Ratio Analysis

DQ 1:

In the textbook there are 21 questions provided regarding items to consider when conducting an industry analysis. Review the questions listed on pages 169 and 170. Choose three that you think are the most important of all questions provided. Discuss why those three items are important when conducting an industry analysis. Participate in follow-up discussion by reviewing classmates’ posts and discussing whether the cost leadership or differentiation competitive strategy would be the most effective approach based on the three items provided.

DQ2:

Chapter 6 provides various exhibits regarding common-size balance sheets or income statements. Refer to Exhibit 6.3 Common-size Financial Statements in the textbook and review the common-size approach. Describe what “common-size” means and why it is used in financial analysis. Using a company from the approved list, perform common-size analysis on the balance sheets or income statements for at least two fiscal years. What does the information tell you? How can you use that information to compare companies within the same industry to each other?

Participate in follow-up discussion by reviewing the results provided by classmates and comment on the usefulness (or lack thereof) of the common-size approach to analyzing financial performance.

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TFord53@my.gcu.edu
Table of Contents
Cover
About the Authors
1 An Introduction to Financial Statements
The Three Principal Financial Statements
Other Items in the Annual Report
Generally Accepted Accounting Principles: The Rules of the Game
The Barriers to Understanding Financial Statements
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
2 The Balance Sheet and Income Statement
A Further Look at the Balance Sheet
Assets
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Liabilities
Shareholders’ Equity
A Further Look at the Income Statement
Other Things You Should Know About the Balance Sheet and the Income
Statement
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
Appendix 2.1 The Mechanics of Financial Accounting: The Double‐Entry
System
KEY TERMS AND CONCEPTS FROM THE APPENDIX
KEY LESSONS FROM THE APPENDIX
PROBLEM
3 A Brief Overview of GAAP and IFRS: The Framework for Financial Accounting
The Core Principles of GAAP and IFRS
The Key Qualitative Characteristics of Financial Information
The Key Assumptions of Financial Information
Modifying Conventions
The Future of Financial Reporting
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
4 Revenue Recognition
Introduction
The Five‐Step Revenue Recognition Model
Revenue‐Recognition Controversies
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
5 The Statement of Cash Flows
Introduction
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The Reporting of Cash Flows from Operations
Preparing the Statement of Cash Flows
IFRS and the Statement of Cash Flows
Analyzing the Statement of Cash Flows
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
6 Financial Statement Analysis
Introduction
Business and Industry Analysis
Accounting Analysis
Financial Analysis
DuPont Analysis
ROE and the Analysis of Financial Risk
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
Appendix 6.1 An Industry and Competitive Analysis of Taiwan Semiconductor
Manufacturing Company (TSMC)
Appendix 6.2 Summary of Financial Statement Ratios
PROBLEMS
7 Business Valuation and Financial Statement Analysis
Valuation Principles
Valuation: From Theory to Practice
The Economic Profit Approach to Valuation
A Case Study in Valuation: TSMC
A Brief Word on Growth Rates
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
8 Accounting for Receivables and Bad Debts
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Introduction
Estimating Bad Debts
Writing‐off Accounts
The Direct Method: An Alternative Approach
What Happens When Written‐off Accounts Are Later Collected?
The “Aging” of Accounts Receivable
Sales Returns and Allowances
Analyzing Receivables
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
Appendix 8.1 Accounting for Loan Loss Reserves
PROBLEMS
9 Accounting for Inventory
Introduction
Inventory Valuation: LIFO, FIFO, and the Rest
The Lower of Cost or Net Realizable Value Rule
The Cost‐flow Assumptions: An Example
Inventory Cost‐flow Assumptions: A Summary
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
10 Accounting for Property, Plant, and Equipment
Introduction
Initial Recognition of PP&E
Subsequent Expenditures: Repair or Improvement?
Accounting for Depreciation
Changes in Depreciation Estimates or Methods
Asset Impairment
Fair Value vs. Historical Cost
Divestitures and Asset Sales
Intangible Assets
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Key Lessons from the Chapter
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
11 Leases and Off‐Balance‐Sheet Debt
Introduction
Leasing Accounting Before 2018: Capital vs. Operating Leases
Accounting for Capital Leases
Accounting for Operating Leases
Lease Accounting: An Example
Interpreting Lease Disclosures
Off‐Balance‐Sheet Debt
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEM
12 Accounting for Bonds
Introduction
Accounting for Bond Issuance
Accounting for Bonds Sold at Par
Accounting for Bonds Sold at a Premium
Bond Redemption Before Maturity
Accounting for Bonds Issued at a Discount
Zero‐Coupon Bonds
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
13 Provisions and Contingencies
Introduction
Defining Provisions
Measuring the Provision
Disclosure of Provisions: Interpreting the Notes
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Contingent Liabilities
Contingent Assets
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
14 Accounting for Pensions
Introduction
A Brief Word on Defined Contribution Plans
Unfunded Defined Benefit Plans
Funded Defined Benefit Plans
American Airlines: An Example of Defined Benefit Plan Disclosure
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
15 Accounting for Income Tax
Introduction
Temporary and Permanent Differences
Deferred Taxes and the Balance Sheet Approach
The Balance Sheet Approach: An Example
Interpreting Income Tax Disclosures: The Case of Intel Corporation
Why Deferred Income Tax is Important
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
16 Accounting for Shareholders’ Equity
Introduction
Shareholders’ Equity: An Introduction
More on Contributed Capital
Accounting for Stock Transactions
Dividends on Common Stock
Stock Dividends and Stock Splits
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Accumulated Other Comprehensive Income
Convertible Bonds
The Statement of Shareholders’ Equity
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
17 Investments
Introduction
Investments at Microsoft
Debt and Passive Equity Investments
The Fair Value Hierarchy
Equity Method
A Further Look at Microsoft’s Investments
Consolidation
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
18 Accounting for Mergers and Acquisitions
Introduction
Purchase Price/Cost of Acquisition
Contingent Consideration
Recognition and Measurement of Identifiable Assets
Subsequent Adjustments to Acquired Assets and Liabilities
Goodwill Impairment
Noncontrolling Interest
KEY LESSONS FROM THE CHAPTER
KEY TERMS AND CONCEPTS FROM THE CHAPTER
QUESTIONS
PROBLEMS
Appendix Tables for Present Value and Future Value Factors
Index
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End User License Agreement
List of Tables
Chapter 1
Exhibit 1-1 TSMC Consolidated Balance Sheet (in NT$ millions)
Exhibit 1-2 TSMC Consolidated Income Statements (in NT$ millions)
Exhibit 1-3 TSMC Consolidated Statements of Cash Flows (in NT$ millions)
Exhibit 1-4 Independent Auditor’s Report
Chapter 2
Table 2A.1 Accounts
Table 2A.2 Misha’s Trial Balance: Preadjusted Trial Balance, 31 December 2018
Table 2A.3 The Postadjusted, Preclosing Trial Balance: Postadjusted, Preclosing
Trial Balance, 31 December 2018
Table 2A.4 Misha’s Income Statement: Truly Books & Co. Income Statement for
Year Ending 31 December 2018
Table 2A.5 Postclosing Trial Balance as at 31 December 2018
Table 2A.6 Truly Books & Co. Balance Sheet: Truly Books and Co. Balance Sheet
as at 31 December 2018
Chapter 4
Table 4.1 Revenues and Expenses Under the Percentage‐of‐Completion
Method
Exhibit 4.1 Starbuck Stock Graph Performance Compared to the NASDAQ
Exhibit 4.2 Starbucks Corp. Balance Sheet
Exhibit 4.3 Starbucks Corp. Income Statement
Exhibit 4.4 Starbucks Corp. Statement of Cash Flows
Exhibit 4.5 Starbucks Corp. Net Revenues, Specialty Operations Revenues,
and Retail Sales for 2004
Exhibit 4.6 Starbucks Corp. Company‐Owned Retail Stores Categorized by
Region
Exhibit 4.7 Cumulative Stock Returns: McAfee vs. S&P 500
Exhibit 4.8 Selected Financial Data for McAfee
Chapter 5
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Exhibit 5.1(a) CVS Health Cash Flows: Direct Method
Exhibit 5.2(a) Morris Distributors Inc., Balance Sheets for December 31,
2017 and 2018
Exhibit 5.2(b) Morris Distributors Inc., Income Statement for 2018
Exhibit 5.3(a) T‐account Worksheet for Morris Distributors
Exhibit 5.3(b) T‐account Worksheet for Morris Distributors (after the first
two entries)
Exhibit 5.3(c) T‐account Worksheet for Morris Distributors (completed
version)
Exhibit 5-4 Morris Distributors Statement of Cash Flows for the Year
Ended December 31, 2018
Table 5.1 The Operating Activities Section of TSMC’s Statement of Cash
Flows
Table 5.2 The Investing and Financing Sections of TSMC’s Statements of
Cash Flows (all amounts in millions of NT$), for the year ended December
31
Exhibit 5.5 Massa Corporation Consolidated Statements of Cash Flows
($millions)
Exhibit 5.6 Blockbuster, Inc., daily stock prices, October 1, 2004–April 1,
2005
Exhibit 5.7 Financial Statements Blockbuster, Inc.: From the 2004 Annual
Report
Exhibit 5.8 Monahan Manufacturing, Inc.: Balance Sheets for December 31,
2011 and 2012 (in thousands of dollars)
Exhibit 5.9 Sun Microsystems Statement of Cash Flows (amounts in
millions)
Exhibit 5.10 Wal‐Mart Statement of Cash Flows (amounts in millions)
Exhibit 5.11 Merck and Company Statement of Cash Flows (amounts in
millions)
Chapter 6
Exhibit 6-1 TSMC Common‐size Income Statements: 2014 in NT$million,
2015 and 2016 as a Percentage of Total Sales
Exhibit 6-2 TSMC Base‐year Income Statements: 2014 in NT$million 2015
and 2016 as a Percentage of 2014
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Exhibit 6-3 Common‐size Financial Statements
Exhibit 6-4 Selected Data for Texas Instruments and Hewlett‐Packard (in
millions)
Exhibit 6-5 Common‐size Financial Statement Data
Chapter 7
Table 7.1 Project Valuation Under the DCF and EP Methods
Exhibit 7-1 Forecasts for TSMC: Free Cash Flows and Economic Profit (NT$
million)
Exhibit 7-2 Valuation Summary for TSMC (NT$ million)
Chapter 8
Table 8.1 Distribution of Morris Inc.’s Outstanding Receivables
Exhibit 8.1 Consolidated Balance Sheets
Exhibit 8.2 Consolidated Balance Sheets
Exhibit 8.3 Johnson Perry Company and Subsidiaries
Exhibit 8.4 Citigroup Inc. Consolidated Income Statement
Chapter 9
Table 9.1 Current Assets of Procter & Gamble (Amounts in Millions)
Table 9.2 Procter & Gamble’s Income Statement for 2014–2016 (Amounts in
Millions Except per Share Amounts)
Table 9.3 Inventory Purchases for Waller & Gamble
Table 9.4 Waller & Gamble’s Income Statement and Balance Sheet
Chapter 10
Table 10.1 McDonald’s Corporation – Assets (in Millions, US$)
Table 10.2 Disclosure from McDonald’s Notes Regarding Breakdown of PP&E
(in Millions, US$)
Table 10.3 Capital Expenditures (in Millions, US$)
Table 10.4 Double‐declining‐balance Depreciation
Exhibit 10-1 Petrobras Disclosures
Chapter 12
Table 12.1 Oracle Corp (A stock corporation incorporated under the laws of the
United States of America, having its corporate seat in Delaware): USD
10,000,000,000 five‐part US dollar Notes
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Table 12.2 The Transactions and Accounting for a Bond Sold at Par.
Table 12.3 Bond Issued at a Premium: Effective Interest and Straight‐Line
Methods (in Box) Amortization
Table 12.4 Bond Issued at a Discount: Effective Interest and Straight‐Line
Methods (in Box) Amortization
Table 12.5 Zero‐Coupon Bonds: Effective Interest and Straight‐Line Methods
(in Box) Amortization
Chapter 14
Table 14.1 Basic Defined Benefit Pension Example
Table 14.2 Basic Defined Contribution Pension Example
Chapter 15
Table 15.1 Income Statements under Book and Tax Accounting
Table 15.2 Measuring the Asset Basis
Table 15.3 Measuring the Asset Basis Through 2019
Table 15.4 Measuring the Asset Basis Through 2020
Table 15.5 Measuring the Asset Basis Through 2021
Table 15.6 Intel Corporation’s Consolidated Statements of Income
Table 15.7 Intel’s Effective Tax Rate
Table 15.8 Intel’s Disaggregation of Provision for Taxes
Table 15.9 Intel’s Deferred Tax Liabilities
Table 15.10 Intel’s Deferred Tax Assets
Exhibit 15.1 Ford Motor Company and Subsidiaries: Income Statements for
the Years Ended December 31, 2011, 2010, and 2009 (in millions, Except
per Share Amounts)
Exhibit 15.2 Ford Motor Company and Subsidiaries
Chapter 16
Exhibit 16.1 The Coca‐Cola Company and Subsidiaries Consolidated
Balance Sheets
Exhibit 16.2 The Coca‐Cola Company and Subsidiaries Consolidated
Statements of Shareowners’ Equity
Table 16.1 Retained Earnings Equation
Chapter 17
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Table 17.1 Microsoft’s Assets for Fiscal Years 2016 and 2017 (in Millions,
US$)
Table 17.2 Detailed Breakdown of Microsoft’s Investments (in Millions),
June 30, 2017
Table 17.3 The Investing Activities Section of Microsoft’s Cash Flow
Statement
Table 17.4 The Income Statement Effects from Microsoft’s Investing
Activities (in Millions)
Chapter 18
Exhibit 18.1 LinkedIn Corporation Consolidated Balance Sheets (In
Thousands, Except Share Data)
List of Illustrations
Chapter 5
FIGURE 5.1 The operating cycle.
Chapter 6
FIGURE 6.1 The regular vs. managerial balance sheet.
Chapter 14
FIGURE 14.1 A graphical overview of Hector’s pension plan.
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Corporate Financial Reporting and
Analysis
FOURTH EDITION
S. David Young,
Jacob Cohen
and
Daniel A Bens
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George Hoffman
EDITORIAL DIRECTOR
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Lise Johnson
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EDITORIAL MANAGER
Judy Howarth
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CONTENT MANAGER
Nichole Urban
SENIOR CONTENT SPECIALIST
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Ameer Basha
COVER PHOTO CREDIT
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ISBN: 978-1-119-49457-7 (PBK)
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Library of Congress Cataloging-in-Publication Data
Names: Young, S. David, 1955- author. | Cohen, Jacob, 1973- author. | Bens, Daniel A., author.
Title: Corporate financial reporting and analysis / S. David Young, Jacob Cohen and Daniel A Bens.
Description: Fourth Edition. | Hoboken : Wiley, [2019] | Revised edition of Corporate financial reporting
and analysis, [2013] | Includes index. | Identifiers: LCCN 2018021868 (print) | LCCN 2018025342 (ebook)
| ISBN 9781119494591 (Adobe PDF) | ISBN 9781119494638 (ePub) | ISBN 9781119494577 (pbk.) | ISBN
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Subjects: LCSH: Financial statements. | Corporations—Accounting. | Corporation reports.
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To Diane – S. David Young
To my parents – Jacob Cohen
To Katrina, Lincoln and Lydia – Daniel Bens
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About the Authors
S. David Young is Professor of Accounting and Control at INSEAD, based in
Fontainebleau (France) and Singapore. He has been there since 1989. Professor
Young holds a PhD from the University of Virginia and is both a Certified Public
Accountant (USA) and a Chartered Financial Analyst. His primary areas of expertise
are corporate financial reporting and value-based management, with works
published in a wide variety of academic and professional journals, including several
articles in the Harvard Business Review.
Professor Young is the author or coauthor of several books, including EVA and ValueBased Management: A Practical Guide to Implementation (McGraw-Hill, 2001), Profits
You Can Trust: Spotting and Surviving Accounting Landmines (Financial Times, Prentice
Hall, 2003), and Attracting Investors: A Marketing Approach to Finding Funds for Your
Business (John Wiley & Sons, 2004). His most recent book is The Blue Line Imperative:
What Managing for Value Really Means (John Wiley & Sons, 2013).
Professor Young is also the recipient of several Outstanding Teaching Awards from
the INSEAD MBA program and the Distinguished Alumni Scholar Award from his
undergraduate alma mater, The George Washington University. He has consulted
extensively for companies in Europe, the United States, and Asia, mainly on issues
related to value-based management and financial analysis.
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Jake Cohen is Senior Associate Dean for Undergraduate and Masters’ Programs at
MIT Sloan School of Management and Senior Lecturer in Accounting and Law, where
he has been since 2012. In his role, he oversees strategy for eight programs. From
2003 to 2011, Jake was an Affiliate Professor of Accounting and Control at INSEAD
and was based in France and Singapore. He served as Director of the INSEADPricewaterhouseCoopers Research Center from 2004 to 2008 and as Dean of the
MBA Program from 2008 to 2011.
He teaches courses in financial and managerial accounting, financial statements
analysis, mergers and acquisitions, corporate restructuring, and business law. Cohen
is a recipient of Outstanding Teaching Awards from the INSEAD MBA for both core
and elective courses.
Prior to joining INSEAD, Cohen was a Senior Teaching Fellow in the Accounting and
Control group at the Harvard Business School, where he was a founding member of
the MBA Analytics Program. Prior to teaching at Harvard, he taught at Syracuse
University as an assistant professor and was named “Professor of the Year.”
Jake Cohen received a Bachelor of Science degree in accounting from Lehigh
University, where he graduated with honors, a Master of Science degree in
accounting, and a Juris Doctor degree in law from Syracuse University.
Prior to his academic career, he worked as a tax accountant at KPMG LLP in
Philadelphia and as a mergers and acquisition consultant for
PricewaterhouseCoopers LLP in New York City.
Daniel Bens is a Professor at INSEAD, currently serving as the Chair of the
Accounting and Control area. Previously, he was a faculty at the University of Arizona
serving as Associate Dean of MBA programs. Prior to that he was a faculty at the
University of Chicago, Booth School of Business from 1999 to 2005.
Professor Bens received his PhD from the Wharton School at the University of
Pennsylvania, his MBA from Indiana University, and his BS from Penn State
University. He was a licensed Certified Public Accountant (CPA) in Pennsylvania,
working for Price Waterhouse and then Westinghouse prior to graduate school.
He has taught in full-time, evening, and executive MBA programs, as well as nondegree executive education programs throughout his career. His teaching has
received special recognition at INSEAD in 2014 and 2015, and at the University of
Arizona with awards in 2011 and 2007. His research has been cited or he has been
quoted in Fortune, Business Week, and various newspapers via the Associated Press
and Reuters news services. His research has appeared in the leading academic
journals including Accounting Horizons, The Accounting Review, Contemporary
Accounting Research, Journal of Accounting, Auditing & Finance, Journal of Accounting and
Economics, and Journal of Accounting Research.
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1
An Introduction to Financial Statements
Imagine that you’re a banker, and you have to determine which companies to lend to
and on what terms. Or you’re an investor who wants to know which companies are
likely to outperform the market averages over the next year or two. In short, where
should you invest your capital? To answer this question, investors turn to corporate
financial statements.
Financial statements exist to provide useful information on businesses to people who
have, or may have, an economic stake in those businesses. These statements should
help:
investors, to make more intelligent decisions on where to put their scarce capital;
bankers, to determine whether or not a company will be able to service its debts;
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suppliers, to assess whether or not a potential customer is a good credit risk;
customers, to determine whether or not the company is strong enough financially
to deliver on long‐term promises of service and warranty coverage;
tax authorities, to determine whether or not a company is paying its fair share of
taxes;
trade union representatives, in forming their negotiating positions with
management;
competitors, to benchmark their performance;
courts of law, to measure, for example, the damage caused by one firm to another
as a result of alleged unfair trade practices;
antitrust regulators, to measure market share and profits relative to competitors;
prospective employees, to determine whether the company is worth pursuing as a
long‐term employer.
You may notice one important constituency missing from this list of financial
statement users: corporate management. Financial statements are the responsibility
of management, but are not designed to meet their own informational needs.
Financial statements are a means for company managers to communicate the
financial strength and profitability of their businesses to investors and other groups,
but are not really intended for internal management use. To understand why, let’s
take a brief look at the financial statements (shown in Exhibits 1.1–1.3) of Taiwan
Semiconductor Manufacturing Company (TSMC), one of the world’s largest
manufacturers of integrated circuits and semiconductors. Based in Taiwan, they
supply components for a variety of consumer and industrial electronic devices.
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EXHIBIT 1-1
TSMC Consolidated Balance Sheet (in NT$ millions)
December 31
2016
2015
Cash and equivalents
541,254
562,689
Financial assets
94,957
27,779
Notes and accounts receivable, net
128,335
85,060
Inventories
48,682
67,052
Other
4,502
4,164
817,730
746,744
Financial assets
26,411
10,902
Investments accounted for using the equity method
19,585
23,971
CURRENT ASSETS
Total current assets
NONCURRENT ASSETS
997,778 853,470
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Property, Plant and Equipment
Intangible assets
14,615
14,066
Deferred income tax assets
8,271
6,385
Other
1,908
1,860
Total noncurrent assets
1,068,568
910,654
TOTAL ASSETS
1,886,298 1,657,398
CURRENT LIABILITIES
Short term loans and financial liabilities
58,149
39,547
Accounts payable
26,062
18,575
Salaries, bonus, and profit sharing payables
36,576
32,661
Payables to contractors and suppliers
63,155
26,012
Income tax payable
70,353
60,445
Provisions
18,038
10,164
Long‐term liabilities ‐ current portion
38,110
23,518
Accrued expenses and other
37,844
28,851
December 31
2016
2015
348,287
239,773
153,116
191,998
Deferred income tax liabilities
141
31
Net defined benefit liability
8,551
7,448
Guarantee deposits
14,670
21,565
Other
1,687
1,613
Total Noncurrent Liabilities
178,165
222,655
TOTAL LIABILITIES
526,452
462,428
Capital stock
259,304
259,304
Capital surplus
56,272
56,300
1,041,811
866,630
1,664
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Noncontrolling interests
795
11,774
Total Current Liabilities
NONCURRENT LIABILITIES
Bonds payable and long term bank loans
SHAREHOLDERS’ EQUITY
Retained earnings
Other
962
TOTAL SHAREHOLDERS’ EQUITY
1,359,846 1,194,970
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
1,886,298 1,657,398
The accompanying notes are an integral part of these consolidated financial statements.
The three principal financial statements – the balance sheet, the income statement,
and the statement of cash flows – are highly aggregated documents: masses of detail
accumulated in a small number of line items. Without this aggregation, the
statements would be unreadable; however, a lot of details are missing. While this lack
of detail might be appropriate for potential investors, who have to compare financial
data across many different companies, the information found in these financial
statements is not sufficiently detailed to be of any practical use to managers in
corporate decision‐making.
This is not to say that managers shouldn’t care about the financial statements.
Managers must understand their financial statements because these are the most
important sources of information used by the investing community to determine
where to invest capital. Managers who don’t understand the signals that their
financial statements are sending to investors are not in a position to compete
effectively in the global capital markets. However, internal decision‐making and
management control require data that are far more detailed (by product line, region,
cost categories, etc.) than the data found in annual reports.
In addition, financial statements are mainly historical. The balance sheet reflects the
financial position at a precise moment in the recent past. The income statement
shows profits over a period of time in the recent past – for example, the year just
completed. Similarly, the statement of cash flows reports on the sources and uses of
cash over a period of time already past. But while appreciating the insights of these
statements is critical to managers in understanding their business and its
competitiveness in the capital markets, they need information systems that are
forward‐looking in nature. Managers plan, budget, and forecast – and they therefore
need systems that help them to perform these critical functions.
Another problem with financial accounting from a management perspective is that
accounting rules that are designed to measure costs or value assets can result in
misleading figures, even when calculated in good faith by managers. For example,
when a manufacturing company measures the cost of its inventory, it must include
not only direct costs of production, such as labor and materials, but also
manufacturing overhead (such as depreciation on equipment, power and electricity,
and maintenance costs). In contrast with direct costs, overhead cannot be directly
traced to individual units of production. Instead, they are assigned to individual
products (and to inventory accounts) using an arbitrary allocation technique. The
resulting inventory figures may be acceptable for the broad overview that an investor
wants from the financial statements, but can be seriously misleading if management
intends to use them to calculate product‐line profitability, to set pricing policy, or to
make product‐mix decisions. In short, managers need cost‐accounting systems that
provide more detailed, and more accurate, costing data.
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The Three Principal Financial Statements
The corporate financial reporting process focuses on the three principal financial
statements – the balance sheet, the income statement, and the statement of cash
flows.
The Balance Sheet1
Take glance at TSMC’s balance sheet (Exhibit 1.1). One of the first things you should
notice is that the balance sheet reports on the company’s financial position at a
moment in time, in this case the end of 2015 and 2016. In other words, it’s a
snapshot, taken at the end of each period, of the assets owned by the company and
the financing for those assets. Assets are economic resources with the ability or
potential to provide future benefits to a business, such as profits or cash flow.
The financing of assets occurs in two basic forms: liabilities and shareholders’ equity.
Liabilities are the company’s debts or obligations. They are the claims on the assets
held by a firm’s creditors. Shareholders’ equity shows the amount of financing
provided by owners of the business, both in the form of direct investment (when
shareholders contribute cash in exchange for shares) and indirect investment (when
profits are reinvested in the firm).
The organization of the balance sheet can thus be summarized like this:
The term “balance sheet” is derived from this equation. It simply reminds us that the
right side and the left side must always equal, for all companies, in all industries, in
all countries, without exception. Simply put, the balance sheet must balance. The
reason why this is can be seen from the right side of the equation. Liabilities and
shareholders’ equity don’t just represent financing, they also represent claims on the
assets from the left side. In the event of liquidation (i.e., when a company goes out of
business), the first claim on resources belongs to creditors. The claims held by
shareholders are residual in nature, which means that they are entitled to whatever
is left over after the creditors have been paid off. Because shareholders’ equity
represents a residual claim on the assets, it will be whatever size it needs to be in
order to ensure that the two sides of the balance sheet are equal.
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TSMC’s balance sheet confirms this equality. Total assets at the end of 2016 of
NT$1,886 billion equal the sum of liabilities, NT$526 billion, and shareholders’ equity,
NT$1,360 billion.
The Income Statement
The income statement reports on a company’s profits, or revenues less expenses,
during the accounting period. Unlike the balance sheet, it’s not a snapshot, but
rather reflects what a firm has accomplished over a period of time. In the case of
TSMC, the income statement (Exhibit 1.2) reports on the company’s performance for
the years 2014, 2015, and 2016. Notice that the accounting year (sometimes called
the “fiscal year”) is the same as the calendar year (1 January–31 December). This is
not required, however. For example, most major retailers in the United States have
accounting years that end between late January and the end of March. This is done to
avoid having to close the books and prepare financial statements at the busiest time
of the year.
EXHIBIT 1-2
TSMC Consolidated Income Statements (in
NT$ millions)
Year Ended December 31
2016
2015
2014
Revenue
947,938 843,497 762,807
Cost of revenue
473,106 433,103 385,084
Gross profit
474,832 410,394 377,723
Research and deve
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lopment
71,208
65,546
56,829
General and administrative
19,796
17,257
18,933
Marketing
5,901
5,665
5,087
(30)
1,881
1,002
Other operating expenses (income)
Income from operations
377,957 320,045 295,872
Share of profits of associates and joint ventures
3,458
4,196
3,920
Finance costs
(3,306) (3,190) (3,236)
Foreign exchange gain
1,161
2,481
2,111
Other income
6,651
26,943
3,408
Income before income tax
385,921 350,475 302,075
Income tax expense
54,124
Net income
331,797 302,830 254,185
47,645
47,890
The accompanying notes are an integral part of these consolidated financial statements.
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The top line of the income statement, revenues (also called “sales” or “sales
revenues”), represents the monetary value of goods or services sold to customers.
Expenses represent the cost of resources used by the company to earn revenues
during the period.
Profit (also known as “earnings” or “income”) is shown in several ways on an income
statement. For example, gross profit, sometimes called “gross margin,” measures
revenues, net of manufacturing costs. For a nonmanufacturing company, such as a
retailer or distributor, gross profit equals revenues net of the cost of merchandise
sold during the year.
Operating income equals sales net of all operating expenses, excluding taxes. It
measures how well the company has done in a given period from its normal,
recurring, day‐to‐day activities of producing and selling its products. For TSMC,
gross profit and operating income in 2016 were NT$475 billion and NT$378 billion,
respectively.
When taxes and the nonoperating sources of income and expense are added or
subtracted from operating income, as appropriate, the result is net income, the
“bottom line” of the income statement. For 2016, TSMC reports net income of
NT$332 billion. Note that companies have discretion in how they categorize these
costs. This discretion, otherwise known as accounting choice, is a theme we will
return to throughout the book. In the case of TSMC, there are significant income
items listed as “nonoperating” that might be classified as operating by other
companies. Such choices can have significant effects. In this case, for example,
TSMC’s nonoperating income was nearly 10% of income before tax in 2015.
The Statement of Cash Flows
The statement of cash flows summarizes the inflows and outflows of cash that arise
from the three primary activities of a typical business: operations, investing, and
financing. For TSMC, operating activities refer mainly (but not exclusively) to the
routine, recurring actions involved in the design, manufacture, and distribution of
semiconductors and integrated circuits. Investing activities involve the buying and
selling of long‐term assets such as machinery and equipment, companies or parts of
companies, and financial securities such as government bonds. Financing activities
refer mainly to actions involving the capital markets such as borrowing, paying off
loans, issuing shares, share buybacks, and the payment of dividends.
The statement is structured in such a way that the net cash flows during the period
for all three activities must equal the change in cash. In other words, the net cash
flows from operating, investing, and financing activities must equal the net increase
or decrease in the cash balance for the year. You can easily confirm this
reconciliation in TSMC’s statement of cash flows.
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What makes this statement so interesting is not just that it summarizes cash flows,
and in so doing reconciles beginning and ending cash, but that it also reveals the sort
of activities that gave rise to those cash flows. In short, the statement reveals where a
company’s cash came from during the year, and what the company did with it.
For example, TSMC’s statement of cash flows (Exhibit 1.3) shows operating cash flow
of nearly NT$540 billion in 2016. Much of this cash generated from TSMC’s day‐to‐
day operations was reinvested in the company. We know this is true because of the
negative cash flows from investing activities (shown in parentheses). Of those
investments, most (NT$329 billion) was committed to property, plant, and
equipment. From the financing section, we see that TSMC returned significant
amounts of cash to its shareholders in the form of dividends (NT$155.5 billion in
2016).
EXHIBIT 1-3
TSMC Consolidated Statements of Cash Flows (in NT$ millions)
Year Ended December 31
2016
2015
2014
385,921
350,475
302,075
Depreciation expense
220,085
219,303
197,645
Amortization expense
3,743
3,202
2,606
Finance costs
3,306
3,190
3,236
Share of profits of associates and joint venture
(3,458)
(4,196)
(3,920)
Interest income
(6,318)
(4,129)
(2,731)
(47)
(434)
(15)
TFord53@my.gcu.edu 122
2,759
1,187
(2,707)
(19,585)
3,742
325
(2,369)
(2,084)
(137)
(622)
(650)
(6,368)
492
(2,269)
Notes and accounts receivable, net
(49,828)
26,491
(43,128)
Inventories
18,370
(655)
(28,872)
Other assets
(251)
265
(743)
Accounts payable
7,295
(2,693)
6,634
Accrued expenses and other current liabilities
3,833
(4,147)
8,238
Salary, bonus and profit sharing payables
3,913
3,805
7,595
Provisions
7,932
(383)
2,837
46
53
60
Cash flows from operating activities
Income before income tax
Adjustments for:
Gain on disposal of property, plant and
equipment, net
Asset impairments
Loss (gain) on financial assets
Loss (gain) on disposal of equity method
investments and subsidiaries
Dividend income
Changes in operating assets and liabilities:
Financial instruments at fair value through profit
and loss, and other financial assets
Net defined benefit liability
Year Ended December 31
2016
2015
2014
Cash generated from operations
585,778
570,822
451,442
Income taxes paid
(45,943)
(40,943)
(29,918)
539,835
529,879
421,524
Financial assets
(117,435)
(44,656)
(6,518)
Property, plant and equipment
(328,851) (257,517) (288,540)
Net cash generated by operating activities
Cash flows from investing activities
Acquisitions of:
Intangible assets
(4,243)
(4,284)
(3,860)
40,753
74,665
4,139
Investments accounted for using equity method
0
5,172
3,472
Property, plant and equipment
98
817
200
6,353
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Proceeds from government grants
1,537
3,642
2,579
0
0
0
549
0
5,479
3,407
3,223
Other dividends received
137
617
646
Refundable deposits refunded (paid)
732
342
2,239
Proceeds from disposal or redemption of:
Financial assets
Interest received
Net cash flow from disposal and acquisition of
subsidiaries
Dividends received from investments using equity
method
Net cash used in investing activities
(395,440) (217,246) (282,421)
Cash flows from financing activities
Increase in short‐term loans
18,969
3,139
18,564
(23,480)
(29)
(28)
Interest paid
(3,302)
(3,156)
(3,193)
Guarantee deposits received net refunds
5,831
12
30,135
Repayment of bonds, long‐term bank loans, and
finance leases
Year Ended December 31
2016
Cash dividends
2015
2014
(155,582) (116,684)
(77,786)
Proceeds from exercise of stock options
0
34
47
(236)
(50)
(67)
(157,800) (116,734)
(32,328)
Decrease in noncontrolling interests
Net cash used in financing activities
Effect of exchange rates on cash and equivalents
(8,030)
8,259
9,060
Net increase (decrease) in cash and equivalents
(21,435)
204,158
115,836
0
82
0
Cash and equivalents beginning of year
562,689
358,449
242,695
Cash and equivalents end of year
541,254
562,689
358,531
Cash and cash equivalents included in other
noncurrent assets
0
0
(82)
Cash and equivalents per the balance sheet
541,254
562,689
358,449
Cash and cash equivalents included in other
noncurrent assets, beginning of year
The accompanying notes are an integral part of these consolidated financial statements.
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How the Financial Statements Relate to Each Other
Although each statement is a separate, discrete entity, it is also linked with the other
two. For example, the net income from the income statement (e.g., NT$332 billion in
2016 for TSMC Group) is reflected in both retained earnings (from the shareholders’
equity section of the balance sheet) and in the operations section of the statement of
cash flows. Also, the net cash flows from the statement of cash flows (see final line)
plus beginning cash (on the balance sheet) must equal ending cash. These
relationships should come as no surprise because, logically, we would expect a
company’s performance, as reflected in its income statement, to influence its cash
flows, and for both profit and cash flows to influence its financial position (i.e., the
balance sheet).
To illustrate these relationships, let’s take another look at TSMC’s financial
statements. Net income in 2016 was NT$332 billion. As revealed in the statement of
cash flows, the company paid NT$156 billion in dividends that year. Retained
earnings (on the balance sheet in the shareholders’ equity section) represent all of
the net income a company has ever earned in its history that has not yet been paid
to shareholders as a dividend. In other words, it measures all of the profits retained
by the business for reinvestment. We would expect retained earnings to change each
year by an amount equal to the year’s net income, less any dividends paid in that
year. In the case of Taiwan Semiconductor, we should see an increase of NT$332
billion minus NT$156 billion, or NT$176 billion. And that is very close to the amount
by which the company’s retained earnings increased from the end of 2015 to the end
of 2016 NT$1,042 billion ‐ NT$867 billion, i.e., NT$175 billion.
Note also that cash flows from operating, investing and financing activities (plus
effect of foreign exchange rates on cash and cash equivalent in 2016, i.e., ‐NT$8
billion) result in a net decrease in cash of NT$21 billion, which is equal to the
difference between the cash balance at the end of 2016 (NT$541 billion) at the end of
2015 (NT$562 billion).
Other Items in the Annual Report
As mentioned earlier, the balance sheet, income statement, and statement of cash
flows are highly condensed. For this reason, firms are required to provide
supplemental information in the form of supporting schedules and notes. An opinion
on the accuracy of the financial statements from a firm of independent public
accountants must also be furnished. Depending on its country of origin, a company
may also include a “management discussion and analysis” of recent performance and
future prospects.
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The Statement of Changes in Shareholders’ Equity
There is, in fact, a fourth financial statement presented in many annual reports,
although it functions more like a supporting schedule, and thus is not usually
accorded the same status as the other three. This schedule, called the statement of
changes in shareholders’ equity (although it sometimes goes under different names),
explains changes to all accounts in the shareholders’ equity section of the balance
sheet.
The Notes
In addition to the principal financial statements, companies must also provide
extensive supplemental disclosures known as “notes” or “footnotes.” You will see
these at the back of any annual report. The importance of these notes can be seen
from the statement at the bottom of each of TSMC’s financial statements: “The
accompanying notes are an integral part of the consolidated financial statements.”
This reminds us that the financial statements cannot be fully understood without
reading the notes. In fact, the term “footnotes” is somewhat misleading, though
widely used, because it may lead you to think that they serve the same function as
footnotes in a book. This is not true because footnotes in the annual report are an
indispensable part of the story. The story doesn’t really hold together without them.
Most notes fall into either of two categories:
The first type describes the accounting policies used by the company to prepare
its financial statements. For example, the first note in most annual reports is a
summary of key accounting principles and policies.
The second type of note presents additional, clarifying detail about one or more
financial statement line items. Examples of this type include notes that elaborate
on debt balances, investments, pensions, and taxes. Companies are also expected
to provide financial details on major business segments either broken down by
industry or geography. TSMC reports that it operates in a single industry segment
that includes integrated circuits and semiconductors. However, in its segment
note, TSMC breaks down its revenues by geographic region. In 2016, the United
States accounted for 64% of its revenues, followed by Asia excluding Taiwan
(15%), Taiwan (13%), and the rest of the world (8%). Interestingly, in the same
segment note, TSMC reveals that its two largest customers account for 28% of its
sales in 2016. However, for competitive reasons, it does not identify these
customers by name.
The Auditor’s Opinion
Annual reports must include an opinion from an independent public accounting firm,
attesting to whether or not the financial statements were correctly prepared and can
therefore be relied on by investors and other parties in making decisions regarding
the business. The opinion shown in Exhibit 1.4 follows a standard format, with
occasional variations.
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EXHIBIT 1-4
Independent Auditor’s Report
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Taiwan Semiconductor Manufacturing Company Limited
We have audited the accompanying consolidated statements of financial position of
Taiwan Semiconductor Manufacturing Company Limited (a Republic of China
corporation) and subsidiaries (the “Company”) as of December 31, 2015 and 2016,
and the related consolidated statements of profit or loss and other comprehensive
income, changes in equity, and cash flows for each of the three years in the period
ended December 31, 2016 (all expressed in New Taiwan dollars). These financial
statements are the responsibility of the Company’s management. Our responsibility
is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
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In our opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of Taiwan Semiconductor Manufacturing Company
Limited and subsidiaries as of December 31, 2015 and 2016, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2016, in conformity with International Financial Reporting Standards
as issued by the International Accounting Standards Board.
Our audits also comprehended the translation of New Taiwan dollar amounts into
U.S. dollar amounts and, in our opinion, such translation has been made in
conformity with the basis stated in Note 3 to the consolidated financial statements.
Such U.S. dollar amounts are presented solely for the convenience of the readers
outside the Republic of China.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the Company’s internal control over
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
financial reporting as of December 31, 2016, based on the criteria established in
Internal Control — Integrated Framework (2013) issued by the Committee of
Sponsoring Organizations of the Treadway Commission and our report dated April
13, 2017 expressed an unqualified opinion on the Company’s internal control over
financial reporting.
/s/ Deloitte & Touche
Taipei, Taiwan
The Republic of China
April 13, 2017
The first paragraph indicates the scope of the opinion and also states that the
responsibility for the financial statements rests with management. This responsibility
has been reinforced by legislation in the United States (known as Sarbanes–Oxley)
that requires chief executive officers and chief financial officers to certify, under oath,
the truthfulness of their companies’ financial statements. This means that while
auditors attest to the reliability of the accounts, the ultimate responsibility rests with
senior managers.2 TSMC produces a similar declaration, signed by the two co‐CEOs
and the CFO that includes, among other language, the following:
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Based on my knowledge, the financial statements, and other financial information
included in this report, fairly present in all material respects the financial condition,
results of operations and cash flows of the company as of, and for, the periods
presented in this report.
The second paragraph affirms that the auditor followed generally accepted auditing
principles. In other words, the audit was conducted according to the standards of the
auditing profession. In the case of TSMC, because its shares are traded on the New
York Stock Exchange, they state that they followed auditing standards from the
United States. The auditor then expresses the opinion in the third paragraph. It is
here that the auditor states that the financial statements “present fairly in all material
respects” the company’s financial position, and results of operations for each of the
years presented in the annual report. Audit standards outside the United States
often use the terminology that the financial statements provide a “true and fair view”
of the company.
Most opinions are unqualified, or “clean,” which means that there are no exceptions,
reservations, or qualifications. In effect, the auditor is telling you, the reader, that the
financial statements can be trusted in making investment and other decisions related
to this business. But while the overwhelming majority of audit opinions are clean,
there are some exceptions.
A qualified opinion may arise because of serious uncertainties regarding the
realization or valuation of assets (which can sometimes occur when companies are
financially distressed), outstanding litigation, or tax liabilities that might compromise
the firm’s financial health. Inconsistencies between periods caused by changes in
accounting rules or policy can also result in a qualified opinion.
An auditor may also disclaim an opinion (i.e., issue no opinion at all) or even issue an
adverse opinion. Disclaimers may arise, for example, because of pending bankruptcy.
The uncertainties regarding the truthfulness of financial statement numbers are so
profound, the auditor is reluctant to issue any opinion on the financial statements.
This happened to Parmalat, the Italian dairy company, after it was embroiled in a
massive financial scandal. Adverse opinions are rare, because an auditor is likely to
resign or be fired by a client before an adverse opinion would ever appear in a
published annual report. The opinion provided by TSMC’s auditor was indeed “clean”
and thus fairly limited in content. This “boilerplate” approach to audit opinions has
long been criticized as being too generic and not alerting users to the more
subjective parts of the financial statements. Recently, global audit standards have
been changed that compel the auditor to state the items in the financial statements
that required more of their attention and how they designed procedures to reach
their conclusion. In the United States (which governs TSMC’s audits), the changes
take effect in 2019, while in the United Kingdom and Ireland, they have been in effect
since 2013; in much of the rest of the world, these changes took effect in 2016.
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Management Discussion and Analysis
Most annual reports include a management discussion and analysis section, often
called the MD&A or “review of operations”. This section is an extended letter from the
firm’s management that summarizes the significant factors affecting the firm’s
operating results, financial strength, and cash flows for the past three years. It also
contains an extensive discussion of business risks and forward‐looking statements
regarding the company’s expectations for future operations, earnings, and prospects.
The review in TSMC’s 2016 financial statements consists of detailed explanations for
the company’s performance and financial condition, with emphasis on changes from
the previous year. Important events from 2016 are also discussed, including
acquisitions and product development. Management contrasts financial figures from
2016 with 2015, explaining why these numbers improved or worsened. For example,
management reveals that of the 12.4% growth in revenue, 9.6% is due to increased
product shipments while the remainder is largely due to the depreciation of the NT$
against the currencies in which it sells its semiconductors. It also discusses the
specific product where volumes increased the most (i.e., the “12‐inch equivalent
wafer”). Considerable attention is also given to liquidity, which is defined here as the
ability of the company to obtain the cash resources it needs for growth and debt
repayment.
Generally Accepted Accounting Principles: The Rules of the Game
When auditors declare that financial statements “present fairly” a company’s financial
condition, profitability, and cash flows, what they really mean is that the statements
were prepared in accordance with Generally Accepted Accounting Principles
(hereafter, GAAP). GAAP comprises the rules and principles that guide managers in
the preparation of their companies’ accounts. These rules provide the filter through
which potentially millions of data points pass to produce the highly summarized
financial statements we see in corporate annual reports.
GAAP sets the “rules of the game” under which financial statements are prepared.
When these rules are implemented in good faith, the chances are high, though far
from assured, that the resulting financial statements can be relied on by users to
make important economic decisions regarding the business.
Here, we focus on two GAAP regimes: the one that prevails in the United States,
otherwise known as US GAAP, and International Financial Reporting Standards (IFRS).
Although many other accounting regimes exist around the world, capital markets
have come to be dominated by these two approaches. Important differences exist
between the two, but their primary objectives are the same. Moreover, there was a
serious ongoing effort at convergence that would have led to a single set of global
financial accounting standards. But as of this writing, that effort has stalled, meaning
that for the foreseeable future, we are left with two dominant regimes instead of
one.
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US GAAP comes from a variety of sources, but the dominant player is the Financial
Accounting Standards Board (FASB), based in Norwalk, Connecticut. The FASB is a
private‐sector body that is tasked with determining the appropriate financial
reporting responses to an ever‐changing business climate. Its official
pronouncements are called “Financial Accounting Standards.” In some cases, these
standards are supplemented by “Interpretations” that augment or clarify key aspects
of the standards.
IFRS is the product of the International Accounting Standards Boards (IASB), based in
London. Since 2005, compliance with IFRS has been required for all publicly traded
companies based in the European Union. It is also widely used in Asia. Today, 135
countries either require or allow the use of IFRS.
The Barriers to Understanding Financial Statements
Businesses can be complex, and if annual reports are to capture economic reality,
they too must be complex. Analyzing and interpreting financial statements can be
highly rewarding for readers who take the time to understand this complexity and
the nature of the problems they are likely to encounter. The following discussion
introduces the major barriers you can expect to face in trying to make sense of
corporate financial reports.
The Volume of Data
The most obvious problem encountered by the reader of financial statements is the
sheer volume of information available, especially for businesses traded on a major
stock exchange. In addition to the principal financial statements, footnotes,
management discussion and analysis, and auditors’ reports, there are also financial
filings with stock exchange and regulatory authorities (such as the Securities and
Exchange Commission in the United States). The result can be a veritable mountain
of information. Although capital markets run on information, the risk is that a reader
can be easily overwhelmed.
A variety of analytical tools, such as financial statement ratios, exist to help readers
overcome this problem. These tools are discussed in detail in later chapters.
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Accounting Choice
Although GAAP and IFRS prescribe a set of rules and guidelines for preparing
financial statements, they also afford corporate executives a broad range of choice.
From the viewpoint of the financial statement reader, accounting choice adds greatly
to the complexity of the task at hand. To some extent, this choice is a logical outcome
of the diversity we observe in the business world. What might be an appropriate
accounting treatment for a steel company might not be appropriate for a
biotechnology firm or an Internet service provider. GAAP/IFRS must be flexible
enough to accommodate all sorts of businesses and all types of business models. But
even within the same industry, significant differences across companies in their
accounting policies are often observed. For example, Coca‐Cola’s approach to
translating the financial statements of its foreign subsidiaries into US dollars is
different from that of PepsiCo, its major industry competitor.
To get a flavor for the nature of accounting choice, consider the following example. A
machine with an expected, but still uncertain, life of five years is purchased for
$500,000. For long‐term assets like this, we must decide on a depreciation method.
Depreciation is the process by which the cost of an asset is allocated to the future
periods that will benefit from its use. The most common method is called “straight‐
line.” Under this approach, each of the next five years (the periods expected to
benefit from the use of the asset) will be assigned $100,000 of depreciation
($500,000 ÷ 5). This means that in the first year, the income statement will include
$100,000 of depreciation expense. The balance sheet will show machinery with a net
book value of $400,000 at the end of the year, the acquisition cost net of the
depreciation charge.
But suppose we elect to use another depreciation method, as GAAP and IFRS allow
us to do. For example, we may choose the “double‐declining balance” method, in
which depreciation is charged to the income statement in an accelerated fashion.
Under this approach, we take the straight‐line rate of 20% (the annual rate of
depreciation on the asset) and multiply it by 2. The resulting figure, 40%, is then
multiplied by the net book value of the asset at the beginning of each year to
determine that year’s depreciation expense. This means that depreciation in the first
year is $200,000, instead of the $100,000 recognized under the straight‐line method.
Therefore, as a result of choosing double declining balance, depreciation expense in
the first year would be $100,000 higher, and operating income $100,000 lower. In
addition, the net book value of the asset at the end of the first year would be
$300,000, instead of $400,000.
What this example shows is that the simple choice of one depreciation method over
another can have a profound impact on both the balance sheet and the income
statement. Which set of numbers is better? It’s hard to say. Under some conditions,
the straight‐line approach may be better, but under other conditions it might not be.
What’s important to recognize is that both methods are allowed. Indeed, other
methods are allowed too. Now imagine having to decide how all of the company’s
long‐term assets are to be depreciated. Further, note that the useful lives are not
known with certainty, and thus are another management estimate (five years in the
example above). Also, management must assess if it will sell the asset when it is done
using it (say a new airplane by a premium airline that is eventually sold to a low cost
airline). In this case management estimates a “salvage value” and does not depreciate
the asset below this amount. Now imagine the range of choices offered to corporate
executives in how they measure other balance sheet items – or how they measure
any transaction that arises in the normal course of their business.
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Quite simply, differences in accounting choice can yield huge differences in financial
statement numbers. One of the ways that a reader copes with this challenge is by
carefully scrutinizing the notes to the financial statements.
In most annual reports, the first note summarizes the significant principles and
policies chosen by the company’s managers, helping the reader to understand the
context under which the financial statements were prepared and key transactions
measured. These disclosures allow analysts and other interested parties to compare
a company’s accounting policies with industry competitors and to make judgments
on the quality of the numbers produced in the annual report.
Earnings Management
Accounting choice doesn’t just make financial statements more complicated. It also
provides a powerful weapon for managers who wish to mislead the capital markets,
for whatever motive. Accounting policy requires judgment, and whenever there is
scope for judgment, there is also scope for manipulation.
“Earnings management” is the term commonly used to describe efforts by corporate
managers to distort or bias their companies’ reported results. “Creative accounting”
is also used. Both terms imply a conscious effort by managers to mislead readers of
financial statements.
Although the opportunities for earnings management are practically limitless, the
most serious efforts fall into either of two categories: faulty revenue recognition, and
the improper recognition of losses and expenses. The Enron fiasco brought to light
another area prone to mischief: off‐balance‐sheet financing. This accounting game
also featured prominently in the global financial meltdown of 2008.
Incompleteness
TSMC was one of the world’s first large‐scale manufacturers that specialized in only
making semiconductors. As a consumer, you may not have the awareness of their
branded products. Yet equipment manufacturers, such as Apple, and other
semiconductor companies, such as Intel, certainly are. These companies are two
customers of TSMC. But while their products and customer relationships obviously
carry great value for TSMC, you won’t see them in the company’s balance sheet. This
fact may seem odd given that these products and customers may be the most
valuable resources the company has.
TFord53@my.gcu.edu
The above example shows that important attributes of a business, attributes with
potentially profound effects on financial performance, may not always find their way
into corporate balance sheets, at least not directly.
Reliability is a key characteristic of financial statements. To be reliable, financial
statements should be verifiable: auditors must be able to check the numbers to
ensure an acceptable degree of accuracy. This is not to say that all numbers have to
be perfectly accurate; such a standard is not feasible. But it does require at least
some degree of objectivity, otherwise there is little for the auditors to observe and
verify. In the example of TSMC, the company’s products are well known by the
electronics companies it sells to, and it has a significant market share. Yet such brand
recognition will not be reported as an asset ‐ unless it has been purchased via the
acquisition of an entire company or an individual product line. In other words,
intangibles acquired from other companies are included, but internally generated
intangibles are not.
Sophisticated readers of financial statements are fully aware of this inconsistency,
and of the need to cast a wide net when gathering information about a company. In
short, they understand that not everything you need to know about a company in
order to value its shares or to assess its creditworthiness is revealed in the accounts.
KEY LESSONS FROM THE CHAPTER
There are many users of financial statements including: investors, bankers,
suppliers, customers, tax authorities, trade unions, competitors, courts of law,
government regulators, and prospective employees. Capital providers (i.e.,
shareholders, bankers, bondholders, and prospective investors) are arguably the
most important constituencies.
Although financial accounting is not targeted to the needs of corporate managers
per se, financial statements are the outside world’s “window” on the company.
Therefore, managers need to know what signals are being sent to investors about
their companies and how those signals are interpreted. Otherwise, their
companies will be at a competitive disadvantage in the global capital markets.
The notes at the back of the annual report complement the three principal
financial statements – the balance sheet, the income statement, and the
statement of cash flows – and provide extensive supplemental disclosures. The
notes describe the accounting policies used by the company and present
additional clarifying detail about financial statement line items.
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Annual reports must include an opinion from an independent public accounting
firm, attesting to whether or not the financial statements were correctly prepared.
US companies prepare their financial statements in accordance with Generally
Accepted Accounting Principles (GAAP). GAAP sets the “rules of the game” under
which financial statements are prepared. Most non‐US companies prepare their
financial statements in accordance with International Financial Reporting
Standards (IFRS).
A serious effort to achieve convergence between US GAAP and IFRS made some
progress, but has recently. Convergence between the two financial reporting
regimes is not imminent.
KEY TERMS AND CONCEPTS FROM THE CHAPTER
Investors
Creditors
Balance sheet
Income statement
Statement of cash flows
Shareholders’ equity
Notes to the financial statements
Audit opinions
Management discussion and analysis
Generally Accepted Accounting Principles (GAAP)
International Financial Reporting Standards (IFRS)
Earnings management
QUESTIONS
1. The balance sheet (or statement of financial position) is often referred to as a
“snapshot.” Why?
2. If the balance sheet is a snapshot, how would you describe the income statement
and the statement of cash flows?
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3. Why must the statement of financial position (i.e., the balance sheet) balance?
4. What is the purpose of the auditor’s opinion?
5. What is Sarbanes–Oxley, and how has it affected corporate financial reporting?
6. Describe the limitations of the financial reporting process.
7. Financial accounting = Economic truth + error + manipulation. Explain.
8. Can you think of instances in which the creation of bias or error in the financial
statements might be justified?
9. Describe how the three principal financial statements are linked.
10. What role is played by the notes in the financial reporting process?
11. What is the primary purpose of the statement of changes in shareholders’ equity?
12. What is meant by the term “accounting choice,” and why is the concept so
important in financial accounting?
13. What is meant by the term “earnings management?”
PROBLEMS
1.1 Balance Sheet Terminology
Below is the statement of financial position (balance sheet) for the global brewing
company, AB InBev. Identify the major differences in format and terminology
between this balance sheet and the one introduced in this chapter for TSMC.
TFord53@my.gcu.edu
Consolidated Statement of Financial Position
As at 31 December Million US dollar
2011
2010
Property, plant and equipment
16,022
15,893
Goodwill
51,302
52,493
Intangible assets
23,818
23,359
Investments in associates
6,696
7,295
Investment securities
244
243
Deferred tax assets
673
744
Employee benefits
10
13
1,339
1,700
Assets
Noncurrent assets
Trade and other receivables
100,04 101,745
Current assets
Investment securities
103
641
TFord53@my.gcu.edu 2,466
2,409
Inventories
Income tax receivable
312
366
Trade and other receivables
4,121
4,638
Cash and cash equivalents
5,320
4,511
1
32
12,323
12,597
Assets held for sale
Total assets
112,427 114,342
Equity and Liabilities
Equity
1,734
1,733
Issued capital
17,557
17,535
381
2,335
Reserves
17,820
13,656
Retained earnings
37,492
35,259
Equity attributable to equity holders of AB InBev
3,552
3,540
Noncontrolling interest
41,044
38,799
Noncurrent liabilities
34,598
41,961
Share premium
As at 31 December Million US dollar
2011
2010
Interest‐bearing loans and borrowings
3,440
2,746
Employee benefits
11,279
11,909
Deferred tax liabilities
1,548
2,295
874
912
51,739
59,823
Current liabilities
8
14
Bank overdrafts
5,559
2,919
449
478
13,337
12,071
241
238
Provisions
19,644
15,720
Total equity and liabilities
112,427 114,342
Trade and other payables
Provisions
Interest‐bearing loans and borrowings
Income tax payable
Trade and other payables
1.2 Understanding Balance Sheet Relationships
Stora Enso is a large pulp and paper company headquartered in Finland. The
company uses IFRS and reports its results in millions of euros (€). Compute the
missing balance sheet amounts for each of the three years.
TFord53@my.gcu.edu
2011
Current assets
2010
2009
€4,610 €4,494
?b
Noncurrent assets
?
8,543
?
Total liabilities
?
?
?
Total assets
?
? €11,593
Current liabilities
2,786
2,569
2,619
Noncurrent liabilities
4,253
?
?
Total shareholders’ equity
?
?
5,183
Share capital
?
3,150
?
3,301
?a
1,200
Total liabilities and shareholders’ equity 12,999
?
?
Retained earnings
a Net income for 2010 is €766 and dividends are €158.
b Current assets – Current liabilities = €1144.
1.3 Interpreting an Auditor’s Opinion
Excerpts are provided below from the auditor’s opinion in the 2011 Annual Report of
Creative Technology, Ltd., a Singapore‐based consumer electronics company.
Required
a. Describe the audit opinion rendered by PwC. Is this opinion “unqualified” or
“qualified?”
b. What is meant by the term “true and fair?”
c. What is the economic significance of this opinion for investors and other
interested parties?
d. In what ways does management’s responsibility for the financial statements differ
from that of the auditor’s?
We have audited the accompanying financial statements of Creative Technology Ltd.
(the “Company”) and its subsidiaries (the “Group”) … which comprise the consolidated
balance sheet of the Group and the balance sheet of the Company as at 30 June
2011, the consolidated statement of comprehensive income, the consolidated
statement of changes in equity and the consolidated statement of cash flows of the
Group for the financial year then ended, and a summary of significant accounting
policies and other explanatory information.
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Management’s responsibility for the financial statements
Management is responsible for the preparation of financial statements that give a
true and fair view in accordance with the provisions of the Singapore Companies Act
(the “Act”) and Singapore Financial Reporting Standards, and for devising and
maintaining a system of internal accounting controls sufficient to provide a
reasonable assurance that assets are safeguarded against loss from unauthorized
use or disposition, that transactions are properly authorized and that they are
recorded as necessary to permit the preparation of true and fair profit and loss
accounts and balance sheets and to maintain accountability of assets.
Auditor’s responsibility
Our responsibility is to express an opinion on these financial statements based on
our audit. We conducted our audit in accordance with Singapore Standards on
Auditing. Those Standards require that we comply with ethical requirements and
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts
and disclosures in the financial statements. The procedures selected depend on the
auditor’s judgment, including the assessment of the risks of material misstatement of
the financial statements, whether due to fraud or error. In making those risk
assessments, the auditor considers internal controls relevant to the entity’s
preparation of financial statements that give a true and fair view in order to design
audit procedures that are appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the entity’s internal controls. An
audit also includes evaluating the appropriateness of accounting policies used and
the reasonableness of accounting estimates made by management, as well as
evaluating the overall presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our audit opinion.
Opinion
In our opinion, the consolidated financial statements of the Group and the balance
sheet of the Company are properly drawn up in accordance with the provisions of
the Act and Singapore Financial Re
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porting Standards so as to give a true and fair view of the state of affairs of the Group
and of the Company as at 30 June 2011, and the results, changes in equity and cash
flows of the Group for the financial year ended on that date.
PricewaterhouseCoopers LLP
Public Accountants and Certified Public Accountants
Singapore
TFord53@my.gcu.edu
Case Study
1‐1 Apple: An Introduction to Financial Statement Analysis
Apple is a global leader in the computing industry, with an emphasis on personal
computing, mobile communication devices, and portable digital music players. It
designs, manufactures, and markets both hardware and software. At the time of
this writing (autumn 2012), Apple is the largest company in history in terms of
market capitalization (i.e., the market value of the company’s equity).
As recently as the late 1990s, however, Apple was perceived as mainly a niche
player in the personal computer business, where the emphasis was on
commoditized, low‐margin products. The return of Steve Jobs, ousted in the
1980s from the company he cofounded, is now legendary in corporate history.
He is credited for refocusing the company on the customer experience with
products that emphasize not only performance and technology, but also
aesthetics.
The excerpts from the company’s financial statements included in this case will
give you a summary view of recent financial performance. As you review these
disclosures, think about what information is excluded, and how the absence of
this information affects the reports’ ability to communicate the true value of
Apple.
TFord53@my.gcu.edu
Required
Balance sheet
a. What was the magnitude and direction of the change to total assets for 2010?
b. What was the magnitude and direction of the change to total liabilities for
2010?
c. What was the magnitude and direction of the change to total shareholders’
equity for 2010?
d. Verify that the sum of your answers to (b) and (c) equals your answer to (a).
e. What specific accounts explain most of the change to total assets?
f. Based on your own experience, think about what makes Apple a valuable
company. Does this “asset” that you’ve imagined appear on Apple’s balance
sheet? Are you satisfied that the balance sheet accurately reflects this value?
Why or why not?
Income statement (“consolidated statement of operations”)
a. What was the magnitude and direction of the change to net sales?
b. What was the magnitude and direction of the change to net income?
c. Do the changes above seem consistent with the changes in total assets you
calculated previously?
d. Based on your own experience, think about the various product lines that
generate these revenues (i.e., “sales”) for Apple. Do you see the revenue from
the individual product lines on the statement? Are you satisfied that the
income statement accurately reflects these revenues? Why or why not?
Statement of cash flows
a. What are the names of the three subsections that present the different
sources of cash flow for the year?
b. Note that net income is the first figure used in calculating cash generated by
operating activities. How does net income compare to cash generated by
operating activities?
c. What does Apple appear to be doing with the cash that it generates from its
day‐to‐day operations? (Hint: review investing activities.)
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d. Does Apple appear to have significant financing activities to report?
The auditor’s opinion
a. Describe Ernst & Young’s role as Apple’s external auditor?
b. How useful is this opinion in helping an investor to value Apple’s shares?
Apple’s financial statements: Consolidated statements of operations (in millions,
except share amounts which are reflected in thousands and per share amounts),
three years ended September 25, 2010
2010
2009
2008
Net sales
$65,225 $42,905 $37,491
Cost of sales
39,541
25,683
24,294
Gross margin
25,684
17,222
13,197
Research and development
1,782
1,333
1,109
Selling, general and administrative
5,517
4,149
3,761
Total operating expenses
7,299
5,482
4,870
Operating expenses
2010
2009
2008
18,385
11,740
8,327
155
326
620
Income before provision for income taxes
18,540
12,066
8,947
Provision for income taxes
4,527
3,831
2,828
$14,013
$8,235
$6,119
Basic
$15.41
$9.22
$6.94
Diluted
$15.15
$9.08
$6.78
Operating income
Other income and expense
Net income
Earnings per common share
Shares used in computing earnings per share
Basic
909,461 893,016 881,592
Diluted
924,712 907,005 902,139
Consolidated balance sheets (in millions, except share amounts)
September 25,
2010
Assets
September 26,
2009
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Current assets
Cash and cash equivalents
$11,261
$5,263
Short‐term marketable securities
14,359
18,201
respectively
5,510
3,361
Inventories
1,051
455
Deferred tax assets
1,636
1,135
Vendor nontrade receivables
4,414
1,696
Other current assets
3,447
1,444
Total current assets
41,678
31,555
Long‐term marketable securities
25,391
10,528
Property, plant, and equipment, net
4,768
2,954
Goodwill
741
206
Acquired intangible assets, net
342
247
2,263
2,011
Accounts receivable, less allowances of $55 and $52,
Other assets
September 25,
2010
September 26,
2009
$75,183
$47,501
Accounts payable
$12,015
$5,601
Accrued expenses
5,723
3,852
Deferred revenue
2,984
2,053
Total current liabilities
20,722
11,506
Deferred revenue – noncurrent
1,139
853
Other noncurrent liabilities
5,531
3,502
Total liabilities
27,392
15,861
Total assets
Liabilities and Shareholders’ Equity
Current liabilities
Commitments and contingencies
Shareholders’ equity:
Common stock, no par value; 1 800 000
000 shares
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authorized; 915 970 050 and 899 805 500
shares issued and
outstanding, respectively
10,668
8,210
Retained earnings
37,169
23,353
(46)
77
Total shareholders’ equity
47,791
31,640
Total liabilities and shareholders’ equity
$75,183
$47,501
Accumulated other comprehensive
(loss)/income
Consolidated statements of cash flows (in millions), three years ended
September 25, 2010
2010
Cash and cash equivalents, beginning of the year
2009
2008
$5,263 $11,875
$9,352
14,013
6,119
Operating activities:
Net income
Adjustments to reconcile net income to cash
generated by operating activities:
8,235
2010
Depreciation, amortization, and accretion
2009
2008
1,027
734
496
879
710
516
1,440
1,040
398
24
26
22
(2,142)
(939)
(785)
(596)
54
(163)
Vendor non‐trade receivables
(2,718)
586
110
Other current assets
(1,514)
163
(384)
Other assets
(120)
(902)
289
Accounts payable
6,307
92
596
Deferred revenue
1,217
521
718
Other liabilities
778
(161)
1,664
18,595
10,159
9,596
Stock‐based compensation expense
Deferred income tax expense
Loss on disposition of property, plant and equipment
Changes in operating assets and liabilities:
Accounts receivable, net
Inventories
Cash generated by operating activities
Investing activities:
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(57,793) (46,724) (22,965)
Purchases of marketable securities
Proceeds from maturities of marketable securities
24,930
19,790
11,804
Proceeds from sales of marketable securities
21,788
10,888
4,439
Purchases of other long‐term investments
(18)
(101)
(38)
Payments made in connection with business
acquisitions, net of cash acquired
(638)
0
(220)
(2,005)
(1,144)
(1,091)
(116)
(69)
(108)
(2)
(74)
(10)
(13,854) (17,434)
(8,189)
Payments for acquisition of property, plant, and
equipment
Payments for acquisition of intangible assets
Other
Cash used in investing activities
Financing activities:
Proceeds from issuance of common stock
912
475
483
Excess tax benefits from stock‐based compensation
751
270
757
Taxes paid related to net share settlement of equity
(406)
(82)
(124)
2010
2009
2008
awards
Cash generated by financing activities
1,257
1,116
663
Increase/(decrease) in cash and cash equivalents
Cash and cash equivalents, end of the year
5,998
(6,612)
2,523
$11,261
$5,263 $11,875
$2,697
$2,997
Supplemental cash flow disclosure:
Cash paid for income taxes, net
$1,267
Report of Ernst & Young LLP, Independent Registered Public Accounting
Firm
The Board of Directors and Shareholders of Apple Inc.
We have audited the accompanying consolidated balance sheets of Apple Inc. as
of September 25, 2010 and September 26, 2009, and the consolidated
statements of operations, shareholders’ equity and cash flows for the years then
ended. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
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We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Apple Inc. at September
25, 2010 and September 26, 2009, and the consolidated results of its operations
and its cash flows for the years then ended, in conformity with US generally
accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), Apple Inc.’s internal control over
financial reporting as of September 25, 2010, based on criteria established in
Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated October 27,
2010 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Jose, California
October 27, 2010
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Case Study
1‐2 PepsiCo: Communicating Financial Performance*
The Chairman’s letter to the shareholders from PepsiCo’s 2007 Annual Report is
presented below.
Delivering Performance with Purpose in 2007
Dear Shareholders:
We have titled this year’s annual report “Performance with Purpose: The Journey
Continues.” That’s because in 2007 PepsiCo made great progress toward the
long‐term corporate objectives we set for ourselves last year: To achieve
business and financial success while leaving a positive imprint on society.
Once more, our extraordinary associates around the world delivered terrific
performance, and I am delighted to share with you the following 2007 financial
results:
Net revenue grew 12%, roughly three times the rate of global GDP growth.
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Division operating profit grew 10%.
Earnings per share grew 13%.
Total return to shareholders was 26%.
Return on invested capital was 29%.
Cash flow from operations was $6.9 billion.
In 2007 PepsiCo took important steps to support future growth.
What makes me particularly proud is that our 2007 performance was strong –
not just measured by these short‐term metrics – but also with the long‐term
equally in mind:
We increased capital expenditures in plant and equipment worldwide to
enable growth of core brands and expand into new platforms such as baked
and crisp‐bread snacks and non‐carbonated beverages.
We added several tuck‐in acquisitions in key markets and segments, and we
further expanded our successful coffee and tea joint ventures.
We created the Chief Scientific Officer position to ensure our technical
capabilities keep pace with increasingly sophisticated consumer demand; and
we funded incremental investment to explore breakthrough R&D
opportunities.
We maintained focus on building next‐generation IT capabilities with Project
One Up, to support our long‐term growth prospects worldwide.
Our brands once again demonstrated competitive strength.
On the ground, in cities and towns around the world, good brand strategies were
implemented with operational excellence. I’d like to share a few notable
examples of the big marketplace wins we enjoyed in 2007:
Our carbonated soft drink and savory snack brands gained market share in
the United States and in many of our top international markets.
In the United Kingdom, Baked Walkers crisps was named “New Product of the
Year” by Marketing Week magazine.
SunChips snacks delivered double‐digit growth in the United States as a
result of great, innovative marketing and in‐store execution.
7UP H2Oh! was our fastest‐growing brand in value and volume share in
Brazil in its launch year.
Pepsi Max came of age as a global brand, with outstanding performance in
the United States as Diet Pepsi Max, after successes in Northern Europe and
Australia and 2007 launches across Asia.
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PepsiCo beverage brands crossed the $1 billion mark in Russia retail sales.
We posted double‐digit volume growth in China beverages and high‐single‐
digit beverage volume growth in India.
And we did all of this while battling increased commodity inflation and more
macroeconomic volatility than in previous years.
Required
In her review of PepsiCo’s performance in 2007, Indra Nooyi, PepsiCo’s Chairman
and CEO, claims that, “Net revenue grew by 12%, roughly three times the rate of
global GDP growth.” What message is she trying to convey in this statement?
After reviewing the disclosure “Results of Operation – Division Review,” which is
found in the notes to the financial statements, do you agree with Mrs. Nooyi’s
assertions about PepsiCo’s growth?
Consolidated Statement of Income
PepsiCo, Inc. and Subsidiaries: Fiscal years ended December 29, 2007,
December 30, 2006, and December 31, 2005
(in millions except per share amounts)
2007
2006
2005
Net Revenue
$39,474 $35,137 $32,562
Cost of sales
18,038
15,762
14,176
Selling, general and administrative expenses
14,208
12,711
12,252
58
162
150
7,170
6,502
5,984
Bottling equity income
560
553
495
Interest expense
(224)
(239)
(256)
Interest income
125
173
159
Income before Income Taxes
7,631
6,989
6,382
Provision for Income Taxes
1,973
1,347
2,304
Net Income
$5,658
$5,642
$4,078
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$3.48
$3.42
$2.43
$3.41
$3.34
$2.39
Amortization of intangible assets
Operating Profit
Net Income per Common Share
Basic
Diluted
Results of Operations—Division Review
The results and discussions below are based on how our Chief Executive Officer
monitors the performance of our divisions.
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FLNA
PBNA
PI
QFNA
Total
Net Revenue, 2007
$11,586 $10,230 $15,798 $1,860 $39,474
Net Revenue, 2006
$10,844
$9,565 $12,959 $1,769 $35,137
% Impact of:
Volume(a)
Effective net pricing(b)
Foreign exchange
Acquisitions/divestitures
% Change(c)
3%
(2)%
7%
2%
3%
4
6
3.5
3
4
0.5
–
6
1
2
–
2
6
–
3
7%
7%
22%
5%
12%
Net Revenue, 2006
$10,844
$9,565 $12,959 $1,769 $35,137
Net Revenue, 2005
$10,322
$9,146 $11,376 $1,718 $32,562
% Impact of:
Volume(a)
1%
3%
6%
1%
3%
FLNA
PBNA
3
1
4
2
3
Foreign exchange
0.5
–
1
1
1
Acquisitions/divestitures
0.5
–
3
–
1
% Change(c)
5%
5%
14%
3%
8%
Effective net pricing(b)
PI
QFNA
Total
(a) Excludes the impact of acquisitions and divestitures. For PBNA and PI, volume growth
varies from the amounts disclosed in the following divisional discussions due primarily to
non‐consolidated joint venture volume and temporary timing differences between BCS
and CSE. Our net revenue for PBNA and PI excludes non‐consolidated joint venture
volume and is based on CSE.
(b) Include the year‐over‐year impact of discrete pricing actions, sales incentive activities
and mix resulting from selling varying products in different package sizes and in different
countries.
(c) Amounts may not sum due to rounding.
* Source: 2007 PepsiCo Annual Report
NOTES
TFord53@my.gcu.edu
1. The balance sheet is also known as the statement of financial position. Although
the latter is the official term, business people everywhere continue to use the term
“balance sheet.” We will do likewise in this book.
2. In some countries, such as the United Kingdom, principal responsibility for the
financial statements rests with the board of directors.
2
The Balance Sheet and Income Statement
In Chapter 1, we introduced the three principal financial statements – the balance
sheet, income statement, and statement of cash flows – and the role they play in the
financial reporting process. In this chapter, we discuss the first two statements in
greater depth, focusing on the statements from Taiwan Semiconductor’s 2016
Annual Report. (Cash flows are examined in Chapter 5.)
A Further Look at the Balance Sheet
The balance sheet reports the financial position of a company at a particular point in
time. By “financial position,” we mean the resources available to managers to run the
business (i.e., “assets”) and the financing that made the acquisition of those
resources possible (liabilities and shareholders’ equity).
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In Exhibit 1.1, you will have noticed the word “consolidated” at the top of TSMC’s
balance sheet. This means that the document before you represents not just the
balance sheet of “Taiwan Semiconductor Manufacturing Company Limited”, the
parent company, but also the balance sheet of any entity controlled by the parent.
It’s not the balance sheet of any one company, but rather that of a group of
companies known to the investing world as “TSMC.”
To understand this idea, imagine that you buy shares in the company. What do you
get for your investment? Not only do you obtain ownership rights over the legal
entity whose shares you are buying, but also you gain indirect ownership rights over
any business or entity effectively controlled by that company. This means that when
you want to know the financial position of TSMC, it’s not the balance sheet of the
parent that you care about, but rather the balance sheet that includes all companies
within the TSMC Group. In fact, the standard practice in Europe and much of Asia is
to refer to consolidated financial statements as “group accounts.”
This example introduces us to an important concept in corporate financial reporting:
economic substance is more important than legal form. Consider the aforementioned
example. There is no legal entity anywhere that can rightly claim ownership of the
TSMC Group balance sheet because the document represents a consolidation, or
aggregation, of many balance sheets. For a company of this size, the number of
individual balance sheets included in the consolidated statement can easily run into
the hundreds. But the consolidated balance sheet does correspond to an economic
entity, namely, what you as an investor get when you buy shares in, or lend money
to, this company. And from the investor’s point of view, this economic perspective is
more useful than the legal perspective. To put it another way, although the
shareholders of TSMC own shares only in the parent company, the parent’s financial
statements will tell them little about what they are really getting from their
ownership interest. For this, they need consolidated accounts.
TSMC’s balance sheets are dated 31 December 2015 and 2016. This tells us that
financial position is measured at a specific point in time. In fact, balance sheets are
sometimes referred to as “snapshots” in that they reflect financial position on a
particular date; they say nothing directly about what the company did in the previous
year. To find out how the company performed over a period of time, we need to look
to the income statement and the statement of cash flows.
Assets
At the end of 2016, TSMC reported total assets of NT$1,886 billion (see Exhibit 1.1).
This does not mean that the company’s assets were worth this much. The market, or
fair, value of a company’s assets can be less than, or greater than, their balance
sheet value. This divergence occurs for two reasons:
TFord53@my.gcu.edu
Many assets, such as land and buildings, are recorded at their acquisition, or
historical, cost (i.e., what the company paid for the assets when they were
acquired). Over time, these costs can sharply diverge from market values. This is
particularly true for real estate. In some countries, companies are permitted
periodically to restate real estate to market values. This treatment is permitted,
though not required, under International Financial Reporting Standards (IFRS).
American companies are constrained by the “historical cost rule,” at least for
nonfinancial assets. This is the valuation principle that says that assets should
appear on the balance sheet at the price paid for them (historical or acquisition
cost), less depreciation (if applicable). For property, plant, and equipment, they
deviate from this rule only when the value of assets is impaired (i.e., fair value is
significantly less than acquisition cost).
Some assets (especially those of an intangible nature) might not even appear on a
balance sheet and, therefore, will not be reflected in total assets. For example,
TSMC’s intellectual capital – arguably one of its most valuable assets – is missing
from the balance sheet. Most intangibles appear on balance sheets only when
acquired from other firms. This rule permits a reasonably objective valuation of
the asset, but in knowledge‐intensive companies, important assets are left out.
Although this treatment may seem inconsistent (reporting assets only when
bought from other firms, and ignoring them if created internally), it is important
to recognize the role it plays in causing a divergence between the book (or
balance sheet) value of assets and what they are really worth.
Current Assets
Current assets are short‐term assets. An asset is short term if we expect to consume
it or convert it into cash within one year or one operating cycle, whichever is longer.
“Operating cycle” refers to the process of converting raw materials into finished
products, selling them, and collecting cash from customers. In the case of TSMC, this
includes the process of purchasing inputs, for example, silicon, from its suppliers;
directing its employees to use production facilities to manufacture semiconductors;
engaging a sales force to sell the finished product to manufacturers of electronics;
and finally, collecting cash from the sales. For the overwhelming majority of
businesses, TSMC included, the amount of time required for this cycle to turn is less
than one year. Therefore, for TSMC, the criterion for “current” is one year.
Total current assets at the end of 2016 are NT$818 billion. One way to interpret this
figure is that it represents the sum of all TSMC’s assets that (1) were already in the
form of cash, or (2) were expected to be consumed or converted into cash some time
in 2017. All other assets are classified as “noncurrent.”
TSMC follows the American convention, also used in Canada and Japan, of listing
current assets in descending order of liquidity (“liquidity” refers to the speed and
ease with which an item can be converted into cash):
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Because it is already in the form of cash, cash is the most “current” or liquid of all
assets and is the first to appear in the balance sheet.
“Financial assets” are comprised of financial securities held for short‐term, cash
management purposes. Government bond investments are common examples.
“Notes and accounts receivable” are the amounts owed by the company’s
customers.
“Inventories” reflect finished goods that TSMC has manufactured, as well as raw
materials and partially completed products. While these are “current” in that they
are expected to be sold within the next year, they are less liquid than receivables
as it will take the company longer to convert these assets into cash.
“Other current assets” consist mainly of prepaid expenses, such as rent and
insurance. These are examples of current assets that will not be converted into
cash, but rather are expected to be consumed in the short term.
Noncurrent (Long‐Term) Assets
Most of TSMC’s noncurrent assets fall into three broad categories:
Investments (“other financial assets”)
Property, plant and equipment
Intangibles (including “goodwill”).
“Investments” are those that management intends to hold for the long term,
including securities in other firms. Some of these investments might represent
excess cash, while others may be more strategic in nature. For example, a company
might acquire shares of stock in one of its suppliers to ensure continued availability
of raw materials. In TSMC’s case, the category “Investments accounted for using the
equity method” reflects companies where TSMC holds a stake between 20 and 50%,
which gives them significant influence, but not control. We discuss this issue in detail
in Chapter 17.
“Property, plant and equipment” (PP&E) are tangible, long‐t…