Overview of financial statement elements

1
Overview of financial statement elements

• Lecture 2

2
Chapter 2

• Asset and Liability Valuation and Income
  Measurement

3
Overview

• Issues in the valuation of assets and liabilities
• Taking stock of a company
• How income measurement affects the valuation of
  assets and liabilities
• How flow with the passage of time affects the
  stock of the company
• Issues introduced by tax considerations
• How each business transaction affects the various
  aspects of the balance sheet

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Topics

• Valuation of assets and liabilities
• Income recognition and implications for the
  valuation of assets and liabilities
• Income tax considerations
• Balance sheet and income statement effects of
  business transactions

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Valuation of assets and liabilities

• Historical Basis
• Acquisition cost
• Adjusted acquisition cost
• Present value of future cash inflows using an
  agreed upon interest rate (contractual,
  historical)
• Current basis
• Entry value
• Exit value
• Present value of future cash inflows using
  current interest rate (contractual, historical)

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Historical basis Acquisition cost

• Acquisition cost
• What to include in it?
• Reliability vs. Relevance
• How reliable is it? Why is reliability important?
• How relevant is it with the passage of time?
• How have accounting standards addressed this
  relevance issue?
• Examples?

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Historical basis Adjusted acquisition cost

• Adjust the value for passage of time
• Relevant for assets that provide benefits
  gradually over time
• The concept of depreciation or amortization
• To adjust the asset value in proportion to time
  passage or usage
• Is this a way to restore some relevance?
• Still the valuation basis is historical
• Examples?

8
Historical basis Present value of future cash
inflows

• Recorded at historical interest rates
• Adjusts downward as payments are made (or
  received)
• Mostly monetary in nature
• Examples?

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Current cost basis Entry value

• Entry value
• Replacement cost to acquire a similar instrument
  (e.g., same use, age, wear and tear for an asset)
• Difficult to determine. Very subjective
• Reliability is an issue?
• How about relevance to financial statement users?

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Current cost basis Exit value

• Exit value
• The price at which you can sell an asset in its
  current condition.
• Subjectivity may be less of an issue if there is
  an active market for the asset.
• More relevant than historical cost basis?
• Examples?

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Current cost basis Present value of future cash
flows

• Using prevailing interest rates
• Incorporates market fluctuations in interest
  rates over time.
• Mostly for monetary items

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Topics

• Valuation of assets and liabilities
• Income recognition and implications for the
  valuation of assets and liabilities
• Income tax considerations
• Balance sheet and income statement effects of
  business transactions

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Reasons for value changes in assets and
liabilities

• Due to operating activities/transactions
• Through income statement
• Due to financing activities/transactions
• Mostly purely balance sheet transactions
• May also have an effect via income statement
• Due to investing activities/transactions
• Mostly balance sheet transactions
• May also have an effect via income statement
• Due to changes in market conditions
• Not triggered by specific transaction

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The three treatments

• Treatment 1
• Recognized on both balance sheet/income statement
  when a transaction occurs
• Operating, financing, investment activities
• Treatment 2
• Recognized on the balance sheet but not on the
  income statement until a specific transaction
  occurs
• Examples?
• Treatment 3
• Recognized on the balance sheet and the income
  statement without a specific transaction
• Examples?

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Topics

• Valuation of assets and liabilities
• Income recognition and implications for the
  valuation of assets and liabilities
• Income tax considerations
• Balance sheet and income statement effects of
  business transactions

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Accounting for Income Taxes

• Income tax effects cannot be overemphasized.
• Income tax expense for a period does not
  necessarily equal income taxes payable for that
  period The balance sheet recognizes the
  difference between the two amounts as a deferred
  tax asset or a deferred tax liability.
• Deferred tax asset measures the future tax saving
  that the firm will realize.
• Deferred tax liability measures the income taxes
  saved in the current year.

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Balance Sheet Approach(SFAS No. 109) 4 steps

• Identify at each balance sheet date all
  differences between the book basis and tax basis
  of assets, liabilities, and tax loss carry
  forwards.
• Eliminate differences that will not have a future
  tax consequence. (Permanent differences).
• Separate the remaining temporary differences into
  those that give rise to future taxable deductions
  and those that give rise to future taxable
  income. (deferred tax assets or deferred tax
  liabilities.)
• Assess the likelihood that the firm will realize
  the benefits of deferred tax assets in the
  future.

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Effects of temporary differences
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Assignment

• Case 2.1

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Topics

• Valuation of assets and liabilities
• Income recognition and implications for the
  valuation of assets and liabilities
• Income tax considerations
• Balance sheet and income statement effects of
  business transactions

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Business transaction analysis

• Balance Sheet equation
• Assets Liabilities Shareholders Equity
• Expand the equation
• Cash Non-cash assets
• Liabilities Contributed capital
  Accumulated other comprehensive income Retained
  earnings
• Using symbols
• C NA L CC AOCI RE

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Chapter 3

• Income and Cash Flow Relations

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Income vs. cashflows

• Accrual accounting and the matching principle
• Income measurement ignores the timing of cash
  flows
• A company can be doing very well from an income
  standpoint, and yet have cash flow problems.
• Note that over a long enough horizon income and
  cash flows should converge
• A separate statement of cash flows to help
  understand cash inflows and outflows

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What do you get from cash flow statements for
analyzing performance?

• Which stage of the life cycle is a company in?
• Is the company generating enough cash flow from
  operations to finance investment and growth?
• Or, is it turning to markets for capital
  acquisition
• Give enough information to analysts to choose the
  right basis for estimating future cash flows and
  for valuation
• That is, which cash flow items have predictive
  value?
• To calculate free cash flow in order to use
  free cash flow valuation models.

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A basic question

• If accrual accounting is being followed because
  it provides a good measure of performance in a
  period, then we have a question
• Shouldnt valuation of a firm be based on future
  estimates of income and not cash flows?
• Valuation models using residual income, PE and
  PEG ratios are examples of income based models
• There is some debate on this issue

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Overview of income and cash flow relations

• Indirect method exploits the relations among
  income and balance sheet accounts to derive cash
  flow statements
• Assume all revenues or expenses (i.e., income)
  are in cash and then start making adjustments
• Add back depreciation
• Adjust for deferred income taxes
• Adjust for gain/loss on disposition of
  non-current assets
• Changes in working capital accounts
• Increase in liability accounts added
• Increase in asset accounts subtracted

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Implications for forecasting

• We are interested in forecasting future cash
  flows from operations
• Which is a better predictor of future cash flows?
• Net income or cash flow from operations?
• Or should we use changes in working capital
  accounts individually (and depreciation) to
  predict future cashflows? For example
• Increase in accounts receivable, signal future
  growth?
• Increase in depreciation expense signals capacity
  expansion?

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Life cycle and cash flow patterns

• Need to take into account which stage of the life
  cycle the firm is in to project future cash flows
• In early stages firms typically look to external
  financing to support operating and investing
  activities
• Net income usually turns positive before cash
  flows become positive.
• In the maturity phase, operations become a net
  provider of cash

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Assignments

• Problem 3.14
• Problem 3.19
• Case 3.1