Chapter 3, 13th edtion
Financial Statements, Cash Flow, and Taxes
After reading this chapter, students should be able to:
◆ List each of the key financial statements and identify the kinds of information they provide to corporate managers and investors.
◆ Estimate a firm’s free cash flow and explain why free cash flow has such an important effect on firm value.
◆ Discuss the major features of the federal income tax system.
The goal of financial management is to take actions that will maximize the value of a firm’s stock. These actions will show up, eventually, in the financial statements, so a general ...view middle of the document...
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 3, which appears at the end of this chapter’s solutions. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 56 DAYS (50-minute periods)
Answers to End-of-Chapter Questions
3-1 The four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders’ equity, and statement of cash flows.
3-2 Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or in which to invest, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to assess taxes in a reasonable way.
3-3 No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm over its life. Consequently, the $20 million would be an investment in all of the firm’s assets.
3-4 The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 2012. It shows each account balance at that particular point in time. For example, the cash account shown on the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 2012. The income statement, on the other hand, reports on the firm’s operations over a period of time, for example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that particular time period. For example, the sales figures reported on the income statement for the period ending December 31, 2012, would represent the firm’s sales over the period from January 1, 2012, through December 31, 2012, not just sales for December 31, 2012.
3-5 Investors need to be cautious when they review financial statements. While companies are required to follow GAAP, managers still have quite a lot of discretion in deciding how and when to report certain transactions. Consequently, two firms in exactly the same operating situation may report financial statements that convey different impressions about their financial strength. Some variations may stem from legitimate differences of opinion about the correct way to record transactions. In other cases, managers may choose to report numbers in a way that helps them present either higher earnings or more stable earnings over time. As long as they follow GAAP, such actions are not illegal, but these differences make it harder for investors to compare companies and gauge their true performances.
Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting...