future payment of the liability.If the future payment isprobable and reasonably estimable, then the loss (expense)and liability must be disclosed on the income statement and balance sheet,respectively.If the future payment isreasonably likely or not reasonably e

55、stimable, then onlyfootnote disclosure is required.If future payment isremote , then no disclosure is required.1.F: Preliminary Reading Long-Term Assetsa: Describe the difference between long-term assets and other kinds of assets.A long-term asset is an asset that has a useful life that is more than one year, is acquired for use in operations, and is not intended for resale to customers. Long-term assets are generally reported at their carrying value or book value. If however, the asset has lost its revenue-