Financial reporting, financial statement analysis, and valuation: a strategic perspective

Title Page......Page 2
Copyright Page......Page 3
Dedication Page......Page 4
Preface......Page 5
About the Authors......Page 18
Brief Contents......Page 20
Contents......Page 21
 Chapter Overview......Page 32
 Overview of Financial Statement Analysis......Page 33
  How Do the Six Steps Relate to Share Pricing in the Capital Markets?......Page 36
   Introducing Starbucks......Page 38
  Pharmaceutical Company......Page 39
  Electric Utility......Page 40
  Tools for Studying Industry Economics......Page 41
 Step 2: Identify the Company Strategies......Page 47
  Application of Strategy Framework to Starbucks......Page 48
 Step 3: Assess the Quality of the Financial Statements......Page 49
  What Is Accounting Quality?......Page 50
  Balance Sheet—Measuring Financial Position......Page 51
  Assets—Recognition, Measurement, and Classification......Page 52
  Liabilities—Recognition, Valuation, and Classification......Page 55
  Shareholders’ Equity Valuation and Disclosure......Page 56
  Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position......Page 57
  Income Statement—Measuring Performance......Page 58
  Accrual Basis of Accounting......Page 59
  Classification and Format in the Income Statement......Page 61
  Comprehensive Income......Page 62
  Assessing the Quality of Earnings as a Complete Representation of Economic Performance......Page 63
  Statement of Cash Flows......Page 64
  Important Information with the Financial Statements......Page 66
 Step 4: Analyze Profitability and Risk......Page 68
  Tools of Profitability and Risk Analysis......Page 69
 Step 5: Prepare Forecasted Financial Statements and Step 6: Value the Firm......Page 74
 Role of Financial Statement Analysis in an Efficient Capital Market......Page 75
  The Association between Earnings and Share Prices......Page 76
 Sources of Financial Statement Information......Page 78
 Questions and Exercises......Page 79
 Problems and Cases......Page 81
 Integrative Case 1.1 Walmart......Page 91
 Case 1.2 Nike: Somewhere between a Swoosh and a Slam Dunk......Page 97
 Chapter Overview......Page 106
 The Mixed Attribute Measurement Model......Page 107
 Asset and Liability Valuation and the Trade-Off between Relevance and Representational Faithfulness......Page 108
  Accounting Quality......Page 110
  Primary Valuation Alternatives: Historical Costversus Fair Value......Page 111
  Contrasting Illustrations of Asset and LiabilityValuations, and Nonrecognition of Certain Assets......Page 115
  Summary of U.S. GAAP and IFRS Valuations......Page 118
 Income Recognition......Page 119
  Accrual Accounting......Page 120
  Approach 1: Economic Value Changes Recognized onthe Balance Sheet and Income Statement WhenRealized......Page 122
  Approach 2: Economic Value Changes Recognized on the Balance Sheet and the Income Statement When They Occur......Page 123
  Approach 3: Economic Value Changes Recognized onthe Balance Sheet When They Occur but Recognizedon the Income Statement When Realized......Page 124
 Income Taxes......Page 125
  Overview of Financial Reporting of Income Taxes......Page 127
  Measuring Income Tax Expense: A Bit More to theStory (to Be Technically Correct)......Page 132
  Income Taxes......Page 135
  Overview of the Analytical Framework......Page 136
 Questions and Exercises......Page 141
 Problems and Cases......Page 143
 Integrative Case 2.1 Walmart......Page 153
 Chapter Overview......Page 154
 Purpose of the Statement of Cash Flows......Page 155
  Cash Flows and Financial Analysis......Page 156
 The Relations among the Cash Flow Activities......Page 158
  A Firm’s Life Cycle: Revenues......Page 159
  A Firm’s Life Cycle: Net Income......Page 160
  A Firm’s Life Cycle: Cash Flows......Page 161
  Four Companies: Four Different Stages of the Life Cycle......Page 162
 Understanding the Relations among Net Income, Balance Sheets, and Cash Flows......Page 165
  The Operating Section......Page 166
  The Relation between Net Income and Cash Flowsfrom Operations......Page 178
 Preparing the Statement of Cash Flows......Page 180
  Algebraic Formulation......Page 181
  Classifying Changes in Balance Sheet Accounts......Page 183
  Illustration of the Preparation Procedure......Page 188
 Usefulness of the Statement of Cash Flows for Accounting and Risk Analysis......Page 190
 Questions, Exercises, Problems, and Cases......Page 193
 Integrative Case 3.1 Walmart......Page 216
 Case 3.2 Prime Contractors......Page 217
 Chapter Overview......Page 220
 Overview of Profitability Analysis Based on Various Measures of Income......Page 221
  Earnings Per Share (EPS)......Page 223
  Common-Size Analysis......Page 226
  Alternative Definitions of Profits......Page 228
 Return on Assets (ROA)......Page 232
  Adjustments for Nonrecurring or Special Items......Page 234
  Two Comments on the Calculation of ROA......Page 235
  Disaggregating ROA......Page 237
 Return on Common Shareholders’ Equity (ROCE)......Page 238
  Benchmarks for ROCE......Page 239
  Relating ROA to ROCE......Page 241
  Disaggregating ROCE......Page 244
 Economic and Strategic Determinants ofROA and ROCE......Page 246
  Trade-Offs between Profit Margin and Assets Turnover......Page 251
  Analyzing the Profit Margin for ROA......Page 254
  Analyzing Total Assets Turnover......Page 261
  Supplementing ROA in Profitability Analysis......Page 266
  Comparisons with Earlier Periods......Page 271
  Comparisons with Other Firms......Page 272
 Summary......Page 273
 Questions and Exercises......Page 274
 Problems and Cases......Page 276
 Integrative Case 4.1 Profitability and Risk Analysis of Walmart Stores......Page 294
 Chapter Overview......Page 306
 Disclosures Regarding Risk and RiskManagement......Page 309
  Firm-Specific Risks......Page 310
  Commodity Prices......Page 311
  Foreign Exchange......Page 312
  Other Risk-Related Disclosures......Page 313
  Analyzing Financial Flexibility by Disaggregating ROCE......Page 314
 Analyzing Short-Term Liquidity Risk......Page 324
  Current Ratio......Page 326
  Quick Ratio......Page 327
  Working Capital Turnover Ratios......Page 328
  Debt Ratios......Page 332
  Interest Coverage Ratios......Page 334
  Operating Cash Flow to Total Liabilities Ratio......Page 335
  Circumstances Leading to Need for the Loan......Page 336
  Cash Flows......Page 337
  Capacity for Debt......Page 338
  Communication......Page 339
  The Bankruptcy Process......Page 340
  Models of Bankruptcy Prediction......Page 341
 Measuring Systematic Risk......Page 347
 Questions, Exercises, Problems, and Cases......Page 349
 Integrative Case 5.1 Walmart......Page 362
 Case 5.2 Massachusetts Stove Company—Bank Lending Decision......Page 363
 Case 5.3 Fly-by-Night International Group: Can This CompanyBe Saved?......Page 370
 Chapter Overview......Page 380
  High Quality Reflects Economic Reality......Page 381
  High Quality Leads to the Ability to Assess EarningsPersistence over Time......Page 384
  Earnings Quality versus Balance Sheet Quality......Page 385
 Earnings Management......Page 386
  Deterrents to Earnings Management......Page 387
  Obligations with Fixed Payment Dates and Amounts......Page 388
  Obligations with Estimated Payment Dates and Amounts......Page 390
  Obligations Arising from Advances from Customers......Page 391
  Obligations under Mutually Unexecuted Contracts......Page 392
  Contingent Obligations......Page 393
  Off-Balance-Sheet Financing Arrangements......Page 394
 Asset Recognition and Measurement......Page 397
  Noncurrent Assets......Page 398
  Gains and Losses from Peripheral Activities......Page 401
  Restructuring Charges and Impairment Losses......Page 402
  Discontinued Operations......Page 404
  Other Comprehensive Income Items......Page 405
  Changes in Accounting Principles......Page 406
  Accounting Classification Differences......Page 408
  Partitioning Earnings into Operating Cash Flow and Accrual Components......Page 410
  A Model to Detect the Likelihood of Fraud......Page 417
 Financial Reporting Worldwide......Page 423
 Questions and Exercises......Page 424
 Problems and Cases......Page 427
 Integrative Case 6.1 Walmart......Page 439
 Case 6.2 Citi: A Very Bad Year......Page 440
 Case 6.3 Arbortech: Apocalypse Now......Page 449
 Chapter Overview......Page 458
  Investments by Shareholders: Common EquityIssuance......Page 459
  Distributions to Shareholders: Dividends......Page 462
  Equity Issued as Compensation: Stock Options......Page 466
  Alternative Share-Based Compensation: RestrictedStock and RSUs......Page 470
  Alternative Share-Based Compensation: Cash-SettledShare-Based Plans......Page 472
  Net Income and Retained Earnings......Page 473
  Summary and Interpretation of Equity......Page 476
  Financing with Long-Term Debt......Page 477
  Financial Reporting of Long-Term Debt......Page 480
  Fair Value Disclosure and the Fair Value Option......Page 481
  Accounting for Troubled Debt......Page 483
  Hybrid Securities......Page 484
  Transfers of Receivables......Page 488
 Leases......Page 489
  Capital Lease Method......Page 490
  Choosing the Accounting Method......Page 491
  The New Lease Standard......Page 497
 The Use of Derivatives to Hedge Interest Rate Risk......Page 499
  Nature and Use of Derivative Instruments......Page 500
  Accounting for Derivatives......Page 501
  Starbucks’ Derivatives Disclosures......Page 503
 Summary......Page 504
 Questions and Exercises......Page 505
 Problems and Cases......Page 510
 Case 7.2 Oracle Corporation: Share-Based Compensation Effects/Statement of Shareholders’ Equity......Page 516
 Case 7.3 Long-Term Solvency Risk: Southwest and Lufthansa Airlines......Page 520
 Chapter Overview......Page 528
  Assets or Expenses?......Page 529
 How Do Managers Allocate AcquisitionCosts over Time?......Page 536
  Useful Life for Long-Lived Tangible and Limited-LifeIntangible Assets......Page 537
  Cost Allocation (Depreciation/Amortization/Depletion) Method......Page 538
  When Will the Long-Lived Assets Be Replaced?......Page 540
 What Is the Relation between the Book Values and Market Values of Long-Lived Assets?......Page 541
  Impairment of Long-Lived Assets Subject toDepreciation and Amortization......Page 542
  Impairment of Goodwill......Page 544
  IFRS Treatment of Upward Asset Revaluations......Page 548
  Summary......Page 549
  Minority, Passive Investments......Page 550
  Minority, Active Investments......Page 557
  Majority, Active Investments......Page 560
  Preparing Consolidated Statements at the Date of Acquisition......Page 566
  Consolidated Financial Statements Subsequent to Date of Acquisition......Page 568
  What Are Noncontrolling Interests?......Page 571
  Corporate Acquisitions and Income Taxes......Page 575
  Consolidation of Unconsolidated Affiliates and Joint Ventures......Page 576
  When Is an Entity Classified as a VIE?......Page 577
 Foreign Currency Translation......Page 580
  Translation Methodology—Foreign Currency IsFunctional Currency......Page 581
  Translation Methodology—U.S. Dollar Is Functional Currency......Page 583
  Interpreting the Effects of Exchange Rate Changes on Operating Results......Page 585
 Questions and Exercises......Page 586
 Problems and Cases......Page 588
 Integrative Case 8.1 Walmart......Page 603
 Case 8.2 Disney Acquisition of Marvel Entertainment......Page 604
 Chapter Overview......Page 608
  The Revenue Recognition Problem......Page 609
  The IASB and FASB’s Revenue Recognition Project......Page 612
  Application of the New Revenue RecognitionMethod......Page 614
  Criteria for Expense Recognition......Page 623
  Cost of Sales......Page 624
  SG&A Costs......Page 630
 Income Taxes......Page 632
  Required Income Tax Disclosures......Page 633
 Pensions and Other PostretirementBenefits......Page 640
  The Economics of Pension Accounting in a DefinedBenefit Plan......Page 641
  Reporting the Income Effects in Net Income andOther Comprehensive Income......Page 644
  Pension Expense Calculation with Balance Sheet andNote Disclosures......Page 645
  Income Statement Effects......Page 646
  Impact of Actuarial Assumptions......Page 649
  Signals about Earnings Persistence......Page 650
 Questions and Exercises......Page 651
 Problems and Cases......Page 654
 Integrative Case 9.1 Walmart......Page 663
 Case 9.2 Coca-Cola Pensions......Page 664
 Chapter Overview......Page 666
 Introduction to Forecasting......Page 667
  General Forecasting Principles......Page 668
  Seven-Step Forecasting Game Plan......Page 669
  Coaching Tips for Implementing the Seven-Step Forecasting Game Plan......Page 671
 Step 1: Project Revenues......Page 673
 Projecting Revenues for Starbucks......Page 674
 Step 2: Project Operating Expenses......Page 685
  Projecting Cost of Sales Including Occupancy Costs......Page 686
  Projecting Store Operating Expenses and Other Operating Expenses......Page 687
  Projecting Property, Plant, and Equipment and Depreciation Expense......Page 688
  Techniques to Project Operating Assetsand Liabilities......Page 693
  Projecting Cash and Cash Equivalents......Page 697
  Projecting Accounts Receivable......Page 702
  Projecting Current and Noncurrent Deferred Income Tax Assets......Page 703
  Projecting Property, Plant, and Equipment and Accumulated Depreciation......Page 704
  Projecting Assets as a Percentage of Total Assets......Page 705
  Projecting Accounts Payable......Page 706
  Projecting Stored-Value Card Liabilities......Page 707
  Projecting Financial Assets......Page 708
  Projecting Short-Term and Long-Term Debt......Page 709
  Projected Total Liabilities......Page 710
  Projecting Interest Expense......Page 711
  Projecting Noncontrolling Interests......Page 712
  Projecting Common Stock, Preferred Stock, and Additional Paid-in Capital......Page 713
 Step 5: Project Provisions for Taxes, Net Income, Dividends, Share Repurchases, and Retained Earnings......Page 714
  Net Income Attributable to Starbucks’ Comm onShareholders......Page 715
  Projecting Dividends and Share Repurchases......Page 716
  Retained Earnings......Page 717
  Balancing Starbucks’ Balance Sheets......Page 718
 Step 7: Project the Statement of CashFlows......Page 720
  Specific Steps for Forecasting Implied Statements of Cash Flows......Page 721
  Projected Total Assets Approach......Page 726
 Test Forecast Validity by Analyzing Projected Financial Statements......Page 727
 Reactions to Announcements......Page 730
 Summary......Page 731
 Questions and Exercises......Page 732
 Problems and Cases......Page 733
 Integrative Case 10.1 Walmart......Page 739
 Case 10.2 Massachusetts Stove Company: AnalyzingStrategic Options......Page 746
 Chapter Overview......Page 756
 The General Valuation Model......Page 757
 Equivalence among Dividends, Cash Flows, and Earnings Valuation......Page 759
 Expected Rates of Return......Page 760
  Cost of Common Equity Capital......Page 761
  Evaluating the Use of the CAPM to Measure the Cost of Equity Capital......Page 767
  Cost of Debt Capital......Page 768
  Cost of Equity Capital Attributable to Noncontrolling Interests......Page 769
  Computing the Weighted-Average Cost of Capital......Page 770
  Dividends-Based Valuation Concepts......Page 774
  Measuring Dividends......Page 778
  Measuring Dividends for Starbucks......Page 779
  Selecting a Forecast Horizon......Page 780
  Projecting and Valuing Continuing Dividends......Page 781
 The Dividends-Based Valuation Model......Page 786
  Using the Dividends-Based Valuation Model to Value Starbucks......Page 787
 Sensitivity Analysis and InvestmentDecision Making......Page 791
 Summary......Page 793
 Questions and Exercises......Page 794
 Problems and Cases......Page 795
 Integrative Case 11.1 Walmart......Page 799
 Chapter Overview......Page 802
 Rationale for Cash-Flow-Based Valuation......Page 804
  A Conceptual Framework for Free Cash Flows......Page 805
  How Do We Measure Free Cash Flows?......Page 807
  Valuation Models for Free Cash Flows for CommonEquity Shareholders......Page 816
 Free Cash Flows Valuation of Starbucks......Page 818
  Starbucks Discount Rates......Page 819
  Valuing Starbucks Using Free Cash Flows......Page 820
  Valuing Starbucks Using Free Cash Flows to CommonEquity......Page 821
  Valuing Starbucks Using Free Cash Flows to All Debtand Equity Capital Stakeholders......Page 825
  Necessary Adjustments to Compute Common EquityShare Value......Page 826
 Sensitivity Analysis and InvestmentDecision Making......Page 829
 Questions and Exercises......Page 831
 Problems and Cases......Page 832
 Integrative Case 12.1 Walmart: Free-Cash-Flows Valuation ofWalmart’s Common Equity......Page 842
 Case 12.2 Holmes Corporation......Page 847
 Chapter Overview......Page 860
 Rationale for Earnings-Based Valuation......Page 862
 Earnings-Based Valuation: PracticalAdvantages and Concerns......Page 864
 Theoretical and Conceptual Foundationsfor Residual Income Valuation......Page 866
  Intuition for Residual Income Measurementand Valuation......Page 868
  Illustrations of Residual Income Measurementand Valuation......Page 869
 Residual Income Valuation with FiniteHorizon Earnings Forecasts andContinuing Value Computations......Page 873
  Valuation of Starbucks Using theResidual Income Model......Page 875
 Residual Income ModelImplementation Issues......Page 881
  Dirty Surplus Accounting......Page 882
  Common Stock Transactions......Page 883
  Negative Book Value of CommonShareholders’ Equity......Page 884
 Consistency in Residual Income,Dividends, and Free Cash FlowsValuation Estimates......Page 885
 Questions and Exercises......Page 886
 Problems and Cases......Page 888
 Integrative Case 13.1 Walmart......Page 893
 Chapter Overview......Page 896
 Market Multiples of Accounting Numbers......Page 898
  A Model of the Value-to-Book Ratio......Page 900
  The Value-to-Book Model with Finite HorizonEarnings Forecasts and Continuing Value......Page 903
  Why Might VB Ratios and MB Ratios Differ from 1?......Page 905
  Application of the Value-to-Book Model to Starbucks......Page 906
  Empirical Data on MB Ratios......Page 909
  Empirical Research Results on thePredictive Power of MB Ratios......Page 911
 Price-Earnings and Value-Earnings Ratios......Page 912
  A Model for the Value-Earnings Ratio with Application to Starbucks......Page 913
  PE Ratios from a Theoretical Perspective: Projecting Firm Value from Permanent Earnings......Page 914
  Price-Earnings Ratios from a Practical Perspective......Page 915
  Benchmarking Relative Valuation: Using MarketMultiples of Comparable Firms......Page 917
  Incorporating Earnings Growth into PE Ratios......Page 921
  Empirical Properties of PE Ratios......Page 924
 Reverse Engineering......Page 926
  Reverse Engineering Starbucks’s Stock Price......Page 927
  What Does ‘‘Capital Market Efficiency’’ Really Mean?......Page 929
  Striking Evidence on the Degree of Market Efficiencyand Inefficiency with Respect to Earnings......Page 930
  Striking Evidence on the Use of Valuation Models toForm Portfolios......Page 932
 Summary......Page 934
 Questions and Exercises......Page 935
 Problems and Cases......Page 936
 Integrative Case 14.1 Walmart......Page 941
Appendix A: Financial Statements and Notes for Starbucks Corporation......Page 944
Appendix B: Management’s Discussion and Analysis for Starbucks Corporation......Page 988
Appendix C: Financial Statement Analysis Package (FSAP)......Page 990
Appendix D: Financial Statement Ratios: Descriptive Statistics by Industry......Page 1034
Index......Page 1036