C h a p t e r One

Economic Environment of
Accounting Information

TAKEAWAYS
When you complete this chapter you should be able to:
1. Identify the basic financial statementsthe income statement, the balance sheet, the statement of cash flow,
and the statement of shareholders equity.
2. Explain how companies acquire capital from investors who purchase the debt and equity securities issued by
such firms to obtain an expected return commensurate with the risk the investors assume.
3. Describe the role of accounting standards in facilitating a properly functioning capital market.
4. Explain the conflicts of interest that can arise between executives, debtholders, and shareholders of a
corporation and the costs associated with the divergent incentives that can arise when ownership and
management of a company are separated.

Where are we? Where are we going?

In the next chapter we illustrate how ac-

In this chapter, the financial statements of Amazon.com are counting events are analyzed, quantified,
used to illustrate the accounting information that compa- summarized, and ultimately disclosed
nies provide to debtholders and shareholders. The chapter in a companys basic financial state-
discusses how the demand for capital by companies that ments. Concepts such as assets, liabili-
ties, revenues, expenses, and cash flow
have insufficient funds to meet their investment needs and
are defined and used in an example that
the supply of capital come together in a capital market to demonstrates the preparation of basic
set equilibrium prices for stocks and bonds. The chapter financial statements. The chapter also in-
also discusses how the credibility of accounting information troduces the use of financial statements
is enhanced when a reputable external auditor provides an for purposes of evaluating a companys
financial performance. Finally, several
opinion about the accounting information. Finally, the chapter
recent accounting scandals are used to
investigates the use of accounting data in internal decision- illustrate how some managers enhance
making by management and its use in contracts between their companys reported financial perfor-
shareholders and managers and between shareholders and mance through the selection and use of
debtholders to attenuate the conflicts of interest that can alternative accounting methods.
arise between the various constituencies of a company.

1
 AMAZON.COM Symbol: AMZN

Amazon.com, Inc. was one of the first, and became perhaps the best known, internet-based reseller of retail goods. The company
was one of the high-flying internet stocks that became a favorite of equity investors during the stock market bubble period of the
late 1990s. Like many dot.com companies that lacked a history of proven earnings, investors began to question Amazons business
model following the U.S. stock market decline of 20012002. Investors also began questioning the way the stock market valued
companies during this period of so-called irrational exuberance. As a consequence, there eventually occurred a shift back to firm
valuations based on such business fundamentals as strong operating earnings and a solid balance sheet.
Amazon.com was founded by Jeff Bezos in 1995 under the name Cadabra.com as an online bookstore to compete with tra-
ditional brick-and-mortar bookstores and mail-order catalogs. Bezos renamed the company Amazon after the worlds largest
river and took the company public in 1997. Like the South American river, Amazon.com was huge in scale, offering many times the
selection of products of even its largest competitors. Amazon has since greatly expanded its product offerings to include DVDs,
music CDs, computer software, video games, electronics, clothing, furniture, food, toys and much more.
Bezos believed in the long-term prospects for his company, although he did not expect the business to produce a profit for
many years. As history has since demonstrated, Bezos business strategy proved successful. Unlike many internet companies,
Amazon grew at a steady pace and focused on such business fundamentals as revenue growth, cash flows, and attaining profit-
ability. The bursting of the dot.com bubble in the early 2000s forced many e-companies out of business. Amazon, however, perse-
vered and eventually reported its first profit in the fourth quarter of 2002. Amazon.com has continued to report profits every year
since then, earning net income of $35 million in 2003, $588 million in 2004, $359 million in 2005, and $190 million in 2006. Despite
its recent financial success, however, Amazons cumulative profit remains negative, largely as a consequence of its early history
of operating losses. Today, Amazon.com trades on the NASDAQ stock exchange under the symbol AMZN and is a member of the
prestigious Standard and Poors 500 Index, an index of the shares of the 500 largest companies traded on U.S. stock exchanges.
In this chapter, we examine the financial statements of Amazon, as well as consider the generally accepted accounting prin-
ciples that have been established to ensure a level of comparability among the many public companies, like Amazon, that produce
financial statements for use by investors, lenders, and shareholders.

EXECUTIVE Economic Environment of Accounting Information

OUTLINE

Financial Accounting Generally Accepted Financial Accounting in The Changing

and Its Relevance Accounting Principles Investment Decisions Economic Landscape

Financial Accounting: Role of the U.S. Demand for and Supply The Sarbanes-Oxley
What is it? Securities and of Capital Act
Qualitative Attributes of Exchange Commission Relation Between Risk Principles-Based GAAP
Accounting Information The FASB and Standard and Return
Amazons Accounting Setting
Methods and the Role
of the Independent
Auditor

FINANCIAL ACCOUNTING AND ITS RELEVANCE

Most individuals are familiar with the game of baseball and its many rules. Most know, for instance, that according
to the rules of the game, the team with the most runs scored at the completion of play is considered to be the winner.
Of course the rules do much more than decide the measure by which we are able to determine which team won and
which team lost; they also provide a framework within which to play the game and settle disagreements along the way.
Imagine the chaos that might ensue if there were no mutually accepted rules of the game. How would it be determined,
for instance, if a base runner was out or was safe, if a pitch was a ball or a strike, and so on? Without an accepted set
of rules governing the game, it would be impossible to play the sport and insure a consistent set of outcomes.
Keeping score with an accepted set of rules applies to more activities than just baseball; it also applies to running
a business like Amazon.com. In fact, the similarities between baseball and financial accounting are probably closer
2
 Chapter 1 | Economic Environment of Accounting Information 3

than you might imagine. Understanding the rules of the game also helps us do more than simply declare the win-
ner of a game or calculate the annual profit of a business; it enables us to keep track of various measures that can be
used to determine the quality of a teams play or the quality of a businesss operations. Our knowledge of the rules
and how teams or businesses have performed in the pastfor example, team batting averages, pitching records, and
fielding percentages for baseball teams and assorted financial ratios such as the return on assets, return on equity or
return on sales for a businesscan, in turn, help us to predict how teams and businesses will perform in the future.
This knowledge, as you will see in subsequent chapters, is invaluable when attempting to assess the value of a sports
franchise or a business enterprise.
Simply reading a rule book, however, may not be sufficient to obtain a complete understanding as to how a
game is played and scored. It is also critical to understand the limitations regarding how the rules are applied, along
with what is not covered by the rules. This caveat especially applies to financial accounting. Imagine the difficulty
that would occur if each baseball team got to decide the distance from home plate to first base in its home stadium.
Or imagine the confusion if, with the bases loaded, a team could choose which direction to run toward home plate,
scoring either from first base or from third base. Unfortunately, as we will see in the following chapters of this text-
book, financial accounting permits considerable flexibility in determining the applicability of its rules to individual
business enterprises. As a consequence, the rules governing financial accounting will be seen to involve considerable
managerial judgment. In baseball, for example, while general guidelines exist as to whether a pitch should be called
a ball or a strike, it is up to an umpires judgment to make the exact call. In a similar fashion, while general account-
ing guidelines exist as to what is considered revenue for a business, financial accounting often requires that corporate
managers exercise judgment in assessing just how much revenue a business earned in a given fiscal period. In addition
to the obvious analytical challenges that can result from this flexibility in the application of the rules of the game,
business analysis is also often hampered by a lack of certain key information. Many of the factors that are critical to a
businesss operating success, to include the quality of its workforce and a well-recognized brand name, are not mea-
sured and reported under current financial accounting rules.
A theme that will be repeated throughout this textbook is that accounting information is useful not only for
keeping score of a businesss past operating performance and financial health but also for predicting its future
performance and financial well-being, and ultimately, for helping to assess firm value. However, to be a good
scorekeeper and a good analyst, one needs to know not only the rules of the game, but also how to interpret the
data resulting from the application of the rules, the limitations of the rules, and when to make adjustments to the
information to aid in its use for decision-making purposes.

Financial Accounting: What is it?

Financial accounting concerns the preparation and use of the accounting information provided in a companys
publicly available financial statements. Users of financial accounting information include, among others, a companys
management, the shareholders who own the company through the shares they purchase, debtholders from whom the
company borrows money, investment professionals who provide financial advice about the company, and govern-
mental agencies like the U.S. Securities and Exchange Commission which regulates the dissemination of accounting
information to the investing public. Unlike the external focus of financial accounting, managerial accounting focuses
on the production of accounting information internal to a firm for deciding such operational questions as how much
inventory to produce, what price to charge customers, and for measuring and rewarding the performance of a firms
managers and employees. Managerial accounting information is rarely provided to anyone other than a firms board
of directors, managers, and employees to avoid revealing proprietary information that might adversely affect a firms
competitive position. The focus of this textbook is on financial accounting, and how financial advisors, investors,
lenders, managers, and shareholders use this information for decision-making purposes.
Before getting into the details of how financial statements are prepared and analyzed, it is useful to see the end
result of the financial accounting processthe financial statements themselves. For the moment, dont worry about
the numerous details that you will see since these details will be explored in later chapters. Company financial reports
include many items besides the basic financial statements, such as explanatory footnotes, a chairmans statement, and
a management discussion and analysis of recent events and company performance. For simplicity, these latter items
have been omitted and will be considered in subsequent chapters.
4 Chapter 1 | Economic Environment of Accounting Information

To begin, it is useful to obtain a big picture view of a company by reading the introductory information about
a companys business and its business strategythat is, managements view of where the company is going based on
the resources it has available (human, physical, and financial). Reading the financial statements will help you deter-
mine whether a company has the necessary financial resources, or can acquire them, to get where they want to be.
Consider, for example, the business strategy of Amazon.com:
Amazon.com seeks to be the worlds most customer-centric company, where customers can find and discover
anything they might want to buy online at a great price.

No small thinking here! If Amazons customer friendliness can attract the millions of customers that the company has
the capacity to handle, and each customer buys something from Amazon, Amazons future sales could be substantial.
Investment professionals who track the performance of companies like Amazon formalize sales and sales growth
projections by gathering data regarding consumer demand, product shipments, product prices and sales discounts.
These projections are integral to the analytical reports developed by investment professionals concerning a companys
current financial health, and hence, its fair market value. Your review of Amazons financial statements is likely to be
enhanced by obtaining and reviewing a copy of a reputable analysts report from any one of a variety of financial web-
sites such as Yahoo.com or MSN.com or from a financial services company like Merrill Lynch or Salomon Smith
Barney. As to the claims that the company is customer-centric and that customers can find and discover anything
they might want to buy, you can verify these assertions yourself by logging on to Amazons website (www.Amazon.
com) if you havent done so already.
The basic financial statements for Amazon.com, Inc.the balance Access to corporate financial statements
sheet, the income statement, and the statement of cash floware provided has increased greatly in recent years thanks
in Exhibits 1.1, 1.2, and 1.3. (A fourth financial statement, the statement to the World Wide Web. Companies such as
of shareholders equity, will be discussed later in this chapter.) The bal- Amazon often provide financial statements
ance sheet in Exhibit 1.1 shows, for example, what resources the com- on their corporate website.
pany currently has and who provided the financing to acquire the various
resourcesdebtholders or shareholders. Specifically, Amazons balance sheet reveals the amount and type of assets
owned, the liabilities owed, and the shareholders equity investment in the company. Assets refer to the resources of a
company that are expected to provide future economic benefit. Liabilities represent the dollar value of the companys
obligations to repay monies loaned to it, to pay for goods or services received by it, or to fulfill commitments made
by it. Shareholders equity, the difference between a companys assets
and liabilities, represents the shareholders (owners) financial stake in a
company. In essence, two investment constituencies provided the neces- The basic accounting equation, Assets 
sary financing for Amazons assetsthe shareholders who own the com- Liabilities  Shareholders equity, provides
pany as a consequence of their share purchases and debtholders who have the foundation not for only the balance
sheet, but more importantly for the entire
loaned money and other assets to the company.
methodology underpinning the recording
Amazons balance sheet is based on the basic accounting equa- of all accounting transactions. Each trans-
tion, which asserts that a businesss assets must always equal the sum action that is recorded must be done so
of its liabilities and its shareholders equity. By the end of 2005, Am- such that the equation remains in balance.
azons balance sheet reveals that it had acquired nearly $3.7 billion in For this reason, the term double-entry
assets while the companys debt stood at $3.45 billion ($1.929 billion accounting is often used to describe this
plus $1.521 billion) and its shareholders equity totaled just $246 mil- method of recording transactions.
lion. Notice that although the shareholders contributed over $2.2 bil-
lion to the business since its inception in 1997, only $246 million in An alternative to the accrual basis of ac-
shareholders equity remains. To identify the cause of this decline in counting is the cash basis of accounting.
shareholders equity, we will need to explore Amazons income state- Under the cash basis, the financial effects
ment, which we consider shortly. of a business event are recorded in the fi-
The presence of various accounts on Amazons balance sheet such as nancial statements when the cash effect of
accounts receivable, the amount that Amazon expects to receive from its the transaction occurs. Thus, a company
customers for prior online purchases, and accounts payable, the amount records revenue from a sales transaction
that Amazon expects to pay to its suppliers for prior credit purchases of only after cash has been collected from the
customer; similarly, expenses are recorded
inventory, indicates that this financial statement was prepared using the
only when they are paid.
accrual basis of accounting. This approach requires Amazon to record
 Chapter 1 | Economic Environment of Accounting Information 5

the financial effects of a business transaction without regard to the timing of the cash effects of the event. Thus, Ama-
zon records the revenue from each sales transaction when it occurs regardless of whether the customer has paid for the
ordered goods or not. Similarly, Amazon records the cost of doing business when such costs are incurred regardless of
whether those costs have been paid or not. The balance sheets and income statements of most businesses are prepared
using the accrual basis of accounting, as this approach is widely recognized as being superior to all other approaches
for measuring the financial performance and health of a company.

EXHIBIT 1.1 Consolidated Balance Sheet

Amazon.com
Consolidated Balance Sheet
December 31

($ millions) 2005 2004

Assets
Current assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,013 $1,303
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 987 476
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566 480
Accounts receivable and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363 280
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,929 2,539
Fixed assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348 246
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419 463
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,696 $3,248
Liabilities and stockholders equity (deficit)
Current liabilities
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,366 $1,142
Other current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563 478
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,929 1,620
Long-term debt and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,521 1,855
Stockholders equity (deficit)
Common stock, 5,000 authorized shares; issued and outstanding shares
416 and 410 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 4
Additional paid-in-capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,263 2,123
Accumulated other comprehensive income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 32
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,027) (2,386)
Total stockholders equity (deficit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 (227)
Total liabilities and stockholders equity (deficit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,696 $3,248

An important tenant underlying the accrual basis of accounting is the going concern assumption; that is, the
notion that the basic financial statements are prepared assuming that a business will continue operating in the future
unless there is substantial evidence to the contrary. If a business is expected to continue operating in the future, inves-
tors will focus on revenues and net income from the income statement in order to forecast a firms future operating per-
formance. If, on the other hand, a business is expected to cease operations, investors are likely to focus their attention
more closely on shareholders equity on the balance sheet to determine what an investor might receive if, and when,
the company is liquidated. Academic research consistent with the going concern assumption indicates that in setting
share prices, investors place relatively more weight on shareholders equity on the balance sheet when a business is
facing financial distress but on net income on the income statement when a business is financially healthy.1
Amazons income statement in Exhibit 1.2 reports how much merchandise the company sold and how much
profit, if any, it made from those sales. Amazons consolidated statement of income reveals that the companys sales

1
See M. Barth, W. Beaver and W. Landsman, Relative Valuation Roles of Equity Book Value and Net Income as a Function of Financial Health,
Journal of Accounting and Economics (February 1998).
6 Chapter 1 | Economic Environment of Accounting Information

grew to nearly $8.5 billion by 2005. The bottom line of the income Exhibit 1.2 presents Amazons consolidated
statement indicates that Amazon earned a profit in each of the three income statement. But just what was con-
years covered by the income statements (2003 to 2005). In contrast, solidated and what remains unconsolidated?
Amazon racked up losses of just over $3 billion in the years prior Under the accounting standards of most coun-
to 2003. A review of Amazons historical financial statements (not tries, when one company obtains a majority of
presented here) reveals that from 1996 until 2002, Amazon failed the voting shares of another company, the finan-
to earn a profit in any of the six years since it became a public com- cial results of the two companies are combined
pany! This history of operating losses explains why the shareholders and reported on a consolidated basis. Thus,
investment on the balance sheet was nearly wiped out. in the case of Amazon, the consolidated income
statement includes the complete financial results
You are probably wondering how a company like Amazon can
of Amazons majority-owned subsidiaries but
sustain six years of operating losses and still remain in business! The
only summary results of its subsidiaries in which
answer to this question resides in Amazons statement of cash flow its ownership interest is less than a majority.
to which we now turn.

EXHIBIT 1.2 Consolidated Income Statement

Amazon.Com Inc.
Consolidated Statement Of Operations
Year Ended December 31,

($ millions) 2005 2004 2003

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,490 $6,921 $5,264

Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,451 5,319 4,007
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,039 1,602 1,257
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,607 1,162 987
Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432 440 270
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 28 22
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92) (107) (130)
Other income (expense), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 (6) (123)
Total non-operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4) (85) (231)
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428 355 39
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 (233) 4
Income before change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 588 35
Cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 359 $ 588 $ 35

Exhibit 1.3 presents Amazons statement of cash flow. The

statement of cash flow tells us how much cash Amazon.com gener- There exists substantial empirical evidence that
ated from its core business operations or received from its share- investors who buy and sell shares use informa-
tion about the past, especially financial state-
holders and debtholders, and how much it spent to buy software and
ment information, to help make predictions about
equipment. Investors are usually very interested in the statement of
a companys future. Financial analysts, individual
cash flow because it provides insight into a business beyond that investors, bankers, and many other interested
provided by a balance sheet, which reflects a firms current finan- parties spend considerable time and resources
cial health, or an income statement, which depicts a firms recent predicting a companys future earnings and cash
operating performance. Amazons statement of cash flow shows, for flows to help assess what a companys share
instance, that its operating activities generated $733 million in cash price should currently be worth. We will have
in 2005 despite reporting net income of only $359 million. Although more to say about how to value a companys
Amazons total cash and cash equivalents decreased by $290 mil- shares in Chapter 12; however, let it suffice for
lion in 2005, the companys cash holdings on the balance sheet were the moment that the value of a share of stock
still in excess of $1.0 billion! Thus, Amazon has substantial cash on today is thought to be a function of a companys
future earnings.
hand despite reporting many years of operating losses on the income
 Chapter 1 | Economic Environment of Accounting Information 7

statement and despite maintaining an accumulated shareholder deficit on the balance sheet. These seemingly con-
flicting financial results are possible because of Amazons use of the accrual basis of accounting in the preparation
of its income statement and its balance sheet.

EXHIBIT 1.3 Consolidated Statement of Cash Flow

Amazon.Com Inc.
Consolidated Statement Of Cash Flow

Year Ended December 31,

($ millions) 2005 2004 2003

Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,303 $1,102 $ 738

Operating activities
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 588 35
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 76 76
Stock-based compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 58 88
Other operating expenses (income). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (8) 3
Gains on sales of marketable securities, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (1) (10)
Non-cash interest expense and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 (251) 144
Cumulative effect of change in accounting principle. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (26)
Changes in operating assets and liabilities:
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (104) (169) (77)
Accounts receivable, net and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (84) (2) 2
Accounts payable and other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 275 132
Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733 566 393

Investing activities
Purchase of fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (204) (89) (46)
Acquisitions, net of cash acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (24) (71)
Sales and maturities of marketable securities and other investments. . . . . . . . . . . . . . . . . . . . . 836 1,427 813
Purchase of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,386) (1,584) (536)
Proceeds from sales of subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Net cash (used in) provided by investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (778) (317) 236

Financing activities
Proceeds from exercises of stock options and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 60 163
Proceeds from long-term debt and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Repayment of long-term debt and capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . (270) (157) (495)
Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (193) (97) (332)
Foreign-currency effects on cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (52) 49 67
Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (290) 201 364
Cash and cash equivalents, end of period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,013 $1,303 $1,102

You might think that Amazon.com, which only recently began to earn an operating profit and with liabilities
nearly as large as its assets, would have a share price that was close to zero. Yet Exhibit 1.4 shows that Amazons
share price soared by nearly 5,000 percent since its initial public offering while the much broader Standard and Poors
500 Index was relatively stable over the same period. Amazons share price at its initial public offering was $1, but
by mid 2007, its share price was over $72 per share giving the company a market value of nearly $30 billion. This il-
lustrates an important distinction between a companys financial statements and its share pricethe former is largely
concerned with the past while the latter is concerned with the future. Financial statements are a description of the
historical financial performance of a company, whereas share prices reflect investor expectations regarding a firms
future financial health and performance. The fact that Amazons market value is nearly $30 billion versus a balance
sheet value of just $246 million for shareholders equity suggests that the stock market is optimistic that Amazons
future is going to be much brighter than its past.
8 Chapter 1 | Economic Environment of Accounting Information

EXHIBIT 1.4 Stock Price of Amazon.com versus Standard and Poors 500 Index

AMZN Daily 6/15/07

8,000%
SP500
7,000%
6,000%
5,000%
4,000%
3,000%
2,000%
1,000%
0%
1,000%

Volume
150

millions
100

50

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

To summarize then, companies like Amazon.com who obtain capital Publicly listed companies in the United
from such external sources as debtholders and shareholders are expected States are required to file a quarterly finan-
to periodically provide these interested stakeholders with financial ac- cial report (Form 10-Q) and an annual set
of financial statements (Form 10-K) with the
counting information. This information includes an income statement,
U.S. Securities and Exchange Commission.
a balance sheet, and a statement of cash flow. A fourth statementthe
This information is also mailed or e-mailed
statement of shareholders equityis also typically provided. The rela- to shareholders and debtholders.
tion between these four financial statements is illustrated in Exhibit 1.5.
Exhibit 1.5 illustrates a number of important points about the basic financial statements. First, a balance sheet
is a description of a businesss assets, liabilities, and shareholders equity as of a particular point in time, usually
the end of the fiscal year or the end of a quarter. The balance sheet is represented by the basic accounting equa-
tion: Total assets equal Total liabilities plus Shareholders equity. Second, the income statement describes a firms
performance over the fiscal period; it is represented by the equation: Revenues minus Expenses equals Net income.
Third, the net income earned by a business may be either distributed to shareholders as a dividend or retained in
the business to provide financing for future operations. The statement of shareholders equity captures this deci-
sionit reveals how the shareholders investment in a business grew by the amount of any net income retained
in the business or declined as a consequence of any dividend distributions to shareholders or any operating losses
sustained by a business. This statement also reveals whether the shareholders investment in a business increased by
any new share sales or declined by any share repurchases. Fourth, the statement of cash flow reports the cash flow
from operations, the cash flow from investing, and the cash flow from financing for a firm. The net cash flow for a
fiscal period equals the change in the cash account on the balance sheet from the beginning of the period to the end
of the period. Finally, note that the financial statements are not independent, but rather they are interrelated. (The
interrelationship of the basic financial statements is referred to in accounting jargon as articulation; that is, the
basic financial statements are said to articulate with one another.) As you will see in subsequent chapters, there is
unique, but interrelated information in each of the basic financial statements that is of interest to lenders, managers,
shareholders, and investment professionals.
 Chapter 1 | Economic Environment of Accounting Information 9

EXHIBIT 1.5 Relation Among the Basic Financial Statements

Change in
Cash

Operating cash flows

Investing cash flows
Financing cash flows
Statement of Cash Flows

Balance Sheet Balance Sheet

(beginning of period) (end of period)

Cash Liabilities Cash Liabilities

Shareholders Shareholders
Other assets Other assets
Equity Equity

Income
Statement

Revenues
Expenses Dividends
Net Income

Change in Shareholders Equity

Statement of Shareholders Equity

EXHIBIT 1.6 Relation Between the Income Statement and the Balance Sheet

Income Statement Income Statement

Balance
Sheet
River River

Lake

Exhibit 1.6 illustrates another example of the interrelationship of the basic financial statements, in this case
between the income statement and the balance sheet, using an analogy of a river and a lake. An income statement,
like a river, measures performance over a period of timea flow concept. On the income statement, performance
is measured in terms of earnings in dollars, and with a river, performance is measured in terms of the flow of wa-
ter in cubic feet or meters. Balance sheets and lakes, in contrast, measure levelsa stock concept. Balance sheets
measure the level of net assets and lakes measure the level of water, both at a point in time. Just as a lakes level of
10 Chapter 1 | Economic Environment of Accounting Information

water rises and falls because of the inflow In Practice 1.1 Fiscal Year-End: A Glimpse of a Sample of Fortune 1000
and outflow of water from a river, the level Companies The following table identifies the month selected as a firms
of net assets on the balance sheet rises and fiscal year-end based on a survey of 600 Fortune 1000 companies. As can
falls as a consequence of the operating earn- be seen, December was selected by nearly two-thirds of the sampled firms,
ings or losses generated by a business and although every month is represented:
reported on its income statement. A similar
400
analogy could be used between the cash Percentage
350
balance on the balance sheet and the state- Number
ment of cash flow. The cash account on the 300
balance sheet reports the level of cash cur- 250
rently available to a business, whereas the 200
statement of cash flow reports the inflows 150
and outflows of cash that occurred over the 100
fiscal period. To repeat, the balance sheet 50
discloses the available stocks of various 0
assets, while the income statement and the Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
statement of cash flow reveal the various Source: 2006 Accounting Trends & Techniques
flows of those assets.

Why Accounting Information Is Important

If you have prior business experience, either working for a company or managing your own business, then you have
personal experience that a working knowledge of accounting is essential to do just about any job successfully. Although
business decisions may involve a careful analysis of nonfinancial factors, they almost always involve a significant con-
sideration of accounting information. Initiating a multimillion-dollar marketing campaign, restructuring a subsidiary,
acquiring another company, deciding on the sales price for a productthese are just some of the business decisions
that require at least a basic knowledge of accounting. Thats why, for instance, Anne Mulcahy, Chief Executive Officer
of Xerox Corporation had to learn about accounting and finance when she took over at Xerox in 2001. As Fortune
magazine explained,
She knew she had to get to the bottom of Xeroxs problems quickly. She cast about for someone, anyone, who
could teach her Balance Sheet 101. The guy she found, Joe Mancini Jr., director of corporate financial analysis . . .
became her tour guide in deciphering the companys $30 billion balance sheet. He taught her about debt structure,
inventory trends, and the impact of taxes and currency moves so that she could understand what would generate
cash and how each of her decisions would affect the balance sheet. (Fortune, June 9, 2003).

Executives, such as Anne Mulcahy, are getting up to speed on accounting issues because the post-Enron cor-
porate environment in the United States puts these individuals at risk for civil and criminal law suits.2 Under the
Sarbanes-Oxley Act, passed into law by the United States Congress in 2002, the Chief Executive Officer (CEO) and
Chief Financial Officer (CFO) of each company (foreign or domestic) with public debt or equity sold in the United
States must certify in writing that the information contained in the companys publicly disseminated financial state-
ments presents, in all material respects, the companys financial condition and results of operations. The Sarbanes-
Oxley Act provides for both financial penalties (up to $5 million) and incarceration (up to 20 years) for executives who
falsely certify their companys financial data.

Qualitative Attributes of Accounting Information

It is generally agreed that accounting information is valuable to analysts, creditors, investors, managers, and share-
holders because it contributes to the making of important economic decisions. For instance, managers use accounting

2
The Wall Street Journal (July 22, 2003) reported that 70 percent of the executives who took a test of basic accounting principles shortly after the
passage of the Sarbanes-Oxley Act failed to earn a passing score. A survey of executives taken two years following the passage of the legislation
indicates that executive understanding of accounting and finance issues has substantially improved since the legislations enactment (CFO Maga-
zine, May 2005).
 Chapter 1 | Economic Environment of Accounting Information 11

information to decide the price that they must charge for their companys products; bank credit analysts use account-
ing information to decide whether to extend a loan to a business; and, investors use accounting information to decide
whether to invest in the shares of a company and at what price. Thus, accounting information is said to have decision
usefulness.
There are two specific attributes which make accounting information decision usefulrelevance and reliability.
Relevance refers to the capacity of accounting information to impact a decision. Relevant information is timely and
possesses feedback value, predictive value, or both. Timeliness alone does not make accounting information relevant,
but a lack of timeliness can render accounting information irrelevant. By preparing periodic financial statements it is
possible for companies to provide analysts, managers, and investors with timely information. Feedback value per-
tains to decisions and actions already taken. Accounting information allows financial statement users to measure those
actions and evaluate their success. Predictive value, on the other hand, suggests that accounting information helps
financial statement users form predictions about future outcomes. Investment professionals and shareholders use the
historical financial statements to help predict a firms future operating
performance, and hence, its market value. Materiality is a disclosure criterion used
Because too much information can overwhelm financial statement by companies to decide what, and how
users (i.e., the problem of information overload), the criteria of ma- much, information to provide in their finan-
teriality is used worldwide to help guide just how much accounting in- cial statements. Although the definition of
formation should be disclosed in the financial statements. Information materiality varies from firm to firm, and of-
ten between external auditors, a common
that is immaterial is unlikely to be relevant to a decision maker. Finally,
threshold for the income statement is five
reliability refers to the fact that accounting information is, or should be,
percent of revenues. Hence, any income
free from error or bias; that is, accounting information should be both statement item that equals or exceeds five
objective and verifiable. Unfortunately, the attributes of relevance and re- percent of revenues presumably merits
liability are often in conflict with one another, forcing trade-offs between disclosure on a firms income statement as
the two. A major role of the independent auditor, to which we now turn, such items are numerically large enough to
is to review a companys publicly available accounting information to potentially influence an investors assess-
insure that it is largely error free. ment of firm performance.

Amazons Accounting Methods and the

Role of the Independent Auditor
By now, one question that you have probably considered about Amazons financial statements is: Could Amazon
have computed its accounting results in more than one way? The answer is yes. Nearly every country around the
world maintains a set of generally accepted accounting principlesor GAAPthat provides guidance to companies
regarding the preferred way to measure and report their performance. The confusing aspect about GAAP, however, is
its flexibility. For example, consider the depreciation on a building. Instead of having just one approach to calculate
depreciation on a building, the GAAP of most countries allows for multiple methods, all of which are considered
generally accepted. As you will see in Chapter 7, just which depreciation method is selected can have a dramatic
effect on a firms reported performance.
Consider, for instance, the $566 million reported by Amazon.com for inventory on its 2005 balance sheet in Ex-
hibit 1.1. Was this the amount that Amazon paid for the inventory? Or, was it what the inventory could be sold for at
the end of the year? Or, was it what the same inventory would cost to replace if it were purchased at the end of 2005?
Companies provide details about their accounting methods and how the various accounts are measured in the foot-
notes to their financial statements. For example, the footnotes to Amazons 2005 financial statements report that:
Inventories, consisting of products available for sale, are accounted for using the FIFO method, and are valued at the
lower of cost or market value. This valuation requires us to make judgments (emphasis added), based on currently
available information, about the likely method of disposition, such as through sales to individual customers, returns to
product vendors, or liquidations, and expected recoverable values of each disposition category. Based on this evalu-
ation, we adjust the carrying amount of our inventories to lower of cost or market value.

There are several points to observe here. First, Amazons financial statements are prepared by the company itself,
raising the concern that the company might be tempted to boost its inventory value to make it appear that Amazon has
more assets than it really does. Second, Amazons top management and financial staff make judgments in deciding
12 Chapter 1 | Economic Environment of Accounting Information

what inventory values to report. But since the financial statements provided by Amazons management are potentially
affected by these judgments, an investor might skeptically discount the reported information and reduce their estimate
of what the company is presumably worth. This issue is known as the lemons problem.3
One solution to the lemons problem is for a
credible, independent party to provide a war- In Practice 1.2 Financial Statement Rounding: A Glimpse of a
ranty as to the quality of the product offered. For Sample of Fortune 1000 Companies The following table identifies
the degree of rounding in financial statements in a survey of 600
example, in the used car market, an auto dealer
Fortune 1000 companies. Nearly all of the sampled firms rounded
might promise to take a vehicle back if the buyer
their reported numbers, with rounding to the nearest thousand dol-
experiences any problems. In the accounting lars the most commonly used choice:
market, independent audit firms such as Deloitte
& Touche, Ernst & Young, KPMG, and Price- 350
waterhouseCoopers provide assurance of the Percentage
reliability of the financial statements of the com- 300 Number
panies they audit in an audit report that accom-
panies the financial statements. Audit firms work 250
hard to provide this assurance because errors in de- 200
tecting defective financial statements can result in
the loss of an audit firms valuable reputation, and 150
ultimately, as illustrated by the demise of Arthur
Andersen in 2002, the collapse of an entire audit 100
firm. Audit firms may also bear civil and criminal
50
penalties from lawsuits brought by shareholders,
debtholders and/or governmental agencies like the 0
To nearest To nearest To nearest
U.S. Securities and Exchange Commission (SEC)
dollar thousand dollars million dollars
if their work is found to be negligent.
The independent auditors report by Ernst & Source: 2006 Accounting Trends & Techniques
Young for Amazons financial statements is pro-
vided in Exhibit 1.7. The first paragraph of the report indicates that the scope of Ernst & Youngs audit includes Am-
azons balance sheet, income statement, statement of shareholders equity, statement of cash flow and other financial
items. This paragraph also highlights the fact that the auditors responsibility is only to provide an opinion, whereas
the responsibility for the preparation of the statements themselves lies with Amazons management. The second para-
graph discloses that the audit firms procedures used in the review of Amazons financial data were in accordance with
generally accepted auditing standards as prescribed by the Public Company Accounting Oversight Board, but that
accepted auditing procedures do not consider every business transaction and instead rely only on a set of sampled
transactions to form an opinion. An audit of a company like Amazon would be prohibitively expensive if every single
business transaction was examined to reach an opinion.
The third paragraph provides Ernst & Youngs opinion that Amazon has prepared its financial statements in ac-
cordance with generally accepted accounting principles and that there are no important (material) errors in represent-
ing the firms accounting information. The fourth paragraph reports that Amazon changed its accounting methods to
comply with a new generally accepted accounting standard for the expensing of employee stock options. In effect,
this paragraph highlights significant changes in accounting methods that could potentially affect a users interpreta-
tion of the accounting information provided. The final paragraph indicates that, in addition to its audit of the financial
statements, Ernst & Young performed an audit of the effectiveness of Amazons internal controls over its financial
reporting.
Amazons audit opinion refers to generally accepted accounting principles, or GAAP. But what principles are
generally accepted, who accepted them, how did they get accepted, and why were they accepted?

3
G.A. Ackerlof, The Market for Lemons: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, (1970). In
markets where buyers are uncertain about the quality of goods offered for sale, markets may break down because buyers reduce the price that they
are willing to pay, causing sellers with high-quality products to withdraw from the market. The downward price spiral continues as products of
continually decreasing quality become the only products available for sale, and eventually, market breakdowns can occur.
 Chapter 1 | Economic Environment of Accounting Information 13

EXHIBIT 1.7 Independent Auditors Report

REPORT OF ERNST & YOUNG LLP

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders Amazon.com, Inc.

We have audited the accompanying consolidated balance sheets of Amazon.com, Inc. as of December 31, 2005 and 2004, and
the related consolidated statements of operations, stockholders equity (deficit), and cash flows for each of the three years in the
period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index as Item 15(a)(2).
These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial
position of Amazon.com, Inc. at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows
for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting prin-
ciples. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based Payments, effective January 1, 2005.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States),
the effectiveness of Amazon.com, Inc.s internal control over financial reporting as of December 31, 2005, based on criteria es-
tablished in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Com-
mission and our report dated February 16, 2006 expressed an unqualified opinion thereon.

/S/ ERNST & YOUNG LLP

Seattle, Washington
February 16, 2006

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Generally accepted accounting principles arose to mutually benefit the capital The expected return on an invest-
market participants who use financial statements to evaluate a securitys ex- ment refers to the expected income
pected return and risk. The standardized conditions provided by the use of to be earned on the investment,
GAAP give market participants confidence that the investment decisions they whereas the riskiness of an invest-
make using accounting information will be the best possible decisions. In the ment refers to the uncertainty asso-
United States, the ultimate power to set accounting standards rests with the U.S. ciated with the expected return. In
Congress, which established the Securities and Exchange Commission (SEC) general, risk and expected return are
by giving it the power to regulate securities markets and establish and enforce positively correlated; that is, invest-
the accounting standards used by companies issuing those securities. The over- ments with higher risk generally earn
a higher rate of a return.
sight role of the SEC is depicted in Exhibit 1.8. The stock market crash of 1929
and the Great Depression of the early 1930s brought turbulent times to the U.S.
financial markets. The scandalous behavior of corporate executives in the downfall of some companies and the sight
of ordinary citizens who had lost all of their savings were all that the U.S. Congress needed to step in and establish
the SEC.
Similar events occurred again 70 years later. Calls for action in the aftermath of the Enron, WorldCom and
Global Crossing debacles resulted in the passage of the Sarbanes-Oxley Act in 2002, bringing greater regulation of the
accounting profession by a new organization called the Public Company Accounting Oversight Board (PCAOB),
which became responsible for overhauling auditing standards, inspecting accounting firms and disciplining wayward
auditors. The PCAOB supplanted a system of self-regulation in which accountants at the American Institute of Cer-
tified Public Accountants (AICPA) oversaw their peers.
14 Chapter 1 | Economic Environment of Accounting Information

EXHIBIT 1.8 Economic Environment of Accounting Information

U.S. Securities & Exchange Commission (SEC)

Firm FASB PCAOB

Board of Directors

Auditors
Managers
Shareholders
Resource/
Capital
Product Equity
Financial Market
Markets
Statements
Assets

Debt Creditors

Products Security Prices

Although the SEC has the final authority over the form and content of financial statements, it has delegated the
responsibility for establishing U.S. GAAP to a private sector organization called the Financial Accounting Standards
Board (FASB). The FASBs position under the oversight of the SEC is depicted in Exhibit 1.8. The FASB was estab-
lished in 1973 after the Accounting Principles Board (APB), the predecessor to the FASB, was discontinued. The APB
was abandoned after losing public confidence and support for its role in setting accounting standards. The FASB is
administered by the Financial Accounting Foundation (FAF), whose trustees are drawn from several different groups
including the American Accounting Association, the American Institute of Certified Public Accountants, the Association
for Investment Management and Research, the Financial Executives Institute, and the Securities Industry Association.
The FASB has seven full-time members who must relinquish all ties to their former employers and accept no other
paid employment during their five-year terms. The FASB issues exposure drafts of its accounting standards for com-
ment at public hearings where interested parties have the opportunity to express their opinion about the proposed rules.
The passage of a proposed accounting rule, called a Financial Accounting Standard (FAS), requires the support of
five of the seven members. The FASB issued its first standard in 1973, but as of the time of the printing of this textbook,
it had issued 158 FASs.
An example of a financial accounting standard is FAS 2, Accounting for Research and Development Costs, is-
sued in 1974, requiring that All research and development costs . . . be charged to expense when incurred. Financial
statement users may disagree with the required accounting treatment of research and development (R&D) costs under
FAS 2, but the knowledge that all companies are required to use the same method is likely to be valuable to analysts
and investors when reviewing the financial statements of companies that incur significant R&D costs.
To the layperson, the notion that accounting standards generate heated debates is almost laughable. But in the
late 1990s, the FASB issued an exposure draft that required companies to charge the cost of executive stock options
against corporate net earnings. Many technology companies feared that the decline in their reported income after
implementation of this proposed accounting standard would cause their companys share price to materially decline.
The debate over stock option accounting even reached the floor of the U.S. Congress. Senator Joseph Lieberman of
Connecticut proposed a law prohibiting the SEC from requiring that executive stock options be expensed. The FASB,
under intense political pressure, ultimately backed down with the issuance of FAS 123. The final standard gave firms
 Chapter 1 | Economic Environment of Accounting Information 15

a choice of deducting the cost of stock options against net income or disclosing in their footnotes what a firms net
income would have been if the options had been charged against its income.
Stock option accounting resurfaced as a controversial topic in the aftermath of the Enron, WorldCom, and Global
Crossing scandals as critics attributed the collapse of these companies, at least in part, to the incentive that option-
holding executives have to drive share prices higher by inflating reported corporate earnings. Numerous companies
began to voluntarily charge the cost of employee stock options against earnings while other companies (such as
Microsoft) abandoned stock options in favor of other compensation arrangements. As of 2006, FAS 123 has been
revised to FAS 123R such that it is now mandatory to charge the expense of employee stock options against corporate
earnings. (We will have more to say about employee stock options in Chapter 11.)

GLOBAL PERSPECTIVE
Accounting standards have traditionally been established on a country-by-country basis. Unfortunately, this situation made the
comparability and transparency of financial information across national borders difficult at best. To overcome the diversity in
transnational GAAP, the International Accounting Standards Board was established in 1973 to harmonize global accounting
practice. Many countries (Bulgaria, Estonia, Jamaica, New Zealand, Russia, Tanzania, and the Ukraine) have replaced their national
GAAP with the International Financial Reporting Standards (IFRS) issued by the IASB. Beginning in 2005, the European Union
(EU) required that all publicly-held companies in EU-member states and EU-applicant states use IFRS in their consolidated finan-
cial statements. Until recently, foreign companies that wanted to raise debt or equity capital in the U.S. were required to prepare
their financial statements for U.S. investors using U.S. GAAP or, if their financial statements were prepared using some other form
of GAAP, to present a reconciliation of their net income and shareholders equity under the foreign GAAP and U.S. GAAP. In late
2007, however, the U.S. Securities and Exchange Commission voted to immediately allow foreign registrants to file their financial
statements with the SEC (on Form F-1) using IFRS. If some other form of foreign GAAP is used, a reconciliation statement is still
required. Many accounting and finance professionals hailed the SEC decision as the first step in a process that could later give
U.S. companies the choice of filing their quarterly and annual financial data with the SEC using U.S. GAAP or IFRS. The decision
was also seen as being a major step toward a unified set of global accounting practices that could be used worldwide.

As a concluding observation, it is helpful to understand that, in most countries, GAAP are used only to prepare
the financial statements distributed to such external parties as financial analysts, shareholders, and debtholders. It is
rare that GAAP are used to prepare a companys income tax statements because income tax regulations are customar-
ily set by elected legislators or governmental agencies, not accounting professionals. The internal financial statements
used by managers to run a company may also differ from those statements issued to shareholders and debtholders. In
short, it is not unusual for a company to maintain three (or more) sets of financial datafor managers, for the taxation
authorities, and for analysts, shareholders, and debtholders. The focus of this textbook is on those financial statements
prepared using GAAP for such external constituencies as financial advisors, lenders, investors, and shareholders.

ROLE OF FINANCIAL ACCOUNTING IN

INVESTMENT DECISIONS
In very simplified terms, the lifetime profile of an individual consists of 12 to 16 years of education, 35 years of em-
ployment, 15 to 20 years of retirement, and finally death. During the first few years of employment, individuals spend
most of their earnings acquiring assets like a car, a house, and taking the occasional vacation. After the basics are
acquired, most individuals begin to consider the possibility that they will need substantial funds to maintain a lifestyle
in retirement that they will have grown accustomed to in their working life. That means developing a retirement plan.
The basic retirement plan consists of decisions about how long to work, the amount of funds to set aside over the
employment period, and how to allocate those funds across different types of investments.
Individuals typically invest some of their retirement funds in the shares of companies or in a portfolio of companies
to diversify their holdings. The old adage Dont put all your eggs in one basket! is good advice since a diversified portfo-
lio reduces risk. Over the last decade, more and more individuals have begun simplifying the process of diversifying their
equity investments by buying shares in mutual funds. By investing in a spectrum of companies, the value of mutual fund
shares is not unduly influenced by the share price performance of a single company but instead by the broad movement
16 Chapter 1 | Economic Environment of Accounting Information

of stock prices in general. Stock market indices such as the Dow Jones Industrial Average (DJIA) and the Standard and
Poors 500 Index (S&P 500) are examples of indexes of a large portfolio of stocks that mutual funds often try to mimic.
Individuals also typically put a sizeable portion of their retirement funds in tax deferred, company-sponsored pension
plans. Some individuals dislike risk so they put more of their funds in government debt securities that provide interest
payments and repayment of principal. Securities issued by the United States government, and the governments of most
developed countries, are considered to be risk-free because of the very low probability that these entities will fail to pay
the interest and principal on their debt securities.
The portfolio decisions of millions of individuals and businesses in allocating funds across different investment
opportunities can be thought of as the supply of capital. At the same time, there are companies that have opportunities
to invest in assets that far exceed their ability to generate the needed investment funds. These unfunded investment
opportunities of millions of businesses can be thought of as the demand for capital. The capital market, on the other
hand, can be thought of as the marketplace in which funds are traded between the suppliers of capital and those firms
in search of capital. The financial statements provided by the multitude of firms seeking capital are used by the vari-
ous suppliers of capital to evaluate the investment alternatives. Equilibrium prices for equity and debt securities result
when millions of buyers and sellers agree to exchange capital on mutually acceptable terms.
Individual companies raise fundsthat is, obtain capitalby issuing
shares to shareholders and/or by borrowing from creditors such as financial Companies go publicthat is, sell owner-
institutions and bond investors. For shareholders, the return on their invest- ship shares in the public capital marketas
ment is derived from dividend payments and any appreciation (or deprecia- a means to gain access to capital to grow,
tion) experienced from changes in a companys share price. In general, the to provide the original investors with li-
quidity (the ability to sell their ownership
return (r) for an equity security over a given period, such as a month or a
interests), and to have shares to be used to
year, is a function of its price at the end of the period (Pt), any dividends facilitate future mergers and acquisitions.
received during the period (Dt) and its price at the beginning of the period
(Pt1). That is,

rt  (Pt  Dt  Pt1)/Pt1

For lenders, a return is generated by the interest payments paid by borrowers and the full and timely repayment
of their initial capital investment.
In Practice 1.3 provides data on the average annual return for various types of securities sold in the United States
over the 76-year period of 1926 to 2002. The In Practice also shows the standard deviation of the annual returns, a
measure of the variation around the average return, which is often used as an indication of the riskiness of a given
investment. According to the data, large company shares earned an average return of 12.7 percent per year compared
to a return of 5.7 percent for long-term government bonds but the standard deviation of the returns for large company
stocks was much higher, 20.2 percent versus 9.4 percent. Small company shares have done even better than large
company shares, having earned an average annual return of 17.3 percent, but the standard deviation of 33.2 percent
is also considerably higher. The high standard deviation for small company shares means that the actual return in any
year will vary considerably more than for large company shares. In short, when small company share prices fall (rise),
they tend to fall (rise) farther than large company share prices; and thus, small company shares are considered to be a
riskier investment than large company shares.

In Practice 1.3 Average Annual Rate of Return by Type of Security: 19262002

Security Classification Average Return Standard Deviation

Large company stocks . . . . . . . . . . . . . . . . . . . . 12.7% 20.2%

Small company stocks . . . . . . . . . . . . . . . . . . . . 17.3 33.2
Long-term corporate bonds . . . . . . . . . . . . . . . . 6.1 8.6
Long-term government bonds . . . . . . . . . . . . . . 5.7 9.4
Intermediate-term government bonds . . . . . . . . 5.5 5.7
U.S. Treasury bills. . . . . . . . . . . . . . . . . . . . . . . . 3.9 3.2
Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 4.4
Source: Ibbotson, Stocks, Bonds, Bills and Inflation
 Chapter 1 | Economic Environment of Accounting Information 17

The data in In Practice 1.3 indicate that investments in shares have provided higher average annual returns than
investments in government bonds. If the standard deviation of the return is a reasonable measure of risk, the data
indicate that shares have higher risk than government bonds, supporting the intuitive notion that higher returns come
at the price of bearing higher risk. Investors in common shares can lose all of their investment whereas an investment
in government bonds is considered to be risk-free (which means, an investor will receive all interest payments when
due and will receive a full return of invested capital). The data also provide support for the notion that shareholders
of large firms bear more risk than corporate bondholders since the standard deviation of corporate bonds is only 8.6
percent versus 20.2 percent for stocks. Yet, shareholders are compensated for this additional risk by earning higher
returns, 12.7 percent versus 6.1 percent for bondholders.
What is the role of accounting information in the capital markets? For investors who follow an active investment
strategy, one very important role for financial statement information is to provide better assessments of the expected
return and risk of individual securities so that the investor can make the best possible investment decisions. This is
called the information role of financial statements. For passive investors who follow a buy-and-hold strategy, ac-
counting information may have only limited value since these investors implicitly operate under the premise that secu-
rity prices reflect all information that is publicly available. Passive investors (such as, individuals who invest in index
funds) believe that it is not possible to earn excess returns above the general market return because the capital markets
are efficient. A market in which security prices correctly reflect all publicly available information (for example, the
information contained in financial statements) is referred to as an efficient market.
Debtholders, on the other hand, use accounting information to assess financial riskthat is, the risk that a firm may
not pay its debt service charges and principal payments on a timely basis. When debtholders determine that financial risk
is high, they will demand commensurately higher returns (by charging higher interest rates) to compensate them for the
additional risk assumed by lending to such a firm.

CHANGING ECONOMIC LANDSCAPE

Enron, WorldCom and Global Crossing are now household names synonymous with the most egregious corporate
wrongdoing in the United States in the last 70 years. These financial scandals brought about significant changes in
U.S. corporate regulation. To demonstrate that it was responsive to the publics demand for action, numerous corpo-
rate executives and employees from Arthur Andersen, auditor for all three failed companies, were questioned on the
floor of the U.S. Congress. In response to their findings, the U.S. Congress quickly enacted the Sarbanes-Oxley Act,
establishing the Public Company Accounting Oversight Board to regulate the accounting profession.
Some observers believe, however, that the enacted changes didnt go to the root cause of the financial scandals,
the seeds of which were sown in regulation changes made 30 years ago. They cite changes made in the 1970s to in-
crease competition in audit markets by permitting accountants to advertise and solicit clients and to changes in the law
which permitted auditors to be sued more easily for financial statement errors as causes of the race to the bottom.4
With decreasing fees from competition and increased legal costs, accounting firms introduced changes in auditing
methodologies to reduce audit costs and lobbied for more precise standards to better defend themselves in lawsuits.
Accounting firms also diversified into corporate consulting to reduce their dependence on auditing fees, the less profit-
able side of the business, and, by rewarding partners on the basis of client retention and new client acquisition, encour-
aged a compliant attitude to financial reporting disagreements. Observers also cite regulatory changes that abolished
fixed brokerage commissions as another root-cause of the scandals. With the profitability of the securities business
reduced, the research side of the securities industry focused more on pleasing clients that brought in underwriting and
investment-banking business by releasing favorable earnings forecasts and assessments. Thus, analysts lost their ob-
jectivity and failed to perform hard-nosed fundamental analysis that previously provided value to investors.5
Over the years, generally accepted accounting standards have become increasingly complicated, often requiring
detailed manuals to interpret the rules and guide companies in their implementation. For example, FAS 2 occupied
only 19 pages when it was issued in 1974, while FAS 133, a complicated standard on derivatives issued in 1998, is
213 pages in length. The Sarbanes-Oxley Act mandated, among other things, an investigation of the possibility of

4
P.M. Healy and K.G. Palepu, How the Quest for Efficiency Corroded the Market, Harvard Business Review (July 2003).
5
ibid.
18 Chapter 1 | Economic Environment of Accounting Information

using principles rather than increasingly detailed rules as a basis for U.S. accounting standards. Whether prin-
ciples become the guiding influence in setting future accounting standards remains to be seen.

ETHICS PERSPECTIVE
There is an intense debate within the U.S. accounting standard-setting community as to whether accounting principles
should be rules-based, as is the case with U.S. GAAP, or principles-based, as is the standard with international GAAP. The
fundamental difference between these approaches is that principles-based accounting provides a conceptual basis for ac-
countants to follow instead of a list of detailed rules. The landmark Sarbanes-Oxley legislation called for the U.S. Securities
and Exchange Commission to study the adoption of principles-based standards for U.S. GAAP. The subsequent SEC staff
report recommended that U.S. GAAP move toward a principles-based approach. In April 2003, the auditing firm of Pricewa-
terhouseCoopers placed a full-page advertisement in the Wall Street Journal. Joining the debate over whether GAAP should
be more principles versus rules-based, the audit firm wrote: Rules-based systems encourage creativity (and not the good
kind) in financial reporting. They allow some to stretch the limits of what is permissible under the law, even though it may not
be ethically or morally acceptable. A principles-based system requires companies to report, and auditors to audit, the sub-
stance or business purpose of transactions, not merely whether they can qualify as acceptable under incredibly complex or
overly technical rules. The accounting firm advertisement further stated: A rules-based system allows managers to ignore
the substance and, instead ask, Where in the rules does it say I cant do this?

SEVEN ACCOUNTING MYTHS

It is rare that someone starting an introductory course in financial accounting begins the experience with
a blank mental slate. Rather, most individuals bring with them a set of expectations. Almost everyone has had experi-
ence with some aspect of accounting, from balancing a checkbook or filling out a credit card application, to reading a
set of financial statements. Through these experiences, and from discussions with others, a certain accounting mystery
develops along with the formation of certain myths and misconceptions. It is the goal of this textbook to take you on
a journey through the world of financial accounting, and along the way, attempt to solve many of the mysteries and
debunk many of the myths and misconceptions.
The first two myths about accounting relate to the underlying rules that govern how accounting numbers are cal-
culated and reported. This set of rules is known as generally accepted accounting principles, or GAAP. Perhaps the
most widely held myth that we explore is the belief that:
1. Generally accepted accounting principles are a set of rigid rules that, if followed correctly, will lead to a unique,
correct representation of the financial performance and health of a firm.
Closely related to myth number one is the belief that:
2. GAAP is created from a comprehensive analytical process, which is free from political influence.
The following four myths relate to the basic financial statements which are the output of the accounting process:
3. The basic financial statements, consisting of a balance sheet, an income statement, a statement of shareholders
equity, and a statement of cash flow, reflect a complete, accurate, and timely portrayal of the financial perfor-
mance and well-being of a firm.
4. All of a firms identifiable assets and liabilities appear on the balance sheet, and the difference between a firms
assets and its liabilities represents the value of the firm.
5. Each of the financial statements is independent, with each reflecting a different aspect of a firms performance and
financial health.
6. Cash flow is ultimately what matters to a firm and its investors; therefore, it is not really necessary to worry about
the definition of earnings used in the preparation of the income statement. Rather, one need only consider the
sources and uses of cash as reflected on a firms statement of cash flow.
Lastly, and what we feel is perhaps the biggest myth of all is:
7. A knowledge of accounting is only necessary for someone who wants to be an accountant.
 Chapter 1 | Economic Environment of Accounting Information 19

Some of the terminology from the above list of myths may be unfamiliar to you at this point. One thing that is
certainly not a myth is that a major challenge associated with learning accounting is to simply understand all of the
jargon. Perhaps we should have added an additional myth: Accounting is hard! While this is certainly a subjective
assessment that each student will make, we believe that the approach followed in this textbook will go a long way to
turning this challenge into a myth as well.
While most individuals reading this book do not plan to pursue a career in accounting, we believe that it is critical
for anyone planning a career in management to understand the fundamentals of accounting, for it is the language of
business. To use an analogy from sports, you dont have to be a great baseball player to enjoy the game of baseball.
Stated alternatively, it is not critical to be trained as an accountant but you must understand how the game is played
and scored.
Accounting, as noted above, has its own language. Two of the words that seem to strike fear into new accounting
students are debit and credit. Debits and credits represent a mechanism for accountants to record business transac-
tions, in other words to keep score of the game. For those executives planning to continue their accounting studies to
a more advanced level, we have included details on using debits and credits in the appendixes to many of the chap-
ters. Sometimes, however, it is difficult to see the forest through all of the trees. Therefore, we utilize a spreadsheet
approach to recording transactions within the chapters to explain the accounting process in a more straightforward,
intuitive manner.

EXECUTIVE SUMMARY
In this chapter we considered the basic financial statements of Amazon.com, an online retailer of products. We examined how the
financial statements can be used by debtholders and shareholders to predict the expected return and risk of individual securities. We
also considered the role of the FASB, the IASB, and the SEC in setting accounting standards and the role of auditors in monitoring
compliance with those standards.
As a validation of your understanding of the content of this chapter, you should now be able to:
Identify the basic financial statementsthe income statement, the balance sheet, the statement of shareholders equity,
and the statement of cash flow.
Understand that companies acquire capital from investors who purchase the debt and equity securities issued by such
firms to obtain an expected return commensurate with the risk the investors assume.
Understand the role of accounting standards in facilitating a properly functioning capital market.
Understand the conflicts of interest that may arise between the executives, shareholders, and debtholders of a
corporation, and the costs associated with the divergent incentives that may arise when the ownership and management
of a company are separated (see appendix).
In Chapter 2, we consider how the basic financial statements are developed from accounting events.

KEY CONCEPTS AND TERMS

Accounting equation, 4 Consolidated income statement, 6 Feedback value, 11
Accounts payable, 4 Contracting role, 21 Financial accounting, 3
Accounts receivable, 4 Corporate charter, 20 Financial Accounting Foundation, 14
Accrual basis of accounting, 4 Corporate governance, 20 Financial Accounting Standard, 14
Agency costs, 21 Corporations, 20 Financial Accounting Standards
American Institute of Certified Public Covenants, 22 Board, 14
Accountants, 13 Debt covenants, 22 Fiscal period, 21
Assets, 21 Decision usefulness, 11 Footnotes, 11
Audit report, 12 Demand for capital, 16 Gains, 22
Balance sheet, 4 Distributions to owners, 22 Generally accepted accounting
Capital market, 16 Economic entity, 21 principles, 12, 18
Cash basis of accounting, 4 Efficient market, 17 Generally accepted auditing
Comparability, 21 Equity, 21 standards, 12
Comprehensive income, 22 Expected return, 13 Going concern, 21
Conservatism, 21 Expenses, 22 Going concern assumption, 5
20 Chapter 1 | Economic Environment of Accounting Information

Income statement, 5 Limited liability, 20 Revenues, 22

Information overload, 11 Losses, 22 Risk, 13
Information role, 17 Managerial accounting, 3 Riskiness, 13
International Accounting Standards Materiality, 11, 21 Securities and Exchange
Board, 15 Monetary unit, 21 Commission, 13
International Financial Reporting PCAOB, 13 Statement of cash flow, 6
Standards, 15 Predictive value, 11 Statement of shareholders equity, 8
Investments by owners, 22 Relevance, 11, 21 Supply of capital, 16
Lemons problem, 12 Reliability, 11, 21
Liabilities, 21 Return, 13

A P P E N D I X 1 A : Agency Costs and the Separation of

Management and Capital Providers
Today, businesses are often organized as corporations owned by shareholders under the laws of the state or province in which a
company is incorporated. State incorporation laws require a company to have a corporate chartera set of by-laws governing the
rights and responsibilities of the board of directors to a firms shareholders and covering such topics as annual meetings, the elec-
tion of directors, the type and quantity of shares to be sold, and shareholder voting rights. Shareholders usually delegate the task of
running a business on their behalf to a board of directors who are elected by shareholders at the annual shareholders meeting. The
board of directors, on the other hand, has oversight responsibility for the company but the day-to-day management of the firm is
directed by the chief executive officer (CEO) who appoints the senior management team including the president, the chief operating
officer (COO) and the chief financial officer (CFO). With the assistance of top management, the board of directors recommends a
firms independent auditors to shareholders who vote on audit firm appointment (and reappointment) at the annual meeting. These
arrangements are collectively referred to as a companys corporate governance, a topic much debated since the collapse of Enron,
WorldCom, Global Crossing, and a host of other trouble-ridden firms.
A noteworthy characteristic of the corporate form of organization is the principle of limited liability, a feature that limits the
liability of a businesss shareholders for the debts incurred by the business. Thus, if a corporations assets are insufficient to pay off
a businesss liabilities when they mature, the lenders are unable to satisfy their claims against the company by attempting to gain
control of the personal assets of the companys shareholders.

BUSINESS PERSPECTIVE
The corporate form of business is one of the two primary organizational forms of companies. The other form is a partnership,
also known as a sole proprietorship when there is only one partner. There are several key differences between these alterna-
tive organizational forms, the principal ones being limited liability, tax status, and ease of ownership transferability. The primary
advantage of the corporate form of business is the limited liability provision in which shareholders are only liable for the debts
of a business to the extent of their investment in the business. Partners in a partnership, in contrast, face joint and severable li-
ability wherein each partner is liable for not only their own acts, but also for the acts of the other partners. In addition, a partners
liability is not limited to just his/her partnership investment, but liability extends to their personal assets as well. The limited
liability attribute of corporations is essential to their ability to raise large amounts of capital because shareholders can invest in
a corporation without risking their entire personal wealth. This attribute also facilitates the transferability of ownership interests
in a corporation relative to a partnership.
Corporations are not without negatives, however, and the principal one is tax status. Corporations face a corporate income
tax on their earnings, which may lead to a situation of double taxation when any previously taxed corporate income is taxed
again to the shareholders when they receive a dividend distribution. Partnerships are not taxed separately; instead, the partner-
ship income is taxed only once at the individual-partner level. In addition to these two primary organizational forms, several
hybrid forms exist that have attributes of both corporations and partnerships. These hybrid forms include limited partnerships,
limited liability partnerships, sub-chapter S corporations, and limited liability corporations.

The development of the concept of limited liability was significant because it enabled the ownership of a firm to be separated
from the day-to-day management of the firm; and, consequently, permitted the segmentation of risk bearing by shareholders from
the operational control of a business by its team of managers. Unfortunately, the separation of the ownership of a business from
the management of a business often leads to a conflict of interest between the preferences of shareholders for greater wealth and
 Chapter 1 | Economic Environment of Accounting Information 21

the preferences of managers for increased leisure and on-the-job perks such as a company-financed jet. The separation of own-
ership and the provision of debt financing can also potentially create a conflict of interest between shareholders with preferences
for higher-valued shares and debtholders with preferences for timely debt servicing and loan repayment. The costs associated with
these divergent self-interests are referred to as agency costs.
Since conflicts of interest are likely to arise among the various constituencies that comprise a corporation (i.e., shareholders,
managers, and creditors), the agency costs associated with these conflicts must be born by the companys shareholders by virtue
of their ownership of the firm. Consequently, it is normally in the shareholders interest to engage in various monitoring and
contracting activities to help control or reduce these conflicts. For example, financial statement information is often used in em-
ployment contracts between managers and shareholders to measure, monitor, and control managerial behavior. This is referred to
as the contracting role of accounting information.

A P P E N D I X 1 B : Generally Accepted Accounting Principles:

Purpose, Concepts, and Elements
Generally accepted accounting principles (GAAP) have as their purpose the measurement of economic activity by a business en-
terprise and the reporting of this activity in the form of financial statements, along with disclosures to aid users in the interpretation
of the financial statements. The primary promulgator of U.S. GAAP is the Financial Accounting Standards Board (FASB). The
FASB has issued a series of pronouncements called Statements of Financial Accounting Concepts (SFAC) that serve to create the
foundation for their Statements of Financial Accounting Standards (SFAS).
The first SFAC identifies the three principal objectives of financial reporting: (1) the creation of information useful in making
economic decisions; (2) providing information to aid in predicting cash flows; and (3) providing relevant information regarding
a businesss economic resources. These objectives facilitate the measurement and reporting of business activity during a fiscal
period by an economic entity that is assumed to be a going concern. The economic entity assumption implies that the business
activity to be measured can be identified with a particular unit of accountability and requires that the activity of the entity be as-
sessed separately from the activities of its owners. It is further assumed that the entity will remain a going concern for the foresee-
able future; in other words, that the enterprise will have a long life. Because the entity will exist for an extended period of time, it
is necessary to segment its operational life into reporting periods, known as fiscal periods, so as to provide interested parties with
timely, relevant information about its various activities. Public corporations that report to the Securities and Exchange Commission
(SEC) file quarterly financial statements, called a 10-Q, and annual financial statements, called a 10-K. An additional monetary
unit assumption implies that only those items that can be expressed in terms of a monetary unit, the U.S. dollar in the United States,
are included in the financial statements. Because inflation is relatively mild in the United States, price-level changes are ignored
and the U.S. dollar is assumed to remain stable over time.
The second FASB concept statement discusses the qualities that make accounting information useful. The primary qualities
are relevance and reliability. For information to be relevant, it should be timely and should either assist in predicting future cash
flows or provide feedback value regarding past events. For information to be reliable, it should be verifiable and faithfully represent
the observed economic activity. Finally, information should also be comparable, consistent, and understandable. Comparability
refers to comparisons made between different business entities, whereas consistency refers to comparisons made across time for a
particular business entity.
The above qualities are subject to a materiality constraint. The materiality constraint is not explicitly defined and conse-
quently requires some judgment in its application. In general, only economic events that are significant enough to affect a users
decisions are required to be accounted for in a manner consistent with GAAP.
Not all of these qualities are compatible, however; for example, there is often a conflict between relevance and reliability.
When trade-offs between the qualities are necessary, GAAP tends to place more weight on data reliability and the role of con-
servatism. Conservatism is a reaction to the uncertainty inherent in many financial events. Conservatism dictates that, when in
doubt, the financial statements should understate assets, overstate liabilities, delay the recognition of revenues, and accelerate the
recognition of expenses.
The third concept statement defines ten elements that form the basic building blocks of the financial statements. The first three
elements relate to the balance sheet, which portrays an entitys net resources as of a particular point in time:
1. AssetsProbable future economic benefits obtained or controlled by a particular entity as a result of past transactions or
events.
2. LiabilitiesProbable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result of past transactions.
3. Equity (net assets)The residual interest in the assets that remain after deducting its liabilities.
The next five elements relate to the income statement, which measures an entitys performance over a given period of time:
22 Chapter 1 | Economic Environment of Accounting Information

4. RevenuesInflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both)
from delivering or producing goods, rendering services, or carrying out other activities that constitute the entities ongoing
major and central purpose.
5. ExpensesOutflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or
producing goods, rendering services, or carrying out other activities that constitute the entities ongoing major and central
purpose.
6. GainsIncreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions
and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
7. Lossesdecreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other
transactions and other events and circumstances affecting the entity except those that result from revenues or investments by
owners.
8. Comprehensive incomeThe change in equity of a business enterprise during a period from transactions and other events
and circumstances from sources other than investments by owners or distribution to owners.
The final two elements relate to transfers between a business enterprise and its owners:
9. Investments by ownersIncreases in equity of a particular business enterprise resulting from transfers to it for the purpose
of increasing ownership interests.
10. Distributions to ownersDecreases in the equity of a particular business enterprise resulting from transferring assets,
rendering services, or incurring liabilities to owners.

Conflicts Between Managers and Shareholders

Since shareholders must bear the agency costs associated with the conflicting self-interests that result from the separation of
management and ownership of a corporation, they are incentivized to develop contracts with corporate management that direct
or control managerial behavior. For example, the shareholders of a business often develop and institute incentive contracts with a
businesss executives that tie an executives compensation to the companys share price, via stock options or a restricted stock plan,
or to the companys accounting earnings which have been shown to be correlated with a companys share price. Thus, incentive
contracts work to align the financial interests of managers with those of a companys shareholders, thereby encouraging the manag-
ers to simultaneously work to maximize their own wealth as well as that of the shareholders. Amazon.com, for example, reported
that the company granted bonus opportunities to various executive officers payable upon the achievement of certain performance
goals. Undoubtedly, some of the performance goals were measured in terms of such accounting numbers as sales, cash flow or prof-
its. By linking executive compensation to measurable accounting variables, management is more likely to take appropriate actions
to see that the performance goals are met or exceeded, thereby increasing the wealth of the shareholders, and that of their own.

Conflicts Between Debtholders and Shareholders

Agency costs can also arise from conflicts between debtholders and shareholders.
When a company borrows funds, the
An extreme example of such behavior would occur in the case of a firm whose
terms of the loan agreement are formal-
shareholders borrow a large amount of money from debtholders only to pay the bor-
ized in a legal contract. Typically, these
rowed funds out as a dividend. In effect, the shareholders redistribute the borrowed
loan contracts contain provisions, called
wealth from the debtholders to themselves, potentially leaving the debtholders with
covenants, which restrict the actions of
a worthless corporate shell and no resources to repay the loan. By virtue of their
the borrower. For example, a common
ownership of the firm, shareholders bear the agency costs of this conflict via higher
debt covenant limits the amount of divi-
interest rates because debtholders can anticipate these potentially unconstrained ac-
dends that can be paid to shareholders.
tions by shareholders. A solution to this conflict is for shareholders to agree to be
Covenants are used by lenders to reduce
bound by a legally enforceable loan contract containing provisions that restrict the
financial risk and increase the likelihood
shareholders behavior. These contract provisions are called debt covenants, and
that borrowers pay their interest and prin-
may, for example, restrict the amount of dividends that may be paid.
cipal repayments in a timely manner.
To illustrate, the following disclosure relates to the long-term debt that appears
on Amazons balance sheet:

The indenture governing the 4.75% Convertible Subordinated Notes contains certain affirmative covenants for us, includ-
ing making principal and interest payments when due, maintaining our corporate existence and properties, and paying
taxes and other claims in a timely manner. We were in compliance with these covenants through December 31, 2005.

Another example of a corporate action creating agency costs is the issuance of new debt with repayment priority over existing
debt. In this situation, there is a redistribution of wealth from the initial debtholders to the shareholders. A solution to this conflict
 Chapter 1 | Economic Environment of Accounting Information 23

is for the shareholders to agree to a legally enforceable contract that limits the firms ability to issue new debt with priority over the
old debt. For example, Amazons borrowing agreements have covenants that restrict the companys ability to borrow by requiring
that the ratio of aggregate indebtedness divided by pre-tax operating earnings be less than 6 to 1. Under the terms of this covenant,
Amazon is required to periodically provide debtholders with audited financial statements from which measures of aggregate in-
debtedness and pre-tax operating earnings can be taken and used to evaluate the firms compliance with the covenant. How does
this help Amazon? By agreeing to the restrictions imposed by the covenant, Amazon.com is able to obtain a loan that it might not
otherwise gain access to.

DISCUSSION QUESTIONS
Q1.1 Financial Statement Data Users. Financial statement data is utilized by a variety of user-groups to include a compa-
nys board of directors, bondholders, corporate employees and executives, customers, investment advisors, labor unions,
loan officers and credit analysts, shareholders and suppliers. For each user-group, discuss how financial statement data
might be used in their decision-making process.
Q1.2 Accounting Standards. Discuss why accounting standards (generally accepted accounting principles) are important
to investors and to a properly functioning, efficient capital market. How do accounting standards help capital markets
be (or become) efficient?
Q1.3 Corporate Governance. Discuss what corporate governance is and why it is important to shareholders.
Q1.4 Risk, Return, and Accounting Information. Discuss the relationship between investment risk and the expected rate
of return on an investment. Explain why accounting information is useful in evaluating the risk/return trade-off inherent
in all investments.
Q1.5 Global GAAP. Discuss the major impediments to the acceptance of a global set of generally accepted accounting
principles. Prepare a list of those key impediments. Of the items on your list, which do you think will be the most
difficult to overcome? Why? Why is having a global set of GAAP desirable?
Q1.6 Asymmetric U.S. GAAP. Under U.S. GAAP, long-lived assets such as real estate are carried on the balance sheet
at the original purchase price of the asset. In the event that the value of a real estate asset becomes impairedthat
is, the current value of the real estate falls below its original purchase price and is unlikely to recover the lost value
in the foreseeable futurethe assets book value is written down to the lower current value and a loss is recorded on
the firms income statement. Under no circumstances, however, can a firm write up the value of its real estate assets
in the event that current value exceeds original purchase price. Discuss whether U.S. GAAP should be changed to al-
low a symmetric treatment of asset value increases and decreases? What are the implications of this asymmetry in the
accounting treatment of assets (like real estate) for current U.S. financial statement users?
Q1.7 Human Assets. The balance sheet allegedly reports all of the assets of a business. But one of the most important assets
of any business is its employees, and this asset is omitted from the balance sheet of every company in every country in
the world. Thus, it can be concluded that the balance sheet of any company understates the true value of its assets. Dis-
cuss what types of companies and which industries are most likely to be impacted by this situation. Prepare a list of the
companies that you feel are most adversely affected by this accounting practice. Why did you select these companies?
Q1.8 Key Performance Indicators: Amazon.com. Based upon your reading of the chapter, specifically a review of the
financial statements of Amazon.com, identify five key indicators of performance (KPIs) for Amazon.com. Explain
why you selected the five KPIs. Identify five KPIs that are not present in Amazons financial statements but that you
believe are important to consider when making a decision about whether to invest in Amazon.com.
Q1.9 Audit Reports. Review Amazon.coms audit report in Exhibit 1.7 and discuss what the report tells you about Ama-
zons financial statements. Is there anything in the audit report that causes you concern? Why or why not? According to
the independent auditors, who has ultimate responsibility for the preparation of and fairness of the companys financial
statements?
Q1.10 Accounting Assumptions and Concepts. Discuss the following accounting assumptions and concepts:
Accrual basis of accounting
Cash basis of accounting
Going concern assumption
Materiality concept
Information role of accounting
Contracting role of accounting
Why are the assumptions and concepts important?
24 Chapter 1 | Economic Environment of Accounting Information

Q1.11 The Basic Financial Statements. Describe or define the four basic financial statements:
Income statement
Balance sheet
Statement of shareholders equity
Statement of cash flow
Discuss how the four statements are interconnected.
Q1.12 Debt Covenants. American Airlines has outstanding lines of credit and various loan agreements with a number of
financial institutions. Under the terms of these debt contracts, American is required to (a) maintain a minimum balance
of $1.25 billion of unrestricted cash and short-term investments, (b) maintain a ratio of operating cash flow to interest
expense of at least 1.3 to 1.0, and (c) restrict any dividend payments to American shareholders to not more than 25
percent of net income. Discuss why Americans lenders would impose these financial and operating restrictions on the
airline. Discuss why American would agree to the restrictions.
Q1.13 Debt Covenants. Titanium Metals Corporation (TIMET) is one of the worlds leading producers of titanium prod-
ucts, a key component used in the manufacture of commercial and military aircraft. In TIMETs 2005 annual report,
the company disclosed the following:
Under the terms of the companys U.S. asset-based revolving credit agreement, borrowings are limited to the lesser of
$105 million or a formula-determined borrowing-base . . . . Borrowings are collateralized by substantially all of the
companys U.S. assets.
The U.S. credit agreement prohibits . . . the payment of dividends on the companys common stock . . . , limits ad-
ditional indebtedness, requires compliance with certain financial covenants including a minimum net worth covenant
and a fixed charge ratio covenant . . . .

Discuss why TIMETs U.S. lenders would impose such restrictions on the company. Discuss why TIMET would agree
to such restrictions.
Q1.14 (Appendix 1A) Separation of Ownership and Management. Describe a conflict that may arise between the share-
holders of a company and the managers of the company. Discuss what the shareholders might do to overcome that
conflict and explain why you feel that your solution to the conflict would be effective.
Q1.15 (Appendix 1A) Conflicts between Shareholders and Debtholders. Describe a conflict that may arise between the
shareholders of a company and the debtholders of the company. Discuss what the debtholders might do to resolve that
conflict and explain why you feel that your solution to the conflict would be effective.
Q1.16 The Going Concern Assumption. Ernst & Young, LLP is the independent public accountant for AMR Corpora-
tion, the parent company of American Airlines and American Eagle. In 2002, Ernst & Young gave AMR a clean
opinion, indicating that its financial statements were fairly presented. In the 2002 auditors report for AMR, however,
Ernst & Young notes:
The accompanying financial statements have been prepared assuming the Company will continue as a going concern
. . . the Companys recent history of significant losses, negative cash flow from operations, uncertainty regarding the
Companys ability to reduce its operating costs to offset the declines in its revenues, the potential failure of the company
to satisfy the liquidity requirements in certain of its credit agreements, raise substantial doubt about the Companys
ability to continue as a going concern.
Discuss why Ernst & Young would issue a clean opinion on the financial statements of AMR Corporation given its
many doubts about the firms ability to continue as a going concern.
Q1.17 Is the Sarbanes-Oxley Act Effective? In 2006, BusinessWeek magazine (April 17, 2006) carried an opinion piece
which questioned the effectiveness of the Sarbanes-Oxley Act of 2002. According to the author, Professor D. Moore,
key business failures that cost investors and employees tens of billions of dollars are all but sure to happen again. The
calamitous scandals of Enron and many other companies were possible only because of breaches in a bulwark of our free
market systemauditor independence. Professor Moore states that the Sarbanes-Oxley Act will be ineffective in pre-
venting future corporate scandals because the act fails to address the real underlying problem, namely the lack of auditor
objectivity. Do you agree with Professor Moore? If so, why? If not, why not?
Q1.18 Should the Sarbanes-Oxley Act Be Revised? In late 2006, BusinessWeek magazine (December 18, 2006) carried
a report on the aftermath of the passage of the Sarbanes-Oxley Act. According to the piece, the intentions were good,
but in the two years since its passing, the Sarbanes-Oxley Act has collapsed into a glob of regulatory confusion costing
U.S. businesses billions of dollars a year in compliance costs. The article further noted that (T)he act never got the
vetting it deserved because of the race to approve it after the Enron and WorldCom meltdowns. . . Nevertheless, one
direct consequence of the Act was that a record number of U.S.-listed firms1,300 companies, or over 8 percent of
 Chapter 1 | Economic Environment of Accounting Information 25

the totalrestated their earnings in 2005. Discuss whether the criticisms of the Act noted in the BusinessWeek article
are justified given the large number of firms that found it necessary to restate their reported earnings following the
passage of the Act.
Q1.19 (Ethics Perspective) Rules-based Versus Principles-based Accounting. Do you believe that rules-based accounting
leads to unethical managerial behavior? If so, why? Do you think that rules-based GAAP allows businesses to design
their financial reporting so as to stay within the letter of the accounting standards even if they clearly violate the spirit
of the standards?
Q1.20 (Appendix 1B) Financial statements must contain objective and verifiable data if they are to be useful. Yet, many
estimates and subjective assumptions are required to facilitate the preparation of these reports. Please reconcile these
apparent inconsistencies in the preparation of the basic financial statements.
Q1.21 (Appendix 1B) Much of the information contained in the balance sheet is reported on a historical cost basis. This
means that such assets as land are reported at the amount that was originally paid for the item when purchased. Al-
ternative possible reporting methods include current value, what a similar item would currently cost to acquire, and
liquidation value, the amount an entity would receive if it was forced to sell the item. Discuss how the concepts of
relevance, reliability, and going concern influence the choice of historical cost as a reporting method.

indicates that check figures are available on the books Website.

EXERCISES
E1.22 Account Identification. Presented below is a list of financial statement accounts. Using the letter A for assets, L for
liabilities, SE for shareholders equity, R for revenue, E for expenses, and NA for not applicable, identify (a) whether the
listed accounts appear on the balance sheet (B/S) or income statement (I/S), and if so, (b) the nature of the account (A, L,
SE, R, E, or NA).
1. Accounts receivable 9. Depreciation expense
2. Common stock 10. Accounts payable
3. Sales 11. Cash flow from operating activities
4. Land 12. Cash
5. Retained earnings 13. Cost of goods sold
6. Notes payable 14. Equipment
7. Dividends paid 15. Selling expense
8. Inventory 16. Interest income
E1.23 The Balance Sheet Equation. The Arcadia Company reported the following financial results during its first two years
of operations:

Year End Assets  Liabilities  Shareholders Equity

Year 1 . . . $80,000  $60,000  $20,000

Year 2 . . . 70,000  40,000  30,000

Assuming that no dividends were declared and that no additional capital was invested in Year 2, determine Arcadias net
income (or loss) for Year 2.
E1.24 The Balance Sheet Equation. The Claremont Company reported the following financial results during its first two
years of operations.

Year End Assets  Liabilities  Shareholders Equity

Year 1 . . . $110,000  $60,000  $50,000

Year 2 . . . 125,000  80,000  45,000

Assuming that no dividends were declared and that no additional capital was invested in Year 2, determine the net income
(loss) for the Claremont Company in Year 2.
E1.25 Key Relations: Revenues, Expenses, Dividends, and Retained Earnings. Compute the missing amounts (in millions)
in the following table. (The balance in retained earnings at year-end 2006 was $2.2.) Comment on the firms performance
 26 Chapter 1 | Economic Environment of Accounting Information

over the three-year period after calculating the level of expenses as a percentage of total revenues and net income as a per-
centage of total revenues. What advice would you give to this company in regards to its dividend policy?

2004 2005 2006

Retained earnings (beginning) . . . . . . . . . . . . . $1.2 $ 2.0 ?

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.8 11.8 11.8
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 ? 11.0
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? .6 .6

E1.26 Key Relations: Revenues, Expenses, Dividends, and Retained Earnings. Compute the missing amounts in the fol-
lowing table. (At the end of 2006, retained earnings had a balance of negative $2,086.) Comment on the companys
performance over the three-year period after calculating the relationship of expenses as a percentage of revenues and net
income as a percentage of revenues. Do you agree with the companys dividend policy? Why?

2004 2005 2006

Retained earnings (beginning) . . . . . . . . . . . . . $(1,746.5) $(1,830.5) $(2,653.0)

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,840.5 5,327.0 ?
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? 5,628.0 5,425.0
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -0- ? 17.5

E1.27 Financial Statement Results. In its 2005 annual report to shareholders, The General Electric Company reported the
following financial results:
Revenues increased from $134.5 billion in 2004 to $149.7 billion in 2005.
Net income decreased from $16.8 billion in 2004 to $16.4 billion in 2005.
Total assets decreased from $750.0 billion in 2004 to $673.5 billion in 2005.
Shareholders equity decreased from $110.8 billion in 2004 to $109.4 billion in 2005.
For 2005, the cash flow from operating activities was $37.6 billion, the cash flow from investing activities was
negative $35.1 billion, and the cash flow from financing activities was negative
$6.2 million.
Discuss the possible explanations for the financial results of the General Electric Company from 2004 to 2005.
E1.28 Financial Statement Results. In its 2005 annual report to shareholders, The Johnson and Johnson Company, a
consumer-products company, reported the following financial results:
Revenues increased from $47.7 billion in 2004 to $50.5 billion in 2005.
Net income increased from $8.5 billion in 2004 to $10.4 billion in 2005.
Total assets increased from $53.3 billion in 2004 to $58.1 billion in 2005.
Shareholders equity increased from $31.8 billion in 2004 to $37.9 billion in 2005.
For 2005, the cash flow from operating activities amounted to $11.9 billion, the cash flow from investing activities
amounted to negative $0.3 billion, and the cash flow from financing activities amounted to negative $4.5 billion.
Discuss the possible explanations for the financial results of The Johnson and Johnson Company from 2004 to 2005.
E1.29 Calculating Security Returns. Presented below are the beginning-of-year common share price (Pt-1), the end-of-year
common share price (Pt), and the annual dividend (Dt) for three competitorsGeneral Electric Company, Phillips
Electronics NV, and Siemens AG.

Pt-1 Pt Dt

General Electric Co. . . . . . . . . . . . . . . . . . . . . . $32.01 $34.50 $0.86

Phillips Electronics NV . . . . . . . . . . . . . . . . . . . 72.52 72.90 1.28
Siemens AG . . . . . . . . . . . . . . . . . . . . . . . . . . . 27.20 25.36 0.52

Calculate the annual return for each of the three individual securities. Which security provided the greatest return over the
one-year period? What other information would you need to assess the return/risk trade-off on each of these individual
securities?
 Chapter 1 | Economic Environment of Accounting Information 27

PROBLEMS
P1.30 Key Financial Statement Relations: Balance Sheet, Income Statement, and Statement of Cash Flow. Compute
the missing amounts in the following financial statements. You may assume that accounts receivable relate only to credit
sales and that accounts payable relate only to credit purchases of inventory. There were no sales of property and equip-
ment during 2006 and any purchases of property and equipment were made using cash. What is your assessment of the
companys financial performance in 2006?

Balance Sheet at December 31, 2005 December 31, 2006

Current assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ? $ 25,000
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 5,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 37,000
Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 52,000 23,000
Prepaid advertising. . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 18,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 92,000 108,000
Property, plant and equipment (cost) . . . . . . . . . . . . . 175,000 ?
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . (35,000) (63,000)
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 ?
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? 7,000
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $258,000 $342,000

Current liabilities
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 23,000
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? 18,000
Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 5,000
Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 ?
Taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 12,000
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . 43,000 60,000
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? 86,000
Shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 172,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 32,000
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000) ?
Total liabilities and shareholders equity. . . . . . . . . . . $258,000 $342,000

Income Statement for Year Ending December 31, 2006

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?
Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,000
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162,000
Expenses:
Wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Income (loss) before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,000
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 53,000
28 Chapter 1 | Economic Environment of Accounting Information

Statement of Cash Flow for Year Ended December 31, 2006

Cash flow from operating activities
Cash collections from customers. . . . . . . . . . . . . . . . . . . . . . . . . . $ 260,000
Cash payments for: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (83,000)
Wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,000)
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000)
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Net cash provided by operations . . . . . . . . . . . . . . . . . . . . . . . . . . 104,000
Cash flow from investing activities
(Purchases) sale of property, plant and equipment . . . . . . . . . . . . (111,000)
(Purchase) sale of marketable securities . . . . . . . . . . . . . . . . . . . . ?
(Purchase) sale of land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Net cash provided by investing activities. . . . . . . . . . . . . . . . . . . . (102,000)
Cash flow from financing activities
Issuance (repayment) of long-term debt . . . . . . . . . . . . . . . . . . . . 34,000
Payment of dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (45,000)
Issuance (repurchase) of common stock . . . . . . . . . . . . . . . . . . . . ?
(Purchase) sale of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Net cash provided by financing activities. . . . . . . . . . . . . . . . . . . . 13,000
Change in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?

P1.31 Key Financial Statement Relations: Balance Sheet, Income Statement, and Statement of Cash Flow. Compute
the missing amounts in the following financial statements. You may assume that accounts receivable relate only to credit
sales and that accounts payable relate only to credit purchases of inventory. There were no sales of property and equip-
ment during 2006 and any purchases of property and equipment were made using cash. What is your assessment of the
companys financial performance in 2006?

Balance Sheet at December 31, 2005 December 31, 2006

Current assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,000 $ ?
Marketable securities . . . . . . . . . . . . . . . . . . . . 2,000 5,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . 8,000 10,000
Merchandise inventory . . . . . . . . . . . . . . . . . . . 41,000 58,000
Prepaid advertising. . . . . . . . . . . . . . . . . . . . . . 13,000 16,000
Total current assets . . . . . . . . . . . . . . . . . . . . . 82,000 104,000
Property, plant and equipment (cost) . . . . . . . . ? 201,000
Accumulated depreciation . . . . . . . . . . . . . . . . (41,000) (52,000)
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 19,000
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . 12,000 ?
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . $227,000 $282,000
Current liabilities
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . $ 18,000 $ ?
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 18,000
Interest payable . . . . . . . . . . . . . . . . . . . . . . . . ? 6,000
Dividends payable . . . . . . . . . . . . . . . . . . . . . . 2,000 4,000
Taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 1,000
Total current liabilities. . . . . . . . . . . . . . . . . . . . 48,000 50,000
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . 46,000 ?
Shareholders equity . . . . . . . . . . . . . . . . . . . .
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . 121,000 160,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . 22,000 32,000
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . ? (12,000)
Total liabilities and shareholders equity. . . . . . $227,000 $282,000
 Chapter 1 | Economic Environment of Accounting Information 29

Income Statement for Year Ending December 31, 2006

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,000
Expenses
Wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Income (loss) before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,000

Statement of Cash Flow for Year Ended December 31, 2006

Cash flow from operating activities

Cash collections from customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?
Cash payments for:
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (101,000)
Wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,000)
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,000)
Net cash provided by operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
Cash flow from investing activities
(Purchases) sale of property, plant and equipment . . . . . . . . . . . . . . . . . . . (39,000)
(Purchase) sale of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)
(Purchase) sale of land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Net cash provided by investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . (49,000)
Cash flow from financing activities
Issuance (repayment) of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Payment of dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000)
Issuance (repurchase) of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,000
(Purchase) sale of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
Net cash provided by financing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (3,000)

C O R P O R A T E A N A LY S I S
CA1.32 The Procter and Gamble Company. The 2005 annual report of The Procter and Gamble Company (P & G) is
available at www.pg.com/annualreports/2005/pdf/pg2005annualreport.pdf. After reviewing P & Gs annual report, re-
spond to the following questions:
a. Prepare a list of some of the products produced by P & G. In what industry does P & G operate? Who are some of
P & Gs key competitors? (To identify the key competitors for P & G, you will need to access the Internet (e.g.,
http://finance.yahoo.com) or obtain a copy of a recent research report for P & G.)
b. How much net income did P & G earn in 2003, 2004, and 2005? How much operating revenue did P & G report
in 2003, 2004, and 2005? Are the trends in operating revenue and net income consistent and positive (i.e.,
increasing)?
30 Chapter 1 | Economic Environment of Accounting Information

c. How much cash flow from operations was generated by P & G in 2003, 2004, and 2005? Is the trend in the cash
flow from operations consistent with the trend in operating revenue and net income? Calculate the ratio of the
cash flow from operations divided by net income for 2003, 2004, and 2005. (Note: The ratio of cash flow from
operations divided by net income is called the operating funds ratio.) What does this ratio tell you?
d. Calculate the ratio of total liabilities divided by total assets for 2004 and 2005. What does this ratio tell you? Is
P & G principally debt-financed or principally equity-financed? Is the form of P & Gs financing changing over
time?
e. Consider the audit report for P & G. Who are P & Gs auditors? What does P & Gs audit report say about the
firms financial statements? Is there anything in P & Gs audit report that causes you any concern? If so, what?
CA1.33 Internet-based Analysis. Consider a publicly held company whose products you are familiar with. Some examples
might include:

Company Product Corporate Website

Johnson & Johnson Company Band-Aids www.jnj.com

Microsoft Corporation Windows XP software www.microsoft.com
Nokia Corporation Cellular phones www.nokia.com
Intel Corporation Pentium processors www.intel.com
Kimberly-Clark Corporation Kleenex www.kimberly-clark.com

Access the companys public website and search for its most recent annual report. (Some companies will provide ac-
cess to their financial data through an investor relations link, while others will provide a direct link to their annual
reports.) After locating your companys most recent annual report, open the file and review its contents. After reviewing
the annual report for your selected company, prepare answers to the following questions:
1. Prepare a list of the companys products.
2. Identify which accounting firm audited the companys financial data. Briefly describe the contents of the audit
report.
3. How much net income did the company earn in each of the past two years?
4. How much cash flow from operations did the company generate in each of the last two years?
5. Explain why the amount of net income and the cash flow from operations differed?
6. Comment on the companys performance and financial health over the last two years. Is the companys
performance and financial health improving or declining? Why?
 C h a p t e r Tw o

From Accounting Events to

Financial Statements

TAKEAWAYS
When you complete this chapter you should be able to:
1. Explain the accounting meaning behind the terms asset, liability, shareholders equity, revenue, expense, and
matching.
2. Prepare financial statements from accounting events.
3. Apply selected financial ratios to evaluate a companys financial performance.
4. Apply the balance sheet equation to understand the managerial motives for selecting between alternative
accounting methods.

Where have we been? Where are we? Where are we going?

Chapter 1 examined why individuals Chapter 3 examines the

use accounting information when In this chapter, we examine various components of the
making financial decisions and how the balance sheet equation income statement and how
this information can be made more and how financial state- cash flow statements can
valuable through the development ments are derived from a be derived from an income
and use of accounting standards. It statement and a set of bal-
set of accounting events
also examined the demand for and ance sheets. The chapter
the supply of capital and how ac- that affect a business. We also examines the alterna-
counting information can help make also investigate how to tive ways that investment
capital markets efficient. Finally, the use financial statements professionals define and
chapter appendix examined the to evaluate a firms perfor- measure earnings and cash
conflicts of interest that can arise flows when they evaluate
mance and to understand
between capital providers and busi- the financial performance
ness managers and how accounting the managerial motives for of a business.
information can be used to attenu- selecting between alterna-
ate those conflicts. tive accounting methods.

31
 CRAZY EDDIE Symbol: CRZY

Crazy Eddie was a discount consumer electronics store chain based in New York. The business was started in 1971 by Eddie Antar
and his cousin, Sam, and soon became well known for its loud radio and television commercials which featured a frenetic spokes-
person who promoted the chains insa-a-a-a-a-ane prices. Eventually, the chain grew to 43 stores and generated over $300 million
in revenues. In 1984, Eddie and Sam took the company public (symbol: CRZY) at an IPO price of $8 per share; by early 1986, the
shares were selling for more than $75 per share.
Almost from the start of business, Eddie and Sam engaged in various forms of financial fraud. Court records indicate that they
routinely skimmed an estimated $4 million per year from the business, which they deposited in off-shore bank accounts. In the early
1980s, Eddie hired his nephew, Sammy, who had earned a degree in accounting, to assist with the fraud. With the help of Sammy
who had become the CFO, Eddie and Sam inflated same-store sales by an estimated $15 to $20 million per year, and likewise falsified
store inventories to justify the inflated revenue figures. Court records indicate that Sammy coerced store employees, using threats of
termination, to falsify sales invoices so that the companys independent auditors would not suspect the presence of fraud.
By mid-1986, the magnitude of the fraud became almost impossible to cover up, and the stock market began to become sus-
picious. By October 1986, the share price had fallen to $17.50 per share, and shortly thereafter, Eddie resigned as the companys
chief executive officer. Just prior to his resignation, Eddie cashed out of his Crazy Eddie stock, sending some $50 million to his
off-shore accounts in Israel.
In June 1989, Crazy Eddie filed for Chapter 11 bankruptcy protection. Shortly thereafter, the U.S. Securities and Exchange
Commission charged Eddie Antar with securities fraud and illegal insider trading. In January 1990, a U.S. Federal district judge
ordered Antar to repatriate the more than $50 million from stock sales that he had illegally transferred to Israel. Instead, Eddie fled
the U.S. using a fake passport; but, in June of 1992, he was arrested in Tel Aviv and extradited to the U.S. In 1996, Eddie Antar was
sentenced to 8 years in prison for stock fraud and racketeering and was ordered to pay more than $150 million in fines.
In 2004, the Crazy Eddie trademark was acquired by the Trident Growth Fund, which placed the trademark and internet
domain name crazyeddie.com on eBay for sale. The auction ended without the reserve price of $800,000 being met; the highest
bid was just $30,100.
In this and subsequent chapters we will learn the techniques needed to understand how financial statements can be derived
from accounting events, both real and fraudulent. The balance sheet equation introduced in this chapter provides a convenient way
to record events in a format that facilitates the financial statement preparation process.

EXECUTIVE From Accounting Events to Financial Statements

OUTLINE

Preparing Financial Evaluating Business

The Balance Statements from Performance and Making Managerial Discretion
Sheet Equation Accounting Events Financial Decisions and Accounting Methods

Accounting Equation Preparing Basic Evaluating Firm Operating Revenues at

Defining Some Financial Statements Profitability B.J.s Wholesale Club
Accounting Terms Articulation of Financial Return on Equity Operating Expenses at
Accounting Equation Statements Analysis America Online
Spreadsheet Accounting Policy Evaluating Financial
Decisions at Russian Risk
River Valley Winery

BALANCE SHEET EQUATION

The purchase of a personal residence is the single largest financial transaction entered into by most individuals. This
purchase generally requires the individual to take out a loan, typically called a mortgage. Before lending any money, a
financial institution will usually request certain information to assess whether an individual or a business represents a
good credit risk. Exhibit 2.1 presents one of the forms that will need to be completed in order to have a loan application
considered. If you have never completed one of these forms, now is a good time to try it out.
32
 Chapter 2 | From Accounting Events to Financial Statements 33

EXHIBIT 2.1 A Typical Loan Application

Lets focus on the left side of the formyour assets. The caption cash or market value indicates that the numbers
that you are requested to insert should be your assets current value. The top part of the form asks for the balance of your
cash and checking/savings accounts, with the names and addresses of the institutions where you keep these accounts so
that the lender can verify the reported amounts. The section below cash and checking/savings accounts asks for the value
of all your stocks and bonds. To fill in this information, you will need to know the number of stocks and bonds that you
own of each company and the current price for each security. If the stocks and bonds are traded on an exchange such
as the New York Stock Exchange, the London Stock Exchange, or the Tokyo Stock Exchange, you can simply access a
34 Chapter 2 | From Accounting Events to Financial Statements

financial internet site to find the current price for each of the securities. Next, you will have to get the cash surrender value
of any life insurance policies. If you have a life insurance policy, your insurance agent can provide that information.
The section below life insurance asks for the market value of any real estate owned, such as a rental house or
a vacation home. Where do you get the market value for your real estate properties? It is harder to get this type of
information because real estate does not have an actively traded market like the London, New York, or Tokyo Stock
Exchanges. You will have to hire an appraiser who will estimate the value of your house by considering comparable
propertiesthat is, houses with the same number of bedrooms, bathrooms, and in the same neighborhood. But deter-
mining the market value for your real estate holdings is considerably more subjective than coming up with a value for
your stock or bond portfolio. If you hired three different appraisers, you would probably get three different estimates.
After you have included any remaining assets that you own, such as a car or a business, you can then total them all up
and put a number in the box for total assets a.
Now turn to the far right column where you are asked to insert amounts for the unpaid balances on all of your
outstanding loans, including credit cards, student loans, and real estate or automobile loans. For each of these loans
you must also disclose the names and addresses of the people you owe money to so that the lender can verify your
reported amounts. The sum of all of these items can be put in the box labeled total liabilities b.
Finally, the form asks you to come up with your net worth, described as a minus b. Your net worth is simply
the difference between your total assets and total liabilities. This is an important relationship so lets write it out:

A  L  NW

This expression says that your personal net worth (NW) is equal to the amount left over from your assets (A) after
paying off all of your liabilities (L). Notice that this expression implicitly suggests that your creditors have first claim
on your assets and you get what remains. Since the lenders have first claim, they are in a less risky position. As we
observed in Chapter 1, there is a positive relationship between the amount of assumed risk and the expected return on
an investment; that is, greater (less) assumed risk implies a higher (lower) expected return.
If we add L to both sides of our expression, we can rearrange the relationship as follows:

A  L  NW

This new expression is called the balance sheet equation. It shows that
the total assets on the left side must exactly equal the sum of the claims on In some countries, the balance sheet equa-
those assets on the right side. There are two types of claimsthe lenders tion is formatted as:
who have first claim on your assetsand youthe person who gets what A  L  NW
is left over. It should now be clear why the balance sheet equation always This format emphasizes the measurement
balances NW is just a balancing or plug figure! of net worth. Regardless of which format
Now if we think about a company instead of an individual, share- is adopted, the information contained in a
holders are those individuals or entities which purchase ownership balance sheet is exactly the same.
shares in the business. In the case of a business, the term NW is usually
replaced by the term SE, for shareholders equity. Therefore, the balance sheet equation that we will use to refer to
a business instead of an individual is:

A  L  SE

In a nutshell, the right side of the balance sheet equation tells us that a business obtains cash and/or other assets
(A) from shareholders by issuing shares (SE) and from lenders by promising to pay interest on any debt and repay any
borrowed funds (L). As you will see in subsequent chapters, some companies borrow sparingly and thus are financed
principally by shareholders. Other companies borrow extensively, and we will refer to these companies as being lever-
aged. The relative mix of funding from shareholders versus lenders is an important financing decision that can have
a dramatic effect on a firms financial performance.
The left side of the balance sheet equation shows how a business invests its resources in various assets (A)
this is known as the investment decision. Who makes the investment decision? Technically, the shareholders have
the right to make such decisions but they usually delegate these decisions to a management team. Not surprisingly,
 Chapter 2 | From Accounting Events to Financial Statements 35

shareholders are preoccupied with maintaining and growing their wealth; thus, they expect the management team
to make investment decisions that increase SE over time.

Defining Some Accounting Terms

We have used the terms asset, liability and shareholders equity without precisely defining these terms. From
the loan application above, it is clear that assets include cash, stocks, bonds, and real estate, among other things. For
now, we will define an asset as an economic resource that is expected to generate future benefits for a business. As we
will see, assets may comprise a variety of economic resources to include those mentioned above, as well as inventory,
property and equipment, and various intangible assets such as copyrights and patents, among others.
From the loan application above, liabilities include car loans, credit card debt, student loans, and mortgages. But
as you will soon see, a businesss liabilities may include many types of obligations. For now, we define a liability
simply as an obligation to make future cash payments. This definition implies that if a business is obliged to make
cash payments in the future, then the obligation qualifies as a liability. In subsequent chapters, we will see that some
liabilities that satisfy this definition need not be (and often are not) reported on the balance sheet. We will refer to these
unreported obligations as off-balance-sheet debt. (Subsequent chapters will reveal that many of a firms economic
assets also fail to appear on the balance sheet!) Finally, we define shareholders equity as the residual value of a
businessthat is, the value of any assets remaining after all liabilities have been satisfied. Shortly, we will see that
shareholders equity has two key componentsthe value of the shareholders direct investment in a business, called
contributed capital or common stock (CS), and the amount of any profits retained in the business to support future
operations, called retained earnings (RE). Incorporating these two components of SE into the balance sheet equation
yields the following:

A  L  (CS  RE)

Preparing Financial Statements from Accounting Events

Recording Transactions
You may feel that there is little reason why you should be subjected to the rigors of learning how to record transac-
tions since you probably have little, if any, desire to become an accountant. In fact, most managers are apt to hire an
accountant to execute these activities. But having some knowledge of the recording process can be invaluable, and this
can be illustrated by way of an analogy.
It is doubtful that the readers of this book will go on to a career in auto repair. Many readers, in fact, may never
even look under the hood of a car. Each of you, however, likely drive a car; and, many of you likely have experienced
mechanical problems at one time or another. It would certainly be helpful to the mechanic who will ultimately be
responsible for repairing your car if you have the ability to provide detailed information regarding what is wrong.
It could also prove financially beneficial if you have some understanding of what the mechanic plans to charge you
for. You certainly do not want to be completely at their mercy. The same applies for business transactions. While you
may not be responsible for the actual recording of a transaction, as a manager you may be responsible for the reported
financial statements. If so, wouldnt you want to be able to intelligently discuss with your accountant what needs to
be done and to also understand what should be done? A basic understanding of the recording process can give you this
necessary competence.
We follow two approaches in this textbook for the recording of transactions. The approach we illustrate in this
chapter utilizes a horizontal spreadsheet built upon the basic accounting equation of Assets equaling Liabilities and
Shareholders equity. This spreadsheet approach is appreciated by many readers for its simplicity; however, this is not
the method used by accounting professionals. Many of you will find the spreadsheet approach more intuitive, and you
will be heartened to know that this approach yields the exact same result as that used by accounting professionals.
The second approach, shown in the appendix to this chapter, represents how transactions are actually recorded.
The recording is most often done by accounting software rather than by hand. This approach involves first record-
ing transactions as journal entries, utilizing a double-entry system of debits and credits. These terms probably
sound quite foreign, and rightly so. Unlike much in the natural sciences that is determined by nature, the accounting
36 Chapter 2 | From Accounting Events to Financial Statements

process of recording transactions is completely designed by man and is therefore somewhat arbitrary. The important
thing, however, is that it works. And, not only does it work, but it also has a built-in error detection mechanism.
While many of the readers may struggle to understand the accounting process, most come to see this system as
somewhat of an art form, poetic in its elegance.
To demonstrate how financial statements are prepared from accounting events, an illustration involving the hypo-
thetical Russian River Valley Winery is presented. Our approach for organizing the firms accounting data is a simple
spreadsheet based on the balance sheet equation, A  L  SE, as follows:

Russian River Valley Winery Spreadsheet

Assets  Liabilities  Shareholders Equity

Intangible Common Retained

Cash Buildings Land Assets Bank Loan Payable Stock Earnings

Because the balance sheet equation must always balance, we know that the value of the winerys assets on the left
side of the spreadsheet will always equal the value of the winerys liabilities plus its shareholders equity on the right side
of the spreadsheet.

THE RUSSIAN RIVER VALLEY WINERY

Matt and Kate Miller established the Russian River Valley Winery near Healdsburg, California. They owned a small
parcel of farmland on which the winery would be operated. Kate further agreed to use her inheritance from her grand-
parents to construct buildings suitable for the new business.
Since Matt and Kate lacked sufficient land to grow their own grapes, they decided that the winery would purchase
grapes from local growers. The wines would be aged in oak barrels, then bottled, corked, and held for a minimum of
six months before sale.
Recognizing that the winery would need additional financial resources, Kate and Matt approached an old
friend, Bob Buck, who worked as a loan officer at the Hap e-Loan Corporation. Via e-mail, Bob indicated that the
business plan for the winery looked promising but that Hap e-Loan would need to review a comprehensive set of
forecasted financial statements before the Millers $4.8 million loan request would be considered. The loan agree-
ment proposed a fixed interest rate of 6 percent per year on the outstanding loan balance and called for the borrowed
amount to be repaid over 10 years in equal annual installments payable at the end of the year.

Establishing the Business On the basis of discussions with the com- One of the most important skills a manager
panys legal advisors, Kate and Matt determined that the following can develop is the ability to prepare forward-
events would likely occur during the start-up phase of the business: looking financial forecasts. These forecasts
are often prepared as proforma financial
statements. The terms proforma and fore-
1. Matt would receive four million shares of common stock, valued at casted can be used interchangeably. Capital
$1 per share, in the Russian River Valley Winery, Inc., in exchange providers such as banks usually require such
for contributing his land to the business. This transaction would statements for new businesses in order to
increase the businesss land (A) account by $4 million and increase help determine whether the business repre-
the common stock (SE) account by $4 million. sents a prudent investment.

Russian River Valley Winery Spreadsheet

(all amounts in thousands)

Assets = Liabilities + Shareholders Equity

Cash Buildings Land Intangible Assets Loan Payable Common Stock

1 4,000 4,000
 Chapter 2 | From Accounting Events to Financial Statements 37

2. Kate would receive two million shares of common stock in the winery for the buildings that she would finance
with her inheritance. This would increase the winerys buildings (A) account by $2 million and increase the com-
mon stock (SE) account by $2 million.

Russian River Valley Winery Spreadsheet

Assets = Liabilities + Shareholders Equity

Cash Buildings Land Intangible Assets Loan Payable Common Stock

2 2,000 2,000

3. When the $4.8 million bank loan was approved and the cash disbursed to the Russian River Valley Winery, the cash
(A) account would increase by $4.8 million and the bank loan payable (L) account would increase by $4.8 million.

Russian River Valley Winery Spreadsheet

Assets = Liabilities + Shareholders Equity

Cash Buildings Land Intangible Assets Loan Payable Common Stock

3 4,800 4,800

4. Cash fees expected to be paid for incorporation costs during the start- Most recorded assets such as cash or
up phase were estimated at $100,000. This would decrease cash (A) buildings have an actual physical presence
by $100,000 and increase intangible assets (start-up costs) by the and are sometimes referred to as tangible
same amount. (Recall that an asset is presumed to generate future assets. In addition, certain recorded assets
lack a physical presence, but still provide
benefits for a business. Thus, the cost of opening a business can rea-
future benefits to the organization. These
sonably be expected to provide such benefits since they are neces-
intangible assets include such items as
sary to enable the enterprise to begin operations; consequently, such patents and start-up costs.
costs are often considered to be an asset on the balance sheet of many
new businesses.)

Russian River Valley Winery Spreadsheet

Assets = Liabilities + Shareholders Equity

Cash Buildings Land Intangible Assets Loan Payable Common Stock

4 100 100

Following the pre-opening events identified by Kate and Matt, the Russian River Valleys balance sheet at the
start of business would appear as follows:

Russian River Valley Winery Spreadsheet

Assets = Liabilities + Shareholders Equity

Cash Buildings Land Intangible Assets Loan Payable Common Stock

1 4,000 4,000
2 2,000 2,000
3 4,800 4,800
4 100 100

Totals 4,700 2,000 4,000 100 4,800 6,000

10,800  4,800  6,000
38 Chapter 2 | From Accounting Events to Financial Statements

Russian River Valley Winery, Inc.

Pre-Opening Balance Sheet

($ thousands)

Assets Liabilities & Shareholders Equity

Cash . . . . . . . . . . . . . . . . . . . . $ 4,700 Liabilities
Buildings. . . . . . . . . . . . . . . . . 2,000 Bank loan payable . . . . . . . . . . . . . . . . . $ 4,800
Land . . . . . . . . . . . . . . . . . . . . 4,000 Shareholders equity
Intangible assets . . . . . . . . . . 100 Common stock. . . . . . . . . . . . . . . . . . . . 6,000
Total assets . . . . . . . . . . . . . . $10,800 Liabilities & shareholders equity . . . . $10,800

The winerys total assets of $10.8 million equal the sum of the winerys liabilities plus shareholders equity of $10.8
million.

Projected Business Events

To comply with the banks request for forecasted financial statementsthat is, financial statements prepared on
an as if basis using assumptions about what might happen in the futureMatt and Kate compiled a list of the
important events that would likely occur during the first year of operations. These events appear below as account-
ing events Number 1 through 14. Matt and Kates analysis of how each of the events would affect the winerys
balance sheet equation appears as bullet items. Observe that the analysis of each event leads to the identifica-
tion of (at least) two financial effects on the balance sheet equation; and, that the financial effects of each trans-
action are recorded in the appropriate columns of the winerys spreadsheet. Further, notice in the Russian River
Valley spreadsheet that after each event is analyzed, the balance sheet equation remains in balance, with total as-
sets equal to the sum of total liabilities and shareholders equity. To help understand how the balance sheet equa-
tion is affected by the various events, each asset account is labeled with an A, each liability account with an L,
and each shareholders equity account as SE. Finally, notice that the account balances from the winerys pre-
opening balance sheet have been entered into the spreadsheet in the row labeled beginning balance.
1. The winery would purchase $380,000 of inventory (grapes, corks, bottles, labels). All purchases would initially
be on credit and would subsequently require payment within 30 days of the initial purchase transaction. It was
estimated that the unpaid balance of this credit purchase would be $20,000 at the end of the year.

Russian River Valley Winery Spreadsheet

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Beg.
Bal. 4,700 0 0 0 2,000 0 4,000 100 0 0 4,800 6,000 0
1(a) 380 380
1(b) 360 360

In 1(a) the winery purchases inventory, but does not immediately Kate and Matts analysis of Russian River
pay for the inventory. Thus, inventory (A) increases by $380,000 Valleys credit purchase of inventory reflects
and accounts payable (L)that is, amounts owed by the winery to the accrual basis of accounting discussed
its suppliersincreases by $380,000. in Chapter 1. Their analysis also reflects the
In 1(b) the winery pays $360,000 ($380,000 less $20,000) to its Entity Principle of accounting, which stip-
suppliers; thus, cash (A) decreases by $360,000 and accounts pay- ulates that the financial affairs of a busi-
able (L) decreases by $360,000. ness must be maintained separate and
distinct from the affairs of the owners of
2. The winery would spend $1.5 million in cash to acquire equipment the business.
to be used in crushing, separating and fermenting the grape juice.
 Chapter 2 | From Accounting Events to Financial Statements 39

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Beg.
Bal. 4,340 0 380 0 2,000 0 4,000 100 20 0 4,800 6,000 0
2 1,500 1,500

The winery increases the equipment (A) account by $1.5 million and decreases cash (A) by $1.5 million.
3. The winery would spend $2 million in cash to purchase oak aging barrels. The barrels would be considered a
long-term investment in equipment because the barrels typically last five or more years.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Beg.
Bal. 2,840 0 380 1,500 2,000 0 4,000 100 20 0 4,800 6,000 0
3 2,000 2,000

Cash (A) is reduced by $2 million and equipment (A) is increased Matt and Kates analysis and recording
by $2 million. of accounting events 2 and 3 reflects the
historical cost principle of accounting,
4. The Russian River Valley Winery would sell two types of wine
which stipules that all assets should ini-
bulk wine and bottled wine. It was estimated that bulk wine sales tially be recorded at their acquisition or
would total 100,000 gallons at $15 per gallon. Sales of bottled wine historical cost.
were estimated to be 50,000 bottles at $8 per bottle. About 20 percent
of the sales would be immediately paid for in cash, with 80 percent of the sales on credit with payment expected
in 30 days after the sale transaction. Of that latter amount, $800,000 was expected to be uncollected at year-end.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 840 0 380 3,500 2,000 0 4,000 100 20 0 4,800 6,000 0
4(a) 380 1,520 1,900
4(b) 720 720

In 4(a), total sales are projected to be $1.9 million (100,000 gal- Revenues (R) are increases in shareholders
lons @ $15 plus 50,000 bottles @ $8). Of this total amount, the equity that result from providing goods and
winery expects to collect $380,000 in cash (20 percent of $1.9 services to customers. Revenue is reported
on the income statement when it has been
million) and will be owed the balance of $1.52 million by its
earnedthat is, when a company has pro-
customers. Thus, cash (A) is increased by $380,000, accounts
vided substantially all of the goods or ser-
receivable (A) is increased by $1.52 million, and shareholders vices it has promised to provideand when
equity (specifically, revenue, a component of retained earnings) the collectibility of the cash from the cus-
is increased by $1.9 million. Accounts receivable represent tomer is reasonably assured. This important
amounts owed to the winery by its customers. concept is known as the revenue recog-
The relation between revenues and expenses, components of nition principle. Recognizing revenue is a
the income statement, and retained earnings, a component of the wealth-increasing event for a business and
shareholders equity portion of the balance sheet, is illustrated be- its shareholders, and this is reflected by an
low. As you will recall from Exhibits 1.5 and 1.6 from Chapter 1, increase in shareholders equity.
40 Chapter 2 | From Accounting Events to Financial Statements

the income statement articulates with the balance sheet through the retained earnings account. Revenues, which
increase net income, also increase retained earnings, whereas expenses, which decrease net income, also decrease
retained earnings. We further illustrate this articulation of the financial statements later in this chapter.

Relation Between Revenues, Expenses, and Retained Earnings

Income Statement Balance Sheet

 Revenues Assets  Liabilities  Shareholders Equity

 Expenses
Common Stock Retained Earnings
Net Income Beginning Retained Earnings
 Revenues
 Expenses
 Dividends
Ending Retained Earnings

In 4(b), customers are expected to owe the winery $800,000 at year-end; hence, they must have paid $720,000
in cash during the year. Thus, cash (A) is increased by $720,000 and accounts receivable (A) is decreased by
$720,000.
5. Payroll expenses for employees were estimated to require cash payments of $100,000 during the year. Selling and
administrative expenses of $300,000 were also expected to be paid.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 1,940 800 380 3,500 2,000 0 4,000 100 20 0 4,800 6,000 1,900
5(a) 100 100
5(b) 300 300

In 5(a), the winery pays $100,000 in cash for employee wage

Expenses (E) represent the using up of goods
expense; thus, cash (A) decreases by $100,000 and sharehold- and services associated with the production
ers equity (specifically, expenses, a component of retained of revenues by a business. Since expenses
earnings) decreases by $100,000. reduce assets, expenses are a wealth-
In 5(b), the winery reduces cash (A) by $300,000 for the reducing event. The cost of the goods and
services consumed in generating revenues
payment of selling and administrative expenses. Since these
are said to be matched with the revenues
services are consumed in the process of generating revenues
they generate; as a consequence, a busi-
from wine sales, the cost of these used-up resources are ness is able to compare its accomplish-
matched with revenues, thus reducing retained earnings (SE) ments (revenue) with its effort (expenses).
by $300,000. This important concept is known as the
6. The loan agreement requires payment of principal and interest at matching principle of accounting.
the end of the year.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 1,540 800 380 3,500 2,000 0 4,000 100 20 0 4,800 6,000 1,500
6(a) 480 480
6(b) 288 288
 Chapter 2 | From Accounting Events to Financial Statements 41

In 6(a), cash (A) is reduced by $480,000, the first of 10 annual loan repayments ($4.8 million divided by 10),
and the loan payable (L) account is reduced by the same amount.
In 6(b), cash (A) is reduced by $288,000 (6 percent of $4.8 million) for the first years interest payment. In-
terest is the cost of borrowing funds from a financial institution and is a financing expense of the business.
Hence, retained earnings (SE) are also reduced by $288,000 as this business expense must be matched with the
enterprises revenues.
7. The winerys policy was to order only as much inventory as would be needed for the current years sales. Thus, it
was estimated that the ending inventory would be zero.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 772 800 380 3,500 2,000 0 4,000 100 20 0 4,320 6,000 1,212
7 380 380

The entire available inventory is assumed to have been used up in the production and sale of wine. Thus, inven-
tory (A) decreases by $380,000, as does retained earnings (SE). The cost of inventory sold is an expense to be
matched with revenues. Notice that inventory is first classified as an asset since it is assumed to provide future
benefit to the enterprise in the form of future cash inflows. When the inventory is sold, and therefore used up, the
asset is removed from the balance sheet and an expense, called cost of goods sold, is recognized as a reduction
in shareholders equity. This is an example of the matching principle in which the cost of goods sold is matched
with the revenues from the sale of the goods, all recognized in the same accounting period.
The entry for item 7 provides insight into one of the methods used in the Crazy Eddie accounting fraud intro-
duced at the beginning of this chapter. Company officials intentionally overstated the businesss inventory when
they performed their physical counts of store inventory. Notice that if a businesss inventory is overstated, the
amount removed from inventory and transferred to cost of goods sold will be understated. This will result in net
income, and retained earnings, being overstated. We will have more to say about the effects of inventory errors in
Chapter 6.
8. Depreciation for the year was determined as follows: $175,000 for equipment, based on an expected useful life of
20 years, and $50,000 for buildings, based on an expected useful life of 40 years.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 772 800 0 3,500 2,000 0 4,000 100 20 0 4,320 6,000 832
8(a) 175 175
8(b) 50 50

Depreciation refers to the systematic expensing of an asset as a

Balance sheet accounts that are subtracted
consequence of the passage of time. Accountants often estimate
from other accounts (such as accumulated
the amount of depreciation to be taken on an asset by estimat- depreciation) are known as contra-accounts
ing the expected useful life of the asset and then allocating its (CA). The difference between the cost of an
cost equally across all years of the assets expected useful life, asset (e.g. equipment) and its accumulated
a method called straight-line depreciation. In 8(a), the expected depreciation is called the book value of the
life of the equipment is 20 years so depreciation expense (E) is asset.
$175,000 ($3.5 million divided by 20 years). Hence, retained
earnings (SE) are decreased by $175,000. Of course, the asset must also be decreased, but by convention,
the equipment account is not decreased directly. Another accountcalled accumulated depreciationis
42 Chapter 2 | From Accounting Events to Financial Statements

increased, and thus, reflects the negative $175,000. The accumulated depreciation account is then subtracted
from the equipment account. We show an increase in accumulated depreciation as a negative number under the
assets section of the spreadsheet. This is because accumulated depreciation is actually a contra-asset, where by
convention it maintains a balance of the opposite sign as a regular asset. We will have much more to say about
both depreciation expense and accumulated depreciation in Chapter 7. Another important point to note is that
the purpose of depreciation is not to reduce the assets book value in an attempt to equate its book value with
its market value. Rather, the purpose of depreciation is to allocate the cost of the asset over time in an attempt
to match the assets cost with the revenue generated by the asset in each future period, an application of the
matching principle.
In 8(b), the depreciation expense associated with using the building for a year is estimated to be $50,000 ($2
million divided by 40 years); hence, retained earnings (SE) are decreased by $50,000. As in 8(a), accumulated
depreciation (CA) is increased by $50,000 and deducted from the building account.
9. Kate and Matt decide that the start-up costs of the business should be expensed over two years.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 772 800 0 3,500 2,000 225 4,000 100 20 0 4,320 6,000 607
9 50 50

The write-off of the start-up costs, called amortization, is an expense of the business. Thus, the intangible asset
account (A) is reduced by $50,000 ($100,000 divided by 2 years), as is retained earnings (SE). If Matt and Kate
had estimated a five-year expected life for the start-up costs instead of just two years, the amortization expense
would be only $20,000 per year ($100,000 divided by five years). Estimating the expected useful life of equip-
ment, buildings, and such intangible assets as start-up costs is an important managerial activity. An incorrect
estimate of an assets expected useful life can have a dramatic positive (or negative) effect on a firms reported
performance. As you will see, many accounting numbers, like amortization expense, are just estimates, and as
such, can be quite imprecise.
10. Matt and Kate issue 200,000 additional shares to an outside investor for $2 per share to finance future expansion
plans.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 772 800 0 3,500 2,000 225 4,000 50 20 0 4,320 6,000 557
10 400 400

The issuance of additional common shares increases common stock (SE) by $400,000 and increases cash (A)
by the same amount. As a consequence of selling shares to the outside investor, Matt and Kate must now share
control of the business and its profits with the investor who has become a co-owner of the winery. Kate and
Matt must have forecasted that they would need the extra cash badly enough to relinquish some control of the
business. If you look at the cash column you can see whythere is a large quantity of cash outflows.
11. Matt and Kate intend to buy grapes from the most respected local growers; and thus, they expect that their wines
will be well received by their customers. As a consequence, Matt and Kate believe that their ownership shares in
the business will be worth considerably more by the end of the year and that this should be reflected in the pro-
jected financial statements.
 Chapter 2 | From Accounting Events to Financial Statements 43

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 1,172 800 0 3,500 2,000 225 4,000 50 20 0 4,320 6,400 557
11

The winery records no transaction for this information. Even Brand names are not reported in the bal-
though a good company reputation and widely-recognized brand ance sheet unless purchased from other
name are valuable assets to a business, they are not recorded in the entities; in some countries (such as France),
financial statements. however, estimating the value of a brand
name and placing that asset on the balance
12. Federal income taxes were estimated to be $240,000 with 60 percent sheet is permitted.
being paid by year-end.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 1,172 800 0 3,500 2,000 225 4,000 50 20 0 4,320 6,400 557
12 144 96 240

In competitive business environments, it is often

Income taxes are a cost of doing business, and conse-
necessary to permit customers to buy goods and
quently, this expense must be matched with the winerys services on credit, allowing them to pay for the pur-
revenue; hence, retained earnings (SE) are reduced by chased goods over 30, 60, or even 90 days without
$240,000. Since the winery expects to pay $144,000 (60 incurring any interest charges. Extending credit to
percent of $240,000), cash (A) is reduced by $144,000 customers, however, carries a hidden cost to a busi-
and the remaining amount of $96,000 is still owed; thus, ness, called an opportunity cost. This opportunity
taxes payable (L) increase by $96,000. cost is equal to a businesss cost of borrowing over
the time period during which the purchase price re-
13. On the last day of the year, Kate and Matt expect to acquire
mains unpaid. We will have more to say about op-
$60,000 of new grape inventory in anticipation of the fol-
portunity costs in Chapter 5. You may also want to
lowing years production. The purchase would be on credit, read the appendix at the end of this book for insights
with payment terms of 30 days. about the time value of money.

Shareholders
Assets  Liabilities  Equity

Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Adj.
Bal. 1,028 800 0 3,500 2,000 225 4,000 50 20 96 4,320 6,400 317
13 60 60

Inventory (A) increases by $60,000 and, since this purchase is not immediately paid for, accounts payable (L)
increases by an equivalent amount.
44 Chapter 2 | From Accounting Events to Financial Statements

14. Matt and Kate expect to declare and pay cash dividends of $260,000.

Russian River Valley Winery Spreadsheet

Shareholders
Assets  Liabilities  Equity
Accounts Inven- Equip- Build- Accum. Intangible Accounts Taxes Loan Common Retained
Cash Receivable tory ment ings Deprec. Land Assets Payable Payable Payable Stock Earnings

Beg.
Bal. 4,700 0 0 2,000 0 4,000 100 0 0 4,800 6,000 0
1(a) 380 380
1(b) 360 360
2 1,500 1,500
3 2,000 2,000
4(a) 380 1,520 1,900
4(b) 720 720
5(a) 100 100
5(b) 300 300
6(a) 480 480
6(b) 288 288
7 380 380
8(a) 175 175
8(b) 50 50
9 50 50
10 400 400
11
12 144 96 240
13 60 60
14 260 260
End
Bal. 768 800 60 3,500 2,000 225 4,000 50 80 96 4,320 6,400 57

$10,953  $4,496  $6,457

The dividend that Matt and Kate expect to pay is a distribution of the winerys earned profit; hence, it reduces
cash (A) by $260,000 and retained earnings (SE) by $260,000. A dividend is considered to be a distribution of a
businesss earnings to its owners and not a cost of doing business; consequently, dividends are not considered in
the calculation of net income on the income statement, although they are reflected in the calculation of retained
earnings on the statement of shareholders equity.

Preparing the Financial Statements

Since all of the projected financial events for the first year of operations for the winery have been analyzed and the fi-
nancial effects entered into the spreadsheet, it is now possible to complete the spreadsheet by summing up the various
values in each of the columns. These final balances are entered in the row labeled ending balance. The completed
spreadsheet for the Russian River Valley Winery thus becomes the basis for preparing the companys basic financial
statements. The ending balance row of the spreadsheet, for example, provides the necessary inputs (the ending account
balances) for the winerys balance sheet as of the end of the first year of operations, and this statement is presented in
Exhibit 2.2.
 Chapter 2 | From Accounting Events to Financial Statements 45

EXHIBIT 2.2 An Illustrative Balance Sheet

Russian River Valley Winery, Inc.

Balance Sheet

Pre- End of Pre- End of

($ thousands) Opening Year 1 Opening Year 1

Assets Liabilities and shareholders equity

Current assets Current liabilities
Cash . . . . . . . . . . . . . . . . . . . . . . . . $ 4,700 $ 768 Accounts payable. . . . . . . . . $ 0 $ 80
Accounts receivable . . . . . . . . . . . . 0 800 Taxes payable. . . . . . . . . . . . 0 96
Inventory. . . . . . . . . . . . . . . . . . . . . 0 60 Loan payable-current . . . . . . 0 480
Total current assets . . . . . . . . . . . . 4,700 1,628 Total current liabilities. . . . . . 0 656
Noncurrent liabilities
Noncurrent assets
Loan payable-noncurrent . . . 4,800 3,840
Property, plant & equipment
Total liabilities . . . . . . . . . . . . 4,800 4,496
Equipment . . . . . . . . . . . . . . . . . . . 0 3,500
Buildings. . . . . . . . . . . . . . . . . . . . . 2,000 2,000 Shareholders equity
Land . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000 Common stock. . . . . . . . . . . 6,000 6,400
6,000 9,500 Retained earnings . . . . . . . . 0 57
Accumulated depreciation . . . . . . . 0 (225) Total shareholders equity . . 6,000 6,457
Property, plant & equipment (net). . 6,000 9,275 Total liabilities &
Intangible assets . . . . . . . . . . . . . . 100 50 shareholders equity. . . . . . $10,800 $10,953

Total noncurrent assets . . . . . . . . . 6,100 9,325

Total assets . . . . . . . . . . . . . . . . . . $10,800 $10,953

Exhibit 2.2 reveals that the winerys total assets are projected to grow from $10.8 million at the beginning of the
year to $10.953 million by year-end. By comparing the various account balances at the beginning of the year with
those at the end of the year, it is possible to identify just which accounts increased and which ones decreased. One of
the objectives in reviewing a companys balance sheet is not only to understand what assets and liabilities a company
has, but also whether and which of these accounts is increasing or decreasing.
Russian River Valleys balance sheets in
Exhibit 2.2 also provide information beyond In Practice 2.1 Balance Sheet Title: A Glimpse of a Sample of
just a listing of the companys assets, liabilities, Fortune 1000 Companies The following table identifies the title
shareholders equity, and whether their balances used on the balance sheet by a sample of 600 Fortune 1000 com-
panies. The title preferred by over 96 percent of the surveyed firms
changed over the fiscal period. The balance sheet
is balance sheet:
provides information, for example, about when
a businesss noncash assets are likely to be con-
verted into cash and when they are expected to
be consumed as part of the businesss regular
operations, as well as information about when its Balance Sheet 96.1%
Statement of Financial Position 3.7%
liabilities are likely to require payment. This in-
Statement of Financial Condition 0.2%
formation is evident from the classification of the
assets and liabilities into the categories of cur-
rent and noncurrent. Current assets are those
Source: 2006 Accounting Trends & Techniques
assets that are expected to be converted into cash
or used to support operations during the next 12
months, while noncurrent assets are those assets expected to be available to support the continuing operations of a
business for many years in the future. Current liabilities are those liabilities that are expected to require payment
46 Chapter 2 | From Accounting Events to Financial Statements

within the next 12 months, whereas noncurrent liabilities are obligations that are not expected to require payment for
more than one year. The phrase long-term is often used instead of noncurrent.
Notice in Exhibit 2.2 that since the second annual principal payment of $480,000 on the winerys outstanding
bank loan is due within 12 months of the date when the balance sheet is prepared, this amount is reclassified from
the noncurrent liabilities section of the balance sheet to the current liabilities section of the winerys balance sheet.
This reclassification is important because it will enable Kate and Matt to fully understand just how much cash will be
needed to satisfy the various claims against the business in the coming year.
Can other information be obtained from the Russian River Valley Winery spreadsheet? Recall that the retained earn-
ings column of the spreadsheet contained all of the revenue and expenses of the business. Thus, an income statement can
be readily prepared from data contained in the retained earnings column of the spreadsheet. The income statement for the
first year of operations for the winery is presented in Exhibit 2.3.

EXHIBIT 2.3 An Illustrative Income Statement

Russian River Valley Winery, Inc.

Income Statement
($ thousands) Year 1

Revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,900
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,520
Operating expenses
Wages and salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Selling & administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 845
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 317

Like the balance sheet, the Russian River Valley income statement provides a number of useful pieces of informa-
tion. For instance, the income statement highlights several key measures of firm performance: revenues, gross profit,
operating income, and net income. Revenues measure the inflow of cash and other assets (such as, accounts receiv-
able) from a firms primary business activity. Gross profit, on the other hand, measures the amount of cash and assets
remaining after deducting the cost of sales, or what is often called the cost of goods sold. Operating income refers to
a firms net income before deducting such items as interest expense and income taxes; and, net income is the firms
bottom-line performancethe businesss net income after all expenses are deducted, both operating and nonoperat-
ing, recurring and non-recurring.
Observe that the top section of the income statement, through operating income, reflects the results of the companys
primary business activitiesthat is, the winerys core business of producing and selling wine, which is often referred to
as its recurring operations. The section below operating income reflects the financing activities of the business and any
non-recurring operations. The winery doesnt expect to have any non-recurring activities for the year but it does expect
to have costs associated with financing its business, namely interest expense on the outstanding bank loan. The winerys
net income of $317,000 is the bottom line profit available to shareholders. The management of a business must decide
whether to reinvest these earnings in the business or to distribute them to shareholders as a dividend, and this decision is
reflected in the statement of shareholders equity.
 Chapter 2 | From Accounting Events to Financial Statements 47

The statement of shareholders equity reveals In Practice 2.2 Income Statement Title: A Glimpse of a Sample
how the shareholders direct investment in a busi- of Fortune 1000 Companies The following table identifies the
ness increased (decreased) due to the companys title used on the income statement by a sample of 600 Fortune
sale (repurchase) of its own common stock and 1000 companies. The survey shows that income statement and
how the retained earnings of a business were in- statement of operations are almost equally preferred by the sur-
creased by net income and decreased by any net veyed firms:
losses or dividends paid to shareholders. A state-
ment of shareholders equity for the Russian River
Valley Winery is presented in Exhibit 2.4. Like the Income Statement 42.5%
income statement, the information needed to pre- Statement of Operations 42.3%
pare a statement of shareholders equity is available Statement of Earnings 14.4%
from the shareholders equity columns of the win- Other 0.8%
erys spreadsheet. Exhibit 2.4 shows that the winery
expects to begin the year with a zero balance in re-
tained earnings but is expected to end the year with Source: 2006 Accounting Trends & Techniques

a balance of $57,000, and that the winery expects to

begin the year with $6 million in common stock but
is expected to end the year with a balance of $6.4 million. Notice how these figures reconcile with the data reported for
retained earnings and common stock on the winerys balance sheet in Exhibit 2.2. In accounting jargon, we say that the
data from the statement of shareholders equity articulate with the data from the winerys balance sheet.

EXHIBIT 2.4 An Illustrative Statement of Shareholders Equity

Russian River Valley Winery, Inc.

Statement of Shareholders Equity
Common Retained
($ thousands) Stock Earnings Total

Balance at beginning of Year 1. . . . . . . . . . . . . . . . . . . . . $6,000 $ 0 $6,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 317
Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (260) (260)
Sale of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 400
Balance at end of Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . $6,400 $ 57 $6,457

In addition to generating profits, a business must make sure that its profits translate into cash so that cash is avail-
able to pay the businesss expenses and obligations as they come due. The information about a companys available
cash flow can be obtained from its statement of cash flow, which can be prepared from the cash inflows and outflows
reported in the cash column of the completed spreadsheet. Exhibit 2.5 presents a statement of cash flow for the Rus-
sian River Valley Winery. Notice that all of the cash inflows and outflows from the cash column of the spreadsheet are
included in this statement.
The statement of cash flow classifies a businesss cash flow into the three activity categories of operating, invest-
ing, and financing, which correspond to the main activities of any business. The operating activities section provides
information about the day-to-day cash inflow and outflow from core business operations. The investing activities
section contains information about the purchase and sale of long-term assets by the firm. This section provides insights
about a companys investment strategy. Finally, the financing activities section provides information regarding how
a business was financed during the period, for example whether the company raised cash from issuing debt or equity
or used cash to repay debt or buy back its shares. This section provides insight about a firms financing strategy.
Notice that the cash dividend paid to shareholders is included in the financing section, yet the cash paid for interest
on the bank loan is listed in the operating section. Under the accounting rules of most countries, interest expense is an
operating cash outflow, whereas dividends are a financing cash outflow. Finally, notice that the bottom line of the
48 Chapter 2 | From Accounting Events to Financial Statements

EXHIBIT 2.5 An Illustrative Statement of Cash Flow

Russian River Valley Winery, Inc.

Statement of Cash Flow
($ thousands) Year 1

Operating activities
Cash receipts
Cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 380
Cash collections on account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100
Cash disbursements
Cash payments for inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
Cash payments for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Cash payments for wages & salaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Cash payments for selling & administrative. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Cash payments for taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
Total cash disbursements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,192
Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92)
Investing activities
Purchases of property, plant & equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,500)
Cash flow from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,500)
Financing activities
Sale of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Repayment of loan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (480)
Payment of common stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (260)
Cash flow from financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (340)
Net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,932)
Cash balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700
Cash balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 768

Change in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(3,932)

statement of cash flowthe net cash flow for the periodequals the change in the cash account from a companys
balance sheet. In the case of the Russian River Valley Winery, the change in cash as reported in Exhibit 2.2 is negative
$3,932 ($768  $4,700  $3,932). In essence, a statement of cash flow provides the detailed information to explain
how and why the cash account on the balance sheet changed from the beginning of the fiscal period to the end. We will
have more to say about the statement of cash flow in Chapter 3.
At this point, Kate and Matt can see a complete financial projection of how they anticipate that their business
will perform during the first year of operations. Kate and Matt are likely to be pleased with the projected net income
of $317,000; however, they are also likely be concerned about the large outflow of cash as shown on the statement of
cash flow. Kate and Matt can explain most of the decrease in their cash balance as a necessary consequence of pur-
chasing property, plant, and equipment, investments that are necessary for a young, growing company. They should be
concerned, however, that they are also spending more cash on normal operating activities than they are taking in from
these activities. As a consequence, Kate and Matt may wish to examine some alternative strategies for their business
plan, such as the way that they price their products for sale or their policies regarding extending credit to, and collect-
ing from, their customers.

Articulation of the Financial Statements

It should be apparent at this point that the basic financial statements of the Russian River Valley Winery are highly in-
terconnected and are not independent from one another. In accounting parlance, we refer to this interconnectedness as
 Chapter 2 | From Accounting Events to Financial Statements 49

articulation. Using the schematic from Exhibit 1-5 in Chapter 1, the articulation of the Russian River Valley Winerys
basic financial statements can be illustrated as follows:

Change in
Cash: ($3,932)

Cash flow from operations ($92)

Cash flow for investing ($3,500)
Cash flow for financing ($340)
Change in cash ($3,932)

Statement of Cash Flow

Balance Sheet Balance Sheet
(beginning of year) (end of year)

Cash $4,700 Liabilities $4,800 Cash  $768 Liabilities  $4,496

Shareholders Equity Shareholders Equity
Other assets $6,100 Common stock  $6,000 Other assets  $10,185 Common stock  $6,400
Retained earnings  $0 Retained earnings  $57

Income Statement
Revenues $1,900
Expenses (1,583) Dividends
Net Income $317  $260

Change in Shareholders Equity:

Common stock: $6,000  $400  $6,400
Retained earnings: $0  $317  $260  $57
Statement of Shareholders Equity

Notice that: The divergent treatment of interest, the

The change in the cash account ($3,962) on the balance sheet from cost of debt financing, and dividends, the
the beginning of the year to the end of the year equals the sum of cost of equity financing, in the statement of
the cash flow from operations ($92), the cash flow from investing cash flow is attributable to the fact that a
($3,500), and the cash flow from financing ($340) on the state- statement of cash flow is prepared from the
ment of cash flow. perspective of shareholders, reporting the
residual cash flows from operations accru-
The change in retained earnings ($57) on the balance sheet equals the ing to the owners after all expenses have
sum of the beginning balance ($0) in retained earnings plus net in- been paid but before any cash distributions
come ($317) from the income statement less any dividends ($260) for dividends have been made.
paid to shareholders.
The change in shareholders equity ($457) on the balance sheet equals the change in retained earnings ($57) plus
the change in common stock ($400) as reported on the statement of shareholders equity.

Although the basic financial statements articulate with one another, they present different types of information
about a business. The income statement, for example, describes a firms operating performance for the current fis-
cal period, whereas the balance sheet describes the firms financial condition as of the beginning or end of the fiscal
period. The statement of shareholders equity, on the other hand, describes how the shareholders investment changed
over the period, and the statement of cash flow explains why (and how) one very important business assetcashin-
creased or decreased over the fiscal period. Like the income statement, the statement of cash flow also describes the
firms operating performance for the current period. The difference between these statements, however, relates to the
50 Chapter 2 | From Accounting Events to Financial Statements

definition of firm operating performance. The income statement defines firm performance in terms of accrual net
earnings whereas the statement of cash flow defines performance in terms of operating cash flow. Thus, although
interconnected, the financial statements each depict a different aspect of a businesss financial information. It is also
important to note that the balance sheet is at a period in time, sometimes referred to as a snapshot. In contrast, the other
statements are reported for a period of time, such as a year.

Accounting Policy Decisions at Russian River Valley Winery

While identifying the expected future events for the winery, Matt and Kate implicitly made a number of accounting
policy decisions that affected the forecasted financial statements of the winery, and thus, its likelihood of getting the bank
loan. For example, by assuming that all of the $800,000 of outstanding accounts receivable at year-end was reasonably
assured of collection, the winerys net income is potentially overstated. For most businesses, the existence of unpaid ac-
counts receivable will usually mean that some future losses can be anticipated for uncollectible accounts. By not estimat-
ing what these losses might be, and by not matching those potential losses with the related operating revenue, Kate and
Matt may have allowed the winerys projected performance for the first year of operations to be overstated.
Further, depreciation on the equipment and buildings was estimated by Matt and Kate based on expected useful
lives of 20 and 40 years, respectively. If Kate and Matt overestimate the length of the useful lives of these assets, the
annual depreciation expense on the income statement will be understated and projected net income overstated. Finally,
the expected life chosen to amortize the start-up costs was estimated to be two years. If Kate and Matt underestimate this
expected life, the amortization expense will be overstated and the winerys net income understated.
These policy choices illustrate a little appreciated fact about accounting: Financial statements require managers to
make many estimates and assumptions which may prove incorrect, and consequently, cause the financial statements to
incorrectly characterize a companys performance. Because of the many estimates and assumptions inherent in preparing
financial statements, it is wise to remember that accounting data, and hence, the financial statements themselves, are not
precise descriptions of a businesss financial performance.
To illustrate this point, consider the following statement from the General Motors Corporation annual report
to shareholders:
The consolidated financial statements of GM are prepared in conformity with generally accepted accounting prin-
ciples, which require the use of estimates, judgments and assumptions . . . . Management believes that the ac-
counting estimates employed are appropriate and resulting balances are reasonable; however, actual results could
differ from the original estimates, requiring adjustments to these balances in future periods.

GLOBAL PERSPECTIVE
The preparation of financial statements around the world proceeds in exactly the same fashion. Not surprisingly, however, some
differences in the actual format of the financial statements and in the labels used to describe various financial statement ac-
counts do arise. For example, in North America, the labels revenue and sales are used to describe the value of the goods
sold by a company as reported on its income statement. In the United Kingdom, however, the label turnover is used instead
to represent the sales of a business. These labeling differences are superficial and in no way alter the content or purpose of
the basic financial statements. In essence, worldwide, an income statement is an income statement; and, a balance sheet is a
balance sheet!

EVALUATING BUSINESS PERFORMANCE AND

MAKING FINANCIAL DECISIONS
Producing financial statements about a business is important, particularly if those statements are useful in decision-
making. Matt and Kate would certainly be interested in using the financial statement information in Exhibits 2.2, 2.3,
2.4, and 2.5 to decide whether they should proceed with their proposed winery. Similarly, Bob Buck of Hap e-Loan
Corporation will find the data in the forecasted financial statements invaluable in helping to decide whether lending
 Chapter 2 | From Accounting Events to Financial Statements 51

money to Russian River Valley is a prudent idea. While a businesss own- Financial ratios are frequently used to eval-
ers are primarily interested in the profitability of the business, a financial uate firm performance. They permit valid
institution is primarily interested in assessing the financial risk that it will comparisons of performance over time or
be exposed to when lending to a business. But how can the financial state- between competitors. By dividing one ac-
ments help us learn about business profitability and the risks inherent in counting measure (such as, net income) by
lending to a business? Stated alternatively, how can financial statements a second accounting measure (such as, net
help us make investment and lending decisions? sales), the resulting ratio is standardized,
thereby enabling an apples-to-apples
comparison of firm performance.
Evaluating Firm Profitability
To evaluate the profitability of a business, it is often useful to consider various performance indicators from the financial
statements. To illustrate, lets consider the most basic measure of firm performancewhether a business made a profit.
The income statement in Exhibit 2.3 shows that net income for the Russian River Valley Winery is indeed expected to be
positivenet income is projected to be $317,000 for its first year of operations. Thats good news! But just looking at the
absolute level of profits ignores how much investment it took to generate those profits. In addition, it is hard to compare
the performance of firms of different sizes or of a company over time by just comparing the level of their profits. For
example, one would certainly expect a firm such as General Electric, with over $670 billion dollars in reported assets,
to have a higher level of profit than a small winery. With far greater levels of sales and investments, it is only natural for
General Electric to show a higher level of profit. Consequently, the use of financial ratios provides one approach to mak-
ing useful comparisons of performance between firms of differing size and for a given firm over various time periods.
One profitability measure that considers relative firm size is the return on sales ratio (ROS), or net income di-
vided by sales revenue:1

Ratio Financial Variables Computation Result

Net income
____________ $317
______
Return on sales (ROS) 16.7%
Sales revenue $1,900

The ROS ratio, which is also referred to as the profit margin ratio, for the Russian River Valley Winery is forecasted to
be 16.7 percent, which indicates that for every dollar of sales revenue, the winery is expected to generate nearly 17 cents
of bottom-line profit. You dont have to know much about wineries to recognize that a 16.7 percent return on sales is quite
high. But to be certain, it would be wise to compare the Russian River Valley Winerys ROS against the ROS for other
small wineries or against the average ROS for the wine industry. By making such inter-firm and industry comparisons,
it is possible to more clearly benchmark the winerys performance and to determine how successfully the business is
expected to perform.
Another measure of profitability that considers relative firm size is the return on assets (ROA) ratio, or net in-
come plus after-tax interest expense divided by total assets:

Ratio Financial Variables Computation Result

Return
[Net income  Interest expense  (1  Tax rate)] $317  $288  [1  ($240/$557)]
on assets _________________________________________ __________________________ 4.4%
Total assets $10,953
(ROA)

1
Some investment professionals calculate the ROS ratio on an unlevered basis as follows:
Net income  Interest (1  Tax rate)
Unlevered ROS  _______________________________
Net sales
Unlevering the ROS ratiothat is, adding the interest expense paid by a company net of the tax benefit of the interest expense back to net in-
comecreates a measure of net income as if the company were all equity financed. This alternative measure of ROS allows the analyst to focus on
the efficacy of managements operating decisions independent of managements financing decisions. We will have more to say about unlevered
ROS in Chapter 4.
52 Chapter 2 | From Accounting Events to Financial Statements

The return on assets ratio represents the amount of earnings available to a businesss capital providers, to include
both its lenders and its shareholders. Since lenders obtain their return in the form of interest payments, and since
this expense is subtracted in the calculation of net income, it is necessary to add the interest expense back to net
income to produce a measure of the total return available to a firms capital providers. Interest expense, however,
is tax deductible by the business, and therefore, effectively reduces a firms total income tax expense. The positive
impact of interest expense on a firms income tax expense is referred to as a tax shield. In order to correctly ac-
count for the tax shield, the amount of interest added back to net income should be reduced by the amount of the
tax shield which is already reflected in a firms income tax provision, and hence, in its net income. The income
tax rate used in this calculation is the companys effective tax rate, or a firms tax expense divided by its income
before income taxes. Note that no such adjustment is needed for dividends paid to shareholders since dividends
are not tax deductible and are not subtracted in the calculation of net income, and consequently, do not need to be
added back.
Russian River Valleys expected ROA, also referred to as the return on investment, is 4.4 percent, indicating that
it takes about $1 of assets to generate about four and a half cents of net income. Is that good? One benchmarkthe
six percent interest rate (but only 3.4 percent after considering the interest tax shield) to be charged by Hap e-Loan
Corporation on the proposed bank loansuggests that the winerys expected ROA is quite low. While the winery
will earn slightly more than its 3.4 percent after-tax cost of borrowed funds, this is not a very large margin.2 The low
projected ROA for Russian River Valley may indicate several thingsthat the wine business is highly competitive,
producing only marginal returns, or alternatively, that the winerys business model needs more work to enable the
business to be more profitable.
From a shareholder perspective, the size of a businesss profit relative to the shareholders investment in the busi-
ness is an important measure of profitability, and this can be evaluated by the return on shareholders equity (ROE)
ratio, or net income divided by shareholders equity.3 This ratio indicates how much profit was generated given the
shareholders investment in a business:

Ratio Financial Variables Computation Result

Net income
_________________ $317
______
Return on equity (ROE) 4.9%
Shareholders equity $6,457

The Russian River Valley Winerys expected ROE is 4.9 percent, which indicates that for every dollar of share-
holders equity invested in the winery, the business is expected to generate less than five cents of profit for its share-
holders. This is a little higher than the after-tax 3.4 percent interest rate to be charged by Hap e-Loan Corporation on
the bank loan, yet Matt and Kate bear much more risk than the lender. (Recall that assuming higher risk should result
in higher returns.) We can tentatively conclude that this expected return is high enough to justify the investment that
Kate and Matt will have to make. But, the two entrepreneurs will certainly want to focus on ways of improving the
profitability of the business and its ROE.

2
Russian River Valleys after-tax cost of borrowed funds is calculated as follows:
After-tax cost of borrowing  Before-tax cost of borrowing  (1  Tax rate)
In the case of Russian River Valley, the effective tax rate is 43 percent ($240/$557); hence, the after-tax cost of borrowing is:

3.4%  6.0%  (1  .43)

3
Many investment professionals define the return on shareholders equity (ROE) ratio as:
Net income  Preferred stock dividends
ROE  _________________________________
Common shareholders equity
This ratio definition reflects the widely held view that preferred stock is a quasi-form of debt, and hence, the cost of preferred stock (preferred
stock dividends) should be subtracted from net income just as the cost of debt financing (interest expense) is subtracted from net income. Common
shareholders equity is then defined as total shareholders equity less preferred stock equity. Since many firms do not issue preferred shares, the
ROE ratio collapses to just net income divided by shareholders equity. In addition, some ratios, like ROE, include a metric in the numerator that is
measured over time (such as net income) and a metric in the denominator that is measured at a point in time (such as shareholders equity). Because
of this mismatch of the time dimension of a ratios components, some analysts use averages, rather than ending balances, for the denominator of
these ratios.
 Chapter 2 | From Accounting Events to Financial Statements 53

Return on Equity Analysis

Investment professionals have devised an ingenious way of analyzing the profitability of a business by breaking the
return on shareholders equity (ROE) ratio into three component financial ratiosthe return on sales, asset turnover,
and financial leverage:

Return on
Shareholders
Equity

Return on Asset Financial

Sales  Turnover  Leverage

This paradigm reveals that there are four ways to improve a Financial leverage refers to the use of debt to finance
companys ROE, and hence, a firms profitability: 1) improve a a business assets and/or its operations. The cost of
businesss return on sales; 2) improve a businesss asset turnover; debt financing is defined as the rate of interest speci-
3) improve a businesss use of financial leverage; or, 4) some fied in a debt contract. If a firm is able to earn a return
combination of items 1, 2, and 3. Asset turnover is a measure of on its borrowed assets greater than its after-tax cost
how effectively a businesss assets are being used by the manage- of borrowing, the excess return accrues to the firms
ment team to generate sales revenue. This ratio is calculated as shareholders. And, as a consequence, a companys
ROE will exceed its ROAfor example, 4.9 percent
sales revenue divided by total assets. This metric is an important
versus 3.4 percent for The Russian River Valley Win-
indicator of firm performance since the principal objective of any
ery. Thus, when we observe that a firms ROE exceeds
business is to generate income, and that is only possible after the its ROA, we can conclude that the firm has been able
business first generates operating revenue. Financial leverage, to successfully utilize financial leverage.
on the other hand, refers to the relative mix of debt versus equity
financing used by a business and is calculated as total assets di-
vided by shareholders equity. Since the after-tax interest rate on the winerys debt is only 3.4 percent, financing some
of the Russian River Valleys assets with debt takes advantage of this cheaper source of financing.4 We can apply ROE
analysis to the winerys forecasted financial data as follows:

Return On Equity  Return On Sales  Asset Turnover  Financial Leverage

Net income Net income Sales revenue Total assets
_________________  ____________  ____________  _________________
Shareholders equity Sales revenue Total assets Shareholders equity
$317 $317 $1,900 $10,953
______  ______  _______  _______
$6,457 $1,900 $10,953 $ 6,457
4.9%  16.7%  0.173  1.70

The ROE analysis for the Russian River Valley Winery reveals why the winerys expected return on equity (4.9
percent) is low. Although the winerys expected ROS is a healthy 16.7 percent, Russian River Valleys expected asset
turnover is only 0.173, which indicates that each dollar invested in the businesss assets is expected to generate less
than 18 cents in sales. Further, the winery has a financial leverage ratio of 1.70, indicating that the winerys assets are

4
For all businesses, the cost of debt financing is cheaper than the cost of equity financing. Recall that since buying shares in a business is riskier
than lending to a business, the returns expected by shareholders should be higher than the returns expected by lenderslenders have first claim on
the assets of a business and shareholders get what is left over.
54 Chapter 2 | From Accounting Events to Financial Statements

forecasted to be about 1.7 times the amount of shareholders equity invested in the business. Put another way, the Rus-
sian River Valley Winery assets are financed with relatively more equity ($6,457) than debt ($4,496). Since the winery
is able to earn a slightly higher return on its borrowed funds than the after-tax cost that the business will be charged for
the use of these funds, the winerys expected ROE is enhanced by its use of financial leverage.
To enable us to benchmark the expected performance of the winery, Exhibit 2.6 presents an ROE analysis for ten
wine companies over a recent five-year period. The data confirms the assessment that Russian River Valley has a low
expected return on equity and asset turnover but a relatively high expected return on sales, as compared to the average
of the other ten wineries. Observe, for instance, that while the expected ROS for Russian River Valley is 16.7 percent,
it averages only about 6.3 percent for the ten wineries; and, while Russian River Valleys expected asset turnover is
only 0.173, it averages 0.59 for the ten wineries, or more than three times higher than the turnover forecasted by the
winery. This kind of information can be very useful to Kate and Matt in that it highlights the various financial strengths
and weaknesses of their proposed business, and thus, highlights those areas in which Matt and Kate should try to im-
prove their business plan. We will have more to say about ROE analysis in Chapter 4.

EXHIBIT 2.6 ROE Analysis: Median Values for 10 Firms in the Wine Industry

Return On Equity  Return On Sales  Asset Turnover  Financial Leverage

7.97%  6.28%  0.59  2.15
Source: Compustat

Evaluating Financial Risk

The concern that the Russian River Valley Winery may have insufficient cash to pay its annual interest payments and
repay the principal on its proposed bank loan on a timely basis are the types of financial risk that financial institutions
must consider when lending to a business. Two financial ratios that assess this form of risk include the long-term
debt-to-equity ratio and the interest coverage ratio:

Ratio Financial Variables Computation Result

Long-term debt
_________________ $4,320
______
Long-term debt-to-equity 0.67
Shareholders equity $6,457
Operating income
_______________ $845
_____
Interest coverage 2.93
Interest expense $288

The long-term debt-to-equity ratio reveals the relative investment of long-term lenders versus that of the share-
holders in the Russian River Valley Winery. A high debt-to-equity ratio, for example, indicates a financing strategy
heavily dependent on borrowed versus shareholder-invested funds. The interest coverage ratio, on the other hand,
reveals the extent to which current operating earnings cover current debt service charges (interest expense). A high
interest coverage ratio, also referred to as the times-interest-earned ratio, indicates that a business has strong operat-
ing earnings (or low interest charges), and thus, has the capacity to take on additional debt and additional debt service
costs, as well as to easily service its existing debt.
The Russian River Valley Winerys expected long-term debt-to-equity ratio is 0.67, indicating that its long-term
debt of $4,320 ($3,840  $480) is about two-thirds the amount of its shareholders equity of $6,457. The winerys
expected interest coverage ratio is 2.93, suggesting that the winerys operating income is projected to be almost three
times the expected interest expense for the period. Both ratios indicate that there is a fair amount of cushion for the
businesss lenders. Overall, with a reasonable debt-to-equity ratio and interest coverage ratio, the winery should have
a good chance of getting the proposed $4.8 million loan because it appears to have a good chance of paying both the
annual interest charge and principal repayments in a timely manner.
 Chapter 2 | From Accounting Events to Financial Statements 55

MANAGERIAL DISCRETION AND

ACCOUNTING METHODS
The balance sheet equation used for analyzing the various accounting events of a business can be helpful in under-
standing the accounting method choices that a company makes and how those choices affect a businesss financial
statements. To illustrate, we use the balance sheet equation to examine how B.J.s Wholesale Club accounted for the
membership fees it charges its customers and how America Online accounted for the cost of computer diskettes it used
to attract new internet customers.

Operating Revenues at B.J.s Wholesale Club

B.J.s Wholesale Club Inc. is a wholesale membership club in the United States. Customers pay an annual fee of $45
for the right to shop at any of B.J.s outlets which offers its customers lower prices on goods which it buys in very
large quantities. B.J.s accounts for the $45 membership fee as operating revenue when it is received. To illustrate
the financial effects associated with this practice, assume that a customer paid the $45 fee on July 1, halfway through
B.J.s fiscal year which ends on December 31. B.J.s would report the event by increasing cash (A) by $45 and increas-
ing operating revenue and retained earnings (SE) by $45 (see Panel A, Exhibit 2.7).

EXHIBIT 2.7 B.J.s: Accounting for Membership Fees

Panel A
Cash Liabilities Retained Earnings

July 1 . . . . . . . . . . . . . . . . . $45.00 $45.00

Ending Balance . . . . . . . . . $45.00 $45.00

Panel B
Cash Liabilities Retained Earnings

July 1 . . . . . . . . . . . . . . . . . $45.00 $45.00

December 31 . . . . . . . . . . . $22.50 $22.50
Ending Balance . . . . . . . . . $45.00 $22.50 $22.50

B.J.s accounting for membership fees, however, came under criticism from the U.S. Securities and Exchange
Commission which required that the company abandon the practice and instead recognize the fee ratably over the
12-month membership period.5 Under the new accounting policy, on July 1, B.J.s would show an increase in cash of
$45 and an increase in a liability account (called unearned revenue) of $45 to recognize B.J.s obligation to provide
member services to its customer for the coming year (see Panel B). By December 31, B.J.s has satisfied six months
(or one-half) of its obligation and thus, would recognize $22.50 of operating revenues and a reduction in the liability
for future services of $22.50. At the end of the year, B.J.s has a remaining liability of $22.50 for services it has agreed
to provide for the next six months.
Lets compare B.J.s former accounting policy with its new policy by contrasting the account balances in Panels
A and B in Exhibit 2.7. The former policy increases earnings by $22.50 for the year, reduces liabilities by $22.50, and
increases shareholders equity by $22.50. Thus, under the old policy, the performance of the company appears supe-
rior. Yet, the cash flows under both accounting policies are identical.
An astute observer might notice that with no new customers next year, the old accounting policy will result in zero
earnings in Year Two. This observation highlights a fundamental difference between accrual accounting and cash ac-
counting. Accrual accounting, with its adherence to revenue recognition and expense matching, creates timing differ-
ences between earnings recognition and cash flows. Over the two-year period, there will be no difference in cumulative

5
Some investment professionals refer to B.J.s original accounting treatment of its membership fees as front-end loading of revenues. Under this
practice, the cash flows from the sale of a membership are immediately recognized as revenue even though some portion of the revenue may relate
to services to be delivered in a future period.
56 Chapter 2 | From Accounting Events to Financial Statements

net income; but, under B.J.s new accounting policy, earnings will be $22.50 in the second year. Thus, the new policy
shifts some revenues and earnings from the current year to the following year but does not change the total revenues
or earnings over the two-year period. But suppose there are more customers in each succeeding yearthen earnings
will be higher under the old accounting policy than under the new accounting policyand B.J.s management team
will appear to be doing a better job.

Operating Expenses at America Online

America Online (AOL) was a pioneer internet service provider that blanketed the United States with computer
diskettes to entice customers to sign up for the companys service. For accounting purposes, AOL accounted for the
cost of the diskettes as an asset on the balance sheet, called deferred marketing costs, and expensed the resulting
asset over a two-year period.6 To see the effect of this accounting policy on AOLs balance sheet, assume that it costs
$2 to produce and distribute each AOL diskette and that a diskette is shipped on January 1. (AOLs fiscal year ends on
December 31.) On January 1, AOL reduces cash (A) by $2 and increases intangible assets (A) by the same amount. On
December 31, AOL expenses $1 by reducing intangible assets by $1 and reducing retained earnings (SE) by $1. These
events are illustrated in Panel A of Exhibit 2.8.

EXHIBIT 2.8 AOL: Accounting for Advertising Costs

Panel A
Intangible
Cash Asset Retained Earnings

June 30. . . . . . . . . . . . . . . . $2.00 $2.00

December 31 . . . . . . . . . . . $1.00 $1.00
Ending Balance . . . . . . . . . $2.00 $1.00 $1.00

Panel B
Intangible
Cash Asset Retained Earnings

June 30. . . . . . . . . . . . . . . . $2.00 $2.00

Ending Balance . . . . . . . . . $2.00 $2.00

After repeated criticism from Wall Street analysts regarding this policy, AOL switched to immediately expensing
the cost of the diskettes. Under immediate expensing, AOL would reduce cash (A) by $2 for the cost of a diskette and
reduce retained earnings (SE) by the same amount. The event would be recorded as shown in Panel B of Exhibit 2.8.
Contrasting the account balances from Panels A and B of Exhibit 2.8 reveals the effect of AOLs decision to
change its accounting policy. Immediately expensing the cost of the diskettes reduces assets on the balance sheet by
$1 at December 31 and reduces earnings for the year by $1. Yet, there is no cash flow effect associated with the change
since cash is initially reduced by $2 under both methods. Over a two-year period, there is no difference in AOLs per-
formance under the two policies; however, under the old policy, net income is higher in Year One.
In both examplesB.J.s and AOLthe selection of a firms accounting policies can materially impact re-
ported firm performance, in many instances making the operating performance look better than it really was. A theme
throughout each of the following chapters is that informed financial statement users must look beyond the reported
numbers and also consider the accounting policy choices made by a companys management. Evaluating a companys
profits without knowledge of how that number is derived is like reporting the temperature on a given day without
understanding what temperature scale was usedCentigrade or Fahrenheit (32 degrees Fahrenheit is quite cold while

6
Some investment professionals refer to AOLs treatment of deferred marketing costs as rear-end loading of expenses. Under this practice, the
cash outflows for advertising and marketing are capitalized to the balance sheet as an asset even though some (or all) of the expenditure should be
currently recognized on the income statement as an expense.
 Chapter 2 | From Accounting Events to Financial Statements 57

32 degrees Centigrade is quite pleasant). As we will see from actual corporate examples, some managers will make
judicious accounting policy choices in an attempt to manage the level of reported firm performance, and consequently,
to influence the perceived value of a firm.

ETHICS PERSPECTIVE
B.J.s Wholesale Club Inc. and America Online represent two examples of how managers can use their discretion to manage
the reported earnings of a firm. Much of this discretion is within the flexible guidelines that are part of the institutional setting of
accounting; however, sometimes managers cross the line of acceptable accounting practice and engage in fraudulent reporting.
Very often the line between the two is quite grey, where it is difficult to separate aggressive financial reporting from fraudulent
financial reporting. In either case, it can be argued that the intent of some corporate managers is to deceive the investing public
by misrepresenting a firms financial performance.
In the post-Enron environment, and with the enactment of the Sarbanes-Oxley Act, many firms are proactively portraying
themselves as being ethical. Ethical behavior is, for example, part of the Corporate Social Responsibility movement. This be-
havior includes many dimensions, including the ethical treatment of employees and the environment, as well as ethical financial
reporting. Academic research has found a positive correlation between a firms reputation and its financial performance. Do
you feel that strong ethics makes good business sense? Why do you think that there is a positive correlation between ethical
behavior and successful corporate financial performance?

REVIEW PROBLEM
The Arcadia Company was founded by Thomas Smith and began operations in July 2006 as a neighborhood hardware store,
selling branded lawn and garden supplies, household products, and small tools. The following transactions occurred during
the second half of 2006:
1. Smith established The Arcadia Company by contributing $250,000 of his personal funds and receiving all of the com-
panys capital stock in return for his equity investment.
2. The company purchased a small shop in a strip mall for $150,000 cash.
3. Needing working capital to purchase inventory, the company borrowed $120,000 cash from a local bank, using the
recently purchased store as collateral for the loan. Interest on the loan was set at six percent per year, payable every six
months. The loan could be repaid at any time, but full loan repayment was required within three years.
4. Smith used the entire loan amount of $120,000 to purchase inventory. In addition, he purchased $30,000 of inventory on
credit. By the end of 2006, all but $6,000 of the credit purchase had been repaid.
5. Smith decided to use a simple rule-of-thumb for pricing his inventory for saleall goods would be marked up 100 per-
cent above their cost. By year-end, Smith noted that he had sold inventory with a cost basis of $80,000. All sales were
for cash or on a debit/credit card.
6. Smith decided to depreciate his shop on a straight-line basis, using an expected useful life of 20 years.
7. During the latter half of 2006, Smith withdrew $20,000 in cash from the business as his salary.
8. Ignore all taxes when answering the following questions.

Required
1. Prepare a spreadsheet for The Arcadia Company using the balance sheet equation, reflecting the financial effects of the
above transactions.
2. Prepare an income statement, balance sheet, and statement of cash flow for The Arcadia Company at the end of the first
year of operations.
3. Compute for the Arcadia Company the following ratios; (1) Return on Sales, (2) Return on Assets, (3) Return on Equity.
4. Show that Return on Equity is equal to the multiplicative combination of Return on Sales, Asset Turnover, and Financial
Leverage. Note: If treated as corporation, the business would be owe payroll taxes on the wages paid to owner, unless
money is paid out as dividends.
58 Chapter 2 | From Accounting Events to Financial Statements

Solutio n
The Arcadia Company
Spreadsheet

Assets  Liabilities  Shareholders Equity

Accum. Accts Loan Capital Retained

Cash Inventory Building Deprec Payable Payable Stock Earnings

1 250,000 250,000
2 150,000 150,000
3a 120,000 120,000
3b 3,600 3,600 (E)*
4a 120,000 120,000
4b 30,000 30,000
4c 24,000 24,000
5a 160,000 160,000 (R)**
5b 80,000 80,000 (E)
6 3,750 3,750 (E)***
7 20,000 20,000 (E)

212,400 70,000 150,000 3,750 6,000 120,000 250,000 52,650

* ($120,000  .06)/2  $3,600

** $80,000  2  $160,000
*** ($150,000/20)/2  $3,750

The Arcadia Company

Income Statement

Revenues . . . . . . . . . . . . . . . . . . . . . . . $160,000
Less: Cost of goods sold. . . . . . . . . . . 80,000
Depreciation expense . . . . . . . . 3,750
Wage expense . . . . . . . . . . . . . . 20,000
Interest expense. . . . . . . . . . . . . 3,600
Net income . . . . . . . . . . . . . . . . . . . . . . $ 52,650

The Arcadia Company

Balance Sheet

Assets Liabilities
Cash . . . . . . . . . . . . . . . . . . $212,400 Accounts payable. . . . . . . . $ 6,000
Inventory. . . . . . . . . . . . . . . 70,000 Loan payable . . . . . . . . . . . 120,000
Total current assets . . . . . . 282,400 Total liabilities . . . . . . . . . . . 126,000
Building . . . . . . . . . . . . . . . 150,000 Shareholders equity
Less Accum. deprec. . . . . . (3,750) Capital stock . . . . . . . . . . . 250,000
146,250 Retained earnings . . . . . . . 52,650
Total . . . . . . . . . . . . . . . . . . 302,650

Total assets . . . . . . . . . . . . $428,650 Total liabilities &

shareholders equity. . . . . $428,650
 Chapter 2 | From Accounting Events to Financial Statements 59

The Arcadia Company

Statement of Cash Flow

Operating Activities
Cash sales . . . . . . . . . . . . . . . . . . . . . . . $ 160,000
Payments for inventory . . . . . . . . . . . . . (144,000)
Cash wages . . . . . . . . . . . . . . . . . . . . . . (20,000)
Interest payment . . . . . . . . . . . . . . . . . . (3,600)
Cash flow from operations. . . . . . . . . . . (7,600)
Investing Activities
Purchase of building . . . . . . . . . . . . . . . (150,000)
Cash flow from investing . . . . . . . . . . . . (150,000)
Financing Activities
Sale of capital stock . . . . . . . . . . . . . . . 250,000
Bank loan . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Cash flow from financing . . . . . . . . . . . . 370,000
Cash, beginning . . . . . . . . . . . . . . . . . . . . . -0-
Cash, ending . . . . . . . . . . . . . . . . . . . . . . . 212,400
Change in cash. . . . . . . . . . . . . . . . . . . . . . $212,400

3. ROS  52,650 / 160,000  32.9%

ROA  (52,650  3600) / 428,650  13.1%
ROE  52,650 / 302,650  17.4%
4. ROE  52,650/160,000  160,000/428,650  428,650/302,650
 0.329  0.373  1.42  17.4%

EXECUTIVE SUMMARY
In this chapter we examined the balance sheet equation and how financial statements are derived from a set of accounting events
that affect a business. We also considered some of the estimates and assumptions inherent in the financial statement preparation
process, observing that since estimates and assumptions can be incorrect, financial statements should never be considered to be a
precise representation of a companys financial performance. Finally, we investigated how to use financial statement data to evalu-
ate a businesss operating performance and its financial risk.
As a validation of your understanding of the content of this chapter, you should now be able to:
Explain the accounting meaning behind the terms asset, liability, shareholders equity, revenue, expense, and matching.
Prepare financial statements from accounting events.
Use selected financial ratios to evaluate a companys financial performance.
Use the balance sheet equation to understand the managerial motives for selecting between alternative accounting
methods.
In the next chapter, we examine the various components of the income statement and also learn how to prepare a statement of cash
flow from just an income statement and a set of balance sheets.

KEY CONCEPTS AND TERMS

Accounting cycle, 60 Book value, 41 Current assets, 45
Adjusting entries, 60 Closing entries, 61 Current liabilities, 45
Articulation, 49 Common stock, 35 Debit, 60
Asset, 35 Contra-accounts, 41 Effective tax rate, 52
Asset turnover, 53 Contributed capital, 35 Entity principle, 38
Balance sheet equation, 34 Credit, 60 Expenses, 39
60 Chapter 2 | From Accounting Events to Financial Statements

Financial leverage, 53 Liability, 35 Recurring operations, 46

Financial ratios, 51 Long-term debt-to-equity ratio, 54 Retained earnings, 35
Financing activities, 47 Matching principle, 40 Return on assets, 51
Financing decision, 34 Net income, 46 Return on investment, 52
Forecasted financial statements, 38 Net worth, 34 Return on sales, 51
Front-end loading of revenues, 55 Noncurrent assets, 45 Return on shareholders equity, 52
Gross profit, 46 Noncurrent liabilities, 46 Revenue recognition principle, 39
Historical cost principle, 39 Off-balance-sheet debt, 35 Revenues, 39, 46
Intangible assets, 37 Operating activities, 47 Shareholders equity, 35
Interest coverage ratio, 54 Operating income, 46 Tangible assets, 37
Investing activities, 47 Opportunity cost, 43 Tax shield, 52
Investment decision, 34 Posted, 60 Times-interest-earned ratio, 54
Journal entry, 60 Profit margin ratio, 51 Trial balance, 60
Leveraged, 34 Rear-end loading of expenses, 56

A P P E N D I X 2 A : Technical Language of Accounting

The Debit and Credit Paradigm
The spreadsheet approach used in Chapter 2 to analyze the effects of various accounting events on the balance sheet equation is
intuitive and closely resembles how modern electronic accounting systems process accounting information. Yet financial profes-
sionals often use the technical accounting language of debit and credit when referring to accounting transactions. To help you
understand this technical language, we revisit the accounting events of the Russian River Valley Winery and process them using the
debit/credit mechanism and double-entry bookkeeping. But first a little history!
Luca Pacioli, an Italian monk, is credited with being the first to describe double-entry bookkeeping in his book, Summa de
Arithmetica, Geometria, Proportioni et Proportionalita, published in Latin in 1494. Some claim that Luca didnt really invent
double-entry bookkeeping; he just took the time to observe what Italian merchants were doing and then documented his observa-
tions. Instead of using pluses and minuses, Luca invented the T-account having two sides. The left side was referred to as the debit
sideoften represented as Drand the right side he called the credit sideor Cr for short. The T-account Luca invented looked
like this:

T-Account

Debit Credit
(Dr) (Cr)

Of course, Luca had to decide which side would be a positive and which would be negative. So, he concluded that an increase
in assets would be a debit (the left side) and a decrease in assets would be a credit (the right side). Similarly, an increase in a liability
must be a credit and a decrease in a liability a debit. And, since shareholders equity is on the same side of the balance sheet equation
as the liabilities, an increase (decrease) in shareholders equity would be a credit (debit). The reasons why Luca selected this particular
convention have been lost with time. Be careful to note that the words debit and credit are not synonymous with increase and decrease.
Instead, they merely identify the left or right side of the T-account. The following diagram summarizes the debit/credit convention
described by Luca:

Asset  Liability  Shareholders Equity

Debit Credit Debit Credit Debit Credit

() () () () () ()

The Accounting Cycle

The process of analyzing and recording accounting data for a business is often referred to as the accounting cycle. The cycle
begins when an accounting event involving a business occurs. The event is analyzed and a determination made as to which of the
businesss accounts are affected. This analysis is then entered into the firms accounting system by means of a journal entry, which
will be illustrated shortly. Immediately after the data is entered into the firms accounting system, it is transferred, or posted, to the
appropriate T-accounts. The preparation of journal entries and posting of data to the T-accounts are daily activities at a business.
At the end of each fiscal period, prior to the preparation of any financial statements, a number of data verification checks are
undertaken. First, adjusting entries are prepared to update various accounts for any new or previously unreported financial infor-
mation and to correct any observed data errors. Second, a trial balance is prepared to insure that the amount of recorded debits
 Chapter 2 | From Accounting Events to Financial Statements 61

equals the amount of recorded credits. Finally, the financial statements are prepared, typically in the following sequence: income
statement, statement of shareholders equity, balance sheet, and statement of cash flow. The preparation sequence reflects the fact
that the basic financial statements are interdependentthat is, they articulate with one another.
Prior to the preparation of the statement of shareholders equity, closing entries are prepared. Closing entries transfer the
results of a businesss operating activitiesthat is, its revenues, expenses, and dividendsto retained earnings on the statement
of shareholders equity (and hence, the balance sheet). The accounts appearing on the income statement, along with the dividend
account, are referred to as temporary accounts because they are closed, or zeroed out, at the end of each accounting period. Each
of these accounts will therefore start the next accounting period with a zero balance. This makes intuitive sense since we wish to
measure performance over a period of time and thus need to start each period with a blank slate. The accounts appearing on the
balance sheet, in contrast, are referred to as permanent accounts because they are not closed out at the end of each accounting pe-
riod. In fact, the temporary accounts are closed to a permanent account, retained earnings. Again, this makes intuitive sense since
it is the purpose of the balance sheet to report a businesss financial condition at a point in time, rather than for a period of time.
Considered a different way, the various accounts such as cash or accounts payable that exist at the end of the period should still
exist at the start of the next period unless all cash is paid out and all accounts payable are paid in full. After the closing entries are
executed, the remaining financial statementsthe statement of shareholders equity, the balance sheet, and the statement of cash
flowcan be prepared.
To summarize, the various steps in the accounting cycle are:
1. Record the daily accounting events using journal entries.
2. Post the journal entry data to the appropriate T-accounts.
3. At the end of the fiscal period, record any needed adjusting entries.
4. Prepare a trial balance.
5. Record the closing entries for the revenue, expense, and dividend accounts.
6. Prepare the financial statements.

The Accounting System

Input: Economic transactions

Journal Entries T-Accounts Trial Balance

Adjusting entries to (a)

correct and (b) update
the financial information

Closing entries for

temporary accounts

Financial
Financial
Financial
Statements
Financial
Statements
Statements
Statements
62 Chapter 2 | From Accounting Events to Financial Statements

There are three arrows originating from the Trial Balance. Each of these loops represents a different version of the trial balance(a)
pre-adjustment, (b) post-adjustment, and (c) post-closing trial balances. It is the final post-closing trial balance that is used to create
the companys financial statements.
To illustrate the accounting cycle, we return to the pre-opening balance sheet for the Russian River Valley Winery presented
in Exhibit 2A.1.

EXHIBIT 2A.1

Russian River Valley Winery, Inc.

Balance Sheet
($ thousands) Pre-Opening

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,700
Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,800

Liabilities and equity

Loan payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,800
Shareholders equity
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Liabilities and shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,800

Step 1Record the accounting events using journal entries.

The 14 events for the Russian River Valley Winery are recorded below using journal entries and the debit/credit paradigm. The
convention is to record the debit portion of a journal entry on top and then to record the credit part of the entry below. Care must be
exercised that the total of the debit portion of each entry exactly equals the credit portion.

Event Accounts Debit Credit

1(a) Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

1(b) Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
2 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
3 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
4(a) Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,520
Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900
4(b) Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . 720
5(a) Wage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
5(b) Selling & Administrative Expense. . . . . . . . . . . . . . . . . . 300
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
6(a) Loan Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
6(b) Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
continued
 Chapter 2 | From Accounting Events to Financial Statements 63

continued from previous page

Event Accounts Debit Credit

7 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
8(a) Depreciation ExpenseEquipment . . . . . . . . . . . . . . . . 175
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . 175
8(b) Depreciation ExpenseBuildings . . . . . . . . . . . . . . . . . 50
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . 50
9 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Intangible asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
11 ( No event is recorded.) . . . . . . . . . . . . . . . . . . . . . . . . .
12 Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . 96
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
13 Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
14 Retained Earnings (dividend declared). . . . . . . . . . . . . . 260
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

Step 2Post the journal entry data to the appropriate T-accounts.

If you examine the T-accounts below, you will see that each of the debits and credits from the journal entries above have been en-
tered into the appropriate T-accounts. Notice that the ending balance for each of the T-accounts exactly corresponds to the ending
balances obtained using the spreadsheet approach followed in the chapter.

Cash Accounts Payable Common Stock

Bal 4,700 0 Bal 6,000 Bal
4(a) 380 360 1(b) 380 1(a) 400 10
4(b) 720 1,500 2 1(b) 360 6,400 Bal
2,000 3 60 13
100 5(a) 80 Bal Retained Earnings
300 5(b) 0 Bal
480 6(a) Income Taxes Payable 14 260
288 6(b) 0 Bal Bal 260 317 17
10 400 144 12 96 12 57 Bal
260 14 96 Bal
Bal 768 Income Summary
Loan Payable 1,900 15
Accounts Receivable 4,800 Bal 16 1,583
Bal 0 6(a) 480 17 317
4(a) 1,520 4,320 Bal 0 Bal
720 4(b) Sales Revenue
Bal 800 1,900 4(a)
15 1,900
Inventory 0 Bal
Bal 0
1(a) 380 Cost of Goods Sold
380 7 7 380
13 60 380 16
Bal 60 Bal 0

continued
64 Chapter 2 | From Accounting Events to Financial Statements

continued from previous page

Equipment Wage Expense
Bal 0 5(a) 100
2 1,500 100 16
3 2,000 Bal 0
Bal 3,500
Depreciation Expense
Buildings 8(a) 175
Bal 2,000 8(b) 50
Bal 225
Accumulated Depreciation 225 16
0 Bal Bal 0
175 8(a)
50 8(b) Selling & Admin Expense
225 Bal 5(b) 300
300 16
Land Bal 0
Bal 4,000
Interest Expense
Intangible Assets 6(b) 288
Bal 100 50 9 288 16
Bal 0
Bal 50
Amortization Expense
9 50
50 16
Bal 0

Income Tax Expense

12 240
240 16
Bal 0

Step 3At the end of the fiscal period, make any needed adjusting entries.
Accounting events such as the recording of depreciation expense (8(a)) and amortization expense (8(b)) are considered to be ad-
justing entries. They are often recorded at the end of each fiscal period when a companys accounting staff reviews the businesss
financial data for completeness. Other examples of adjusting entries include correcting any amounts that were previously incor-
rectly recorded and estimating and recording the estimated losses associated with any uncollected accounts receivable.

Step 4Prepare a trial balance.

The trial balance is a listing of the account balances from the companys various T-accounts. Russian River Valleys trial balance
is presented in Exhibit 2A.2. Notice in the winerys trial balance that the total debit balance ($13,021) for the winerys T-accounts
equals the total credit balance ($13,021). If the balances were not equal, it would indicate that an error had been made in recording
some piece of accounting information.

Step 5Record closing entries for the temporary accounts.

Closing entries (events 15, 16, and 17) transfer the ending balances from the revenue and expense T-accounts to an income sum-
mary account, and then ultimately to the retained earnings account on the statement of shareholders equity, and thus, the balance
sheet. Closing entries also serve another functionthey set the revenue and expense T-accounts equal to zero at the end of each
 Chapter 2 | From Accounting Events to Financial Statements 65

EXHIBIT 2A.2

Russian River Valley Winery, Inc.

Trial Balance
Account Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 768
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500
Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 225
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Loan payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,320
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,400
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Depreciation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Selling & administrative expense . . . . . . . . . . . . . . . . . . . . . . . 300
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Amortization expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,021 $13,021

fiscal period (see the closing balances for the T-accounts from Step 2). By doing so, the revenue and expense T-accounts only
contain information from the current period, thus facilitating comparisons of net income from one fiscal period to the next.

Event Account Debit Credit

15 Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900

Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900
16 Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,583
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Wage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . 225
Selling & administrative expense . . . . . . . . . . . . . . . . 300
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . 50
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
17 Income summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

Step 6Prepare the financial statements.

The financial statements prepared from data organized using the debit/credit paradigm will be identical to those derived using the
spreadsheet approach, as presented in Exhibits 2.2 through 2.5, and consequently, are not reproduced here.
66 Chapter 2 | From Accounting Events to Financial Statements

Summary
The use of journal entries and T-accounts to record accounting information is still integral to those businesses in which financial
data is hand-collected. Increasingly, however, accounting data is processed electronically; and, consequently, the technical lan-
guage of accounting is changing to reflect this reality.

DISCUSSION QUESTIONS
Q2.1 Accounting Terminology. Describe or define the following terms:
Asset
Liability
Shareholders equity
Revenue
Expense
Discuss how the five terms relate to one another.
Q2.2 Historical versus Forecasted Financial Statements. Discuss the difference between historical and forecasted (or pro
forma) financial statements. How are these different sets of financial statements used by managers and shareholders for
decision-making purposes?
Q2.3 Accounting Principles. Consider the following accounting principles:
Entity principle
Revenue recognition principle
Matching principle
Define these accounting principles. Discuss how these principles relate to one another.
Q2.4 Balance Sheet Classifications. Most balance sheets are defined as classified balance sheets in that both the assets and
liabilities are dichotomized into the categories of current and noncurrent. [Note: In those industries in which the business
operating cycle is longer than one year (such as the wine industry, the real estate industry, the financial services industry),
classified balance sheets are not required under U.S. GAAP.] Discuss how the balance sheet classifications of current
versus noncurrent convey important information about a firms financial condition to managers and shareholders.
Q2.5 Key Performance Indicators: The Income Statement. Describe or define the following key performance indicators
(KPIs) from the income statement:
Operating revenue
Gross profit
Operating income
Net income
Discuss how each of these measures depicts a firms performance.
Q2.6 Key Performance Indicators: The Statement of Cash Flow. Describe or define the following key performance
indicators (KPIs) from the statement of cash flow:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Discuss how each of these measures conveys important information about firm performance to managers and
shareholders.
Q2.7 Return on Shareholders Equity. The return on shareholders equity ratio can be decomposed into three separate fi-
nancial ratiosthe return on sales, total asset turnover, and financial leverage. Define each of the ratios assuming the firm
is all equity financed and discuss what actions a manager might take to increase a firms return on shareholders equity.
Q2.8 Evaluating Financial Risk. Investment professionals use a variety of financial ratios to evaluate a companys financial
risk. Two popular financial risk ratios include:
Total debt to total assets ratio
Interest coverage ratio
Define each ratio and discuss what actions a manager might take to reduce a firms financial riskiness.
Q2.9 Managing Operating Revenues. Some corporate executives have reportedly attempted to manage their firms op-
erating revenues through such actions as front-end loading or rear-end loading of operating revenues. Explain the
 Chapter 2 | From Accounting Events to Financial Statements 67

concepts of front-end loading and rear-end loading of operating revenues. Discuss why some managers might undertake
these actions. Discuss how you might be able to identify that a manager is managing a firms operating revenues.
Q2.10 Net Income, Cash Flow from Operations, and Dividend Policy. The Arizona Corporation reported positive net
income but negative cash flow from operations. Further, despite the negative cash flow from operations, the company
continued to pay its regular dividend on its common shares. Discuss why it is possible for a company to report positive
net income when the cash flow from operations is negative. Do you agree with the firms strategy of maintaining its
regular dividend? Why or why not?
Q2.11 Debt Covenants. Bristol-Myers Squibb (BMS) Company reports that it maintains a $2 billion, five-year revolving
line of credit with a syndicate of lenders. The company disclosed in its annual report that:
The availability of the line of credit is subject to the Companys ability . . . . to meet certain conditions, including a
financial covenant in which net debt-to-capital cannot exceed 50 percent.
Discuss why BMS would agree to the above financial covenant. Discuss why the syndicate of lenders would impose such a
constraint on BMS. How would you calculate the net debt-to-capital ratio? What does the ratio reveal about a company?
Q2.12 Managing Operating Expenses. Some corporate executives have reportedly attempted to manage their firms operat-
ing expenses through such actions as front-end loading or rear-end loading of their operating expenses. Explain the
concepts of front-end loading and rear-end loading of operating expenses. Discuss why some managers might undertake
these actions. Discuss how you might be able to identify that a manager is managing a firms operating expenses.
Q2.13 Net Loss, Cash Flow from Operations, and Dividend Policy. The Phoenix Corporation reported a net loss but a
positive cash flow from operations. Further, despite the net loss, the company continued to pay its regular dividend.
Discuss why it is possible for a company to report a net loss while also reporting a positive cash flow from operations.
Do you agree with the companys decision to continue the payment of its regular dividend? Why or why not?
Q2.14 (Ethical Perspective) Corporate Social Responsibility and Ethics. In the post-Enron environment, and with the
enactment of the Sarbanes-Oxley legislation, many firms are proactively portraying themselves as being ethical.
Ethical behavior is, for example, part of the Corporate Social Responsibility movement. This behavior includes many
dimensions, from the ethical treatment of employees and the environment, to ethical financial reporting. Academic
research has found a positive correlation between a firms reputation and its financial performance. Do you feel that
strong ethics makes good business sense? Why do you think that there is a positive correlation between ethical behavior
and successful corporate financial performance?

indicates that check figures are available on the books Website.
EXERCISES
E2.15 The Balance Sheet Equation. Fernandez & Co. experienced the following six events during the current year:
1. The sale of common stock to investors for $5 million cash.
2. The sale of a new bond issue to investors for $10 million cash.
3. The purchase of $500,000 of inventory for cash.
4. The purchase of $700,000 of equipment using bank financing.
5. The payment of $100,000 cash for income taxes associated with last years operations.
6. The CFO determined that net income for the most recent month was $2 million.
Using the balance sheet equation as illustrated in this chapter, describe how each of the above six events would affect the
balance sheet of Fernandez & Co.
E2.16 Account Classification. Presented below is a list of income statement and balance sheet accounts:
a. Interest expense j. Depreciation expense
b. Land k. Equipment
c. Cost of goods sold l. Loan payable
d. Intangible assets m. Wages and salaries expense
e. Income tax expense n. Buildings
f. Inventory o. Retained earnings
g. Revenues p. Selling and administrative expense
h. Accounts payable q. Amortization expense
i. Accounts receivable r. Cash
For each account, indicate whether it would appear on the balance sheet (B/S) or the income statement (I/S). For those
accounts appearing on the balance sheet, indicate whether the account is an asset (A), liability (L), or shareholders equity
 68 Chapter 2 | From Accounting Events to Financial Statements

(SE) account. For those accounts appearing on the income statement, indicate whether the account is a revenue (R) ac-
count or an expense (E) account.
E2.17 Asset or Expense. The Rankine Corporation reported net income of $10 million in 2006, and it appears that net income
for 2007 will be the same. During 2007, the company made the following expenditures:
1. $250,000 was spent to resurface the company parking lot. The resurfacing has to be done about every five years.
2. $500,000 was spent to upgrade the companys air filtration system in the plating department. The system worked
satisfactorily, but the U.S. Department of Labor recently promulgated new rules (effective three years from today)
that would have required the changes the company made voluntarily.
3. $900,000 was paid to a consultant for the design of a new manufacturing facility. The new plant was the dream of
the prior CEO but had been shelved because the current CEO was uncertain about the firms future.
4. $600,000 was spent on the development of a new inventory control system. The system was designed to allow
salespeople in the field to electronically enter orders into the system so that they could be shipped the next day.
The system appeared to be on track, but another $200,000 would have to be spent before it could be demonstrated
that it would function as planned.
5. The companys Arizona plant was shut down for three months because of the slow economy. The company
struggled to find ways to keep its employees busy so they could retain as many as possible. Some employees
agreed to accept half pay while the company found maintenance work and training for the other employees. At the
end of three months, about 85 percent of the workforce was still on the payroll when the company resumed normal
production. The maintenance work done by the employees during this time cost about $1 million; the training cost
the company another $800,000.
Indicate whether the above expenditures should be considered as an asset or as an expense. Be prepared to justify your
answer.
E2.18 The Statement of Cash Flow. The following cash flow information was taken from The Johnson and Johnson Com-
pany (J&J) 2005 annual report. Compute the missing values in the table (amounts are in millions). Based on this data,
how does J&J finance its ongoing operations and asset purchases?

2005 2004 2003

Cash, beginning balance . . . . . . . . . . . . . . . . . . $ 9,013 $ ? $3,171

Cash flow from operating activities . . . . . . . . . . 11,877 ? 10,595
Cash flow from investing activities. . . . . . . . . . . (279) (2,347) ?
Cash flow from financing activities. . . . . . . . . . . ? (5,148) (3,863)
Cash, ending balance. . . . . . . . . . . . . . . . . . . . . $16,055 $ ? $5,377

E2.19 The Statement of Cash Flow. The following cash flow information was taken from The General Electric Company
(GE) 2005 annual report. Compute the missing values in the table (amounts are in millions). Based on this data, describe
GEs cash flow performance for the three-year period.

2005 2004 2003

Cash, beginning balance . . . . . . . . . . . . . . . . . . $ ? $12,664 $ ?

Cash flow from operating activities . . . . . . . . . . 37,641 36,484 29,229
Cash flow from investing activities. . . . . . . . . . . ? (38,414) (21,843)
Cash flow from financing activities. . . . . . . . . . . (6,119) ? (3,632)
Cash, ending balance. . . . . . . . . . . . . . . . . . . . . $11,801 $15,328 $ ?

E2.20 Preparing the Basic Financial Statements. Marilyn Miller opened a floral shop using $5,000 of her own cash savings
and with $15,000 in cash borrowed from her parents. She signed a lease on a small store for one year, agreeing to pay $350
per month in rent. During the first year of operations, Marilyn purchased fresh flowers from a local nursery for $2,500, paid
$1,200 for utilities, and generated floral sales totaling $12,000. (Assume all transactions were cash transactions.) Marilyn
was hoping to be able to repay her parents one-half of the borrowed money at the end of the first year of operations.
Prepare an income statement, balance sheet, and statement of cash flow for the floral shop. Can Marilyn achieve her
goal of repaying one-half of the $15,000 loan at the end of the first year of operations?
E2.21 Preparing Cash Flow Data. Marilyn Miller began the second year of her floral business with $12,000 in cash in her
bank account. Using the information below, all of which occurred during Year 2, prepare a statement of cash flow for
Marilyn. Evaluate her cash management strategy during Year 2.
 Chapter 2 | From Accounting Events to Financial Statements 69

1. Sold an equity interest in the business for $13,000 cash.

2. Generated revenue from floral sales of $20,000, collecting all but $5,000.
3. Incurred operating expenses totaling $9,000, of which $2,000 remained unpaid at the end of Year 2.
4. Purchased new store equipment for $5,000, with a down payment of $2,500 cash and signing a note payable for
$2,500.
5. Paid shareholders a cash dividend of $2,800.

PROBLEMS
P2.22 Accounting Event Analysis and Financial Statement Preparation. Smith & Co. experienced the following six
events in its first year of operations:
1. Shareholders contributed $60,000 cash.
2. Purchased land for $40,000 cash.
3. Borrowed $18,000 in cash from a bank.
4. Provided services for $16,000, which will be paid to Smith & Co. next year.
5. Paid $11,000 cash for miscellaneous operating expenses.
6. Paid a $1,000 cash dividend to shareholders.
Required
Using the balance sheet equation as illustrated in this chapter, identify how each of the above six events affected the vari-
ous accounts involved. Prepare an income statement, a statement of shareholders equity, a balance sheet, and a statement
of cash flow for the first year of operations. What is your assessment of the companys financial performance in its first
year of operations?
P2.23 Accounting Event Analysis and Financial Statement Preparation. Wilmot Real Estate Company experienced the
following events during its first year of operations:
1. Received $50,000 in cash from investors as an equity investment.
2. Borrowed $40,000 in cash from a bank.
3. Purchased two parcels of land, each costing $15,000, for a total of $30,000 cash. The land was purchased for
investment purposes.
4. Paid $10,000 cash to rent office equipment for the year.
5. Provided real estate appraisal services valued at $25,000, receiving $20,000 in cash and an account receivable for
an additional $5,000.
6. Paid miscellaneous expenses totaling $11,000 in cash.
7. Sold one parcel of land, costing $15,000, for $22,000 cash.
8. Paid a $5,000 cash dividend to shareholders.
Required
Using the balance sheet equation as illustrated in this chapter, identify how each of the above events affect the balance
sheet equation of A  L  SE. Prepare an income statement, a statement of shareholders equity, a balance sheet, and a
statement of cash flow for the first year of operations. Evaluate the companys financial performance during its first year
of operations.
P2.24 Accounting Event Analysis and the Balance Sheet. Presented below are the balance sheet accounts of the Mayfair
Company as of December 1, 2006. The accounts are listed in random order.

Machinery & equipment (net) . . . . . . $15,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Accounts payable. . . . . . . . . . . . . . . 10,000 Notes payable . . . . . . . . . . . . . . . . . 9,500
Note receivable . . . . . . . . . . . . . . . . 2,000 Accounts receivable . . . . . . . . . . . . . 15,000
Inventory. . . . . . . . . . . . . . . . . . . . . . 3,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . 8,000
Bank loan . . . . . . . . . . . . . . . . . . . . . 10,500 Additional paid-in-capital . . . . . . . . . 76,000
Building (net). . . . . . . . . . . . . . . . . . . 30,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Capital stock ($1 par value) . . . . . . . 5,000 Retained earnings . . . . . . . . . . . . . . 12,000

During the month of December 2006, the following events occurred:

1. Purchased inventory on credit that cost $3,000.
2. Issued capital stock at par value in exchange for machinery and equipment valued at $12,000.
3. The building was appraised at a value of $45,000 by a certified real estate appraiser.
4. The note receivable of $2,000 was collected.
 70 Chapter 2 | From Accounting Events to Financial Statements

5. $8,000 cash was paid on the outstanding accounts payable.

6. Purchased land valued at $25,000, paying $3,000 in cash and signing a five-year note for the remaining amount.
Required
1. Prepare the balance sheet as of December 1, 2006, for the Mayfair Company
2. Prepare a spreadsheet using the balance sheet equation as illustrated in this chapter for the December events.
3. Prepare the balance sheet as of December 31, 2006, for the Mayfair Company.
4. Evaluate the companys financial leverage at year-end 2006.
P2.25 Preparing a Balance Sheet. The following financial information is known about Pfizer, Inc. as of December 31, 2005
(all amounts in millions):
a. The balance of cash and cash equivalents was $2,247.
b. Short-term investments have a fair market value of $19,979.
c. Gross accounts receivable total $9,948, which includes $183 that is not expected to be collected.
d. Inventory has a cost basis of $6,900 but a replacement cost of $6,709.
e. Prepaid expenses total $3,196.
f. Property, plant and equipment have a cost basis of $29,587, a current fair value of $42,500, and accumulated
depreciation taken to date of $10,000.
g. Intangible assets have a cost basis of $76,582 and accumulated amortization of $20,500.
h. Accounts payable total $2,226; accrued expenses payable total $14,633; and, short-term borrowings total $11,589.
i. Long-term debt totals $6,347, and post-retirement benefit obligations total $17,143.
j. Shareholders equity totals $65,627, composed of retained earnings of $37,608, other comprehensive income of
$479, treasury stock of negative $39,767, and contributed capital of $67,307.
Required
Prepare a balance sheet for Pfizer, Inc. as of December 31, 2005. Evaluate Pfizers financial risk at year-end 2005.
P2.26 Analysis of Financial Statement Data. The following data was taken from the financial statements of The Amphlett
Corporation, which is all equity financed.

2005 2006

Net sales. . . . . . . . . . . . . . . . . . $145,860 $161,585

Net income . . . . . . . . . . . . . . . . 24,765 28,340
Total assets. . . . . . . . . . . . . . . . 171,225 192,440
Shareholders equity . . . . . . . . 101,975 121,165

Required
1. Calculate the following ratios for 2005 and 2006:
a. Return on equity
b. Return on assets
c. Return on sales
d. Total assets to shareholders equity (financial leverage)
e. Total asset turnover
2. Comment on the financial performance of The Amphlett Corporation based on your ratio calculations.
P2.27 Analysis of Financial Statement Data. The following data was taken from the financial statements of The Mann
Corporation, which is all equity financed.

2005 2006

Net sales. . . . . . . . . . . . . . . . . . $1,300,000 $2,320,000

Net income . . . . . . . . . . . . . . . . 100,000 220,000
Total assets. . . . . . . . . . . . . . . . 558,659 894,309
Shareholders equity . . . . . . . . 303,030 371,622

Required
1. Calculate the following ratios for 2005 and 2006:
a. Return on equity
b. Return on assets
c. Return on sales
 Chapter 2 | From Accounting Events to Financial Statements 71

d. Total assets to shareholders equity (financial leverage)

e. Total asset turnover
2. Comment on the financial performance of The Mann Corporation based on your ratio calculations.
P2.28 Analyzing Financial Statement Information. The Thunderbird Corporation has applied to the Biltmore National Bank
for a $100,000 loan to purchase new equipment for its manufacturing operations. As part of the loan application, the chief
financial officer of Thunderbird submitted the following financial statement information:

2006 2005

Balance sheet
Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,000 $ 42,000
Noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . 175,000 150,500
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224,000 192,500
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 24,500 21,000
Noncurrent liabilities . . . . . . . . . . . . . . . . . . . . . . 91,000 73,500
Shareholders equity . . . . . . . . . . . . . . . . . . . . . . 108,500 98,000
Income statement
Operating revenues . . . . . . . . . . . . . . . . . . . . . . . $122,500 $112,000
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . (80,500) (91,000)
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $ 21,000
Statement of cash flow
Cash flow from operating activities . . . . . . . . . . . $ 52,500 $ 31,500
Cash flow from investing activities . . . . . . . . . . . (49,000) (42,000)
Cash flow from financing activities . . . . . . . . . . . 24,500 17,500
Change in cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28,000 $ 7,000

Required
Analyze the financial statement information of The Thunderbird Corporation and indicate whether you believe that the
firms loan application should be approved. And, if so,why?
P2.29 The Operating Cycle and Financial Statements. Presented below is the year-end 2005 balance sheet for The Little
Corporation.

The Little Corporation

Balance Sheet
December 31, 2005

Assets Liabilities & Shareholders Equity

Current Current liabilities
Cash. . . . . . . . . . . . . . . . . . . . $ 510,000 Accounts payable . . . . . . . . . . . . $ 650,000
Accounts receivable (net). . . . 564,000 Wages payable . . . . . . . . . . . . . . 173,000
Inventory . . . . . . . . . . . . . . . . 720,000 Interest payable . . . . . . . . . . . . . . 56,000
Prepaid rent . . . . . . . . . . . . . . 222,000 Total current liabilities . . . . . . . . . 879,000
Total current assets . . . . . . . . 2,016,000 Noncurrent liabilities
Noncurrent Bank loan . . . . . . . . . . . . . . . . . . . 450,000
Long-term investments . . . . . 496,500 Bonds payable . . . . . . . . . . . . . . . 1,950,000
Equipment . . . . . . . . . . . . . . . $1,440,000 Total liabilities . . . . . . . . . . . . . . . . . . 3,279,000
Less Accum depreciation . . . (288,000)
1,152,000 Shareholders equity
Machinery . . . . . . . . . . . . . . . 2,850,000 Common stock . . . . . . . . . . . . . . 1,200,000
Retained earnings . . . . . . . . . . . . 1,548,000
Less Accum depreciation . . . (712,500)
2,137,500 Total shareholders equity . . . . . . . . 2,748,000
Intangible assets (net) . . . . . . 225,000 Total liabilities &
Total assets . . . . . . . . . . . . . . . . $6,027,000 shareholders equity. . . . . . . . . . . . $6,027,000

During 2006, the company entered into the following events:

72 Chapter 2 | From Accounting Events to Financial Statements

1. Sales to customers totaled $2 million, of which $1.6 million were on credit and the remainder was cash sales. The
cost of goods sold totaled $800,000.
2. Purchased $700,000 of inventory on credit.
3. Paid $620,000 cash to employees as wages. (This amount includes the wages payable at December 31, 2005.)
4. Collected $1.75 million cash from customers as payment on outstanding accounts receivable.
5. Paid $1.2 million cash to suppliers on outstanding accounts payable.
6. Sold machinery for $120,000 cash on January 1, 2006. The machinery had cost $370,000 and at the time of sale it
had a net book value of $160,000.
7. Paid miscellaneous expenses totaling $98,000 cash.
8. Sold common stock for $450,000 cash.
9. Invested $200,000 of excess cash in short-term marketable securities.
10. Declared and paid a cash dividend of $100,000.
As part of the year-end audit, the internal audit staff identified the following additional information:
1. $180,000 of prepaid rent was consumed during the year.
2. The equipment had a useful life of ten years and the machinery of 20 years. The company uses straight-line
depreciation. (No depreciation should be recorded for machinery in Item 6 above.)
3. The intangible assets had a remaining useful life of ten years.
4. Interest on the bank loan and bonds payable was ten percent. During the year, interest payments totaling $260,000
had been paid in cash.
Required
1. Using the balance sheet equation as illustrated in this chapter, prepare a spreadsheet reflecting the events of the
Little Corporation during 2006.
2. Prepare the income statement for 2006.
3. Prepare the statement of shareholders equity, balance sheet, and statement of cash flow for 2006.
4. How has the companys use of leverage changed from 2005 to 2006?
P2.30 Preparing Financial Statements from Accounting Events Photovoltaics, Inc. is an Arizona-based manufacturer and
distributor of photovoltaic solar energy units. The company was founded in 2005 by Arthur Manelas and Harry Linn.
Manelas, formerly a research scientist with NASA, had been operating a small photovoltaic manufacturing company in
Massachusetts when Linn, a marketing consultant to industry and himself an owner of a solar energy company in Oregon,
proposed the joint venture.
Convinced that excellent market opportunities for the solar arrays existed, Linn began preparing a prospectus that
could be used to help raise capital to significantly expand Manelass current operations. The two founders had located a
manufacturing facility in Tucson, Arizona, that would cost approximately $8 million to acquire and equip with updated
production equipment. Based on his prior experience, Linn knew that prospective venture capital investors would expect
to see the following:
A balance sheet identifying the companys assets and equities as they would appear at the start of operations.
A pro forma income statement for the first year of operations.
A pro forma balance sheet as it would appear at the end of the first year of operations.
A pro forma statement of cash flow for the first year of operations.
In anticipation of preparing these reports, Linn collected the following information and arrived at the following projec-
tions for the first year of operations:

Data related to pre-opening events

1. Ten million shares of common stock (par value $1) were authorized for sale by the companys charter of
incorporation. Manelas received 500,000 shares in exchange for the rights to the photovoltaic patent, and Linn
received an equal number of shares after contributing $500,000 in personal funds to the firm.
2. Incorporation and attorneys fees (start-up costs) amounted to $27,000 and would be paid in cash.
3. Sales of common stock to venture capitalists would total 2.5 million shares. A selling price of $3.25 per share
was set, and transaction costs of 1.5 percent of the stock proceeds were projected (to be paid in cash).
4. The $8 million purchase price of the manufacturing facility was to be allocated as follows: building  $4.5
million; land  $750,000; and, equipment  $2.75 million. In addition, raw materials and partially completed
solar units would be purchased on credit from Manelass original manufacturing company at a cost of $1.3 million.
A note, secured by the inventory itself and accruing interest at a rate of 10 percent per year on the unpaid balance,
would be issued to Manelas.
 Chapter 2 | From Accounting Events to Financial Statements 73

Projected events
5. Revenues from the sale of solar arrays for the first year were projected to be $480,000, with 20 percent of this
amount estimated to be uncollected at year-end. The company had decided to follow a particularly rigid credit-
granting policy until operations were well established; hence, no provision for bad debts would be established
because no uncollectible accounts were anticipated.
6. Cash purchases of inventory were estimated at $70,000; the cost of inventory sold was projected to be $215,000.
7. Insurance on the building, equipment, and inventory was expected to cost $2,700 per year.
8. Employee wages were estimated at $72,000; selling and administrative costs were projected at 2 percent of gross
sales.
9. The useful life of the acquired assets were estimated as follows:

Building . . . . . . . 20 years
Equipment . . . . . 10 years

Linn decided to write the patent off over its remaining legal life of 17 years and to write off the start-up costs over
five years.
10. Salaries to Linn and Manelas were set at $20,000 each for the first year.
11. Interest payments, but no principal repayments, would be made on the ten-percent notes issued to Manelas during
the first year of operations.
12. Income taxes were estimated at 22 percent of pre-tax net income.
13. A cash dividend of $100,000 would be paid at the end of the first year to the equity investors.
Required
1. Using the balance sheet equation as illustrated in this chapter, prepare the following financial statements:
a. Opening balance sheet as of the start of operations (i.e., after pre-opening events).
b. Income statement for the first year.
c. Balance sheet at the end of the first year.
d. Statement of cash flow for the first year.
2. As a prospective investor in the company, what factors would you look for in the financial statements to help you
decide whether to invest in the venture? Do you agree with the decision to pay a $100,000 cash dividend at the end
of the first year of operations? Why?
P2.31 Preparing Financial Statements from Accounting Events. In January 2005, Susan and Clark Shipley, co-owners of
Island Foods, Inc. began discussing the possibility of expanding their restaurant business from a single location in Glen-
dale, Arizona to two additional locationsone in Scottsdale and a second in Phoenix. Although the Glendale restaurant
had only been open for about two years, it had attracted a loyal customer base from neighborhood businesses and schools.
Despite the success of the Glendale restaurant in its first two years of operations, the Shipleys would still need to borrow
money to finance the two new restaurants. Susan and Clark knew that they would be expected to present a set of recent
financial statements as part of any loan proposal. So, the co-owners spent an afternoon compiling data regarding the key
transactions of the two preceding years.
Background
In early 2003, Clark and Susan Shipley moved from the damp, gray environment of Seattle, Washington to the dry, sunny
climate of Phoenix, Arizona. After some reflection on their life in Seattle, as well as an analysis of the local business
environment in the Phoenix area, they concluded that they would like to own and manage a restaurant. Glendale was
Arizonas third largest city, but it was not noted for a plethora of eating establishments, and those that did exist were
principally Italian, Mexican, or fast food. The Shipleys concluded that their restaurant would feature Japanese rice bowls
and operate under the name Island Teriyaki.
With that decision made, Clark and Susan began the long and difficult process of setting up their restaurant. In
March 2003, they formed Island Foods, Inc. by contributing $10,000 in cash in exchange for all of the companys 1,000
shares of stock. Clark convinced his parents to loan the new venture $120,000 in cash, with principal payable at the rate
of $12,000 per year over ten years and interest payable at a rate of 7.5 percent on the outstanding balance as of the begin-
ning of the loans year. The loan agreement was signed on March 31, 2003, and provided that both principal and interest
would be paid only once a year on March 31.
During March, the Shipleys searched for a suitable location for the restaurant. Clark negotiated a lease for approxi-
mately 2,000 square feet of retail space at a rate of $1,400 per month. The lease agreement ran for five years, with an option
to renew for five more years. The landlord agreed to give the Shipleys three months of free rent on the front end of the lease
in order to help the new business survive the critical start-up period.
74 Chapter 2 | From Accounting Events to Financial Statements

Also during the month of March, Clark arranged to buy a commercial refrigerator, range, and grill for $26,000
in cash, to be delivered and installed on March 31. Discussions with the seller indicated that the kitchen equipment
should last for five years. Clark and Susan also purchased a computer system, with restaurant-specific software already
installed, at a cost of $12,000 cash. While the system could last indefinitely, Susan suggested that it be depreciated
over six years. Other purchases included food preparation equipment at a cost of $1,200 cash and various restaurant
furniture and fixtures at a cost of $2,700 in cash; the equipment, furniture and fixtures were expected to have a useful
life of three years.
To enable the restaurant to be fully operational on April 1, the landlord allowed the Shipleys carpenter, electrician,
painters, and plumbers to begin renovations to the leased store on March 30 and 31. Working round-the-clock, the work-
men completed all necessary improvements and renovations to the leased space at a cost of $68,000 in cash. On March
31, the purchased kitchen equipment was delivered and Island Teriyaki opened for business as planned on April 1,
2003.
First Two Years of Operations
Although Susan and Clark had prepared a timely U.S. income tax return in April of 2004 (for 2003 income taxes), they
had not bothered to prepare a full set of financial statements using the accrual method of accounting. Since Clark had
backed up the hard drive on their computer system on a weekly basis, he had a CD containing all of the 2003 transac-
tions and one of 2004 transactions. Working from the CD, Clark generated the necessary accounting information regard-
ing the first two years of operations; he assembled the cash flow information in columnar form (see below) and relevant
accrual information by each income statement account:

2003 2004

Revenues $212,000 $327,000

In general, all restaurant sales were cash transactions; however, the Shipleys had devel-
oped a personal relationship with the general manager of one of Glendales local busi-
nesses. As a courtesy to him, they had agreed to cater the companys New Years Eve
party each year and to bill the company directly. The billings totaled $3,000 in 2003 and
$5,000 in 2004, and were paid by the company within 15 days of the following month.
Expenses
o Food costs $60,000 $105,000
Susan usually sat down once a week to write checks for any recent bills. Conse-
quently, by year-end, only one week of food costs remained unpaid, totaling $9,000
in 2003 and $12,000 in 2004.
o Supply costs $4,800 $6,200
Since payment on delivery was required for these miscellaneous restaurant supplies
(such as ice, napkins, etc.), Susan usually paid this bill directly out of petty cash.
o Utility charges $8,000 $12,000
At year-end one months payment for electricity, telephone, and water remained due.
o Employee wages $44,000 $76,000
Because Clark did much of the cooking himself while Susan worked on food and
sauce preparation, the Shipleys were able to keep their labor costs fairly low. They
also made a conscious decision to hire local high school and college students. At
year-end, Clark determined that one week of wages, amounting to $1,100 in 2003
and $1,400 in 2004, were due to the employees.
o Licenses $900
Clark paid the one-time Glendale new business license fee at 9am on April 1,
2003, to enable the business to immediately begin operations.
o Insurance $18,000
On April 1, 2003, the Shipleys purchased a three-year all risks insurance policy
for $18,000 cash. The policy was very comprehensive, covering loss due to theft,
fire, or storm damage, as well as such business-related risks as lawsuits arising from
customer injury while on the restaurant premises.
continued
 Chapter 2 | From Accounting Events to Financial Statements 75

continued from previous page

2003 2004

o Income taxes
For purposes of preparing the accrual financial statements, Clark and Susan decided
to assume that income taxes would be paid on April 15 at a rate of 15 percent.
o Owner compensation $25,000 $40,000
A review of the stored data revealed that the Shipleys had withdrawn $25,000 in
cash for personal use in 2003 and $40,000 in 2004. For purposes of the loan pro-
posal, Susan decided to treat these withdrawals as dividends.

Required
1. Prepare a balance sheet for Island Foods, Inc. as of March 31, 2003.
2. Prepare a balance sheet, income statement, and statement of cash flow as of December 31, 2003.
3. Prepare a balance sheet, income statement, and statement of cash flow as of December 31, 2004.
4. Calculate the following financial ratios for the restaurant for 2003 and 2004.

Probability Solvency
Return on sales Financial leverage
Return on assets Total debt-to-equity
Return on equity Interest coverage ratio
Liquidity Asset management
Quick ratio Total asset turnover

Would you extend a loan to the Shipleys in the amount of $200,000 in order to open two new restaurants?
P2.32 (Appendix) Recording Transactions Using the Debit/Credit Paradigm. Miller & Co. experienced the following six
events in its first year of operations:
1. Shareholders contributed $60,000 cash.
2. Purchased land for $40,000 cash.
3. Borrowed $18,000 in cash from a bank.
4. Provided services for $16,000, which will be paid to Miller & Co. next year.
5. Paid $11,000 cash for miscellaneous operating expenses.
6. Paid a $1,000 cash dividend to shareholders.
Required
Prepare journal entries using the debit/credit paradigm to record the above transactions.
P2.33 (Appendix) Recording Transactions Using the Debit/Credit Paradigm. The following events occurred for The
KMF Corporation during 2006:
1. Sales of products totaled $219,000, of which $15,000 remained uncollected at year-end.
2. The cost of goods sold during the year was $56,000.
3. A cash disbursement of $50,000 was made on July 1, 2006, to pay for a 12-month office equipment lease that
expires on June 30, 2007.
4. Depreciation expense for the year on the companys warehouse amounted to $7,500.
5. Employee wages for the year totaled $40,000, of which $2,000 was unpaid at year-end.
6. Selling, general, and administrative expenses amounted to $10,000 for the year and were paid in full.
7. A cash payment of $25,000 was made to reduce the balance of accounts payable.
8. Interest expense on long-term debt was $18,000 for the year, of which $4,500 was unpaid at year-end.
9. The company paid income taxes of $25,000 on its earnings.
Required
Prepare journal entries using the debit/credit paradigm to record the above transactions.
76 Chapter 2 | From Accounting Events to Financial Statements

C O R P O R A T E A N A LY S I S
CA2.34 The Procter and Gamble Company. The 2005 annual report of The Procter and Gamble Company (P & G) is
available at www.pg.com/annualreports/2005/pdf/pg2005annualreport.pdf. After reviewing P & Gs annual report, re-
spond to the following questions:
a. P & Gs net income increased each year from 2003 through 2005. Looking at the companys income statement,
explain why P & Gs net income increased if every one of its operating expenses also increased over the same
period. (To answer this question, divide each of P & Gs operating expenses by operating revenues and consider
the trend over the three-year period.)
b. P & Gs total assets increased by approximately $4.5 billion from 2004 to 2005. Which assets principally
accounted for this growth? Is this growth a problem? If so, why? If not, why not?
c. Consider the change in P & Gs total debt and total shareholders equity from 2004 to 2005. Did P & G finance the
$4.5 billion growth in its assets principally with debt or principally with equity? Do you agree with this strategic
financing decision? Why or why not?
d. Consider P & Gs statement of cash flow. What were the four major cash outflows for the company in 2005? How
did P & G finance these cash outflows?
e. Compare P & Gs dividend payments to its net income in 2004 and 2005. (Note: The ratio of dividends paid
divided by net income is called the dividend payout ratio.) What percentage of net income does P & G pay to its
shareholders? How does this payout percentage compare to P & Gs competitors (such as Johnson and Johnson,
Kimberly-Clark Corporation)? Do you agree with this dividend payment policy? What message does this policy
convey to investors about the companys future growth potential?
CA2.35 Internet-based Analysis. Consider a publicly-held company whose products you are familiar with. Some examples
might include:

Company Product Corporate Website

Johnson & Johnson Company Band-Aids www.jnj.com

Microsoft Corporation Windows XP software www.microsoft.com
Nokia Corporation Cellular phones www.nokia.com
Intel Corporation Pentium processors www.intel.com
Kimberly-Clark Corporation Kleenex www.kimberly-clark.com

Access the companys public website and search for its most recent annual report. (Note: Some companies will provide
access to their financial data through an investor relations link, while others will provide a direct link to their annual
reports.) After locating your companys most recent annual report, open the file and review its contents. After reviewing
the annual report for your selected company, prepare answers to the following questions:
1. Calculate the cost of goods sold, operating expenses, and net income as a percentage of net sales for the last two
years. What is the trend in each of these percentages? Explain what might be driving the trend.
2. Calculate the companys total liabilities as a percentage of total assets for the last two years. Did this percentage
increase or decrease? Is the company principally debt-financed or equity-financed?
3. Determine if the company paid dividends to its shareholders. (Hint: Look at the statement of shareholders
equity or the statement of cash flow.) If the company paid dividends, calculate the ratio of dividends paid
divided by net income. (Note: This ratio is known as the dividend payout ratio.) What percentage of its net
income did the company pay to its shareholders in each of the last two years?
4. Review the companys statement of cash flow. Identify the major sources of financing used by the company in
each of the last two years?
5. Review the companys Summary of Significant Accounting Policies. Identify how the company recognizes
revenue. Identify if the company uses any estimates in the preparation of its financial statement, and if so, prepare
a list of the estimates used in its financial report.
 C h a p t e r Three

Measuring Performance:
Cash Flow and Net Income

TAKEAWAYS
When you complete this chapter you should be able to:
1. Interpret a statement of cash flow to explain a companys financing and investing strategies.
2. Prepare a statement of cash flow using the indirect method.
3. Interpret the components of net income to evaluate a companys sustainable earnings.
4. Explain the difference between EBITDA, free cash flow, and discretionary cash flow.

Where have we been? Where are we? Where are we going?

Chapter 2 illustrated how ac- In Chapter 4, additional fi-

counting events are analyzed, In this chapter, we explore the content nancial statement analysis
quantified, summarized, and and preparation of the statement of tools to evaluate a companys
ultimately, reported in a com- cash flow. The chapter demonstrates financial performance are in-
panys financial statements. how cash flow statements can be pre- troduced and their use illus-
The chapter also examined trated. Specifically, financial
pared using only balance sheet and in-
how the financial information statement analysis techniques
of a business can be analyzed come statement information and how to assess a firms profitability,
and used to make investment cash flow statements can be analyzed asset management, and finan-
and credit decisions. Finally, to understand a companys sources and cial risk are explored. These
the notion that, in some in- uses of cash. The chapter then turns its techniques are then used to
stances, management can illustrate how lenders evalu-
attention to the income statement and
make strategic accounting ate the risk associated with
policy choices to enhance re- explores the components of net income extending debt financing to
ported firm performance was to help in identification of a companys Outback Steakhouse, a casual
introduced and illustrated with sustainable earnings. Financial theory dining restaurant company.
two corporate examples. posits that the value of a share of stock Finally, the preparation of pro
forma financial statements are
is a function of a companys recurring,
discussed and illustrated.
sustainable earnings. Finally, alterna-
tive definitions of cash flow as used
by investment professionalsEBITDA,
free cash flow, and discretionary cash
floware defined and explored.

77
 BRISTOL-MYERS SQUIBB COMPANY Symbol: BMY

The Bristol-Myers Squibb Company was formed in 1989 with the merger of pharmaceutical companies Bristol-Myers Company
and the Squibb Corporation. The company is best known for its prescription pharmaceutical drugs such as TAXOL for use in che-
motherapy treatment; however, it also manufactures over-the-counter drugs and health-care products, and sells nutritional products
through its subsidiary Mead Johnson. The company has been rumored to be an acquisition target for one of the larger European
pharmaceutical companies, such as Glaxosmithkline plc, Novartis AG, or Sanofi-Aventis SA.
Lance Armstrong, seven-time winner of the Tour de France and a cancer survivor, acts as the companys spokesperson, per-
haps to deflect attention away from recent adverse publicity resulting from an accounting scandal. In 2002, Bristol-Myers Squibb
agreed to pay $150 million to the U.S. Department of Justice and the U.S. Securities and Exchange Commission in settlement of
a lawsuit alleging improper recording of $2.5 billion in revenue between 1999 and 2001. According to the government allegation,
the company engaged in channel stuffing in order to report higher product sales on its income statement, presumably to meet
Wall Street earnings expectations. Channel stuffing refers to the practice of shipping unordered goods to retailers, usually with a
guarantee to allow the retailers to return any unsold merchandise.
Bristol-Myers Squibb apparently felt it was important to report strong results on its income statement even if it meant violating
the rules of the game. There was, however, one telltale sign that something was wrong with the companys reported results: While
the company was reporting inflated sales and earnings on the unordered product it shipped to its customers, its operating cash flow
failed to reflect the apparent increase in sales. Where would this information appear in a companys financial statements?
In addition to the income statement that included the inflated sales, Bristol-Myers Squibb was also required to disclose its
statement of cash flow to its shareholders. This statement includes a reconciliation of a firms reported net income and its cor-
responding cash flow from operations. In 2001, the year prior to the alleged channel stuffing, Bristol-Myers reported net earnings
in excess of $2 billion and cash flow from operations in excess of $5 billion. The company had in prior years consistently reported
cash flow from operations that equaled or exceeded its reported net income. This changed in 2002, however, when the company
reported net income in excess of $2 billion, but cash flow from operations of less than $1 billion.
In this chapter, we examine how firm performance is measured. Both the income statement and the statement of cash flow
contain important indicators of a companys operating performance. Public companies like Bristol-Myers Squibb are required to
include both financial statements in their filings with the U.S. Securities and Exchange Commission and in their annual report to
shareholders. To be fully informed, financial statement users must understand the information that each statement conveys about
a companys operating performance.

EXECUTIVE Measuring Performance: Cash Flow and Net Income

OUTLINE

Analyzing and Computing Identifying and Understanding

Cash Flow Information Sustainable Earnings

Statement of Cash Flow Special Items and Extraordinary Items

Presenting Cash Flow Information Discontinued Operations
Computing Cash Flow under the Indirect Method Earnings per Share
Analysis of the Statement of Cash Flow Pro Forma Earnings
Cash Flow Ratios
Alternative Measures of Cash Flow

ANALYZING AND COMPUTING CASH FLOW

INFORMATION
In the minds of most investment professionals, lenders, and managers, the two most important measures of a firms
financial health and performance are its operating cash flow and its net income. In this chapter, we explore these two
measures in greater detail, examining their similarities and differences, and how they are interrelated. We will see that
78
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 79

the accrual accounting process imbeds estimates of future cash flow into current net income, and as a consequence,
that current period net income is often a very good predictor of future operating cash flow.
We begin this chapter by considering the various ways that cash flow data can be presented. We then consider how
cash flow information can be extracted from balance sheets and income statements. Finally, we consider the important
concept of sustainable earnings and the various alternative measures of cash flow used by investment professionals.

Statement of Cash Flow

The statement of cash flow summarizes a firms inflows and outflows of cash by segmenting a firms total cash flow
into three activity categories:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
These three categories represent the three key activities undertaken by all businessesproviding a good or ser-
vice (operating activities), obtaining the assets necessary to provide a good or service (investing activities), and fi-
nancing both the basic operations of a business and the investment in assets required to produce a product or provide
a service (financing activities). The three basic activities can be illustrated with a simple example of a pizza delivery
business. Before the business can start delivering pizzas, it must first obtain the necessary funds to buy a delivery van.
Taking out a loan at a bank is an example of a financing activity. The borrowed cash can then be used to buy the van,
representing an investing activity. Having purchased the van, the business can then begin using it to make deliveries
and collecting cash from customers, an operating activity.
Analyzing and understanding the contents of the statement of cash flow provides financial statement users with
critical insights about a companys operating, investing, and financing strategies. Exhibit 3.1, for example, provides an
illustration of a typical statement of cash flow. This exhibit reveals that the cash flow from operations represents the
aggregate of the cash received from the sale of goods and services less the cash spent on operating expenses. The cash
flow from investing, on the other hand, is the aggregate of the cash received from the sale of investments, property
and equipment, and intangible assets less the cash spent to acquire these various types of assets. Finally, the cash flow
from financing represents the aggregate of the cash received from the sale of debt and equity securities less the cash
paid to retire debt, repurchase equity securities, or pay dividends to shareholders.
The statement of cash flow can be presented in two alternative formatsthe direct and indirect methodto which
we now turn.

EXHIBIT 3.1 An Illustrative Statement of Cash Flow

V
Operating Activities
Cash received from the sale of goods and services Operating
 Cash spent on operating expenses Strategy
Cash Flow from Operations (CFFO)

V
Investing Activities
Cash received from the sale of investments, property and
equipment, or intangible assets Investing
 Cash invested in investments, property and equipment, or Strategy
intangible assets
Cash Flow from Investing (CFFI)

V
Financing Activities
Cash received from the sale of debt or equity securities Financing
 Cash paid to retire debt or equity securities and to Strategy
pay dividends
Cash Flow from Financing (CFFF)
80 Chapter 3 | Measuring Performance: Cash Flow and Net Income

Presenting Cash Flow Information

There are two formats available under GAAP to present the statement of cash flowthe direct method format and the
indirect method format. These approaches differ only in how the cash flow from operations is constructed. The cash
flow from investing and the cash flow from financing are identical under the two formats.
Since the vast majority of publicly held companies (about 99 percent) utilize the indirect method format, we will
principally focus on this format. Appendix 3A at the end of this chapter illustrates how to construct a direct method
statement of cash flow. Under the direct method statement of cash flow, cash flow from operations is computed di-
rectly from the companys cash transactions.
Under the indirect method a company computes its cash flow from operations by making various adjustments
to convert its accrual-based net income to its cash-based cash flow from operations. In other words, cash flow from
operations is computed indirectly by starting with accrual net income and then making adjustments to determine cash
flow from operations. Exhibit 3.2 presents an indirect method statement of cash flow for Sun Microsystems.
Exhibit 3.2 reveals that Suns cash flow from operations begins with the companys 2005 net loss of $107 million
and then reports the various adjustments needed to convert its net loss under the accrual basis of accounting to its cash
flow from operations of $369 million under the cash basis of accounting. Suns statement of cash flow reveals that
the principal positive adjustments to its net loss from operations were depreciation and amortization expense ($671
million), the change in accounts payable ($105 million), and the change in accounts receivable ($111 million). These
accrual accounting adjustments illustrate how it is possible for a company like Sun Microsystems to report negative
net income while also reporting a positive cash flow from operationsnet income includes, among other things, such
noncash expenses as depreciation and amortization expense.
Suns statement of cash flow also reveals the companys investing and financing strategies. In 2005, for example,
the company used its available cash flow to acquire property, plant and equipment ($257 million), spare parts and other
assets ($90 million), and for various acquisitions ($95 million). Financing for these capital investments came from the
issuance of new common stock ($218 million), net of payments on corporate borrowings ($252 million), and from the
companys operating cash flow. Notice that the sum of Suns operating cash flow ($369 million) plus its financing cash
flow ($34 million) was insufficient to cover its capital investment of $425 million in 2005, forcing the company to draw
down on its existing cash.

Computing Cash Flow under the Indirect Method

Although a statement of cash flow is a required corporate disclosure for public companies in their annual report to
shareholders and their annual 10-K filing with the U.S. Securities and Exchange Commission, it is not a required
disclosure for unaudited financial data (such as quarterly financial data). Thus, an important skill for investors, invest-
ment professionals, and managers is the ability to estimate a companys cash flow using only those statements that are
routinely available, namely income statements and balance sheets. (This skill is also important in the construction of
pro forma financial statements, which are discussed in Chapters 4 and 12.) In this section, we illustrate how to prepare
an indirect method statement of cash flow using only two balance sheets and an income statement.
To begin, it is important to understand exactly what we are accomplishing with the statement of cash flow. This
statement details a firms cash flow activity during a given fiscal period. It reveals how the cash balance on the bal-
ance sheet increased or decreased from the beginning of the period to the end of the period (the change in cash). The
principal events that cause a firms cash balance to change include the sale of goods, the purchase of inventory, the
payment of operating expenses, the payment of dividends, the purchase or sale of property and equipment, and the sale
or repurchase of stock, among other things. In short, all of the financial events that result in a change in a companys
cash account are reported in some form on the firms income statement or balance sheet. And, as a consequence, a
statement of cash flow can be prepared using only a companys income statement and the changes in its balance sheet
accounts. This can be seen by reference to the balance sheet equation:
Assets (A)  Liabilities (L)  Shareholders Equity (SE) (1)
Separating a firms assets into its cash assets (CA) and its noncash assets (NCA):
CA  NCA  L  SE (2)
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 81

EXHIBIT 3.2 Illustration of the Indirect Method for Statement of Cash Flow

Sun Microsystems, Inc.

Consolidated Statements of Cash Flows

2004 2003
Fiscal Years Ended June 30 (in millions) 2005 (Restated) (Restated)

Cash flows from operating activities

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (107) $ (388) $(3,384)
Adjustments to reconcile net loss to net cash provided by operating activities
Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671 730 918
Amortization of other intangible assets and unearned
equity compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 83 110
Impairment of goodwill and other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . 49 2,125
Tax benefits from employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 4 9
Deferred taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (315) 620 654
Loss on investments, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 64 84
Purchased in-process research and development . . . . . . . . . . . . . . . . . . . . . . . . . 70 4
Changes in operating assets and liabilities
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 61 387
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 (44) 181
Prepaid and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (19) (288) (231)
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 158 (133)
Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (239) 1,107 313
Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369 2,226 1,037
Cash flows from investing activities
Purchases of marketable debt securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,154) (8,469) (6,958)
Proceeds from sales of marketable debt securities . . . . . . . . . . . . . . . . . . . . . . . . 6,181 5,795 6,476
Proceeds from maturities of marketable debt securities . . . . . . . . . . . . . . . . . . . . . 941 854 578
Purchases of equity investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (19) (21)
Proceeds from sales of equity investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 49 17
Acquisition of property, plant and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . (257) (249) (373)
Acquisition of spare parts and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (90) (71) (217)
Payments for acquisitions, net of cash acquired. . . . . . . . . . . . . . . . . . . . . . . . . . . (95) (201) (30)
Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (425) (2,311) (528)
Cash flows from financing activities
Acquisition of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (499)
Proceeds from issuance of common stock, net . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 239 182
Principal payments on borrowings and other obligations . . . . . . . . . . . . . . . . . . . . (252) (28) (201)
Net cash provided by (used in) financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . (34) 211 (518)
Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . (90) 126 (9)
Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,141 2,015 2,024
Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,051 $2,141 $2,015

Supplemental disclosures of cash flow information

Interest paid (net of interest received from swap agreements of
$62, $72 and $70 in fiscal 2005, 2004 and 2003, respectively). . . . . . . . . . . . . . . . $ 27 $ 26 $ 36
Income taxes paid (received) (net of refunds of $34, $143 and $351
in fiscal 2005, 2004 and 2003, respectively) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 371 $ 70 $ (91)
Supplemental schedule of noncash investing activities
Stock and options issued in connection with acquisitions . . . . . . . . . . . . . . . . . . . $ 1 $ 125 $ 193

And, rewriting the balance sheet equation in changes form where  means changes, yields:
CA  NCA  L  SE (3)
Finally, rearranging the components of the balance sheet equation shows that the change in cash can be computed from
the change in all of the other balance sheet accounts:
CA  L  NCA  SE (4)
82 Chapter 3 | Measuring Performance: Cash Flow and Net Income

Five Steps to Cash Flow. Since you are already familiar with the financial affairs of the Russian River Valley
Winery from Chapter 2, we will use this data for purposes of illustrating an approach for generating cash flow data
from balance sheets and income statements. The process involves five steps, resulting in the preparation of an indirect
method statement of cash flow. The approach begins by focusing initially only on the balance sheet and then proceeds
to integrate a businesss income statement through a series of systematic adjustments to a preliminary statement of
cash flow derived solely from balance sheet data. Exhibit 3.3 presents the beginning of year (column 1) and end of
year (column 2) balance sheets for the Russian River Valley Winery.

Step One. Using just the beginning and ending balance sheets (see Columns 1 and 2 in Exhibit 3.3), calculate the
change in each balance sheet account by subtracting the beginning balance sheet amount from the ending amount. The
results of this step for Russian River Valley are presented in Column 3 of Exhibit 3.3. To simplify this step, the change
in the property, plant, and equipment accounts are calculated as an aggregate amount after deducting any accumulated
depreciation (on a net-of-accumulated-depreciation basis).
To verify the accuracy of the Step One calculations, simply compare the sum of the changes in the asset accounts
($153) to the sum of the changes in the liability and shareholders equity accounts ($153). These totals must be equal.
If the totals are not equal, it indicates the presence of a subtraction error that must be identified and corrected before
progressing to Step Two.

EXHIBIT 3.3 Preparing a Statement of Cash Flow: The Indirect Method

Russian River Valley Winery, Inc.

Balance Sheet
(1) (2) (3) (4)
Beginning End of Change Cash Flow
($ thousands) Of Year 1 Year 1 For Year Classification

Current assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,700 $ 768 $(3,932) Net cash flow
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 800 800 Operating
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 60 60 Operating
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700 1,628
Noncurrent assets
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 3,500
Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000
6,000 9,500
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 (225)
Property, plant & equipment, net . . . . . . . . . . . . . . . . . . . . . . 6,000 9,275 3,275 Investing/Operating
Intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 50 (50) Investing/Operating
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,800 $10,953 $ 153
Current liabilities
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 80 $ 80 Operating
Taxes payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 96 96 Operating
Notes payable, current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 480 480 Financing
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 656
Notes payable, noncurrent . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800 3,840 (960) Financing
Shareholders equity
Common stock, $1 par. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 6,400 400 Financing
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 57 57 Financing/Operating
Shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 6,457
Liabilities & shareholders equity . . . . . . . . . . . . . . . . . . . . . . $10,800 $10,953 $ 153

An important figure identified during Step One is the final result of the statement of cash flow, namely the change
in the cash account. The bolded area in Exhibit 3.3 reveals that the cash account of the Russian River Valley Winery
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 83

declined by $3,932 from the beginning of the year to the end of the year. Hence, all of the various cash inflows and
outflows for the winery must aggregate to this figure.

Step Two. Step Two involves identifying the In Practice 3.1 Balance Sheet Caption: A Glimpse of a Sample of
appropriate cash-flow activity categoryoper- Fortune 1000 Companies The following table identifies the caption
ating, investing, or financingfor each balance used by a sample of 600 Fortune 1000 companies on their balance
sheet account, and this is illustrated in Column 4 sheets to describe the cash account. The overwhelming majority of
of Exhibit 3.3. Although measuring the change in firms utilize the caption cash and cash equivalents.
the balance sheet accounts in Step 1 is straight-
forward, there can be some confusion over the Balance Sheet Captions Number Percentage
correct activity classification for some of the bal- Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 3.7
ance sheet accounts in Step 2. Accounts receiv- Cash and cash equivalents* . . . . . . . . . . 528 88.0
able, inventory, accounts payable and taxes pay- Cash and equivalents. . . . . . . . . . . . . . . 34 5.6
Cash combined with marketable
able are all easily identified as operating activity securities . . . . . . . . . . . . . . . . . . . . . . . . 13 2.2
items because they are associated with the day- Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0.5
to-day operations of a business. Notes payable
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 100.0
(current and noncurrent) and common stock,
on the other hand, are clearly financing activ- Source: 2006 Accounting Trends & Techniques
ity items because they are associated with rais- * As this textbook went to press in 2007, the FASB took steps to eliminate the
ing capital to finance a business. Net property, term cash equivalents from corporate financial statements. Items currently
classified as cash equivalents, such as certificates of deposit and money market
plant and equipment (P,P&E), however, can be
accounts, will now be classified as short-term investments.
both an investing activity item and an operating
activity item. Purchases and sales of P,P&E are
associated with the capital investment needed to run a business, and thus, are an investing activity item; but, the de-
preciation expense associated with P,P&E is an operating activity item since the depreciation of P,P&E is deducted
as an operating expense in the calculation of accrual net income. Similarly, intangible assets can be both an investing
activity item and an operating activity item because the acquisition or sale of intangibles is an investing activity item,
whereas the amortization of intangibles is an operating expense deducted in the calculation of accrual net income,
and hence, an operating activity item. Finally, retained earnings can be both an operating activity item and a financing
activity item because retained earnings is increased by net income, an operating activity item, but decreased by the
payment of dividends, a financing activity item.
As a general rule, the following cash flow activity classifications apply, although exceptions will exist:

Balance Sheet Account Cash Flow Activity Category

Current assets . . . . . . . . . . . . . Operating

Noncurrent assets . . . . . . . . . . Investing/Operating
Current liabilities. . . . . . . . . . . . Operating
Noncurrent liabilities. . . . . . . . . Financing
Capital stock . . . . . . . . . . . . . . Financing
Retained earnings . . . . . . . . . . Operating/Financing

Examples of exceptions to the above general activity classifications include the following:
Marketable securities, a current asset, are an investing activity item.
Current maturities of long-term debt, a current liability, are a financing activity item.
Employee pension obligations, a noncurrent liability, are an operating activity item.

Step Three. Having completed Steps One and Two, you are now ready to build a preliminary statement of cash flow
using the calculated increases or decreases in the various balance sheet accounts from Step One and the identified
activity classifications from Step Two. The preliminary statement of cash flow for the Russian River Valley Winery,
using the values from Column 3 of Exhibit 3.3 and the cash flow activity categories from Column 4, is presented in
Exhibit 3.4.
84 Chapter 3 | Measuring Performance: Cash Flow and Net Income

EXHIBIT 3.4 An Illustration of a Preliminary Statement of Cash Flow: The Indirect Method

Russian River Valley Winery Inc.

Preliminary Statement of Cash Flow
($ thousands) Year 1

Operating activities
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 57
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (800)
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60)
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
CFFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (627)
Investing activities
Property, plant & equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,275)
Intangible assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
CFFI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,225)
Financing activities
Notes payable, current. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Notes payable, noncurrent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (960)
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
CFFF. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (80)
Change in cash (from balance sheet) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(3,932)

Since a statement of cash flow measures the inflows and outflows of cash for a business, it is important to
note that the sign of the asset account changes calculated in Step One must be reversed for purposes of preparing
the preliminary statement of cash flow in Exhibit 3.4. This can be seen in equation (4) above in which the change
in noncash assets has a negative sign. For instance, Exhibit 3.3 shows that the change in accounts receivable was
an increase of $800, whereas the change in intangible assets was a decrease of $50. When preparing the indirect
method cash flow statement, an $800 increase in accounts receivables represents a subtraction from net income (a
cash outflow), and a decline in intangible assets of $50 represents an addition to net income (a cash inflow), to ar-
rive at the cash flow from operations. To illustrate why an increase in accounts receivable must be subtracted from
net income to arrive at operating cash flow, consider how sales are initially recorded. Recall that under the indirect
method, cash flow from operations begins with accrual net income. Therefore we will need to make adjustments
to accrual net income in order to find the cash that has been received or used. Assume that a $2,000 sale of in-
ventory is paid for with $1,200 in cash and the remaining $800 recorded as an increase in accounts receivable. In
this example, net income increases by $2,000 but cash is only increased by $1,200. Therefore, net income must be
reduced by the $800 increase in accounts receivable to yield the correct cash flow from operations. Similar logic
explains why it is necessary to add back the decrease in intangible assets to net income to arrive at the correct
cash flow from operations. Intangible assets were reduced by amortizing the cost of the asset by $50. This $50 expense
reduced net income; however, no cash outflow was involved. Therefore, it is necessary to add $50 back to net income
to yield the correct change in cash. Hence, when preparing the preliminary statement of cash flow in Step Three, it
is important to remember to reverse the sign of the change values for the asset accounts. This is unnecessary for the
liability and shareholders equity accounts as can be seen from equation (4) above.
Exhibit 3.4 presents the preliminary statement of cash flow for the Russian River Valley Winery. This preliminary
statement suggests that the firms cash flow from operating activities (CFFO) for the period was negative $627, the
cash flow from investing activities (CFFI) was negative $3,225, and the cash flow from financing activities (CFFF)
negative $80. As required, the cash inflows and outflows aggregate to the change in the cash account from the balance
sheet of a decrease of $3,932.

Step Four. To this point we have used the balance sheet exclusively to provide the needed inputs to our statement of
cash flow. For most businesses, however, cash flow will be generated by the firms ongoing operations and not just by
various events affecting the balance sheet accounts. Hence, it is now appropriate to introduce the operations-related
data found on the winerys income statement (see Exhibit 3.5).
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 85

EXHIBIT 3.5 Income Statement

Russian River Valley Winery, Inc.

Income Statement
($ thousands) Year 1

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,900
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,520
Operating expenses
Wages & salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Selling, general & administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 845
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 317

In this step, we will accomplish two important actions involving our preliminary statement of cash flow in Ex-
hibit 3.4. First, we will replace the change in retained earnings from the balance sheet with net income from the in-
come statement. In the event that the change in retained earnings does not equal net income, we will assume that
any difference represents cash dividends paid to shareholders. For the Russian River Valley Winery, net income is
$317 and the change in retained earnings is $57. Thus, it is necessary to gross up the change in retained earnings by
$260 to equal the current net income ($57  $260  $317) under the operating activities section; and, to keep the
statement of cash flow in balance with the decrease in cash of $3,932, insert the cash outflow for dividends ($260)
under the financing activities section.
Second, we will adjust Russian River Valleys net income for any noncash expenses such as the depreciation of
plant and equipment and the amortization of intangibles that were deducted in the process of calculating the firms
accrual net income. These noncash expenses must be added back to net
income in the operating activities section to correctly measure the firms Depreciation expense and amortization
operating cash flow. However, to keep the preliminary statement of cash expense are called noncash expenses
because these expenses do not involve
flow in balance with the check figure of a decrease in cash of $3,932, it
any current-period cash outflow. Deprecia-
is also necessary to subtract equivalent amounts in the investing activi-
tion expense, for example, represents the
ties section. allocation of the purchase price of plant
To summarize, the adjustments to the Russian River Valley Winery and equipment over the many periods
preliminary statement of cash flow in Exhibit 3.4 are as follows: that these assets produce revenues for a
business. The matching principle requires
1. Net income of $317 replaces the change in retained earnings of that the cost of plant and equipment be
$57 in the operating activities section. This action added $260 to matched with the revenues produced by
the CFFO. To keep the statement of cash flow in balance with the these assets, and this is accomplished on
check figure of negative $3,932 (the decrease in cash), it is neces- the income statement by the inclusion of
sary to subtract $260 elsewhere on the statement. Since retained the periodic depreciation expense.
earnings is calculated as follows:

Retained earnings (beginning)

 Net income for the period
 Dividends paid
Retained earnings (ending)

the outflow of $260 is reflected as a cash dividend paid to shareholders under the financing activities section.
86 Chapter 3 | Measuring Performance: Cash Flow and Net Income

2. Depreciation expense of $225, a noncash deduction In Practice 3.2 Method of Reporting the Cash Flow
from net income, is added back to net income to avoid from Operations: A Glimpse of a Sample of Fortune 1000
understating the cash flow from operations. However, Companies The following table identifies the method of
to keep the statement of cash flow in balance with the reporting the cash flow from operations as used by a
change in cash of negative $3,932, a similar amount sample of 600 Fortune 1000 companies. Over 98 percent
must be subtracted from property and equipment under of all companies surveyed used the indirect method:
the investing activities section.
3. Amortization expense of $50, another noncash deduction Method of Reporting Number Percentage
from net income, is added back to net income to avoid Indirect method . . . . . . . . 592 98.7
understating the cash flow from operations. To insure Direct method. . . . . . . . . . 8 1.3
that the statement is in balance with the check figure of Total . . . . . . . . . . . . . . . . . 600 100.0
negative $3,932, an equivalent amount is subtracted from
intangible assets under the investing activities section.1 Source: 2006 Accounting Trends & Techniques

The results of these adjustments are displayed in Exhibit

3.6, which presents the final statement of cash flow for the Russian River Valley Winery. Note that the winerys state-
ment of cash flow remains in balance with the change in the cash account of negative $3,932 after the three adjustments.
This result is possible because whatever amount was added to (or subtracted from) net income under the CFFO, an equal
amount was subtracted from (or added to) CFFI or CFFF.

EXHIBIT 3.6 Statement of Cash Flow: Indirect Method

Russian River Valley Winery, Inc.

Statement of Cash Flow
($ thousands) Year 1

Operating activities
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 317
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
(Increase) in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (800)
(Increase) decrease in inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (60)
Increase (decrease) in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Increase (decrease) in taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92)
Investing activities
Purchase of property, plant & equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,500)
Cash flow from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,500)
Financing activities
Sale of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Payment of notes payable (current) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (480)
Payment of cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (260)
Cash flow from financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (340)
Change in cash (on balance sheet). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,932)
Beg. cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700
End. cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 768

Step Five. To provide the most useful cash flow data, a final step is required: Make any appropriate adjustments to
the CFFO to calculate the recurring or sustainable CFFO. As noted above, the CFFO should include only the cash flow
from operating activities. Consequently, to calculate the CFFO of a business, it is necessary to review a companys
income statement to identify and remove the financial effects of any nonoperating and/or nonrecurring transactions.

1
Another example of a noncash/nonoperating item that will need to be removed from net income when calculating the CFFO is any income (loss)
from equity investments. We will have more to say about this adjustment and the accounting for equity investments in Chapter 8.
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 87

(An exception is interest expense, which many investment professionals view as a financing activity item; regardless,
interest payments are required to be included in the CFFO under U.S. GAAP.)
To illustrate this point, assume that the Russian River Valley Winery sold property and equipment during the year
at a loss of $25 and that the loss was included in its net income. This event is an investing activity and therefore prop-
erly belongs under CFFI. To correctly calculate the winerys CFFO, it is necessary to remove this loss from net income
in the operating activity section and to add it to property and equipment under the investing activities section. These
actions allow us to correctly measure the companys CFFO, as well as to correctly assess its cash flow for property and
equipment. We will have more to say about this type of operating cash flow adjustment in subsequent chapters.
Exhibit 3.6 presents the final indirect method statement of cash flow for Russian River Valley and includes not
only the adjustments from Step Four, but also, if needed, any adjustments to remove any nonoperating or nonrecur-
ring gains and losses from the CFFO (Step 5). Russian River Valleys cash flow statement in Exhibit 3.6 using the
indirect method reveals that the cash flow from operating activities is negative $92, the cash flow from investing
activities is negative $3,500, and the cash flow from financing activities is negative $340. The resulting net cash
flow of negative $3,932 exactly equals the decrease in cash on the balance sheet of $3,932, as required.
The following illustration summarizes the five-step process to preparing an indirect method statement of cash flow:

Five Steps To Cash Flows

Statement of cash flows

Remove any nonrecurring and/or

5 nonoperating financial effects from
net income.

Integrate the income statement data by (a)

replacing the change in retained earnings with
4 net income and dividends, and (b) add back to
net income the noncash expenses of
depreciation and amortization.

Prepare a preliminary statement of cash flows using

3 the change values from step one and the activity
classifications from step two.

Classify each of the balance sheet accounts into one of the

2 three cash flow activity categories: Operating, Investing, or
Financing.

Calculate the change in all balance sheet accounts by subtracting the

1 beginning account balance from the ending account balance.
88 Chapter 3 | Measuring Performance: Cash Flow and Net Income

Analysis of the Statement of Cash Flow

Like the income statement, the statement of cash flow portrays another aspect of a businesss performance over a
period of time. The major difference between these two financial statements concerns how performance is defined.
The income statement defines performance in terms of a businesss accrual net income, where earned revenues are
matched against the expenses associated with generating that revenue. The statement of cash flow, by contrast, defines
performance in terms of a businesss operating cash flow, with the statement showing a companys sources and uses
of cash. Rather than debating which statement is more important, it is better to understand what each statement tells
us and how the statements complement each other.
As mentioned earlier in the chapter, the statement of cash flow can be prepared in two alternate formats, the
indirect method as shown in Exhibit 3.6, and the direct method, as previously shown in Exhibit 2.5. Notice that each
method provides identical totals for each of the three sections of the statement. The only difference between the two
formats is in the presentation of the cash flow data in the operating activities section. As can be seen in Exhibit 2.5, the
direct method format is prepared directly from the cash account and simply displays the sources and uses of operating
cash flows. The indirect method, by contrast, comes to the same total operating cash flow in an indirect approach by
starting with net income and then adjusting net income for the various noncash effects included in the measurement of
net income under the accrual method. Net income, as we have seen, is computed by matching the earned revenues of
a business, whether received in cash or not, with the related business expenses, regardless of whether those expenses
have been paid in cash or not. Quite often, the revenues and expenses are recognized on a businesss income state-
ment in a different period than the corresponding cash inflow or outflow associated with those revenues and expenses.
Consequently, it is necessary to adjust net income for these timing differences when calculating a businesss operating
cash flow using the indirect approach.
By partitioning a businesss cash flow into the three categories of operating, investing, and financing activities,
the statement of cash flow tells the reader much more than just how much its cash balance increased or decreased
during the period; it also provides an explanation as to why the cash balance increased or decreased. For instance, the
statement of cash flow enables a financial statement user to understand whether a businesss cash balance increased
because the cash was earned from operations or because of an increase in bank borrowings. Similarly, statement us-
ers need to understand whether cash declined as a consequence of capital investments in new productive capacity or
because the business is losing money from its operations. A review of the statement of cash flow facilitates this type
of understanding.
Most statement users agree that the most important component of the statement of cash flow is the cash flow
from operating activities. This figure reflects the lifeblood of a company and is the principal source of financing for
long-term survival. Regardless of the industry or life-stage of a business, it is always better for a company to generate
a positive cash flow from operations. It should be noted, however, that many early-stage companies will show nega-
tive operating cash flows as a result of such normal business activities as building up inventory to service a growing
customer base.
While it is unambiguous that a businesss cash flow from operating activities should be positive, the same cannot
be said of the other two activity categories, investing and financing. A negative balance in the cash flow from invest-
ing activities, for example, will result when a firm spends more cash to purchase new equipment than it receives from
the sale of old equipment. For many growth-oriented companies, a negative cash flow from investing activities is the
norm, since investing in new productive capacity will ultimately result in future positive operating cash inflows. Most
financial statement users expect to see a negative cash flow from investing activities since it indicates that a firm is
maintaining itself as a going concern. In fact, a positive cash flow from investing activities may in some instances be
a sign of concern since it may indicate that a business is liquidating its long-term, revenue-producing assets like plant
and equipment.
Similar to the cash flows from investing activities, one cannot unambiguously say whether a positive or nega-
tive balance in financing activities is good or bad. A negative cash flow from financing activities will result when a
company repays its loans and pays dividends to its shareholders, two activities that are usually considered positive by
shareholders. A positive balance, on the other hand, could result from new business financing, perhaps from additional
loans or the sale of capital stock. These activities may be necessary to finance new business growth, especially if a
companys cash flows from operating activities are insufficient to finance this growth using internally generated cash
flow, which is often the case for early-stage companies.
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 89

As this discussion implies, the statement of cash flow provides a great deal of important information, but it also
requires the user to have a solid understanding of what the statement is reporting. At the simplest level, the statement
of cash flow merely tells the reader how much the companys cash balance changed during the period, reconciling the
beginning and ending cash balances appearing on a companys balance sheet. At a more sophisticated level, the state-
ment reveals just where a businesss cash came from and how it was used.
Exhibit 3.7 provides an illustration of the typical sources and uses of cash in each of the three cash flow categories
as a business progresses through its life cycle from a young start-up, through maturity, and later decline. As noted
above, it is always the case that the cash flow from operating activities should be positive; however, for start-up com-
panies, this is rarely the case. Likewise for start-up businesses, the cash flow from investing activities is often negative
as the firm uses its available cash to invest in its future. As a firm matures, this category of cash flow tends to even
out, as the firms investing activities are generally for replacement of assets rather than growth. In the later, declining
stage of a firm, the cash flow from investing may be positive as the firm sells off its assets as it exits certain markets.
Finally, the cash flow from financing activities is likely to be positive for young companies as they require external
financing to fund their growth. As the firm matures, its cash flow from financing tends to stabilize as the firm repays
debt and begins paying dividends. Finally, in the declining stage, a firm is less likely to secure external financing and
more likely to repay obligations and pay dividends as it tries to retain its equity investors, leading to a negative cash
flow from financing activities.
The opening vignette to this chapter observed that an analysis of the statement of cash flow could have alerted
a financial statement user about the problems at Bristol-Myers Squibb. The practice of channel stuffing, in which
large amounts of unordered goods are sent to retailers, is illustrated in the spreadsheet below.

Bristol-Myers Squibb
Assets = Liabilities + Shareholders Equity

Cash Accounts Receivable Retained earnings

Beginning Balance . . . . . . . . . 1,000 1,000 2,000

Channel Stuffing. . . . . . . . . . . 500 500
Ending Balance . . . . . . . . . . . 1,000 1,500 2,500

When a company stuffs its sales channel, it recognizes revenue for the shipped-but-unsold inventory, which in
turn leads to an increase in net earnings; however, as can be seen in the spreadsheet, this leads to an increase in ac-
counts receivable but not an increase in cash, unless and until the sales channel is able to absorb the additional product
through an increase in sales volume. These financial effects are revealed in the statement of cash flows in the operating
activities section.2

EXHIBIT 3.7 Cash flow and a Companys Life Cycle

Life Cycle of the Firm

Activity section of the
statement of cash flow Young/start-up Mature Declining

Operating . . . . . . . . . . . . . . . . . . . . . . . Likely negative Likely positive Uncertain

Investing . . . . . . . . . . . . . . . . . . . . . . . . Likely negative Uncertain, but likely negative Likely positive
Financing . . . . . . . . . . . . . . . . . . . . . . . Likely positive Uncertain, but likely negative Likely positive

Cash Flow Ratios

Investment professionals frequently use components of the statement of cash flow to form financial ratios that help
highlight certain aspects of a firms operating performance that might otherwise be obscured from financial statement

2
A firm must include a reconciliation between net income and cash flow from operating activities even if the firm elects to use the direct method
format of the statement of cash flow.
90 Chapter 3 | Measuring Performance: Cash Flow and Net Income

users. For example, the operating funds ratio indicates the portion of a businesss cash flow from operations provided
by a firms earnings and is calculated as follows:

Cash flow from operations

Operating Funds Ratio  _______________________
Net income

This ratio frequently approximates one for most firms, although during a period of business expansion (contraction),
the ratio may decrease (increase) to less (more) than one. The operating funds ratio is not meaningful for the Russian
River Valley Winery since its cash flow from operations is negative.
Another cash-flow-based ratio is the operating-cash-flow-to-current-liabilities ratio, which is calculated as
follows:

Cash flow from operations

Operating Cash Flow to Current Liabilities Ratio  _______________________
Current liabilities

This ratio provides insights about a firms liquidity, specifically the extent to which a companys current obligations
can be satisfied by its operating cash flow. This ratio highlights the fact that business liquidity is available not only
from a firms existing liquid assets and its ability to borrow or refinance, but also from its ongoing operations.
A final cash-flow-based ratio is the cash conversion ratio, calculated as follows:

Cash from sales

Cash Conversion Ratio  ______________
Net sales

This ratio reveals the extent to which the sales reported on the income
Cash from sales is calculated as net sales
statement are converted into cash. Like the operating funds ratio, this plus/minus the change in accounts receiv-
ratio typically approximates one, although smaller (or larger) ratio values able plus/minus the change in unearned (or
are possible depending upon the growth (or decline) in a firms accounts deferred) revenue.
receivable and its deferred or unearned revenue. Since this ratio features
the cash collected from sales, it is most readily calculated when using the direct method format of the statement of cash
flows. The cash conversion ratio for the Russian River Valley Winery is 0.58, indicating that the winery is projected
to collect only $0.58 for each dollar of reported revenue
during its first year of operations. (Can you verify the cal- In Practice 3.3 Average Dollar Amount of the Adjustments
culation of this ratio? Hint: Read Appendix 3A at the end to net income when computing the cash flow from opera-
of this chapter.) tions using the indirect method format. The largest ad-
justment to net income is the depreciation and amortization
expense, which averaged 83 percent of net income.
Alternative Measures of
Operating activities (in millions)
Cash Flow Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $171.9
Although the statement of cash flow highlights the three Depreciation and Amortization . . . . . . . . . . . . . 142.7
cash flow measures of CFFO, CFFI, and CFFF, investment Gain on sale of assets . . . . . . . . . . . . . . . . . . . (12.8)
Earnings from subsidiaries . . . . . . . . . . . . . . . . (2.3)
professionals often use other cash flow measures depend-
Funds from operationsother . . . . . . . . . . . . . 59.8
ing upon the purpose of their analysis. Three widely used Increase in accounts receivable . . . . . . . . . . . . (28.8)
alternative measures are EBITDA, free cash flow, and dis- Increase in inventory . . . . . . . . . . . . . . . . . . . . (56.8)
cretionary cash flow. Increase in accounts payable. . . . . . . . . . . . . . 18.4
EBITDA, or earnings before interest, taxes, depre- Increase in taxes payable. . . . . . . . . . . . . . . . . 2.2
Sources of fundsother . . . . . . . . . . . . . . . . . 16.9
ciation and amortization (and other noncash charges,
extraordinary items and nonrecurring charges) is often Cash flow from operations . . . . . . . . . . . . . . . . $311.2
used as an alternative measure of a firms operating cash
Source: Standard and Poors Compustat, based on 6,316 firms
flow in those industries commonly referred to as capital reporting cash flow from operations in 2005.
intensivethat is, in those industries characterized by
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 91

large capital investments in property, plant and equipment and/or intangible assets. The financial statements of firms
in capital-intensive industries typically include large noncash expenses for amortization and depreciation. As a conse-
quence, the net income of companies in these industries may be substantially burdened by these charges, particularly
as compared to companies in non-capital-intensive industries.
To make more effective performance comparisons between companies from different industries and even within
the same industry, some analysts rely on such metrics as EBITDA to level the performance playing field. For ex-
ample, to help analysts correctly evaluate the companys performance, CSK Auto Corporation reports both EBITDA
and EBITDAR in its annual report. According to the company,
While EBITDA is not intended to represent cash flow from operations as defined by GAAP, it is included herein be-
cause we believe it is a meaningful measure which provides additional information with respect to our ability to meet
our future debt service, capital expenditure and working capital requirements. EBITDAR, on the other hand, repre-
sents EBITDA plus operating lease rental expense. Because the proportion of stores leased versus owned varies
among industry competitors, we believe that EBITDAR permits a meaningful comparison of operating performance
among industry competitors. We lease substantially all of our stores.

EBITDA is thought to provide an easily calculated alternative to operating cash flow as both measures begin with net
income and both measures adjust for the noncash operating expenses of depreciation and amortization.
Another cash flow measure, free cash flow (FCF), is often used by analysts to evaluate a companys cash-flow
strength. For instance, Acxiom Corporation, a company that integrates data, services and technology, reported that
it generated free cash flow of $199.0 million in fiscal 2003, compared to operating cash flow of $253.8 million. The
company noted that free cash flow provides investors with a useful alternative measure of operating performance
by allowing an assessment of the amount of cash available for general corporate and strategic purposes after funding
operating activities and capital expenditures, capitalized software expenses and deferred costs. FCF is an important
performance reference point for many investment professionals because it is less subject to the accounting trickery
that often characterizes accrual net income. Free cash flow is calculated as follows:

FCF  CFFO  CapEx

where CapEx is the required reinvestment in the assets of a business necessary to enable the firm to maintain itself as
a going concern. It should be clear that a firm with strong free cash flow will carry a higher firm value than one with
weak (or no) free cash flow. Some investment professionals incorporate the construct of free cash flow into a ratio
called the free cash flow yield to facilitate interfirm comparisons of cash flow strength. A firms free cash flow yield
is defined as its free cash flow divided by its market capitalization. Businesses with high free cash flow yields are
frequently seen as attractive additions to a portfolio of investment securities. We will have more to say about FCF in
Chapter 12.3
While FCF addresses the issue of, How much cash is available for general corporate use? the concept of discre-
tionary cash flow addresses the question, How much internally-generated operating cash flow is available to permit
a companys management to undertake a discretionary, value-creating action? A businesss discretionary cash flow
(DisCF) is calculated as follows:

DisCF  CFFO  Required debt payments  Dividend payments

This expression reveals that DisCF is a companys internally-generated operating cash flow less any required
payments to debtholders and any expected dividend payments to shareholders. Thus, DisCF is a measure of the excess
internally-generated operating cash flow available to a business enterprise to undertake a discretionary project, for
example investing in a new plant or acquiring a company. When DisCF is large, it indicates that a firms internally-
generated cash flow is strong relative to existing claims on those flows. When DisCF is small, it indicates that a firm

3
A companys capital expenditures, or CapEx, are frequently segmented into maintenance CapEx and incremental CapEx. Maintenance CapEx is
the amount of capital investment required to leave a going concern as well off at the end of a fiscal period as it was at the start of the fiscal period.
Maintenance CapEx is frequently estimated by the amount of depreciation expense taken in a given period. Incremental CapEx, on the other hand,
is any capital investment in excess of maintenance CapEx and is usually associated with an expansion in the productive capacity of a business.
92 Chapter 3 | Measuring Performance: Cash Flow and Net Income

will need additional external funding to facilitate a plant expansion, merger or acquisition, or debt retirement. Some
analysts look to a businesss discretionary cash flow as another indication of a businesss cash flow health.

IDENTIFYING AND UNDERSTANDING

SUSTAINABLE EARNINGS
Net income or net earnings is the bottom line measure of firm perfor-
mance. It is a measure that depends on such accrual accounting proce- Market capitalization refers to a firms
dures as the revenue recognition and expense matching policies selected current fair market value, calculated as its
by a firms management. Generally accepted accounting practice has market price per share times the number
of shares outstanding. A businesss market
historically emphasized the importance of accounting earnings because
capitalization reflects the capital markets
past accounting earnings have been found to be a good predictor of a
outlook regarding the companys future
firms future operating cash flow. In Chapter 12, we will see that in earn- operating performance and differs from
ings-based valuation models, the value of a companys share price largely a firms book value (i.e., the value of its
depends on a firms expected future earnings. Thus, an important role shareholders equity) which is based on
for historical accounting numbers is their use in forecasting a companys past performance.
future earnings, and hence, a firms market capitalization.
One of the determinants of the ability of historical earnings to predict future earnings is the extent to which
earnings reoccur over time, or what is known as earnings persistence. Since the value of a share of stock today is a
function of a firms ability to consistently generate earnings year in and year out, the sustainability or persistence of
a companys operating earnings is closely linked to its value. Sustainable earnings are also sometimes referred to as
permanent earnings, whereas non-sustainable earnings are often referred to as transitory earnings. In general, tran-
sitory earnings include such single-period items as extraordinary gains/losses, special items, restructuring charges,
changes in accounting principle, and discontinued operations.
To assist investors in their assessment of a companys sustainable Intrinsic value refers to the underlying
earnings, and hence in assessing a firms intrinsic value, companies are economic value of a business as a going
required under GAAP to classify income statement accounts in a man- concern; that is, the value that a business
ner that aids the user in assessing a firms sustainable earnings. Exhibit could be sold for in an efficient market.
3.8 illustrates the basic format of the income statement. Notice that the
income statement is organized in such a way that items with greater persistence are reported higher in the income
statement, whereas items considered more transitory are reported further down in the statement. Thus, accounts
representing financial events that are both usual and frequent are reported first. Usual refers to whether an item is
central to a firms core operations, whereas unusual items display a high degree of abnormality and/or are unre-
lated, and/or only incidentally related, to the ordinary and typical activities of the enterprise. Frequent refers to how
often an item is expected to occur, with infrequent items not reasonably expected to recur in the foreseeable future.4
Usual and frequent items typically consist of such income statement accounts as sales, cost of goods sold, and other
operating expenses. Just below these usual and frequent items are items that are either unusual or infrequent, but not
both. Examples of these special items include such financial events as asset write-downs and restructuring charges.
While these items are not expected to occur regularly, they are not considered unusual in nature. Income statement
accounts such as interest expense, interest income, and gains on sales of equipment are often frequently recurring
items; however, they are not considered part of a firms central operations and therefore are considered unusual.
Each of the above items is reported as part of continuing operations and is shown before any tax expense. GAAP,
however, requires two single-period items, or one-time events, to be reported on an after-tax basis. These two items,
discontinued operations and extraordinary items, are each shown net of any applicable income taxes. Reporting
these items on a net-of-tax basis allows the income tax expense reported on the income statement to reflect only
the income taxes associated with a firms continuing operations, consequently enabling financial statement users to
more readily predict a firms future expected effective income tax rate.

4
Accounting Principles Board, Opinion No. 30, Reporting the Results of Operations, 1973. The Accounting Principles Board was the predecessor
to the Financial Accounting Standards Board.
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 93

EXHIBIT 3.8 The Income Statement

Savanna Company
Income Statement
For Year Ended December 31

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500 Usual and frequent

Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Usual and frequent
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200 Usual and frequent
Special items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 250 Unusual or infrequent
Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Other income and expense
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Unusual
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35) Unusual
Gain on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5 Unusual
Net income from continuing operations before tax . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Net income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Gain (loss) on disposal of segment, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Infrequent
Net income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Extraordinary gain (loss), net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15) Unusual and infrequent
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30
Earning per share (100 shares outstanding)
Net income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .35
Disposal of business segment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10
Extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (.15)
Total earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .30

Special Items and Extraordinary Items

There is no generally accepted definition as to what constitutes a special item, therefore there is some variation in
what firms will classify as special. Special items often include gains or losses that are outside a firms normal op-
erations. For example, litigation settlements, impairment charges for long-lived assets, and the gains or losses asso-
ciated with the sale of property, plant and equipment are typically classified as special items. The income statement
for CSK Auto Corporation presented in Exhibit 3.9 reveals several special items, including a litigation settlement
of $8.8 million in 2001, a write-off of unamortized management fee of $3.6 million in 1999, and $770,000 for the
cost of a secondary share offering in 1999.
A controversial type of special item that some companies include in their income statement involves restructur-
ing charges associated with changing a businesss operations. Restructuringalso sometimes referred to as right-
sizing or down-sizingusually involves employee layoffs, closing facilities, and changing the companys financial
structure by paying down debt with the issuance of new equity. For example, in Exhibit 3.9, CSK Auto Corporation
reports transition and integration expenses in each year from 1999 to 2001 for the conversion of acquisition-related
stores to the CSK format, store closing costs associated with the closure of CSK stores that overlapped with better-
situated, acquired stores, and the operating losses of acquired automotive service centers that were closed.
In recent years, there has been increasing criticism of companies that report annual restructuring charges because
it is believed that these write-offs have become a device for managing earnings. For example, Eastman Kodak
Company has taken one-time restructuring charges every year for fourteen consecutive years, from 1992 to 2005.
By taking recurring write-downs of property and equipment, management may attempt to convey the impression to
investors, shareholders and investment professionals that the resulting restructuring charges are one-time eventsthat
is, that they are transitory in nature and consequently should be ignored for purposes of valuing the firm. It should be
observed, however, that these charges effectively reduce the regular depreciation expense on the income statement,
and thus improve future operating income on an annual basis. Critics of this practice also note that restructuring
94 Chapter 3 | Measuring Performance: Cash Flow and Net Income

EXHIBIT 3.9 An Illustration of Extraordinary and Special Items

CSK Auto Corporation

Consolidated Statements of Income
($ thousands) 2001 2000 1999

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,452,109 $1,231,455 $1,004,385

Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769,043 636,239 531,073
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683,066 595,216 473,312
Other costs & expense
Operating & administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568,873 471,340 391,528
Store closing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,060 4,900 335
Legal settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,800
Transition & integration expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,818 30,187 3,075
Equity in loss of joint venture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,168
Goodwill amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,799 1,941
Write-off of unamortized management fee . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,643
Secondary stock offering costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770
Operating profit 67,548 86,848 73,961
Interest expense, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,355 41,300 30,730
Income before income taxes, extraordinary loss &
cumulative effect of change in accounting principle. . . . . . . . . . . . . . . . . . . . . . . . 5,193 45,548 43,231
Income tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 17,436 15,746
Income before extraordinary loss & cumulative effect
of change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 28,112 27,485
Extraordinary loss, net of $4,236 of income taxes . . . . . . . . . . . . . . . . . . . . . (6,767)
Income before cumulative effect of change in
accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 28,112 20,718
Cumulative effect of change in accounting principle,
net of $468 of income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (741)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 27,371 $ 20,718

charges are often taken in a bad year in which operating earnings are unusually weak. Lumping restructuring charges
in years characterized by poor operating results to enhance the probability of improved performance in future years
has become known as taking a bath. Available evidence suggests that restructuring charges are often reversed in
subsequent periods to enable a firm to beat analysts earnings forecasts, to avoid reporting losses, or to avoid a decline
in earnings from a prior year.5
Another one-time item is the additional income or charges that result from the implementation of a voluntary or
mandatory change in accounting principle. Mandatory accounting changes occur when an accounting regulatory
body, such as the FASB or IASB, changes the generally accepted accounting practice that is applicable to all audited
companies. For example, in Exhibit 3.9, CSK Auto Corporation discloses that in 2000 it implemented a mandatory
change in its method of accounting for store opening costs, from deferring these costs to immediately expensing the
costs. This accounting policy change resulted in a reduction in CSKs net income of $741,000, net of income tax sav-
ings of $468,000.
A basic principle within U.S. GAAP is the consistency principle. Consistency requires that a firm use the same ac-
counting measurement principles from one fiscal period to the next. This is not to be confused with uniformity, where all
firms would need to report their financial results using a uniform set of principles and methods. Instead, consistency allows
different firms to use different reporting methods; however, a firm is expected to report its performance on a consistent
basis from one year to the next. The consistent use of accounting policies enables financial statement users to make valid,
and hence useful, comparisons of performance across multiple time periods. Voluntary accounting policy changes can, and
do occur, however, when the management of a company and its independent auditor decide that an alternative account-
ing method better reflects a firms operations. Fortunately, voluntary changes in accounting methods dont happen very

5
S.R. Moehrle, Do Firms Use Restructuring Charge Reversals to Meet Earnings Targets? The Accounting Review (April 2002).
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 95

oftenon average, less than two accounting policy changes per firm over a 20-year period. The capital market generally
regards voluntary accounting policy changes suspiciously, often penalizing the share price of companies that make such
changes. We will have more to say about voluntary accounting policy changes in Chapter 7.
As reflected in Exhibit 3.9, firms like CSK Auto Corporation were required in the past to separately show the
cumulative financial effect of an accounting policy change, net of any income tax effect, as a separate line item on
the income statement following the income from continuing operations. Under a new GAAP standard, the financial
effect of a change in a companys accounting policies are now applied retrospectively to all prior periods to which the
change can be estimated, with the financial effect of the change reported as an adjustment to retained earnings on the
statement of shareholders equity rather than on the income statement.
Extraordinary gains (losses) are gains (losses) that are both unusual and infrequent in nature. Extraordinary
items are reported in the income statement net of any applicable income taxes and are reported after income from con-
tinuing operationsthat is, the unusual and infrequent nature of these items is highlighted by prominently displaying
them near the bottom of the income statement. Just what constitutes an extraordinary item, however, can be confusing.
Consider, for example, a company whose uninsured building in California was destroyed in an earthquake. The firm
would not be able to classify the loss as extraordinary because although the occurrence of earthquakes in California
is infrequent, it would not be considered unusual since it is part of the business risk of operating in California. Ex-
traordinary items include such items as a gain or loss resulting from a natural disaster when such events are unusual
and infrequent (such as a hurricane) or a gain or loss resulting from new government regulations, such as an asset
expropriation by a foreign government (such as Venezuelas 2007 expropriation of international oil company assets).
CSK Auto Corporations income statement presented in Exhibit 3.9 includes an extraordinary item of $6.8 million, net
of $4.2 million of income tax benefits, for losses incurred in connection with the retirement of some of the companys
outstanding debt (see bolded area). This disclosure is consistent with the prior reporting requirement under U.S.
GAAP, since revised, that gains and losses from early debt retirement be classified as an extraordinary item.6

Discontinued Operations
When a company discontinues a separately identifiable business unit, such as an existing division, to focus on other
activities, it will generally incur costs to lay off employees, liquidate inventory, and shutter facilities. These costs and
the profits (or losses) from operating the business unit until it can be disposed of are categorized as discontinued op-
erations on the income statement. GAAP requires that companies separate the results of their continuing operations
from their discontinued operations to facilitate shareholder assessment of sustainable earnings. As shown in Exhibit
3.10, Ford Motor Companys income from discontinued operations, after applicable income taxes, totaled $41 mil-
lion in 2005. This amount is further partitioned into two componentsoperating income from discontinued operations
and a loss on discontinued operations. Whereas the first component represents the net operating income for the period
up to the time of the disposition of the discontinued operations, the second component represents the difference be-
tween the proceeds from the sale and the depreciated cost of the net assets disposed.

Earnings per Share

Since investors own shares whose prices are customarily quoted in terms of a price per share, public companies are
required to provide earnings numbers that are scaled by the number of shares held by its shareholders. For example,
basic earnings per share (EPS) are net income divided by the actual number of common shares outstandingthat is,
the number of shares held by a companys shareholders. Diluted earnings per share, on the other hand, is net income
divided by the number of shares outstanding but adjusted for the possibility that some existing claims against the busi-
ness might be converted into additional shares of common stock, thus increasing the number of shares outstanding.
Claims against a firm that can be satisfied by the issuance of additional shares of common stock are called dilutive
claims because the issuance of shares to satisfy these claims will lower, or dilute, basic EPS. Examples of dilutive
claims include convertible bonds, employee stock options, and convertible preferred shares (which are discussed in
Chapters 9 and 11, respectively).

6
FAS No. 145, issued in 2002, rescinded the requirement that gains (losses) on the early retirement of debt be classified as extraordinary under
U.S. GAAP.
96 Chapter 3 | Measuring Performance: Cash Flow and Net Income

EXHIBIT 3.10 Illustration of Discontinued Operations

Ford Motor Company and Subsidiaries

Notes to the Financial Statements

Note 4. Discontinued Operations, Held-for-Sale Operations, Other

Dispositions, and Acquisitions (continued)
Financial Services Sector
Discontinued Operations. Consistent with our strategy to focus on our core business, we completed the disposition of the op-
erations discussed below.
In 2004, we committed to a plan to sell Triad Financial Corporation, our operation in the United States that specialized in
automobile retail installment sales contracts with borrowers who generally would not be expected to qualify, based on their credit
worthiness, for traditional financing sources such as those provided by commercial banks or automobile manufacturers affili-
ated finance companies. During 2005, we completed the sale of this business and recognized a pre-tax loss of approximately
$16 million.
In 2004, we completed the sale of AMI Leasing and Fleet Management Services, our operation in the United States that of-
fered full service car and truck leasing. During 2003, we recognized a pre-tax charge of $50 million, reflected in Income/(loss) from
discontinued operations for the loss on sale. This amount represented the difference between the selling price of these assets,
less costs to sell them, and their recorded book value.
In 2003, we completed the sale of Axus, our all-makes vehicle fleet leasing operations in Europe, New Zealand and Australia.
In 2002, we recognized a pre-tax charge of $31 million, reflected in Income/(loss) from discontinued operations for the loss on
sale. This amount represented the difference between the selling price of these assets, less costs to sell them, and their recorded
book value.
The results of all discontinued Financial Services sector operations are as follows (in millions):

2005 2004 2003

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $118 $493 $550

Operating income (loss) from discontinued operations . . . . . . . . . . . . . . . . . . . . . . $ 59 $138 $ 84
Gain (loss) on discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (16) (50)
(Provision for) benefit from income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2) (57) (36)
Income (loss) from discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 41 $ 81 $ (2)

Since Kohls diluted EPS in 2005 was $2.43 versus a basic EPS of $2.45 (see Business Perspective: Kohls
Corporation), the company must have had some dilutive claims outstanding. Does the capital market consider the
impact of these dilutive claims by relying more heavily on diluted EPS than on basic EPS when assessing a com-
panys intrinsic value? Available evidence that diluted EPS explains more of the variation in share prices than basic
EPS does suggest that investors do indeed focus more closely on diluted EPS in setting share prices.7 However,
available evidence also suggests that alternative EPS measures that better capture the potential dilutive effect of
employee stock options explain more of the variation in share prices than does even diluted EPS.8 This is consistent
with the notion that investors make additional adjustments to diluted EPS when assessing the performance of firms
that issue employee stock options.

Pro Forma Earnings

In recent years, companies have begun reporting a variety of alternative measures of earnings that exclude certain
expenses or write-offs, jokingly referred to by investment professionals as EBBS or earnings before bad stuff. One
such measure is pro forma earnings. While there is no generally accepted definition for the calculation of pro forma
earnings, a commonly used calculation is net income before discontinued operations, restructuring charges, extraordi-
nary and special items, and the effect of any mandatory or voluntary accounting policy changes.

7
R. Jennings, M.J. LeClere and R.B. Thompson, Evidence on the Usefulness of Alternative Earnings per Share Measures, Financial Analysts
Journal (November/December 1997).
8
J.E. Core, W.R. Guay and S.P. Kothari, The Economic Dilution of Employee Stock Options: Diluted EPS for Valuation and Financial Reporting,
The Accounting Review (July 2002).
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 97

BUSINESS PERSPECTIVE: KOHLS CORPORATION

Operating versus Nonoperating Earnings
The income statement for Kohls Corporation is presented below. Kohls consolidated income statement discloses
such operating expenses as the cost of merchandise sold, depreciation and amortization on property and equip-
ment, and selling and administrative expenses (see bolded areas). Kohls separates the results of its core retailing
business from the financing of its business by reporting interest expense as a nonoperating item. It also separates
the financial investing side of its business from its core business by reporting interest income on its investments
and security holdings as a nonoperating item. The underlying logic of this distinction is that Kohls could relatively
quickly change the way it finances its business and/or liquidate its investmentshence these items are considered
to be transitorybut that exiting its core retailing business would require a longer period of time.

Kohls Corporation
Consolidated Statements of Income
Fiscal Year Ended

January 29, January 31,

January 28, 2005 2004
($ thousands, except per share data) 2006 (Restated) (Restated)

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,402,217 $11,700,619 $10,282,094

Cost of merchandise sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,639,278 7,586,992 6,887,033
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,762,939 4,113,627 3,395,061
Operating expenses
Selling, general and administrative . . . . . . . . . . . . . . . . . 2,963,472 2,582,996 2,157,030
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . 338,916 288,173 239,558
Pre-opening expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,370 49,131 47,029
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,346,758 2,920,300 2,443,617
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,416,181 1,193,327 951,444
Other expense (income)
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,086 64,761 76,371
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,695) (2,309) (3,440)
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 1,345,790 1,130,875 878,513
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503,830 427,474 332,050
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 841,960 $ 703,401 $ 546,463
Net income per share
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.45 $2.06 $1.61
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.43 $2.04 $1.59

Under the requirements of the Sarbanes-

Oxley Act passed in 2002, companies that In Practice 3.4 GAAP EPS versus Pro Forma EPS*
include a non-GAAP financial measure
4th Quarter 2004
such as pro forma earnings with their au-
dited financial statements must also provide GAAP Pro Forma Percentage
the most directly comparable GAAP num- Company EPS EPS Difference
bers. These firms must also provide a recon- Eastman Kodak . . . . . . . . . . . . $0.04 $0.78 NM
ciliation between the two sets of numbers. Georgia Pacific . . . . . . . . . . . . . 0.06 0.51 750
For example, Eastman Kodak Company Rowan . . . . . . . . . . . . . . . . . . . 0.02 0.15 650
reported a loss of $0.04 per share for the last Ford Motor . . . . . . . . . . . . . . . . 0.05 0.28 460
Clorox . . . . . . . . . . . . . . . . . . . . 0.72 3.69 413
quarter of 2004 using GAAP. Yet, on a pro
Genzyme . . . . . . . . . . . . . . . . . 0.42 0.52 NM
forma basis, Kodak announced operational Halliburton . . . . . . . . . . . . . . . . 0.45 0.44 NM
earnings of $0.78 per share, a swing of
$0.82 per share from GAAP EPS. Kodaks *Source: CFO Magazine (May 2005). NM  not meaningful.
98 Chapter 3 | Measuring Performance: Cash Flow and Net Income

pro forma earnings, a figure tracked by analysts who follow the company, excluded such costs as the companys re-
structuring charges.
The divergence between the generally higher pro forma earnings and GAAP earnings has increased over time. In
Practice 3.4 presents, for example, GAAP EPS and pro forma EPS for the fourth quarter of 2004 for a selection of S&P
500 companies. Unfortunately, the capital markets reliance on pro forma earnings as a performance metric has also
increased as suggested by evidence that share prices track pro forma earnings more closely than GAAP earnings.9 To
ensure that investors consider GAAP EPS, the U.S. Securities and Exchange Commission adopted Regulation G in
2003, which requires that firms put GAAP-based earnings first in their public earnings announcements, as well as to
reconcile any non-GAAP earnings numbers (e.g., pro forma earnings) with their GAAP-based earnings. The intent
of Regulation G is to insure transparency regarding the differences between GAAP earnings and any non-GAAP
earnings reported by companies.

ETHICS PERSPECTIVE

One of the potential problems associated with the corporate form of business is the agency costs that can result
from the separation of the ownership of a corporation from those that manage the corporation. One mechanism
used to mitigate these potential agency costs are employment compensation contracts. The theory underlying
this mechanism is that if a compensation contract is properly structured, goal congruence between the manager
and the corporations shareholders will result. Thus, properly structured employment contracts provide perfor-
mance incentives that result in larger amounts of compensation being paid when managers achieve better finan-
cial performance.
A potential unintended consequence of executive compensation contracts is that managers may also have
an incentive to cook the books in order to report higher firm performance, and therefore, achieve higher per-
sonal compensation. In other words, rather than achieving goal congruence by working hard to sell more goods
or to produce goods more efficiently, higher performance may be achieved through accounting trickery. Clearly,
earnings management for purely personal gain can be argued to be an ethical breach of an executives job.

REVIEW PROBLEM
The following balance sheet and income statement data were taken from the financial records of The Arcadia Company.

The Arcadia Company

Balance Sheets
2006 2005 2006 2005

Assets Liabilities & Shareholders Equity

Cash . . . . . . . . . . . . . . . . . . . $ 30,000 $ 7,000 Accounts payable. . . . . . . . . $ 63,000 $ 65,500
Marketable securities . . . . . . 60,000 67,500 Wages payable . . . . . . . . . . . 47,500 37,000
Inventory. . . . . . . . . . . . . . . . 22,500 49,000 Total current liabilities. . . . . . 110,500 102,500
Prepaid insurance. . . . . . . . . 4,500 6,000 Bank loan payable . . . . . . . . 85,000 83,000
Total current assets . . . . . . . 117,000 129,500 Capital stock . . . . . . . . . . . . 75,000 75,000
Building (net). . . . . . . . . . . . . 190,000 187,500 Retained earnings . . . . . . . . 36,500 56,500
Totals . . . . . . . . . . . . . . . . . . $307,000 $317,000 Totals . . . . . . . . . . . . . . . . . . $307,000 $317,000

9
M.T. Bradshaw and R.G. Sloan, GAAP versus The Street: An Empirical Assessment of Two Alternative Definitions of Earnings, Journal of
Accounting Research (March 2002).
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 99

The Arcadia Company

Income Statement (2006)

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 480,000
Less
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,500
Wage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000
Insurance expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (18,000)

Required
Prepare an indirect method statement of cash flow for The Arcadia Company for 2006 and calculate the following cash flow
ratios for 2006: (a) operating funds ratio; (b) operating cash flow to current liabilities ratio; (c) cash conversion ratio.

Solu tio n

The Arcadia Company

Statement of Cash Flow
For Year Ended 12/31/06
(Indirect Method)

Operating Activities
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(18,000)
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,500
Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,500)
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500
Cash flow from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,500
Investing Activities
Marketable securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Building, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (31,000)
Cash flow from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (23,500)
Financing Activities
Bank loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
Cash flow from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -0-
Net increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
Cash, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Cash, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Change in cash (from balance sheet) . . . . . . . . . . . . . . . . . . . . . . . $ 23,000
Operating funds ratio = $46,500/$(18,000)  Not meaningful
Operating cash flow to current liabilities ratio  $46,500/$110,500  0.42
Cash conversion ratio = $480,000/$480,000  1.00

EXECUTIVE SUMMARY
In this chapter, we examined the components of a companys net income in an effort to identify its sustainable earnings. Sustain-
able earnings are those operating and nonoperating income flows that are expected to persist over many fiscal periods; they are the
permanent earnings of a business. Sustainable earnings are important to managers and investors because they are a key determinant
of firm value.
100 Chapter 3 | Measuring Performance: Cash Flow and Net Income

We also illustrated how a companys statement of cash flow can be prepared from its income statement and balance sheets.
Finally, we examined the various alternative measures of cash flow that investors and investment professionals use to evaluate a
firms financial health: EBITDA, free cash flow, and discretionary cash flow.
As a validation of your understanding of the content of this chapter, you should now be able to:
Use a statement of cash flow to explain a businesss financing and investing strategies.
Prepare a statement of cash flow using the indirect method.
Explain the difference between EBITDA, free cash flow, and discretionary cash flow.
Understand the components of net income to evaluate a companys sustainable earnings.

KEY CONCEPTS AND TERMS

Basic earnings per share, 95 Discontinued operations, 95 Operating cash flow to current
Capital intensive, 90 Discretionary cash flow, 91 liabilities ratio, 90
Cash conversion ratio, 90 Earnings persistence, 92 Operating funds ratio, 90
Cash flow from financing, 79 EBITDA, 90 Permanent earnings, 92
Cash flow from investing, 79 Extraordinary gains (losses), 95 Pro forma earnings, 96
Cash flow from operations, 79 Free cash flow, 91 Restructuring charges, 93
Cash from sales, 90 Free cash flow yield, 91 Single-period items, 92
Change in accounting principle, 94 Indirect method, 80 Special item, 93
Consistency principle, 94 Intrinsic value, 92 Taking a bath, 94
Diluted earnings per share, 95 Market capitalization, 92 Transitory earnings, 92
Dilutive claims, 95 Noncash expenses, 85 Unusual items, 92
Direct method, 80

A P P E N D I X 3 A : Converting Indirect Method Cash Flows to

Direct Method Cash Flows
Although it is quite straightforward to create a direct method statement of cash flow given access to a companys internal accounting
records, such access is rarely available to anyone except a companys management team. The Russian River Valley cash flow statement
that appears in Exhibit 2.5 in the previous chapter, for example, is simply a compilation of the cash inflows and outflows reported in
the cash column from the Russian River Valley spreadsheet. All that is necessary is to pull the numbers directly off the spreadsheet and
place them in the appropriate section of the cash flow statement. This is why, in fact, the direct method is referred to as directthe
cash flow from operations is taken directly from the companys accounting records rather than being indirectly computed from net in-
come. Unfortunately, investors and lenders rarely have access to such proprietary internal data. Thus, it is necessary to be able to create
direct method cash flow information using only such publicly available data as the indirect method statement of cash flow.
The process of converting an indirect method statement of cash flow to the direct method requires two steps. First, replace net
income (the first line item under the operating activities section of the indirect method statement format) with the key line items
appearing on a firms income statement. For instance, Russian River Valleys income statement in Exhibit 3.5 contains the follow-
ing key line items (in thousands):

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . $1,900
Cost of goods sold. . . . . . . . . . . . . . . . . . (380)
Operating expenses . . . . . . . . . . . . . . . . . (675)
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . (288)
Income taxes . . . . . . . . . . . . . . . . . . . . . . (240)
Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 317

Thus, for the winery, we begin by replacing the net income of $317 under the operating activities section in Exhibit 3.6 with
the five key income statement line items shown above, which aggregate to $317.
The second step involves adjusting the key income statement line items identified in step one with the remaining line items
from the operating activities section of the indirect method statement of cash flow. Using Russian River Valleys data in Exhibit
3.6, those adjustments would appear as follows:
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 101

Income Statement Operating Activities Direct Method

Line Items Line Items Cash Flow

Revenues $1,900 Less $800 Accounts receivable Cash collections from customers $1,100
Cost of goods sold (380) Less $60 Inventory
Add $80 Accounts payable
V Cash paid for inventory (360)

Operating expenses (675) Add $225 Depreciation

Add $50 Amortization
V Cash paid for operating expenses (400)

Interest (288) (no adjustment required) Cash paid for interest (288)
Income taxes (240) Add $96 Taxes payable Cash paid for income taxes (144)
Net income $ 317 Cash flow from operations $ (92)

Exhibit 3A.1 presents the winerys direct method statement of cash flow after undertaking the above two steps. As expected,
the direct method CFFO of negative $92 is exactly equivalent to the indirect method CFFO of negative $92 as reported in Exhibit
3.6. Note that the CFFI and CFFF are exactly the same in both Exhibit 3.6 and Exhibit 3A.1. The only difference between the two
exhibits is the manner in which the CFFO is calculated. In Exhibit 3.6, the CFFO is calculated by beginning with net income and
then adjusting for various noncash expenses (e.g., depreciation and amortization), as well as adjusting for the changes in the various
working capital accounts (e.g., accounts receivable, inventory, accounts payable, and taxes payable). In Exhibit 3A.1, net income
is replaced with the key income statement line items and the noncash expenses and working capital adjustments are disaggregated
to the individual line items. But in each case, the CFFO total remains the same.

EXHIBIT 3A.1 Statement of Cash Flow: The Direct Method

Russian River Valley Winery, Inc.

Statement of Cash Flow
($ thousands) Year 1

Operating activities
Cash from customer collections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,100
Cash paid for inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (360)
Cash paid for operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . (400)
Cash paid for interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (288)
Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (144)
Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (92)
Investing Activities
Purchase of property, plant & equipment . . . . . . . . . . . . . . . . . . . . . . (3,500)
Cash flow from investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,500)
Financing Activities
Sale of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Payment of notes payable (current) . . . . . . . . . . . . . . . . . . . . . . . . . . . (480)
Payment of common stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . (260)
Cash flow from financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (340)
Net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,932)
Beg. cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700
End. cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 768
Change in cash (on balance sheet). . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(3,932)

DISCUSSION QUESTIONS
Q3.1 Building Shareholder Value. Describe at least three ways that corporate managers can build shareholder value (in-
crease their firms share price). Rank-order the various managerial actions you identified according to their effectiveness
in building shareholder value. Be prepared to justify your rank-ordering.
Q3.2 Litigation, Reported Income and Share Price. In early 2006, Merck AG, a global pharmaceutical company, saw its
share price decline dramatically after a jury in the United States found the company guilty of failing to warn consumers
about safety issues surrounding one of the companys products, a painkilling drug called Vioxx. Although Merck was
102 Chapter 3 | Measuring Performance: Cash Flow and Net Income

found not guilty in one case involving a plaintiff who died while taking the drug, the company was found guilty in a
second case, with the court awarding the survivors of the deceased plaintiff $4.5 million in compensatory damages.
At the time of the trial, over 5,000 separate Vioxx-related lawsuits had been filed against Merck. Discuss how Merck
should disclose the $4.5 million lawsuit award in its 2006 annual report. How should Merck disclose the 5,000 pending
lawsuits in its 2005 financial statements before the court case was decided against the company? How should Merck
report the pending Vioxx-related lawsuits in its 2006 annual report?
Q3.3 Basic versus Diluted Earnings per Share. In 2005, Pfizer, Inc., reported that its basic earnings per share would be
$1.11 per share while its diluted earnings per share would be $1.08 per share. Discuss the factors that might cause the
number of shares used in the calculation of earnings per share to increase, and thus, cause diluted earnings per share
(EPS) to be less than basic earnings per share. Which measure do you feel is most important to shareholdersbasic
EPS or diluted EPS? Why?
Q3.4 Assessing the Quality of Reported Earnings Using Cash Flow Data. Although much of the work of an equity
analyst involves quantitative analysis, some analysts also engage in various qualitative analyses to help them assess the
persistence of a firms current earnings. Consider, for example, the case of Blockbuster Entertainment Corporation.
In 1989, Lee J. Seidler, a senior analyst with Bear, Stearns & Co., issued a research report critical of Blockbusters
earnings. Mr. Seidler observed that although Blockbusters 1988 net income was $15.5 million and its cash flow from
operating activities $48.4 million, his review of the firms cash flow data revealed that Blockbusters purchases of new
videocassette rental inventory had been classified as an investing activity rather than as an operating activity on
the companys statement of cash flow. Presented below is selected financial statement information for Blockbuster:

(in millions) 1988 1987

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15.5 $4.09
Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48.3 10.3
Purchases of videocassette rental inventory . . . . . . . . . . . . . . (51.3) (14.3)

Discuss how the statement of cash flow can be used to help evaluate the quality of a companys reported earnings.
Describe how Blockbusters cash flow data can be used to illustrate this. Do you agree with Blockbusters decision to
classify its videocassette inventory purchases as an investing activity? Why or why not? How does Blockbusters
cash flow classification of its video inventory purchases affect its cash flow from operations?
Q3.5 Earnings Announcements and Share Prices. In April 2006, Alcoa, Inc., the worlds largest aluminum company,
reported its highest quarterly income in the companys history. Alcoas earnings per share increased by more than 100
percent from $0.30 per share in 2004 to $0.69 per share in 2005. In response to the announcement, the companys share
price rose over six percent, or an increase of $2.00 per share. On the same day, the Shaw Group, Inc., an engineering
company, also reported a 100 percent increase in earnings per share, from $0.14 per share a year earlier to $0.31 per
share in 2005. The Shaw Groups share price, however, fell $1.97 per share, or six percent. Discuss why the earnings
announcement of Alcoa led to a share price increase and why the earnings announcement of the Shaw Group might
have led to its share price decline.
Q3.6 Managing Earnings. Some members of the financial community allege that corporate managers manage their
companys reported accounting results. Discuss the possible motivations behind this behavior. Can you envision a
situation where a manager might manage a companys earnings downward? If so, why?
Q3.7 Goodwill Impairment and Sustainable Earnings. In 2002, the FASB adopted Statement of Financial Accounting
Standard No. 142. Under SFAS No. 142, the amortization of goodwill is no longer required, and instead, goodwill
is subject to an annual impairment test to verify that its value has not declined. If a decline in value is observed, the
goodwill account is written down and an impairment loss is recorded on the income statement.
On February 27, 2006, Vodafone, a United Kingdom-based mobile telecommunications company, announced
that it would write off $49 billion of goodwill associated with its $192 billion acquisition of Germanys Mannesmann
AG. Vodafones share price dropped three percent following the news announcement. At the time of the impairment
announcement, the companys market capitalization was $140 billion while its book value was $202 billion.
Discuss how Vodafone will account for the goodwill write-down in its financial statements. How will the impair-
ment charge affect the firms book value? How will the impairment charge impact the firms sustainable earnings? Why
was the firms market capitalization less than its book value?
Q3.8 Special Charges. On September 11, 2001, two American Airlines aircraft were hijacked and destroyed in terrorist
attacks on The World Trade Center in New York City and the Pentagon in northern Virginia. As a consequence of these
actions, AMR Corporation, the parent company of American Airlines, concluded that its fleet of aircraft had become
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 103

impaired, and consequently, took a special charge of $718 million against 2001 net income and an additional $1,466
million charge against 2002 net income.
Discuss how these special charges will be reflected in AMRs financial statements. Given the unusual circumstances
associated with these charges, could they be considered extraordinary? Why or why not? Will these charges be included
in the companys sustainable earnings? Why or why not?
Q3.9 New Accounting Standard. Effective January 1, 2002, the FASB required the implementation of Statement of Finan-
cial Accounting Standard No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 142 requires
that a company annually evaluate the value of its goodwill and indefinite-lived intangible assets for impairment. During
2002, AMR Corporation, the parent company of American Airlines and American Eagle, adopted SFAS No. 142 and
conducted an impairment test of its existing goodwill. Based on this test, AMR Corporation concluded that its entire
balance of $1.4 billion of goodwill had been impaired. Consequently, at year-end 2002, the company recorded a one-
time, noncash charge to write off all of its goodwill. The charge-off of AMRs goodwill was reported as a cumulative
effect of accounting change in the amount of $988 million, net of the related income tax effect of $412 million, on
its consolidated statement of earnings.
Discuss AMRs treatment of its goodwill impairment charge. Do you agree with the disclosure adopted by the
company? Why or why not? How will the impairment affect the firms future sustainable earnings?
Q3.10 Market Capitalization, Book Value, and Intrinsic Value. Discuss the concepts of book value, intrinsic value, and
market capitalization. Using a financial website such as Yahoo.Finance or MSN.Money, identify the market capitaliza-
tion and book value of The Procter and Gamble Company. Calculate the difference between these values. Why do
these measures differ in value?
Q3.11 Accounting Statement Restatements. According to CFO Magazine (April, 2006), the number of companies that
issued corrections to their financial statements hit a new high in 2005. A total of 1,195 U.S. public companies, or about
8.5 percent of the total, filed financial statement restatements in 2005. That amount was approximately twice the total
restatements (613) filed in 2004. The major types of accounting restatements for the period 2003 to 2005 were identi-
fied as follows:

Number of Restatements 2003 2004 2005

Lease accounting . . . . . . . . . . . . . . . . . . . . . . . . 23 22 249
Stock option accounting . . . . . . . . . . . . . . . . . . 30 39 71
Hedge accounting . . . . . . . . . . . . . . . . . . . . . . . 13 25 57

Discuss why the number of financial statement restatements increased so dramatically from 2004 to 2005. Discuss how
and why the capital markets respond to financial statement restatements.
Q3.12 (Ethics Perspective) Earnings Management to Prevent Technical Defaults. Earnings management may be used
to avoid a technical default of a covenant under a loan agreement. Loan covenants are written into loan agreements
in order to protect a lender from various actions that a borrower might undertake. These covenants often require at-
tainment of certain target financial ratios calculated using reported GAAP numbers. Failing to achieve these minimum
target ratios, and hence falling into technical default, can be very costly to a firm. Earnings management to prevent
a technical default will likely save a corporation and its shareholders from experiencing a large loss in market value,
without necessarily providing any direct personal benefit to the companys managers. Is earnings management to avoid
a loan covenant violation an ethical breach by management?

indicates that check figures are available on the books Website.

EXERCISES
E3.13 Classifying Accounting Events. Presented below is a list of accounting events for the Longo Corporation. Classify
each of the events as an operating (O) activity event, an investing (I) activity event, a financing (F) activity event, or as
none-of-the-above (N).
1. Sale of common stock for cash
2. Collection of cash on accounts receivable
3. Purchase of equipment for cash
4. Sale of inventory on credit
5. Borrowed cash from a bank
 104 Chapter 3 | Measuring Performance: Cash Flow and Net Income

6. Payment of a cash dividend

7. Payment of utility expense using cash
8. Purchase of land using bank financing
9. Repurchase of previously issued stock using cash
10. Cash payment of interest on a bank loan
E3.14 Classifying Accounting Transactions. Presented below is a list of accounting transactions for the Davis Company.
Classify each of the transactions as an operating (O) activity transaction, an investing (I) activity transaction, a financing
(F) activity transaction, or as none-of-the-above (N).
1. Purchase of machinery for cash
2. Cash payment on loan principal
3. Collection of cash on outstanding accounts receivable
4. Payment of a stock dividend
5. Sale of preferred stock for cash
6. Prepaid the office rent for six months
7. Cash payment of income tax expense
8. Sale of land held as an investment for cash
9. Declared (but did not pay) a cash dividend
10. Purchased treasury stock using cash
E3.15 Analyzing Cash Flow Data. Presented below is cash flow information for two competitorsThe Longo Corporation
and The Davis Company (amounts in thousands):

Cash Flow From

Operating
Company Profit Operations Investing Financing

Longo Corporation . . . . . . . . . . . . . . . . . . . . . . $(6,050) $(1,320) $ (693) $ 415

Davis Company . . . . . . . . . . . . . . . . . . . . . . . . (2,980) (3,260) 1,502 1,809

Describe the cash management strategy of each company by identifying the key sources and uses of cash by each firm.
Explain why the cash flow from operations of The Longo Corporation differs from the companys operating loss of
$6,050. Calculate the change in the cash balance for The Davis Company.
E3.16 Analyzing Cash Flow Data. Presented below is cash flow information for two competitorsPfizer, Inc., and The
Johnson and Johnson Company (amounts in millions):

Cash Flow From

Operating
Company Profit Operations Investing Financing

Pfizer, Inc. $ 8,085 $14,733 $(5,072) $(9,222)

Johnson and Johnson 10,411 11,877 (279) (4,521)

Describe the cash management strategy of each company by identifying the key sources and uses of cash by each firm.
Calculate the change in the cash balance for each firm. Explain why the cash flow from operations for Pfizer, Inc. of
$14,733 is greater than its operating profit of $8,085.
E3.17 Calculating Earnings per Share. During 2006, Mayfair Enterprises had the following securities outstanding:
1. 250,000 shares of common stock with an average market price of $25 per share.
2. 9.5% convertible preferred, which had been sold at its par value of $100. The preferred stock is convertible into
three shares of common stock and 3,000 preferred shares are currently outstanding.
During 2006, Mayfair Enterprises earned net income after income taxes of $3.2 million. Calculate the (a) basic earnings
per share and (b) diluted earnings per share for Mayfair Enterprises for 2006.
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 105

E3.18 Calculating Earnings per Share. Little, Inc., reported earnings of $159,000 for 2006, and at the end of the year, had
the following securities outstanding:
1. 60,000 shares of common stock. (The year-end share price was $25 per share.)
2. Employee stock options for the purchase of 8,000 common shares at an exercise price of $22 per share. (The
options are fully vested.)
Calculate the (a) basic earnings per share and (b) diluted earnings per share for Little, Inc. for 2006.
E3.19 Permanent versus Transitory Earnings. Entrust, Inc., is a global provider of security software; it operates in one
business segment involving the design, production, and sale of software products for securing digital identities and in-
formation. Presented below are the consolidated statements of operations for the period 2002 to 2004 (all values in thou-
sands). On January 1, 2002, the Entrust common shares traded at $10.40 per share; by year-end 2004, the shares traded
at $3.80 per share. The companys cash flow from operations was $(27,411), $(20,908), and $9,606, for 2002, 2003, and
2004, respectively.
Calculate the permanent earnings of Entrust, Inc., for each of the three years. Compare the companys reported net
income (loss) with its permanent earnings. Does Entrusts share price at year-end 2004 reflect the firms apparent turn-
around? Why or why not?

Entrust, Inc.
Consolidated Statements of Operations
Year Ended December 31 ($ thousands) 2004 2003 2002

Revenues
Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $29,295 $ 30,974 $ 44,734
Services and maintenance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,662 56,920 58,013
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,957 87,894 102,747

Cost of Revenues
Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,149 5,341 5,281
Services and maintenance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,105 29,825 32,073
Amortization of purchased product rights . . . . . . . . . . . . . . . . . 384 568 1,136
Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,638 35,734 38,490
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,319 52,160 64,257

Operating expenses
Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,322 34,985 44,128
Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,266 22,566 24,151
General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,569 13,143 14,840
Impairment of purchased product rights . . . . . . . . . . . . . . . . . . 1,134
Restructuring charges and adjustments . . . . . . . . . . . . . . . . . . 13,623 (1,079)
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,157 85,451 82,040
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,162 (33,291) (17,783)

Other income (expense)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,281 1,680 3,346
Foreign exchange gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . 429 (431) (72)
Loss from equity investments . . . . . . . . . . . . . . . . . . . . . . . . . . (1,111) (603) (602)
Realized loss on investments . . . . . . . . . . . . . . . . . . . . . . . . . . (220)
Write-down of long-term strategic investments . . . . . . . . . . . . (2,780) (1,238)
Total other income (expense) . . . . . . . . . . . . . . . . . . . . . . . . . 599 (2,134) 1,214
Income (loss) before income taxes and minority interest. . . . . . . . 1,761 (35,425) (16,569)
Minority interest in subsidiary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Income (loss) before income taxes. . . . . . . . . . . . . . . . . . . . . . . . . 1,765 (35,425) (16,569)
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687 441 1,350
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,078 $(35,866) $(17,919)
106 Chapter 3 | Measuring Performance: Cash Flow and Net Income

E3.20 (Appendix A) Converting Indirect Method Cash Flows to Direct Method Cash Flows. The Miller Corporation
disclosed the following statement of earnings in its 2005 annual report (amounts in thousands):

Earnings Statement
2005

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,430
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500)
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 930
Selling, general and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . (200)
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 730
Unusual gain on sale of land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800

In addition, the company reported the following data regarding its operating cash flow in its year-end statement of cash
flow (amounts in thousands):

Statement of Cash Flow

(Indirect Method) 2005
Operating Activities
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800
Depreciation and amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (150)
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15)
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Gain on sale of land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (70)
Cash flow from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $875

Using the above information for 2005, construct the Miller Companys cash flow from operating activities on a direct
method basis.
E3.21 Measuring Sustainable Earnings. Harnishfeger Corporation was a mining machinery and equipment company
based in Wisconsin. The company voluntarily changed its depreciation accounting policy from the accelerated method to
the straight-line method. It disclosed the cumulative effect of this accounting policy change, equal to $11.005 million (net
of applicable income taxes), in its financial statements. In addition, the company also voluntarily changed the estimated
useful lives of certain of its U.S. plant and equipment. This estimate change increased its pretax reported profit by $3.2
million. The following are selected excerpts from the companys financial statements:

(in thousands)
Income before income taxes, equity items, and cumulative
effect of accounting method change. . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,738
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,425)
Income after taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,313
Equity items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 858
Cumulative effect of change in depreciation method . . . . . . . . . . . . . . . 11,005
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,176

Calculate Harnishfegers sustainable earnings. How would the capital market react to the companys decision to change
its depreciation accounting policy and to change the estimated useful lives of its depreciable assets? Why?
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 107

PROBLEMS
P3.22 Statement of Cash Flow. Presented below are the financial statements for the Amphlett Corporation, as of year-end
2005 and 2006.

Amphlett Corporation
Consolidated Balance Sheets
As of Year-End ($ thousands) 2005 2006

Assets
Current
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000 $ 15,000
Marketable securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Accounts receivable (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000 590,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615,000 600,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,145,000 1,405,000

Noncurrent
Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390,000 310,000
Property & equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 1,800,000
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . (500,000) (500,000)
Property & equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 1,300,000
Intangibles (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000 95,000
Total noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,095,000 1,705,000
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,240,000 $3,110,000

Liabilities & Shareholders Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 850,000 $ 900,000
Short-term bank debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000 1,090,000

Shareholders equity
Common stock, $10 par value. . . . . . . . . . . . . . . . . . . . . . . . . . 675,000 775,000
Additional paid-in-capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 380,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415,000 865,000
Total shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,390,000 2,020,000

Total liabilities & shareholders equity . . . . . . . . . . . . . . . . . . . . $2,240,000 $3,110,000

Amphlett Corporation
Consolidated Income Statement
For Year Ended ($ thousands) 2005 2006

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000 $1,430,000

Less: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 500,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 780,000 930,000
Less: Selling, general & administrative expenses . . . . . . . . . . . . . 120,000 150,000
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660,000 780,000
Gain on sale of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660,000 850,000
Less: Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 50,000
Net income after taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 649,000 $ 800,000

The footnotes to the Amphlett Corporations financial statements revealed the following additional information:
1. Property and equipment costing $450 million was sold for its book value of $200 million.
2. Long-term investments were sold for $150 million, which included a gain of $70 million.
 108 Chapter 3 | Measuring Performance: Cash Flow and Net Income

Required
Using the above financial data for the Amphlett Corporation, prepare the firms statement of cash flow for 2006 using the
indirect method. What does the companys statement of cash flow reveal about the businesss financial health?
P3.23 Statement of Cash Flow. Presented below are the consolidated financial statements of The Mann Corporation as of
year-end 2005 and 2006.

The Mann Corporation

Consolidated Balance Sheets

As of Year-End ($ thousands) 2005 2006

Assets
Current assets
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 250,000 $ 400,000
Accounts receivable (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 760,000 990,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 710,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,510,000 2,200,000
Investments in affiliate companies . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Property and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 1,310,000
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . (80,000) (110,000)
Property & equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000 1,200,000
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,230,000 $3,500,000

Liabilities & Shareholders Equity

Current liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 $ 570,000
Accrued expenses payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 200,000
Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000 840,000
Note payabledue in ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720,000 1,340,000

Shareholders equity
Common stock ($5 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 300,000
Additional paid-in-capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,160,000 1,200,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 660,000
Total shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,510,000 2,160,000
Total liabilities & shareholders equity . . . . . . . . . . . . . . . . . . . . $2,230,000 $3,500,000

The Mann Corporation

Consolidated Income Statement
For Year Ended ($ thousands) 2005 2006

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000,000 $16,800,000

Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,400,000 14,000,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000 2,800,000
Selling & administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,048,000 1,930,000
Depreciation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,000 240,000
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 380,000 $ 600,000

Required
Using the above financial data, prepare the statement of cash flow for 2006 using the indirect method. What does the
companys statement of cash flow reveal about the businesss financial health?
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 109

P3.24 Statement of Cash Flow. Presented below are the consolidated financial statements of Casual Clothing, Inc.

Casual Clothing Inc.

Consolidated Balance Sheet
12/31/06 12/31/05

Assets
Current Assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,794 $ 7,352
Merchandise inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,153 42,045
Accounts receivable (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,700 17,800
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,103 25,393
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163,750 92,590
Noncurrent Assets
Buildings, furniture & equipment (net) . . . . . . . . . . . . . . . . . . . . 1,826,863 1,658,990
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,279,946 1,458,832
Construction-in-process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615,722 414,725
Intangibles (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,780 6,700
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,896,061 $3,631,837

Liabilities & Shareholders Equity

Current liabilities
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 779,904 $ 176,884
Current maturities of long-term debt . . . . . . . . . . . . . . . . . . . . . 250,000 350,000
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167,207 185,945
Accrued expenses & other liabilities . . . . . . . . . . . . . . . . . . . . . 384,209 351,710
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,824 26,263
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,599,144 1,090,802
Long-term liabilities
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880,216 780,925
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,479,360 1,871,727
Shareholders Equity
Common stock ($.05 par value). . . . . . . . . . . . . . . . . . . . . . . . . 146,961 146,961
Additional paid-in-capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,294,967 1,294,967
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 974,773 318,182
Total shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,416,701 1,760,110
Total liabilities & shareholders equity . . . . . . . . . . . . . . . . . . . . $4,896,061 $3,631,837

Casual Clothing, Inc.

Consolidated Statement of Earnings
For Year Ended 12/31/06

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,673,460

Costs & expenses
Costs of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,599,442
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,629,257
Interest expense (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,876
12,291,575
Earnings before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,381,885
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504,388
Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 877,497

Note: In 2006, amortization expense for intangibles was $2,700 and depreciation expense for buildings, furniture
& equipment was $123,000.

Required
Using the above financial data, prepare the statement of cash flow for 2006 for Casual Clothing, Inc. using the indirect
method. What does the companys statement of cash flow reveal about the businesss financial health?
110 Chapter 3 | Measuring Performance: Cash Flow and Net Income

P3.25 Statement of Cash Flow. The following financial data were taken from the Catalina Divers Supply Company for the
year ended December 31, 2006.

Catalina Divers Supply Company

Balance Sheet Data
12/31/06 12/31/05

Assets
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 10,800
Accounts receivable (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,400 18,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 31,200
Prepaid rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400 3,600
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,800 63,600
Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,000 104,000
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $182,800 $167,600

Liabilities & Shareholders equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,400 $ 29,200
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 13,600
Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,400
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 9,400
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,400 56,600
Bank loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000 56,800
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,400 113,400
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 20,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400 34,200
Total Shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,400 54,200
Total Liabilities & Shareholders equity . . . . . . . . . . . . . . . . . . . $182,800 $167,600

Catalina Divers Supply Company

Income Statement
For the Year Ended December 31, 2006

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $218,200
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,200
Wage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,400
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,800
Depreciation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,400
Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,400
Net income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,200
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,800
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,400

Required
Using the above data, prepare the 2006 statement of cash flow for Catalina Divers Supply Company using the indirect
method. What does the companys statement of cash flow reveal about the businesss financial health?
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 111

P3.26 Analyzing and Interpreting Cash Flow Data: A Growing Enterprise. Presented below are cash flow data for L.A.
Gear Inc. During this period of time, the manufacturer of athletic shoes and sportswear experienced a 1200 percent
growth in net income.

L.A. Gear Inc.

Statement of Cash Flow
For Year Ended 12/31
(in thousands) Year 1 Year 2 Year 3

Cash flow from operations

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,371 $22,030 $55,059
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 446 1,199
Noncash compensation to employees. . . . . . . . . . 558
Increase in accounts receivable . . . . . . . . . . . . . . . (12,410) (34,378) (51,223)
Increase in inventories . . . . . . . . . . . . . . . . . . . . . . (1,990) (50,743) (72,960)
Increase in prepayments . . . . . . . . . . . . . . . . . . . . (599) (2,432) (8,624)
Increase in accounts payable. . . . . . . . . . . . . . . . . 1,656 7,197 17,871
Increase (Decrease) in other current liabilities . . . . (537) 11,193 10,587
Cash flow from operations. . . . . . . . . . . . . . . . . (9,376) (46,687) (47,533)
Cash flow from investing
Sale of marketable securities . . . . . . . . . . . . . . . . . 5,661
Acquisition of property, plant & equip. . . . . . . . . . . (874) (2,546) (6,168)
Acquisition of other noncurrent assets. . . . . . . . . . (241) (406) (246)
Cash flow from investing . . . . . . . . . . . . . . . . . . 4,546 (2,952) (6,414)
Cash flow from financing
Increase (Decrease) in short-term borrowing . . . . . 4,566 50,104 (19,830)
Issue of common stock . . . . . . . . . . . . . . . . . . . . . 495 69,925
Cash flow from financing . . . . . . . . . . . . . . . . . . 4,566 50,599 50,095
Change in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (264) $ 960 $ (3,852)

Required
1. Explain why the cash flow from operations is negative.
2. How did the company finance its operations during the three-year period? Explain the logic of this strategy.
3. Depreciation expense as a percent of net income is only two to three percent during this period. What might
explain this?
112 Chapter 3 | Measuring Performance: Cash Flow and Net Income

P3.27 Analyzing and Interpreting Cash Flow Data: A Failing Enterprise. L.A. Gear, a manufacturer of sports shoes and
sportswear, began operations in the early 1980s. By late 1996, however, the company was in bankruptcy. Presented below
are cash flow data for the company for the period 19951996.

L.A. Gear Inc.

Consolidated Statements of Cash Flow
For Year Ended 12/31
($ thousands) 1995 1996

Operating activities
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(51,397) $(61,689)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . 7,266 4,555
Minority interest in net loss of joint venture . . . . . . . . . . . . . . (1,324) (6,986)
Loss on sale or abandonment of property and equipment . . 417 77
Increase in reserve for unused barter credits. . . . . . . . . . . . . 4,568
Write-off of goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,012 8,324
Unrealized foreign exchange gain . . . . . . . . . . . . . . . . . . . . . (570)
(Increase) decrease, net of effects of acquisitions, in
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 30,603 20,581
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100 18,095
Prepaid expenses & other current assets. . . . . . . . . . . . . . 3,320 1,507
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,624 (12)
Increase (decrease), net of effects of acquisitions, in
Accounts payable & accrued liabilities. . . . . . . . . . . . . . . . . . (12,831) 16,166
Net cash provided by (used in) operating activities . . . . . . . . . . . . (11,212) 618
Investing activities
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,256) (710)
Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . (3,256) (710)
Financing activities
Costs related to issuance of Series B Shares . . . . . . . . . . . . . . (661)
Net (repayments) borrowings under international
credit facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622 (1,216)
Net cash (used in) provided by financing activities . . . . . . . . . . . . 622 (1,877)
Effect of exchange rate changes on cash & cash equivalents. . . . 92 252
Net (decrease) increase in cash & cash equivalents . . . . . . . . . . . (13,754) (1,717)
Cash & cash equivalents at beginning of year . . . . . . . . . . . . . . . . 49,710 35,956
Cash & cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . $ 35,956 $ 34,239

Required
Explain how L.A. Gear generated cash to sustain its operations during the period prior to its bankruptcy filing. What other
financing options were available to the company?
 Chapter 3 | Measuring Performance: Cash Flow and Net Income 113

P3.28 Statement of Cash Flow: International. Presented below are recent financial statements for The Hoechst Group, a
German conglomerate with operations in agriculture, chemicals, pharmaceuticals, and veterinary products:

The Hoechst Group

Consolidated Balance Sheet
(in millions of Deutsche Marks)
For Year Ended 12/31
Year 2 Year 1

Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,077 15,200

Property, plant & equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,958 15,861
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,336 7,562
Noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,371 38,623
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,507 6,739
Receivables & prepaid items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,630 14,908
Liquid assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 635
Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,528 22,282
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,899 60,905

Equity of Hoechst AG stockholders . . . . . . . . . . . . . . . . . . . . . . . . 16,599 16,012

Minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,580 3,097
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,179 19,109
Provisions for pensions & similar obligations. . . . . . . . . . . . . . . . . 6,883 6,910
Other provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,751 9,476
Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,634 16,386
Corporate debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,509 16,615
Liabilities & deferred income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,577 8,795
Total stockholders equity & liabilities . . . . . . . . . . . . . . . . . . . . . . 55,899 60,905

The Hoechst Group

Consolidated Statement of Profit & Loss
(in millions of Deutsche Marks)
For Year Ended 12/31
Year 2 Year 1

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,704 52,100

Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (25,533) (31,533)
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,171 20,567
Distribution & selling costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,940) (10,206)
Research & development costs . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,820) (3,990)
General & administrative costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,680) (2,808)
Other operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,331 1,834
Other operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,891) (1,744)
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,171 3,653
Result on sale & transfer of business . . . . . . . . . . . . . . . . . . . . . . . 64 304
Investment income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,062 309
Interest expense, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,037) (1,019)
Other financial expense, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (157) (90)
Profit before taxes on income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,103 3,157
Taxes on income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (944) (1,383)
Income before minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . 2,159 1,774
Minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (264) (431)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,895 1,343
114 Chapter 3 | Measuring Performance: Cash Flow and Net Income

The following additional information was contained in the companys footnotes:

1. Depreciation expense of 2,190 in Year 2 was included in the cost of goods sold.
2. Amortization of intangible assets totaled 1,000 in Year 2 and was included in General and Administrative Costs.
3. A gain on the sale of investments of 300 in Year 2 was included in Investment income, net.
4. There were no sales or repurchases of Hoechst capital stock during Year 2.
5. What does the companys statement of cash flow reveal about the businesss financial health?
Required
Prepare a statement of cash flow for The Hoechst Group for Year 2 using the indirect method.

C O R P O R A T E A N A LY S I S
CA3.29 The Procter and Gamble Company. The 2005 annual report of The Procter and Gamble Company (P & G) is
available at www.pg.com/annualreports/2005/pdf/pg2005annualreport.pdf. After reviewing P & Gs annual report, re-
spond to the following questions:
a. P & Gs 2005 statement of cash flow is presented using the indirect method format. Convert P & Gs indirect
method cash flow from operating activities to the direct method format (see Appendix 3A). After converting
the indirect method to the direct method, calculate P & Gs cash conversion ratio for 2005. What does the cash
conversion ratio tell you about P & Gs operating revenues? Is this good news or bad news? Why?
b. Calculate P & Gs EBITDA, free cash flow, and discretionary cash flow for 2003, 2004, and 2005. What can you
conclude about P & Gs cash position from these measures?
c. Calculate P & Gs sustainable earnings for 2003, 2004, and 2005. What can you conclude about the persistence of
P & Gs earnings?
CA3.30 Internet-based Analysis. Consider a publicly-held company whose products you are familiar with. Some examples
might include:

Company Product Corporate Website

Johnson & Johnson Company Band-Aids www.jnj.com

Microsoft Corporation Windows XP software www.microsoft.com
Nokia Corporation Cellular phones www.nokia.com
Intel Corporation Pentium processors www.intel.com
Kimberly-Clark Corporation Kleenex www.kimberly-clark.com

Access the companys public website and search for its most recent annual report. (Note: Some companies will provide
access to their financial data through an investor relations link, while others will provide a direct link to their annual
reports.) After locating your companys most recent annual report, open the file and review its contents. After reviewing
the annual report for your selected company, prepare answers to the following questions:
1. Identify the companys basic and diluted earnings per share (EPS) for the past two years. Is there a difference
between these EPS numbers? If so, what dilutive claims are responsible for the decline in basic earnings per share?
2. Review the companys income statement. Are there any extraordinary or special items, restructuring charges,
changes in accounting principles, or discontinued operations in either of the last two years? If so, calculate the
companys sustainable earnings for each year.
3. Consider the companys statement of cash flow. What formatindirect or directis used to present the cash flow
from operations? Convert the companys cash flow from operations from the indirect (direct) format to the direct
(indirect) format (see Appendix A).
4. Calculate the companys EBITDA, free cash flow, and discretionary cash flow for each of the past two years.
Comment on the companys cash flow health.