1 Financing the EnterprisePart 6 Chapter 14 Financing the Enterprise We begin part 6 of your textbook, Financing the Enterprise, with chapter 14, Accounting and Financial Statements. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2 CHAPTER 14 CHAPTER 15 Accounting and Financial StatementsMoney and the Financial System CHAPTER 16 Financial Management and Securities Markets APPENDIX D Personal Financial Planning In chapter 14, we take a look at accounting and financial statements. This chapter explores the role of accounting in business and its importance in making business decisions. First, we discuss the uses of accounting information and the accounting process. Then, we briefly look at some simple financial statements and accounting tools that are useful in analyzing organizations worldwide. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

3 Learning Objectives LO 14-1 Define accounting and describe the different uses of accounting information. LO 14-2 Demonstrate the accounting process. LO 14-3 Examine the various components of an income statement to evaluate a firm’s bottom line. LO 14-4 Interpret a company’s balance sheet to determine its current financial position. LO 14-5 Analyze the statement of cash flows to evaluate the increase and decrease in a company’s cash balance. LO 14-6 Assess a company’s financial position using its accounting statements and ratio analysis. After reading this chapter, you will be able to: Define accounting and describe the different uses of accounting information. Demonstrate the accounting process. Examine the various components of an income statement to evaluate a firm’s bottom line. Interpret a company’s balance sheet to determine its current financial position. Analyze the statement of cash flows to evaluate the increase and decrease in a company’s cash balance. Assess a company’s financial position using its accounting statements and ratio analysis. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

4 The Nature of AccountingThe recording, measurement and interpretation of financial information Certified Public Accountant An individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records Accounting is the recording, measurement, and interpretation of financial information. The Financial Accounting Standards Board has been setting principles standards since Its mission is to establish and improve standards of financial accounting and reporting. Accounting scandals happen when accounting firms and businesses fail to abide by generally accepted accounting principles, or GAAP. The federal government has taken a greater role in making rules, requirements, and policies for accounting firms and businesses through the Securities and Exchange Commission’s (SEC) Public Company Accounting Oversight Board. To better understand the importance of accounting, we must first understand who prepares accounting information and how it is used. Many of the functions of accounting are carried out by public or private accountants. Individuals and businesses can hire a certified public account (CPA), an individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records. Most public accountants are self-employed or members of large public accounting firms. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

5 Prestige Rankings of Accounting FirmsCompany 1 (PricewaterhouseCoopers) LLP 2 Ernst & Young LLP 3 Deloitte LLP 4 KPMG LLP 5 Grant Thornton LLP 6 McGladrey LLP 7 BDO USA LLP 8 Crowe Horwath LLP 9 Moss Adams LLP 10 Baker Tilly Virchow Krause Most public accounts are either self-employed or members of large public accounting firms such as Ernst & Young, KPMG, Deloitte, and PricewaterhouseCoopers, together referred to as “the Big Four” Many CPAs work for one of the second-tier accounting firms that are much smaller than the Big Four firms as illustrated in the table on this slide: 2015 Rank Rank Company Revenues* (in millions) Score Location (PricewaterhouseCoopers) LLP $11, New York, NY Ernst & Young LLP $ 9, New York, NY Deloitte LLP $13, New York, NY KPMG LLP $ 6, New York, NY Grant Thornton LLP $ 1, Chicago, IL McGladrey LLP $ 1, Chicago, IL BDO USA LLP $ Chicago, IL Crowe Horwath LLP $ Chicago, IL Moss Adams LLP $ Seattle, WA Baker Tilly Virchow Krause, LLP $ Chicago, IL © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

6 Legislation After the accounting scandals of Enron and Worldcom in the early 2000s, Congress passed Sarbanes-Oxley Act – required firms to be more rigorous in their accounting and reporting practices During the latest financial crisis, banks developed questionable lending practices, leading to Dodd Frank Act – strengthens the oversight of financial institutions After the accounting scandals of Enron and Worldcom in the early 2000s, Congress passed the Sarbanes-Oxley Act, which required firms to be more rigorous in their accounting and reporting practices. This act made accounting firms separate their consulting and auditing businesses and punished corporate executives with potential jail sentences for inaccurate, misleading, or illegal accounting statements. Declining housing prices exposed some of the questionable practices by banks and mortgage companies so only five years after the passage of the Sarbanes-Oxley Act, the world experienced a financial crisis starting in Congress passed the Dodd Frank Act in 2010 to strengthen the oversight of financial institutions, giving the Federal Reserve Board the task of implementing the legislation. This legislation limits the types of assets commercial banks can buy; the amount of capital they must maintain; and the use of derivative instruments such as options, futures and structured investment products. DID YOU KNOW? : Corporate fraud costs are estimated as $3.7 trillion annually. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

7 Accounting Standards (1 of 2)Public and private businesses follow the Generally Accepted Accounting Principles (GAAP) method GAAP is generally used in the United States as the standard for accounting methods (established by the Financial Accounting Standards Board (FASB)) Local government entities have a different set of accounting standards which are set by the Governmental Accounting Standards Board (GASB) Different entities have different standards for their accounting methods. For example, public and private businesses follow the Generally Accepted Accounting Principles (GAAP) method. GAAP is generally used in the United States as the standard for accounting methods. These principles are established by the Financial Accounting Standards Board (FASB). Local government entities have a different set of accounting standards which are set by the Governmental Accounting Standards Board (GASB) © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

8 Accounting Standards (2 of 2)Federal government follows yet another set of standards determined by the Federal Accounting Standards Advisory Board (FASAB) Another set of standards for international companies which follow the International Financial Reporting Standards (IFRS) the federal government follows yet another set of standards determined by the Federal Accounting Standards Advisory Board (FASAB). Further, there is another set of standards for international companies which follow the International Financial Reporting Standards (IFRS). © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

9 Accounting that is fit for legal reviewForensic Accounting Accounting that is fit for legal review Involves analyzing financial documents in search of fraudulent entries or financial misconduct Function as much as detectives as accountants Used since the 1930s Booming since the accounting scandals of the early 2000s Root out evidence of “cooked books” for federal agencies A growing area for public accountants is forensic accounting, which is accounting that is fit for legal review. It involves analyzing financial documents in search of fraudulent entries or financial misconduct. Functioning as much like detectives as accountants, forensic accountants have been used since the 1930s. In the wake of the accounting scandals of the early 2000s, many auditing firms are rapidly adding or expanding forensic or fraud-detection services. Additionally, many forensic accountants root out evidence of “cooked books” for federal agencies like the Federal Bureau of Investigation or the Internal Revenue Service. The Association of Certified Fraud Examiners, which certifies accounting professionals as certified fraud examiners (CFEs), has grown to more than 70,000 members. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

10 Private Accountants Private AccountantsEmployed by large corporations, government agencies, and other organizations to prepare and analyze their financial statements Deeply involved in most of the most important financial decisions of the organization Certified Management Accountants (CMAs) Private accountants who are certified by the National Association of Accountants and who have some managerial responsibility Large corporations, government agencies, and other organizations may employ their own private accountants to prepare and analyze their financial statements. With titles such as controller, tax accountant, or internal auditor, private accountants are deeply involved in many of the most important financial decisions of the organizations for which they work. Private accountants can be CPAs and may become certified management accountants (CMAs) by passing a rigorous examination by the Institute of Management Accountants. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

11 Accounting or Bookkeeping?Bookkeeping is typically limited to the routine, day- to-day recording of business transactions Much narrower and far more mechanical than accounting Require less training than accountants Responsible for obtaining and recording the information accounts require to analyze a firm’s financial position Accountants usually complete course work beyond their basic 4 or 5 year college degree The terms accounting and bookkeeping are often mistakenly used interchangeably Bookkeeping is typically limited to the routine, day-to-day recording of business transactions Much narrower and far more mechanical than accounting Require less training than accountants Responsible for obtaining and recording the information accounts require to analyze a firm’s financial position Accountants usually complete course work beyond their basic 4 or 5 year college degree © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

12 Users of Accounting Information (1 of 3)Managers and owners use financial statements: Aid in internal planning and control External purposes such as reporting to the Internal Revenue Service, stockholders, creditors, customers, employees, and other interested parties Basically, managers and owners use financial statements (1) to aid in internal planning and control and (2) for external purposes such as reporting to the Internal Revenue Service, stockholders, creditors, customers, employees, and other interested parties. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

13 Users of Accounting Information (2 of 3)Organizational Use Board of Directors Owners, shareholders Managers Management Information Systems Business research Internal control this slide shows some of the organizational users of the accounting information generated by a typical corporation. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

14 Users of Accounting Information (3 of 3)Stakeholder Use Tax collecting agencies Regulatory agencies Special interest groups Customers Financial analysis Employees Media this slide shows some of the stakeholder users of the accounting information generated by a typical corporation. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

15 Internal Uses of Accounting InformationManagerial Accounting The internal use of accounting statements by managers in planning and directing the organization’s activities Cash Flow The movement of money through an organization over a daily, weekly, monthly or yearly basis Budget An internal financial plan that forecasts expenses and income over a set period of time Managerial accounting refers to the internal use of accounting statements by managers in planning and directing the organization’s activities. Perhaps management’s single greatest concern is cash flow, the movement of money through an organization over a daily, weekly, monthly, or yearly basis. It is not uncommon for even successful companies to struggle making payments because of inadequate cash flow. One common reason for a so-called cash crunch, or shortfall, is poor managerial planning. Managerial accountants also help prepare an organization’s budget, an internal financial plan that forecasts expenses and income over a set period of time. Think of a budget as a financial map, showing how the company expects to move from Point A to Point B over a specific period of time. While most companies prepare master budgets for the entire firm, many also prepare budgets for smaller segments of the organization such as divisions, departments, product lines, or projects. “Top-down” master budgets begin at upper management and filter down. While “bottom up” budgets start at the department or project level and are combined at the CEO’s office. Regardless of focus, the principal value of a budget lies in the breakdown of cash inflows and outflows. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

16 External Uses of Accounting InformationUsed for filing income taxes, obtaining credit and reporting results to stockholders Annual Report A summary of a firm’s financial information, products, and growth plans for owners and potential investors Audited financial statements are those signed off on by a certified public accountant Managers also use accounting statements to report the business’s financial performance to outsiders. Such statements are used for filing income taxes, obtaining credit from lenders, and reporting results to the firm’s stockholders. They become the basis for the information provided in the official corporate annual report, a summary of the firm’s financial information, products, and growth plans for owners and potential investors. The single most important component of an annual report is the signature of a certified public accountant attesting that the required financial statements are an accurate reflection of the underlying financial condition of the firm. Financial statements meeting these conditions are termed audited. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

17 Greece and Deceptive Accounting PracticesDuring global financial crisis, Greece was engaging in deceptive accounting practices with the help of U.S. investment banks Used financial techniques to hide massive amounts of debt from its public balance sheet Eventually markets discovered the country might not be able to pay off its creditors European Union and International Monetary Fund gave some credit relief PIGS (Portugal, Italy, Ireland, Greece, Spain) all had debt problems Germany demanded austerity, but others wanted more growth- oriented strategies During the global financial crisis, it turns out that Greece had been engaging in deceptive accounting practices, with the help of U.S. investment banks. Greece used financial techniques to hide massive amounts of debt from its public balance sheets. Eventually, the markets figured out the country might not be able to pay off its creditors. The European Union and the International Monetary Fund came up with a plan to give Greece some credit relief, but tied to this was the message to “get your financial house in order.” The European problem was often referred to as the PIGS. This referred to Portugal, Italy, Ireland, Greece and Spain—all of which were having debt problems. The PIGS caused cracks in the European Monetary Union. While Germany demanded austerity, others wanted more growth-oriented strategies. By the middle of 2014, Europe was pursuing more growth strategies but the PIGS were still stuck in the mud, except for Ireland, which was making better progress than the others. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

18 Banks and Financial StatementsWells Fargo specializes in banking, mortgage, and financial services Data it provides can be used in financial statements Short-term lender examines a firm’s cash flow to assess its ability to repay a loan quickly with cash generated from sales Long-term lender more interested in the company’s profitability and indebtedness to other lenders As one of the biggest banks in the United States, Wells Fargo specializes in banking, mortgage, and financial services. The data it provides can be used in financial statements. Banks and other lenders look at financial statements to determine a company’s ability to meet current and future debt obligations if a loan or credit is granted. To determine this ability, a short-term lender examines a firm’s cash flow to assess its ability to repay a loan quickly with cash generated from sales. A long-term lender is more interested in the company’s profitability and indebtedness to other lenders. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

19 The Accounting EquationAssets = Liabilities + Owner’s Equity Assets A firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things Liabilities Debts that a firm owes to others Owner’s Equity Equals assets minus liabilities and reflects historical values Many view accounting as a primary business language. It is of little use unless you know how to “speak” it. Fortunately, the fundamentals – the account equation and the double-entry bookkeeping system – are not difficult to learn. These two concepts serve as the starting point for all currently accepted accounting principles. The accounting equation is assets equal liabilities plus owners’ equity. Assets are a firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things. Liabilities are debts that a firm owes to others. Owners’ equity equals assets minus liabilities and reflects historical values. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

20 Owner’s Equity The owner’s equity portion of a company’s balance sheet: Rendezvous Barbecue in Memphis, TN Includes the money the company’s owners have put into the firm The owner’s equity portion of a company’s balance sheet, such as that of Rendezvous Barbecue in Memphis, Tennessee, includes the money the company’s owners have put into the firm. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

21 Double-Entry BookkeepingA system of recording and classifying business transactions that maintains the balance of the accounting equation Balance: To keep the accounting equation in balance, each transaction must be recorded in two separate accounts Classification: All business transactions are classified as either assets, liabilities, or owner’s equity Break Down: Assets broken down into cash, inventory and equipment; Liabilities broken down into bank loans, supplier credit, and other debts Double-entry bookkeeping is a system of recording and classifying business transactions in separate accounts in order to maintain the balance of the accounting equation. To keep the accounting equation in balance, each business transaction must be recorded in two separate accounts. In the final analysis, all business transactions are classified as assets, liabilities, or owners’ equity. However, most organizations further break down these three accounts to provide more specific information about a transaction. For example, assets may be broken down into specific categories such as cash, inventory, and equipment, while liabilities may include bank loans, supplier credit, and other debts. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

22 The Accounting Cycle (1 of 2)The four-step procedure of an accounting system Examining source documents Recording transactions in an accounting journal Posting recorded transactions Preparing financial statements In any accounting system, financial data typically pass through a four-step procedure sometimes called the accounting cycle. The steps include examining source documents, recording transactions in an accounting journal, posting recorded transactions and preparing financial statements. Traditionally, all of these steps were performed using paper, pencils, and erasers (lots of erasers!), but today the process is often fully computerized. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

23 The Accounting Cycle (1 of 2)Journal A time-ordered list of account transactions Ledger A book or computer file with separate sections for each account Record each financial transaction in a journal, which is basically just a time-ordered list of account transactions. Transfer the information from her journal into a ledger, a book or computer program with separate files for each account. This process is known as posting. At the end of the accounting period (usually yearly, but occasionally quarterly or monthly), prepare a trial balance, a summary of the balances of all the accounts in the general ledger. The information from the trial balance is also used to prepare the company’s financial statements. In the case of public corporations and certain other organizations, a CPA must attest, or certify, that the organization followed generally accepted accounting principles in preparing the financial statements. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

24 Income Statement Income Statement Revenue Cost of Goods SoldA financial report that shows an organization’s profitability over a period of time – month, quarter, or year Revenue The total amount of money received from the sale of goods or services, as well as from related business activities Cost of Goods Sold The amount of money a firm spent to buy or produce the products it sold during the period to which the income statement applies The question, “What’s the bottom line?” derives from the income statement, where the bottom line shows the overall profit or loss of the company after taxes. The income statement is a financial report that shows and organization’s profitability over a period of time, be that a month, quarter, or year. This statement offers one of the clearest possible pictures of a company’s overall revenues and the costs incurred in generating those revenues. Other names include profit and loss statement or operating statement. Revenue is the total amount of money received (or promised) from the sale of goods or services, as well as from other business activities such as the rental of property and investments. Nonbusiness entities typically obtain revenues through donations and/or grants. For most manufacturing and retail concerns, the next major item on the income statement is the cost of goods sold, the amount of money the firm spent (or promised to spend) to buy and/or produce the products it sold during the accounting period. This figure can be calculated as follows: Cost of goods sold = Beginning inventory + Interim purchases – Ending inventory © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

25 Equivalent Terms in AccountingRevenues Sales Goods or services sold Gross profit Gross income Gross earnings Operating income Operating profit Earnings before interest and taxes (EBIT) Income before taxes (IBT) Earnings before taxes (EBT) Profit before taxes (PBT) Net income (NI) Earnings after taxes (EAT) Profit after taxes (PAT) Income available to common stockholders Earnings available to common stockholders Each country has a different set of rules that the businesses within that country are required to use for their accounting process and financial statements. However, a number of countries have adopted a standard set of accounting principles known as International Financial Reporting Standards. The United States has discussed adopting these standards to create a more standardized system of reporting for global investors. Moreover, as is the case in many other disciplines, certain concepts have more than one name. For example, sales and revenues are often interchanged, as are profits, income, and earnings. The table on this slide lists a few common equivalent terms that should help you decipher their meaning in accounting statements. Term Equivalent Term Revenues Sales Goods or services sold Gross profit Gross income Gross earnings Operating income Operating profit Earnings before interest and taxes (EBIT) Income before interest and taxes (IBIT) Income before taxes (IBT) Earnings before taxes (EBT) Profit before taxes (PBT) Net income (NI) Earnings after taxes (EAT) Profit after taxes (PAT) Income available to common stockholders Earnings available to common stockholders © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

26 Gross Income and ExpensesGross Income (or Profit) Revenues minus the cost of goods sold required to generate the revenues The income available after paying all expenses of production Expenses The costs incurred in the day-to-day operations of an organization Selling, general, and administrative expenses (including depreciation) Research, development and engineering expenses Interest expenses Gross income or profit are revenues minus the cost of goods sold required to generate the revenues. Following the earlier example of Anna’s Flowers, If Anna had total revenues of $10,000 for the accounting period, we subtract her costs of goods sold ($3,500) to give her a gross income of $6,500. ($10,000 - $3,500 = $6,500) So, gross income is the income available after paying all expenses of production. Expenses are the costs incurred in the day-to-day operations of an organization. Three common expense accounts are: Selling, general, and administrative expenses – these include advertising costs, sales salaries and executive salaries and the costs of maintaining the office. Research, development and engineering expenses – these include costs for scientific, engineering and marketing personnel and resources used to design and build prototypes and samples. Interest expense includes the direct cost of borrowing money. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

27 Depreciation The process of spreading the costs of long-lived assets such as building and equipment over the total number of accounting periods in which they are expected to be used A manufacturer purchases a $100,000 machine expected to last about 10 years Rather than showing an expense of $100,000 in the first year and no expense for the item over the next 9 years, manufacturer allowed to depreciation expenses of $10,000/year in each of the next 10 years Better matches cost of equipment to years item is used Depreciation is “written off” as an expense and book value of the machine is also reduced by $10,000 The number and type of expense accounts vary from organization to organization. Included in the general and administrative category is a special type of expense known as depreciation, the process of spreading the costs of long-lived assets such as buildings and equipment over the total number of accounting periods in which they are expected to be used. Consider a manufacturer that purchases a $100,000 machine expected to last about 10 years. Rather than showing an expense of $100,000 in the first year and no expense for that equipment over the next nine years, the manufacturer is allowed to report depreciation expenses of $10,000 per year in each of the next 10 years because that better matches the cost of the machine to the years the machine is used. Each time this depreciation is “written off” as an expense, the book value of the machine is also reduced by $10,000. The fact that the equipment has a zero value on the firm’s balance sheet when it is fully depreciated (in this case, after 10 years) does not necessarily mean that it can no longer be used or is economically worthless. Indeed, in some industries, machines used every day have been reported as having no book value whatsoever for more than 30 years. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

28 Net Income The total profit (or loss) after all expenses, including taxes, have been deducted from revenue; also called net earnings Most companies present the current year’s results along with the previous two years’ income statements Gross profit, earnings before interest and taxes, and net income are the results of calculations made from the revenues and expenses accounts; they are not actual accounts When corporation elects to pay dividends, it decreases the cash account as well as a capital account Net income (or net earnings) is the total profit (or loss) after all expenses including taxes have been deducted from revenue. Generally, accountants divide profits into individual sections such as operating income and earnings before interest and taxes. Most companies present not only the current year’s results but also the previous two years’ income statements to permit comparison of performance from one period to another. Gross profit, earnings before interest and taxes, and net income are the results of calculations made from the revenues and expenses accounts; they are not actual accounts. At the end of each accounting period, the dollar amounts in all the revenue and expense accounts are moved into an account called “Retained Earnings,” one of the owners’ equity accounts. Revenues increase owners’ equity, while expenses decrease it. A note about income statements: You may remember that corporations may choose to make cash payments called dividends to shareholders out of their net earnings. When a corporation elects to pay dividends, it decreases the cash account (in the assets category of the balance sheet) as well as a capital account (in the owners’ equity category of the balance sheet). © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

29 Balance Sheet A “snapshot” of an organization’s financial position at a given moment Shows assets and the funding used to pay for these assets, such as bank debt or owners’ equity Takes its name from its reliance on the accounting equation: assets must equal liabilities plus owners’ equity An accumulation of all financial transactions since company’s founding Traditional balance sheet places assets on the left side and its liabilities and owners’ equity on the right Vertical format has assets on the top followed by liabilities and owners’ equity The second basic financial statement is the balance sheet, which presents a “snapshot” of an organization’s financial position at a given moment. The balance sheet shows what the organization owns or controls (its assets), and the various sources of funding (or liabilities) used to pay for those assets. The balance sheet takes its name from its reliance on the accounting equation; assets must equal liabilities plus owners’ equity. Unlike the income statement, which covers a specific period of time, the balance sheet is an accumulation of all transactions since the company’s founding. Balance sheets are often presented in two different formats. The traditional balance sheet format placed the organization’s assets on the left side and its liabilities and owners’ equity on the right. More recently, a vertical format, with assets on top followed by liabilities and owners’ equity, has gained wide acceptance. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

30 Balance Sheet - Assets Listed in descending order of liquidity – how fast they can be turned into cash Current Assets Assets used or converted into cash within the course of a calendar year Cash, temporary investments, accounts receivable and inventory Accounts Receivable Money owed a company by its clients or customers who have promised to pay for the products at a later date All asset accounts are listed in descending order of liquidity—that is, how quickly each could be turned into cash. Current assets, also called short-term assets, are those that are used or converted into cash within the course of a calendar year. Cash is followed by temporary investments, accounts receivable, and inventory, in that order. Accounts receivable refers to money owed the company by its clients or customers who have promised to pay for the products at a later date. Accounts receivable usually includes an allowance for bad debts that management does not expect to collect. Long-term, or fixed assets represent a commitment of organizational funds of at least one year. Items classified as fixed include long-term investments, plant and equipment, and intangible assets, such as corporate “goodwill,” or reputation, as well as patents and trademarks © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

31 Balance Sheet - LiabilitiesCurrent Liabilities A firm’s financial obligation to short-term creditors, which must be repaid within one year Accounts Payable The amount a company owes to suppliers for goods and services purchased with credit Accrued Expenses An account representing all unpaid financial obligations incurred by the organization As seen in the accounting equation, total assets must be financed either through borrowing (liabilities) or through owner investments (owners’ equity). Current liabilities include a firm’s financial obligations to short-term creditors, which must be repaid within one year, while long-term liabilities have longer repayment terms. Accounts payable represents amounts owed to suppliers for goods and services purchased with credit. Other liabilities include wages earned by employees but not yet paid and taxes owed to the government. Occasionally, these accounts are consolidated into an accrued expenses account, representing all unpaid financial obligations incurred by the organization. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

32 Balance Sheet – Owners’ EquityOwners’ equity includes: The owners’ contributions to the organization Income earned by the organization retained to finance continued growth and development Accounts listed as owners’ equity on a balance sheet may differ dramatically from company to company Corporations sell stock to investors, who then become owners of the firm Many corporations issue several different classes of common and preferred stock Owners’ equity includes the owners’ contributions to the organization along with income earned by the organization and retained to finance continued growth and development. If the organization were to sell off all of its assets and pay off all of its liabilities, any remaining funds would belong to the owners. Not surprisingly, the accounts listed as owners’ equity on a balance sheet may differ dramatically from company to company. Corporations sell stock to investors, who then become the owners of the firm. Many corporations issue two, three, or even more different classes of common and preferred stock, each with different dividend payments and/or voting rights. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

33 Pro Forma Financial StatementsPro forma financial statements are used to make decisions about future operations changes within a company Include balance sheets, income statements, and cash flow statements. Pro forma financial statements will show Whether profits will increase or decrease The magnitude of expenses involved Whether the company needs financing to facilitate the proposed change Pro forma financial statements are used to make decisions about future operations changes within a company. They include balance sheets, income statements, and cash flow statements. When a company is considering a change, composing pro forma financial statements will show whether profits will increase or decrease, the magnitude of expenses involved, and whether the company needs financing to facilitate the proposed change. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

34 Statement of Cash Flows (1 of 2)Explains how the company’s cash changed from the beginning of the accounting period to the end Balance sheet shows the cash account in one point of time; most investors want a better picture of how cash flows into and out of the company Statement of cash flows takes the cash balance from one year’s balance sheet and compares it with the next while providing detail about how the firm used the cash The third primary financial statement is called the statement of cash flows, which explains how the company’s cash changed from the beginning of the accounting period to the end. Cash is an asset shown on the balance sheet, but only the amount of cash as a given moment in time. Many investors and other users of financial statements want more information about the cash flowing into and out of a company in order to get a better idea of the company’s financial health. The statement of cash flows takes the cash balance from one year’s balance sheet and compares it with the next while providing detail about how the firm used the cash. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

35 Statement of Cash Flows (2 of 2)Cash from operating activities Calculated by combining the changes in the revenue, expense, current assets and current liability accounts Cash from investing activities Calculated from changes in the long-term or fixed asset accounts Cash from financing activities Calculated from changes in the long-term liability accounts and the contributed capital accounts in owners’ equity The change in cash is explained through details in three categories: cash from (used for) operating activities, cash from (used for) investing activities, and cash from (used for) financing activities. Cash from operating activities is calculated by combining the changes in the revenue accounts, expense accounts, current asset accounts, and current liability accounts. This category of cash flows includes all the accounts on the balance sheet that relate to computing revenues and expenses for the accounting period. Cash from investing activities is calculated from changes in the long-term or fixed asset accounts. A positive figure usually indicates a business that is selling off existing long-term assets and reducing its capacity for the future. Finally, cash from financing activities is calculated from changes in the long-term liability accounts and the contributed capital accounts in owners’ equity. If this amount is negative, the company is likely paying off long-term debt or returning contributed capital to investors © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

36 Ratios Ratio Analysis Profitability RatiosCalculations that measure an organization’s financial health Brings complex information from the income statement and balance sheet into sharper focus To measure and compare the organization’s productivity, profitability, and financing mix with other similar entities Profitability Ratios Ratios measuring the amount of operating income or net income an organization is able to generate relative to its assets, owners’ equity, and sales The income statement shows a company’s profit or loss, while the balance sheet itemizes the value of its assets, liabilities and owner’s equity. Together, the two statements provide the means to answer two critical questions: (1) How much did the firm make or lose? And (2) How much is the firm presently worth based on historical values found on the balance sheet? Ratio analysis, calculations that measure an organization’s financial health, brings the complex information from the income statement and balance sheet into sharper focus so that managers, lenders, owners, and other interested parties can measure and compare the organization’s productivity, profitability, and financing mix with other similar entities. As you know, a ratio is simply one number divided by another, with the result showing the relationship between the two numbers. Whether these numbers are good or bad depends on their relation to other numbers, such as ratios of prior performance or the performance of “peers.” Remember, while the profitability, asset utilization, liquidity, debt ratios and per share data we’ll look at here can be very useful, you will never see the forest by looking only at the trees. Profitability ratios measure how much operating income, or net income, an organization is able to generate relative to its assets, owners’ equity and sales. Common profitability ratios include profit margin, return on assets and return on equity. The following slide examples are taken from the Microsoft sample financial statements in your textbook. The numerator (top number) in all examples is net income after taxes and in millions unless noted otherwise. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

37 Financial Ratios A ratio is simply one number divided by another, with the result showing the relationship between the two numbers Financial ratios used to weigh and evaluate firm performance Whether numbers are good or bad depends on their relation to other numbers If a company earned $70,000 on $700,000 in sales (10% return) such an earnings level might be satisfactory The president of the company earning this same $70,000 on sales of $7 million (1% return) should probably start looking for another job As you know, a ratio is simply one number divided by another, with the result showing the relationship between the two numbers. For example, we measure fuel efficiency with miles per gallon. This is how we know that 55 mpg in a Toyota Prius is much better than the average car. Financial ratios are used to weigh and evaluate a firm’s performance. An absolute value such as earnings of $70,000 or accounts receivable of $200,000 almost never provides as much useful information as a well-constructed ratio. Whether those numbers are good or bad depends on their relation to other numbers. If a company earned $70,000 on $700,000 in sales (a 10 percent return), such an earnings level might be quite satisfactory. The president of a company earning this same $70,000 on sales of $7 million (a 1 percent return), however, should probably start looking for another job! © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

38 Profit Margin Net income divided by salesMicrosoft’s profit margin calculated by taking net income (net earnings) and dividing by sales (total net revenues) $21,863 million divided by $77,849 million equals a profit margin ratio of 28.08% For every $1 in sales, Microsoft generated profits after taxes of nearly 28 cents The profit margin, computed by dividing net income by sales, shows the overall percentage profits earned by the company. It is based solely upon data from the income statement. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. Microsoft’s profit margin is calculated as follows: Profit margin = net income (net earnings) divided by sales (total net revenues) Microsoft’s net income was $21,863 million divided by its sales of $77,849 million giving a profit margin ratio of 28.08% So, for every $1 in sales, Microsoft generated profits after taxes of cents. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

39 Return on Assets Net income divided by assetsMicrosoft’s return on assets calculated by taking net income (net earnings) and dividing by total assets $21,863 million divided by $142,431 million equals a return on assets of 15.35% For every $1 in assets, Microsoft generated a return of 15.34% or profits of $15.35 Return on assets, net income divided by assets, shows how much income the firm produces for every dollar invested in assets. A company with a low return on assets is probably not using its assets very productively – a key managerial failing. For this equation, we need information from both the income statement and the balance sheet. Return on assets = net income (net earnings) divided by total assets. Microsoft’s net income of $21,863 million divided by its total assets of $142,431 million gives a return on assets of 15.35%. For every $1 in assets, Microsoft generated a return of 15.35%, or profits of cents. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

40 Return on Equity Net income divided by owners’ equity; also called return on investment (ROI) Microsoft’s return on equity calculated by taking net income (net earnings) and dividing by stockholders’ equity $21,863 million divided by $78,944 million equals a return on equity of 27.69% For every $1 invested by Microsoft stockholders, the company earns 27.69% return or $27.69 Stockholders are always concerned with how much money they will make on their investment, and they frequently use the return on equity ratio as one of their key performance yardsticks. Return on equity (also called return on investment, or ROI), calculated by dividing net income by owners’ equity, shows how much income is generated by each $1 the owners have invested in the firm. A low ROI means low stockholder returns. Microsoft’s return on equity is calculated as follows: Return on equity = net income divided by stockholders’ equity Microsoft’s net income of $21,863 million is divided by their stockholders’ equity of $78,944 million for an ROI of 27.69% For every dollar invested by Microsoft stockholders, the company earned a percent return, or cents per dollar invested. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

41 Asset Utilization RatiosRatios that measure how well a firm uses its assets to generate each $1 of sales Managers use asset utilization ratios to pinpoint areas of inefficiency in their operations These ratios – receivables turnover, inventory turnover, and total asset turnover – relate balance sheet assets to sales, which are found on the income statement Asset utilization ratios measure how well a firm uses its assets to generate each $1 of sales. Obviously, companies using their assets more productively will have higher returns on assets than their less efficient competitors. Similarly, managers can use asset utilization ratios to pinpoint areas of inefficiency in their operations. These ratios (receivables turnover, inventory turnover, and total asset turnover) relate balance sheet assets to sales, which are found on the income statement. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

42 Receivables Turnover Sales divided by accountants receivableMicrosoft’s receivables turnover calculated by taking sales (total net revenues) and dividing by receivables $77,849 million divided by $17,486 million equals a receivables turnover of 4.45X Microsoft collected it receivables 4.45 times per year; which translates to about 80 days that receivables are outstanding The receivables turnover, sales divided by accounts receivable, indicates how many times a firm collects its accounts receivable in one year. It also demonstrates how quickly a firm is able to collect payments on its credit sales. Obviously, no payments means no profits. Microsoft collected its receivables 4.45 times per year, which translates to about 80 days that receivables are outstanding. This is most likely due to the trade terms they give their corporate customers. Receivables turnover = sales (total net revenues) divided by receivables So, Microsoft’s sales of $77,849 million is divided by their receivables of $17,486 million for a receivables turnover of 4.45 times. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

43 Inventory Turnover Sales divided by total inventoryMicrosoft’s inventory turnover calculated by taking sales (total net revenues) and dividing by inventory $77,849 million divided by $1,938 million equals an inventory turnover of 40.17X Microsoft’s inventory turnover indicates they replaced inventory times last year, or about every nine days Inventory turnover, sales divided by total inventory, indicates how many times a firm sells and replaces its inventory over the course of a year. A high inventory turnover ratio may indicate great efficiency but may also suggest the possibility of lost sales due to insufficient stock levels. Microsoft’s inventory turnover indicates it replaced its inventory times last year, or about every 9 days. Inventory turnover = sales (total net revenues) divided by inventory Microsoft’s $77,849 million in sales divided by its inventory of $1,938 million dollars gives an inventory turnover of times. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

44 Total Asset Turnover Sales divided by total assetsMicrosoft’s total asset turnover calculated by taking sales (total net revenues) and dividing by total assets $77,849 million divided by $142,431 million equals a total asset turnover of 0.55X Microsoft generated $0.55 in sales for every $1 in total corporate assets Total asset turnover, sales divided by total assets, measures how well an organization uses all of its assets in creating sales. It indicates whether a company is using its assets productively. Microsoft generated $0.55 in sales for every $1 in total corporate assets. Total asset turnover = sales (total net revenues) divided by total assets So, Microsoft $77,849 million dollars in sales is divided by its $142,431 million in total assets for 0.55 times or $0.55 in sales. Inventory turnover = sales (total net revenues) divided by inventory Microsoft’s $77,849 million in sales divided by its inventory of $1,938 million dollars gives an inventory turnover of times. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

45 Liquidity Ratios Ratios that measure the speed with which a company can turn its assets into cash to meet short-term debt High liquidity ratios may satisfy a creditor’s need for safety, but may indicate the company is not using its current assets efficiently Liquidity ratios are best examined in conjunction with asset utilization ratios because high turnover ratios imply cash is flowing through very quickly Liquidity ratios compare current (short-term) assets to current liabilities to indicate the speed with which a company can turn its assets into cash to meet debts as they fall due. High liquidity ratios may satisfy a creditor’s need for safety, but ratios that are too high may indicate that the organization is not using its current assets efficiently. Liquidity ratios are generally best examined in conjunction with asset utilization ratios because high turnover ratios imply that cash is flowing through an organization very quickly – a situation that dramatically reduces the need for the type of reserves measured by liquidity ratios. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

46 Current Ratio Current assets divided by current liabilitiesMicrosoft’s current ratio calculated by taking current assets and dividing by current liabilities $101,466 million divided by $37,417 million equals a current ratio of 2.71X Microsoft’s current ratio indicates that for every $1 of current liabilities, the firm had $2.71 of current assets on hand The current ratio is calculated by dividing current assets by current liabilities. Microsoft’s current ratio indicates that for every $1 of current liabilities, the firm had $2.71 of current assets on hand. Microsoft’s current assets of $101,466 million is divided by its current liabilities of $37,417 million for a current ratio of 2.71 times. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

47 Quick Ratio (Acid Test)A stringent measure of liquidity that eliminates inventory Microsoft’s quick ratio calculated by taking current assets minus inventory and dividing by current liabilities $99,528 million divided by $37,417 million equals a quick ratio of 2.66X In 2011, Microsoft’s had $2.66 of current assets (after subtracting inventory) for every $1 of current liabilities The quick ratio (also known as the acid test) is a far more stringent measure of liquidity because it eliminates inventory, the least liquid current asset. It measures how well an organization can meet its current obligations without resorting to the sale of its inventory. Microsoft had $2.66 invested in current assets (after subtracting inventory) for every $1 of current liabilities. Microsoft’s quick ratio takes their current assets (less inventory) of $99,528 million and divides by its current liabilities of $37,417 million for a quick ratio of 2.66 times. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

48 Debt Utilization RatiosRatios that measure how much debt an organization is using relative to other sources of capital, such as owners’ equity Debt financing riskier than equity as it demands a monthly payment regardless of profitability Recessions affect heavily indebted firms far more than those financed through equity Companies tend to keep debt-to-asset levels below 5% Debt utilization ratios provide information about how much debt an organization is using relative to other sources of capital, such as owners’ equity. Debt financing is riskier than equity as it demands a monthly payment regardless of profitability. In addition, recessions affect heavily indebted firms far more than those financed through equity. Most companies tend to keep debt-to-asset levels below 50 percent. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

49 Debt to Total Assets RatioA ratio indicating how much of the firm is financed by debt and how much by owners’ equity Microsoft’s ratio calculated by taking debt (total liabilities) and dividing by total assets $63,487 million divided by $142,431 million equals debt to total assets ratio of 45% For every $1 of Microsoft’s total assets, 45% is financed with debt and 55% with owners’ equity The debt to total assets ratio indicates how much of the firm is financed by debt and how much by owners’ equity. To find the value of Microsoft’s total debt, you must add current liabilities to long-term debt and other liabilities. So, their debt to total assets ratio is their debt (total liabilities) of $63,487 million divided by their total assets of $142,431 million for a ratio of 45%. For every $1 of Microsoft’s total assets, 45 percent is financed with debt. The remaining 55 percent is provided by owners’ equity. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

50 Times Interest Earned RatioOperating income divided by interest expense Microsoft’s times interested earned ratio calculated by taking EBIT (operating income) and dividing by interest (from note 3) $26,863 million divided by $429 million equals times interest earned ratio of 62.39X Microsoft paid $429 million in interest expense, but that amount was covered times by income before interest and taxes The times interest earned ratio, operating income divided by interest expense, is a measure of the safety margin a company has with respect to the interest payments it must make to its creditors. A low times interest earned ratio indicates that even a small decrease in earnings may lead the company into financial straits. For this ratio, Microsoft’s EBIT, or operating income, of $26,863 million is divided by their interest. Microsoft had so little interest expense that it did not list it as a separate item on the income statement. In this case, the analyst has to go searching through the footnotes to the financial statements. In note 3, we find that interest expense was $429 million. Putting this into the calculation, we find that interest expense is covered times by operating income. A lender would have no worries about receiving interest payments from Microsoft. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

51 Diluted Earnings Per Share (1 of 2)Per Share Data Data used by investors to compare the performance of one company with another on a equal, per share basis Earnings Per Share Net income or profit divided by the number of stock shares outstanding Investors may use per share data to compare one company with another on an equal, or per share, basis. Earnings per share is calculated by dividing net income or profit by the number of shares of stock outstanding. This ratio is important because yearly changes in earnings per share, in combination with other economy-wide factors, determine a company’s overall stock price. Diluted earnings per share equals net income divided by the number of shares outstanding but diluted. Diluted shares include potential shares that could be issued due to the exercise of stock options or the conversion of certain types of debt into common stock. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

52 Diluted Earnings Per Share (1 of 2)Microsoft’s diluted earnings per share calculated by taking net income and dividing by the number of shares outstanding (diluted) $21,863 million divided by $8,470 million equals a diluted earnings per share of $2.58 Microsoft’s basic earnings per share declined from $ per share to $2.58, and this decline also shows up in diluted earnings per share Microsoft’s diluted earnings per share equals their net income of $21,863 million divided by the diluted number of shares outstanding of 8,470 for $2.58 per share. We can see from the income statement that Microsoft’s basic earnings per share declined from $2.69 per share to $2.58, and this decline also shows up in diluted earnings per share. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

53 Dividends Per Share The actual cash received for each share ownedMicrosoft’s dividends per share calculated by taking dividends paid and dividing by the number of shares outstanding $7,456 million divided by $8,103 million equals dividends per share of $0.92 Since 2004, Microsoft has raised its dividend every year, from $0.16 per share to $0.92 per share Dividends per share are paid by the corporation to the stockholders for each share owned. The payment is made from earnings after taxes by the corporation but is taxable income to the stockholders. So, dividends result in double taxation. Since 2004, Microsoft has raised its dividend every year, from $0.16 per share to $0.92 per share. Microsoft’s dividends paid of $7,456 million divided by the number of shares outstanding of 8,103 million shares equals a dividends per share of .92 cents. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

54 Importance of Integrity in AccountingThe recent financial crisis and recession showed another example of a failure in accounting reporting Many firms attempted to exploit loopholes and manipulate accounting reporting Banks and other financial institutions often held assets off their books by manipulating accounts Transparency and accuracy in reporting revenue, income and assets develops trust from investors and other stakeholders The financial crisis and the recession that followed provided another example of a failure in accounting reporting. Many firms attempted to exploit loopholes and manipulate accounting processes and statements. Banks and other financial institutions often held assets off their books by manipulating their accounts. On the other hand, strong compliance to accounting principles creates trust among stakeholders. Accounting and financial planning is important for all organizational entities, even cities. The City of Maricopa in Arizona received the Government Finance Officers Association of the United States and Canada (GFOA) Distinguished Budget Presentation Award for its governmental budgeting. The city scored proficient in its policy, financial plan, operations guide, and communications device. It is most important to remember that integrity in accounting processes requires ethical principles and compliance with both the spirit of the law and professional standards in the accounting profession. Transparency and accuracy in reporting revenue, income, and assets develops trust from investors and other stakeholders. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

55 Compliance to Accounting PrinciplesStrong compliance to accounting principles creates trust among stakeholders Accounting and financial planning is important for all organizational entities even cities Integrity in accounting is crucial to: Create trust Understanding the financial position of an organization or entity Making financial decisions that will benefit the organization On the other hand, strong compliance to accounting principles creates trust among stakeholders. Accounting and financial planning is important for all organizational entities, even cities. The City of Maricopa in Arizona received the Government Finance Officers Association of the United States and Canada (GFOA) Distinguished Budget Presentation Award for its governmental budgeting. The city scored proficient in its policy, financial plan, operations guide, and communications device. Integrity in accounting is crucial to creating trust, understanding the financial position of an organization or entity, and making financial decisions that will benefit the organization. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

56 Solve the Dilemma (1 of 3) Exploring the Secrets of AccountingYou have been promoted from vice president of marketing of BrainDrain Co. to president and CEO You know marketing like the back of your hand, but know next to nothing about finance BrainDrain is in danger of failure if steps to correct large and continuing financial losses are not taken at once You asked vice president of finance and accounting for a complete set of accounting statements Statements detail the financial operations of the company You decide to attack the problem systematically and learn “hidden secrets” of the company statement by statement This Solve the Dilemma is taken from Chapter 14, page 453: You have just been promoted from vice president of marketing of BrainDrain Corporation to president and CEO! That’s the good news. Unfortunately, while you know marketing like the back of your hand, you know next to nothing about finance. Worse still, the “word on the street” is that BrainDrain is in danger of failure if steps to correct large and continuing financial losses are not taken immediately. Accordingly, you have asked the vice president of finance and accounting for a complete set of accounting statements detailing the financial operations of the company over the past several years. Recovering from the dual shocks of your promotion and feeling the weight of the firm’s complete accounting report for the very first time, you decide to attack the problem systematically and learn the “hidden secrets” of the company, statement by statement. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

57 Solve the Dilemma (2 of 3) Exploring the Secrets of AccountingSearching for answers With the firm’s trusted senior financial analyst by you side, you delve into the accounting statements Resolved to “get to the bottom” of the firm’s financial problems Set new course that will take the firm from insolvency and failure to financial recovery and perpetual prosperity With Mary Pruitt, the firm’s trusted senior financial analyst, by your side, you delve into the accounting statements as never before. You resolve to “get to the bottom” of the firm’s financial problems and set a new course for the future—a course that will take the firm from insolvency and failure to financial recovery and perpetual prosperity. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

58 Solve the Dilemma (3 of 3) Exploring the Secrets of AccountingDiscussion Questions Describe the three basic accounting statements. What types of information does each provide that can help you evaluate the situation? Which of the financial ratios are likely to prove to be of greatest value in identifying problem areas in the company? Why? Which of your company’s financial ratios might you expect to be especially poor? Discuss the limitations of ratio analysis. Discussion Questions 1. Describe the three basic accounting statements. What types of information does each provide that can help you evaluate the situation? 2. Which of the financial ratios are likely to prove to be of greatest value in identifying problem areas in the company? Why? Which of your company’s financial ratios might you expect to be especially poor? 3. Discuss the limitations of ratio analysis. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

59 Discussion Why are accountants so important to a corporation? What function do they perform? Describe the accounting process and cycle. The income statements of all corporations are in the same format. True or false? Discuss. Why are debt ratios important in assessing the risk of the firm? Why are accountants so important to a corporation? What function do they perform? Accountants are important because they analyze and interpret financial information to determine if the organization is using its funds efficiently and to make plans for increasing profits. Accountants develop systems that summarize all transactions into comprehensive financial statements. Describe the accounting process and cycle. The accounting process involves the accounting equation and double‑entry bookkeeping. The accounting equation is Assets = Liabilities + Owners’ equity. Double-entry bookkeeping is a system of recording and classifying business transactions in accounts that maintain the balance of the accounting equation. The income statements of all corporations are in the same format. True or false? Discuss. False. Different types of firms (service, manufacturing, financial, etc.) use their own accounting principles, for which the profession has agreed. These are called generally accepted accounting principles (GAAP). One way in which the format differs is in the slightly different terminology used in the financial statements. Why are debt ratios important in assessing the risk of the firm? Debt utilization ratios are critical to assessing the risk of the firm because a high debt level and interest obligations can threaten the existence of the firm. The more assets are financed by debt, the higher the risk level of the firm. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.