Financial Reporting, Financial Statement Analysis, and Valuation A Strategic Perspective docx

LibraryPirate LibraryPirate Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Financial Reporting, Financial Statement Analysis, and Valuation A Strategic Perspective 7e James M. Wahlen Professor of Accounting James R. Hodge Chair of Excellence Kelley School of Business, Indiana University • Stephen P. Baginski Herbert E. Miller Professor of Accounting J.M. Tull School of Accounting Terry College of Business, The University of Georgia • Mark T. Bradshaw Associate Professor of Accounting Carroll School of Management Department of Accounting, Boston College CHE-WAHLEN-09-1211-Title Page.indd iCHE-WAHLEN-09-1211-Title Page.indd i 6/30/10 3:23:35 PM6/30/10 3:23:35 PM Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 52609_00_fm_pi-pxxvi.indd ii52609_00_fm_pi-pxxvi.indd ii 2/1/10 11:37:43 PM2/1/10 11:37:43 PM This ia an electronic version of the print textbook. Due to electronic rights restrictions, some third party may be suppressed. Edition review has deemed that any suppres ed content does not materially affect the over all learning experience. The publisher reserves the right to remove the contents from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate format, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. s Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Financial Reporting, Financial Statement Analysis, and Valuation: A Strategic Perspective, Seventh Edition James M. Wahlen, Stephen P. Baginski, Mark T. Bradshaw Vice President of Editorial, Business: Jack W. 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May not be copied, scanned, or duplicated, in whole or in part. For our students, with thanks for permitting us to take the journey with you For Clyde Stickney and Paul Brown, with thanks for allowing us the privilege to carry on their legacy of teaching through this book For our families, with love, Debbie, Jessica, Jaymie, Lynn, Drew, Marie, Kim, Ben, and Lucy CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page iii Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Preface The process of financial reporting, financial statement analysis, and valuation is intended to help investors and analysts to deeply understand a firm’s profitability and risk and to use that information to forecast future profitability and risk and ultimately value the firm, enabling intelligent investment decisions. This process lies at the heart of the role of accounting, financial reporting, capital markets, investments, portfolio management, and corporate management in the world economy. When conducted with care and integrity, thorough and thoughtful financial statement analysis and valuation is a fascinating and potentially rewarding activity that can create tremendous value for society. However, as the recent financial crises in our capital markets reveal, when financial statement analysis and valuation is conducted carelessly and without integrity, it can create enormous loss of value in our capital markets and trigger deep recession in even the most powerful economies in the world. The stakes are high. In addition, the game is changing. The world is shifting toward a new approach to finan- cial reporting, and expectations for high quality and high integrity financial analysis and valuation are increasing among investors and securities regulators. Many of the world’s most powerful economies, including the European Union, Canada, and Japan, have already shifted or will soon shift to International Financial Reporting Standards (IFRS). The U.S. Securities and Exchange Commission (SEC) has already begun to accept financial state- ment filings based on IFRS from non-U.S. registrants, and is seriously considering whether to converge financial reporting from U.S. Generally Accepted Accounting Principles (GAAP) to IFRS for U.S. registrants. Given the pace and breadth of financial reform legis- lation, it is clear that it is no longer “business as usual” on Wall Street and around the world for financial statement analysis and valuation. Given the profound importance of financial reporting, financial statement analysis, and valu ation, and given our rapidly changing world in accounting and the capital markets, this textbook provides a principled and disciplined approach to analysis and valuation. This text- book demonstrates and explains a thoughtful and thorough six-step framework for financial statement analysis and valuation. The effective analysis of a set of financial statements begins with an evaluation of (1) the economic characteristics and current conditions of the industries in which a firm competes, and (2) the particular strategies the firm executes to compete in each of these industries. It then moves to (3) assessing how well the firm’s financial statements reflect the economic effects of the firm’s strategic decisions and actions. This assessment requires an understanding of the accounting principles and methods used to create the financial statements, the relevant and reliable information that the financial statements provide, and the appropriate adjustments that the analyst should make to improve the quality of the information the finan- cial statements provide. In this text we embrace financial reporting and financial statement analysis based on U.S. GAAP and IFRS—new for the seventh edition. Next, the analyst (4) assesses the profitability and risk of the firm using financial statement ratios and other ana- lytical tools, and then (5) forecasts the firm’s future profitability and risk, incorporating infor- mation about expected changes in the economics of the industry and the firm’s strategies. Finally, the analyst (6) values the firm using various valuation methods, making an investment decision by comparing likely ranges of the value of the share to the share price observed in the capital market. This six-step process forms the conceptual and pedagogical framework for this book, and it is a principled and disciplined approach to intelligent analysis and valuation. All textbooks on financial statement analysis include step (4), assessing the profitability and risk of a company. Textbooks differ, however, with respect to their emphases on the other five steps. Consider the following depiction of these steps. CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page iv Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Preface v (5) Forecasts of Future Profitability and Risk and (6) Valuation of Firms (4) Assessment of Profitability and Risk (1) Industry Economics (3) Accounting Principles and and Quality of (2) Business Strategy Accounting Information Our view is that these six steps must form an integrated endeavor for effective and com- plete financial statement analysis. We have therefore structured and developed this book to provide balanced, integrated coverage of all six elements. We sequence our study by begin- ning with industry economics and firm strategy, moving to a general consideration of GAAP and IFRS and the quality of accounting information, and providing a structure and tools for the analysis of profitability and risk. We then delve more deeply into specific accounting issues and the determinants of accounting quality, and then conclude with fore- casting and valuation. We anchor each step in the sequence on the firm’s profitability and risk, which are the fundamental drivers of value. We continually relate each part to those preceding and following it to maintain this balanced, integrated perspective. The premise of this book is that you will learn financial statement analysis most effec- tively by performing the analysis on actual companies. The book’s narrative sets forth the important concepts and analytical tools and demonstrates their application using the financial statements of PepsiCo. Each chapter contains a set of questions, exercises, prob- lems, and cases based primarily on financial statement data of actual companies. Each chapter also contains an integrative case involving Starbucks so you can apply the tools and methods throughout the text. A financial statement analysis package (FSAP) is available to aid in the analytical tasks (discussed later). MAJOR CHANGES IN THIS EDITION The most significant change in this edition is the addition of two excellent new coauthors, Stephen Baginski and Mark Bradshaw, to replace Clyde Stickney and Paul Brown. Clyde Stickney, the original author of the first three editions of this book and coauthor of the fourth, fifth, and sixth editions, is enjoying his well-earned retirement. Paul Brown, a coauthor of the fourth, fifth, and sixth editions, is now the Dean of the College of Business and Economics at Lehigh University. Mark and Steve are both outstanding research scholars and award-winning teachers in accounting, financial statement analysis, and valuation. They bring many fresh new ideas and insights to produce a new edition with a strong focus on thoughtful and disciplined fundamental analysis, a broad and deep coverage of accounting issues including IFRS, and expanded analysis of companies within a global economic environment. The next section discusses the content of each chapter and the changes made in this edi- tion. Listed below are the major changes made in this edition that impact all chapters or groups of chapters. CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page v Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 1. The chapters on accounting quality have been restructured to provide broader and deeper coverage of accounting for financing, investing, and operating activities. The reorganization provides a logical flow of discussion across the primary business activities of firms in the natural sequence in which the activities occur—raising financial capital, investing that capital in productive assets, and operating the busi- ness. Chapter 6 discusses accounting for financing activities. Chapter 7 describes accounting for investing activities, and Chapter 8 deals with accounting for operat- ing activities. Chapter 9 describes how to evaluate accounting quality and adjust reported earnings and financial statements to cleanse low-quality accounting items. 2. The chapters on profitability analysis (Chapter 4) and risk analysis (Chapter 5) now also provide disaggregation of return on common equity along traditional lines of profitability, efficiency, and leverage, as well as along operating versus financing lines. 3. The book contains a new Appendix D with descriptive statistics on 24 commonly used financial ratios computed over the past eleven years as well as the most recent three years for 48 industries. These ratios data enable you to benchmark your analy- ses and forecasts against industry averages. 4. Each chapter includes relevant new discussion of how U.S. GAAP compares to IFRS, and how analysts should deal with such differences in financial statement analysis. End-of-chapter materials contain many problems and cases involving non- U.S. companies, with application of financial statement analysis techniques to IFRS-based financial statements. 5. Each chapter provides references to specific standards in U.S. GAAP using the tradi- tional citations (such as SFAS numbers) as well as the new FASB Codification system. 6. The chapters provide a number of relevant new insights from empirical accounting research, added because they are pertinent to financial statement analysis and valuation. 7. The end-of-chapter material for each chapter contains portions of an updated, inte- grative case applying the concepts and tools discussed in that chapter to Starbucks. This series of cases builds on the illustrations in the chapter in which the concepts and tools are applied to PepsiCo. 8. Each chapter contains approximately 50 percent new or substantially revised and updated end-of-chapter material, including new problems and cases. This is a doubling of the amount of new or revised material that appeared in the sixth edition, and this material is relevant, real-world, and written for maximum learning value. 9. The Financial Statement Analysis Package (FSAP) available with this book has been substantially revised and made more user-friendly. OVERVIEW OF THE TEXT This section describes briefly the content of each chapter, indicating the major changes made since the previous edition. Chapter 1—Overview of Financial Reporting, Financial Statement Analysis, and Valuation. This chapter introduces the six interrelated sequential steps in financial state- ment analysis that serve as the organization structure for this book. It presents several frameworks for understanding the industry economics and business strategy of a firm and applies them to PepsiCo. It also reviews the purpose, underlying concepts, and content of each of the three principal financial statements, including those of non-U.S. companies appearing in a different format. It also contains a section with key provisions of the Sarbanes-Oxley Act of 2002 that are of particular relevance to the analyst. Another new vi Preface CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page vi Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Assets Liabilities Shareholders’ Equity CC AOCI RE = + 1. Cash ϩ300,000 Land Ϫ210,000 Gain on Sale of Land ϩ90,000 Cash 300,000 Land 210,000 Gain on Sale of Land 90,000 Assets Liabilities Shareholders’ Equity CC AOCI RE = + 2. Cash Ϫ36,000 Income Tax Expense Ϫ36,000 Income Tax Expense 36,000 (0.40 ϫ [300,000 Ϫ 210,000]) Cash 36,000 section provides the rationale for analyzing financial statements in capital market settings, including showing the results from an empirical study of the association between unexpected earnings and market-adjusted stock returns as well as various empirical results showing that fundamental analysis can help investors generate above-market returns. The appendix presents an extensive discussion to help students do a term project involving the analysis of one or more companies. Our examination of the course syllabi of users of the previous edition indicated that most courses require students to engage in such a project. This appendix should guide students in how to proceed, where to get information, and so on. In addition to the new integrative case involving Starbucks, the chapter includes an updated version of a case involving Nike. Chapter 2—Asset and Liability Valuation and Income Recognition. This chapter covers three topics we believe our students need to review from previous courses before delving into the more complex topics in this book. • First, we discuss the link between the valuation of assets and liabilities on the balance sheet and the measurement of income. We believe that students understand topics such as revenue recognition and accounting for marketable securities, derivatives, pensions, and other topics more easily when they examine them with an apprecia- tion for the inherent trade-off of a balance sheet versus income statement perspective. A new aspect of this chapter to the seventh edition is that it reviews the trade-offs faced by accounting standard setters, regulators, and corporate managers who attempt to simultaneously provide both reliable and relevant financial statement information. We also examine whether firms should recognize value changes imme- diately in net income or delay their recognition, sending them temporarily through other comprehensive income. • Second, we present a framework for analyzing the dual effects of economic transac- tions and other events on the financial statements. This framework relies on the bal- ance sheet equation to trace these effects through the financial statements: A BEG ϭ L BEG ؉ CC BEG ؉ AOCI BEG ؉ RE BEG ؉ΔA ؉ΔL ؉ΔStock ؉OCI ؉NI ؊ D A END ϭ L END ؉ CC END ؉ AOCI END ؉ RE END This framework manifests itself in how we present transactions in the text; for example: Preface vii CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page vii Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. viii Preface Even students who are well grounded in double-entry accounting find this frame- work helpful in visually identifying the effects of various complex business transac- tions, such as corporate acquisitions, derivatives, and leases. We use this framework in subsequent chapters as we discuss various GAAP topics. • Third, we discuss the measurement of income tax expense, particularly with regard to the treatment of temporary differences between book income and taxable income. Virtually every business transaction has income tax consequences, and it is crucial that analysts grasp the information conveyed in income tax disclosures. Delaying consideration of the income tax consequences until later in the text hinders effective coverage of such topics as restructuring charges, asset impairments, depre- ciation, and leases. The end-of-chapter materials include various new asset and liability valuation problems involving Walmart, Biosante Pharmaceuticals, Prepaid Legal Services, and Nike, as well as an integrative case involving Starbucks. Chapter 3—Income Flows Versus Cash Flows: Understanding the Statement of Cash Flows. Chapter 3 reviews the statement of cash flows and presents a model for relating the cash flows from operating, investing, and financing activities to a firm’s position in its product life cycle. The chapter demonstrates procedures for preparing the statement of cash flows when a firm provides no cash flow information. The chapter also addresses EBITDA (earnings before interest, taxes, depreciation, and amortization), which is becoming increasingly widely used by analysts of financial statements. We describe the differences between EBITDA and cash flow from operations. The chapter also provides new insights that place particular emphasis on how to use information in the statement of cash flows to assess earnings quality. The end-of-chapter materials utilize cash flow and earnings data for a number of com- panies including eBay, Amazon, The Walt Disney Company, Fedex, Kroger, Coca-Cola, Texas Instruments, Sirius XM Radio, Sunbeam, AerLingus, and Fuso Pharmaceuticals. A case (Prime Contractors) illustrates the relation between earnings and cash flows as a firm experiences profitable and unprofitable operations and changes its business strategy. The classic W. T. Grant case illustrates the use of earnings and cash flow information to assess solvency risk and avoid bankruptcy. Chapter 4—Profitability Analysis. This chapter discusses the concepts and tools for analyzing a firm’s profitability, integrating industry economic and strategic factors that affect the interpretation of financial ratios. It then applies these concepts and tools to the analysis of the profitability of PepsiCo. The analysis of profitability centers on the rate of return on assets and its disaggregated components, the rate of return on common share- holders’ equity and its disaggregated components, and earnings per share. The chapter con- tains a section on the well-publicized measurement of EVA (economic value added) and shows its relation to net income under GAAP. This chapter also considers analytical tools unique to certain industries, such as airlines, service firms, and financial institutions. A number of new problems and exercises at the end of the chapter cover profitability analyses for companies such as Nucor Steel, Boston Scientific, Valero Energy, Microsoft, Oracle, Dell, Sun Microsystems, Texas Instruments, Hewlett Packard, Georgia Pacific, General Mills, Abercrombie & Fitch, Hasbro, Coca-Cola and many others. The integrative case on Starbucks involves analysis of Starbucks in both a time-series setting and in a cross- sectional setting in comparison to Panera Bread Company. Another case involves the time- series analysis of Walmart Stores and the cross-sectional analysis of its profitability versus Target and Carrefour. CHE-WAHLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page viii Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. [...]... Chapter 9 Accounting Quality 729 Chapter 10 Forecasting Financial Statements 783 Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach 884 Chapter 12 Valuation: Cash-Flow-Based Approaches 928 Chapter 13 Valuation: Earnings-Based Approaches 1004 Chapter 14 Valuation: Market-Based Approaches 1041 Financial Statements and Notes for PepsiCo, Inc and Subsidiaries 1097 Managementʼs... Page 2 2 Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation This book has three principal purposes, each designed to help you gain important knowledge and skills necessary for financial statement analysis and valuation: 1 To demonstrate how you can link the economics of an industry, a firm’s strategy, and its financial statements, gaining important insights about the... structure for financial statement analysis and valuation, and establishes the foundation for this book This framework enables the analyst to link the economic characteristics and strategies of a firm, its financial statements and notes, assessments of its current and forecasted profitability and risk, and its market value 2 Apply three tools for assessing the economic characteristics and dynamics that drive... Sarbanes-Oxley Act of 2002 that relate to financial statement information 6 Obtain an introduction to the tools used to analyze a firm’s profitability and risk, including financial ratios, common-size financial statements, and percentage change financial statements 7 Obtain an overview of how to use financial statement information to forecast the future business activities of a firm and to value a. .. and operating activities, and assessing the quality of accounting information under U.S GAAP and IFRS Chapters 10 to 14 focus primarily on forecasting financial statements and valuation Some schools teach U.S GAAP and IFRS topics and financial statement analysis in separate courses Chapters 6 to 9 are an integrated unit and sufficiently rich for the U.S GAAP and IFRS course The remaining chapters will... Examine the role of financial statement analysis in an efficient capital market 9 Review sources of financial information available for publicly held firms 10 Obtain guidance and direction for conducting a financial statement analysis project (Appendix 1.1) T he principal activity of security analysts is to value firms Security analysts collect and analyze a wide array of information from financial statements... 3: Assess the Quality of the Financial Statements Accounting Principles 18 Balance Sheet—Measuring Financial Position 19 Income Statement Measuring Operating Performance 27 Statement of Cash Flows 33 Important Information with the Financial Statements 36 Summary of Financial Statements, Notes, MD &A, and Managers’ and Auditors’ Attestations 40 Step 4: Analyze Profitability and Risk Tools of Profitability... differentiate itself from competitors as a basis for evaluating a firm’s competitive advantages, the sustainability of a firm’s earnings, and its risks HLEN-09-1211-001.qxd: 6/30/10 2:58 PM Page 3 3 Overview of Financial Statement Analysis EXHIBIT 1.1 Building Blocks for Financial Statement Analysis Financial Statement Analysis y Strateg Financial Statements Econo mics 3 Evaluating the financial statements,... Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation 1 Chapter 2 Asset and Liability Valuation and Income Recognition 96 Chapter 3 Income Flows versus Cash Flows: Understanding the Statement of Cash Flows 153 Chapter 4 Profitability Analysis 246 Chapter 5 Risk Analysis 345 Chapter 6 Financing Activities 439 Chapter 7 Investing Activities 522 Chapter 8 Operating Activities... Problems and Cases Integrative Case 12.1 Starbucks Case 12.2 Holmes Corporation: LBO Valuation Chapter 13 Valuation: Earnings-Based Approaches 943 954 957 971 971 971 972 988 990 1004 Introduction and Overview Rationale for Earnings-Based Valuation Earnings-Based Valuation: Practical Advantages and Concerns Theoretical and Conceptual Foundations for Residual Income Valuation Intuition for Residual Income . care and integrity, thorough and thoughtful financial statement analysis and valuation is a fascinating and potentially rewarding activity that can create. importance of financial reporting, financial statement analysis, and valu ation, and given our rapidly changing world in accounting and the capital markets,