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CHAPTER TWO Introduction to the Financial Statements Stephen H. Penman The web page for Chapter Two runs under the following headings: What this Chapter is Doing Linking to Financial Statements: the SEC EDGAR Database Linking to the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) Linking to Other Financial Information SEC Reporting Requirements XBRL Regulation FD Introduction to International Reporting Standards Dell’s Full Financial Statements and Other Information on Dell Financial Reports in Countries other than the U.S. Accounting Relations: How They Help in Building Analysis Tools A Balance Sheet Presentation that Emphasizes the Shareholder’s View of the Firm: Dell Computer Book Values and Earnings: the Starting Points for P/B and P/E Valuation Historical P/B and P/E Ratios More P/E and P/B Graphs Multiple screeners Financial Reporting During the Stock Market Bubble of the 1990s Readers’ Corner


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What this Chapter is Doing Chapter 2 does two things. First, it familiarizes you with the financial statements, both the form in which the statements are prepared and the measurement rules behind the numbers. Much of the material should be familiar from earlier accounting courses, but it is presented with valuation in mind. When you come to analyze financial statements (in Part II) and prepare financial statement spreadsheets (using the BYOAP feature on the web site), you must have this chapter as background. The material on cash accounting and accrual accounting (and cash flow valuation versus accrual valuation) in Chapter 4 builds from this chapter. Second, the chapter gives you an introduction to intrinsic price-to-book ratios (P/B) and price-earnings ratios (P/E). You see here how these ratios are determined by how book values and earnings are measured. Your understanding of these ratios – and how they are estimated – will be completed in Chapters 5 and 6. If you have had an accounting course, the material on financial statements serves as a review. But make sure you understand the accounting relations that dictate the form of the statements, for these will be used in constructing analysis tools later. Spend some time on learning how to access financial information through the links on the book’s web page (see below). Linking to Financial Statements: the SEC EDGAR Database Go to the Web Links in the Student Edition of the web site (under Course-wide Content). The set of links, SEC Filings and Annual Reports, gets you through to the EDGAR files at the U.S. Securities and Exchange Commission (the SEC), at http://www.sec.gov/edgarhp.htm. All firms traded on U.S. stock exchanges must file reports with the Commission, and EDGAR is the database houses all electronic filings since 1993. EDGAR stands for Electronic Data Gathering, Analysis and Retrieval. First go to the Quick EDGAR Tutorial on the SEC’s site. Note the search features. Also read About EDGAR. Then look at the list of types of filings by clicking on Corporate Filings. You will be most concerned with quarterly financial reports filed on form 10-Q and annual reports filed on form 10-K. You can access any firm’s filings through the Search EDGAR feature on the SEC’s site. But you will have to load the full filing in each case and scroll through it. Commercial services have engines that allow you to load selected features of a report – a balance sheet, for example – and also download parts of reports into excel spreadsheets for further analysis. It has become increasing difficult to use these services (as a free service), due to demand. You can often get the filings through the firm’s own web site (look for the investor relations page), but sometime they are in pdf format.


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In you wish to look at the annual reports that are sent to shareholders (rather than the 10-K filed with the SEC), Report Gallery links you. FreeEDGAR also provides links. You can order hard copy of reports through the link to PRARS. You will also find annual and quarterly reports on firms’ own web sites through Company Web Sites. 10K Wizard (next on the links page under Keyword Search for SEC filings) is a good search engine if you want to find some particular item in 10-K reports. So, for example you can search for all references to “interest expense” in IBM’s 10-K reports for the last five years. Linking to the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) The web site for the FASB is http://www.fasb.org This site will give you considerable detail on FASB Statements and other professional announcements. http://www.iasb.org For more coverage of international accounting standards, see IAS Plus: http://www.iasplus.com/index.htm See also Wikipedia: http://en.wikipedia.org/wiki/International_Accounting_Standards_Board Linking to Other Financial Information Scroll through the other features on the Links page. A number of them link you to financial information. Good First Stop Sites. These sites give an array of financial information on firms: current and historical prices, price charts, some ratios, some historical multiples, some news archives, and considerably more. Look over these sites and choose one as your home. Try Yahoo and Google finance sites. Financial Web Browsers lead you to additional resources on the web. The Ohio State University Virtual Finance Library is a great directory: http://fisher.osu.edu/fin/overview.htm


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Browse the other features on the Links page. You will be introduced to many of these in the web page for subsequent chapters. Note: Web sites come and go. And web sites that once were free sometimes convert to a paid subscription service. SEC Reporting Requirements The SEC web site gives you a full list of the forms that firms file with the Commission. Filings are required for all firms that wish to offer their securities to the public in the United States. The main forms are as follows: For an initial offering of securities: Registration statement (S-1 and higher S- numbers). For communication with shareholders, the main forms are: Solicitation of proxies (the proxy statement) (14A) Annual report to shareholders (10K) Quarterly report to shareholders (10Q) Report of securities offered to employees (11K) Notification of significant events (8K) Notification of tender offers by others (Schedule 14D-1) Notification of tender offers by issuer (repurchases) (Schedule 13E-4) Notification of five percent equity holding or change in beneficial ownership (Schedule 13D) For foreign firms: Registration and annual filing for foreign registrant and reconciliation to US GAAP accounting (F20-F) For firms with a market capitalization of over $700 million, 10-K reports must be filed within 60 days of fiscal-year end, and 10-Q reports within 40 days of quarter’s end. Smaller firms have a longer filing period, ranging from 75 days to 90 days for 10-K reports, and 45 days for 10-Qs. XBRL eXtensible Business Reporting Language works like bar coding. Each item in a 10-K, 10-Q, or other filing is coded with a computer-readable tag. Knowing the tag, an analyst (with the appropriate software) can pull out a specific line item and enter it into his or her analysis. So, rather than being limited to the format in the original document, the analyst can pull down information in the form desired by providing the appropriate tag identification. There are over 10,000 tags, covering everything from line items in the financial statements themselves to details in the footnotes. If, for example, an analyst


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used a diagnostic for earnings quality, he or she could calculate the diagnostic directly from the 10-K by supplying the relevant tags. The analysis in this book could be set up a particular set of tags. Get the analysis by the press on a button. The dictionary that sullies the tags is called the XBRL taxonomy. Look at www.xbrl.us for the U.S. GAAP taxonomy. Note the ABRL will not change the content on reports; it will just add tags. For more discussion, go to Microsoft’s Investor Central at www.microsoft.com/msft/ic And the to information on XBRL at http://www.microsoft.com/msft/ic/XBRL_pop_up.aspx The SEC proposes to make XBRL tagging compulsory for filings in the near future. Look for some of the larger companies filing with XBRL in 2009. For further coverage, go to http://www.cfainstitute.org/centre/topics/reporting/xbrl/ Regulation FD In early 2001, the SEC issued regulation FD (Full Disclosure). This regulation forbids the practice of selective disclosure by managements to analysts. If management releases information it must do so publicly, not to individual analysts. The SEC saw the regime of selective disclosure as detrimental to a “level playing field.” They also saw selective disclosure as being used as a threat against management: if management did not like what analysts were saying about their firms, they might cut them off from selected information; or, they could reward analysts with private information if they wrote positively about the firm. Regulation FD is designed to end these practices. Critics maintain, however, the regulation will result in less disclosure rather than more: rather than sharing information, firms will disclose less. Introduction to International Reporting Standards As in other countries, the U.S is moving towards adopting international accounting standards. See Box 2.5 of this chapter. For U.S. student unfamiliar with IFRS, the following web sites give you an introduction: http://www.iasb.org/About+Us/International+Accounting+Standards+Board++About+Us.htm http://en.wikipedia.org/wiki/International_Financial_Reporting_Standards


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http://knowledge.wharton.upenn.edu/article.cfm?articleid=1847 http://www.pcfr.org/downloads/06_08_Meeting_Materials/IFRS_Backgrounder_AICPA. pdf

Dell’s Full Financial Statements and Other Information on Dell Chapter 2 presents the 2008 financial statements for Dell Computer Corporation. You should go to the EDGAR files and view the complete 10-K report for 2008 and later years. Browse the statement footnotes. Look at the discussion of the business that precedes the financial statements. Compare the 10-K to the quarterly 10-Q. Browse Dell’s other SEC filings. Tour Dell’s investor relation’s site at: http://www.dell.com and click on About US and then Investors. Now see how much information you can get on Dell through the Links page. Go to a first stop site like Yahoo! Finance. Go to the company research links. Look at analysts’ forecasts and analysts’ research reports (does your institution subscribe to IBES or Zacks forecast services, or to First Call research reports?) Search news reports. Browse with the aid of the finance browsers. Use the company comparison tools. Look for additional information through your library.

Accounting Relations: How They Help in Building Analysis Tools Chapter 2 introduces you to a number of accounting relations that govern the financial statements. The balance sheet equation (2.1), for example, says that the balance sheet must balance: Shareholders’ Equity = Assets – Liabilities. The income statement equations (2.2 and 2.2a) give the calculation of net income from components of the statement. The cash flow statement equation (2.3) lays outs how the change in cash is explained in that statement. These equations give the structure of each statement. That is, they explain how the components within the statements are tied together. Why is an understanding of these accounting relations important for financial analysis? Well, Chapter 1 explained that fundamental analysis involves forecasting. Future earnings and book values (of equity) will be particularly important. These two numbers are the “bottom line” numbers of the income statement and balance sheet. To forecast them, we forecast the line items – the components of the two statements – that sum to the two bottom line numbers. The accounting relations tell us how they sum. Accounting relations give us the structure for forecasting. So, if we wish to forecast future book values, for example, we forecast assets and liabilities that, by the balance sheet equation, give us


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shareholders’ equity. Or, the accounting relation for the statement of shareholders’ equity (2.4) tells us that we can forecast the book value of shareholders’ equity by forecasting comprehensive income minus net payout to shareholders added to the current book value. Indeed, to build a forecasting program in a spreadsheet, we structure the spreadsheet so that the operations within the spreadsheet obey these accounting relations. Take a peek at Build Your Own Analysis Product (BYOAP) under Course-wide Content in the Student Edition on the book’s web site. This is a guide for developing an analysis and valuation tool. Once you get into it (after covering more chapters in the book), you will see how the output from using this tool is generated by manipulating input according to rules dictated by accounting relations. The accounting relations in Chapter 2 are elementary ones. Box 2.1 summarizes them. Chapter 7 completes the set that you will need to build your spreadsheet tool.

A Balance Sheet Presentation that Emphasizes the Shareholders’ View of the Firm The standard balance sheet in the US presents asset of the left-hand and claims against those assets – liabilities and shareholders’ equity – on the right. A presentation of Dell’s 2002 balance sheet that highlights the shareholders – the owners – is as follows (in millions):

Dell Computer Corporation Shareholders’ Equity

$4,694

The shareholders’ interested is determined as follows: Assets Liabilities

$13,535 8,841

$4,694

This presentation shows that the owners’ interest is a residual interest in the assets after deducting the claims of the liabilities. Book Values and Earnings: the Starting Points for P/B and P/E Valuation In the web page for Chapter 1 we showed that a savings account can be valued in two ways: 1. The book value method


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2. The capitalized earnings method With the book value method, value is set equal to book value. With the earnings capitalization method, earnings are capitalized at a rate equal to the required return (earnings divided by the required return). Book value and earnings (income or profit) are prominent numbers for a firm, book value being the bottom line number in the balance sheet, earnings the bottom line number in the income statement. The accountant is saying of the book value: here is my calculation of the value of shareholders’ equity. Indeed, the book value is sometimes called “net worth.” He or she is also saying that the value is given by a set of assets and liabilities (accounting relation 2.1 tells you that). Earnings are the amount by which book value increases each period before paying net dividends (accounting relation 2.4 tells you that). So the accountant is also saying of the earnings: here is my calculation of how the value of shareholders’ equity increased from the business operations during the period. The book value is a stock of value, the earnings are a flow (change) of value, as the Chapter 2 explains. Just as with a saving account, we can value a firm using its stock of value in the balance sheet. Or we can value it by capitalizing the flow: flows are converted to stocks of value by capitalization. The problem with equities is that book value is typically not a good measure of value and earnings is typically not a good measure of change in value. If there were any doubt, look at the graphs of median P/B and P/E ratios in Figures 2.2 and 2.3. Median P/B ratios are typically not 1. If the required return for equities were 10 percent, the P/E ratio for capitalizing a dollar of forward earnings is 1/0.10 = 10.0, or 8.3 if the required return were 12 percent (compared to 1/0.05 = 20 for a savings account with a 5 percent required return). Median P/E ratios (in Figure 2.3) are considerably higher than these numbers. So firms typically trade at multiples of book value greater than 1 and at P/E ratios greater than earnings capitalized at the required return. One reaction to this might be to throw out the financial statements: they report imperfect measures of value and changes in value. That would be a mistake. The imperfect measures are a staring point; they provide part of the valuation. Indeed, as you proceed through the book, you will see that there are two complementary approaches to valuation based on financial statements: P/B Approach: Value = Book Value + Extra Value Not in Book Value P/E Approach: Value = Capitalized Earnings + Extra Value Not Indicated by Earnings The P/B approach starts with the value in the balance sheet and calculates extra value. The extra value is called the premium over book value, as explained in the chapter. The P/E approach starts with capitalizing earnings and calculates extra value. For the savings account, it so happens that there is no extra value to be calculated: the book value and earnings suffice. For a firm, this is usually not the case. We have to develop methods of calculating the extra value, as we will surely do in this book.


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Historical P/B and P/E Ratios Figures 2.2 and 2.3 give median P/B and P/E ratios for NYSE and AMEX stocks since 1963. Always refer to history to get an idea of what in normal. Compare the P/B ratios in the 1970s to those in the 1990s. Quite a difference! The market in the 1970s saw less value in companies than was on their balance sheets, but considerably more value than their balance sheet values in the 1990s. What would explain this? Well, one of two things: either accountants were excluding more value from the balance sheet in the 1990s or the market was mispricing balance sheets. Certainly stock prices rose significantly after the 1970s (as if stocks were undervalued) and declined in 2000 (as if stocks were overvalued). But, with more value coming from intangible assets in the 1990s – knowledge assets in the information economy – one would expect P/B values to be higher because knowledge assets are not on the balance sheet. That tells us that analysts in the 1990s had a bigger premium to calculate to get the intrinsic P/B ratio. Go to Global Financial Data through the Historical Indices and Returns on the Links page. Click on US Stock Markets Since 1800 and you will be able to plot the P/E ratio for the S&P 500 from the nineteenth century on. Your will notice that the S&P P/E ratios tend to be higher than the median P/E ratios for all NYSE and AMEX firms in Figures 2.2 and 2.3. They are for different sets of firms, but also the S&P ratios are weighted averages whilst those in the figures are medians. Indeed, typical multiples that are quoted vary considerably, depending on the set of stocks to which they refer and whether the number is an arithmetic average, a weighed average or the median of the set. So, in June 2001, for example, the (weighted average) P/E for the S&P500 stood at 26, but the median P/E for the 3,000 largest stocks by market capitalization was only 16. Further displays of historical multiples (for the S&P 500 stocks, for example) can be found on the BARRA website. Go to http://www.barra.com/research/ and look under Fundamental Charts. More P/E and P/B Graphs Here are graphs that break the P/E and P/B graphs for all US listed firms in Figures 2.2 and 2.3 into NYSE and AMEX listed firms and NASDAQ firms. Note the big run up in the ratios for NASDAQ firms (including many technology and internet firms) in the late 1990s. NYSE and AMEX firms


Full file at http://testbank360.eu/solution-manual-financial-statement-analysis-and-security-valuation-4th-editionpenman 50, 75 and 90 percentiles of price to earnings (P/E) ratios for NYSE and AMEX firms, 1963-1999 25

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Source: Calculated from Standard & Poor's COMPUSTAT data.

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NASDAQ firms 50, 75 and 90 percentiles of price to earnings (P/E) ratios for NASDAQ firms, 1963-1998 60

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Source: Calculated from Standard & Poor's COMPUSTAT data. 1999 was excluded from the graph.

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Multiple Screeners A multiple screening engine identifies firms with a particular level of a certain multiple. One might, for example, be interested in firms with P/E rations below 10. A multiple screener will identify those firms within a universe that you specify. You will find screeners on the Links page on the book’s web site (under Course-wide Content). For example, go to http://screen.yahoo.com/stocks.html) Financial Reporting During the Stock Market Bubble of the 1990s Chapter 1, along with the web page for that chapter, discusses the stock market bubble and analysts’ role in perpetuating the bubble. Bubbles can be promoted by speculative analysis but also by poor accounting. Chapter 2 makes the point that, from the fundamentalist’s point of view, accounting should not contaminate reliable information with speculation: Don’t mix what you know with what you don’t know. Unfortunately, some of the accounting during the bubble helped to reinforce speculation. The accounting scandals that followed the bursting of the bubble brought this point home. The WorldCom case in Box 2.4 of the text was but one example. Read Box 2.5 again, then go to The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble This paper can be downloaded at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=319262 This paper is also available in Accounting Horizons, Vol. 17 (Supplement 2003), pp. 7796. A number of issues in this paper arise in later chapters of the book. Readers’ Corner At this point you should review a financial accounting text. Keep it by your side and refer to it when accounting issues arise as you proceed with financial statement analysis. Standard texts that cover U.S. accounting standards include Donald Keiso, Jerry Weygandt, and Terry Warfield. Intermediate Accounting, 11th ed. (New York: Wiley & Sons, 2005) Lawrence Revsine, Daniel Collins, W. Bruce Johnson, and F. Mittelstaedt, Financial Reporting & Analysis, 4th ed. (McGraw-Hill 2009) Original Pronouncements of the FASB are published in a two-volume set by Wiley.


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For coverage of accounting standards internationally, see Frederick Choi, International Accounting and Finance Handbook, 2nd ed., 2001 Cumulative Supplement (New York: Wiley & Sons, 2001) For other books on financial statement analysis, see Stickney P., P.Brown, and J. Wahlen, Financial Reporting and Statement Analysis: A Strategic Perspective, Dryden Press, 5th edition, 2004. White G., Sondhi A., and Fried D., The Analysis and Use of Financial Statements, Wiley, 3rd edition, 2003. Palepu K., Healy P., and Bernard V., Business Analysis and Valuation Using Financial Statements, South-Western, 3rd edition, 2004. Subramanyam, K., and Wild, J., Financial Statement Analysis, 10th ed. (McGraw-Hill, 2009)

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