A partnership consists of two or more owners who have joined together legally to manage a business. About 10 percent of all businesses in the United States are organized in this manner. To form a partnership, the owners enter into an agreement that details how much capital each partner will contribute to the partnership, what their management roles will be, how key management decisions will be made, how the profits will be divided, and how ownership will be transferred in case of specified events, such as the retirement or death of a partner.
A general partnership has the same basic advantages and disadvantages as a sole proprietorship. A key disadvantage of a general partnership is that all partners have unlimited liability for the partnership's debts and actions, regardless of what proportion of the business they own or how the debt or obligations were incurred. The problem of unlimited liability can be avoided in a limited partnership, which consists of general and limited partners. Here, one or more general partners have unlimited liability and actively manage the business, while each limited partner is liable for business obligations only up to the amount of capital he or she contributed to the partnership. In other words, the limited partners have limited liability. To qualify for limited partner status, a partner cannot be actively engaged in managing the business.
Most large businesses are corporations. A corporation is a legal entity authorized under a state charter. In a legal sense, it is a "person" distinct from its owners. Corporations can sue and be sued, enter into contracts, issue debt, borrow money, and own assets, such as real estate. They can also be general or limited partners in partnerships, and they can own stock in other corporations. Because a corporation is an entity that is distinct from its owners, it can have an indefinite life. Although only 15 percent of all businesses are incorporated, corporations hold nearly 90 percent of all business assets, generate nearly 90 percent of revenues, and account for about 80 percent of all business profits in the United States. The owners of a corporation are its stockholders.
Starting a corporation is more costly than starting a sole proprietorship or partnership. Those starting the corporation, for example, must create articles of incorporation and by-laws that conform to the laws of the state of incorporation. These documents spell out the name of the corporation, its business purpose, its intended life span (unless explicitly stated otherwise, the life is indefinite), the amount of stock to be issued, and the number of directors and their responsibilities.
A major advantage of the corporate form of business organization is that stockholders have limited liability for debts and other obligations of the corporation. The corporate veil of limited liability exists because corporations are legal persons that borrow in their own names, not in the names of any individual owners. A major disadvantage of the most common corporate form of organization, compared with sole proprietorships and partnerships, is the way they are taxed. Because the corporation is a legal person, it must pay taxes on the income it earns. If the corporation then pays a cash dividend, the stockholders pay taxes on that dividend as income. Thus, the owners of corporations are subject to double taxation—first at the corporate level and then at the personal level when they receive dividends.
Corporations can be classified as public or private. Most large companies prefer to operate as public corporations because large amounts of capital can be raised in public markets at a relatively low cost. Public markets, such as the New York Stock Exchange (NYSE) and NASDAQ, are regulated by the federal Securities and Exchange Commission (SEC).2 Although firms whose securities are publicly traded are technically called public corporations, they are generally referred to simply as corporations. We will follow that convention.
In contrast, privately held, or closely held, corporations are typically owned by a small number of investors, and their shares are not traded publicly. When a corporation is first formed, the common stock is often held by a few investors, typically the founder, a small number of key managers, and financial backers. Over time, as the company grows in size and needs larger amounts of capital, management may decide that the company should "go public" in order to gain access to the public markets. Not all privately held corporations go public, however.
In contrast, privately held, or closely held, corporations are typically owned by a small number of investors, and their shares are not traded publicly. When a corporation is first formed, the common stock is often held by a few investors, typically the founder, a small number of key managers, and financial backers. Over time, as the company grows in size and needs larger amounts of capital, management may decide that the company should "go public" in order to gain access to the public markets. Not all privately held corporations go public, however. The accounting fraud at WorldCom followed similar scandals at Enron, Global Crossing, Tyco, and elsewhere. These scandals—and the resulting losses to stockholders—led to a set of far-reaching regulatory reforms passed by Congress in 2002.6 The most significant reform measure to date is the Sarbanes-Oxley Act of 2002, which focuses on (1) reducing agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3) improving the integrity of accounting reporting system within firms.
Overall, the new regulations require all public corporations to implement five overarching strategies. (Private corporations and partnerships are not required to implement these measures.)
1. Ensure greater board independence. Firms must restructure their boards so that the majority of the members are outside directors. Furthermore, it is recommended that the positions of chair and CEO be separated. Finally, Sarbanes-Oxley makes it clear that board members have a fiduciary responsibility to represent and act in the interest of stockholders, and board members who fail to meet their fiduciary duty can be fined and receive jail sentences.
2. Establish internal accounting controls. Firms must establish internal accounting control systems to protect the integrity of the accounting systems and safeguard the firms' assets. The internal controls are intended to improve the reliability of accounting data and the quality of financial reports and to reduce the likelihood that individuals within the firm engage in accounting fraud.
3. Establish compliance programs. Firms must establish corporate compliance programs that ensure that they comply with important federal and state regulations. For example, a compliance program would document whether a firm's truck drivers complied with all federal and state truck and driver safety regulations, such as the number of hours one can drive during the day and the gross highway weight of the truck.
4. Establish an ethics program. Firms must establish ethics programs that monitor the ethical conduct of employees and executives through a compliance hotline, which must include a whistleblower protection provision. The intent is to create an ethical work environment so that employees will know what is expected of them and their relationships with customers, suppliers, and other stakeholders.
5. Expand the audit committee's oversight powers. The external auditor, the internal auditor, and the compliance/ethics officer owe their ultimate legal responsibilities to the audit committee, not to the firm. In addition, the audit committee has the unconditional power to probe and question any person in the firm, including the CEO, regarding any matter that might materially impact the firm or its financial statements.
Exhibit 1.5 summarizes some of the recent regulatory changes that are designed to reduce agency costs.
Conflicts of interest often arise in agency relationships. A conflict of interest in such a situation can arise when the agent's interests are different from those of the principal. For example, suppose you're interested in buying a house and a local real estate agent is helping you find the home of your dreams. As it turns out, the dream house is one for which your agent is also the listing agent. Your agent has a conflict of interest because her professional obligation to help you find the right house at a fair price conflicts with her professional obligation to get the highest price possible for the client whose house she has listed.
Organizations can be either principals or agents and, hence, can be parties to conflicts of interest. In the past, for example, many large accounting firms provided both consulting services and audits for corporations. This dual function may compromise the independence and objectivity of the audit opinion, even though the work is done by different parts of the firm. For example, if consulting fees from an audit client become a large source of income, is the auditing firm less likely to render an adverse audit opinion and thereby risk losing the consulting business?
Conflicts of interest are typically resolved in one of two ways. Sometimes complete disclosure is sufficient. Thus, in real estate transactions, it is not unusual for the same lawyer or realtor to represent both the buyer and the seller. This practice is not considered unethical as long as both sides are aware of the fact and give their consent. Alternatively, the conflicted party can withdraw from serving the interests of one of the parties. Sometimes the law mandates this solution. For example, recent legislation requires that public accounting firms stop providing certain consulting services to their audit clients.
Information asymmetry occurs when one party in a business transaction has information that is unavailable to the other parties in the transaction. The existence of information asymmetry in business relationships is commonplace. For example, suppose you decide to sell your 10-year-old car. You know much more about the real condition of the car than does the prospective buyer. The ethical issue is this: How much should you tell the prospective buyer? In other words, to what extent is the party with the information advantage obligated to reduce the amount of information asymmetry?
Society imposes both market-based and legal solutions for transactional information asymmetries. Consider the prospective car buyer in the previous example. You can be reasonably sure that the buyer understands that he or she has less information about the car's condition than the seller and, as a result, will pay a lower price for the vehicle. Conversely, sellers who certify or provide a warranty with respect to the condition of the vehicle reduce the concerns that buyers have about information asymmetries and therefore tend to receive higher prices.
Legal solutions often require sellers to disclose material facts to buyers or prohibit trading on information that is not widely available. For example, when you sell a car, you are required to disclose to the seller whether it has been in an accident and whether the odometer has been altered. Similarly, in many states home sellers must disclose if they are aware of any major defects in their home. In the investment world, the trading of stocks based on material inside information (e.g., which is not available to the public) has been made illegal in an effort to create a "level playing field" for all investors.
The financial system consists of financial markets and financial institutions. Financial market is a general term that includes a number of different types of markets for the creation and exchange of financial assets, such as stocks and bonds. Financial institutions are firms such as commercial banks, credit unions, insurance companies, pension funds, and finance companies that provide financial services to the economy. The distinguishing feature of financial institutions is that they invest their funds in financial assets, such as business loans, stocks, and bonds, rather than real assets, such as plant and equipment.
The critical role of the financial system in the economy is to gather money from people and businesses with surplus funds to invest and channel that money to those who need it. Businesses need money to invest in new productive assets to expand their operations and increase the firm's cash flow, which should increase the value of the firm. Consumers, too, need money, which they use to purchase things such as homes, cars, and boats—or to pay college tuition bills. Some of the players in the financial system are household names such as the New York Stock Exchange, Bank of America, Merrill Lynch, and State Farm Insurance. Others are lesser-known but important firms, such the multinational giant GE Capital.
A well-developed financial system is critical for the operation of a complex industrial economy such as that of the United States. Highly industrialized countries cannot function without a competitive and sound financial system that efficiently gathers money and channels it into the best investment opportunities. Let's look at a simple example to illustrate how the financial system channels money to businesses.
In this section we turn our attention to direct financing, in which funds flow directly through the financial system. In direct transactions, the lender-savers and the borrower-spenders deal directly with one another; borrower-spenders sell securities, such as stocks and bonds, to lender-savers in exchange for money. These securities represent claims on the borrowers' future income or assets. A number of different interchangeable terms are used to refer to securities, including financial securities, financial instruments, and financial claims.
The financial markets in which direct transactions take place are wholesale markets with a typical minimum transaction size of $1 million. For most business firms, these markets provide funds at the lowest possible cost. The major buyers and sellers of securities in the direct financial markets are commercial banks; other financial institutions, such as insurance companies and business finance companies; large corporations; the federal government; hedge funds; and some wealthy individuals. It is important to note that financial institutions are major buyers of securities in the direct financial markets. For example, life and casualty insurance companies buy large quantities of corporate bonds and stocks for their investment portfolios. In Exhibit 2.1 the arrow leading from financial institutions to financial markets depicts this flow.
Although few individuals participate in direct financial markets, individuals can gain access to many of the financial products produced in these markets through retail channels at investment or commercial banks or independent brokerage firms (the lower route in Exhibit 2.1). For example, individuals can buy or sell stocks and bonds in small dollar amounts at Bank of America's retail brokerage business or the discount brokerage firm Ameritrade. We discuss indirect financing through financial institutions later in this chapter.
Financial markets can be classified as either "organized" markets (more commonly called exchanges) or over-the-counter markets. Traditional exchanges, such as the New York Stock Exchange (NYSE), provide a physical meeting place and communication facilities for members to buy and sell securities or other assets (such as commodities like oil or wheat) under a specific set of rules and regulations. Members are individuals who represent securities firms as well as people who trade for their own accounts. Only members can use the exchange.
Securities not listed on an exchange are bought and sold in the over-the-counter (OTC) market. The OTC market differs from organized exchanges in that the "market" has no central trading location. Instead, investors can execute OTC transactions by visiting or telephoning an OTC dealer or by using a computer-based electronic trading system linked to the OTC dealer. Traditionally, stocks traded over the counter have been those of small and relatively unknown firms, most of which would not qualify to be listed on a major exchange. However, electronic trading has become much more important in recent years. Many large well-known firms, such as Google and Microsoft, now trade on electronic exchanges such as NASDAQ. In fact, even in organized markets like the NYSE, a large fraction of trades are now completed electronically
Money markets are global markets where short-term debt instruments, which have maturities of less than one year, are traded. Money markets are wholesale markets in which the minimum transaction is $1 million and transactions of $10 million or $100 million are not uncommon. Money market instruments are lower in risk than other securities because of their high liquidity and low default risk. In fact, the term money market is used because these instruments are close substitutes for cash. The most important and largest money markets are in New York City, London, and Tokyo. Exhibit 2.2 lists the most common money market instruments and the dollar amounts outstanding as of June 2010.Large companies use money markets to adjust their liquidity positions. Liquidity, as mentioned, is the ability to convert an asset into cash quickly without loss of value. Liquidity problems arise because companies' cash receipts and expenditures are rarely perfectly synchronized. To manage liquidity, a firm can invest idle cash in money market instruments; then, if the firm has a temporary cash shortfall, it can raise cash overnight by selling money market instruments.
Recall from Chapter 1 that capital markets are markets where equity and debt instruments with maturities of greater than one year are traded. In these markets, large firms finance capital assets such as plants and equipment. The NYSE, as well as the London and Tokyo stock exchanges, are capital markets. Exhibit 2.2 also lists the major U.S. capital market instruments and the dollar amounts outstanding. Compared with money market instruments, capital market instruments are less marketable, have higher default risk, and have longer maturities.
Financial markets, such as the bond and stock markets, help bring buyers and sellers of securities together. They reduce the cost of buying and selling securities by providing a physical location or computer trading system where investors can trade securities. The supply and demand for securities are better reflected in organized markets because much of the total supply and demand for securities flows through these centralized locations or trading systems. Any price that balances the overall supply and demand for a security is a market equilibrium price.
Ideally, economists would like financial markets to price securities at their true (intrinsic) value. A security's true value is the present value (the value in today's dollars) of the cash flows an investor who owns that security can expect to receive in the future. This present value, in turn, reflects all available information about the size, timing, and riskiness of the cash flows at the time the price was set.3 As new information becomes available, investors adjust their cash flow estimates and, through buying and selling, the price of a security adjusts to reflect this information.
A weaker form of the efficient market hypothesis, known as the semistrong-form, holds only that all public information—information that is available to all investors—is reflected in security prices. Investors who have private information are able to profit by trading on this information before it becomes public. For example, suppose that conversations with the customers of a firm indicate to an investor that the firm's sales, and thereby its cash flows, are increasing more rapidly than other investors expect. To profit from this information, the investor buys the firm's stock. By buying the stock, the investor helps drive up the price to the point where it accurately reflects the higher level of cash flows.
The concept of semistrong-form efficiency is a reasonable representation of the public stock markets in developed countries such as the United States. In a market characterized by this sort of efficiency, as soon as information becomes public, it is quickly reflected in stock prices through trading activity. Studies of the speed at which new information is reflected in stock prices indicate that by the time you read a hot tip in the Wall Street Journal or a business magazine, it is too late to benefit by trading on it.
Now let's look at some market data to see how interest rates have actually fluctuated over the past five decades in the United States. Exhibit 2.5 plots the interest rate yield on 10-year government bonds since 1960 to represent interest rate movements. In addition, the exhibit plots the annual rate of inflation, represented by the annual percent change in the consumer price index (CPI). The CPI is a price index that measures the change in prices of a market basket of goods and services that a typical consumer purchases. Finally, the shaded areas on the chart indicate periods of recession. Recession occurs when real output from the economy is decreasing and unemployment is increasing. Each shaded area begins at the peak of the business cycle and ends at the bottom (or trough) of the recession. From our discussion of interest rates and an examination of Exhibit 2.5, we can draw two general conclusions:
The level of interest rates tends to rise and fall with changes in the actual rate of inflation. The positive relation between the rate of inflation and the level of interest rates is what we should expect given Equation 2.1. Thus, we feel comfortable concluding that inflationary expectations have a major impact on interest rates.
Our findings also explain in part why interest rates can vary substantially between countries. For example, in 2009 the rate of inflation in the United States was 2.7 percent; during the same period, the rate of inflation in Russia was 14.1 percent. If the real rate of interest is 3.0 percent, the short-term interest rate in the United States should have been around 5.7 percent and the Russian interest rate should have been around 17.1 percent . In fact, during January 2009 the U.S. short-term interest rate was about 0.5 percent and the Russian rate was 13.0 percent. Though hardly scientific, this analysis illustrates the point that countries with higher rates of inflation or expected rates of inflation will have higher interest rates than countries with lower inflation rates. The fact that both of these interest rates are below the rates of inflation reflects the weak economic conditions in 2009.
The level of interest rates tends to rise during periods of economic expansion and decline during periods of economic contraction. It makes sense that interest rates should increase during years of economic expansion. The reasoning is that as the economy expands, businesses begin to borrow money to build up inventories and to invest in more production capacity in anticipation of increased sales. As unemployment begins to decrease, the economic future looks bright, and consumers begin to buy more homes, cars, and other durable items on credit. As a result, the demand for funds by both businesses and consumers increases, driving interest rates up. Also, near the end of expansion, the rate of inflation begins to accelerate, which puts upward pressure on interest rates. At some point, the Federal Reserve System (the Fed) becomes concerned over the increasing inflation in the economy and begins to tighten credit, which further raises interest rates, slowing the economy down. The higher interest rates in the economy choke off spending by both businesses and consumers.
During a recession, the opposite takes place; businesses and consumers rein in their spending and their use of credit, putting downward pressure on interest rates. To stimulate demand for goods and services, the Fed will typically begin to make more credit available. The result is to lower interest rates in the economy and encourage business and consumer spending.
Also notice in Exhibit 2.5 that periods of business expansion tend to be much longer than periods of contraction (recessions). Since the end of the Great Depression (1929-1933), the average period of economic expansion has lasted three to four years, and the average period of contraction, about nine months. Keep in mind that the numbers given are averages and that actual periods of economic expansion and contraction can vary widely from averages. For example, the last period of business expansion lasted about 6 years (October 2001 to December 2007), and the last recession lasted 18 months (December 2007 to June 2009).
The annual report is the most important report that firms issue to their stockholders and make available to the general public. Historically, annual reports were dull, black-and-white publications that presented audited financial statements for firms. Today some annual reports, especially those of large public companies, are slick, picture-laden, glossy "magazines" in full color with orchestrated media messages.
Annual reports typically are divided into three distinct sections. First are the financial tables, which contain financial information about the firm and its operations for the year, and an accompanying summary explaining the firm's performance over the past year. For example, the summary might explain that sales and profits were down because of declining consumer demand in the wake of the 2008 financial crisis. Often, there is a letter from the chairman or CEO that provides some insights into the reasons for the firm's performance, a discussion of new developments, and a high-level view of the firm's strategy and future direction. It is important to note that the financial tables are historical records reflecting past performance of the firm and do not necessarily indicate what the firm will do in the future.
The second part of the report is often a corporate public relations piece discussing the firm's product lines, its services to its customers, and its contributions to the communities in which it operates.
The third part of the annual report presents the audited financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Overall, the annual report provides a good overview of the firm's operating and financial performance and states why, in management's judgment, things turned out the way they did.
The going concern assumption is the assumption that a business will remain in operation for the foreseeable future. This assumption underlies much of what is done in accounting. For example, suppose that Kmart has $4.6 billion of inventory on its balance sheet, representing what the firm actually paid for the inventory in arm's-length transactions. If we assume that Kmart is a going concern, the balance sheet figure is a reasonable number because in the normal course of business we expect Kmart to be able to sell the goods for its cost plus some reasonable markup.
However, suppose Kmart declares bankruptcy and is forced by its creditors to liquidate its assets. If this happens, Kmart is no longer a going concern. What will the inventory be worth then? We cannot be certain, but 50 cents on the dollar might be a high figure. The going concern assumption allows the accountant to record assets at cost rather than their value in a liquidation sale, which is usually much less.
You can see that the fundamental accounting principles just discussed leave considerable professional discretion to accountants in the preparation of financial statements. As a result, financial statements can and do differ because of honest differences in professional judgments. Of course, there are limits on honest professional differences, and at some point, an accountant's choices can cross a line and result in "cooking the books."
The balance sheet reports the firm's financial position at a particular point in time. Exhibit 3.1 shows the balance sheets for Diaz Manufacturing on December 31, 2010 and December 31, 2011. The left-hand side of the balance sheet identifies the firm's assets, which are listed at book value. These assets are owned by the firm and are used to generate income. The right-hand side of the balance sheet includes liabilities and stockholders' equity, which tell us how the firm has financed its assets. Liabilities are obligations of the firm that represent claims against its assets. These claims arise from debts and other obligations to pay creditors, employees, or the government. In contrast, stockholders' equity represents the residual claim of the owners on the remaining assets of the firm after all liabilities have been paid.2 The basic balance sheet identity can thus be stated as follows:3
Since stockholders' equity is the residual claim, stockholders would receive any remaining value if the firm decided to sell off all of its assets and use the money to pay its creditors. That is why the balance sheet always balances. Simply put, if you total what the firm owns and what it owes, then the difference between the two is the total stockholders' equity:
Notice that total stockholders' equity can be positive, negative, or equal to zero. It is important to note that balance sheet items are listed in a specific order. Assets are listed in order of their liquidity, with the most liquid assets, cash and marketable securities, at the top. The liquidity of an asset is defined by how quickly it can be converted into cash without loss of value. Thus, an asset's liquidity has two dimensions: (1) the speed and ease with which the asset can be sold and (2) whether the asset can be sold without loss of value. Of course, any asset can be sold easily and quickly if the price is low enough. Liabilities on the balance sheet are listed based on their maturity, with the liabilities having the shortest maturities listed at the top. Maturity refers to the length of time remaining before the obligation must be paid.
Next, we examine some important balance sheet accounts of Diaz Manufacturing as of December 31, 2011 (see Exhibit 3.1). As a matter of convention, accountants divide assets and liabilities into short-term (or current) and long-term parts. We will start by looking at current assets and liabilities.
Current assets are assets that can reasonably be expected to be converted into cash within one year. Besides cash, which includes investments in marketable securities such as money market instruments, other current assets are accounts receivable, which are typically due within 30 to 45 days, and inventory, which is money invested in raw materials, work-in-process inventory, and finished goods. Diaz's current assets total $1,039.8 million.
Current liabilities are obligations payable within one year. Typical current liabilities are accounts payable, which arise in the purchases of goods and services from vendors and are normally paid within 30 to 60 days; notes payable, which are formal borrowing agreements with a bank or some other lender that have a stated maturity; and accrued taxes from federal, state, and local governments, which are taxes Diaz owes but has not yet paid. Diaz's total current liabilities equal $377.8 million.
Recall from Chapter 1 that the dollar difference between total current assets and total current liabilities is the firm's net working capital:
Net working capital is a measure of a firm's ability to meet its short-term obligations as they come due. One way that firms maintain their liquidity is by holding more current assets.
For Diaz Manufacturing, total current assets are $1,039.8 million, and total current liabilities are $377.8 million. The firm's net working capital is thus:
To interpret this number, if Diaz Manufacturing took its current stock of cash and liquidated its marketable securities, accounts receivables, and inventory at book value, it would have $1,039.8 million with which to pay off its short-term liabilities of $377.8 million, leaving $662.0 million of "cushion." As a short-term creditor, such as a bank, you would view the net working capital position as positive because Diaz's current assets exceed current liabilities by almost three times .
Inventory, as noted earlier, is a current asset on the balance sheet, but it is usually the least liquid of the current assets. The reason is that it can take a long time for a firm to convert inventory into cash. For a manufacturing firm, the inventory cycle begins with raw materials, continues with goods in process, proceeds with finished goods, and finally concludes with selling the asset for cash or an account receivable. For a firm such as The Boeing Company, for example, the inventory cycle in manufacturing an aircraft can be nearly a year.
An important decision for management is the selection of an inventory valuation method. The most common methods are FIFO (first in, first out) and LIFO (last in, first out). During periods of changing price levels, how a firm values its inventory affects both its balance sheet and its income statement. For example, suppose that prices have been rising (inflation). If a company values its inventory using the FIFO method, when the firm makes a sale, it assumes the sale is from the oldest, lowest-cost inventory—first in, first out. Thus, during rising prices, firms using FIFO will have the lowest cost of goods sold, the highest net income, and the highest inventory value. In contrast, a company using the LIFO method assumes the sale is from the newest, highest-cost inventory—last in, first out. During a period of inflation, firms using LIFO will have the highest cost of goods sold, the lowest net income, and the lowest inventory value.
Because inventory valuation methods can have a significant impact on both the income statement and the balance sheet, when financial analysts compare different companies, they make adjustments to the financial statements for differences in inventory valuation methods. Although firms can switch from one inventory valuation method to another, this type of change is an extraordinary event and cannot be done frequently.
Diaz Manufacturing reports inventory values in the United States using the LIFO method. The remaining inventories, which are located outside the United States and Canada, are calculated using the FIFO method. Diaz's total inventory is $423.8 million.
Long-term productive assets are the assets that the firm uses to generate most of its income. Long-term assets may be tangible or intangible. Tangible assets are balance sheet items such as land, mineral resources, buildings, equipment, machinery, and vehicles that are used over an extended period of time. In addition, tangible assets can include other businesses that a firm wholly or partially owns, such as foreign subsidiaries. Intangible assets are items such as patents, copyrights, licensing agreements, technology, and other intellectual capital the firm owns.
Goodwill is an intangible asset that arises only when a firm purchases another firm. Conceptually, goodwill is a measure of how much the price paid for the acquired firm exceeds the sum of the values of its individual assets. There are a variety of reasons why the purchase price of an asset might exceed its value to the seller. Goodwill may arise from improvements in efficiency, the reputation or brands associated with products or trademarks, or even a valuable client base for a particular service. For example, if Diaz Manufacturing paid $2.0 million for a company that had individual assets with a total fair market value of $1.9 million, the goodwill premium paid would be $100,000 .
Diaz Manufacturing's long-term assets comprise net plant and equipment of $399.4 million and intangible and other assets of $450.0 million, as shown in Exhibit 3.1. The term net plant and equipment indicates that accumulated depreciation has been subtracted to arrive at the net value. That is, net plant and equipment equals total plant and equipment less accumulated depreciation; accumulated depreciation is the total amount of depreciation expense taken on plant and equipment up to the balance sheet date. For Diaz Manufacturing, the above method yields the following result:
We have summarized the types of assets and liabilities that appear on the balance sheet. Now we look at the equity accounts. Diaz Manufacturing's total stockholders' equity at the end of 2011 is $937.4 million and is made up of four accounts—common stock, additional paid-in capital, retained earnings, and treasury stock—which we discuss next. We conclude with a discussion of preferred stock. Although a line item for preferred stock appears on Diaz Manufacturing's balance sheets, the company has no shares of preferred stock outstanding.
The Common Stock Accounts
The most important equity accounts are those related to common stock, which represent the true ownership of the firm. Certain basic rights of ownership typically come with common stock; those rights are as follows:
The right to vote on corporate matters such as the election of the board of directors or important actions such as the purchase of another company.
The preemptive right, which allows stockholders to purchase any additional shares of stock issued by the corporation in proportion to the number of shares they currently own. This allows common stockholders to retain the same percentage of ownership in the firm, if they choose to do so.
The right to receive cash dividends if they are paid.
If the firm is liquidated, the right to all remaining corporate assets after all creditors and preferred stockholders have been paid.
A common source of confusion is the number of different common stock accounts on the balance sheet, each of which identifies a source of the firm's equity. The common stock account identifies the initial funding from investors that was used to start the business and is priced at a par value. The par value is an arbitrary number set by management, usually a nominal amount such as $1.
Clearly, par value has little to do with the market value of the stock when it is sold to investors. The additional paid-in capital is the amount of capital received for the common stock in excess of par value. Thus, if the new business is started with $40,000 in cash and the firm decides to issue 1,000 shares of common stock with a par value of $1, the owners' equity account looks as follows:
Common stock (1,000 shares @ $1 par value)
Additional paid-in capital
Total paid-in capital
Note the money put up by the initial investors: $1,000 in total par value (1,000 shares of common stock with a par value of $1) and $39,000 additional paid-in capital, for a total of $40,000.
As you can see in Exhibit 3.1, Diaz manufacturing has 54,566,054 shares of common stock with a par value of 91.63 cents, for a total value of $50.0 million . The additional paid-in capital is $842.9 million. Thus, Diaz's total paid-in capital is $892.9 million .
Preferred stock is a cross between common stock and long-term debt. Preferred stock pays dividends at a specified fixed rate, which means that the firm cannot increase or decrease the dividend rate, regardless of whether the firm's earnings increase or decrease. However, like common stock dividends, preferred stock dividends are declared by the board of directors, and in the event of financial distress, the board can elect not to pay a preferred stock dividend. If preferred stock dividends are missed, the firm is typically required to pay dividends that have been skipped in the past before they can pay dividends to common stockholders. In the event of bankruptcy, preferred stockholders are paid before common stockholders but after bondholders and other creditors. As shown in Exhibit 3.1, Diaz Manufacturing has no preferred stock outstanding, but the company is authorized to issue up to 10 million shares of preferred stock. Although accounting statements are helpful to analysts and managers, they have a number of limitations. One of these limitations, mentioned earlier, is that accounting statements are historical—they are based on data such as the cost of a building that was built years ago. Thus, the value of assets on the balance sheet is what the firm paid for them and not their current market value—the amount they are worth today.
Investors and management, however, care about how the company will do in the future. The best information concerning how much a company's assets can earn in the future, as well as how much of a burden its liabilities are, comes from the current market value of those assets and liabilities. Accounting statements would therefore be more valuable if they measured current value. The process of recording assets at their current market value is often called marking to market.
In theory, everyone agrees that it is better to base financial statements on current information. Marking to market provides decision makers with financial statements that more closely reflect a company's true financial condition; thus, they have a better chance of making the correct economic decision, given the information available. For example, providing current market values means that managers can no longer conceal a failing business or hide unrealized gains on assets.
On the downside, it can be difficult to identify the market value of an asset, particularly if there are few transactions involving comparable assets. Critics also point out that estimating market value can require complex financial modeling, and the resulting numbers can be open to manipulation and abuse. Finally, mark-to-market accounting can become inaccurate if market prices deviate from the "fundamental" values of assets and liabilities. This might occur because buyers and sellers have either incorrect information, or have either over-optimistic or over-pessimistic expectations about the future. `
For current assets, market value and book value may be reasonably close. The reason is that current assets have a short life cycle and typically are converted into cash quickly. Then, as new current assets are added to the balance sheet, they are entered at their current market price.
In contrast, long-term assets, which are also referred to as fixed assets, have a long life cycle and their market value and book value are not likely to be equal. In addition, if an asset is depreciable, the amount of depreciation shown on the balance sheet does not necessarily reflect actual loss of economic value. As a general rule, the longer the time that has passed since an asset was acquired, the more likely it is that the current market value will differ from the book value.
For example, suppose a firm purchased land for a trucking depot in Atlanta, Georgia, 30 years ago for $100,000. Today the land is nestled in an expensive suburban area and is worth around $5.5 million. The difference between the book value of $100,000 and the market value is $5.4 million. In another example, say an airline company decided to replace its aging fleet of aircraft with new fuel-efficient jets in the late 1990s. Following the September 11, 2001, terrorist attack, airline travel declined dramatically; and during 2003 nearly one-third of all commercial jets were "mothballed." In 2003 the current market value of the replacement commercial jets was about two-thirds their original cost. Why the decline? Because the expected cash flows from owning a commercial aircraft had declined a great deal.
The market value of liabilities can also differ from their book value, though typically by smaller amounts than is the case with assets. For liabilities, the balance sheet shows the amount of money that the company has promised to pay. This figure is generally close to the actual market value for short-term liabilities because of their relatively short maturities.
For long-term debt, however, book value and market value can differ substantially. The market value of debt with fixed interest payments is affected by the level of interest rates in the economy. More specifically, after long-term debt is issued, if the market rate of interest increases, the market value of the debt will decline. Conversely, if interest rates decline, the value of the debt will increase. For example, assume that a firm has $1 million of 20-year bonds outstanding. If the market rate of interest increases from 5 to 8 percent, the price of the bonds will decline to around $700,000.4 Thus, changes in interest rates can have an important effect on the market values of long-term liabilities, such as corporate bonds. Even if interest rates do not change, the market value of long-term liabilities can change if the performance of the firm declines and the probability of default increases.
The book value of the firm's equity is one of the least informative items on the balance sheet. The book value of equity, as suggested earlier, is simply a historical record. As a result, it says very little about the current market value of the stockholders' stake in the firm.
In contrast, on a balance sheet where both assets and liabilities are marked to market, the firm's equity is more informative to management and investors. The difference between the market values of the assets and liabilities provides a better estimate of the market value of stockholders' equity than the difference in the book values. Intuitively, this makes sense because if you know the "true" market value of the firm's assets and liabilities, the difference must equal the market value of the stockholders' equity.
You should be aware, however, that the difference between the sum of the market values of the individual assets and total liabilities will not give us an exact estimate of the market value of stockholders' equity. The reason is that the true total value of a firm's assets depends on how these assets are utilized. By utilizing the assets efficiently, management can make the total value greater than the simple sum of parts. We will discuss this concept in more detail in Chapter 18.
Finally, if you know the market value of the stockholders' equity and the number of shares of stock outstanding, it is easy to compute the stock price. Specifically, the price of a share of stock is the market value of the firm's stockholders' equity divided by the number of shares outstanding.
Let's look at an example of how a market-value balance sheet can differ from a book-value balance sheet. Marvel Airline is a small regional carrier that has been serving the Northeast for five years. The airline has a fleet of short-haul jet aircraft, most of which were purchased over the past two years. The fleet has a book value of $600 million. Recently, the airline industry has suffered substantial losses in revenue due to price competition, and most carriers are projecting operating losses for the foreseeable future. As a result, the market value of Marvel's aircraft fleet is only $400 million. The book value of Marvel's long-term debt is $300 million, which is near its current market value. The firm has 100 million shares outstanding. Using these data, we can construct two balance sheets, one based on historical book values and the other based on market values:
Based on the book-value balance sheet, the firm's financial condition looks fine; the book value of Marvel's aircraft at $600 million is near what the firm paid, and the stockholders' equity account is $300 million. But when we look at the market-value balance sheet, a different story emerges. We immediately see that the value of the aircraft has declined by $200 million and the stockholders' equity has declined by $200 million!
Why the decline in stockholders' equity? Recall that in Chapter 1 we argued that the value of any asset—stocks, bonds, or a firm—is determined by the future cash flows the asset will generate. At the time the aircraft were purchased, it was expected that they would generate a certain amount of cash flows over time. Now that hard times plague the industry, the cash flow expectations have been lowered, and hence the decline in the value of stockholders' equity.
The firm's net income reflects its accomplishments (revenues) relative to its efforts (expenses) during a time period. If revenues exceed expenses, the firm generates net income for the period. If expenses exceed revenues, the firm has a net loss. Net income is often referred to as profits, as income, or simply as the "bottom line," since it is the last item on the income statement. Net income is often reported on a per-share basis and is then called earnings per share (EPS), where EPS equals net income divided by the number of common shares outstanding. A firm's earnings per share tell a stockholder how much the firm has earned (or lost) for each share of stock outstanding.
Income statements for Diaz Manufacturing for 2010 and 2011 are shown in Exhibit 3.2. You can see that in 2011 total revenues from all sources (net sales) were $1,563.7 million. Total expenses for producing and selling those goods were $1,445.2 million—the total of the amounts for cost of goods sold, selling and administrative expenses, depreciation, interest expense, and taxes.5\
Using Equation 3.3, we can use these numbers to calculate Diaz Manufacturing's net income for the year:
Since Diaz Manufacturing had 54,566,054 common shares outstanding at year's end, its EPS was $2.17 per share .
Amortization is the process of writing off expenses for intangible assets—such as patents, licenses, copyrights, and trademarks—over their useful life. Since depreciation and amortization are very similar, they are often lumped together on the income statement. Both are noncash expenses, which means that an expense is recorded on the income statement, but the associated cash does not necessarily leave the firm in that period. For Diaz Manufacturing, the depreciation and amortization expense for 2011 was $83.1 million.
At one time, goodwill was one of the intangible assets subject to amortization. As of June 2001, however, goodwill could no longer be amortized. The value of the goodwill on a firm's balance sheet is now subject to an annual impairment test. This test requires that the company annually value the businesses that were acquired in the past to see if the value of the goodwill associated with those businesses has declined below the value at which it is being carried on the balance sheet. If the value of the goodwill has declined (been impaired), management must expense the amount of the impairment. This expense reduces the firm's reported net income.
The statement of cash flows shows the company's cash inflows (receipts) and cash outflows (payments and investments) for a period of time. We derive these cash flows by looking at the firm's net income during the period and at changes in balance sheet accounts from the beginning of the period (end of the previous period) to the end of the period. In analyzing the statement of cash flows, it is important to understand that changes in the balance sheet accounts reflect cash flows. More specifically, increases in assets or decreases in liabilities and equity are uses of cash, while decreases in assets or increases in liabilities and equity are sources of cash. These changes in balance sheet items can be summarized by the following:
Working capital. An increase in current assets (such as accounts receivable and inventory) is a use of cash. For example, if a firm increases its inventory, it must use cash to purchase the additional inventory. Conversely, the sale of inventory increases a firm's cash position. An increase in current liabilities (such as accounts or notes payable) is a source of cash. For example, if during the year a firm increases its accounts payable, it has effectively "borrowed" money from suppliers and increased its cash position.
Fixed assets. An increase in long-term fixed assets is a use of cash. If a company purchases fixed assets during the year, it decreases cash because it must use cash to pay for the purchase. If the firm sells a fixed asset during the year, the firm's cash position will increase.
Long-term liabilities and equity. An increase in long-term debt (bonds and private placement debt) or equity (common and preferred stock) is a source of cash. The retirement of debt or the purchase of treasury stock requires the firm to pay out cash, reducing cash balances.
Dividends. Any cash dividend payment decreases a firm's cash balance.
Managers and investors are primarily interested in a firm's ability to generate cash flows to meet the firm's obligations to its debt holders and that can be distributed to stockholders; the cash flow to investors. These cash obligations and distributions include interest payments and the repayment of principal to the firm's debt holders, as well as distributions of cash to its stockholders in the form of dividends or stock repurchases. Cash flow to investors is the cash flow that a firm generates for its investors in a given period (cash receipts less cash payments and investments), excluding cash inflows from investors themselves, such as from the sale of new equity or long-term interest-bearing debt.
So how is cash flow to investors different from net income? One significant difference arises because accountants do not necessarily count the cash coming into the firm and the cash going out when they prepare financial statements. Under GAAP, accountants recognize revenue at the time a sale is substantially completed, not when the customer actually pays the firm. In addition, because of the matching principle, accountants match revenues with the costs of producing those revenues regardless of whether these are cash costs to the firm during that period.8 Finally, cash flows for capital expenditures occur at the time that an asset is purchased, not when it is expensed through depreciation and amortization. As a result of these accounting rules, there can be a noticeable difference between the time when revenues and expenses are recorded and when cash is actually collected (in the case of revenue) or paid (in the case of expenses).
Cash flow to investors is one of the most important concepts in finance as it identifies the cash flow in a given period that is available to meet the firm's obligations to its debt holders and that can be distributed to its stockholders. This, in turn, defines the value of their investments in the firm. The cash flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow invested in net working capital, minus the cash flow invested in long-term assets.
The difference between the average tax rate and the marginal tax rate is an important consideration in financial decision making. The average tax rate is simply the total taxes paid divided by taxable income. In contrast, the marginal tax rate is the tax rate that is paid on the last dollar of income earned. Exhibit 3.6 shows both the marginal tax rates and average tax rates for corporations.
A simple example will clarify the difference between the average and marginal tax rates. Suppose a corporation has a taxable income of $150,000. Using the data in Exhibit 3.6, we can determine the firm's federal income tax bill, its marginal tax rate, and its average tax rate. The firm's total tax bill is computed as follows:
The firm's average tax rate is equal to the total taxes divided by the firm's total taxable income; thus, the average tax rate is , or 27.8 percent. The firm's marginal tax rate is the rate paid on the last dollar earned, which is 39 percent.
When you are making investment decisions for a firm, the relevant tax rate to use is usually the marginal tax rate. The reason is that new investments (projects) are expected to generate new cash flows, which will be taxed at the firm's marginal tax rate.
To simplify calculations throughout the book, we will generally specify a single tax rate for a corporation, such as 40 percent. The rate may include some payment for state and local taxes, which will make the total tax rate the firm pays greater than the federal rate.