Review of Accounting (part A)
by
Charles Lamson
The language of finance flows logically from accounting. To ensure that one is adequately prepared to learn significant financial concepts, we must look in the preparatory material from the accounting area. Much of the early frustrations suffered by people who have difficulty with finance can be overcome if such concepts as retained earnings, shareholders' equity, depreciation, and historical/replacement cost accounting are brought into focus.
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In the next few posts, we examine the three basic types of financial statements---the income statement, the balance sheet, and the statement of cash flows---with particular attention paid to the interrelationships among these three measurement devices. As special preparation for the financial manager, we briefly examine income tax considerations affecting financial decisions. Income Statement The income statement is the major device for measuring the profitability of a firm over a period of time. An example of the income statement for the Kramer Corporation is presented in Table 1. Table 1  First, note that the income statement covers a defined period of time, whether it is one month, three months, or a year. The statement is presented in a stair-step or progressive fashion so we can examine the profit or loss after each type of expense item is deducted. We start with sales and deduct the cost of goods sold to arrive at gross profit. The $500,000 thus represents the difference between the cost of purchased or manufactured goods and the sales price. We then subtract selling and administrative expense and depreciation from gross profit to determine our profit (or loss) purely from operations of $180,000. It is possible for a company to enjoy a high gross profit margin (25-50) percent but a relatively low operating profit because of heavy expenses incurred in marketing the product and managing the company. Having obtained operating profit (essentially a measure of how efficient management is in generating revenues and controlling expenses), we now adjust for revenues and expenses not related to operational matters. In this case we pay $20,000 in interest and arrive at earnings before taxes of $160,000. The tax payments are $49,500 leaving after tax income of $110,500.
Return to Capital Before proceeding further, we should know that there are three primary sources of capital---the bondholders, who received $20,000 in interest (item 7); the preferred stockholders, who receive $10,500 in dividends (item 11) and the common stockholders. After the $10,500 dividend has been paid to the preferred stockholders, there will be $100,000 in earnings available to the common stockholders (item 12). In computing earnings per share, we must interpret this in terms of the number of shares outstanding. As indicated in item 13, there are 100,000 outstanding, so the $100,000 of earnings available to the common stockholders may be translated into earnings per share of $1. Common stockholders are sensitive to the number of shares outstanding---the more shares, the lower the earnings per share. Before any new shares are issued. The financial manager must be sure they will eventually generate sufficient earnings to avoid reducing earnings per share. The $100,000 of profit ($1 earnings per share) may be paid out to the common stockholders in the form of dividends or retained in the company for subsequent reinvestment. The reinvested funds theoretically belong to the common stockholders, who hope they will provide future earnings and dividends. In the case of the Kramer Corporation, we assume $50,000 in dividends will be paid out to the common stockholders, with the balance retained in the corporation for their benefit. A short supplement to the income statement, a statement of retained earnings (Table 2) usually indicates the disposition of earnings. Table 2  We see a net value of $50,000 has been added to previously accumulated earnings of $250,000 to arrive at $300,000.  A concept utilized throughout this analysis is the price-earnings ratio. This refers to the multiplier applied to earnings per share to determine current value of the common stock. In the case of the Kramer Corporation, earnings per share were $1.00. If the firm had a price-earnings ratio of 20, the market value of each share would be $20 ($1 * 20). The price earnings ratio (or P/E ratio, as it is commonly called) is influenced by the earnings and the sales growth of the firm, the risk for volatility and performance, the debt-equity structure of the firm, the dividend payment policy, policy of management, and a number of other factors. Since companies have various levels of earnings per share, price-earnings ratios allow us to compare the relative market value of many companies based on $1 of earnings per share. The P/E ratio indicates expectations about the future of a company. Firms expected to provide returns greater than those for the market in general with equal or less risk often have P/E ratios higher than the market P/E ratio. Expectations of returns and P/E ratios to change over time. Price-earnings ratios can be confusing. When a firm's earnings are dropping rapidly or perhaps even approaching 0, its stock price, though declining to, may not match the magnitude of the fall off in earnings. This process can give the appearance of an increasing P/E ratio under adversity. This happens from time to time in the steel, oil, chemical, and other cyclical Industries.  Limitations of the Income Statement The economist defines income as the change in real worth that occurs between the beginning and the end of a specified time. To The economist an increase in the value of a firm's land as a result of a new airport being built on adjacent property is an increase in the real worth of the firm and therefore represents income. Similarly, the elimination of a competitor might also increase the firm's real worth and therefore result in income in an economic sense. The accountant does not ordinarily employ such broad definitions. Accounting values are established primarily by actual transactions, and income that is gained or lost during a given period is a function of veritable transactions. While the potential sales price of a firm's property may go from $100,000 to $200,000 as a result of new developments in the area, stockholders may perceive only a much smaller gain or loss from actual day-to-day operations. Also, as will be pointed out in a future post that will be covering financial analysis, there is some flexibility in the reporting of transactions, so similar events may result in differing measurements of income at the end of a time period. The intent of this section is not to criticize the accounting profession, but to alert you to imperfections already well recognized within the profession.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 24-28* end |
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