2 Chapter 2 The Financial Statements

Business Activities Business activities are reflected in financial statements; business activities include: – Operating activities – selling goods and services. – Investing activities – acquisition and sale of productive assets. – Financing activities – issue and retirement/repayment of liabilities and equity.

4 The Balance Sheet The balance sheet reports the financial position at a point in time (end of the quarter or year). The Balance Sheet is also called: Statement of Financial Position The components of the Balance Sheet are: Assets Liabilities Shareholders’ (Owners’) Equity

5 The Balance Sheet The balance sheet is represented by the fundamental accounting equation: Assets = Liabilities + Shareholders’ Equity A = L + SE The effects of all business transactions may be represented in this formula.

6 Assets Definition? Current assets – Cash – Short-term investments – Accounts receivable – Inventory – Prepaid expenses Long-term investments Property, plant, and equipment Intangible assets

7 Liabilities Definition? Current liabilities – Accounts payable – Wages payable – Interest payable – Short-term notes payable – Current maturities of long-term debt – Deferred revenues – Other payables Long-term liabilities

8 Owners’ (Shareholders’) Equity Definition? Contributed capital – Shareholders’ equity (par or stated value) – Paid-in capital in excess of par value Earned capital - Earned Capital has 2 components: Retained Earnings and Other accumulated comprehensive income. We will cover other accumulated comprehensive income in Chapter 13. – Retained earnings represent the excess earnings retained in the company after dividends have been paid to shareholders. This represents the equity generated by the company for the shareholders.

9 The Statement of Shareholders’ Equity (SSE) The following formula represents the basic SSE: Beginning shareholders’ equity Plus: Issuance of stock Plus: Net income Less: Dividends Ending shareholders’ equity SE Begin + Issue + NI - D = SE End

10 The Statement of Retained Earnings The statement of retained earnings is a subset of the SSE, and calculates the changes in the retained earnings component. Beginning retained earnings Plus: Net income Less: Dividends Ending retained earnings RE Begin + NI - Div = RE End

International Perspective – Balance Sheet Many non-U.S. firms that publish IFRS-based balance sheets add shareholder’s equity to non-current liabilities, referring to the total as capital employed. Consequently, the balance sheet format looks like: Non-current assets + Current assets - Current liabilities = Non-current liabilities + Shareholders’ equity Under U.S. GAAP balance sheet accounts are listed in order of liquidity. Many non-U.S. firms that publish IFRS-based balance sheets list their assets in the opposite order, starting with non-current assets, followed by current assets. Many non-U.S. companies, especially in Europe, use the term “turnover” instead of revenue.

12 The Income Statement Operating revenues – Sales – Fees earned – Other revenues Operating expenses – Cost of goods sold – Wage expense – Rent expense – Selling expense – Depreciation expense – Amortization expense – Other expenses Operating revenues and expenses: usual and frequent Other revenues and expenses: unusual or infrequent Disposal of a business segment Extraordinary items: unusual and infrequent

13 The Statement of Cash Flows Cash flows from operating activities: – Cash flows associated with the acquisition and sale of a company’s products and services – Collections from sales, rent, interest, etc. – Cash paid to suppliers and employees, and for rent, selling activities, interest, and taxes etc. Cash flow from investing activities: – Cash flows associated with the purchase and sale of a company’s investments. – Proceeds from sale of investment securities, land, buildings, equipment, etc. – Purchase of investment securities, land, buildings, equipment, etc. Cash flow from financing activities: – Cash flows associated with a company’s two sources of outside capital: liabilities and contributed capital. – Proceeds from issuance of notes, debt, sale of equity, etc. – Payments on notes, debt, dividends, etc.

14 Classifying Financing, Investing, and Operating Transactions Financing and Investing Transactions Operating Transactions Balance Sheet Income Statement 1 1. Exchanges with shareholders 2 2. Exchanges of liabilities and shareholders’ equity 3 3. Issues and payments of debt 4 4. Purchases, sales, and exchanges of assets 5 5. Revenues and expenses

15 Classifying Operating Transactions TransitoryPersistent Group C Gains and losses due to change in accounting principles Group A Normal and recurring operating revenues and expenses Group B Revenues and expenses from activities not germane to a company’s primary activity Extraordinary items Disposals of segments Other revenues and expenses

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Relationships Among the Financial Statements Statement of Cash Flows Income Statement Statement of Stockholders’ Equity Ending Balance Sheet Assets (Cash) = Liabilities + Equity Beginning Balance Sheet Assets (Cash) = Liabilities + Equity

18 Exercise 2-3 Balance Sheet (B) or Income Statement (I) a. Equipment b. Fees Earned c. Retained Earnings d. Wage Expense e. Patent f.Cost of Goods Sold g.Common Stock h.Dividend Payable i.Accumulated Depreciation B I B I B I B B B

19 Exercise 2-3 Balance Sheet (B) or Income Statement (I) j.Prepaid Expense k.Gain on Sale of Short-term Investment l.Rent Revenue m. Supplies Inventory n.Accounts Receivable o.Land p.Insurance Expense q.Interest Payable r.Deferred (Unearned) Revenue B I I B B B I B B

20 Exercise Given (in billions): Beginning RE ? Revenues Expenses 3.9 ? 3.5 Div. declared.3.3 ? Ending RE 1.6 ? ? Now, using the following formulas and relationships, solve for the other missing items: (1) Rev - Exp = NI (2) RE(B) + NI - Div = RE(E) (3) RE(E) becomes RE(B) in the next year

21 Exercise, 2010 Solve for RE(B) using: RE(B) + NI - Div = RE(E) NI = 4.4 – 3.9 =.5 RE(B) = 1.6 RE(B) = 1.4

22 Exercise, 2009 First, find RE(E): RE(E) 2009 = RE(B) 2010 = 1.4 Now find Expenses: RE(B) + Rev. – Exp. - Div = RE(E) – Exp -.3 = 1.4 Exp. = 3.7

23 Exercise, 2008 First, find RE(E): RE(E) 2008 = RE(B) 2009 = 1.3 Now find Div: RE(B) + Rev – Exp. - Div = RE(E) – 3.5 – Div. = 1.3 Div. =.3

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