## Financial Reporting, Financial Statement Analysis, and Valuation: A Strategic Perspective, 9th Edition

By James M Wahlen, Stephen P Baginski and Mark T Bradshaw

**Contents:**

Preface iv

About the Authors xvii

CHAPTER 1 Overview of Financial Reporting, Financial Statement

Analysis, and Valuation 1

Overview of Financial Statement Analysis 2

How Do the Six Steps Relate to Share Pricing in the Capital Markets? 5 •

Introducing Starbucks 7

Step 1: Identify the Industry Economic Characteristics 8

Grocery Store Chain 8 • Pharmaceutical Company 8 • Electric Utility 9 •

Commercial Bank 10 • Tools for Studying Industry Economics 10

Step 2: Identify the Company Strategies 16

Framework for Strategy Analysis 17 • Application of Strategy Framework to

Starbucks 17

Step 3: Assess the Quality of the Financial Statements 18

What Is Accounting Quality? 19 • Accounting Principles 20 • Balance Sheet—

Measuring Financial Position 20 • Assets—Recognition, Measurement,

and Classification 21 • Liabilities—Recognition, Valuation, and

Classification 24 • Shareholders’ Equity Valuation and Disclosure 25 •

Assessing the Quality of the Balance Sheet as a Complete

Representation of Economic Position 26 • Income Statement—

Measuring Performance 27 • Accrual Basis of Accounting 28 •

Classification and Format in the Income Statement 30 • Comprehensive

Income 31 • Assessing the Quality of Earnings as a Complete

Representation of Economic Performance 32 • Statement of Cash Flows

33 • Important Information with the Financial Statements 35

Step 4: Analyze Profitability and Risk 37

Tools of Profitability and Risk Analysis 38

Step 5: Prepare Forecasted Financial Statements and Step 6: Value

the Firm 43

Role of Financial Statement Analysis in an Efficient Capital Market 44

The Association between Earnings and Share Prices 45

Sources of Financial Statement Information 47

Summary 48

Questions and Exercises 48

Problems and Cases 50

Integrative Case 1.1 Walmart 60

Case 1.2 Nike: Somewhere between a Swoosh and a Slam Dunk 66

CHAPTER 2 Asset and Liability Valuation and Income Recognition 75

The Mixed Attribute Measurement Model 76

The Complementary Nature and Relative Usefulness of the Income

Statement and Balance Sheet 77

Asset and Liability Valuation and the Trade-Off between Relevance

and Representational Faithfulness 77

Relevance and Representational Faithfulness 79 • Accounting Quality 79 •

Trade-Off of Relevance and Representational Faithfulness 80 • Primary

Valuation Alternatives: Historical Cost versus Fair Value 80 • Contrasting

Illustrations of Asset and Liability Valuations, and Nonrecognition of

Certain Assets 84 • Summary of U.S. GAAP and IFRS Valuations 87

Income Recognition 88

Accrual Accounting 89 • Approach 1: Economic Value Changes Recognized

on the Balance Sheet and Income Statement When Realized 91 •

Approach 2: Economic Value Changes Recognized on the Balance Sheet

and the Income Statement When They Occur 92 • Approach 3: Economic

Value Changes Recognized on the Balance Sheet When They

Occur but Recognized on the Income Statement When Realized 93 •

Evolution of the Mixed Attribute Measurement Model 94

Income Taxes 94

Overview of Financial Reporting of Income Taxes 96 • Measuring Income Tax

Expense: A Bit More to the Story (to Be Technically Correct) 101 •

Reporting Income Taxes in the Financial Statements 104 • Income Taxes

104

Framework for Analyzing the Effects of Transactions on the Financial

Statements 105

Overview of the Analytical Framework 105

Summary 110

Questions and Exercises 110

Problems and Cases 112

Integrative Case 2.1 Walmart 122

CHAPTER 3 Income Flows versus Cash Flows: Understanding the

Statement of Cash Flows 123

Purpose of the Statement of Cash Flows 124

Cash Flows versus Net Income 125 • Cash Flows and Financial Analysis 125

The Relations among the Cash Flow Activities 127

Cash Flow Activities and a Firm’s Life Cycle 128

A Firm’s Life Cycle: Revenues 128 • A Firm’s Life Cycle: Net Income 129 •

A Firm’s Life Cycle: Cash Flows 130 • Four Companies: Four Different

Stages of the Life Cycle 131

Understanding the Relations among Net Income, Balance Sheets,

and Cash Flows 134

The Operating Section 135 • The Relation between Net Income and Cash

Flows from Operations 147

Preparing the Statement of Cash Flows 149

Algebraic Formulation 150 • Classifying Changes in Balance Sheet

Accounts 152 • Illustration of the Preparation Procedure 157

Usefulness of the Statement of Cash Flows for Accounting and

Risk Analysis 159

Summary 162

Questions and Exercises 162

Problems and Cases 165

Integrative Case 3.1 Walmart 185

Case 3.2 Prime Contractors 186

CHAPTER 4 Profitability Analysis 189

Overview of Profitability Analysis Based on Various Measures

of Income 190

Earnings Per Share (EPS) 192 • Common-Size Analysis 195 • Percentage

Change Analysis 197 • Alternative Definitions of Profits 197

Return on Assets (ROA) 201

Adjustments for Nonrecurring or Special Items 203 • Two Comments on the

Calculation of ROA 204 • Disaggregating ROA 206

Return on Common Shareholders’ Equity (ROCE) 207

Benchmarks for ROCE 208 • Relating ROA to ROCE 210 • Disaggregating

ROCE 213

Economic and Strategic Determinants of ROA and ROCE 215

Trade-Offs between Profit Margin and Assets Turnover 220 • Starbucks’

Positioning Relative to the Restaurant Industry 223 • Analyzing the Profit

Margin for ROA 223 • Analyzing Total Assets Turnover 230 •

Summary of ROA Analysis 235 • Supplementing ROA in Profitability

Analysis 235

Benefits and Limitations of Using Financial Statement Ratios 240

Comparisons with Earlier Periods 240 • Comparisons with Other Firms 241

Summary 242

Questions and Exercises 243

Problems and Cases 245

Integrative Case 4.1 Profitability and Risk Analysis of Walmart Stores 263

CHAPTER 5 Risk Analysis 275

Disclosures Regarding Risk and Risk Management 278

Firm-Specific Risks 279 • Commodity Prices 280 • Foreign Exchange 281 •

Interest Rates 282 • Other Risk-Related Disclosures 282

Analyzing Financial Flexibility by Disaggregating ROCE 283

Analyzing Short-Term Liquidity Risk 293

Current Ratio 295 • Quick Ratio 296 • Operating Cash Flow to Current

Liabilities Ratio 297 • Working Capital Turnover Ratios 297

Analyzing Long-Term Solvency Risk 301

Debt Ratios 301 • Interest Coverage Ratios 303 • Operating Cash Flow to

Total Liabilities Ratio 304

Analyzing Credit Risk 305

Circumstances Leading to Need for the Loan 305 • Credit History 306 • Cash

Flows 306 • Collateral 307 • Capacity for Debt 307 • Contingencies 308 •

Character of Management 308 • Communication 308 • Conditions or

Covenants 309

Analyzing Bankruptcy Risk 309

The Bankruptcy Process 309 • Models of Bankruptcy Prediction 310

Measuring Systematic Risk 316

Summary 318

Questions and Exercises 318

Problems and Cases 320

Integrative Case 5.1 Walmart 331

Case 5.2 Massachusetts Stove Company—Bank Lending Decision 332

Case 5.3 Fly-by-Night International Group: Can This Company

Be Saved? 339

CHAPTER 6 Accounting Quality 349

Accounting Quality 350

High Quality Reflects Economic Reality 350 • High Quality Leads to the

Ability to Assess Earnings Persistence over Time 353 • Earnings Quality

versus Balance Sheet Quality 354

Earnings Management 355

Incentives to Practice Earnings Management 356 • Deterrents to Earnings

Management 356

Recognizing and Measuring Liabilities 357

Obligations with Fixed Payment Dates and Amounts 357 • Obligations with

Fixed Payment Amounts but Estimated Payment Dates 359 • Obligations

with Estimated Payment Dates and Amounts 359 • Obligations Arising

from Advances from Customers 360 • Obligations under Mutually

Unexecuted Contracts 361 • Contingent Obligations 362 • Off-Balance-

Sheet Financing Arrangements 363

Asset Recognition and Measurement 366

Current Assets 366 • Noncurrent Assets 367

Specific Events and Conditions That Affect Earnings Persistence 370

Gains and Losses from Peripheral Activities 370 • Restructuring Charges and

Impairment Losses 371 • Discontinued Operations 373 • Other

Comprehensive Income Items 374 • Changes in Accounting Principles

375 • Changes in Accounting Estimates 377 • Accounting Classification

Differences 377

Tools in the Assessment of Accounting Quality 379

Partitioning Earnings into Operating Cash Flow and Accrual

Components 379 • A Model to Detect the Likelihood of Fraud 386

Financial Reporting Worldwide 392

Summary 393

Questions and Exercises 393

Problems and Cases 396

Integrative Case 6.1 Walmart 408

Case 6.2 Citi: A Very Bad Year 409

Case 6.3 Arbortech: Apocalypse Now 418

CHAPTER 7 Financing Activities 427

Equity Financing 428

Investments by Shareholders: Common Equity Issuance 428 • Distributions

to Shareholders: Dividends 431 • Equity Issued as Compensation: Stock

Options 435 • Alternative Share-Based Compensation: Restricted Stock

and RSUs 439 • Alternative Share-Based Compensation: Cash-Settled

Share-Based Plans 441

Net Income, Retained Earnings, Accumulated Other Comprehensive

Income, and Reserves 442

Net Income and Retained Earnings 442 • Summary and Interpretation of

Equity 445

Debt Financing 446

Financing with Long-Term Debt 446 • Financial Reporting of Long-Term

Debt 449 • Fair Value Disclosure and the Fair Value Option 450 •

Accounting for Troubled Debt 452 • Hybrid Securities 453 • Transfers of

Receivables 457

Leases 458

Operating Lease Method 459 • Capital Lease Method 459 • Choosing the

Accounting Method 460 • The New Lease Standard 466

The Use of Derivatives to Hedge Interest Rate Risk 468

Nature and Use of Derivative Instruments 469 • Accounting for Derivatives 470 •

Disclosures Related to Derivative Instruments 472 • Starbucks’ Derivatives

Disclosures 472 • Accounting Quality Issues and Derivatives 473

Summary 473

Questions and Exercises 474

Problems and Cases 479

Integrative Case 7.1 Walmart 485

Case 7.2 Oracle Corporation: Share-Based

Compensation Effects/Statement of Shareholders’ Equity 485

Case 7.3 Long-Term Solvency Risk: Southwest and Lufthansa Airlines 489

CHAPTER 8 Investing Activities 497

Investments in Long-Lived Operating Assets 498

Assets or Expenses? 498

How Do Managers Allocate Acquisition Costs over Time? 505

Useful Life for Long-Lived Tangible and Limited-Life Intangible Assets 506 •

Cost Allocation (Depreciation/Amortization/Depletion) Method 507 •

When Will the Long-Lived Assets Be Replaced? 509

What Is the Relation between the Book Values and Market Values

of Long-Lived Assets? 510

Impairment of Long-Lived Assets Subject to Depreciation and

Amortization 511 • Impairment of Intangible Assets Not Subject to

Amortization 513 • Impairment of Goodwill 513 • IFRS Treatment of

Upward Asset Revaluations 517 • Summary 518

Investments in Securities 519

Minority, Passive Investments 519 • Minority, Active Investments 526 •

Majority, Active Investments 529 • Preparing Consolidated Statements

at the Date of Acquisition 535 • Consolidated Financial Statements

Subsequent to Date of Acquisition 537 • What Are Noncontrolling

Interests? 540 • Corporate Acquisitions and Income Taxes 544 •

Consolidation of Unconsolidated Affiliates and Joint Ventures 545

Primary Beneficiary of a Variable-Interest Entity 546

When Is an Entity Classified as a VIE? 546

Foreign Currency Translation 549

Functional Currency Concept 550 • Translation Methodology—Foreign

Currency Is Functional Currency 550 • Translation Methodology—U.S.

Dollar Is Functional Currency 552 • Interpreting the Effects of Exchange

Rate Changes on Operating Results 554

Summary 555

Questions and Exercises 555

Problems and Cases 557

Integrative Case 8.1 Walmart 572

Case 8.2 Disney Acquisition of Marvel Entertainment 573

CHAPTER 9 Operating Activities 577

Revenue Recognition 578

The Revenue Recognition Problem 578 • The IASB and FASB’s Revenue

Recognition Project 581 • Application of the New Revenue Recognition

Method 583

Expense Recognition 592

Criteria for Expense Recognition 592 • Cost of Sales 593 •

SG&A Costs 599 • Operating Profit 601

Income Taxes 601

Required Income Tax Disclosures 602

Pensions and Other Postretirement Benefits 609

The Economics of Pension Accounting in a Defined Benefit Plan 610 •

Reporting the Income Effects in Net Income and Other Comprehensive

Income 613 • Pension Expense Calculation with Balance Sheet and

Note Disclosures 614 • Income Statement Effects 615 • Gain and Loss

Recognition 618 • Impact of Actuarial Assumptions 618 • Other

Postretirement Benefits 619 • Signals about Earnings Persistence 619

Summary 620

Questions and Exercises 620

Problems and Cases 623

Integrative Case 9.1 Walmart 632

Case 9.2 Coca-Cola Pensions 633

CHAPTER 10 Forecasting Financial Statements 635

Introduction to Forecasting 636

Preparing Financial Statement Forecasts 637

General Forecasting Principles 637 • Seven-Step Forecasting

Game Plan 638 • Coaching Tips for Implementing the Seven-Step

Forecasting Game Plan 640

Step 1: Project Revenues 642

Projecting Revenues for Starbucks 643

Step 2: Project Operating Expenses 654

Projecting Cost of Sales Including Occupancy Costs 655 • Projecting Store

Operating Expenses and Other Operating Expenses 656 • Projecting

Property, Plant, and Equipment and Depreciation Expense 657

Step 3: Project Operating Assets and Liabilities on the Balance Sheet 662

Techniques to Project Operating Assets and Liabilities 662 • Projecting Cash

and Cash Equivalents 666 • Projecting Short-Term Investments 671 •

Projecting Accounts Receivable 671 • Projecting Inventories 672 •

Projecting Prepaid Expenses and Other Current Assets 672 •

Projecting Current and Noncurrent Deferred Income Tax Assets 672 •

Projecting Long-Term Investments 673 • Projecting Equity and Cost

Investments 673 • Projecting Property, Plant, and Equipment and

Accumulated Depreciation 673 • Projecting Other Long-Term Assets,

Other Intangible Assets, and Goodwill 674 • Projecting Assets as a

Percentage of Total Assets 674 • Projected Total Assets 675 • Projecting

Accounts Payable 675 • Projecting Accrued Liabilities 676 • Projecting

Insurance Reserves 676 • Projecting Stored-Value Card Liabilities 676 •

Projecting Other Long-Term Liabilities 677

Step 4: Project Financial Leverage, Financial Assets, Common Equity

Capital, and Financial Income and Expense Items 677

Projecting Financial Assets 677 • Projecting Short-Term and Long-Term

Debt 678 • Projected Total Liabilities 679 • Projecting Interest

Expense 680 • Projecting Interest Income 681 • Projecting Noncontrolling

Interests 681 • Projecting Common Stock, Preferred Stock, and

Additional Paid-in Capital 682 • Projecting Accumulated Other

Comprehensive Income or Loss 683

Step 5: Project Provisions for Taxes, Net Income, Dividends, Share

Repurchases, and Retained Earnings 683

Projecting Provisions for Income Taxes 684 • Net Income Attributable to

Starbucks’ Common Shareholders 684 • Projecting Dividends and Share

Repurchases 685 • Retained Earnings 686

Step 6: Balance the Balance Sheet 687

Balancing Starbucks’ Balance Sheets 687 • Closing the Loop: Solving for

Codetermined Variables 689

Step 7: Project the Statement of Cash Flows 689

Tips for Forecasting Statements of Cash Flows 690 • Specific Steps for

Forecasting Implied Statements of Cash Flows 690

Shortcut Approaches to Forecasting 695

Projected Revenues and Income Approach 695 • Projected Total Assets

Approach 695

Test Forecast Validity by Analyzing Projected Financial Statements 696

Reactions to Announcements 699

Summary 700

Questions and Exercises 701

Problems and Cases 702

Integrative Case 10.1 Walmart 708

Case 10.2 Massachusetts Stove Company: Analyzing

Strategic Options 715

CHAPTER 11 Risk-Adjusted Expected Rates of Return and the Dividends

Valuation Approach 725

The General Valuation Model 726

Equivalence among Dividends, Cash Flows, and Earnings Valuation 728

Expected Rates of Return 729

Cost of Common Equity Capital 730 • Evaluating the Use of the CAPM to

Measure the Cost of Equity Capital 736 • Cost of Debt Capital 737 • Cost

of Preferred Equity Capital 738 • Cost of Equity Capital Attributable to

Noncontrolling Interests 738 • Computing the Weighted-Average Cost of

Capital 739

Dividends-Based Valuation: Rationale and Basic Concepts 743

Dividends-Based Valuation Concepts 743

Dividends-Based Valuation: Advanced Concepts 747

Measuring Dividends 747 • Measuring Dividends for Starbucks 748 •

Selecting a Forecast Horizon 749 • Projecting and Valuing Continuing

Dividends 750

The Dividends-Based Valuation Model 755

Applying the Dividends-Based Valuation Model to Value Starbucks 756

Using the Dividends-Based Valuation Model to Value Starbucks 756

Sensitivity Analysis and Investment Decision Making 760

Summary 762

Questions and Exercises 763

Problems and Cases 764

Integrative Case 11.1 Walmart 768

CHAPTER 12 Valuation: Cash-Flow-Based Approaches 771

Rationale for Cash-Flow-Based Valuation 773

Measuring Free Cash Flows 774

A Conceptual Framework for Free Cash Flows 774 • How Do We Measure

Free Cash Flows? 776

Cash-Flow-Based Valuation Models 785

Valuation Models for Free Cash Flows for Common Equity

Shareholders 785 • Valuation Models for Free Cash Flows for

All Debt and Equity Stakeholders 786

Free Cash Flows Valuation of Starbucks 787

Starbucks Discount Rates 788 • Valuing Starbucks Using Free Cash Flows

789 • Valuing Starbucks Using Free Cash Flows to Common Equity 790 •

Valuing Starbucks Using Free Cash Flows to All Debt and Equity Capital

Stakeholders 794 • Necessary Adjustments to Compute Common Equity

Share Value 795

Sensitivity Analysis and Investment Decision Making 798

Summary 800

Questions and Exercises 800

Problems and Cases 801

Integrative Case 12.1 Walmart: Free-Cash-Flows Valuation of

Walmart’s Common Equity 811

Case 12.2 Holmes Corporation 816

CHAPTER 13 Valuation: Earnings-Based Approach 829

Rationale for Earnings-Based Valuation 831

Earnings-Based Valuation: Practical Advantages and Concerns 833

Theoretical and Conceptual Foundations for Residual Income

Valuation 835

Intuition for Residual Income Measurement and Valuation 837 • Illustrations

of Residual Income Measurement and Valuation 838

Residual Income Valuation with Finite Horizon Earnings

Forecasts and Continuing Value Computation 842

Valuation of Starbucks Using the Residual Income Model 844

Residual Income Model Implementation Issues 850

Dirty Surplus Accounting 851 • Common Stock Transactions 852 • Portions of

Net Income Attributable to Equity Claimants Other Than Common

Shareholders 853 • Negative Book Value of Common Shareholders’

Equity 853

Consistency in Residual Income, Dividends, and Free Cash Flows

Summary 855

Questions and Exercises 855

Problems and Cases 857

Integrative Case 13.1 Walmart 862

CHAPTER 14 Valuation: Market-Based Approaches 865

Market Multiples of Accounting Numbers 867

Market-to-Book and Value-to-Book Ratios 869

A Model of the Value-to-Book Ratio 869 • The Value-to-Book Model with

Finite Horizon Earnings Forecasts and Continuing Value 872 • Why Might

VB Ratios and MB Ratios Differ from 1? 874 • Application of the Valueto-

Book Model to Starbucks 875 • Empirical Data on MB Ratios 878 •

Empirical Research Results on the Predictive Power of MB Ratios 880

Price-Earnings and Value-Earnings Ratios 881

A Model for the Value-Earnings Ratio with Application to Starbucks

882 • PE Ratios from a Theoretical Perspective: Projecting Firm

Value from Permanent Earnings 883 • Price-Earnings Ratios from a

Practical Perspective 884 • Benchmarking Relative Valuation: Using

Market Multiples of Comparable Firms 886 • Incorporating Earnings

Growth into PE Ratios 890 • Empirical Properties of PE Ratios 893

Reverse Engineering 895

Reverse Engineering Starbucks’ Stock Price 896

The Relevance of Academic Research for the Work of the Security

Analyst 898

What Does ‘‘Capital Market Efficiency’’ Really Mean? 898 • Striking Evidence

on the Degree of Market Efficiency and Inefficiency with Respect to

Earnings 899 • Striking Evidence on the Use of Valuation Models to Form

Portfolios 901

Summary 903

Questions and Exercises 904

Problems and Cases 905

Integrative Case 14.1 Walmart 910

APPENDIX A Financial Statements and Notes for

Starbucks Corporation A-1

APPENDIX B Management’s Discussion and Analysis for

Starbucks Corporation Online

APPENDIX C Financial Statement Analysis Package (FSAP) C-1

APPENDIX D Financial Statement Ratios: Descriptive Statistics

by Industry Online

INDEX I-1