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