Introducing Financial Statements and Transaction Analysis Introducing Financial Statements and Transaction Analysis

Flow of Costs

Four Main Financial Statements Balance Sheet Balance Sheet Income Statement Income Statement Statement of Stockholders’ Equity Statement of Stockholders’ Equity Statement of Cash Flows Statement of Cash Flows

The Financial Statements Balance Sheet – assets, liabilities and equity at one point in time Balance Sheet – assets, liabilities and equity at one point in time Income Statement – revenues, expenses, and profit over a period of time Income Statement – revenues, expenses, and profit over a period of time Statement of Equity – changes in contributed and earned capital Statement of Equity – changes in contributed and earned capital Statement of Cash Flows – net cash inflows (outflows) form operating, investing and financing activities Statement of Cash Flows – net cash inflows (outflows) form operating, investing and financing activities

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

Balance Sheet A balance sheet reports on investing and financing activities. A balance sheet reports on investing and financing activities. It lists amounts for assets, liabilities, and equity as of a point in time. It lists amounts for assets, liabilities, and equity as of a point in time. The accounting equation (also called the balance sheet equation) is the basis of the balance sheet: The accounting equation (also called the balance sheet equation) is the basis of the balance sheet: Assets = Liabilities + Equity

The Accounting Equation

Berkshire Hathaway’s Balance Sheet

Assets To be reported on a balance sheet, an asset must 1. Be owned (or controlled) by the company 2. Must possess expected future economic benefits  Assets are listed in order of liquidity Current assets comprise assets that can be converted to cash within a year Current assets comprise assets that can be converted to cash within a year Long-term assets cannot be easily converted to cash within a year. Long-term assets cannot be easily converted to cash within a year.

Examples of Current Assets Cash Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents); Marketable securities Marketable securities—short-term investments that can be quickly sold to raise cash; Accounts receivable, net Accounts receivable, net—amounts due to the company from customers arising from the sale of products and services on credit (“net” refers to uncollectible accounts ); Inventory Inventory—goods purchased or produced for sale to customers; Prepaid expenses Prepaid expenses—costs paid in advance for rent, insurance, advertising or other services.

Examples of Long-term Assets Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment and other items used in operating activities (“net” refers to subtraction of accumulated depreciation, the portion of the assets’ cost that has been transferred from the balance sheet to the income statement); Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment and other items used in operating activities (“net” refers to subtraction of accumulated depreciation, the portion of the assets’ cost that has been transferred from the balance sheet to the income statement); Long-term investments—investments that the company does not intend to sell in the near future; Long-term investments—investments that the company does not intend to sell in the near future; Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits. Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits.

Apple’s Assets

Cisco Systems, Inc. Assets

Assets are Reported at Historical Cost Historical Cost is Historical Cost is Objective Objective Verifiable Verifiable “Relevance vs. Reliability” “Relevance vs. Reliability” Only include items that can be reliably measured. Only include items that can be reliably measured. Considerable amount of “assets” may not be reflected on a balance sheet Considerable amount of “assets” may not be reflected on a balance sheet Strong management team, a well-designed supply chain, or superior technology. Strong management team, a well-designed supply chain, or superior technology.

Knowledge Based Assets are not Reflected on the Balance Sheet NOTE: While resources expended for research and development reflect an economic asset, they generally are expensed as incurred. NOTE: While resources expended for research and development reflect an economic asset, they generally are expensed as incurred. INSIGHT: Pharmaceutical firms do not have assets reflecting the full amount of money that they have spent developing drugs. These amounts, for the most part, have been expensed in the past and serve to reduce retained earnings. Internally developed trade marks are also economic assets, but may not show up on the balance sheet. [The purchase of externally developed trademarks are treated as assets.] INSIGHT: Pharmaceutical firms do not have assets reflecting the full amount of money that they have spent developing drugs. These amounts, for the most part, have been expensed in the past and serve to reduce retained earnings. Internally developed trade marks are also economic assets, but may not show up on the balance sheet. [The purchase of externally developed trademarks are treated as assets.]

Disney’s Assets Where’s Mickey? The market value of the Mickey Mouse trademark does not explicitly show up here.

Apple’s Liabilities and Equity

Examples of Current Liabilities Accounts payable Accounts payable —amounts owed to suppliers for goods and services purchased on credit. Accrued liabilities Accrued liabilities —obligations for expenses that have been incurred but not yet paid; examples are accrued wages payable (wages earned by employees but not yet paid), accrued interest payable (interest that is owing but has not been paid), and accrued income taxes (taxes due). Unearned revenues Unearned revenues —obligations created when the company accepts payment in advance for goods or services it will deliver in the future; also called advances from customers, customer deposits, or deferred revenues. Short-term notes payable Short-term notes payable —short-term debt payable to banks or other creditors. Current maturities of long-term debt Current maturities of long-term debt —principal portion of long-term debt that is due to be paid within one year.

Cisco systems, Inc. Current Liabilities

Net Working Capital

Operating Cycle

Examples of Noncurrent Liabilities Long-term debt Long-term debt —amounts borrowed from creditors that are scheduled to be repaid more than one year in the future; any portion of long-term debt that is due within one year is reclassified as a current liability called current maturities of long-term debt. Long-term debt includes bonds, mortgages, and other long-term loans. Other long-term liabilities Other long-term liabilities —various obligations, such as pension liabilities and long-term tax liabilities, that will be settled a year or more into the future.

Cisco Systems, Inc. Long-term Liabilities

Statement of Equity The statement of equity reports on changes in the accounts that makeup equity The statement of equity reports on changes in the accounts that makeup equity Contributed capital Contributed capital Earned capital (retained earnings and accumulated other comprehensive income) Earned capital (retained earnings and accumulated other comprehensive income) This statement is useful in identifying and analyzing reasons for changes in owners’ claims on a company’s assets. This statement is useful in identifying and analyzing reasons for changes in owners’ claims on a company’s assets.

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

Berkshire Hathaway’s Statement of Stockholders’ Equity

Examples of Equity Accounts Common stock Common stock —par value received from the original sale of common stock to investors. Preferred stock Preferred stock —value received from the original sale of preferred stock to investors; preferred stock has fewer ownership rights compared to common stock. Additional paid-in capital Additional paid-in capital —amounts received from the original sale of stock to investors in addition to the par value of common stock. Treasury stock Treasury stock —amount the company paid to reacquire its common stock from shareholders. Retained earnings Retained earnings —accumulated net income (profit) that has not been distributed to stockholders as dividends. Accumulated other comprehensive income or loss Accumulated other comprehensive income or loss —accumulated changes in equity that are not reported in the income statement.

Cisco Systems, Inc. Stockholders’ Equity

Income Statement An income statement reports on operating activities. An income statement reports on operating activities. It lists amounts for sales (and revenues) less all expenses (and costs) over a period of time. It lists amounts for sales (and revenues) less all expenses (and costs) over a period of time. Sales less expenses yield the “bottom-line” net income amount. Sales less expenses yield the “bottom-line” net income amount.

Income Statement

Berkshire Hathaway’s Income Statement

Apple’s Income Statement

Cisco Systems, Inc. Income Statement

When are Revenues and Expenses Recognized? Revenue Recognition Principle—recognize revenues when earned Matching Principle—recognize expenses when incurred.

Profit vs. Cash Net Income does not necessarily correspond to a net cash flow. A firm could have “good income” but “poor cash flow” or vice versa (i.e., there are two dimensions to consider). Net Income does not necessarily correspond to a net cash flow. A firm could have “good income” but “poor cash flow” or vice versa (i.e., there are two dimensions to consider). We have previously summarized the mechanics of the balance sheet with the expanded accounting equation: We have previously summarized the mechanics of the balance sheet with the expanded accounting equation:

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

Transitory Items in the Income Statement

Transitory items Discontinued operations Discontinued operations Gains or losses (and net income or loss) from business segments that are being sold or have been sold in the current period. Extraordinary items Extraordinary items Gains or losses from events that are both unusual and infrequent.

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).

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

Apple’s Statement of Stockholders’ Equity

Statement of Cash Flows Statement of cash flows (SCF) reports cash inflows and outflows Statement of cash flows (SCF) reports cash inflows and outflows Cash flows are reported based on the three business activities of a company: Cash flows are reported based on the three business activities of a company: Cash flows from operating activities - Cash flows from the company’s transactions and events that relate to its operations. Cash flows from operating activities - Cash flows from the company’s transactions and events that relate to its operations. Cash flows from investing activities - Cash flows from acquisitions and divestitures of investments and long-term assets. Cash flows from investing activities - Cash flows from acquisitions and divestitures of investments and long-term assets. Cash flows from financing activities- Cash flows from issuances of and payments toward borrowings and equity. Cash flows from financing activities- Cash flows from issuances of and payments toward borrowings and equity.

Statement of Cash Flows The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time. The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time.

Apple’s Statement of Cash Flows

Cisco Systems, Inc. Statement of Cash Flows

Relation of SCF to Income Statement and Balance Sheet

General Coding of Balance sheet Changes

Working Capital Accounts

Articulation of Financial Statements Financial statements are linked within and across time – they articulate. Financial statements are linked within and across time – they articulate. Balance sheet and income statement are linked via retained earnings. Balance sheet and income statement are linked via retained earnings.

Apple’s Retained Earnings Reconciliation

Financial Statements

Information Beyond Financial Statements Management Discussion and Analysis (MD&A) Management Discussion and Analysis (MD&A) Independent Auditor Report Independent Auditor Report Financial Statement Footnotes Financial Statement Footnotes Regulatory Filings and Proxy Statements Regulatory Filings and Proxy Statements

Economics of Accounting Information: Demand & Supply Demand for financial accounting information extends to numerous users that include: Demand for financial accounting information extends to numerous users that include: Managers and employees Managers and employees Creditors and suppliers Creditors and suppliers Shareholders and directors Shareholders and directors Customers Customers Regulators Regulators Voters and their representatives Voters and their representatives

Supply of Accounting Information Determined by a company’s estimates of the benefits and costs of disclosure. Determined by a company’s estimates of the benefits and costs of disclosure. Regulation and bargaining power also play roles in determining the supply of financial accounting information. Regulation and bargaining power also play roles in determining the supply of financial accounting information. The SEC requires financial statements, various note disclosures, and other reports on a regular basis. The SEC requires financial statements, various note disclosures, and other reports on a regular basis.

Supply of Accounting Information Benefits of disclosure Benefits of disclosure lower capital cost from improved transparency lower capital cost from improved transparency reputation effects enhance labor recruiting reputation effects enhance labor recruiting Costs of disclosure Costs of disclosure Information gathering costs Information gathering costs More information to competitors More information to competitors Potential litigation costs Potential litigation costs Potential political costs Potential political costs

Accounting Principles and Governance Structures Information in financial statements enables company valuation and, by extension, the valuation of its debt and equity securities. Information in financial statements enables company valuation and, by extension, the valuation of its debt and equity securities. The importance of financial statements means that their accuracy is of paramount importance. The importance of financial statements means that their accuracy is of paramount importance. To the extent that financial performance and condition are accurately communicated to business decision makers, debt and equity securities will be more accurately priced. To the extent that financial performance and condition are accurately communicated to business decision makers, debt and equity securities will be more accurately priced.

Audit Report Financial statements present fairly and in all material respects company financial condition. Financial statements present fairly and in all material respects company financial condition. Financial statements are prepared in conformity with GAAP Financial statements are prepared in conformity with GAAP Financial statements are management’s responsibility. Auditor responsibility is to express an opinion on those statements Financial statements are management’s responsibility. Auditor responsibility is to express an opinion on those statements Auditing involves a sampling of transactions, not investigation of each transaction Auditing involves a sampling of transactions, not investigation of each transaction Audit opinion provides reasonable assurance that the statements are free of material misstatements Audit opinion provides reasonable assurance that the statements are free of material misstatements Auditors review accounting policies used by management and estimates used in preparing the statements Auditors review accounting policies used by management and estimates used in preparing the statements

Sarbanes-Oxley Act The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the company’s financial statements. The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the company’s financial statements. The statements signed by both the CEO and CFO contain the following commitments: The statements signed by both the CEO and CFO contain the following commitments: The CEO and CFO have personally reviewed the annual report The CEO and CFO have personally reviewed the annual report There are no untrue statements of a material fact or failure to state a material fact necessary to make the statements not misleading There are no untrue statements of a material fact or failure to state a material fact necessary to make the statements not misleading The financial statements fairly present in all material respects the financial condition of the company The financial statements fairly present in all material respects the financial condition of the company All material facts are disclosed to the company’s auditors and Board of Directors All material facts are disclosed to the company’s auditors and Board of Directors No changes to the company’s system of internal controls are made unless properly communicated No changes to the company’s system of internal controls are made unless properly communicated

Financial Accounting: not an exact science GAAP allows companies choices in preparing financial statements (inventories, property, and equipment). GAAP allows companies choices in preparing financial statements (inventories, property, and equipment). Companies must choose among the alternatives that are acceptable under GAAP. Companies must choose among the alternatives that are acceptable under GAAP. Financial statements also depend on countless estimates. Financial statements also depend on countless estimates.

Financial Accounting in Context A company’s financial statements only tell part of the story. A company’s financial statements only tell part of the story. You must continually keep in mind the world in which the company operates. You must continually keep in mind the world in which the company operates. Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance. Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance.

Recording transactions – Pay $100 Wages in Cash Cash assets are reduced by $100, and wage expense of $100 is reflected in the income statement, which reduces income and retained earnings by that amount. All transactions incurred by the company during the accounting period are recorded similarly.

Adjusting Accounts

Prepaid Rent

Unearned Revenue

Accrual of Wages

Accrual of Revenue

Exercise: The Ice Cream Store, Inc. The Ice Cream Store, Inc. incurred the following start-up costs: 1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of GHS90,000 in cash by the owners. 2. Obtained a bank loan and received the proceeds of GHS35,000 on October 2. The cash will be used for operations. 3. Purchased equipment for GHS25,000 cash on October Acquired a building at a cost of GHS80,000. It was financed by making a GHS20,000 down-payment and obtaining a mortgage for the balance. The transaction occurred on October On October 2, the President of Ghana publicly declared that he will eat (and plug) our ice cream while entertaining guests in the Flagstaff House. Prepare a transaction analysis of 1. – 5. using the financial statement effects template:

Balance Sheet Income Statement TransactionCash Asset+ Noncash Assets = Liabi -lities + Contrib. capital + Retained Earnings Revenues– Expenses 1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of GHS90,000 by the owners Obtained a bank loan and received the proceeds of GHS35,000 on October 2. The cash will be used for operations. +35 N/P 3. Purchased equipment for GHS25,000 cash on October Equip 4. Acquired a building at a cost of GHS80,000. It was financed by making a GHS20,000 down- payment and obtaining a mortgage for the balance. The transaction occurred on October Bldg. +60 M/P 5. The President agreed to eat (and plug) our ice cream while entertaining guests in the Flagstaff House on Oct. 2.

ASSETS Cash GHS80,000 Equipment 25,000 Building 80,000 Total Assets GHS185,000 LIABILITY AND STOCKHOLDERS' EQUITY Liabilities: Note Payable GHS35,000 Mortgage Payable 60,000 Total Liabilities 95,000 Stockholders Equity: Capital Stock 90,000 Total Liabilities and Stockholders Equity GHS185,000 Ice Cream Shop Balance Sheet:

Ice Cream Shop – additional transactions 6. On October 4, purchased merchandise inventory (i.e., ice cream) at a cost of GHS 15,000 by paying GHS5,000 cash and receiving short-term credit for the remainder from the supplier. 7. Immediately returned some of the ice cream because some of the flavors delivered were not ordered. The cost of the inventory returned was GHS3, Sales of ice cream for the month of October, 20XX, totaled GHS8,000. All sales were for cash. The ice cream cost GHS3, For all of October, total employee wages and salaries earned/paid were GHS3, As of the end of October, one month's depreciation on the equipment and building was recognized -- GHS383 for the building and GHS167 for the equipment. 11. GHS450 interest expense on the note and mortgage was due and paid on October 31. Assume that the principal amounts (GHS35,000 + GHS60,000) of the note and mortgage remain unchanged. Prepare a transaction analysis of using the balance sheet/income statement template presented above:

Balance Sheet Income Statement Transaction Cash Asset +Noncash Assets= Liabi- lities + Contrib. capital + Retained Earnings Revenues– Expenses Inv. +10 A/P Inv. -3 A/P Inv Sales -3.5 COGS Wage exp Bldg., net Equip., net Dep. exp Int. Exp. Prepare the following financial statements (ignore income taxes): (i) an updated Balance Sheet as of October 31, 20XX; and (ii) an Income Statement for the month of October 20XX.

Cash (GHS80,000 -5,000 +8,000 -3, ) GHS79,550 Merchandise Inventory (GHS0 + 15,000 -3,000 -3,500) 8,500 Equipment (GHS25,000 ) 25,000 Less: Accumulated Depreciation (383) Building (GHS80,000) 80,000 Less: Accumulated Depreciation(167) Total Assets GHS192,500 Accounts Payable (GHS0 + 10,000 – 3,000) GHS7,000 Note Payable (GHS35,000 principal is unchanged) 35,000 Mortgage Payable (60,000 principal is unchanged) 60, ,000 Stockholders' Equity: Capital Stock 90,000 Retained Earnings ,500 Total Liabilities and Stockholders' Equity GHS192,500

REVENUES: Sales of Ice Cream GHS8,000 Cost of Sales 3,500 GROSS PROFIT:4,500 Payroll Expense 3,000 Depreciation Expense550 INCOME FROM OPERATIONS950 Interest Expense450 NET INCOMEGHS500 Note: Assume no income taxes.

Preparing the Financial Statements

Balance Sheet and Income Statement

Statement of Stockholders’ Equity