Introduction to Financial Statement

Form of Financial Statement Accounting Equation The Balance Sheet The Income Statement The Cash Flow Statement The statement of Stockholders’ Equity Statement of Retain Earnings Foot notes and supplement information to financial statement

Assets = Liabilities + Equity Balance Sheet Mirrors the Accounting Equation Assets = Liabilities + Equity Uses of funds = Sources of funds Assets are listed in order of liquidity Liabilities are listed in order of maturity Equity consists of Contributed Capital and Retained Earnings

Assets To be reported on a balance sheet, an asset must Be owned or controlled by the company Generally, this means owning title to the asset Leased assets are recorded under certain circumstances Must possess expected future benefits Generally this means cash inflow Future benefits may mean the receipt of another asset or the reduction of a liability When the receipt of future benefits is in doubt, the asset may become “impaired” and written down of off entirely

Assets are Reported in Order of Liquidity Liquidity refers to the ease of converting a noncash asset to cash. Asset portion of the balance sheet is divided into Current and Noncurrent Assets Current assets comprise assets that can be converted to cash within a year Noncurrent assets (long-term assets) cannot be easily converted to cash within a year.

Assets are Reported at Historical Cost Historical Cost is Objective Verifiable Therefore, not subject to bias However, historical cost is not particularly “relevant” to most readers of the balance sheet “Relevance vs. Reliability” is an important issue with accountants.

Liabilities Liabilities are listed in order of maturity Current Liabilities come due in less than a year. Noncurrent liabilities come due after a year. Companies desire more current assets than current liabilities – this difference is called net working capital

Net Working Capital

Tactics Used to Reduce Operating Cycles Increase trade credit to minimize the cash invested in inventories Reduce inventory levels by improved production systems and management Decrease accounts receivable by better collection procedures

Equity Equity consists of: Contributed Capital (cash raised from the issuance of shares) Earned Capital (retained earnings). Retained Earnings is updated each period as follows:

Market Value vs. Book Value Stockholders’ equity = Company book value Book value is determined using GAAP. Book value is not the same as Market Value. Market Value = # of Shares x Price per share On average, the book value is roughly two-thirds of market value.

Income Statement

Income Statement Revenues are increases in net assets as a result of business activities. Expenses are the outflow or use of assets to generate revenues, including costs of products and services sold, operating costs like wages and advertising, and nonoperating costs like interest on debt.

Operating vs. Nonoperating Operating expenses are the usual and customary costs that a company incurs to support its main business activities Nonoperating expenses relate to the company’s financing and investing activities

Accrual Accounting Accrual accounting refers to the recognition of revenue when earned (even if not received in cash) and the matching of expenses when incurred (even if not paid in cash).

Accrual Accounting Accrual accounting rests on two guiding principles: Revenue Recognition Principle – record revenue when Earned Realized or Realizable Matching Principle – record expenses when Incurred Neither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash

Accrual Example Assume the following: Purchase of $100 of inventory on account Sale of all of the inventory for $150 on account Employees earn $20 of wages to be paid next period

Transitory vs. Core Transitory items are one-time events (e.g., not likely to recur) Core items are likely to recur (persist) and are, therefore, more relevant for company valuation

Transitory Items Discontinued operations: net income or loss from business segments that are up for sale or sold in the current period Extraordinary items: revenue and expenses that are both unusual and infrequent Changes in accounting principles: cumulative income or loss from changes in accounting methods (may be reflected in income from continuing operations in the future)

Transitory Items Income from Continuing Operations may still contain transitory items: Gains (losses) on asset sales Restructuring expenses Asset write-downs Accruals

Statement of Stockholders’ Equity Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. Main equity categories are: Contributed capital Retained earnings (including Other Comprehensive Income or OCI) Treasury stock

Statement of Cash Flows Statement of cash flows (SCF) reports cash inflows and outflows Cash flows are reported based on the three business activities of a company: Operating activities: transactions related to the operations of the business. Investing activities: acquisitions and divestitures of long-term assets Financing activities: issuances and payments toward equity, borrowings, and long-term liabilities.