Module 1: Introducing Financial Accounting for MBAs

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Module 1: Introducing Financial Accounting for MBAs

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Title: Module 1: Introducing Financial Accounting for MBAs


1
Module 1 Introducing Financial Accounting for
MBAs
2
Buffets Acquisition Criteria
  • Large purchases (at least 50 million of
    before-tax earnings),
  • Demonstrated consistent earning power (future
    projections are of no interest to us, nor are
    turnaround situations),
  • Businesses earning good returns on equity while
    employing little or no debt,
  • Management in place (we cant supply it),
  • Simple businesses (if theres lots of technology,
    we wont understand it),
  • An offering price (we dont want to waste our
    time or that of the seller by talking, even
    preliminarily, about a transaction when price is
    unknown).

Financial performance is an important factor in
Buffets criteria
3
Buffets Concept of Intrinsic Value
  • Intrinsic value is an all-important concept that
    offers the only logical approach to evaluating
    the relative attractiveness of investments and
    businesses. Intrinsic value can be defined
    simply It is the discounted value of the cash
    that can be taken out of a business during its
    remaining life.

4
Buffets Three Suggestions for Investors
  • Beware of companies displaying weak accounting.
    If a company still does not expense options, or
    if its pension assumptions are fanciful, watch
    out. When managements take the low road in
    aspects that are visible, it is likely they are
    following a similar path behind the scenes.
    There is seldom just one cockroach in the
    kitchen.
  • Unintelligible footnotes usually indicate
    untrustworthy management. If you cant
    understand a footnote or other managerial
    explanation, its usually because the CEO doesnt
    want you to. Enrons descriptions of certain
    transactions still baffle me.
  • Be suspicious of companies that trumpet earnings
    projections and growth expectations. Businesses
    seldom operate in a tranquil, no-surprise
    environment, and earnings simply dont advance
    smoothly (except, of course, in the offering
    books of investment bankers).

5
Business Activities
6
Planning Activities
  • A company exists to implement specific goals and
    objectives.
  • A companys goals and objectives are captured in
    a business plan.
  • Information on planning activities is often
    obtained through
  • The Letter to Shareholders
  • The Management Discussion and Analysis (MDA)

7
Financing Activities
  • A company requires financing to carry out its
    business plans.
  • Financing activities refer to methods that
    companies use to raise the funds to pay for
    resources such as land, buildings, and equipment
  • There are two main sources of financing
  • Equity financing
  • Creditor (or debt) financing

8
Examples of Company Financing
9
Types of Creditor Financing
  • Investing creditorsthose who primarily finance
    investing activities (such as bank lenders).
  • Operating creditorsthose who primarily finance
    operating activities (such as suppliers).

10
Breakdown of Creditor Financing
11
Investing Activities
  • Investing activities are the acquisition and
    disposition of resources (assets) that a company
    uses to produce and sell its products and
    services.
  • The investing resources, or assets, are of two
    types
  • Operating assetsresources devoted to operating
    activities
  • Nonoperating (financial) assetsresources devoted
    to nonoperating activities

12
Breakdown of Operating and Financial Assets
13
The Accounting Equation
14
Operating Activities
  • Operating activities are the use of company
    resources to produce, promote, and sell its
    products and services.
  • Operating Revenues (or sales) - the inflow of
    assets from selling products and services.
  • Operating Expenses (or costs) - the outflow of
    assets to support operating revenues
  • Operating Income Operating Revenues Operating
    Expenses

15
Defining Company Value
  • Most owners and nonowners formalize their claims
    on a company in the form of a contract or a
    security.
  • Equity securities are common for owners and bonds
    (notes) are common for nonowners.
  • These securities are traded in capital markets.
  • Value of Company
  • Value of Nonowner Claims Value of Owner Claims

16
The Financial Statements
  • Balance Sheet assets, liabilities and equity at
    one point in time
  • Income Statement revenues, expenses, and profit
    over a period of time
  • Statement of Equity changes in contributed and
    earned capital
  • Statement of Cash Flows net cash inflows
    (outflows) form operating, investing and
    financing activities

17
Financial Statements
18
Balance Sheet
  • A balance sheet reports on investing and
    financing activities.
  • It lists amounts for assets, liabilities, and
    equity as of a point in time.
  • The accounting equation (also called the balance
    sheet equation) is the basis of the balance
    sheet
  • Assets Liabilities Equity

19
Berkshire Hathaways Balance Sheet
20
Income Statement
  • An income statement reports on operating
    activities.
  • It lists amounts for sales (and revenues) less
    all expenses (and costs) over a period of time.
  • Sales less expenses yield the bottom-line net
    income amount.

21
Berkshire Hathaways Income Statement
22
Statement of Equity
  • The statement of equity reports on changes in the
    accounts that makeup equity
  • Contributed capital
  • Earned capital (retained earnings and accumulated
    other comprehensive income)
  • This statement is useful in identifying and
    analyzing reasons for changes in owners claims
    on a companys assets.

23
Berkshire Hathaways Statement of Stockholders
Equity
24
Statement of Cash Flows
  • The statement of cash flows reports on cash flows
    for operating, investing, and financing
    activities over a period of time.

25
Financial Statement Linkages
26
Information Beyond Financial Statements
  • Management Discussion and Analysis (MDA)
  • Independent Auditor Report
  • Financial Statement Footnotes
  • Regulatory Filings and Proxy Statements

27
Buffet on MDA
28
Economics of Accounting Information Demand
Supply
  • Demand for financial accounting information
    extends to numerous users that include
  • Managers and employees
  • Creditors and suppliers
  • Shareholders and directors
  • Customers
  • Regulators
  • Voters and their representatives

29
Supply of Accounting Information
  • Determined by a companys estimates of the
    benefits and costs of disclosure.
  • Regulation and bargaining power also play roles
    in determining the supply of financial accounting
    information.
  • The SEC requires financial statements, various
    note disclosures, and other reports on a regular
    basis.

30
Supply of Accounting Information
  • Benefits of disclosure
  • lower capital cost from improved transparency
  • reputation effects enhance labor recruiting
  • Costs of disclosure
  • Information gathering costs
  • More information to competitors
  • Potential litigation costs
  • Potential political costs

31
Market Efficiency
32
Profitability Analysis
  • Return on Assets (ROA)
  • ROA Net Income / Average Assets
  • For example, if we invest 100 in a savings
    account yielding 3 at year-end, the return on
    assets is 3.

33
Disaggregating Return on Assets
34
Profit Margin, Asset Turnover, and Return on
Assets for Selected Industries
35
Competitive Analysis
  • Bargaining Power of Buyers Buyers with strong
    bargaining power can exact price concessions and
    demand a higher level of service and delayed
    payment terms
  • Bargaining Power of Suppliers Suppliers with
    strong bargaining power can demand a higher price
    for their goods and early payments.
  • Threat of Substitution When the number of
    product substitutes increases, sellers lose their
    ability to raise prices and/or pass on cost
    increases to buyers
  • Threat of Entry New entrants to a market
    increase competition. To mitigate that threat,
    companies expend money to erect barriers to
    entry. These include RD, advertising, management
    hires with special expertise, and mergers to
    create economies of scale.

36
Five Forces of Competitive Intensity
37
Business Context for Financial Statements
38
Accounting Principles and Governance Structures
  • Information in financial statements enables
    company valuation and, by extension, the
    valuation of its debt and equity securities.
  • The importance of financial statements means that
    their accuracy is of paramount importance .
  • To the extent that financial performance and
    condition are accurately communicated to business
    decision makers, debt and equity securities will
    be more accurately priced.

39
Oversight of Financial Accounting
  • Oversight of Financial Accounting
  • SEC oversees all publicly traded companies
  • EDGAR database (www.sec.gov)
  • Financial Accounting Standards Board (FASB)
  • Generally Accepted Accounting Principles (GAAP)
  • Board of Directors
  • Audit Committee
  • Courts

40
Audit Report
  • Financial statements present fairly and in all
    material respects company financial condition.
  • Financial statements are prepared in conformity
    with GAAP
  • Financial statements are managements
    responsibility. Auditor responsibility is to
    express an opinion on those statements
  • Auditing involves a sampling of transactions, not
    investigation of each transaction
  • Audit opinion provides reasonable assurance that
    the statements are free of material misstatements
  • Auditors review accounting policies used by
    management and estimates used in preparing the
    statements

41
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43
Sarbanes-Oxley Act
  • The SEC requires the CEO and CFO of a company to
    personally sign a statement attesting to the
    accuracy and completeness of the companys
    financial statements.
  • The statements signed by both the CEO and CFO
    contain the following commitments
  • The CEO and CFO have personally reviewed the
    annual report
  • There are no untrue statements of a material fact
    or failure to state a material fact necessary to
    make the statements not misleading
  • The financial statements fairly present in all
    material respects the financial condition of the
    company
  • All material facts are disclosed to the companys
    auditors and Board of Directors
  • No changes to the companys system of internal
    controls are made unless properly communicated

44
Financial Accounting not an exact science
  • GAAP allows companies choices in preparing
    financial statements (inventories, property, and
    equipment).
  • Companies must choose among the alternatives that
    are acceptable under GAAP.
  • Financial statements also depend on countless
    estimates.

45
Financial Accounting in Context
  • A companys financial statements only tell part
    of the story.
  • You must continually keep in mind the world in
    which the company operates.
  • Financial statement analysis must be conducted
    within the framework of a thorough understanding
    of the broader forces which impact company
    performance.

46
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