corporate finance chapter 3.docx

1、corporate finance chapter 3Chapter 3Financial Statements, Cash Flows, and TaxesLearning Objectives1. Discuss generally accepted accounting principles (GAAP) and their importance to the economy.2. Know the balance sheet identity, and explain why a balance sheet must balance.3. Describe how market-val

2、ue balance sheets differ from book-value balance sheets.4. Identify the basic equation for the income statement and the information it provides.5. Explain the difference between cash flows and accounting income.6. Explain how the four major financial statements discussed in this chapter are related.

3、7. Discuss the difference between average and marginal tax rates.I. Chapter Outline3.1 Financial Statements and Accounting PrinciplesA. Annual Reports The annual report is a vehicle by which management communicates with the firms shareholders and members of the public. The annual report has three se

4、ctionsa financial summary related to the past years performance; information about the company, its products, and its activities; and audited financial statements, including historical financial data.B. Generally Accepted Accounting Principles (GAAP) These are accounting rules and standards that com

5、panies need to adhere to when they prepare financial statements and reports. GAAP is prepared by the Financial Accounting Standards Board (FASB) and is authorized by the SEC.C. Fundamental Accounting Principles The Assumption of Arms-Length TransactionTwo parties involved in an economic transaction

6、arrive at a decision independently and rationally. The Cost PrincipleTransactions are recorded at the cost at which they occurred. The Realization PrincipleRevenue is recognized when transaction is completed, while cash may not be collected until a later time. The Matching PrincipleExpenses related

7、to generating any revenue are matched. The Going Concern AssumptionIt is assumed that a company will continue to operate for the predictable future.D. International GAAP The International Accounting Standards Board promotes uniform accounting rules and procedures. All European Union firms are expect

8、ed to comply with International Accounting Standards (IAS), since 2007. The SEC does not recognize IAS and requires foreign firms listed on U.S. stock exchanges to use U.S. GAAP.3.2 The Balance SheetA. This financial statement identifies all the assets and liabilities of a firm at a point in time. T

9、he left-hand side of the balance shows all the assets that the firm owns and uses to generate revenues. The right-hand side represents the liabilities of the firmthat is, the money that the firm has borrowed from both creditors and shareholders. In addition to the amount borrowed from suppliers and

10、other creditors, the balance sheet also lists the capital raised from its shareholders. While assets are listed in their order of their liquidity, the liabilities are listed in the order in which they must be paid. Shareholders of the firms common equity are listed last as they will be paid with wha

11、tever remains after paying all other suppliers of funds.B. Current Assets and Liabilities All assets that are likely to be converted to cash within a year are considered to be current assets. These include cash and marketable securities, accounts receivables, and inventory. All liabilities that have

12、 to be paid within a year are listed as part of the current liabilities. Thus, bank loans and other borrowings with less than a years maturity, accounts payables, accrued wages, and taxes are included here. The difference between the amount of current assets and current liabilities is called net wor

13、king capital.C. Net Working Capital Net working capital is a measure of the liquidity of a firm, which is the ability of the firm to meet its obligations as they come due. As expressed in Equation 3.2, net working capital is the difference between total current assets and total current liabilities.D

14、. Accounting for Inventory Inventory, the least liquid of current assets, is reported in one of two different ways on the balance sheet. First in, first out, or FIFO, refers to the practice of recognizing a sale as being made up of inventory that was purchased earlier and having the lowest cost. Las

15、t in, last out, or LIFO, calls for the firm to attribute any sale made to the most recently acquired and most expensive inventory. FIFO reporting leads to higher current asset value and higher net income. Firms may switch from one to another only under extraordinary circumstances and not frequently.

16、E. Long-Term Assets These are the real assets that the firm acquires to produce its products and generate cash flows. These include land, buildings, plant, and equipment. Intangible assets, such as goodwill, patents, and copyrights, are also listed here. All long-term real assets are depreciated, wh

17、ile intangible assets are amortized. Depreciating assets allows a firm to lower taxable income and reduce taxes. Firms are allowed to depreciate assets using the straight-line method or an accelerated depreciation method that is allowed by the IRS.F. Long-Term Liabilities These consist of the long-t

18、erm debt of the company. They include bank loans, mortgages, and bonds that have a maturity of one year or longer.G. Equity There are two sources of equity fundscommon equity and preferred equity. Common equity represents the true ownership of the firm. Multiple accounts identify the various sources

19、 of equity fundspar value, additional paid-in capital, retained earnings, and treasury stock. Par value and paid-in capital represent the outside equity capital raised by the firm by issuing shares. Retained earnings result from the funds that the firm has reinvested in the firm from its earnings. T

20、hese funds are not cash since they already have been put to work. The treasury stock account reflects the value of the shares that the firm repurchased from investors. The other source of equity capital is preferred stock. It has features that make it a combination of a fixed income security and an

21、equity security.3.3 Market Value versus Book ValueTraditionally, all assets are reported at their historical cost. The balance sheet does not reflect the current market value of the assets, only their acquired cost. Adopting a marking to market approachthat is, reporting assets at their current mark

22、et valueprovides better information to management and investors. Downside is the difficulty in estimating market values of assets. When both the liabilities and assets of a firm are reported at their current market value, their difference represents the true market value of shareholders equity.3.4 T

23、he Income Statement and the Statement of Retained EarningsA. The Income Statement The profitability of a firm for any reporting period is measured in the financial statement. The basic identity is shown in Equation 3.3. Revenues represent the value of the products and services sold by the firm, and

24、they include both cash and credit sales. Expenses range from the cost of producing goods for sale and asset utilization costs such as depreciation or amortization. Net income is the difference between the firms revenues and expenses. B. Depreciation, Amortization, and Other Income Statement Accounts

25、 Depreciation is the writing off of the cost of any physical asset like plant or machinery over its lifetime. This is a noncash expense. Depreciation expense reduces a firms taxable income as well as the firms taxes, while increasing the cash flow available to shareholders. Firms can use one of two

26、methods of depreciating an asset: the straight-line method and the accelerated depreciation method. Firms are allowed to use one approach for internal purposes and another for tax purposes. Firms prefer the accelerated depreciation method for tax purposes because it allows the firm to write off larg

27、er amounts of the cost of an asset over a shorter period. Amortization expenses are related to the writing off of the value of intangible assets like goodwill, patents, and licenses. It is also a noncash expense like depreciation. Nonrecurring expenses are associated with the closing down of unprofi

28、table operations or the restructuring of a firms operations. Extraordinary items refer to income or expenses associated with events that are not expected to happen on a regular basis.C. Bottom-Line Accounts The first bottom-line income figure that would be of interest to shareholders and creditors i

29、s earnings before interest, taxes, depreciation, and amortization (EBITDA), which is the earnings generated from operations prior to the recognition of expenses not directly connected to the production of the products. After netting out the expenses related to depreciation and amortization, we arriv

30、e at earnings before interest and taxes (EBIT). The next important income line is earnings before taxes (EBT) and represents the taxable income for the period. Finally, subtracting taxes from EBT yields net income, or net income after taxes. This amount tells us the amount available to management to

31、 pay dividends, pay off debt, or reinvest in the firm.D. The Statement of Retained Earnings This financial statement shows the changes in this account from one period to the next. This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared.3.5 Cash Fl

32、owsA. Net Income versus Cash Flows While accountants focus on net income, shareholders are more interested in net cash flows. Net income and cash flows are not the same because of the presence of noncash revenues and expenses. Equation 3.4 shows how we can derive the net cash flows from operating activities (NCFOA) from net income. A simplified version of Equation 3.4 is used when the only significant non cas