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