Module 1: Introducing Financial Accounting for MBAs

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Module 1 Introducing Financial Accounting for
MBAs
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Buffets Acquisition Criteria

• Large purchases (at least 50 million of
  before-tax earnings),
• Demonstrated consistent earning power (future
  projections are of no interest to us, nor are
  turnaround situations),
• Businesses earning good returns on equity while
  employing little or no debt,
• Management in place (we cant supply it),
• Simple businesses (if theres lots of technology,
  we wont understand it),
• An offering price (we dont want to waste our
  time or that of the seller by talking, even
  preliminarily, about a transaction when price is
  unknown).

Financial performance is an important factor in
Buffets criteria
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Buffets Concept of Intrinsic Value

• Intrinsic value is an all-important concept that
  offers the only logical approach to evaluating
  the relative attractiveness of investments and
  businesses. Intrinsic value can be defined
  simply It is the discounted value of the cash
  that can be taken out of a business during its
  remaining life.

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Buffets Three Suggestions for Investors

• Beware of companies displaying weak accounting.
  If a company still does not expense options, or
  if its pension assumptions are fanciful, watch
  out. When managements take the low road in
  aspects that are visible, it is likely they are
  following a similar path behind the scenes.
  There is seldom just one cockroach in the
  kitchen.
• Unintelligible footnotes usually indicate
  untrustworthy management. If you cant
  understand a footnote or other managerial
  explanation, its usually because the CEO doesnt
  want you to. Enrons descriptions of certain
  transactions still baffle me.
• Be suspicious of companies that trumpet earnings
  projections and growth expectations. Businesses
  seldom operate in a tranquil, no-surprise
  environment, and earnings simply dont advance
  smoothly (except, of course, in the offering
  books of investment bankers).

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Business Activities
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Planning Activities

• A company exists to implement specific goals and
  objectives.
• A companys goals and objectives are captured in
  a business plan.
• Information on planning activities is often
  obtained through
• The Letter to Shareholders
• The Management Discussion and Analysis (MDA)

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Financing Activities

• A company requires financing to carry out its
  business plans.
• Financing activities refer to methods that
  companies use to raise the funds to pay for
  resources such as land, buildings, and equipment
• There are two main sources of financing
• Equity financing
• Creditor (or debt) financing

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Examples of Company Financing
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Types of Creditor Financing

• Investing creditorsthose who primarily finance
  investing activities (such as bank lenders).
• Operating creditorsthose who primarily finance
  operating activities (such as suppliers).

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Breakdown of Creditor Financing
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Investing Activities

• Investing activities are the acquisition and
  disposition of resources (assets) that a company
  uses to produce and sell its products and
  services.
• The investing resources, or assets, are of two
  types
• Operating assetsresources devoted to operating
  activities
• Nonoperating (financial) assetsresources devoted
  to nonoperating activities

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Breakdown of Operating and Financial Assets
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The Accounting Equation
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Operating Activities

• Operating activities are the use of company
  resources to produce, promote, and sell its
  products and services.
• Operating Revenues (or sales) - the inflow of
  assets from selling products and services.
• Operating Expenses (or costs) - the outflow of
  assets to support operating revenues
• Operating Income Operating Revenues Operating
  Expenses

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Defining Company Value

• Most owners and nonowners formalize their claims
  on a company in the form of a contract or a
  security.
• Equity securities are common for owners and bonds
  (notes) are common for nonowners.
• These securities are traded in capital markets.
• Value of Company
• Value of Nonowner Claims Value of Owner Claims

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The Financial Statements

• Balance Sheet assets, liabilities and equity at
  one point in time
• Income Statement revenues, expenses, and profit
  over a period of time
• Statement of Equity changes in contributed and
  earned capital
• Statement of Cash Flows net cash inflows
  (outflows) form operating, investing and
  financing activities

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Financial Statements
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Balance Sheet

• A balance sheet reports on investing and
  financing activities.
• It lists amounts for assets, liabilities, and
  equity as of a point in time.
• The accounting equation (also called the balance
  sheet equation) is the basis of the balance
  sheet
• Assets Liabilities Equity

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Berkshire Hathaways Balance Sheet
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Income Statement

• An income statement reports on operating
  activities.
• It lists amounts for sales (and revenues) less
  all expenses (and costs) over a period of time.
• Sales less expenses yield the bottom-line net
  income amount.

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Berkshire Hathaways Income Statement
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Statement of Equity

• The statement of equity reports on changes in the
  accounts that makeup equity
• Contributed capital
• Earned capital (retained earnings and accumulated
  other comprehensive income)
• This statement is useful in identifying and
  analyzing reasons for changes in owners claims
  on a companys assets.

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Berkshire Hathaways Statement of Stockholders
Equity
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Statement of Cash Flows

• The statement of cash flows reports on cash flows
  for operating, investing, and financing
  activities over a period of time.

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Financial Statement Linkages
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Information Beyond Financial Statements

• Management Discussion and Analysis (MDA)
• Independent Auditor Report
• Financial Statement Footnotes
• Regulatory Filings and Proxy Statements

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Buffet on MDA
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Economics of Accounting Information Demand
Supply

• Demand for financial accounting information
  extends to numerous users that include
• Managers and employees
• Creditors and suppliers
• Shareholders and directors
• Customers
• Regulators
• Voters and their representatives

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Supply of Accounting Information

• Determined by a companys estimates of the
  benefits and costs of disclosure.
• Regulation and bargaining power also play roles
  in determining the supply of financial accounting
  information.
• The SEC requires financial statements, various
  note disclosures, and other reports on a regular
  basis.

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Supply of Accounting Information

• Benefits of disclosure
• lower capital cost from improved transparency
• reputation effects enhance labor recruiting
• Costs of disclosure
• Information gathering costs
• More information to competitors
• Potential litigation costs
• Potential political costs

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Market Efficiency
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Profitability Analysis

• Return on Assets (ROA)
• ROA Net Income / Average Assets
• For example, if we invest 100 in a savings
  account yielding 3 at year-end, the return on
  assets is 3.

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Disaggregating Return on Assets
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Profit Margin, Asset Turnover, and Return on
Assets for Selected Industries
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Competitive Analysis

• Bargaining Power of Buyers Buyers with strong
  bargaining power can exact price concessions and
  demand a higher level of service and delayed
  payment terms
• Bargaining Power of Suppliers Suppliers with
  strong bargaining power can demand a higher price
  for their goods and early payments.
• Threat of Substitution When the number of
  product substitutes increases, sellers lose their
  ability to raise prices and/or pass on cost
  increases to buyers
• Threat of Entry New entrants to a market
  increase competition. To mitigate that threat,
  companies expend money to erect barriers to
  entry. These include RD, advertising, management
  hires with special expertise, and mergers to
  create economies of scale.

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Five Forces of Competitive Intensity
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Business Context for Financial Statements
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Accounting Principles and Governance Structures

• Information in financial statements enables
  company valuation and, by extension, the
  valuation of its debt and equity securities.
• The importance of financial statements means that
  their accuracy is of paramount importance .
• To the extent that financial performance and
  condition are accurately communicated to business
  decision makers, debt and equity securities will
  be more accurately priced.

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Oversight of Financial Accounting

• Oversight of Financial Accounting
• SEC oversees all publicly traded companies
• EDGAR database (www.sec.gov)
• Financial Accounting Standards Board (FASB)
• Generally Accepted Accounting Principles (GAAP)
• Board of Directors
• Audit Committee
• Courts

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Audit Report

• Financial statements present fairly and in all
  material respects company financial condition.
• Financial statements are prepared in conformity
  with GAAP
• Financial statements are managements
  responsibility. Auditor responsibility is to
  express an opinion on those statements
• Auditing involves a sampling of transactions, not
  investigation of each transaction
• Audit opinion provides reasonable assurance that
  the statements are free of material misstatements
  
• Auditors review accounting policies used by
  management and estimates used in preparing the
  statements

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Sarbanes-Oxley Act

• The SEC requires the CEO and CFO of a company to
  personally sign a statement attesting to the
  accuracy and completeness of the companys
  financial statements.
• The statements signed by both the CEO and CFO
  contain the following commitments
• The CEO and CFO have personally reviewed the
  annual report
• There are no untrue statements of a material fact
  or failure to state a material fact necessary to
  make the statements not misleading
• The financial statements fairly present in all
  material respects the financial condition of the
  company
• All material facts are disclosed to the companys
  auditors and Board of Directors
• No changes to the companys system of internal
  controls are made unless properly communicated

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Financial Accounting not an exact science

• GAAP allows companies choices in preparing
  financial statements (inventories, property, and
  equipment).
• Companies must choose among the alternatives that
  are acceptable under GAAP.
• Financial statements also depend on countless
  estimates.

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Financial Accounting in Context

• A companys financial statements only tell part
  of the story.
• You must continually keep in mind the world in
  which the company operates.
• Financial statement analysis must be conducted
  within the framework of a thorough understanding
  of the broader forces which impact company
  performance.

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