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                                   ACTG 511 - Fall 2004

Dr. Donn...
1) Study Guide to accompany Stickney and Weil (available at PSU bookstore)

The syllabus gives recommended homework problems for each chapter. You are not required to hand in so...
f. Select my name under Instructor, then click “View”
          g. Select the course ACTG 511
          h. Enter password ...
Financial Accounting
                                          WEEK 1 – September 28, 2004

1. Accounting standard...
Financial Accounting
                                             WEEKS 2 – October 5, 2004

1. Measuring financia...
Financial Accounting
                                            WEEK 3 –October 12, 2004

1. Continuation of Week...
Financial Accounting
                                             WEEK 4 – October 19, 2004

1. Statement of Cash ...
Financial Accounting
                                           WEEK 5 – October 26, 2004

1. Revenue Recognition ...
Financial Accounting
                                            WEEK 6 – November 2, 2004

   1. Inventory valuat...
Financial Accounting
                                          WEEK 7 –November 9, 2004

1. Property, Plant and Eq...
Financial Accounting
                                            WEEK 8 –November 16, 2004

1. Current liabilities...
Financial Accounting
                                            WEEK 9-November 23, 2004

1. Complete discussion ...
Financial Accounting

                                          WEEK 10: November 30, 2004

1. Stock transactions

Often the goal of financial analysis is to answer a specific question....
2. Is the firm diversified with respect to:
            a. Products
            b. Geographic segments. Where does the fir...
Chapter 5 of SW provides a set of basic ratios. Remember, that not all ratios are appropriate for every firm. For
4.   As far as the timing of reports. It may be that the fiscal year end of your company does not match the fiscal
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  1. 1. FUNDAMENTALS OF ACCOUNTING FOR FINANCIAL STATEMENT USERS ACTG 511 - Fall 2004 Dr. Donna R. Philbrick Office: 466 E-mail address: Office hours: Tuesday 3:00-5:00 and by appointment* Phone: 503-725-3725 See discussion on page 3 regarding use of voice mail and e-mail. Fax: 503-725-5850 * Faculty meetings are often scheduled on Tuesdays. In the event that a faculty meetings conflicts with office hours, office hours will be moved earlier in the day. COURSE DESCRIPTION This course is an introduction to the reporting system used by businesses to convey financial information to external parties. Primary emphasis is placed on understanding the financial reports that are the end product of this system; what they do and do not tell the user about a business enterprise. The accounting principles, conventions, and concepts underlying financial reporting are examined with the objective of developing the ability to prepare, read, comprehend and perform basic analysis of financial statements. Although you may never need to construct financial statements, the process of developing statements leads to a better understanding of what underlies the numbers that are presented. This in turn facilitates interpretation of financial statements. Because of the short amount of time allocated to financial accounting you will not reach the point where you are comfortable reading and understanding any set of financial statements that you encounter. You will, however, know what to expect when you see a set of statements and what questions to ask to gain the necessary understanding. This course is not intended to be a complete course in financial statement analysis and will not provide you with the background necessary to perform a sophisticated analysis of financial data. As evidenced by recent publicity regarding companies such as Enron, WorldCom and Global Crossing, even the experts have trouble deciphering financial statements. STUDENTS WITH PRIOR ACCOUNTING IN THEIR ACADEMIC OR PROFESSIONAL BACKGROUND. This course is intended to be understandable for students with no prior background, although it will require a committed effort. People with prior background will find the first part of the course undemanding. There will be a tendency to raise more advanced issues and topics as we discuss various financial statements. I ask your indulgence in holding back on these questions and issues until after we have the opportunity to complete coverage of the basic accounting framework and have established the fundamental vocabulary and essential structure for students new to accounting. People with prior training are an extraordinary resource for classmates and teammates. I rely on those individuals with prior background to keep me honest and to assist in identifying those concepts that are most important. COURSE OBJECTIVES 1) Understand basic accounting terminology & concepts 2) Understand the purpose of and interaction among, the basic financial statements 3) Prepare the three basic financial statements for a simple for-profit business entity 4) Read and comprehend financial statements of a for-profit business entity 5) Identify the accounting choices made by company management 6) Use publicly available sources of data to help analyze a firm's standing in the industry 7) Perform basic analysis of a firm’s financial performance, using financial statements, footnotes, and other available data REQUIRED TEXT AND MATERIALS 1) Stickney & Weil, Financial Accounting: An Introduction to Concepts, Methods and Uses, 10th edition, (2003), Thomson Southwestern Publishing. There is a website that accompanies the textbook. See page xi of the Preface to the textbook for information on accessing the website. (available at the PSU bookstore) 2) American Greetings annual report * (to be distributed in class) 3) Readings packet (available via electronic reserve on the PSU Library website) 4) Overheads and Supplemental Materials (available at the PSU bookstore) *Other information about the company may be found at
  2. 2. OPTIONAL MATERIALS 1) Study Guide to accompany Stickney and Weil (available at PSU bookstore) GRADING PROCEDURES Assignments & Participation 25% Financial Analysis Project (due November 30) 25% Exam I (probable due date is November 2) 25% Exam II (Tuesday, December 7 at 5:30 p.m.) 25% Required Assignments There are required problems/cases, which must be handed in throughout the quarter. You are free to consult with each other on these problems. However, each student must hand in his or her own assignment. No late assignments are accepted. See summary of due dates at the back of the syllabus. Class Conduct and Participation Each class meeting consists of discussion of the readings and examples. The readings for each day should be completed prior to coming to class. It is imperative that you learn to express your ideas and defend them. Further, you should be able to do so when requested, not just when you want to. The only way to become comfortable with this business skill is to practice it. You may volunteer comments at any time. In addition, I will call on students on a random basis. My objective will be to see that you have prepared for class. A portion of your grade is based on your ability to contribute to class discussions. It will be useful to bring the annual report and overheads to class each meeting. Financial Statement Project This project is to be done in teams of 3 or 4 students. Please form groups of 3 or 4 before the third week of the quarter. Anyone not in a group by then will be assigned to an existing team. The project grade will be composed of two parts. First, I will assign a grade based on the content and written presentation of the project. Each member of the group will share equally in this grade. In addition, each member of the team will be evaluated by their fellow team members on the quality, quantity, and dependability of their contribution. Although you will be able to find out the overall grade based on the peer evaluations, the confidentiality of each team member's evaluation will be maintained. My evaluation comprises 75% of the project grade. Peer evaluations account for 25% of the grade. In order to avoid unpleasant surprises, I suggest you evaluate each other informally as the quarter progresses. An evaluation sheet will be distributed near the end of the quarter. The project is due no later than June 1. Late projects will have five (5) points subtracted from the score assigned by the instructor for each day (including weekends) the project is late. The project is explained in detail later in the syllabus. READ THIS CAREFULLY! Exams Unlike the required assignments on which you are welcome to confer, the exams will represent an individual effort. As the exam dates approach, we will discuss the nature of the exams. The midterm will likely be a take home exam. The final will be an in-class exam given during the regular exam period. Attendance at exams is viewed as a very serious matter. Any absence not approved by me in advance of the examination will result in a failing grade on that exam. Approved absences will be rare and must be supported with satisfactory documentation. Examples of old midterms can be found on the library’s Electronic Reserve website. See discussion under Format of Weekly Summaries below for information on accessing Electronic Reserves. ACADEMIC INTEGRITY A requirement for passing this course is academic honesty and integrity. Failure to demonstrate honesty and integrity will result in a course grade of F. 2
  3. 3. RECOMMENDED PROBLEMS The syllabus gives recommended homework problems for each chapter. You are not required to hand in solutions to these problems. Copies of the solutions to the recommended problems will be available. I have tried to select recommended problems that correspond with the learning objectives for each topic. I am aware that time may not permit you to work through all of these problems. However at a minimum, if you are having difficulty with any of the learning objectives for a given week, you should identify the problem that corresponds to that objective (if one is listed) and attempt it. Unfortunately accounting is one of those disciplines that requires hands on involvement and problem solving. Just reading the textbook is not sufficient. Also, your textbook has an extensive glossary starting on page 865. USE IT! WITHDRAWALS AND AUDITS University regulations provide that a student registered in a course may withdraw at the student's discretion through the fourth week of a term. After the fourth week through the eighth week, students may withdraw only with instructor's signature. Approved withdrawals from accounting courses during this period will be granted only in instances of documented extraordinary circumstances. Approval will not be granted on the basis that the grade currently being earned is not deemed desirable. After week eight, withdrawals from a registered course are only by petition to the Deadline Appeals Committee. Students registering for a grade of “Audit” or who change their grade option to “Audit” must consult with me to determine the work necessary to earn an “Audit” designation. OFFICE HOURS AND THE USE OF VOICE MAIL & E-MAIL I am happy to talk to you between class meetings. I can be reached in my office at 503-725-3725 or via e-mail at 1. If you leave a voice mail message, please indicate likely or preferred times over the next day or two when you can be reached, or when a message can be left. I will do my best to return phone calls within 24 hours or on Monday if received over the weekend. The same is true for e-mail. 2. Occasionally, messages are lost. Please persist and let me know if you having problems reaching me. 3. I do not answer the phone during office hours when I am meeting with a student. Please leave a message. Just because I do not answer my phone does not mean that I am not there during office hours. When I am done assisting the student in my office, I will return your call. FEEDBACK Do not hesitate to offer feedback on how the class can be more useful to you. Feedback is appreciated. ADDITIONAL COMMENTS I reserve the right to make changes to the syllabus as required. FORMAT OF WEEKLY SUMMARIES The weekly summaries are divided into sections. 1. Topics - a short summary of the topics to be covered that week. 2. Objectives - a more detailed list of specific learning objectives for the week. You will note that some of the objectives have parenthetical comments at the end. These refer to any recommended problem, required problem or illustration that is directly applicable to that learning objective. 3. Readings - Lists the readings for the week. SW refers to the textbook. The items listed in quotations are the titles of articles that are (with luck) available through electronic reserve. You are expected to read these articles as well as the textbook. To utilize the library website: a. Go to the PSU library website ( b. Under “Get It” click on “Reserves” c. Under “Information for Students” click on “Course Reserves” d. Click on “Electronic Reserves and Reserves Pages” e. Click on “Course Reserves Pages by Instructor” tab 3
  4. 4. f. Select my name under Instructor, then click “View” g. Select the course ACTG 511 h. Enter password (philbrick) and click “Accept” i. Click on the document you want j. Now you can view the article or print it out It will be necessary to have Adobe Acrobat Reader to open these files as they are in “pdf” format. 4. Recommended Problems - These come from SW. See discussion of Recommended problems on page 2 of the syllabus. 5. Hand in: Indicates what is due on that date. 6. Required Problems - These appear on the syllabus in the week BEFORE they are due. The problems themselves are either included in the overheads packet available through the PSU bookstore or will be handed out in class the week before they are due. If a required problem appears in the overhead packet, it is included in the Week it is due. 7. In some weeks there are additional categories. These include supplemental write-ups on selected topics and illustrations covering the topic for the week. These materials will be included in the overheads packet available at the bookstore. There are few copyright costs associated with this packet so it is not very expensive. It is, however, critical to the class. 4
  5. 5. Financial Accounting WEEK 1 – September 28, 2004 Topics: 1. Accounting standard setting process 2. Financial statement overview 3. The basic accounting model Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Develop a general understanding of the accounting framework and the relationship between the three principal financial statements that firms prepare to measure and report the results of their business activities: (a) balance sheet, (b) income statement, and (c) statement of cash flows. (1-15, 1-19, 1-21, 1-23, 1-27, 1-28) 2. Develop a sensitivity to financial reporting issues, including the following: (a) the multiple users of financial accounting reports, (b) the alternative approaches to establishing accounting measurement and reporting standards, and (c) the role of the independent audit of a business firm's financial statements. 3. Understand the accounting concepts of assets, liabilities, and shareholders' equity, including the conditions when firms recognize such items (recognition issues), the amounts at which firms report these items (valuation issues) and the manner in which firms disclose them on the balance sheet (classification issues). Begin to develop an understanding of the nature of information contained in footnotes. (2-10, 2-14, 2-18) Readings: SW Chapters 1 & 2 (pages 45-64) “The Big Four: Too Few to Fail?” “Auditors’ Methods Make it Hard to Catch Fraud by Executives” “FASB: Rewriting the Book on Bookkeeping” “EU Lobbies U.S. to Adopt Global Accounting Rules” “Corporate Reform: The First Year, Cleaner Living” “Debating Sarbanes-Oxley: Give Us Disclosure, Not Audits” “Accounting Board’s Chief Auditor Speaks Out” “Don’t Forget the Fine Print” Supplemental Readings (in overheads packet): “Audit Opinions” “Clarification of certain components of Shareholders’ Equity” Web Resources: These are all optional resources for those with an interest. • Look at the section of FASB Facts. You will also see that there is information about recent and pending accounting decisions. • Information (more than you could ever want) about the Sarbanes-Oxley Act of 2002 may be found (at least at the writing of this syllabus) at: Look at the Spotlight on the upper right side of the home page and click on Sarbanes-Oxley/PCAOB. This will display multiple links related to Sarbanes-Oxley. Recommended Problems: Chapter 1 Problems: 15, 19, 21, 23, 27, 28 Chapter 2 Problem: 10, 14, 18 Required Problems/Cases due next week: American Greetings to be handed in on October 5 5
  6. 6. Financial Accounting WEEKS 2 – October 5, 2004 Topics: 1. Measuring financial position and income using accrual accounting 2. Double entry accounting procedures Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Distinguish the two methods of measuring income: accrual accounting and cash accounting. And understand the difference between operating cash flows and accrual net income. (3-20) 2. Understand the concepts of revenue and expense recognition. (3-10, 3-11, 3-13) 3. Understand how to analyze basic business transactions and relate them to changes in the balance sheet and income statement. (2-32, 2-37, 2-38, 3-18) 4. Understand the principles of double entry accounting and the use of T-accounts and journal entries to analyze accounting relationships. (2-19) 5. Prepare an income statement and balance sheet. (2-27, 3-22) 6. Understand how to account for the declaration and payment of cash dividends. 7. Understand the concept of a contra account. Readings: SW Chapters 2 (continued) and 3 “Creative Accounting: How to Buff a Company” “Deciphering the Black Box: Many Accounting Practices, Not Just Enron’s Are Hard to Penetrate” Illustration: Special Consensus (included in overhead packet) This is an example of a company that is just starting up. A list of transactions that occurred in the first month of operation is given (unrealistic though they may be). You are to record the journal entries necessary to reflect these transactions in the financial statements. I expect this illustration to serve as the basis for discussion. Recommended Problems: Chapter 2 Problems: 19, 27, 32, 37, 38 Chapter 3 Problems: 10, 11, 13, 18, 20, 22 Hand in: American Greetings Required Problems/Cases due next week: None 6
  7. 7. Financial Accounting WEEK 3 –October 12, 2004 Topics: 1. Continuation of Week 2 as needed 2. Adjusting entries 3. Introduction to the fundamentals of analysis Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand the need for end of the period adjusting entries under the accrual basis of accounting and extend your skills in the recording process to include adjusting entries. (3-24, 3-31) 2. Understand how to account for the sale of fixed assets. 3. Compute and explain basic profitability ratios: ROA, ROE, profit margins, etc. (5-11, 5-27) 4. Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio and dividend payout ratio. 5. Compute and explain short-term liquidity ratios. (5-13, 5-14, 5-21)* 6. Compute and explain long-term liquidity ratios. (5-24)* * These two objectives may be deferred and covered in subsequent chapters Readings: SW Chapter 3 (continued), Chapter 5 “The Effects of Business Environment and Strategy on a Firm’s Rate of Return on Assets” Recommended Problems: Chapter 3 Problems: 24, 31 Chapter 5 Problems: 11,13, 14, 21, 24, 27 Hand in: There is nothing to be handed in on October 12. Required Problem/Cases due next week: Woodstone Company is to be handed in October 19. 7
  8. 8. Financial Accounting WEEK 4 – October 19, 2004 Topics: 1. Statement of Cash Flows- We will explore the Statement of Cash Flows in greater depth than we did in the overview. A firm’s cash flows will not correspond exactly to the income flows because cash receipts (disbursements) do not necessarily occur in the same period as the revenue (expense) is recognized. It is also true that cash inflows and outflows from investing and financing activities do not flow through the income statement. The statement of cash flows reports the relation between income flows and cash flows from operations and reports the cash flow effects of investing and financing transactions. 2. Disclosure of non-recurring items Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand why the use of the accrual basis of accounting to prepare the balance sheet and income statement creates the need for a statement of cash flows. Be able to reconcile activity in the three primary financial statements. (4-35) 2. Understand the types of transactions that are classified as operating, investing and financing in a statement of cash flows. (4-17, 4-21) 3. Prepare a statement of cash flows using both the direct and indirect methods of presenting the operating section. (4-17, 4-19, 4-23 4. Understand how a comparison of cash flow from operations to net income is a measure of "earnings quality." 5. Interpret a statement of cash flows. (4-36) 6. Understand the concepts of nonrecurring items, discontinued operations, extraordinary items and changes in accounting method. Readings: SW Chapter 4, Chapter 12 (pg. 685-690: Section on “Overview of GAAP Reporting of Operating Transactions”) “The Ins and Outs of Cash Flow” “ ‘Cash Flow,’ A Highly Touted Measure of Strength is Open to Interpretation” “Cash Flow Hocus Pocus” “Cash Flows: Another Approach to Ratio Analysis” “The Secret Behind Those Profit Jumps” “A Closer Look at All Those Write-offs” “Earnings: A Cleaner Look: “Ouch! Real Numbers” “The SEC’s G-Day” Supplemental Readings (in overheads packet): “Note: Statement of Cash Flow Analysis” (in overhead packet) “Disclosure of Non-recurring Items” (in overhead packet) Illustration: Vincent Corporation Example. (included in overheads packet) Recommended Problems: Chapter 4 Problems: 17, 19, 21, 23, 35, 36 Hand in: Woodstone Company due October 19 Required Problem/Cases due next week: Statement of Cash Flows problem will be due October 26. 8
  9. 9. Financial Accounting WEEK 5 – October 26, 2004 Topics: 1. Revenue Recognition and Accounts Receivable 2. Marketable Securities (briefly) 3. Comprehensive Income Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Develop an awareness of issues in recognizing and measuring revenues and expenses for various types of business. (6-24) 2. Understand the issues that surround accounting for sales returns, sales discounts and bad debts. 3. Understand why the allowance method for uncollectible accounts matches bad debts with revenues better than the direct write-off method. 4. Apply the allowance method for uncollectible accounts. (6-13, 6-16) 5. Assess the level of accounts receivable and Accounts Receivable turnover. (6-26, 6-29) 6. Understand the basics of accounting for marketable securities. (11-13, 11-19) 7. Understand the treatment of other comprehensive income. Readings: SW Chapter 6, Chapter 11 (se selected pages below), Chapter 12 (pg. 690-691) In Chapter 11 read: Introduction (pg. 597-599), section on Minority, Passive Investments (pg. 599-608), section on Minority, Active Investments (pg. 608 to middle of 609), section on Majority, Active Investments (pg. 612 & 613) “Analysts Knock Impath’s Revenue Accounting, Citing Company’s Trouble With Getting Paid” “Impath Warns It Might Have Overstated Accounts Receivable” Recommended Problems: Chapter 6 Problems: 13, 16, 24, 26, 29 Chapter 11 Problem: 13, 19 Hand in: Hand in Statement of Cash Flows problem Required Problem/Cases due next week: Midterm to be handed in November 2 9
  10. 10. Financial Accounting WEEK 6 – November 2, 2004 Topics: 1. Inventory valuation 2. Inventory systems 3. Inventory cost flow assumptions 4. Manufacturing environment Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand the use of the lower-of-cost-or-market method for valuing inventory. (7-21) 2. Link inventory valuation to gross profit. 3. Understand the difference between a periodic and a perpetual inventory system for tracing costs. 4. Compute Cost of goods sold and ending inventory using a first-in, first-out (FIFO), a last-in, last-out (LIFO), and an average cost flow assumption. (7-25) 5. Extend the skills learned in a retail environment to the accounting for a manufacturing environment. (7-18, 7-19, 7-33, 7-35) 6. Understand the effects on the balance sheet and income statement of FIFO, LIFO, and average cost flow assumptions. (7-27, 7-30) 7. Convert balance sheet and income statement amounts under a LIFO cost flow assumption to a FIFO cost flow assumption. (7-48) 8. Assess inventory levels and turnover. Readings: SW Chapter 7 “How Efficient is this Company” (in the Supplemental Readings Section of the overhead packet) Illustration: Harriet's Hats (included in overhead packet This is a problem similar to Special Consensus. The important differences are that Harriet's Hats is not a new company so preparation of financial statements requires consideration of the activity of prior periods. Also, Harriet's Hats is a manufacturing firm, which requires an understanding of the tracking of costs through various inventory categories. Recommended Problems: Chapter 7 Problems: 18, 19, 21, 25, 27, 30, 33,35, 48 Hand in: Midterm due Required Problems/Cases due next week: Inventory problem 10
  11. 11. Financial Accounting WEEK 7 –November 9, 2004 Topics: 1. Property, Plant and Equipment 2. Intangible Assets Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand and apply the concepts distinguishing expenditures that accountants capitalize as assets, and subsequently amortize, from expenditures that accountants expense in the period incurred. (8-14) 2. Understand the circumstances under which firms are allowed to capitalize interest. 3. Understand the role of estimates in computing depreciation and amortization. (8-23) 4. Develop the skills to compute depreciation under various commonly used depreciation methods. (8-19) 5. Understand the effect on the balance sheet and income statement of different types of depreciation and the retirement of assets. (8-26) 6. Differentiate financial statement depreciation from income tax depreciation. 7. Understand how to account for various intangible assets and research and development expenditures. (8-33, 8-37) 8. Assess property, plant and equipment levels, ages and values. (8-34) Readings: SW Chapter 8 “How Much is Goodwill Worth?” (in Supplemental Readings section of the overheads packet) “The Perils of Impairment” Supplemental Readings (in overhead packet): “How Much is Goodwill Worth?” Recommended Problems: Chapter 8 Problems: 14, 19, 23, 26, 33, 34, 37 Hand in: Inventory problem Required Problem/Cases for next week: None planned at this point 11
  12. 12. Financial Accounting WEEK 8 –November 16, 2004 Topics: 1. Current liabilities 2. Contingent liabilities 3. Review time value of money 4. Basics of bond valuation and reporting Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand and apply the concept of accounting liability to obligations whose certainty of payment dates and whose amounts vary. (9-23) 2. Understand restructurings and the liabilities they create. 3. Review the concept of time value of money. (Appendix problems) 4. Develop the skills to compute the issue price, book value, and current market value of various debt obligations in an amount equal to the present value of future cash flows. (9-26) 5. Understand and apply the concept of debt amortization using the effective interest rate method for various long- term debt obligations. (9-29) 6. Understand the accounting procedures for bond retirements, whether at or before maturity, and the reporting of any gain or loss on retirement. (9-32) 7. Understand how to account for the issuance of bonds between interest payment dates. 8. Understand the characteristics and consequences of zero coupon bonds. Readings: SW Appendix pg. 831-847, Chapter 9 Recommended Problems: Appendix (as needed) Chapter 9: 23, 26, 29, 32 Illustration: Central Power Company Hand in: Nothing to be handed in. Required Problem/Cases for next week: Valuation of long term debt (this may end up being postponed for a week) 12
  13. 13. Financial Accounting WEEK 9-November 23, 2004 Topics: 1. Complete discussion of bonds 2. Leases 3. Deferred Taxes (briefly)* Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Distinguish between the economic characteristics and accounting criteria for an operating lease and a capital lease and the financial statement effects of each type of lease. (10-26, 10-44) 2. Perform constructive capitalization of an operating lease. (10-41) 3. Understand the concept of deferred income taxes. (10-32) 4. Use ratio analysis to assess a company's debt levels. Readings: SW Chapter 10 (pg. 535-556) “Getting to the Bottom of a Company’s Debt?” (in Supplementary Readings section of overhead packet) “Debt? Who Me?” “Understanding the Tax Footnote” “How to Spot Tax Tinkering” (in Supplementary Readings section of overhead packet) Recommended Problems: Chapter 10 Problems: 26, 32,41, 44 Supplemental Readings (in overhead packet): “Getting to the Bottom of a Company’s Debt” Financial statements to accompany article entitled “Getting to the Bottom of a Company’s Debt” “How to Spot Tax Tinkering” Hand in: Valuation of long-term debt Required Problems/Cases due next week: Financial Analysis Project *The authors provide more information about the accounting for deferred taxes on their website. 13
  14. 14. Financial Accounting WEEK 10: November 30, 2004 Topics: 1. Stock transactions 2. Stock options 3. Pensions (if time permits…this is not likely) Objectives: Parenthetical notation indicates a problem or illustration that covers the objective 1. Understand transactions involving the issuance and repurchase of stock 2. Understand the distinction between common and preferred stock 3. Understand the impact of different types of dividends 4. Understand the accounting disclosure related to stock options Readings: SW Chapter 12 “When Is a Stock More Like a Bond?” “Beware of Fat Dividends” (in Supplemental Readings section of overhead packet) “Splitsville” “Smart Companies Weigh their Options” “Options: Cutting Through the Thicket” (in Supplemental Readings section of overhead packet) Recommended Problems: None Supplemental Materials: (in overhead packet) “Beware of Fat Dividends” "Background on Options and Related Accounting” “Options: Cutting Through the Thicket” Financial Statements to accompany article entitled “Options: Cutting Through the Thicket” Hand in: Financial Analysis Project 14
  15. 15. FINANCIAL STATEMENT ANALYSIS PROJECT PROJECT GOAL: Often the goal of financial analysis is to answer a specific question. For example, should you invest in the company or not? Is the company a winner or a loser? For purposes of this project, I am not looking for conclusions of this sort. The analysis is too preliminary to warrant such a conclusion. At this stage the goal is to gain facility with the financial statements, become familiar with some of the financial data resources available, and gain an understanding of commonly used ratios and analysis techniques. COMPANY SELECTION: Select a publicly traded U.S. company of interest to your group. Privately held companies, not-for-profit organizations, governmental entities, or foreign companies, may not be used. • Privately held companies are difficult to use as the basis for this project due to lack of data and the fact that their financial statements may not be prepared using the accounting principles we will examine during the term. • Most foreign companies prepare financial statements based on the accounting rules and regulations that govern the country in which they are domiciled (although some also prepare financials based on U.S. GAAP. Since foreign rules and regulations (including International Accounting Standards) often do not agree with GAAP, I require that you select a U.S. based company. Although the financial statements of foreign companies may look similar on the surface, without an understanding of the rules by which they were formed, they are difficult to interpret. • I recommend that you avoid financial institutions such as banks, insurance companies or savings and loans; brokerage and investment companies; health care companies; and firms in regulated industries such as public utilities. An understanding of special accounting rules that are beyond the scope of this class are required to analyze these types of firms as well as not-for-profits and governmental entities. • It is helpful if the company you select is not too diversified across industry segments as this makes the identification of a competitor or industry benchmark difficult. • Companies that have engaged in significant merger, acquisition or divestiture activity are not good candidates for the project. Many firms have engaged in a modest amount of this activity; that is unavoidable and not too problematic. However, companies that have been on a merger binge are difficult to analyze because their financial statements effectively represent different entities from year to year. • Lastly, in selecting a firm I recommend you select a company that has operated at a profit rather than a loss in recent years. • Financial statements can be downloaded from the SEC's Edgar Database found on the SEC’s website at Also, most companies have their annual reports available on their web sites. If the need arises, I can assist you in identifying an appropriate company. PROJECT INSTRUCTIONS: Introduction to the firm Given that a company’s financial performance is in part a function of its industry and strategies, it is necessary to have a sense of these factors before attempting o analyze the company’s performance. The first step in analysis is to obtain an overview of the firm and its strategies. Much of this information can be found in a publicly traded firm’s 10-K and Management Discussion and Analysis. The second step is to evaluate the structure of the industry in which the firm operations. Below you will find a list of questions that may help you obtain useful information. This list is not intended to be all-inclusive. There may be things that are pertinent to your particular company that are not listed. On the other hand, I do not expect an answer to all of these questions. The questions are designed to give you some idea of the types of things you need to consider in writing an introduction to the firm. Some questions may be completely irrelevant for your company. Questions related to the firm and its strategies: 1. In what lines of business does the firm operate? 15
  16. 16. 2. Is the firm diversified with respect to: a. Products b. Geographic segments. Where does the firm do business? c. Customer base 3. What are the firm’s major products and services? a. Are its products mature or new? b. Does the company have other products in the pipeline? c. What share of the market does the company have? 4. What is the firm’s current operating strategy? Is it restructuring, downsizing, diversifying, in a growth phase, etc? 5. How does the firm market and distribute its products and services? Questions related to the industry: 1. Does the industry consist of many firms? A few firms? 2. Who are some of the company’s major competitors in the industry? 3. How does the firm fit into the industry? Is it a giant? A niche player? 4. What is the level of competitiveness within in the industry? 5. What is the industry growth profile? Is the industry in decline? In a growth phase? 6. What is the regulatory environment? 7. Is the industry sensitive to macroeconomic conditions? 8. What is the importance of technological change and innovation? 9. What is the production profile of the industry? a. Is it labor or capital intensive? b. Is it unionized? c. Are their constraints on the availability of raw materials and labor? 10. Are the barriers to entry high or low? You can begin this part of the project before we have covered analysis techniques. Analysis (both time-series/trend analysis and cross sectional analysis) Using financial analysis techniques (e.g., ratios, common size financial statements, etc.) discussed in class and in the textbook, you must prepare a three-year time-series analysis of the company you have selected. This time-series (or trend) analysis will examine ratios over the three-year time frame as well as trends in common size financial statements over that time period. When appropriate, you should consider the following ratios (at a minimum): Current Ratio Quick Ratio (Acid Test Ratio) Cash Flow from Operations to Average Current Liabilities Cash Flow from Operations to Average Total Liabilities Accounts Receivable Turnover Inventory Turnover Total Asset Turnover Accounts Payable Turnover Fixed Asset Turnover Total Debt to Total Stockholders' Equity (or another variation of debt to equity) Times Interest Earned (Interest Coverage) Gross Profit Margin Net Profit Margin Ratio Rate of Return on Total Assets Rate of Return on Common Stockholders' Equity EPS Price Earnings Ratio Dividend pay-out 16
  17. 17. Chapter 5 of SW provides a set of basic ratios. Remember, that not all ratios are appropriate for every firm. For example, if the firm does not pay dividends, the dividend ratios will not be appropriate. If the firm is a service organization, there may be no inventory. Also, some students may find there are ratios specific to the industry that are appropriate additions to the project. I encourage you to enhance the project by including other ratios or types of analysis, which you believe are useful. In cases where there are multiple formulas commonly used to compute a given ratio, it is necessary to indicate which version is used. For example, some ratios can be computed either before or after tax. Other ratios can be computed using either ending balances or average balances (e.g., the Accounts Receivable turnover or Inventory turnover ratios). Also, if industry data is being used as a comparison for the firm, it is important to indicate the source of that industry information. Calculating and reporting the ratio figures is not sufficient. You need to interpret what the ratios imply about the company's performance. When ratios have changed significantly from one year to the next, you need to consider the cause of the change. If ratios differ significantly between the chosen firm and the industry or competitor benchmark, you should think about reasons for the differences. In many instances it may not be possible to pin down an exact cause. In that case, you might: (a) list alternative explanations for the difference, (b) list questions you would ask to try to identify the cause, and/or (c) list data you would need in order to reach a conclusion. Analysis is a process (it is endless); you need to provide evidence that you have gained an initial understanding of the process. If possible, the performance of your chosen firm should be compared to a benchmark; industry standards or a direct competitor are good choices. This is cross-sectional analysis. You can determine the appropriate industry classification using SIC (NAISC) codes. Pre-computed industry ratios and the data to compute additional ratios can be found in: (1) Dun and Bradstreet’s Industry Norms and Key Business Ratios and (2) RMA Annual Statement Studies, among other sources. Additional sources that may be useful include Standard and Poors’ Industry Reports, Value Line Investment Surveys and various Moody’s publications. As Portland State University students, you have access to significant resources, both print and electronic, through the Portland State library. A word of caution about many Internet sites. In many cases they do not provide the formulas used to compute the ratios reported. There is often more than one way to compute a given ratio. You must be certain that the formulas used for industry ratios and for your company are consistent. Even in the hard copy sources, (Dunn & Bradstreet, Robert Morris, S & P, Value Line, & Moodys’) referenced earlier, there are differences in ratio formulas. The Internet sources that are available frequently compute ratios based on the most recent 12 months. They refer to this as trailing 12 months or TTM. Do not use these ratios. Your calculations must be based on the most recent audited annual financial statements. For certain ratios, industry data may not be available. For those ratios only time-series (trend) analysis will be possible. In addition, you should discuss any unique accounting issues that apply to the industry and the specific firm. You will be required to submit: (1) a summary of your ratios and the industry averages (or the ratios for a competitor if this is approach taken), (2) a copy of the financial statements and accompanying footnotes of the company, and (3) your written report. There is no page limit on the project but you should try to employ as much restraint in the volume of materials as possible. More is not always better. The project is due November 30. A few more detailed points follow: 1. Be sure to include a list of references for material you include in the project. Think of this as a research paper from the standpoint of rules regarding attribution and citation of material. 2. If you are comparing your company to a competitor, it is not necessary to do a three-year trend analysis of the competitor. You can compute ratios for the competitor for the most recent year and focus your cross-sectional discussion on a comparison of the most recent year for the two firms. In a “full blown” analysis, you would examine the trends for both companies in order to glean insights into the effects of general industry and economic conditions but we need to make this project manageable in the time allowed. 3. If you are comparing your company to industry standards, the same thing applies. Although you will be doing a three-year time series analysis for your own company, you do not need to gather three years worth of industry standard information. The most recent year available is sufficient. 17
  18. 18. 4. As far as the timing of reports. It may be that the fiscal year end of your company does not match the fiscal year end of the competitor or the aggregation date for the industry standards. Students sometimes attempt to “roll up” the quarterly financial data so that times periods align. This would help eliminate difference in firm performance due to shifts in economic and industry condition. Unfortunately, the “rolling up” of quarterly data is not as simple as it may at first appear. Quarterly financial data contains even more estimates and assumptions than annual data. Data for the first 3 quarters of a company’s year do not necessarily represent the actual activity for those quarters, as certain things must be estimated on an annualized basis. For example, tax expense in the first quarter does not necessarily represent the taxes on the income earned during the first quarter. Rather it represents one quarter of the total taxes that the company expects to incur that year. Each quarter as more information becomes available about how the year is likely to shake out, the estimate is refined. But prior quarters figures are not automatically revised. So combining the 3rd and 4th quarter of one fiscal year with the 1st and 2nd quarter of another year introduces another set of problems. The sum of those 4 quarters does not represent what the financial statements would be if those 4 quarters represented the firm’s fiscal year. You essentially trade off one set of problems (differences in economic climate) for another. Do not attempt to do this adjustment. If you have a time discrepancy between your firm and your comparator data, you might discuss in the write up the fact that differing year-ends make the numbers not directly comparable and speak to what has happened in the economy or industry in the intervening time periods. 5. Length. I would guess that the average project length over the last few years has been in the neighborhood of 20 pages, inclusive of any charts or tables. This assumes double spacing (or 1 and ¾) as my eyes are getting old. Also, if projects are double spaced there is more room to provide comments. I have certainly received quality projects that were shorter than this. It will depend in part on the nature and sophistication of your company. 6. I do not have strong preferences about paper organization. Some students discuss their time-series findings first and then speak to cross-sectional comparisons. Other students combine these different forms of analysis. Students frequently break the ratios down into broad categories such as profitability or financing. Some projects have reported all the actual ratio figures in tables, other have incorporated those into the body of the text. Students often categorize ratios into broad categories. 18