Class Note for SCH-MGMT 797 at UMass(1)
Class Note for SCH-MGMT 797 at UMass(1)
Popular in Course
Popular in Department
This 8 page Class Notes was uploaded by an elite notetaker on Friday February 6, 2015. The Class Notes belongs to a course at University of Massachusetts taught by a professor in Fall. Since its upload, it has received 18 views.
Reviews for Class Note for SCH-MGMT 797 at UMass(1)
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 02/06/15
Eugene M Is enb erg School ofManagemem SCHMGMT 797AA Financial Statement Analysis Notes for fourth day of class Ray Pfeiffer July 13 2005 Administrative items Music Today Questions Reformulating the statement of stockholders equity Reformulating the balance sheet and income statement Reformulating the cash flow statement For Monday Analyzing profitability and growth Study chapters 11 and 12 complete homework 5 Recommended problems E8lE82 E88 E93 E97 Why do we need to reformulate the statement of stockholders equity gt For residual earnings valuation we need appropriate measures of book value CSE and of comprehensive income How to do the reformulation gt Template for the reformulated statement page 242 Beginning book value of common equity Net effect of transactions with common shareholders capital contributions share issues share repurchases dividends Net cash contribution negative net dividends Effect of operations and nonequity financing Net income from income statement Other comprehensive income Preferred dividends Comprehensive income available to common Closing book value of common equity gt Note the following 1 The focus is on common shareholders the preferred shares are viewed as financial obligations 2 Effects of transactions with shareholders are separated from effects from business activities and 3 Operations and nonequity financing are combined which means that preferred dividends are viewed as an expense like interest expense from the point of view of the common shareholders Reformulation procedures 1 Restate beginning and ending balances for items that are not part of common shareholders39 equity a Preferred stock issues should be separated and treated as financial obligations Note that redeemable39 preferred stock really isn39t part of equity so if it39s not in equity no adjustment is required b Dividends payable are treated as a liability in GAAP but they really aren39t a liability because shareholders can39t have obligations to themselves They are also a liability that does not provide debt financing So they are reclassified from liabilities to equity c Unearned compensation or deferred compensation If a firm issues shares at less than market value current shareholders incur a loss Firms grant shares to employees often at less than full market price The discount can be thought of as compensation to the employee The equity statement recognizes this as deferred compensation the idea being that the compensation is for future work to be performed and the amount is amortized to income over the service period Penman says that if this is sort of prepaid compensation it39s an asset and it shouldn39t be considered a contraequity account so it is reclassified Add the amounts back to beginning and ending equity and ignore any transactions related to it during the period 2 Calculate net transactions with shareholders the net dividend Dividends need to be cash dividends not dividends declared and not yet paid dividends payable 3 Calculate comprehensive income That means adding back or subtracting any of the weird accounting issues and also subtracting preferred dividends because they39re an expense from the perspective of the common shareholders gt Look at Exhibit 82 Reebok page 246 Explain how it is done there Comprehensive income under SFAS 130 is NOT comprehensive There are quite a few accounting issues that cause dirty surplus but that are not viewed as other comprehensive income Examples are included among the items in Table 81 page 248 Also there are hidden items Issuing shares at amounts less than market value Contingent equity claims put options 7 refer to Dell example in Box 84 convertible securities Illustrate a hidden item for Whole Foods Whole Foods financial statements on their website httpwwwwholefoodsmarketcominvestorannualreportshtml Whole Foods hidden dirty surplus unrecorded stock option expense estimated by Penman s method 1quot page 254 Reported tax benefit of exercise of stock options 25917 Statutory tax rate 40 ETR Implied expense difference between exercise price and market price 64793 25917O40 Tax benefit 25917 Aftertax expense not recorded 38876 Use this estimated expense to reduce comprehensive income and increase contributed capital additional paidin capital Note that there is no effect on book value only a reclassification from retained earnings to contributed capital gt Have the students reformulate their statements of Stockholders Equity Rationale for reformulating income statements and balance sheets Value according to the residual earnings valuation model is book value and the present value of residual earnings where residual earnings can be written as RE t ROCEt p E 1 Bt1 From this perspective value is generated by growing book value and ROCE Identifying value then lies in identifying the drivers of ROCE and B Thus we want financial statements that help us to clearly identify ROCE and B and their components Reformulating the Balance Sheet Show page 226 as the end product Operating Assets Operating Liabilities NOA Financial Obligations Financial Assets NFO NFA CSE CSE NOA NFO or NOA NFA Specific issues see also pages 2797283 in the text 1 Cash Working cash also called operating cash is the cash used to pay bills as they fall due This is an operating asset But cash equivalents should be financing Shorteterm notes receivable If shortterm receivables are trade receivables and the trade notes are part of the effort to get customers offering rates below market rates then they should be part of operations and so too should the related interest revenue Debt investments If a firm holds debt securities in a trading portfolio it probably means that they are trying to make money from investments so that makes them an operating asset Longeterm equity investments These are investments in the operations of other companies so classify them as operating assets See Accounting Clinic V on website for explanation of the relevant features of equity accounting and consolidations Shorteterm equity investments same deals as with debt investments 7 if they re in a trading portfolio then they are operating assets Shorteterm notes payable if these are traderelated and are at rates below market then treat them as operating liabilities Otherwise they re financing Accrued expenses these are all operating with the exception that interest payable on financial obligations is a financing liability 10 11 12 13 14 Deferred revenues unearned revenues definitely operating liabilities because they relate to transactions with customers Leases capitalized leases recorded assets are operating assets but the liabilities are financing obligations Deferred tax assets and liabilities these are treated as operating because they relate to operating income Dividends payable These are classified as shareholders equity not as liabilities Preferred stock is considered financial obligation quotOtherquot items The detail can usually be discovered in the notes to statements or MDampA Penman argues that they tend not to be material and tend also to be operating items Minority interest think of it as an equity sharing in the results of consolidated operations not as a financial obligation because the firm isn t required to satisfy the obligation with cash from operations You try it Reformulate your company s balance sheets Reformulating the Income Statement gt Tr in to et too eratin income includin allocated tax and financin Y 4 g P g g g incomeexpense including allocated tax gt See p 227 for the template Operating revenue Operating expense Operating income Financial revenue Financial expense Net financial incomeexpense Comprehensive income earnings gt Explain tax allocation 7 show a simple example Assume the following income statement Revenue 100 COGS 50 Interest expense Income before tax 40 Income tax expense Net income 26 If we reformulate the income statement above to separate out the financing part interest expense then we must allocate the 14 of income tax to the operating and financing sections of the income statement Operating income Revenue 100 COGS Pretax operating income 50 Tax on operating income 175 Operating income 3350 Financial incomegexpense Interest expense 10 Tax benefit from interest 350 Net financial expense 750 Net income amp gt Must add dirty surplus items gt Have to deal with extraordinary items discontinued operations gt Try to disaggregate where possible gt Challenges insufficient details capitalized interest unconsolidated subsidiaries minority interest see p 282 NOA NFO CSE MI and in the absence of a split of the minority interest into financing and operating activities treat MI as a deduction from operating income 7 that is income that belongs to a different set of shareholders You try it Reformulate your company s income statement Why reformulate the cash flow statement If you want to use cash flows for valuation or other analysis It isn t directly needed for valuation using the residual earnings valuation approach Deficiencies in GAAP cash flow statements Note that we can get free cash flows without a cash flow statement The four cash flows C I d and F See p 326 for the template 1 Changes in cash equivalents not working cash should be viewed as financing activities investmentsliquidations of excess cash 2 Investments inliquidations of financial assets are distinct from investments inliquidation of N OA and should not be part of computing free cash flow 3 Interest flows should not be part of operating cash ow 4 Taxes on financing flows should be treated as financing flows 5 Noncash transactions should be recorded as if cash were involved Reformulating a cash flow statement See exhibit 101 for Nike s GAAP cash flow statement and box 104 p 333 for the reformulated statement See quotNike reformulated statementsxls for the reformulated statement See also box 4 on page 331 and box 1 on page 329 for details Try it yourself Reformulate your company s cash flow statement Summary You learned why it is necessary to reformulate the financial statements for use in valuation You learned how to reformulate a statement of stockholders equity an income statement a balance sheet and a statement of cash flows How does all of this fit in From chapter 8 1 Reformulate the statement of stockholders equity on a comprehensive income basis Compute comprehensive income including both explicit OCI items and hidden dirty surplus items Calculate the comprehensive rate of return on common equity ROCE and the growth in equity from the reformulated statement of stockholders equity From chapter 9 3 Reformulate the balance sheet to distinguish operating and financial assets and obligations 4 Reformulate the income statement on a comprehensive income basis to distinguish operating and financing income Compute basic ratios that help to evaluate the profitabilityefficiency of the two business activities operating and financing 5 Compare the reformulated balance sheets and income statements with the equivalent statements of comparison firms through commonsize and trend analysis From chapter 10 6 Reformulate the cash flow statement From chapters 11 and 12 7 Carry out the analysis of ROCE 8 Carry out an analysis of growth While the steps in these reformulations seem mechanical they require knowledge of the firm s business knowledge of accounting and details from the footnotes and MDampA to incorporate as much detail as possible into the reformulated statements
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'