Module 1 Financial Accounting for MBAs

TO BEGIN A BUSINESS YOU NEED MONEY.  HOW DO YOU GET MONEY?

(1)  Business owners (investors or stockholders).  They expect to earn a return on their
investment by:

 Being able to sell their ownership interest (stock) in the future at a higher price than they
paid.
 Receiving a portion of what the company earns in the form of cash payments (called
dividends).

(2)  Loans from non-owners (lenders or creditors).  They expect to earn a return on their

investment by:

 Receiving periodic interest on the money they lent.

 Receiving the money back they lent.

NOTE:  The managers of the business may or may not be the owners!!!

How do we report back to these owners and Non-owners?

The ACCOUNTING SYSTEM collects and processes financial information about a business

and reports that information in the form of Financial statements. Demand for financial
statements information is driven as users need to assess the risk and return of a
business. Supply for financial statements information is driven by managers’ need to
lower cost of financing for their business as well as contracting and labor costs.
Managers decide how much information to supply by offsetting the costs of supplying
information against the benefits from supplying this information. Regulators also
dictate some minimum level of supply of information to all stakeholders.

There are many USERS that DEMAND financial information contained in

the Financial Statements.

1. Managers and Employees: demand information on the company financial

condition, future profitability, as well as information on the competition and
business opportunities. They also demand information for compensation and
bonuses purposes. Profit sharing plans and stock ownership plans have
increased the need for such information. Unions also demand information for
linking wages and pension plans to financial performance of the business.
Financial and accounting information helps provide answers to the following
questions: a) what product lines, geographies, business segments are
performing well or poorly, b) which parts of the business should be expanded
 or contracted, and c) how will current and future business prospects impact
profit-sharing and stock compensation plans.
2. Investment Analysts: demand information on the company’s financials because
it impacts the company’s future profitability, ability to generate cash, impacts
the company’s stock price, the company’s ability to borrow on favorable versus
unfavorable terms, and sheds light on claims by lenders and stockholders. This
information allows analysts to issue buy/sell/hold recommendations on the
company’s stock, and set price targets for the stock.
3. Creditors: demand financial accounting information to determine suitable loan
terms (interest rate, term, collateral needed, as well as impose any restrictive
covenants that protect the creditors’ claims on the company by restricting the
borrower’s behavior in some way). These covenants can be in the form of a
minimum amount of working capital, minimum debt-to-equity ratio, or
minimum interest coverage ratio.
4. Stockholders and Directors: Stockholders demand financial accounting
information to assess the profitability of a business, and potential return and
risks from investing in the business. Directors use financial accounting
information to evaluate management’s performance in running the business.
Management should run the business in the interest of stockholders as well as
other stakeholders (creditors, employees, etc.).
5. Customers and Strategic Partners: Customers use financial accounting
information to assess reliability and staying power of the business. This is
particularly important for businesses that produce products with long lives.
Customers are more likely to commit to buying long-life products made by
stable, growing, and profitable businesses, and are skeptical of businesses
whose financial condition is in doubt. Strategic partners need information to
assess the viability of long-term strategic alliances with businesses.
6. Regulators and Tax Authorities: need financial accounting information for
antitrust assessments, tax collection, and to assess the reliability of company
disclosed financial accounting information. Some businesses are granted
monopoly rights in providing a service or good in exchange for oversight by
regulatory bodies over prices charged to customers.

There are many Benefits and Costs that affect SUPPLY of financial
information contained in the Financial Statements.

Benefits of Disclosure of Information: companies benefit from disclosing

financial accounting information by being able to raise debt and equity capital at
reasonable terms in the capital markets, being able to recruit the best employees,
and being able to establish strong supplier and customer relationships. The quality
 of information supplied is constrained by the audit process, and the legal
consequences of falsifying information.

Costs of Disclosure of Information: these costs can be:

1. Costs of preparing and disseminating the information (auditing fees, costs

associated with SEC compliance, legal fees, etc.). These costs can be time
consuming and expensive.
2. Costs in disclosing information about the business involve loss of competitive
advantage as a result of releasing information on products, geographies,
strategic alliances, future prospects, etc.
3. Legal costs, releasing too much information exposes the business to litigation
risk and costs (if expectations are not met). Customer and investor lawsuits can
involve considerable costs in defending the business against these lawsuits.
4. Political/regulation costs associated with some high profile businesses.
Regulation Fair Disclosure (Reg FD) requires firms to release material, non-
public information simultaneously to all stakeholders to prevent any one party
from having an unfair advantage.

To ensure every company follows the same rules in what to report and how to value
what is reported on the Financial Statements, the accounting profession (FASB –
private body) has a set of generally accepted accounting principles (GAAP) that must
be followed. GAAP ensures every company has some guidance on what to report, also
allowing outsiders to understand the rules used by management to prepare the
Financial Statements. 

However, GAAP isn’t perfect. GAAP allows for choices in preparing Financial
Statements. GAAP also requires numerous estimates to be made by management:
 Bad debt allowance
 Depreciable lives
 Value of impairments
 Estimate of warranty liabilities
 Pension estimates
 Postretirement benefit estimates

The SEC’s primary responsibility is to make sure investors are provided with full and fair
information about publicly traded companies.  They work with professional accounting
organizations (Currently the Financial Accounting Standards Board (FASB)) to establish
measurement rules.
In the U.S, publicly traded companies must file financial accounting information with the
SEC. Two examples are the 10-K (audited annual report) and 10-Q (unaudited
quarterly reports) which are filed on the sec.gov website.
 Management is responsible for putting together the financial statements
following GAAP as well as establishing and maintaining an adequate internal
control structure and procedures.
 Independent auditors are responsible for writing an opinion on whether or not
they believe management followed GAAP and therefore presented its Financial
Statements fairly as well as giving an opinion on the effectiveness of the internal
control system. The independent audit adds credibility to the financial
statements and notes prepared by management.

There are real economic incentives for companies to disclose reliable (audited)
accounting information enabling them to better compete in capital, labor and markets –
especially if it is good news. Do companies present false good news then? What stops
them? Recent examples are SOX, Reg FD and just auditing in general.

Sarbanes-Oxley Act (SOX) summary:

CEO and CFO sign statement attesting to the accuracy and completeness of the
financial statements.
To ensure all information is available to everyone, the SEC adopted Regulation Fair
Disclosure (FD), to stop the practice of selective disclosure by public companies to
certain shareholders and financial analysts. It states, “Whenever an issuer discloses
any material nonpublic information regarding that issuer, the issuer shall make public
disclosure of the information … simultaneously, the case of an intentional disclosure;
and ... promptly, in the case of a non-intentional disclosure.”

This course is applicable to ALL professionals. I believe everyone needs a framework to

analyze a company’s Financial Statements and to evaluate the company’s performance
and health. This is the major goal of this course of which I, along with the text book, will
help you do. In this course, you will learn how selection of accounting policies made by
management effect the interpretation of the company’s Financial Statements. I will
focus this course on ensuring you obtain an UNDERSTANDING of the Financial
Statements, which will be reinforced when you complete the first required case: “Do
Earnings Lie?” developed by me.
 BUSINESS ENVIRONMENT AND ACCOUNTING INFORMATION:
All companies sell a product or service! Investors, lenders, management and regulators
need to understand how the business is doing. The way management communicates
how well they are doing is through their Financial Statements (which reports on their
profitability as well as their financial condition).

We must understand the company’s business activities and business strategies in

order to understand their 4 Financial Statements (Balance Sheet, Income Statement,
Changes in Cash Flows, and Changes in Stockholders’ Equity accounts).

Obtain information on Company’s Business Strategy

1. Identify the economic characteristics of the industry in which a particular firm
participates: Competition, uniqueness of product, degree of technology, maturity
of industry.
2. Identify the strategies that the firm pursues to gain and sustain a competitive
advantage: Identify customers, degree of supplier and retail integration, degree
of geographic and industry diversification.
3. Understand the goals and objectives of the company as well as their strategic
plan on how they will obtain their goals and objectives. Without an
understanding of the business plan we cannot analyze or evaluate the financial
statements.
a. Is the company’s strategy to obtain product differentiation –are they
able to charge a premium sales price for their unique product as there are
not many substitutes? This requires high costs for research and
development, advertising and other marketing costs.
b. Is the company’s strategy to be a cost leader –are they keeping their
costs low for both raw materials and labor through use of cost-efficient
manufacturing processes or bargaining power with their suppliers?

Analysis of Financial Statements

A company’s profitability must be assessed with respect to the size of its investment. 

  ROA (Net income/average total assets) = profitability *productivity

Profitability is called profit margin – net income / sales
Productivity is called asset turnover – sales / average total assets

The economic characteristics of the industry are important for analyzing ROA as
some industries focus on profitability and some industries focus on productivity.
  Year Net Income Sales Total assets
McDonalds Dec. 31, 2017 $5,192,300,000 12,718,900,000 $33,803,700,000
Dec. 31, 2018 $5,924,300,000 $10,012,700,000 $32,811,200,000
  Dec.31, 2019 $6,025,400,000 $9,420,800,000 $47,510,800,000
Target Feb. 3, 2018 $2,914,000,000 $72,714,000,000 $38,999,000,000
Feb. 2, 2019 $2,937,000,000 $75,356,000,000 $41,290,000,000
  Feb. 1, 2020 $3,281,000,000 $78,112,000,000 $42,779,000,000
 McDonalds:- focuses on profitability (high profit margin)
Profitability (net income/sales):
McDonalds (12/31/2019) =$6,025,400,000 /$9,420,800,000=0.639 or 63.9%
McDonalds (12/31/2018) =$5,924,300,000 /$10,012,700,000=0.592 or 59.2%

Productivity (sales/average assets):

McDonalds (12/31/2019)= $9,420,800,000 / {($47,510,800,000+$32,811,200,000) /2]=
$10,012,700,000 / $40,161,000,000 = 0.249
McDonalds (12/31/2018)= $10,012,700,000 / [($32,811,200,000+$33,803,700,000) /2]=
$10,012,700,000 / $33,307,450,000 = 0.301

ROA (net income/average assets):

McDonalds (12/31/2019) =$6,025,400,000 / [($47,510,800,000+$32,811,200,000) /2]=
$6,025,400,000 / $40,161,000,000 = 0.15 or 15%
McDonalds (12/31/2018) =$5,924,300,000 / [($32,811,200,000+$33,803,700,000) /2]=
$5,924,300,000 / $33,307,450,000 = 0.18 or 18%

Target: - focuses on productivity (high sales volume)

Profitability (net income/sales):
Target (2/1/2020) = $3,281,000,000 / $78,112,000,000=0.042 or 4.2%
Target (2/1/2019) = $2,937,000,000 / $75,356,000,000=0.039 or 3.9%

Productivity (sales/average assets): 

Target (2/1/2020) =$78,112,000,000 / [($42,779,000,000+$41,290,000,000) /2]=
$78,112,000,000 / $42,034,500,000 = 1.86
Target (2/1/2019) =$75,356,000,000 / [($41,290,000,000 + $38,999,000,000) /2]
=$75,356,000,000 / $40,144,500,000= 1.88

ROA (net income/average assets):

Target (2/1/2020) = $3,281,000,000 / [($42,779,000,000+$41,290,000,000) /2]=
$3,281,000,000 / $42,034,500,000 = 0.078 or 7.8%
Target (2/1/2019) = $2,937,000,000 / [($41,290,000,000+$38,999,000,000) /2]=
$2,937,000,000 / / $40,144,500,000 = 0.073 or 7.3%
 Financial statements:

BALANCE SHEET – shows the company’s financial position at a point in time

 Reports assets (what the company owns) and how these asses were financed,
either through (1) liabilities (financing by non-owners through banks, creditors or
suppliers) or (2) stockholders’ equity (financing by owners).

Since all the assets the company owns or invested in were financed by someone we
get the ACCOUNTING EQUATION: Assets = liabilities + stockholder’s equity

CLASSIFICATION of ASSETS
Current assets – will be converted into cash or used in operations within the next year.
Long-term assets – expected to be around for a long time

STARBUCKS SOUTHWEST AIRLINES

Consolidated Balance Sheet ($ million) Consolidated Balance Sheet ($ million)

2019 2020 2019 2020

Assets:
Short-term assets 12,494.2 5,283.4 5,974 5,028
Long-term assets 11,662.2 9,082.2 19,921 21,215
TOTAL ASSETS 24,156.4 14,365.6 25,895 26,243

Liabilities:
Short-term liabilities 5,684.2 4,220.7 8,952 7,905
Long-term liabilities 17,296.4 4,687.9 7,111 8,485
TOTAL LIABILITIES 22,980.6 8,908.6 16,063 16,390

Stockholders’ Equity
Contributed capital 42.4 42.5 2,389 2,318
Retained earnings 1,457.4 5,563.2 17,945 15,967
Other equity (324) (148.7) (10,502) (8,432)
TOTAL STOCKHOLDERS’ 1,175.8 5,457 9,832 9,853
EQUITY

TOTAL LIABILITIES AND 24,156.4 14,365.6 25,895 26,243

STOCKHOLDERS’ EQUITY

The relative proportion of short-term and long-term investments in assets depends upon a
companies’ business model and the industry in which they operate.

STARBUCKS carries lots of inventory (cost of products available to sell to customers) so they
have more short-term or current assets.

SOUTHWEST AIRLINES has most of their investments in long-term assets (airplanes).

CLASSIFICATION of LIABILITIES
Current liabilities must be paid back within one year.
Long-term liabilities are obligations due after one year.

TARGET ALPHABET
Consolidated Balance Sheet Consolidated Balance Sheet
($ millions) ($ millions)

Feb. 1, 2020 Feb. 1, 2019 Dec. 31, 2019 Dec. 31, 2018

Assets:
Short-term assets 12,519 12,540 152,578 135,676
Long-term assets 28772 27,763 123,331 97,116
41,290 40,303 275,909 232,792
TOTAL ASSETS

Liabilities:
Short-term liabilities 15,014 13,052 45,221 34,620
Long-term liabilities 14,979 15,600 29,246 20,554
29,993 28,652 74,467 55,164
TOTAL LIABILITIES

Stockholders’ Equity
Contributed capital 6,085 5,903 50,552 45,049
6,017 6,495 152,122 134,885
Retained earnings
(805) (747) (1,232) 2,306
Other equity
TOTAL STOCKHOLDERS’ EQUITY
11,297 11,651 201,442 177,628

TOTAL LIABILITIES AND 41,290 40,303 275,909 232,792

STOCKHOLDERS’ EQUITY

The relative proportion of non-owner (liabilities) and owner (stockholders’ equity) financing
is largely determined by a companies’ business model and the industry in which they operate.

TARGET has stable cash flows and can operate with more debt.

Technology companies like ALPHABET have higher business risk and therefore prefer not to
take on a lot of debt, which would increase their financial risk (as debt requires payment of
interest as well as the repayment of the borrowed money at a specified date).
Owner financing (Equity) can come from cash contributed to the company (in exchange for
stock) or earned capital (profits retained by the company).

CLASSIFICATION of OWNER FINANCING OR EQUITY

Contributed capital – net funding that a company received from issuing and
reacquiring its equity shares.

Earned capital – cumulative net income (loss) that has been retained by the company
(not paid out in dividends to shareholders).

Owners of corporate stock are generally not personally liable for the company’s
debt. If the company goes bankrupt though, the money received from the sale of
the assets will go to the creditors first, before going to the stockholders.

How does management decide who to obtain sources of capital from?

They look at relative costs.
Creditors have the first claim on the assets so they charge less (interest rate) than
shareholders require for a return on their stock investment. Also, interest is tax
deductible whereas dividends are not. Downside of debt is that there are required
interest and principle payments to be made whereas stockholders cannot require
payments to be made to them. Thus, companies take on a level of debt that they can
comfortably repay at reasonable interest costs. Companies with relatively stable cash
flows can take on higher levels of debt. Companies that operate in industries that
change rapidly cannot afford the borrowing risk.
Limitations of the Balance Sheet –
 Assets are listed at their purchase price (historical cost) not current market value.
 Many assets are missing from the balance sheet because they are hard to value
objectively.
 Lots of items represent estimates.
Therefore many assets are not reported on the balance sheet as they cannot be
measured with relative certainty (brand name image, knowledge-based assets, superior
technology).

Currently, book value on the Financial Statement (Balance Sheet) is, on average
smaller than the market value of the company.

Market-to-book ratios are greater for companies with large knowledge–based assets
that are not reported on the balance sheet but are reflected in company’s market value.

Target:
Feb. 3, 2020: #sh=504,200,000, BV of Equity= $11,297,000,000, Price/share=$20.04,
Market Value of Equity=Price/sh x # shares = $20.04/sh x 504,200,000 sh=$10,104,168,000,
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $10,104,168,000 /
$11,297,000,000 =0.89

Feb. 1, 2019: #sh=517,800,000 , BV of Equity=$11,651,000,000, Price/share=$15.78,

Market Value of Equity=Price/sh x # shares =$15.78/sh x 517,800,000 sh= $8,170,884,000.
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $8,170,884,000 /
$11,651,000,000 = 0.70

Microsoft:
July 1, 2019: #shares outstanding=7,643,000,000, Price/share=$134.40
Market Value of Equity=Price/sh x # shares = $134.40/sh x 7,643,000,000 sh=$1,027,219,200,000,
BV of Equity= $102,330,000,000
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $1,027,219,200,000 / $102,330,000,000
=10.04 times

July 2, 2018: #sh outstanding=7,677,000,000, Price/share=$97.49

Market Value of Equity=Price/sh x # shares =$97.49/sh x 7,677,000,000 sh= $748,430,730,000.
BV of Equity=$82,718,000,000
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $748,430,730,000 / $82,718,000,000 =
9.05 times
 BALANCE SHEET EQUATION:

Assets = Liabilities + Equity

Analyzing the Balance Sheet

Assets tell us whether the firm has sufficient resources available to operate.
Liabilities will need to be paid with cash. Both creditors and stockholders need to
ensure that this will happen.
INCOME STATEMENT – shows revenues less expenses for the accounting period

Revenues = based on net SALES price of products or services sold

- Cost of Goods Sold expense = based on COST of products or services sold.
GROSS PROFIT

- Operating expenses (Selling, general and admin. Expenses) =salaries, marketing

INCOME FROM OPERATIONS

+/- Nonoperating items = income/expenses not related to product or service sold.

- Income tax expense (income before income taxes * statutory tax rate)
INCOME FROM CONTINUING OPERATIONS

+/- INCOME/LOSS FROM DISCONTINUED OPERATIONS (NET OF TAXES)

NET INCOME

IMPORTANT SUBTOTALS on the INCOME STATEMENT:

1) GROSS PROFIT – profit from the sales price being greater than the cost.
2) INCOME FROM OPERATIONS - Operating income deducts only operating
expenses from sales revenue. Operating expenses are usual costs incurred to
support its operating activities (cost of goods sold and S,G &A expenses)
3) INCOME FROM CONTINUING OPERATIONS - (persistent) income is the
income that is likely to persist in the future (which consists of sales less operating
expenses less non-operating expenses less tax expense). Non-operating
revenue/expenses are costs related to financing and investment activities
(interest and dividend revenue, interest expense, gain and losses from sale of
investments).
4) INCOME/LOSS FROM DISCONTINUED OPERATIONS – Revenue less
expenses for the part of the company that is discontinued. This is reported at
bottom of income statement, and is net of taxes, that is the taxes are already
deduced. Transitory income is the income that is not likely to continue in the
future and will not be helpful in predicting future earnings

Revenues = Recorded (recognized) in the period in which the goods and services
are sold (or performance obligation is satisfied), not necessarily the period in
which cash is received.

Expenses = Recorded (recognized) in the period in which the expense are

incurred not necessarily the period in which cash is paid. The period in which an
expense is reported on the income statement is the period in which goods and services
are used to earn revenues, not necessarily the period in which cash is paid. An asset
remains on the company’s Balance Sheet until it is used up. The asset’s cost is
transferred from the Balance Sheet to the Income Statement where it becomes an
expense - when it is used up (or incurrent to generate the revenue in that period).
 INCOME STATEMENT EQUATION:

Net Income = Revenues - Expenses

Analyzing the Income Statement:

Net income tells us the firm’s ability to sell goods for more than they cost to purchase (if
merchandiser) or produce (if manufacturer). Investors buy stock when they believe that
future earnings will improve and lead to a higher stock price.
Lenders rely on future earnings to determine if the loan will be repaid on time.
Details of the income statement tell us sales dollars as well as expense totals and what
they are spending a majority of their sales dollars on. All expenses on the income
statement can be represented as a percent of sales by taking the expense amount and
dividing it by sales (especially net income as a percent of sales).

Gross Profit margin = Gross profit / Sales Revenue

Higher or increasing gross profit margin indicates the sales price is increasing and or
the cost to purchase the product or produce the product is decreasing. This is a good
sign.

Margins for operating expenses = operating expense / Sales Revenue

Each expense is divided by Sales Revenue indicating the percentage of sales revenue
incurred for that expense.
STATEMENT OF CHANGES IN RETAINED EARNINGS - reports the way that net
income and the distribution of dividends affected the financial position of the
company during the accounting period.

Below is FACEBOOK’s information on changes in their retained earnings balance, which

consists of all its net income since inception.

RETAINED EARNINGS EQUATION:

Beginning Retained earnings + Net Income – Dividends = Ending Retained Earnings

STATEMENT OF CHANGES IN RETAINED EARNINGS, in millions

Balance at Dec. 31, 2009 -
Net income 606
Balance at Dec. 31, 2010 $ 606
Net income 1,000
Balance at Dec. 31, 2011 $ 1,606
Net income 53
Balance at Dec. 31, 2012 $ 1,659
Net income 1,500
Balance at Dec. 31, 2013 $3,159
Net income 2,940
Balance at Dec. 31, 2014 $ 6,099
Net income 3,688
Balance at Dec. 31, 2015 $ 9,787
Cumulative-effect adjustment from adoption of ASU 2016-09 1,666

Analyzing Retained Earnings:

Firm’s policy on dividend payments to the stockholders affects its ability to repay its
debts to outside creditors. The board of directors decides whether or not to pay
dividends.

Retained Earnings are NOT CASH! Some of the earnings may still be in the form of
cash. The cash earnings may also have been used to purchase other assets or pay off
loans.
STATEMENT OF CASH FLOWS - reports a summary of where cash went
(payments) as well as where cash came from (receipts).
Allows us to assess a company’s cash management to help ensure they don’t end up
with cash shortages. It tells us how the company generated its cash and what it used
the cash generated for.

CLASSIFICATION
1. Cash flow from operating activities – related to its operations
2. Cash flow from investing activities – acquisition and divestitures of investments
and long-term assets.
3. Cash flow from financing activities – issuances of and payments toward
borrowings and equity.

CASH FLOW STATEMENT EQUATION

CFO + CFI + CFF = change in cash
 
Analyzing the cash flow statement:
Useful to both creditors and investors in predicting future cash flows that may be
available for payment of debt to creditors and dividends to investors.  The
operating activities section indicates the company’s ability to generate cash from
sales to meet its current cash needs.  Any amount left over can be used to pay
back the bank debt, pay dividends in stock or buy back stock, or invest to expand
the company.  Investment section shows investments in new manufacturing
equipment indicating growth of company.
The top line (net income) of the operating section represents the accrual-based
net income reported on the Income Statement. The bottom line of the operating
section represents the cash-based net income number (if the company has used
the cash based method to report revenue and expenses).

FINANCIAL STATEMENT LINKAGES:

1. Retained earnings – links Balance Sheet and Income Statement. Net income
from the Income statement is shown as an increase to retained earnings on the
Statement of Changes in Retained Earnings.
2. Cash – links Statement of Changes in Cash Flow and Balance Sheet. The
Statement of cash flows shows the change in cash from last year’s ending cash
on the Balance sheet to this year’s ending cash balance under assets on the
Balance sheet.
3. Changes in stockholder’s equity section – links Statement of Changes in
Retained Earnings and Balance Sheet. Ending retained earnings on the
Statement of Changes in Retained Earnings is shown as retained earnings under
stockholders’ equity on the Balance sheet.
The notes attached to the financial statements explain
 The accounting rules applied
 Details about line items in the statements
 Disclosures about items not listed in the statements.