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1．FRAMEWORK FOR FINANCIAL STATEMENT ANALYSIS 1

Need for Financial Statement Analysis 2

Introduction 2

Focus on Investment Decisions 3

Classes of Users, 4

Financial Information and Capital Markets, 4

The Financial Reporting System 5

General Principles and Measurement Rules, 5

The U．S．Financial Reporting System 6

Securities and Exchange Commission, 6

Financial Accounting Standards Board, 7

International Accounting Standards 11

International Organization of Securities Commissions, 12

International Accounting Standards Board, 12

European Financial Reporting Standards, 13

SEC Reporting Requirements for Foreign Registrants 13

Principal Financial Statements 14

The Balance Sheet, 14

The Income Statement, 15

Statement of Comprehensive Income, 16

Statement of Cash Flows, 17

Statement of Stockholders'Equity, 17

Footnotes, 18

Contingencies, 18

Other Sources of Financial Information 20

Management Discussion and Analysis, 20

Supplementary Schedules, 20

Other Data Sources, 21

Role of the Auditor 22

Reporting on Uncertainties, 23

Changing Auditors, 25

Audi？ing Outside ofthe United States, 25

Other Auditor Services, 25

Summary 26

2．ACCOUNTING INCOME AND ASSETS:THE ACCRUAL CONCEPT 28

Introduction 29

Income,Cash Flows,and Assets:Definitions and Relationships 29

The Accrual Concept of Income 31

Income Statement, 34

Accounting Income:Revenue and Expense Recognition, 39

Issues in Revenue and Expense Recognition, 45

Summary of Review Recognition Methods, 52

Nonrecurring Items 52

Types of Nonrecurring Items, 53

IAS Standards for Nonrecurring Items, 56

Analysis of Nonrecurring Items, 56

Quality of Earnings, 61

The Balance Sheet 61

Format and Classification, 61

Measurement of Assets and Liabilities, 63

Uses of the Balance Sheet, 64

Statement of Stockholders'Equity 65

Format,Classification,and Use, 65

Summary 68

3．ANALYSIS OF CASH FLOWS 74

Statement of Cash Flows 75

Direct and Indirect Method Cash Flow Statements, 75

Preparation of a Statement of Cash Flows, 78

Transactional Analysis, 78

Preparation of a Direct Method Statement of Cash Flows, 79

Indirect Method, 82

Reported versus Operating Changes in Assets and Liabilities, 83

Effect of Exchange Rate Changes on Cash, 85

Analysis of Cash Flow Information 87

Free Cash Flows and Valuation, 87

Relationship of Income and Cash Flows, 88

Analysis of Cash Flow Trends, 92

Cash Flow Classification Issues, 94

Cash Flow Statements:An International Perspective 98

Summary 99

4．FOUNDATIONS OF RATIO AND FINANCIAL ANALYSIS 110

Introduction 111

Purpose and Use of Ratio Analysis, 111

Ratio Analysis:Cautionary Notes, 112

Common-Size Statements 114

Discussion of Ratios by Categery 119

Activity Analysis, 119

Liquidity Analysis, 124

Long-term Debt and Solvency Analysis, 130

Profitability Analysis 133

Opcrating and Financial Leverage, 135

Ratios:An Integrated Analysis 139

Analysis of Firm Performance, 140

Economic Characteristics and Strategies, 145

Classification and Selection of Ratios, 148

Earnings per Share and Other Ratios Used in Valuation 149

Earnings per Share, 149

Cash Flow per Share, 151

EBITDA per Share, 152

Book Value per Share, 153

Price-to-Earnings and Price-to-Book-Value Ratios, 153

Dividend Payout Ratio, 153

Patterns of Ratio Disclosure and Use 153

Perceived Importance and Classification, 153

Disclosure of Ratios and Motivation, 154

Summary 154

5．EMPIRICAL RESEARCH:IMPLICATIONS FOR FINANCIAL STATEMENT ANALYSIS 163

Introduction 164

Classical Approach 165

Market-Based Research 166

Efficicnt Market Theory, 166

Modern Portfolio Theory, 167

Tests of the EMH versus the Mechanistic Hypothesis, 168

Ball and Brown Study, 169

Information Content Studies, 169

Relationship Between Earnings and Stock Returns, 170

Disclosure and Regulatory Requirements, 173

Agency Thcory, 173

Positive Accounting Research 173

Summary of the Research, 175

Empirical Research A Mid-Course Evaluation, 176

Ball and Brown Revisited, 181

Direction of Current Research:Back to the Future？ 181

Contextual Approaches and Fundamental Analysis, 183

Coming Full Circle:From Edwards and Bell to Ohlson, 184

Im？lications of Empirical Research for Financial Statement Analysis 185

6．ANALYSIS OF INVENTORIES 192

Inventory and Cost of Goods Sold:Basic Relationships 193

Introduction 193

Scenario 2:Rising Prices, 194

Scenario 1:Stable Prices, 194

Comparison of Information Provided by Alternative Methods 195

Balance Sheet Information:Inventory Account, 195

Income Statement Information:Cost of Goods Sold, 196

LIFO Versus FIFO:Income,Cash Flow,and Working Capital Effects 198

Adjustment from LIFO to FIFO 200

Adjustment of Inventory Balances, 200

Adjustment of Cost of Goods Sold, 201

Adjustment of Income to Current Cost Income 202

Financial Ratios:LIFO Versus FIFO 206

Profitability:Gross Profit Margin, 207

Liquidity:Working Capital, 208

Activity:Inventory Turnover, 209

Solvency:Debt-to-Equity Ratio, 211

Declines in LIFO Reserve 211

LIFO Liquidations, 212

Declining Prices, 214

Initial Adoption of LIFO, 215

Initial Adoption of LIFO and Changes to andfrom LIFO 215

Change from LIFO Method, 216

Overview of FIFO/LIFO Choice, 217

Summary of FIFO/LIFO Choice, 217

LIFO:A Historical and Empirical Perspective 217

International Accounting and Reporting Practices 219

IASB Standard 2, 220

Summary and Concluding Comments 220

7．ANALYSIS OF LONG-LIVED ASSETS:PARTI—THE CAPITALIZATION DECISION 227

Introduction 228

Acquiring the Asset:The Capitalization Decision 228

Capitalization Versus Expensing:Conceptual Issues 229

Financial Statement Effects of Capitalization, 229

Capitalization of Interest Costs, 233

Capitalization Versus Expensing:General Issues 233

Intangible Assets, 235

Asset Revaluation, 240

Regulated Utilities, 241

Capitalization Versus Expensing:Industry Issues 241

Computer Software Development Costs, 242

CONTENTS 244

Accounting for Oil and Gas Exploration, 244

Need for Analytical Adjustments, 246

Analytical Adjustments for Capitalization and Expensing 246

Valuation Implications, 248

Other Economic Consequences, 248

Additional Analysis of Fixed A sset Data, 250

Summary 252

8．ANALYSIS OF LONG-LIVED ASSETS:PART II—ANALYSIS OF DEPRECIATION AND IMPAIRMENT 257

Introduction 258

The Depreciation Concept 258

Depreciation Methods, 259

Depletion, 264

Amortization, 264

Impact of Depreciation Methods on Financial Statements, 265

Depreciation Method Disclosures, 265

Impact of Inflation on Depreciation, 266

Accelerated Depreciation and Taxes, 266

Changes in Depreciation Method, 268

Analysis of Fixed Asset Disclosures 272

Estimating Relative Age and Useful Lives, 273

Estimating the Age of Assets, 273

Impairment of Long-Lived Assets 275

Financial Reporting of Impaired Assets, 275

Impai rment of Assets Held for Sale, 275

Impairment of Assets Remaining in Use, 276

Effect of SFAS 121 on Analysis of Impairment, 277

Financial Statement Impact of Impairments, 277

Empincal Findings, 278

Liabilities for Asset Retirement Obligations 280

Provisions of SFAS 143, 280

Effccts of SFAS 143, 281

Summary 282

9．ANALYSIS OF INCOME TAXES 290

Introduction 291

Basic Income Tax Accounting Issues 291

The Liability Method:SFAS 109 and IAS 12 291

Treatment of Operating Losses, 299

Deferred Tax Asscts and the Valuation Allowance, 299

Deferred Tax Liabilities, 299

Finan？al Statement Presentation and Disclosure Requirements, 300

Deferred Taxes:Analytical Issues 301

Factors Influencing the Level and Trcnd of Deferrcd Ta？es, 301

Liability or Equity？, 304

Analysis of Deferred Tax Assets and the Valuation Allowance, 306

Effective Tax Rates, 307

Accounting for Taxes:Specialized Issues 308

Temporary versus Permancnt Differcnces, 308

Indefinite Reversals, 308

Analysis of Income Tax Disclosures:Pfizer 309

Accounting for Acquisitions, 309

Analysis of the Effective Tax Rate, 310

Analysis of Deferred Income Tax Expense, 311

Using Deferred Taxes to Estimate Taxable Income, 312

Analysis of Deferred Tax Assets and Liabilities, 313

Other Issues in Income Tax Analysis, 314

Financial Reporting Outside the United States 314

IASB Standards, 314

Other National Standards, 315

Summary 316

10．ANALAYSIS OF FINANCING LIABILITIES 322

Current Liabilities, 323

Balance Sheet Debt 323

Introduction 323

Long-Term Debt, 325

Debt with Equity Features, 337

Effects of Changes in Interest Rates, 342

Debt of Firms in Distress, 347

Retirement of Debt Prior to Maturity, 348

Bond Covenants 350

Nature of Covenants, 351

Summary 354

11．LEASES AND OFF-BALANCE-SHEET DEBT 363

Leases 364

Introduction 364

Incentives for Leasing, 365

Lease Classification:Lessees, 365

Financial Reporting by Lessees:Capital versus Operating Leases, 368

Analysis of Lease Disclosures, 371

Other Lease-Related Issues, 375

Off-Balance-Sheet Financing Activities 376

Take-or-Pay and Throughput Arrangements, 376

Sale of Receivables, 378

Other Securitizations, 381

Joint Ventures,Finance Subsidiaries,and Investment in Affiliates, 382

Analysis of OBS Activities:Texaco 383

Adjustments to 1999 Debt, 383

Financial Reporting by Lessors 386

Lease Classification:Lessors, 387

Sales-Type Leases, 387

Direct Financing Leascs, 390

IAS Standards for Lessors, 391

Summary 393

11．PENSIONS AND OTHER EMPLOYEE BENEFITS 400

Introduction 401

Pension Plans 401

Defined Contribution Plans, 404

Defined Benefit Plans, 404

Defined Benefit Pension Plans 405

Estimating Benefit Obligations 405

Factors Affecting Benefit Obligations, 407

Factors Affecting Plan Assets, 410

Funded Status of Pension Plan, 411

Financial Reporting for Pensions:SFAS 87 and SFAS 132 412

Pension Cost:Components and Measurement, 413

Balance Sheet Carrying Amounts and Reconciliation to Funded Status, 415

Analysis of Pension Plan Disclosures 418

Importance of Assumptions, 418

Analysis of Pension Plan:Status,Costs,and Cash Flows, 421

Analysis of Texaco Pension Plan Disclosures, 425

Other Pension Fund Issues 429

Acquisitions and Divestitures, 429

Curtailments and Settlements, 429

Cash Balance Plans, 430

IASB and Non-U．S．Reporting Requirements 431

Other Postemployment Benefits 432

Computing Postretirement Benefit Cost, 433

Estimating Health Care Benefits, 433

Disclosure of Plan Status, 434

Importance of Assumptions, 434

Analysis of Westvaco's Postretirement Health Care Costs, 437

Using SFAS 106 and SFAS 132 Disclosures, 437

Postretirement Benefits Outside the United States, 438

Preretirement Benefits 438

Stock Compensation Plans 438

Using SFAS 123 Disclosures, 441

Effect on the Statement of Cash Flow s, 441

Stock Repurchase Programs and Sales of Put Warrants, 442

Summary 442

13．ANALYSIS OF INTERCORPORATE INVESTMENTS 454

Introduction 455

Cost Method, 456

I nvestments in Securities 456

Market Method, 457

Lower of Cost or Market Method, 457

U．S．Accounting Standards for Investments in Securities, 457

Analysis of Marketable Securities 461

Separation of Operating from Investment Results, 461

Effects of Classification of Marketable Securities Under SFAS 115, 462

Analysis of Investment Performancc, 462

Summary of Analytical Procedures, 466

Equity Method of Accounting 466

Conditions for Use, 466

Illustration of the Equity Method, 467

Comparison of the Equity Method and SFAS 115, 468

Equity Method of Accounting and Analysis, 469

Consolidation 471

Comparison of Consolidation with the Equity Method 473

Illustration of Consolidation, 473

Conditions for Use, 473

Consolidation versus the Equity Method:Analytical Considerations, 475

Proportionate Consol idation, 478

Significance of Consolidation:Summary, 481

Analysis of Minority Interest 482

Consolidation Practices Outside the United States 483

Analysis of Segment Data 484

Disclosure Requirements of SFAS 131 and IAS 14, 484

Illustration of Industry Segments:Lucent and Roche, 486

Illustration of Geographical Segments:Honda, 488

Management Discussion and Analysis, 489

Uses and Limitations of Segment Data, 490

Using Segment Data to Estimate Consolidated Earnings and Risk, 490

Summary 492

14．ANALYSIS OF BUSINESS COMBINATIONS 503

Introduction 504

Accounting for Acquisitions 504

Conditions Necessary for Use of the Pooling of Interests Method, 505

Illustration of the Purchase and Pooling Methods 506

The Purchase Method, 506

The Pooling of Interests Method, 509

Effects of Accounting Methods 509

Comparison of Balance Sheets, 509

Comparison of Income Statements, 510

Ratio Effects, 514

Cash Flow Statement Effects, 515

Complicating Factors in Purchase Method Acquisitions 520

Contingent Payments, 520

Allocation of Purchase Price, 520

Income Tax Effects of Business Combinations 521

Restructuring Provisions, 521

Differences in Historical Treatment of Goodwill, 524

International Differences in Accounting for Business Combinations 524

Analysis of Goodwill 525

Goodwill Amortization, 526

Goodwill Impairment, 526

Goodwill Impairment Under SFAS 142, 527

Choosing the Acquisition Method 528

Income Maximization as Motivation for the Pooling/Purchase Choice, 529

Market Reaction and the Pooling/Purchase Choice, 529

Interpreting the Research Results, 530

Push-Down Accounting 532

Example:Genentech, 532

Impact on the Balance Sheet, 533

Impact on the Income Statement, 534

Push-Down Summed Up, 535

Spinoffs 535

Effect on Cash Flows, 535

Effect on Financial Ratios, 535

Analysis of Spinoffs, 536

Example:Lucent, 536

Reasons for Investment in Spinoffs, 537

Summary 538

15．ANALYSIS OF MULTINATIONAL OPERATIONS 546

Introduction 547

Effects of Exchange Rate Changes 547

Basic Accounting Issues 549

Foreign Currency Translation Under SFAS 52 550

Role of the Functional Currency, 550

Remeasurement:The Temporal Method, 551

Treatment of Exchange Rate Gains and Losses, 552

Translation:The All-Current Method, 552

Remeasurement versus Translation, 553

Illustration of Translation and Remeasurement 555

Translation:The All-Current Method, 556

Cumulative Translation Adjustment, 559

Remeasurement:The Temporal Method, 561

Comparison of Translation and Remeasurement 562

Income Statement Effects, 562

Balance Sheet Effects, 563

Impact on Financial Ratios, 564

Impact on Reported Cash Flows, 566

Analysis of Foreign Currency Disclosures 568

Exchange Rate Changes:Exposure and Effects, 568

Hyperinflationary Economies 573

Changes in Functional Currency 574

Alternative Accounting Methods for Hyperinflationary Subsidia ries, 574

Effects of Debt Denominated in Hyperinflationary Currencies, 574

Analytical Difficulties Related to Foreign Operations 575

Relationships Among Interest Rates,Infation,and Exchange Rates, 575

Consistency in Reporting, 576

Economic Interpretation of Results, 577

Impact of SFAS 8 and SFAS 52 on Management and Investor Bchavior, 579

Financial Reporting Outside of the United States 580

International Accounting Standards, 580

Summary 580

16．DERIVATIVES AND HEDGING ACTIVITIES 589

Introduction 590

Defining Risk 590

Interest Rate Risk, 592

Commodity Risk, 592

Foreign Currency Risk, 592

Risk of Changes in Market Value, 593

Event Risk, 593

Hedging Techniques 593

Forward Contracts, 593

Options, 595

Economic Hedges, 595

Accounting Standards for Derivative Instruments and Hedging Activities 596

Recognition of Derivatives and Measurement of Derivatives and Hedged Items, 597

Hedge Qualification Criteria, 600

Types of Hedges, 600

Embedded Derivatives, 603

Hedge Effectiveness, 604

Hedge Termination, 605

Effect of Hedging on Impairment, 605

Related Financial Reporting Requirements, 606

Disclosure Requirements, 606

Analysis of Hedging Disclosures 608

Analysis of IBM's Risk Managcment Disclosures, 608

Analysis of AMR's Risk Management Disclosures, 610

Risk Factors in Derivatives and Hedging Activities, 612

Summary 613

17．ANALYSIS OF FINANCIAL STATEMENTS:A SYNTHESIS 619

I ntroduction 620

Analysis of and Adjustments to the Balance Sheet 620

Analysis of Book Value, 620

Adjustments to Assets, 621

Adjustments to Liabilities, 622

Balance Sheet Adjustments for Westvaco, 622

Adjustments to Stockholders'Equity, 628

Adjusted Book Value per Common Share, 628

Analysis of Capital Structure, 629

Balance Sheet Adjustments for Non-U．S．Companies, 630

Adjustments to Reported Income 631

Normalization of Reported Income, 631

Analytical Treatment of Nonrecurring Items, 634

Income Normalization for Non-U．S．Firms, 636

Normalization Over the Economic Cycle, 636

Acquisitions Effects, 636

Exchange Rate Effects, 637

Effect of Accounting Changes, 637

Quality of Earnings, 637

Comprehensive Income, 639

Analysis of Cash Flow 640

Analysis of Cash Flow Components, 641

International Cash Flow Comparisons, 643

Free Cash Flow, 643

Adjusted Financial Ratios 644

International Ratio Comparisons, 645

Summary 645

18．ACCOUNTING-AND FINANCE-BASED MEASURES OF RISK 646

Introduction 647

Earnings Variability and Its Components, 647

Credit Risk 648

Bankruptcy Prediction, 648

Research Results, 649

The Prediction of Bond Ratings, 658

Usefulness of Bond Ratings Predictions, 662

The Significance of Ratings:Another Look, 665

Equity Risk:Measurement and Prediction 666

Risk and Return:Theoretical Models, 666

Review of Theoretical and Empirical Findings, 668

Importance and Usefulness of Beta（β）, 668

The Attack on the CAPM and β, 673

Summary 677

19．VALUATION AND FORECASTING 682

Introduction 683

VALUATION MODELS 683

Overview of Models 683

Asset-Based Valuation Models 685

Market Price and Book Value:Theoretical Considerations, 685

Book Value:Measurement Issues, 686

Tobin's Q Ratio, 687

Stability and Growth of Book Value, 687

Discounted Cash Flow Valuation Models 689

Dividend-based Models, 689

Earnings-based Models, 690

Free Cash Flow Approach to Valuation, 702

The Abnormal Earnings or EBO Model 705

EBO versus DCF Models, 707

The EBO Model:Concluding Comments, 714

FORECASTING MODELS AND TIME SERIES PROPERTIES OF EARNINGS 714

Forecasting Models, 714

Extrapolative Models, 714

Forecasting with Disaggregated Data, 717

Comparison with Financial Analyst Forecasts 720

Analyst Forecasts;Some Caveats, 721

FINANCIAL STATEMENT FORECASTS 724

Alpha Growth, 725

Summary 731

PRESENT VALUE TABLES 739

BIBLIOGRAPHY 743

INDEX 755