Corporate Financial Reporting and Analysis

S. David Young is Professor of Accounting and Control at INSEAD, based in Fontainebleau (France) and Singapore. He has been there since 1989. Professor Young holds a PhD from the University of Virginia and is both a Certified Public Accountant (USA) and a Chartered Financial Analyst. His primary areas of expertise are corporate financial reporting and value-based management, with works published in a wide variety of academic and professional journals, including several articles in the Harvard Business Review.Jake Cohen is Senior Associate Dean for Undergraduate and Masters' Programs at MIT Sloan School of Management and Senior Lecturer in Accounting and Law, where he has been since 2012. In his role, he oversees strategy for eight programs. From 2003 to 2011, Jake was an Affiliate Professor of Accounting and Control at INSEAD and was based in France and Singapore. He served as Director of the INSEAD-PricewaterhouseCoopers Research Center from 2004 to 2008 and as Dean of the MBA Program from 2008 to 2011.Daniel Bens is a Professor at INSEAD, currently serving as the Chair of the Accounting and Control area. Previously, he was a faculty at the University of Arizona serving as Associate Dean of MBA programs. Prior to that he was a faculty at the University of Chicago, Booth School of Business from 1999 to 2005.

• About the Authors iv1 An Introduction to Financial Statements 1The Three Principal Financial Statements, 2Other Items in the Annual Report, 9Generally Accepted Accounting Principles: The Rules of the Game, 12The Barriers to Understanding Financial Statements, 12Key Lessons from the Chapter, 14Key Terms and Concepts from the Chapter, 15Questions, 15Problems: 151.1 Balance Sheet Terminology, 151.2 Understanding Balance Sheet Relationships, 161.3 Interpreting an Auditor’s Opinion, 16Case Studies: 171-1 Apple: An Introduction to Financial Statement Analysis, 171-2 Pepsico: Communicating Financial Performance, 20Notes, 232 The Balance Sheet and Income Statement 24A Further Look at the Balance Sheet, 24Assets, 25Liabilities, 27Shareholders’ Equity, 28A Further Look at the Income Statement, 29Other Things You Should Know About the Balance Sheet and the Income Statement, 30Key Lessons from the Chapter, 32Key Terms and Concepts from the Chapter, 33Questions, 33Appendix 2.1 The Mechanics of Financial Accounting: The Double-Entry System, 33Key Terms and Concepts from the Appendix, 42Key Lessons from the Appendix, 42Problem: 422.1 Preparing a Balance Sheet and an Income Statement, 42Case Study: 432-1 JanMar Fabrics: Preparing the Balance Sheet and Income Statement, 433 A Brief Overview of GAAP and IFRS: The Framework for Financial Accounting 45The Core Principles of GAAP and IFRS, 45The Key Qualitative Characteristics of Financial Information, 47The Key Assumptions of Financial Information, 48Modifying Conventions, 48The Future of Financial Reporting, 49Key Lessons from the Chapter, 50Key Terms and Concepts from the Chapter, 51Questions, 514 Revenue Recognition 52Introduction, 52The Five-Step Revenue Recognition Model, 52Revenue-Recognition Controversies, 65Key Lessons from the Chapter, 68Key Terms and Concepts from the Chapter, 68Questions, 68Problems: 684.1 Revenue Recognition at and After Time of Sale, 684.2 Recognizing Revenue Over Time, 694.3 Journal Entries for Gift Cards, 694.4 Recognizing Revenue Over Time, 694.5 Revenue Recognition in Different Types of Businesses, 69Case Studies: 704-1 Kiwi Builders, Ltd., 704-2 Revenue Recognition at Starbucks Corporation, 704-3 Network Associates (McAfee): A Case of “Channel Stuffing”, 77Notes, 795 The Statement of Cash Flows 80Introduction, 80The Reporting of Cash Flows from Operations, 80Preparing the Statement of Cash Flows, 82IFRS and the Statement of Cash Flows, 90Analyzing the Statement of Cash Flows, 90Key Lessons from the Chapter, 94Key Terms and Concepts from the Chapter, 94Questions, 95Problems: 955.1 Interpreting the Statement of Cash Flows, 955.2 Adjustments on the Statement of Cash Flows, 955.3 Preparing and Analyzing a Statement of Cash Flows, 975.4 Interpreting the Role of Accounts Payable in Cash Flow from Operations, 975.5 Manipulating the Statement of Cash Flows, 985.6 Analysis of the Statement of Cash Flows, 985.7 Cash Flow and Credit Risk, 995.8 Preparing and Interpreting the Statement of Cash Flows, 100Case Studies: 1005-1 Blockbuster Inc.: Movie Rentals, Profits, and Operating Cash, 1005-2 Monahan Manufacturing: Preparing and Interpreting a Statement of Cash Flows, 1075-3 A Tale of Three Companies: Cash Flows at Sun Microsystems,Wal-Mart, and Merck, 1085-4 Inditex: Analyzing the Statement of Cash Flows, 110Notes, 1146 Financial Statement Analysis 115Introduction, 115Business and Industry Analysis, 116Accounting Analysis, 119Financial Analysis, 119Dupont Analysis, 122ROE and the Analysis of Financial Risk, 129Key Lessons from the Chapter, 136Key Terms and Concepts from the Chapter, 137Questions, 137Appendix 6.1 An Industry and Competitive Analysis of Taiwan Semiconductor Manufacturing Company (TSMC), 137Appendix 6.2 Summary of Financial Statement Ratios, 139Problems: 1416.1 Financial Statement Detective Exercise, 1416.2 Effects of Transactions on Selected Balance Sheet Figures, 1436.3 Calculating and Interpreting PP&E Turnover Ratios, 1446.4 Financial Statement Detective Exercise in the Pharmaceutical Industry, 1446.5 Comprehensive Financial Ratio Analysis, 1466.6 Profitability Analysis for The Home Depot, 1466.7 Comparative Analysis of Receivables and Inventories, 147Case Studies: 1476-1 Profitability Analysis and WalMart’s Suppliers, 1476-2 LVMH and Warnaco: Strategy and Financial Statement Analysis, 148Notes, 1537 Business Valuation and Financial Statement Analysis 154Valuation Principles, 154Valuation: From Theory to Practice, 155The Economic Profit Approach to Valuation, 156A Case Study in Valuation: TSMC, 158A Brief Word on Growth Rates, 162Key Lessons from the Chapter, 165Key Terms and Concepts from the Chapter, 165Questions, 165Problems: 1657.1 Estimating the Value of The Home Depot, 1657.2 Explaining Differences in P/E Ratios, 1667.3 Explaining Differences in P/E Ratios, 166Case Study: 1667-1 Valuation Based on Discounted Cash Flows: The Case of Vardon Golf Ltd., 166Notes, 1678 Accounting for Receivables and Bad Debts 168Introduction, 168Estimating Bad Debts, 168Writing off Accounts, 169The Direct Method: An Alternative Approach, 169What Happens When Written-off Accounts are Later Collected?, 170The “Aging” of Accounts Receivable, 170Sales Returns and Allowances, 171Analyzing Receivables, 172Key Lessons from the Chapter, 173Key Terms and Concepts from the Chapter, 173Questions, 173Appendix 8.1 Accounting for Loan Loss Reserves, 173Problems: 1758.1 Bad Debts on Loans Receivable, 1758.2 Determining Bad Debt Expense from an Aging Schedule, 1758.3 Analyzing Receivables and the Allowance for Doubtful Accounts, 1758.4 Provisions for Credit Losses, 181Case Studies: 1828-1 Receivables and Bad Debts at Toyota, 1828-2 Johnson Perry, 1828-3 Citigroup Inc.: Accounting for Loan Loss Reserves, 185Notes, 1919 Accounting for Inventory 192Introduction, 192Inventory Valuation: LIFO, FIFO, and the Rest, 195The Lower of Cost or Net Realizable Value Rule, 196The Cost-Flow Assumptions: An Example, 196Inventory Cost-Flow Assumptions: A Summary, 199Key Lessons from the Chapter, 200Key Terms and Concepts from the Chapter, 200Questions, 200Problems: 2019.1 Calculating Inventory Under the FIFO and Average-Cost Methods, 2019.2 Inventories and Ratio Analysis, 2019.3 Correcting Inventory Errors, 2019.4 The Lower of Cost or Net Realizable Value Rule, 2019.5 Calculating Cost of Goods Sold Under FIFO and Specific Identification, 201Case Studies: 2029-1 LIFO Accounting at Tamar Chemicals, 2029-2 Deere and CNH Global: Performance Effects of Inventory Accounting Choice, 202Notes, 20810 Accounting for Property, Plant, and Equipment 209Introduction, 209Initial Recognition of PP&E, 210Subsequent Expenditures: Repair or Improvement?, 211Accounting for Depreciation, 211Changes in Depreciation Estimates or Methods, 213Asset Impairment, 214Fair Value vs. Historical Cost, 215Divestitures and Asset Sales, 216Intangible Assets, 216Key Lessons from the Chapter, 218Key Terms and Concepts from the Chapter, 218Questions, 218Problems: 21910.1 Comparing the Effects of Depreciation Choice on Financial Ratios, 21910.2 Analyzing Depreciation on PP&E, 21910.3 Calculating and Analyzing Amortization Expense, 22010.4 Calculating Depreciation Expense, 22010.5 Effects of Changes in Estimates on Depreciation Expense, 22110.6 Interpreting Disclosures for Property, Plant and Equipment, 22110.7 Capitalizing or Expensing Costs, 22410.8 Journal Entries for Depreciation and Amortization Expense, 22411 Leases and Off-Balance-Sheet Debt 225Introduction, 225Leasing Accounting Before 2018: Capital vs. Operating Leases, 225Accounting for Capital Leases, 226Accounting for Operating Leases, 227Lease Accounting: An Example, 227Interpreting Lease Disclosures, 229Off-Balance-Sheet Debt, 230Recent Developments in Lease Accounting, 231Key Lessons from the Chapter, 233Key Terms and Concepts from the Chapter, 233Questions, 233Problem: 23311.1 The Financial Reporting Effects of Selling Receivables, 233Case Studies: 23411-1 Lease Accounting at Metro AG, 23411-2 Pennzoil-Quaker State and the Sale of Receivables, 23511-3 Executory Contracts, 235Note, 23512 Accounting for Bonds 236Introduction, 236Accounting for Bond Issuance, 237Accounting for Bonds Sold at Par, 238Accounting for Bonds Sold at a Premium, 238Bond Redemption Before Maturity, 242Accounting for Bonds Issued at a Discount, 242Zero-Coupon Bonds, 244Key Lessons from the Chapter, 246Key Terms and Concepts from the Chapter, 246Questions, 247Problems: 24712.1 Journal Entries and Balance Sheet Presentation for Bonds, 24712.2 Amortization of Bond Discount and Premium, 24712.3 Journal Entries for Bond Issuance and Subsequent Interest Payments, 24713 Provisions and Contingencies 248Introduction, 248Defining Provisions, 249Measuring the Provision, 249Disclosure of Provisions: Interpreting the Notes, 250Contingent Liabilities, 251Contingent Assets, 254Key Lessons from the Chapter, 254Key Terms and Concepts from the Chapter, 254Questions, 254Problems: 25513.1 Accounting for Warranties, 25513.2 Analyzing and Interpreting Disclosures on the Provision for Warranties, 255Case Studies: 25513-1 Accounting for Contingent Assets: The Case of Cardinal Health, 25513-2 Firestone Tire and Rubber Company (A), 25713-3 Firestone Tire and Rubber Company (B), 259Notes, 25914 Accounting for Pensions 260Introduction, 260A Brief Word on Defined Contribution Plans, 260Unfunded Defined Benefit Plans, 261Funded Defined Benefit Plans, 261American Airlines: An Example of Defined Benefit Plan Disclosure, 267Key Lessons from the Chapter, 269Key Terms and Concepts from the Chapter, 270Questions, 270Case Study: 27014-1 Comprehensive Pension Review Problem: Cathay Pacific, 270Note, 27315 Accounting for Income Tax 274Introduction, 274Temporary and Permanent Differences, 275Deferred Taxes and the Balance Sheet Approach, 276The Balance Sheet Approach: An Example, 277Interpreting Income Tax Disclosures: The Case of Intel Corporation, 279Why Deferred Income Tax is Important, 284Key Lessons from the Chapter, 285Key Terms and Concepts from the Chapter, 285Questions, 285Problems: 28515.1 Calculating Temporary and Permanent Differences, 28515.2 Interpreting Income Tax Disclosures, 28615.3 Deferred Income Taxes and the Statement of Cash Flows, 286Case Study: 28815-1 Deferred Tax Assets and the Valuation Allowance: The Case of Ford Motor Company, 288Notes, 29216 Accounting for Shareholders’ Equity 293Introduction, 293Shareholders’ Equity: An Introduction, 293More on Contributed Capital, 297Accounting for Stock Transactions, 298Dividends on Common Stock, 301Stock Dividends and Stock Splits, 303Accumulated Other Comprehensive Income, 305Convertible Bonds, 305The Statement of Shareholders’ Equity, 307Key Lessons from the Chapter, 308Key Terms and Concepts from the Chapter, 308Questions, 308Problems: 30916.1 Effect of Selected Transactions on Net Income and Shareholders’ Equity, 30916.2 Share Buybacks, 30916.3 The Financial Statement Effects of Dividend Payments and Buybacks, 30916.4 The Accounting and Economic Consequences of Stock Splits and Stock Dividends, 310Case Studies: 31016-1 Stock Options, Stock Dividends, and Stock Splits, 31016-2 Share Buybacks: Economic Rationale and Financial Reporting Effects, 31116-3 The Accounting for Convertible Bonds, 31116-4 Why Do Companies Buy Back Their Own Shares? The Case of the Scomi Group, 311Notes, 31217 Investments 313Introduction, 313Investments at Microsoft, 313Debt and Passive Equity Investments, 314The Fair Value Hierarchy, 316Equity Method, 317A Further Look at Microsoft’s Investments, 319Consolidation, 321Key Lessons from the Chapter, 323Key Terms and Concepts from the Chapter, 324Questions, 324Problems: 32417.1 Classification of Long-Term Investments, 32417.2 The Effect of Transaction Cost on Marketable Securities and Investments, 32517.3 Journal Entries and Analysis Under the Equity Method, 32517.4 Review Problem, 32517.5 Mark-to-Market Accounting for Trading Securities, 32617.6 The Equity Method and the Statement of Cash Flows, 326Case Studies: 32717-1 Stora Enso: Accounting for Investments, 32717-2 Coca-Cola and Coca-Cola Enterprises: The EquityMethod in Practice, 328Notes, 32818 Accounting for Mergers and Acquisitions 329Introduction, 329Purchase Price/Cost of Acquisition, 329Contingent Consideration, 330Recognition and Measurement of Identifiable Assets, 330Subsequent Adjustments to Acquired Assets and Liabilities, 334Goodwill Impairment, 334Noncontrolling Interest, 335Key Lessons from the Chapter, 336Key Terms and Concepts from the Chapter, 336Questions, 336Problems: 33618.1 Journal Entry for an Acquisition, 33618.2 Analysis of an Acquisition, 33718.3 Accounting for an Acquisition: Carrefour and BLC (China), 33718.4 Business Combinations at Tesco, 33818.5 AB InBev acquires SABMiller, 338Appendix: Tables for Present Value and Future Value Factors 342Index 351