A manager’s primary goal is to maximize the value of his or her! rm’s stock, and value
is based on the! rm’s future cash " ows. But how do managers decide which actions
are most likely to increase those " ows, and how do investors estimate future cash
" ows? The answers to both questions lie in a study of! nancial statements that pub-
licly traded! rms must provide to investors. Here investors include both institutions
(banks, insurance companies, pension funds, and the like) and individuals like you.
Much of the material in this chapter deals with concepts you covered in a basic
accounting course. However, the information is important enough to warrant a review.
Also, in accounting, you probably focused on how accounting statements are made;
the focus here is on how investors and managers interpret and use them. Accounting is
the basic language of business, so everyone engaged in business needs a good work-
ing knowledge of it. It is used to “keep score”; and if investors and managers do not
know the score, they won’t know whether their actions are appropriate. If you took
midterm exams but were not told your scores, you would have a di# cult time knowing
whether you needed to improve. The same idea holds in business. If a! rm’s managers—
whether they are in marketing, personnel, production, or! nance—do not understand
! nancial statements, they will not be able to judge the e$ ects of their actions, which
will make it hard for the! rm to survive, much less to have a maximum value.
When you! nish this chapter you should be able to:
- List each of the key! nancial statements and identify the kinds of information
they provide to corporate managers and investors. - Estimate a! rm’s free cash " ow and explain why free cash " ow has such an impor-
tant e$ ect on! rm value. - Discuss the major features of the federal income tax system.
3-1 FINANCIAL STATEMENTS AND REPORTS
The annual report is the most important report that corporations issue to stockhold-
ers, and it contains two types of information.^2 First, there is a verbal section, often
presented as a letter from the chairperson, which describes the! rm’s operating
Annual Report
A report issued annually
by a corporation to its
stockholders. It contains
basic financial statements
as well as management’s
analysis of the firm’s past
operations and future
prospects.Annual Report
A report issued annually
by a corporation to its
stockholders. It contains
basic financial statements
as well as management’s
analysis of the firm’s past
operations and future
prospects.the banks had to acknowledge their losses, which ran into
many billions of dollars.
It turns out that the banks had tried to avoid writing
down their mortgages; but a newly formed organization set
up by the Big Four accounting firms, called the Center for
Audit Quality, took a hard line and forced the write-downs.
That led Lynn Turner, former chief accountant for the SEC
and a frequent critic of the accounting profession, to state,
“The accounting firms are doing a much better job than
they did in the past.”^1P U T T I N G T H I N G S I N P E R S P E C T I V E
CHAPTER 3 Financial Statements, Cash Flow, and Taxes
(^1) David Reilly, “Behind Bank’s Credit Rescue Fund: “With New, United Voice, Auditors Stand Ground On How to
Treat Crunch,” The Wall Street Journal, October 17, 2007, p. C1.
(^2) Firms also provide quarterly reports, but these are much less comprehensive than the annual report. In addition,
larger! rms! le even more detailed statements with the Securities and Exchange Commission (SEC), giving break-
downs for each major division or subsidiary. These reports, called 10-K reports, are made available to stockholders
upon request to a company’s corporate secretary. In this chapter, we focus on annual data—balance sheets at
the ends of years and income statements for entire years rather than for shorter periods.