From Accounts to Financial Statements
Financial Reporting Requirements:
SEC requires filings and are displayed on the website sec.gov
Company websites have investor relations sections you can get financials and aggregators like yahoo finance
Must file 10k report – overview of business and finances. 60 to 90 day filings. Large filer 60 days, smaller 90 days. Specific and requires financial disclosures and is the most detailed.
Annual report that is a marketing document and is not the complete 10k vs. the 10k (sec website)
10q is quarterly first 3 quarters. Less detailed but include financials
10k stock options, fixed and intangible assets, debt, future performance expectations, MD&A.
10k audited, 10q is not. Auditors note will note any issues
8k required announcing material significant, ex. acquisition. Within 4 days of event
14A proxy required with shareholder meeting. Also when requires a shareholder vote.
S1 goes public
S4 when deal is done for acquisition
20F outside USA, file with SEC in this form
Look through a bunch of 10ks
15 items required in 10k
Part I: general information about business
Part II: MD&A and financial statements and footnotes
Part III & IV: Executive compensation and audit results
Edgar is name of SEC database
Basic share count is bottom of first page as of filing date
Table of contents itemizes the sections
Business- company background, business strategy, descriptions of products, markets and distributions, competition, suppliers
Selected financial data – most important financial highlights, not complete FSs
MD&A – what happened during the year and what expectations are even at segment level. Analyzing company, read this.
Financial statements – spend most time here, IS, BS, SCF (analysts)
Financial footnotes – disclosures
The Income Statement:
First line item on IS
Total dollar payments that are recognized by a company over a period
Also called sales, net sales, net revenues
Not all income is revenue. Only operating income is revenue. Anything other than operating income is called ‘Other income’ (ex. interest income)
Revenue is all about the recognition principle!
Accrual which is dictated by FASB & SEC states that revenue can only be recorded when it is earned and measureable. Cannot record until order is shipped and collection is reasonable.
Product and service structure determines when to recognize revenue.
Bundled Products: For companies that have bundled products, values must be assigned to each of the components and the components can either be recognized immediately or over several years evenly (ex. software)
Long Term Projects: Company has two options on how they will record:
- Percentage of completion – revenue recognized based upon % of work completed during the period
- Completed contract – only when the project is finished
Cost Matching Principle:
Expenses should be matched to revenues
Accrual accounting = Revenue recognition (when economic exchange occurs) + cost matching to associated revenues
Problem is that analysts cannot track what is going on with cash since some revenue and expenses not matched to when cash was actually received or spent. SCF allows you to address this problem.
Cash accounting not allowed under GAAP
Accrual accounting can lead to revenue manipulation. Subjective assessments to shift revenues from one period to another. Conservative recognition vs. aggressive
COGS (Cost of Goods Sold aka Cost of Sales):
Direct costs to manufacture (manufacturing) or procure (merchandisers) a good or service to generate revenues
Inventory cycles out through the income statement in COGS
- Manufactured goods inventory (raw material, direct labor, factory overhead associated with manufacturing directly), depreciation of fixed assets directly used in manufacturing
Costs here recognized only when associated revenue is recognized on IS so not immediate
Does not include administrative costs.
Business model determines the COGS structure (ex. manufacturing, merchandiser, service provider)
Key Question: What is the structure/components of cost of goods sold (COGS)? Determine what type of company we are dealing with and what should be going into COGS. (ex. manufacturing, merchandising, service). Look at the disclosure in the footnotes the 10-k to analyze COGS
Can also be called Cost of Revenue or Direct Costs on 10k
Management offices are SG&A while salary of factory supervisor (factory overhead) is COGS
COGS is all about the matching principle!
Revenues – direct expenses (COGS) = Gross profit
Gross profit is profit after direct costs (COGS) accounted for.
Selling, general & administrative (SG&A):
Costs not associated with the direct manufacturing or procurement of goods or services. These include marketing, payroll, wages.
Still operating expenses, simply not directly tied to manufacturing.
Examples: salaries and commissions of sales people, marketing and advertising, executive salaries, legal expenses
May also be called Sales & Marketing or General & Administrative
Key Question: What is the structure of SG&A? Look at the disclosure in the footnotes of the 10-k to analyze SG&A
Not the engineers associated with developing the product, but rather the sales, marketing and management people. Engineers go in R&D costs
Research & development:
Costs associated with the building of new products & services (procedures).
Industries like energy, tech, and healthcare are R&D heavy so they include another line item for R&D
Industries that are not R&D heavy may include R&D in SG&A
R&D is employees, equipment and facilities in R&D process.
Proxy for cash flow. Gross profit – SG&A – R&D. Or EBIT + D&A.
Depreciation & Amortization (D&A):
Allocation of costs over a fixed asset’s useful life to match the benefits of asset (revenues) to cost.
If expense is associated with generating revenue for several years, shouldn’t that expense be spread out evenly over the useful life of the asset. This annual expense is called depreciation.
Productive assets have expenses associated with them that are expensed in the IS over the useful life of the asset due to the matching principle with revenues associated with the productive assets. Depreciation of the asset evenly.
Decrease of the book or historical value of the asset.
Ex. Fixed assets such as plants and buildings, machinery and equipment, computer software and hardware, furniture and fixtures
Land never affects the IS.
Benefits more than one year, then depreciation
Benefits more than one year, then expensed in COGS
In most 10k ISs will not see specific line item for depreciation expense. Depreciation is included in COGS or SG&A depending on whether asset is associated with manufacture/procurement or with selling or marketing.
Depreciation taken from SCF
Depreciation is a noncash expense
IS is a pool tool to track cash position
Depreciation methods that companies can use:
Straight line – cost of asset spread evenly over asset’s useful life.
SL depreciation expense = depreciable cost / useful life
Depreciable cost = original cost – salvage value (what you can sell it for at the end of its useful life)
Asset Book Value roll forward:
Beginning book value
- Depreciation expense
= End of period book value
Accumulated depreciation tracks the sum of the roll forward changes
GAAP and IFRS allow you to use accelerated depreciation methods including:
Sum of years digits
Units of production
Majority of companies use straight line since it shows lower depreciation and thus higher profits on the IS
Allocation of intangible assets costs instead of fixed/tangible assets over life of the asset. Matching principle associated with benefits of the asset that generate the revenue.
Amortization expense is how it is recognized on the income statement.
Lumped into D&A since identical to depreciation but simply for intangible assets.
Ex. customer lists, franchise rights, licenses, patents, trademarks (brand name), goodwill
Goodwill and trademark has indefinite useful life, so not amortized
Look at 10K disclosures and read through to see what makes up the Goodwill & Other Intangible Assets footnote. Future amortization expenses are disclosed here as well.
Expenses associated with internally developed intangible assets such as trademarks and patents are expensed fully when incurred, thus no amortization
Not allowed to write up value of intangible assets that are developed internally, so only showing on the balance sheet for acquired intangible assets.
Key Question: Should an expense be expensed, amortized or depreciated? Does the expense go in COGS or SG&A?
What are the function of the assets (manufacturing vs. marketing)?
Trademarks never cycle out through the income statement
Expenses not in COGS, SG&A, R&D or D&A
Not tied to core operations
“Below the line” (Operating income)
Operating Profit (EBIT):
EBITDA – D&A
NOW NONOPERATING EXPENSES ON INCOME STATEMENT
Interest expense on debt owed.
Regular interest payments
Sometimes netted against interest income
Revolver cash plug derivative
Interest income on cash balances and investments.
Excess cash plug derivative
Nonrecurring income associated with sale of business (accounting gain) Nonrecurring expenses restructuring, impairments, write-offs, legal, insurance proceeds
Analysts ignore, nonrecurring or unpredictable
Income tax expense:
Tax liability on IS
US GAAP and IFRS
Tax expense line is not equal to cash taxes company has to pay
Because of deferring taxes, cash taxes using tax code from country. US GAAP is calculated using different book rules
Companies have to prepare two sets of books (tax and financials)
Accounting rules differences: depreciation, rev rec and how losses are treated are differences
Current taxes lower, deferred is different. Current is what is actually paid.
EBIT – net interest expense – nonoperating income/expense – taxes
Final measure of profitability
Number of shares of common stock
One unit of ownership
Shareholders can vote on matters and receive dividends per share
Treasury shares – repurchased and nolonger outstanding
Basic vs. Diluted – Basic is actual shareholders (front cover of company’s 10k), more important and useful is diluted shares outstanding (impact of dilutive securities that expand share base, can convert into common stock, potential shareholders must be factored in)
Basic earnings per share (EPS):
Net income allocated to individual basic shares outstanding
Investors analyze net income by EPS
Total period profits belong to each shareholder
Incorporates the impact of dilutive securities in calculated how much income per share.
Diluted EPS is more real
Analysts, talking about beating EPS expectations
EPS on weighted average basis as shares from options and preferred or repurchases
During period of IS average shares
Not year ending share count
What to do with net income?
Portion of it may be returned to shareholders on quarterly basis
Dividend policy set by board of directors
Dividend policy discussed in footnotes of 10k
Dividends below EPS on IS; what % of profits?
What to do with extra cash?
Keep and reinvest (acquisitions, CAPEX for growth)
Pay down debt
EBIT & EBITDA:
EBIT is operating income
Analysts compare performance to other businesses, want operating performance to compare (EBIT), comparing profitability (debt and taxes skew comparability), want to isolate operations of the business (to ignore nonoperating)
Used more frequently
Way to compare company profitability
D&A is noncash (Different useful life and depreciation methods, skews comparability)
Proxy for cash flow, see more real profits
Accrual based profit (EBIT) with taking out biggest noncash measure
Not cash flow measure (FCF)
Have to go to SCF to add back to operating income
D&A buried in COGS or SG&A
Not GAAP recognized metric
Ideal income statement, D&A would be broken out, could see EBITDA right away
Profitability is a corporate arbitrage metric
Operating vs. non-operating important for IS
Net income, EBIT & EBITDA are profitability metrics
The sources & uses of capital (Double entry accounting)
Resources and how they were funded
Reports resources on date and time (snapshot), End of period
Sources must = uses
A = L + E
Balance sheet is not market value but historical cost (original)
The accounting equation and double entry accounting (sources change, uses must change to balance)
Each change on the BS has a cash impact
Each transaction has a source and use of funds (ex. cash & investment)
A framework to track movements on the balance sheet (double entry accounting) records funding source and use of capital
Double Entry Accounting:
Credit is a source of capital
Debit is a use of capital
Credit and debit happen for every transaction together (offset eachother)
Depicted in accounting as T account, looks like a T,
Debits on left as increases in assets, or decreases in L or E
Credits on right side decrease assets, or increases in L or E
T accounts consolidated into one aggregated table that lists all the transactions together
Facilitates understanding of sources & uses
BS & SCF connected BS changes over periods shown as changes in SCF items
From T accounts to aggregate net change in a line item (ex. Net change in cash, net change in all equity) will be a debit or a credit simply netted against eachother which will balance in the final T account
Take the final T accounts for each line item and use it to build a CLOSING BALANCE SHEET. Net debits and credits change each line item in the balance sheet to get CLOSING BS. Net debits and credits act as the roll forward change in the account
Historical cost reporting of assets
Asset is owned, of value and quantifiable/measurable cost
Cash – money held by company in bank account, US treasury (less than 90 days)
Marketable securities – stock or debt securities, some interest income (ST investments)
Can be aggregated with cash
Accounts receivable – already delivered products and services (expected payments), customers are invoiced, sales on credit but not received
AR is linked to revenue on the IS
Inventory – finished or unfinished goods, include direct cost of producing the goods. Goods waiting to be sold. Includes cost of producing finished inventory and work in progress (WIP).
Inventory cycles out of BS and onto IS as COGS
Inventory sits on BS, and then when revenue associated with the inventory is sold, matching principle dictates that we recognize the cost of the inventory, this is done as COGS
Inventory roll forward = Beginning inventory + purchases of new inventory – COGS = Ending Inventory
Different inventory costing methods (FIFO vs. LIFO vs. Average Cost): We are trying to figure out the value of the COGS and the amount to Credit inventory assets to decrease them.
FIFO – Remaining inventory reflects latest cost, inventory cycled through COGS reflects the cost of first inventory
LIFO – Remaining inventory reflects first cost, inventory cycled through COGS reflects the cost of the latest inventory
Average costing – (Unit sold/total) x total value of inventory
Value COGS amount of inventory depending on the method and then do the same valuing of inventory left on the balance sheet doing the same method (inventory balance after the year’s operations).
Read the footnotes to see the inventory accounting method. It is going to effect what the profitability looks like if there is a period of rising/declining prices for inventory. If prices stay the same, won’t matter. With rising prices for inputs, LIFO will show lower profitability and FIFO will show higher profitability, average costing in the middle
Doesn’t matter which inventory you sell, simply has to do with inventory valuation.
US GAAP says you have to disclose what inventories would have been under FIFO method. The difference is the LIFO reserve.
LIFO Inventory + LIFO reserve = FIFO Inventory
FIFO COGS + LIFO reserve = LIFO COGS
Subtract LIFO reserve from LIFO COGS to compare FIFO
Marking Down Inventory
Inventories cannot be marked up to market value under US GAAP due to conservatism principle. They are carried at historical cost but when the value of the inventories becomes less than the historical cost, you mark them down under the rule of lower of cost of market (LCM). It is called writing them down. The loss is recognized immediately on the IS (debit retained earnings with the expense in COGS, other operating or nonoperating expenses, and credit assets, inventory)
Prepaid expenses – insurance, utilities and rents (benefits as an assets), cash reduced, but expense not recognized, but is listed as an asset due to the accrual accounting principles
BS asset, not impact the IS right away
Property, plant & equipment – Land building machinery used in manufacturing plus transportation and installation
PP&E cycles onto IS as depreciation in COGS or SG&A
Listed in order of how quickly they can be converted into cash (liquidity) with most like cash at the top and least to the bottom. This forms categories called CURRENT (can convert within 12 months to cash) and LT ASSETS (longer than 12 months)
PP&E shows its roll forward of accumulated depreciation
+ New PP&E (CAPEX)
- Asset Sales
- Write downs
Depreciation debits retained earnings since it decreases net income
PP&E reported net of accumulated depreciation in balance sheet so it will say Net PP&E on the BS
Contra account (negative account) is accumulated depreciation since reducing an asset, net PP&E
Write downs need to be recognized immediately on the IS and will be in COGS or SG&A. Required LCM as well like inventory
Asset sales: Gross PP&E and accumulated depreciation are removed. If there is a difference, recognize a gain on sale on the IS and thus Credit goes to the Retained Earnings for BS to balance. See this as an OTHER operating or nonoperating line item. Only book value is removed from PP&E.
UNDERSTAND THE ROLL FORWARDS FOR EACH LINE ITEM IN THE BS
Self developed trademarks are not listed as an asset on BS sheet (internally generated)
Order of liquidity
Value must be easily measurable
Intangible Assets & Goodwill
Non-physical acquired assets, not self-built non-physical assets
Linked to amortization on the income statement
Identical to PP&E
Accumulated amortization is the offset to intangible assets
IA Roll Forward
+ New purchases
- Amortization expense
- IA sales
- Write down
Goodwill: for acquisitive companies
Amount of purchase price over Fair Market Value of the company acquired and represents the intangible value of the business related to brand value
Acts as a plug to balance the BS (Debit Goodwill)
Goodwill not amortized but tested every year for impairment. The loss is recognized immediately on the IS and Retained Earnings is debited, decreasing it. Goodwill cannot be written up, only written down. Goodwill writedowns means company overpaid for acquisition. Goodwill is an accounting assets.
+ New Goodwill
Liabilities & Equity
Sources of capital, how funded resources
Liabilities are company’s obligation to others. To qualify, must be measureable and probable.
Current liabilities – 12 months or less
Long term liabilities – Greater than 12 months
Accounts payable – obligations to suppliers that have been purchased but not paid for (unpaid bills on credit)
Instead of cash credited (decreased), crediting AP liability (money owed to suppliers)
Accrued expenses – incurred but not yet paid, employee compensation (ex. year end bonus), insurance, dividends, taxes, leasing. Benefits happened, cash payouts yet to happen.
Debit retained earnings (recognize the expense), instead of cash credited, credit accrued expense liability (money owed)
Deferred revenue – unearned revenue, paid but not yet earned. Rev recognition says some now recognized, but defers the remaining as a liability (deferred revenue liability) (ex. gift cards)
Deferred revenue is a current liability if expected to be recognized within the year, otherwise a long term liability
Credit deferred revenue
Short term debt – due in 12 months (maturity of 1 year or less)
Current portion of long term debt – due within a year. Can be aggregated.
LT debt – over 12 months (maturity) –
Interest expense debit to retained earnings and cash goes down (credit)
Lenders can trigger a bankruptcy if they don’t get paid
Listed in order of how quickly they are to be paid. This forms categories of CURRENT and LT LIABILITIES (longer than 12 months)
Liabilities cycled through the IS as expenses
Capital leases – retail and office space ex. Contractual agreements allowing company to lease PP&E
US GAAP and IFRS allow leases to be treated two ways:
- Capital leases – liability and asset (PP&E) on BS. During every period during the year: Interest expense on IS as if debt obligation (lease fees), and amortization expense on IS from PP&E (reduced). Treats the lease as an asset as if it owns it. Cash lease payments not recognized, but recognized as two things. Qualifications that if title expected to be transferred then capital, if lessee can purchase for less than market value, exceeds 75% of economic life of asset, PV of minimum lease payments is more than 90% of assets fair value.
- Operating leases – if under GAAP, straightforward, no asset or liability, lease expense. Off balance sheet leasing. In order to qualify as operating, don’t want capital leases. Operating lease expense on IS.
Footnote for lease commitments breakdown between capital and operating leases. Imputed payment as if debt, accounting way to recognize payments to lessors.
Source of funds via:
Preferred – priority over common, special stock rights (preferences), capital from preferred shareholders.
Raise capital at early stages. Class of stock that has special rights. Structured to include conversion to benefit from dividend and common stock upside.
Common stock – when companies issue shares (capital received)
Accounting convention includes splitting into two:
- Common stock par value – arbitrary value assigned to a share of stock (ex. $.05 per share). Credit nominal par value
- Additional paid in capital (APIC) – excess over the par value
As analysts, don’t care that two components.
Can never write up common equity due to historical cost principle. Own equity has to stay at historical. Common stock understates true market value of equity.
Treasury stock – common stock issued then reacquired (contra account, reduction to equity) (roll forward for equity). To boost EPS due to less shares outstanding and to change company’s capital structure. Captures value of common stock:
Cash credited, treasury stock becomes more negative as it increases
Treasury stock can be larger since common stock and APIC cannot be written up while treasury stock recognizes the value of common stock now
Retained earnings – Total earnings/losses over all time of existence of business
Financing through retained earnings. Cumulative earnings recognized on IS net of dividends. All income on the income statement increases retained earnings and all expenses on IS decrease retained earnings.
Retained earnings BOP
Retained earnings EOP
Other Comprehensive Income (loss) – Equity line item captures other income, not recognized on IS. Ex. foreign currency translation, gain/loss on sale.
Not tied to core operations. 5th statement on financial statements. Hard to predict as an analyst
Total comprehensive income BOP
Other comprehensive income/loss
Total comprehensive income EOP
How IS Connects to BS
Income Statement is connected to the balance sheet through equity’s retained earnings account. Any expenses on IS reduce retained earnings (source).
Revenues increases retained earnings and thus cash
COGS – Inventories cycled through IS decrease inventories in Assets on BS, direct labor has cash go down in Assets on BS, depreciation reduces PP&E in Assets on BS
SG&A – Retained earnings goes down by employee expense, depreciation on selling PP&E reduces PP&E in Assets on BS
Interest expense – Expense reduces retained earnings, decrease to cash, increase to cash
Statement of Cash Flows:
The SCF reconciles cash changes in the balance sheet. Reconcile the accrual IS to cash change in cash balances on BS. IS requires management judgement due to accrual basis. IS is disconnected to cash. Resolve disconnect with SCF, to understand what happened to cash.
IS and SCF need to be understood together by analysts
Cash in vs. cash out
Direct method vs. Indirect method (used by almost all companies)
Cash flows from operations – solely to operations, indirect method says start with accounting net income and make adjustments to convert this to cash flows from operations. Back all noncash out to get CFO (cash in my pocket). Biggest adjustment is depreciation expense. CHANGES in working capital assets/liabilities (tied up in ordinary course of operations, that is why called working capital). When assets are increasing, this is a usage of funds so it is an outflow (-), thus subtracted from Net Income to get to CFO. Increases in liabilities/equity, this is a source of funds so it is an inflow, +, thus added to Net Income to get to CFO.
How much cash went into company’s pocket as a result of operations? Cash flow from operations answers this
NI is accounting profit vs. Cash
Other items changes – ex. asset writedowns (not cash impact since an accounting adjustment), stock based compensation, impairments, gain on sale, deferred tax assets and liabilities
Cash from investing – CAPEX
Tracks additions and subtractions to LT assets. Intangible assets as well. Purchases and sales from equity and debt investments
Cash from financing – Associated with financing
Tracks changes in sources of company’s financing. LT liabilities and equity items.
Inflows from issuing debt, outflow repay debt, inflow from issuing stock, outflow distributing dividends
Total net change in cash from SCF and then EOP cash and equivalents. The cash flow statement is the magnifying glass on the cash line item for balance sheet. Income statement is the magnifying glass on the retained earnings line item for the balance sheet.
Statement of Cash Flows is the linkage between the income statement and the balance sheet. Retained earnings is the link between the B/S and the I/S.
Get D&A from SCF (CF from Operations) and CAPEX from SCF (CF from Investing)
From Accounts to Financial Statements:
Once monetary values for each account are determined via roll forward T accounts, the financial statements are then pulled together and are the output of the financial reporting process.
Balance sheet: Sources & uses of capital snapshot (PV outlay)
Income statement: Return on uses of capital over the period (FV inflow)
Statement of cash flows: Change in sources & uses over the period
Example of Financial Statements:
Get comfortable finding, reading, analyzing and spreading historical financial statements into financial statement models
The following is a 10-K from Berkshire Hathaway:
The following is the IS from Berkshire Hathaway:
The following is the BS from Berkshire Hathaway:
The following is the SCF from Berkshire Hathaway:
The following is the MD&A on the 10k from Berkshire Hathaway: