Financial Statements:An OverviewFinancial Statements:An Overview

C H A P T E R 2

Learning Objective 1Understand the basic elements and formats of the three primary financial statements.

Balance Sheet

Income Statement

Statement of Cash Flows

What are the three basic financial statements?

Primary Financial Statements

These financial statements answer basic questions:

What is the company’s current financial status?

What were the company’s operating results for the period?

How did the company obtain and use cash during the period?

Sometimes referred to as a

Statement of Financial Position

• What are the resources of the company?

• What are the company’s existing obligations?

• What are the company’s net assets?

Summary of the financial position of a company at a particular date.

The Balance Sheet

Assets: cash, accounts receivable, inventory, land, buildings, equipment, and intangible items.

Liabilities: accounts payable, notes payable, and mortgages payable.

Owners’ Equity: net assets after all obligations have been satisfied.

Assets: cash, accounts receivable, inventory, land, buildings, equipment, and intangible items.

Liabilities: accounts payable, notes payable, and mortgages payable.

Owners’ Equity: net assets after all obligations have been satisfied.

What Is the Accounting Equation?

Assets = Liabilities + Owners’ Equity

Define double-entry accounting

A system of recording transactions in a way that

maintains the equality of the accounting equation.

Accounting Equation

Assets = Liabilities + Owners’ Equity

Sources of Funding

Creditors’claimsagainst

resources

= + Owners’claimsagainst

resources

Resources

Resources to use to generate revenues

AssetsCash $ 40

Accounts receivable 100

Land 200

Total assets $340

LiabilitiesAccounts payable $ 50

Notes payable 150

$200Owners’ EquityCapital stock $100

Retained earnings 40

$140

Total liabilities and owners’ equity $340

Sample Balance Sheet

Must Equal

What Are Classified and Comparative Balance Sheets?

They distinguish between

current and long-term assets.

current and long-term liabilities.

Listed in decreasing order of liquidity.

Comparative so financial statement users can identify significant changes over time. They have more than one year on the Balance Sheet.

Assets recorded at historical value.

Only recognizes assets that can be expressed in monetary terms.

Owners’ equity is usually less than the company’s market value.

Describe Three Balance Sheet Limitations.

Sometimes referred to

as a Statement of

Earnings

• What goods were sold or services performed that provided revenue for the company?

• What costs were incurred in normal operations to generate these revenues?

• What are the earnings or company profit?

Shows the results of a company’s operations over a period of time.

The Income Statement

RevenuesAssets (cash or AR) created through business operations

ExpensesAssets (cash or AP) consumed through business operations

Net Income or (Net Loss)

Revenues - Expenses

Sample Income StatementThe Example Company

Income StatementFor the Years Ended December 31, 2003 and 2002

2003 2002

Revenues:Sales $100 $ 85Other revenue 30 15

Total revenues $130 $100

Expenses:Cost of goods sold $ 62 $ 58Operating & admin. 16 12Income tax 20 18

Total expenses $ 98 $ 88

Net Income $ 32 $ 12

How Do You Calculate Earnings Per Share?

Tells the owner of a single share of stock how much of the net income for the year belongs to him or her.

Earnings per share (EPS):

Net Income (Net Loss)# of Shares of Stock Outstanding

An additional financial statement that identifies changes in retained earnings from one accounting period to the next.

Statement of Retained Earnings

Beginning retained earnings

+ Net income

– Dividends paid

= Ending retained earnings

Beginning retained earnings

+ Net income

– Dividends paid

= Ending retained earnings

Net income results in:Increase in net assetsIncrease in retained earningsIncrease in owners’ equity

Dividends result in:Decrease in net assetsDecrease in retained earningsDecrease in owners’ equity

Reports the amount of cash collected and paid out by a company in operating, investing, and financing activities.

How did the company receive cash?

How did the company use its cash?

Statement of Cash Flows

Statement of Cash FlowsCash inflows

Sell goods or services.Sell other assets or by borrowing.Receive cash from investments by owners.

Cash outflowsPay operating expenses.Expand operations, repay loans.Pay owners a return on investment.

What Are The Three Primary Types Of Activities On A

Statement Of Cash Flows?

Operating Activities: A company’s day-to-day activities.

Major operating cash inflow—cash receipts from selling goods or from providing services.

Major operating cash outflow—payments to purchase inventory and to pay operating expenses.

Investing Activities: Buying and selling long-term assets.

Financing Activities: Cash is obtained from or repaid to owners and creditors.

Statement of Cash Flows

CASH OUTFLOWS

OperatingActivities

FinancingActivities

InvestingActivities

CASH INFLOWS

FinancingActivities

OperatingActivities

InvestingActivities

The Example CompanyStatement of Cash Flows

December 31, 2003

Cash Flows From Operating Activities:Receipts 48 Payments (43) 5

Cash Flows From Investing Activities:Receipts 0 Payments (4) (4)

Cash Flows Used By Financing Activities:Receipts 10 Payments (6) 4

Net Cash Flow 5

Sample Statement of Cash Flows

How the Financial Statements Tie Together Is Called?

Articulation--the relationship between an operating statement (the income statement or the statement of cash flows) and comparative balance sheets.

Financial Statement Articulation

Balance Sheet 12/31/02

Cash $ 80,000Other 4,550,000 Total $4,630,000

Liabilities $2,970,000Cap. stock 900,000R/E 760,000 Total $4,630,000

Revenues $12,443,000Expenses 11,578,400 Net income $ 864,600

Income StatementCash $ 110,000Other 4,975,000 Total $5,085,000

Liabilities $2,860,400Cap. stock 1,000,000R/E 1,224,600 Total $5,085,000

Balance Sheet 12/31/03

Cash--Op. Act. $ 973,000 Cash--Inv. Act. (1,188,000)Cash--Fin. Act. 245,000 Net increase $ 30,000 Beg. cash 80,000 End. cash $ 110,000

Cash Flow Statement

R/E 12/31/02 $ 760,000Net income 864,600Dividends (400,000) R/E 12/31/03 $1,224,600

Stmt of Retained Earnings

Learning Objective 2

Recognize the need for financial statement notes and identify the types of information included in the notes.

Notes to the Financial Statements

What are the four general types?Summary of significant accounting policies:

assumptions, estimates, and judgments.Additional information about the summary

totals.Disclosure of important information that is

not recognized in the financial statements.Supplementary information required by

the FASB or the SEC. Notes are an acceptable way to convey

information to users when the information is too uncertain or needs further explanation.

Learning Objective 3

Describe the purpose of an audit report and the incentives the auditor has to perform a good audit.

The Audit Report

Owners and managers want the most favorable results possible.• Bank credit• Bonuses• Public stock price

CPA firms have economic incentives to perform credible audits.• Reputation• Lawsuits

The Audit Report Issued by independent CPA firms. CPAs attest to conformity with GAAP. Financial

statements are the responsibility of the company’s management and not the CPA.

Learning Objective 4

Use financial ratios to identify a company’s strengths and weaknesses and to forecast its future performance.

What Is the Debt Ratio and Its Purpose?

Measure of leverage.

Varies from industry to industry, but should be around 50%.

Total liabilities

Total assets

Total current assets

Total current liabilities

What Is the Current Ratio and Its Purpose?

Measure of liquidity.Also called Working Capital Ratio.Some successful companies have current

ratios less than 1.0.

What Is Asset Turnover and Its Purpose?

Measure of company efficiency.The higher the asset turnover ratio, the more

efficient the company is using its assets to generate sales.

Sales

Total assets

What Is Return on Sales and Its Purpose?

Measure of the amount of profit earned per dollar of sales.

Evaluated within the appropriate industry.

Net income

Sales

What Is Return on Equity and Its Purpose?

Overall measure of performance--profit earned per dollar of investment.

Typically between 15% and 25%.

Net income

Owners’ equity

What Is the Price-Earnings Ratio and Its Purpose?

Measure of growth potential, earnings stability, and management capabilities.

In the U.S., typically between 5 and 30.

Market price per share

Earnings per share

Financial Ratios

Debt ratio

Current ratio

Asset turnover

Return on sales

Return on equity

Price-earnings ratio

Total liabilitiesTotal assets

Current assetsCurrent liabilities

SalesTotal assets

Net incomeSales

Net incomeOwners’ equity

Market price per shareEarnings per share

Learning Objective 5

Explain the fundamental concepts and assumptions that underlie financial accounting.

The basic accounting assumptions, concepts, principles, and procedures that determine the manner of recording, measuring, and reporting a company’s transactions.

Accounting Model

Separate Entity Concept

Arm’s-Length Transactions

Cost Principle

Monetary Measurement Concept

Going Concern Assumption

What Are The Fundamental Concepts and Assumptions?

Entity--The organizational unit for which accounting records are maintained.

Separate entity concept--The activities of an entity are to be separate from those of its individual owners.

Proprietorship

Partnership

Corporation

Describe the Separate Entity Concept.

The exchange of goods or services between independent and rational parties, each looking out for their company’s best interests.

What Is An Arm’s-Length Transaction?

What Is Meant By The Cost Principle?

All transactions are recorded at historical cost.

Historical cost is assumed to represent the fair market value of the item at the date of the transaction because it reflects the actual use of resources by independent parties.

What Is The Monetary Measurement Concept?

Accountants measure only those economic activities that can be measured in monetary terms.Listed values may not be the same as actual market values:

Inflation.Measurement issues.

What Do We Mean By The Going Concern Assumption?

An entity will have a continuing existence for the foreseeable future.

“If You Always Do What You Always Did, You Always Get

What You Always Got.”W. Edward Deming

End Chapter 2