THE THREE FINANCIAL REPORTS OR statements required under accounting rules are the balance sheet, the income statement, and the statement of cash flows. These rules are established by the Financial Accounting Standards Board (FASB), a self-regulating organization managed by the accounting profession, with oversight by the Public Company Accounting Oversight Board (PCAOB) for companies traded on stock exchanges (“public companies”). FASB oversees GAAP (generally accepted accounting principles), which provides accounting standards that are considered as the foundation of financial reporting.

Public companies are required to publish annual reports containing an explanation of the past year's activities, nonconfidential plans for the future, and financial reports including an opinion letter by external auditors as to their accuracy. In addition, they must file detailed financial analyses with the primary regulatory agency, the Securities and Exchange Commission (SEC). The annual version of this report is called a 10-K; quarterly reports are known as 10-Qs. Most public companies provide them on their websites.

GENERAL BALANCE SHEET ISSUES

Several issues relate to the entire balance sheet:

• Date. The balance sheet in Exhibit 1.1 is as of December 31 for two recent years. All balance sheets are as of a particular date and are valid only for that date. This particular business uses a calendar year reporting period. However, any date can be used to show financial results, and the period that is used is referred to as the fiscal year. As an example, retailers often close the accounting (fiscal) year before or after the Christmas selling season; Best Buy closes its year at the beginning of March.
• Asset/liability life. By convention, the lives of current assets are presumed to be less than one year, while fixed assets are expected to be used by a company and reported on the balance sheet for greater than one year. These assumptions can change and are simply what is expected or known on the balance sheet date, and are limited by tax regulation.
• Listing order. Assets and liabilities are presented in the order they are likely to be turned into cash, with cash and near-cash items listed first and other items listed later. This characteristic is known as liquidity and is used throughout finance in evaluating investment decisions and calculating capital requirements.
• Valuation. All balance sheet items are valued at the lower of cost or market value; cost means the full acquisition cost including freight and installation. Market is used when an asset has permanently lost value due to deterioration, changes in style or other obsolescence, or the loss of a customer for whom inventory was acquired. This convention is particularly important when a business has owned an asset that has greatly increased in value, such as real estate in New York City, which must be carried at cost and not the current market.
• Balance. The left side of the balance sheet—total assets—must equal the right side of the balance—the total of liabilities and net worth. This is accomplished by the procedure of double-entry accounting, with a left-side entry (a debit) equaled by a right-side entry (a credit) as entries are made to reflect transactions that occur.
• Notes to financial statements. The notes that accompany the financial statements may significantly affect the meaning of the data. For example, long-term contractual obligations (such as an operating lease) may be reported only in the notes; yet few investors, lenders, or others who rely on these reports bother to examine the notes.

ASSETS AND LIABILITIES

As we discussed in Chapter 1, working capital involves current assets and current liabilities. In this section we define noncurrent entries on the balance sheet. The fixed asset that is presented in Exhibit 1.1 (i.e., assets with lives of more than one year) is plant and equipment, calculated at cost less depreciation. The concept of “net” refers to the accounting convention of writing off a portion of the cost of a fixed asset over the estimated life of the asset. In making this calculation, various methods are permitted as selected by management.

These methods are collectively known as depreciation, and the choice is usually made for tax reasons. The total original cost of the plant and equipment was $85 million. If the life of these assets was estimated to be five years, the company would be allowed to expense $17 million each year ($85 million divided by 5 years). Accelerated depreciation methods are also permitted.

There are various conventions used to write down the value of fixed assets. If a company acquires such intangible property as patents, copyrights, or licenses, these assets are subject to amortization, which is treated in the same way as depreciated property. If it owns natural assets such as oil or gas reserves, coal, or other minerals, this property would be subject to a similar treatment known as depletion. Land is presumed to exist forever and is not depreciated or depleted.

The two long-term liabilities will be due in periods beyond one year, and include bonds payable and mortgage payable. Bonds payable is debt held by outside investors; mortgage payable is a loan taken to acquire real property (land and buildings).

NET WORTH

Net worth is what the company is worth after liabilities are subtracted from assets. The two accounts in net worth are defined as follows:

1. Common stock. This account represents the total of all monies paid for stock, including various stock offerings as new stock is sold to investors.
2. Retained earnings. All of the income (after taxes) remaining (i.e., not paid as dividends) is included in retained earnings.

COST OF CAPITAL

Cost of capital is the calculation of the cost to finance a business based on several factors:

• The interest yield on debt
• The corporate tax rate (as interest is a deductible expense in computing taxable income)
• The dividend yield on equity shares
• The expected growth in the price of equity shares
• The weighting of debt and equity on a company's balance sheet

Exhibit A.1 shows a company that has a 10 percent cost of capital. This is the assumption used throughout this book. However, each business would have to do this calculation based on its own unique situation.

Any investment above this cost should be considered, assuming it is consistent with the company's long-term strategy. Any investment returning less than this cost should be rejected as it would negatively affect owners' equity and impair shareholder value. Calculations of returns are a concern of capital budgeting, which includes such techniques as net present value (NPV) and internal rate of return (IRR).

An alternative method for the cost of equity capital is the capital asset pricing model (CAPM). The idea of the CAPM is that the relationship between the expected return and beta can be quantified. In this method, the risk-free return (the rate on U.S. Treasury Bills) is added to the beta (β_e) for the company multiplied by the risk premium required by the market for that class of securities. The concepts of beta and risk premium effectively require that the equity be a publicly traded security. The equation that determines this result is as follows:

Expected return of a stock (based on CAPM) = Risk-free return + β of the stock × Market's expected return – Risk-free return (on a short-term U.S. Treasury security)

or

R_e = R_f + [β_e × (R_m − R_f)]

CAPM shows that the expected return of a stock (or other asset) depends on the risk-free return that is available to investors, the reward for bearing systematic risk, and the amount of systematic risk.

For a discussion of these concepts, the interested reader should consult any standard finance text.