1. Chapter 2: The Financial Statements

2. 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.

3. Financial Statements
Financial statements report the company activity during the year and the financial condition of the company at the end of the year.
The required financial statements are:
Balance Sheet
Income Statement
Statement of Stockholders’ Equity
Statement of Cash Flows

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 divided into three major categories:
Assets
Liabilities
Stockholders’ equity

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

6. The Balance Sheet (B/S)
Assets - represent future benefit to the company, and are classified in order of liquidity (current assets; property, plant and equipment; long-term investments)
Liabilities - represent obligations of the company, and are classified according to payment date (current liabilities, long-term liabilities)
Stockholders’ equity - represents the residual claims of the owners, and is classified based on source (contributed capital and retained earnings)

7. B/S Assets: Current Assets
Current assets include
Cash: checking and savings accounts; petty cash.
Short-term investments: investments in stocks and bonds of other companies.
Accounts receivable: amounts owed to a company from its customers.
Inventory: products on hand designated for sale to customers.
Prepaid expenses: amounts paid for future expenses.

8. B/S Assets: Property, Plant and Equipment
Property, plant, and equipment are assets that are used in the production of goods and services. These productive assets are long-term in nature, and include the following:
Land: property upon which the productive facilities are located.
Building: the physical structure of the company’s operations.
Machinery and Equipment: include operating machinery, vehicles, computers, copy machines, etc.

9. B/S Assets: Long-term Investments
Long-term investments are assets acquired by the company to provide long-term benefits to the company. Long-term investments include:
Long-term notes receivable owed to the company (from customers or others).
Investments in stock of other companies: held for expectation of dividends and/or stock price increase.
Investment in bonds of other companies: held for expectation of dividends and/or stock price increase.
Other assets, like land, held for the long term.

10. B/S Assets: Intangible Assets
Intangible assets are long-lived assets that have no physical substance. Examples include:
Patents: legal claim to produce and sell a product.
Copyrights: legal claims to books, art, music and other created works.
Goodwill: recognized when one company buys another company, and the purchase price is greater than the fair value of the identifiable net assets.

11. B/S Liabilities: Current Liabilities
Current liabilities are obligations expected to be paid (or services expected to be performed) within the next year or operating cycle. The elimination of the current liabilities requires the use of current assets (most commonly cash). Examples include:
Accounts payable
Wages payable
Interest payable
Short-term notes payable
Current maturities of long-term debt
Deferred (unearned) revenues

12. B/S Liabilities: Long-term Liabilities
Long-term liabilities are obligations expected to require payments beyond the current year. Examples of long-term liabilities include:
Notes payable: amounts owed to banks and other creditors beyond the current year.
Mortgage payable: amounts owed to mortgage company beyond the current year.
Bonds payable: amounts owed to investors holding bond investments issued by the company, where payments of principal and interest are beyond the current year.

13. B/S Stockholders’ Equity: Contributed Capital
Contributed capital is generated when owners (shareholders) of the company contribute cash and other assets into the company. Components of contributed capital include
Common stock: shares of stock issued to owners to to reflect ownership.
Additional paid in capital: excess amounts contributed by shareholders for various activities.

14. B/S Stockholders’ Equity: Retained Earnings
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.

15. The Statement of Stockholders’ Equity (SSE)
Explains the changes in contributed capital and retained earnings during the year. A basic version of the SSE is represented in the following schedule (Figure 2-5):
Contributed Retained
Capital Earnings Total
Dec. 31, $ 6, $ $ 6,950
Net income , ,085
Less: dividends (200) (200)
Issue of stock , ,100
Dec. 31, $ 9, $ 1, $10,935

16. The Statement of Stockholders’ Equity (SSE)
The following formula represents the basic SSE:
Beginning stockholders’ equity
Plus: Issuance of stock
Plus: Net income
Less: Dividends
Ending stockholders’ equity
SEBegin + Issue + NI D = SEEnd

17. 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
REBegin + NI Div = REEnd

18. The Income Statement (I/S)
The income statement shows the components of net income in detail.
Revenues represent the inflow of assets (or decrease in liabilities) due to a company’s operating activities.
Expenses represent the outflow of assets (or increases in liabilities) due to a company’s operating activities.
The general formula for the I/S is:
Revenues - Expenses = Net Income

19. The Income Statement Format
Operating revenues
Sales
Fees earned
Other revenues
Less: Operating expenses
Cost of goods sold
Wage expense
Rent expense
Selling expense
Depreciation expense
Other expenses
Net Income

20. The Statement of Cash Flows
Cash flows from operating activities:
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:
Proceeds from sale of investment securities, land, buildings, equipment, etc.
Purchase of investment securities, land, buildings, equipment, etc.
Cash flow from financing activities:
Proceeds from issuance of notes, debt, sale of equity, etc.
Payments on notes, debt, dividends, etc.

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

22. Problem 2-1
Presented below are the main section headings of the balance sheet:
a. Current assets
b. Long-term investments
c. Property, plant, and equipment
d. Intangible assets
e. Current liabilities
f. Long-term liabilities
g. Contributed capital
h. Retained earnings

23. Problem 2-1 1. Dividend Payable 2. Payments Received in Advance
3. Allowance for Uncollectible Accounts
4. Inventories
5. Capital Stock
6. Accumulated Depreciation - Building
7. Bonds Payable
8. Machinery and Equipment

24. Problem 2-1 9. Accounts Receivable 10. Short-term Investments
11. Buildings
12. Patents
13. Property
14. Investment Fund for Plant Expansion
15. Wages Payable
16. Cash

25. Problem 2-1 17. Accumulated Depreciation - Equip 18. Prepaid Rent
19. Trademarks
20. Land Held for Investment
21. Current Portion of Long-Term Debt
22. Accounts Payable
23. Short-term Notes Payable

26. 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

27. 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

28. Exercise 2-4 Given (in billions): 2003 2002 2001
Beginning RE ?
Revenues
Expenses ?
Div. declared ?
Ending RE ? ?
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

29. Exercise 2-4, 2003
Solution for 2003:

30. Exercise 2-4, 2002
Solution for 2002:

31. Exercise 2-4, 2001
Solution for 2001: