University of Virginia

Darden School of Business

INDIAN INSTITUTE OF PLANNING AND MANAGEMENT

GLOBAL MANAGEMENT PROGRAM

ASSIGNMENT

Topic: How to Interpret Financial Statements

Material: The PepsiCo, Inc. 2008 Annual Report

To access the annual report for download please follow the below link:
http://www.pepsico.com/Investors/Annual-Reports.html

Assignment:

Part of our class session will be devoted to a discussion of the information contained in
PepsiCo's 2008 Annual Report, with particular emphasis on the financial statements and related
footnotes. Notice that PepsiCo presents four such statements.

1. Consolidated Statement of Income (p. 66)

2. Consolidated Statement of Cash Flows (p. 67)

3. Consolidated Balance Sheet (p. 68)

4. Consolidated Statement of Common Shareholders' Equity (p. 69)

The financial statements are accompanied by a "Management’s Discussion and Analysis" section
(pp. 42-65) which provides interpretative commentary on the data presented. The annual report
also includes the "Notes to Consolidated Financial Statements" (pp. 70-90), which amplify the
financial statements and provide some important qualitative information that cannot be
communicated solely through the data presented in the financial statements. The reports from
management and the auditors (pp. 91-93) outline their respective responsibilities and state their
opinions as to the accuracy of the company's financial statements. PepsiCo presents some
additional selected financial data on pp. 94 and 95 and there is a glossary on p. 96. The
management team is described on pp. 97-99.

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In undertaking your class preparation, we suggest that you first skim the “Dear Fellow
Shareholders” letter that begins on page 4 in order to develop some context for your review of
the financial statements. Then skim pages 8-40 for further context. You should then review the
financial statements and skim the footnotes, referring back to the related financial statements as
appropriate. Finally, read the Management’s Discussion and Analysis.

There are several basic concepts underlying the financial statements prepared in accordance with
U.S. generally accepted accounting principles. Think about these as they apply to PepsiCo, and
make a note of any questions of your own which your study may have raised.

1. The Entity. An accounting report communicates the activities of a specific entity,

and the reader of the report must understand the parameters of the reported-on entity.
An internal accounting report may summarize the activities of a department, a plant
with many departments, a division or an entire company, or a family of companies.
Accounting reports directed to external readers usually include the activities of a
legal entity, including the parent company and subsidiaries in which the parent
company has controlling interest. These are called consolidated reports.

2. Accrual-versus Cash-Basis Accounting. There are two primary ways to measure and
report an entity's results -- a cash basis or an accrual basis. Using the cash basis, an
entity records an event in the period when the event has a cash effect, and measures
its financial status solely by the size of its bank account. Most entities of any
complexity use the accrual basis of accounting, which recognizes the financial effect
of an activity when the activity takes place, without regard to the timing of its cash
effects. Use of the accrual basis leads to interesting allocation and matching
questions.

a. Allocation to Accounting Periods. Measuring financial success would be simple

if an entity had only to summarize and report its activities at the end of its life.
Cash results and accrual results would be exactly the same: we would measure
results by simply asking whether the entrepreneurs had more cash at the end than
they had at the start. Unfortunately, both management and outsiders demand
information about an entity's performance during interim periods of its life.
Accounting rules and conventions are designed to allocate (or assign) the
financial effect of an entity's activities to specific periods of time. For example,
Ford records the sale of an auto when it is sold and delivered to a dealer, not
when it’s built.

b. Matching. Accounting standards and conventions are also designed to report

comprehensively all of a transaction's financial effects in the applicable period.
The objective of this matching principle is to report revenues in the period in
which they are earned and to report all expenses related to those revenues in the
same period. In the Ford example, they only recognize the cost of that vehicle as
an expense when it records the sale, so as to match expense with revenue.

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3. Estimates and Judgment. Accounting reports are not as precise as they might appear.
In the process of allocating the financial effects of transactions over different periods,
many estimates and judgments must be made.

4. Conservatism. In normal circumstances, the matching principle dictates the time (the
accounting period) when expenses will be recognized and charged against revenue.
However, if a current cost is to be matched against a future revenue, and if there is a
serious question about the certainty of that future revenue, the expense will be
recognized now, in the current period. That concept, known as conservatism, requires
that losses be recognized sooner rather than later. Still, the matching concept and the
concept of conservatism are often in conflict and balancing the two requires careful
judgment.

5. Historical-Cost Accounting. For external accounting reports, transactions are usually

reported using the dollars involved at the time of transaction. So, for example, when
prior years' financial statements are re-published for comparative purposes, they are
not restated to recognize subsequent changes in the purchasing power of the dollar.
In some countries (e.g., Australia) long-lived assets may be periodically revalued to
reflect market value changes. In the U.S., long-lived assets must remain at
depreciated historical cost. For internal reports, some companies restate all of their
original historical costs to measure the impact of inflation or to reflect the current
market value of their assets and liabilities, most don’t.

Although assets are only rarely written up, they may (in an application of the
conservatism concept) be written down to reflect an impairment if their cash
producing potential drops below their cost. Unless there is strong evidence to the
contrary, businesses are considered to be a going concern and so assets need not be
written down to immediate cash value, so long as their long term cash value is in
excess of their cost.

6. Diversity and Consistency. For many transactions, there are a number of alternative
accounting methods available, which temporarily produce different accounting
results. Where there are alternatives available, the accounting standards simply
require that companies disclose in a footnote to their reports the alternative they
have selected, and that they use that alternative consistently from one reporting
period to another. Companies may change their accounting methods only with
good justification and with disclosure of the financial effects of the change.

7. Substance Over Form. Accounting reports are intended to measure the substance of
economic events, and accounting decisions are not necessarily driven by legal
determinations. Business transactions can be structured in many ways for legal
purposes, yet still have the same business substance. Therefore accounting is
concerned with the substance of activities and attempts to measure that reality.

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The following questions should aid you in your study of the PepsiCo Annual Report.

1. Net Income for 2008 was $5,142 million, but Cash and Cash Equivalents (p. 68)
increased only $1,154 million. Why is there such a difference between the
company’s reported earnings and its net cash flow?

2. The “book value” of the company was $7.86 a share at the end of 2008:

Total Common Shareholder’s Equity

Total Common Shares Outstanding

$12,203 million = $7.86

(1782 – 229) million

The “market value” of the shares at year end was $54.56 a share. Why are these two
values so different?

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