Chapter 1

Chapter 1
Financial Statements
& Business Decisions
Chapter One Slide 1 of 36

Class Objective
Identify the users of accounting information
Be familiar with the four basic financial statements (the purpose,

info content, structures, key elements, and the relation among
them)
Be introduced to the balance sheet equation, income statement

equation, retained earnings equation and cash flow equation.
Financial analysis

The business operations of a Manufacturer
Shareholders Build factory/warehouse

contribute Cash Purchase materials/parts
Creditors lend Hire employees
Manufacture products
Distribute
dividends
Pay interests
Cash collected Inventory

Profits made Sell products
or merchandises
Pay income tax

The Business Operations
Manufacturer
Makes the products it sells
Service organization
Provide service rather than selling products
Merchandising business
Buy goods, then sells them to customers
Retail or wholesale

Users of accounting information
Shareholders buy ownership in the

company in the form of stock.
Shareholders
Buy low, sell high
Dividends
Creditors lend money for a specific period

of time and gain by charging interest on
the money they lend.
Creditors
Lend the money or not
Buy low, sell high
Chapter One Interest income Slide 5 of 36
Users of accounting information
Marketing managers and credit managers use

customers financial statements to decide
whether to extend credit.
Purchasing managers use suppliers financial

statements to decide whether suppliers have the
resources to meet our demand for products.
Employees union and human resource

managers use the companys financial
statements as a basis for contract negotiations
over pay rates.
The Accounting System:
Accounting System
Financial Accounting System Managerial Accounting System

Periodic financial statements and Detailed plans and continuous
related disclosures performance reports
External Decision Makers Internal Decision Makers

Shareholders, creditors, Managers throughout the
suppliers, customers, etc. organization

The objective of Financial Reporting:
Contract and Decision Making
In this course, we focus on external users of financial
statements, which provide useful economic information
about a business to help external parties, primarily
shareholders and creditors, make sound financial
decisions.
Others such as government, competitors, press, public,

will also use it.

Contracts
Many contracts use accounting numbers.

Debt covenants
Compensation contracts
VC / PE investments
The counterparties of many contracts use accounting

numbers.
Suppliers and customers, Employees,
Not surprisingly, managers will try to manipulate the

numbers.
But, people who write the contracts will try to anticipate it.
You need to understand how to anticipate it if you will be one of those
people

Contracts
Anticipation and informed due diligence are extremely

important.
Enron, Parmalat,any other you know?
A random inspection of 152 mainland enterprises by the [PRC]

Ministry of Finance has found that every one of them falsified their
accounts.
HK Standard, 10/01/04

Evidence that Investors do not fully understand financial
info, i.e., if you understand better, you can make money
Anomalies / Investment Signals

E.g., Post Earnings Announcement Drift (PEAD) anomaly
means the tendency for stocks to earn abnormally high returns in
the three quarters following a positive earnings announcement,
and to earn abnormally low returns in the three quarters following
a negative earnings announcement.

The Four Basic Financial Statements
Companies can prepare financial statements at the end

of the year, quarter or month.
2011
Financial statements prepared at the end of the fiscal

year are called annual reports.

The Four Basic Financial Statements
The financial position The performance (change

of an entity at a in the financial position)
given point of an entity
in time during a given period
Balance Sheet
Income Statement of
(Statement of Statement Cash Flow
Financial Position
Statement of
Retain Earnings
Income Statement
What is an Income Statement?

Financial statements that reports the economic
value created (or destroyed) by the organization.
It is a movie.
What are the main types of accounts on an I/S?

Revenues
Expenses
Gains
Losses

Formats of Income Statement
Format under US GAAP

2016 2017
Revenues 100 95
Cost of Good Sold (50) (48)
Gross Profit 50 47
Selling, General and
Administrative Expense (35) (36)
Operating Income 15 11
Interest Revenue 3 4
Interest Expense (2) (2)
Earnings Before Income Tax 16 13
Income Tax (5) (4)
Net Earnings 11 9
Earnings Per Share 1 0.8

Income Statement
What is a common size income statement?

It scales each income statement line by net sales.
Useful for comparisons over time and across
firms
Misleading if comparing the same item across
time without scaling by net sales when net sales
change significantly

Common Size IS
Compare changes 2017 2016
Cost of sales 42.5% 40.8%

=3,999,124/9,411,497 =3,178,791/7,786,942
Store Operating 34.2% 34.5%
Expenses
General & Admin. 5.2% 6.1%
Expenses =489,249/9,411,497 =473,023/7,786,942
Other operating 3.1% 3.3%

Expenses
Depreciation 5.0% 5.0%

Balance Sheet
What is a Balance Sheet?

A financial document that reports what the
organization owns and owes.
It is a picture.
What are the main types of accounts on a B/S?

Assets
Liabilities
Owners equity.

Accounting Equation
Assets = Liabilities + Shareholders

equity
Current assets Current Contributed

+ liabilities capital
= + + +
Noncurrent
assets Long-term liab. Earned capital

Common-Size Balance Sheets
A common-size balance sheet standardizes each line item

on the balance sheet
Use total assets to standardize balance sheet
How does common-size balance sheet contribute to

analysis?
Useful for assessing significant changes in asset
mix and/or financing mix across time

What do we learn about assets by comparing the balance

sheets of Google and Zoomlion?
Major assets:
PP&E, inventories & cash
Changes in asset mix?

Cash, long term investment, PPE & Goodwill

What do we learn about financing from Googles common-

size balance sheets?
How financed?
Primarily equity
Long-term debt
Changes in financing mix?:

Long term debt

Statement of Cash Flows
What is the purpose of the SCF?

Explains changes in cash and cash equivalent
Useful to predicts future cash flows and
evaluates cash efficiency
Both operating cash flows and net income measure

performance; how are they different?
Former based on cash flows while net income
based on wealth flows

Which is a broader measure of performance?

Net income provides a better measure of change
in wealth.
But you can go bankrupt because you dont have
enough cash to pay your debt, even if your net
income is growing extremely fast.
If you make a sale on your credit to customers,
you do not get cash now, and maybe never if
they default
Enrons booking of future revenue stream from
long term project
What are the three major sections of statement of cash-

flows?
Operating
Investing
Financing activities
What were major sources and uses of cash?

Check the CF statement of Google and Zoomlion,
for example.

Stmt. of Shareholders Equity
What is the purpose of a SSE?

Provides information about the investments
made by the owners of the firm

Stmt. of Shareholders Equity
What are the major components of Google shareholders

equity?
Common stock
Retained earnings
Accumulated other comprehensive income
Note that the book often use something called

Additional paid-in capital (APIC). Please
forget it and only Paid-in capital under
stockholders equity.
Shareholders Equity
Shareholders Equity
Contributed Retained
+
Capital Earnings
Begin retained earnings + Net income -

Dividends
Revenue Expenses + Gains - Losses

Financial Stmt. Relationships
2017 Statement of CF
Operating cash 2,000
31 Dec. 2016 Investing cash (2,900) 31 Dec. 2017
Balance Sheet Financing cash 1,100 Balance Sheet
Increase in cash 200
Cash 400 Beginning cash
Cash 600
400
Other assets 4,600 Ending cash 600
Other assets 6,700
Total assets 5,000 Total assets 7,300
Liabilities 2,100 2017 Income Statement Liabilities 2,400
Contributed cap. 1,300 Revenue 9,000 Contributed cap. 1,300
Retained earnings 1,600 Expenses 6,000 Retained earnings 3,600
Total 5,000 Net income 3,000 Total 7,300
2017 Stmt. of R/E

Begin balance 1,600
Plus: Net income 3,000
Less: Dividends 1,000
Chapter One Ending balance 3,600 Slide 30 of 36
1. Name of entity
MAXIDRIVE CORP.
2. Title of statement
Balance Sheet
3. Specific date At December 31, 2017
4. Unit of measure (in thousands of dollars)
Assets
The Cash $ 4,895
Balance
Accounts receivable 5,714
Inventories 8,517
Sheet Plant and equipment 7,154
reports the Land
Total assets
981
$ 27,261
financial Liabilities and Stockholders' Equity
position of Liabilities
an entity at Accounts payable $ 7,156
a particular Notes payable 9,000

Total liabilities $ 16,156
point in Stockholders' Equity
time. Contributed capital $ 2,000
If you have dollar Retained earnings 9,105
on heading, you Total stockholders' equity 11,105
dont need $ sign Total liabilities and stockholders' equity $ 27,261
in table
MAXIDRIVE CORP. 1-32
Balance Sheet
At December 31, 2017
(in thousands of dollars)
Assets are Assets
economic Cash $ 4,895
resources Accounts receivable 5,714
Inventories 8,517
owned by the Plant and equipment 7,154
business as a Land 981
result of past Total assets $ 27,261
transactions. Liabilities and Stockholders' Equity
Amount of cash in the companys bank
Liabilities
Cash
accounts.
Accounts payable $ 7,156
Accounts
Notes payable Amounts owed by customers 9,000 from prior
receivable sales.
Assets are listed
Parts and
Stockholders' completed but unsold
Equity
by their ease of Inventories
products.
Contributed capital $ 2,000
conversion into Retained earnings
Plant and 9,105
cash. Factories
Total stockholders' and production machinery.
equity 11,105
equipment
Total liabilities and stockholders' equity $ 27,261
Land Land on which factories are built.
MAXIDRIVE CORP. 1-33
Balance Sheet
Assets
Cash $ 4,895
Liabilities are
debts or Inventories 8,517
obligations of the Plant and equipment 7,154
business that Land 981
result from past Total assets $ 27,261
transactions. Liabilities and Stockholders' Equity
Liabilities
Notes payable 9,000
Stockholders' Equity
Accounts AmountsContributed
owed to suppliers
capital
for prior $ 2,000
payable purchases.
Retained earnings 9,105
Notes Amounts owed
Totalon written debt
stockholders' equity 11,105
payable contracts.Total liabilities and stockholders' equity $ 27,261
MAXIDRIVE CORP.
Balance Sheet
Equity is the At December 31, 2017
amount of (in thousands of dollars)
financing Assets
provided by Cash $ 4,895
owners of the
Inventories 8,517
business and Plant and equipment 7,154
accumulated Land 981
undistributed Total assets $ 27,261
earnings. Liabilities and Stockholders' Equity
Liabilities
Contributed Amounts invested in the business by
capital stockholders.
Notes payable 9,000
Retained Past earnings not distributed to
earnings stockholders.Total liabilities $ 16,156
Stockholders' Equity
Contributed capital $ 2,000
Total stockholders' equity 11,105
Balance sheet equation
Basic Accounting Equation

Assets = Liabilities + Stockholders Equity
Golden rule!
A = L + SE Must always balance!
Economic resources = Sources of financing

What you have = Where it came from

MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
Revenues
Sales
1. Namerevenue
of entity $ 37,436
Expenses
2. Title of statement
Cost of goods
3. Specific sold
date $ 26,980
(Unlike the balance sheet, this
Selling, general
statement and a
covers administrative 3,624
specified period of time.)
Research
4. Unit ofand development
measure 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300
MAXIDRIVE CORP.
The Income Statement reports the
Income Statement
revenues less expenses of
the
accounting
(in thousands ofperiod.
dollars)
Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
R
Interest expense - E = NI
450
Net income $ 3,300
MAXIDRIVE CORP.
Income Statement
Revenues
Expenses
Revenues are earnings from the sale of goods
or services to customers.
Research and is
Revenue development
recognized in the period1,982
in which
Interest expense
goods 450
and services are sold, not necessarily
Total expenses
the period in which cash is received. 33,036
Net income $ 3,300
MAXIDRIVE CORP.
Expenses are the dollar Statement
Income amount of resources used
up byFor
thethe
entity
Yearto Ended
earn revenues
Decemberduring a period.
31, 2009
An expense is recognized in the period in which
goods and services are used, not necessarily
Revenues
the period in which cash is paid. $ 37,436
Sales revenue
Expenses
Net income $ 3,300
MAXIDRIVE CORP.
Statement of Retained Earnings
Ending RE Year
For the = Beginning RE + NI -31,
Ended December Dividends
2009
Retained earnings, January 1, 2009 $ 6,805

Net income for 2009 3,300
Dividends for 2009 (1,000)
Retained earnings, December 31, 2009 $ 9,105
The Statement of Retained Earnings reports the way that net

income and the distribution of dividends affect the financial
position of the company during a period.

Statement of retained earnings
Balance Sheet - January 1 Balance Sheet - December 31
Liabilities Liabilities
These are Shareholders Equity
Assets Shareholders Equity changes in Assets
Paid-In Capital Paid-In Capital
Equity and
Retained Earnings R/E Retained Earnings
Revenue Dividends
+ Expenses - declared
during
Net Income the Year
link between the balance sheet and the income statement

sum of all net incomes earned less dividends declared
since the firm began operations
Accounting description of business operations
APPLICATIONS SOURCES
Assets Liabilities & Shareholders
Equity
Cash START HERE
Build factories
Buy equipments Get money from
Manufacture products Shareholders and
creditors
Expenses Revenues
Assets is used Hopefully leads to... More wealth
Products sold can then buy more assets
Manufacture more products
Equipment consumed Hire more employees
Salaries paid
Because . . . and expenses

revenues reported reported do not
do not always equal always equal
cash collected. . . cash paid . . .
net income is
usually not equal
to the change
in cash for
the period.

MAXIDRIVE CORP.
Cash flows from operating activities:

Cash collected from customers $ 33,563
1.Cash
Namepaidofto entity
suppliers and employees (30,854)
2.Cash paid
Title of for interest
statement (450)
Cash paid for taxes (1,190)
3.Net
Specific
cash flowdate
from (Like theactivities
operating income statement and $ 1,069
Cash statement
flow from investing activities:
of retained earnings, this
Cash paid to purchase equipment $ (1,625)
statement
Net covers
cash flow from a specified
investing activities period of time.) (1,625)
4. Unit
Cash of measure
flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895

The Statement of CashMAXIDRIVE
FlowsCORP.
reports the inflows and
outflows of cash during the period in the categories of
operating, investing, and financing.

Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Change in Cash = CFO + CFI + CFF
Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Net cash flow from investing activities (1,625)
Cash flow from financing activities:

MAXIDRIVE CORP.

Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
A little note on cash flows
Why a non-financial corporations borrow from banks, it is

financing activities, whereas the same corporations lending
to other parties is investing activities?
Lending is bank's main business. Unless your firm is in
the business of financing other companies, you must do it
for strategic reason, thus it is investing activities.

Relationship Among the Statements
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009 Net income from the
income statement
Revenues
increases ending retained
Expenses earnings on the statement
Selling, general and administrative 3,624 of retained earnings.
MAXIDRIVE CORP.
Net income $ 3,300 Statement of Retained Earnings


MAXIDRIVE CORP.
Balance Sheet
Ending retained earnings
Assets from the statement of
Cash $ 4,895
Accounts receivable 5,714 retained earnings is one of
Inventories 8,517
Plant and equipment 7,154
the components of
Land 981 stockholders equity on the
Total assets $ 27,261
Liabilities and Stockholders' Equity balance sheet.
Liabilities
Notes payable 9,000 MAXIDRIVE CORP.
Total liabilities $ 16,156 Statement of Retained Earnings
Stockholders' Equity For the Year Ended December 31, 2009
Contributed capital $ 2,000 (in thousands of dollars)

MAXIDRIVE CORP. MAXIDRIVE CORP.

Balance Sheet Statement of Cash Flows
Assets
Cash $ 4,895
Accounts receivable 5,714 Cash flows from operating activities:
Inventories 8,517 Cash collected from customers $ 33,563
Plant and equipment 7,154 Cash paid to suppliers and employees (30,854)
Land 981 Cash paid for interest (450)
Total assets $ 27,261
Liabilities and Stockholders' Equity
Liabilities Cash paid to purchase equipment $ (1,625)
Accounts payable $ 7,156 Net cash flow from investing activities (1,625)
Notes payable 9,000 Cash flow from financing activities:
Total liabilities $ 16,156 Cash received from bank loan $ 1,400
Stockholders' Equity Cash paid for dividends (1,000)
Contributed capital $ 2,000 Net cash flow from financing activities 400
Retained earnings 9,105 Net decrease in cash during the year $ (156)
The change in cash on the statement of cash flows

= the ending balance of cash on the balance sheet minus the
Chapter One
beginning balance of cash on the balance sheet Slide 50 of 36
Financial Stmt. Relationships
2017 Statement of CF
Operating cash 2,000
31 Dec. 2016 Investing cash (2,900) 31 Dec. 2017
Balance Sheet Financing cash 1,100 Balance Sheet
Increase in cash 200
Cash 400 Beginning cash
Cash 600
400
Other assets 4,600 Ending cash 600
Other assets 6,700
Total assets 5,000 Total assets 7,300
Liabilities 2,100 2017 Income Statement Liabilities 2,400
Contributed cap. 1,300 Revenue 9,000 Contributed cap. 1,300
Retained earnings 1,600 Expenses 6,000 Retained earnings 3,600
Total 5,000 Net income 3,000 Total 7,300
2007 Stmt. of R/E

Begin balance 1,600
Plus: Net income 3,000
Less: Dividends 1,000
Chapter One Ending balance 3,600 Slide 51 of 36
Balance Sheet Equation
A = L + SE

Shareholders Equity
Shareholders Equity
Contributed Retained
+
Capital Earnings
Begin retained earnings + Net income -

Dividends
Revenue Expenses + Gains - Losses

Relations among financial statements
Balance Sheet Stmt. Of Retained Earnings
Assets = Liabilities Income Stmt.
+ Contributed capital + Beginning retained earnings
+ Revenue Expenses + Gains Losses Dividends
Assets = Liabilities + Contributed capital +

Beginning retained earnings + Revenue -
Expenses + Gains - Losses - Dividends
Rearrange terms so only + signs
Assets + Expenses + = Liabilities + Contributed capital +

Losses + Dividends Beginning retained earnings + Revenue +
Gains
CH 1- Q. 1
PLANKSHIRE REALTY
Income Statement
Revenues
Commissions earned $
Rental service fees
Total revenues $
Expenses
Salaries expense
Commission expense
Payroll tax expense
Rent expense
Utilities expense
Promotion and advertising expense
Miscellaneous expenses
Total expenses (excluding income taxes) $
Pretax income
Income tax expense $
Net income $

CH 1- Q. 2

Notes
Notes provide supplemental information about the

financial conditions and economic performance of a
company
Three basic types of notes:
(1) Description of accounting rules applied

(2) Presentation of additional details about an item on
the financial statements
(3) Provide additional information about an item not
on the financial statements

Notes: Description of accounting rules applied

Notes: Additional details about an item on

Notes: Additional details about an item on

Notes: Additional information about an item
not on the financial statements

Management Discussion Analysis
What is management discussion analysis (MDA)?

A required section of annual reports that
concentrates on explaining the major changes in
the income statement and the major changes in
liquidity and capital resources.

What does Starbucks MDA tell you?

Primary driver for revenue growth: opening of 1,342 new
retail stores in 2007
Increase comparable store sales from existing stores
Growth in Specialty Operations revenues, i.e., licensing

revenues, food service and other revenues
Starbucks faces increasing challenges in the U.S. due to

the economic slow down and price increases implemented
in 2007

Li (2006) shows that if the annual report is more gloomy,

firm is more likely to have a loss next year.
Market seems to ignore this: you can make a 10% extra

return by shorting (selling shares you do not own) firms
that are the most gloomy.

What determine the content of financial
statements?
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP)
Measurement rules applied in computing the numbers on the financial

statements.
Changes in measurement rules can change the appearance of a

companys financial positions and economic performance, which
further affect:
selling price of a companys stock to shareholders

the amount of bonuses received by management and employees
leaking information to the companys competitors in the same
industry
Therefore, knowledge of GAAP is necessary for accurate interpretation

and understanding of the numbers in the financial statements.

Who formulate GAAP; Convergence to IFRS
US
Financial Accounting Standard Board (FASB)
Hong Kong
Hong Kong Institute of Certified Public Accountants
(HKICPA)
China
Ministry of Finance of Peoples Republic of China
International
International Accounting Standard Board (IASB)
International Financial Reporting Standards (IFRS)
Accounting standard harmonization
reduces PEAD: Hung, Li, Wang (2014)
PEAD, pre-shock PEAD, post-shock
[-2,-1] years [1, 2] years Difference
Country (1) (2) (3)
Australia 0.0601** 0.0249* -0.0352**
Belgium 0.0100 0.0327 0.0227
Denmark 0.0179 0.0028 -0.0151
Finland -0.0336 0.0240* 0.0576*
France 0.0440** 0.0006 -0.0434**
Germany 0.0390* 0.0196 -0.0194**
Greece 0.0640* 0.0180 -0.0460*
Hong Kong 0.0317* 0.0134** -0.0183
Ireland 0.0596 0.0201 -0.0395
Italy 0.0274 0.0109* -0.0165
Netherlands 0.0230** 0.0006 -0.0224*
Norway -0.0019 -0.0402 -0.0383*
Philippines 0.0497 0.0225 -0.0272
South Africa 0.0529** 0.0093 -0.0436**
Spain -0.0012 0.0282 0.0294
Sweden 0.0554** 0.0191* -0.0363**
Switzerland 0.0171* 0.0041 -0.0130*
U.K. 0.0362** 0.0122** -0.0240**
Treatment countries 0.0244*** 0.0106 -0.0138***
Brazil -0.0337 0.0541* 0.0878
Canada 0.0528*** 0.0765** 0.0236*
China 0.0662* 0.0491 -0.0171
India -0.0177 0.0311 0.0489
Indonesia 0.0179 0.0427 0.0248
Japan 0.0455*** 0.0529*** 0.0074
Malaysia 0.0500** 0.0700** 0.0201*
Mexico 0.0768*** 0.0174 -0.0594
South Korea 0.0312 0.0589 0.0277
Taiwan 0.0212** 0.0416** 0.0205
Thailand 0.0801*** 0.0255* -0.0546**
U.S. 0.0157** 0.0405*** 0.0248**
Benchmark countries 0.0280*** 0.0415*** 0.0135**
Difference, treatment versus
benchmark countries -0.0036 -0.0309*** -0.0273***

Accounting standard harmonization
reduces PEAD: Hung, Li, Wang (2014)
Treatment sample Benchmark sample Full sample
Variables (1) (2) (3) (4) (5) (6)
QSUE 0.0296*** 0.0281*** 0.0323*** 0.0312*** 0.0322*** 0.0312***
(4.38) (4.34) (3.79) (4.03) (3.92) (4.15)
POSTQSUE -0.0276*** -0.0275*** 0.0086* 0.0062 0.0090* 0.0063
(-3.15) (-3.11) (1.80) (1.29) (1.94) (1.36)
POSTTreatment 0.0099 0.0086
(0.97) (0.87)
QSUETreatment -0.0005 -0.0015
(-0.04) (-0.13)
POSTQSUETreatm
ent -0.0385*** -0.0353***
(-3.59) (-3.31)
SIZE 0.0046*** 0.0043*** 0.0044***
(3.17) (4.54) (5.86)
MTB -0.0003 -0.0015** -0.0010**
(-0.74) (-2.43) (-2.25)
BETA -0.0220*** -0.0176*** -0.0183***
(-4.31) (-2.78) (-3.41)
PRERET 0.0388** 0.0305*** 0.0324***
(2.55) (2.64) (3.63)
Fixed effects Country, industry, year
No. of obs. 6,862 6,862 14,258 14,258 21,120 21,120
Adj. R2 0.05 0.05 0.04 0.04 0.04 0.04
Auditors
What are the 4 big audit firms?

Ernst & Young
Deloitte & Touche
KPMG
PWC
What accounting firm audits the company your are

interested in?
Why are auditors needed?

The adverse selection (or lemons).

Auditors
What are the main types of audit opinions?

Unqualified (Clean)
Unqualified with comments
Qualified
Adverse
Going concerns
If the firm is going to be liquidated, we should use the
liquidating value for the assets.

NRCC (National Republican
Congressional Committee)
The former treasurer for the National Republican
Congressional Committee diverted [] possibly as much
as $1 million of the organization's funds into his personal
accounts.
Ward was the only NRCC official empowered to use wire

transfers to shift money into any account without a
second approval.

The five previous audit submitted to [audit committee]
were bogus.
The audit reports [] looked very genuine and carried the

logotype of a recognized auditing firm. [] They might
have appeared real to most people who were not
sophisticated readers of such reports.

NRCC had not met with its outside auditors for nearly five
years, describing that as unusual. (!?!?)
The scheme began to unravel this year, when the new

head of the audit committee insisted on meeting the
auditors.
NYT and WashingtonPost, 14/03/08

Bayou
Federal prosecutors sued the Bayou funds yesterday,

saying the hedge fund company and securities firm run by
Samuel Israel III directed a years-long fraud that attracted
more than $300 million from investors.
Bayou also created a bogus accounting firm, Richmond-

Fairfield Associates, to certify Bayou's false financial
statements, the complaint stated.
New York Times, 02/09/05

Bayou
A judge sentenced the co-founder of the defunct hedge

fund Bayou Group to 20 years in prison on Monday for his
role in a scheme that cheated investors out of more than
$400 million.
Reuters, 14/04/08

Auditors in China
The survey, which received 378 responses, found that

most CFOs in China think that their auditor would change
its opinion if offered more fees. A quarter of the
respondents said that the levels of integrity in China's
auditing are unsatisfactory or poor, and more than half
ranked the auditing industry's integrity as average. Some
saw the profession as rife with and open to corruption.
CFO Asia (February 2005)

Financial Analysis

Profitability
Was Google profitable in fiscal year 2013?

Yes, both net income and cash-flows are positive
Was its level of profitability good or bad?
Cannot judge on an absolute basis; must use
some type of comparative basis; possibilities are:
Compare to prior year
Compare to industry
Compare to expectations
Compare to resources committed

Two key ratios
There is no official way of doing financial analysis.
One way to standardize the performance evaluation is by

considering two key ratios:
ROA
ROE

Return on Assets (ROA)
Wealth from operations generated during period

ROA =
Total resources available during period
Net Operating Profit After Tax

ROA =
Average total assets
NOPAT
ROA =
Average total assets
NOPAT
NOPAT: Net Operating Profit After Tax
NOPAT= Net Income + interest expense (1 tax rate)
It measures how much profit the firm generated during the

period independent of its capital structure (i.e.,
independently of how much debt versus equity is used).

What is NOPAT?
NOPAT is what the company would have reported for

net income before paying any shareholders (creditors)
As Reported NOPAT
Revenues $600,000 $600,000
Operating expenses 460,000 460,000
Interest expense 40,000 0
Income before taxes $100,000 $140,000
Income taxes (30%) 30,000 42,000
Net income $70,000 $98,000
NOPAT = Net income + [Interest expense x (1 - Tax rate)]

Starbucks ROA
2006
[$564,259 + $8,400 x (1 0.358)]
= 14.34%
[($3,513,693 + $4,428,941) 2]
2007
[$672,638 + $38,200 x (1 0.363)] = 14.27%

[($4,428,941 + $5,343,878) 2]

Starbucks ROA: Good or Bad?
Still need a benchmark, such as industry average

Minimum acceptable benchmark is companys Weighted
Average Cost of Capital (WACC)
Measures companys financing cost for its given
mix of debt and equity financing
WACC = (WD x After-tax cost of debt) + (WE x Cost of
equity)
Why is WACC minimum acceptable benchmark?

Closer Look at WACC
WACC = {WD x [rD (1 - Tc)]} + (WE x rE)

WD = Debt weight based on portion of debt in financing mix
= Debt mkt. value / (Debt mkt. value + Equity mkt. value)
rD = Pre-tax cost of debt
Tc = Corporate tax rate
WE = Equity weight based on portion of equity in financing mix
= Equity mkt. value / (Debt mkt. value + Equity mkt. value)
rE = Cost of equity

WACC
You will learn more in your finance class about how to

calculate your cost of equity and your cost of debt.

China Ltd. Macau Ltd.

Gross profit 500,000 500,000
Operating expenses 300,000 300,000
Interest expense 60,000 0
Net income 140,000 200,000
Total assets 1,000,000 1,000,000

Debt (15% interest rate) 400,000 0
Shareholders equity 600,000 1,000,000
Total debt and equity 1,000,000 1,000,000
ROA focuses on earnings generated from total resources available
to company; ignores source of resources
Which company used its resources more efficiently to generate income?

Earnings
Gross profit 500,000 500,000
available
for capital Operating expenses 300,000 300,000
providers Interest expense 60,000 0
Net income 140,000 200,000
Total
resources Total assets 1,000,000 1,000,000
Capital Shareholders equity 600,000 1,000,000
providers Total debt and equity 1,000,000 1,000,000
If the tax rate is greater than zero, then China Ltd. Is more efficient
for shareholders.
Return on Equity (ROE)

Gross profit 500,000 500,000
Earnings Operating expenses 300,000 300,000
available for Interest expense 60,000 0
shareholders Net income 140,000 200,000
Total assets 1,000,000 1,000,000

Shareholders Shareholders equity 600,000 1,000,000
Total debt and equity 1,000,000 1,000,000
ROE focuses on earnings generated only from
resources provided by shareholders
Return on Equity (ROE)
Wealth from operations generated during

period for shareholders
ROE =
Total shareholder wealth held by company
during period
Net income available for common shareholders

ROE =
Average common shareholders equity

Starbucks ROE
$564,259
2006: = 26.1%
[($2,090,262 + $2,228,506) 2]
$672,638
2007: = 29.8%
[($2,228,506 + $2,284,117) 2]
Was Starbucks ROE good or bad?

Need benchmark (e.g., industry ROE)

DuPont ROE Analysis
Powerful model for understanding a companys ROE
What proportion How much sales How much of

of assets belong does company each sales
to shareholders? x get from each x dollar does
asset dollar? company keep?
(leverage) (sales efficiency)
(cost efficiency)
Capital Structure Asset Turnover Profit Margin

Assets x Sales x Net Income
Cmn. Equity Assets Sales
Profit Margin Components
Profit Margin
How much of each sales How much of each

dollar does company NOPAT dollar does
keep after covering all company keep after
expenses except for x covering interest (and
interest (and taxes taxes associated with
associated with interest)? interest)?
(operating efficiency)
(interest efficiency)
NOPAT x Net income

Sales NOPAT
Starbucks DuPont Analysis
Sales Operating ROA
Efficiency Efficiency
Assets Sales NOPAT NI

ROE = x x x
Equity Assets Sales NOPAT
2006 =
2007 =


ROE = x x x
7,786,942
2006 =
3,971,317
= 1.9608
9,411,497
2007 =
4,886,409
= 1.9261
Starbucks DuPont Insights
What do we learn about sales efficiency?

Slightly decreased sales efficiency
Sales increased by 20%
Average total assets utilized increased by 23%
This may be due to the opening of slightly too

many stores.


ROE = x x x
7,786,942 569,652
2006 =
3,971,317 7,786,942
= 1.9608 0.0732
9,411,497 696,971
2007 =
4,886,409 9,411,497
= 1.9261 0.0741
What do we learn about operating efficiency?

Pretty stable
We need industry benchmark and some times
series
What are some possible reasons?

Starbucks may have decided to protect its margin
at the expense of its volume


ROE = x x x
7,786,942 569,652
2006 =
3,971,317 7,786,942
= ROA = 14.35% 1.9608 x 0.0732
9,411,497 696,971
2007 =
4,886,409 9,411,497
= ROA = 14.27% 1.9261 x 0.0741

What do we learn about sales efficiency?
What do we learn about operating efficiency?
ROA is pretty stable

Small drop caused by a small drop in sales
efficiency.


ROE = x x x
3,971,317 7,786,942 569,652

2006 =
2,159,384 3,971,317 7,786,942
= 1.8391 1.9608 0.0732
4,886,409 9,411,497 696,971

2007 =
2,256,311 4,886,409 9,411,497
= 2.1656 1.9261 0.0741

What do we learn about leverage?

Starbucks relies more on debt vs. equity than last
year
Starbucks did not use a lot of long-term debt.
This year, the increase is due to both short term
and long-term borrowing.


ROE = x x x
3,971,317 7,786,942 569,652 564,259

2006 =
2,159,384 3,971,317 7,786,942 569,652
= 1.8391 1.9608 0.0732 0.9905
4,886,409 9,411,497 696,971 672,638

2007 =
2,256,311 4,886,409 9,411,497 696,971
= 2.1656 1.9261 0.0741 0.9651

What do we learn about leverage?
What do we learn about interest efficiency?

Slightly decrease
Expected since Starbucks has more long term
debt than last year
Generated almost the same earnings regardless
of the debt borrowed


ROE = x x x
3,971,317 7,786,942 569,652 564,259

2006 =
2,159,384 3,971,317 7,786,942 569,652
26.15% = 1.8391 1.9608 0.0732 0.9905
4,886,409 9,411,497 696,971 672,638

2007 =
2,256,311 4,886,409 9,411,497 696,971
29.83% = 2.1656 1.9261 0.0741 0.9651

What do we learn about ROE?

The ROA is pretty much the same but the ROE
increased.
Starbucks made a more efficient use of its capital
structure.
More on capital structure decisions in your
finance class.

Additional Analysis Tools
Common-size financial statements
Trend analysis
Ratios
Financial statements
Segment analysis

Trend Analysis
Trend analysis is an across-time analysis
Trend financial statements

For each line item, the amount for a given year is
stated as a percentage of the line item amount in the
base year
Complements common-size financial statements
Helps explain trends in common-size statements

Segment Analysis
Segment information and analysis

Provides select income statement and balance sheet
information broken down by business segments
and/or geographic segments

Segment Analysis
What does segment info contribute to analysis?

Can apply modified ROA or ROE decomposition
Can apply trend analysis
More useful when segments are very different.

Starbucks Segment Analysis
2007 2006 2005

Earnings / Assets 0.4399 0.4797 0.5790
U.S. Sales / Assets 2.9939 3.0950 3.2652
Earnings / Sales 0.1469 0.1550 0.1773
Earnings / Assets 0.1319 0.1467 0.1427
International Sales / Assets 1.5198 1.7456 1.7084
Earnings / Sales 0.0868 0.0840 0.0835
There is a decline in profitability in the US and to

some extent internationally.

Should We Buy?
Starbucks appears to be a growing firms with a very

healthy financial situation.
We have some concern about the US situation.
But the price may already reflect this.
There are some uncertainty.

How long will the growth last?
Are we sure the numbers are right?

Take Aways
Why accounting matters.

Information role
Contractual role
Trading rule (Post Earnings Announcement Drift)
Role of auditors

Take Aways
Familiarity with financial statements

Purpose and elements of each statement
Accounting equation
Relation of financial statements

Take Aways
Financial Analysis
Common size analysis
DuPont model and additional analysis tools
Sometimes need to use best information available

Chapter 1 - S

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Chapter 1 - S

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Chapter One Slide 1 of 36

Identify the users of accounting information

Be familiar with the four basic financial statements (the purpose,

Be introduced to the balance sheet equation, income statement

Chapter One Slide 2 of 36

Shareholders Build factory/warehouse

Cash collected Inventory

Chapter One Slide 3 of 36

Chapter One Slide 4 of 36

Shareholders buy ownership in the

Creditors lend money for a specific period

Marketing managers and credit managers use

Purchasing managers use suppliers financial

Employees union and human resource

Financial Accounting System Managerial Accounting System

External Decision Makers Internal Decision Makers

Chapter One Slide 7 of 36

Others such as government, competitors, press, public,

Chapter One Slide 8 of 36

Many contracts use accounting numbers.

The counterparties of many contracts use accounting

Not surprisingly, managers will try to manipulate the

Chapter One Slide 9 of 36

Anticipation and informed due diligence are extremely

Enron, Parmalat,any other you know?

A random inspection of 152 mainland enterprises by the [PRC]

Chapter One Slide 10 of 36

Anomalies / Investment Signals

Chapter One Slide 11 of 36

Companies can prepare financial statements at the end

Financial statements prepared at the end of the fiscal

Chapter One Slide 13 of 36

The financial position The performance (change

What is an Income Statement?

What are the main types of accounts on an I/S?

Chapter One Slide 15 of 36

Format under US GAAP

Chapter One Slide 16 of 36

What is a common size income statement?

Chapter One Slide 17 of 36

Compare changes 2017 2016

Cost of sales 42.5% 40.8%

Other operating 3.1% 3.3%

Chapter One Slide 18 of 36

What is a Balance Sheet?

What are the main types of accounts on a B/S?

Chapter One Slide 19 of 36

Assets = Liabilities + Shareholders

Current assets Current Contributed

Chapter One Slide 20 of 36

A common-size balance sheet standardizes each line item

How does common-size balance sheet contribute to

Chapter One Slide 21 of 36

What do we learn about assets by comparing the balance

Changes in asset mix?

Chapter One Slide 22 of 36

What do we learn about financing from Googles common-

Changes in financing mix?:

Chapter One Slide 23 of 36

What is the purpose of the SCF?

Both operating cash flows and net income measure

Chapter One Slide 24 of 36