THE ACCOUNTING CYCLE AND FINANCIAL REPORTING

William L. Smith, CPA, CGMA, Ph.D.

This will serve as an introduction to accounting and the related financial statements. Accounting is the language of business and, accordingly, it is very important that we have a basic understanding of key concepts. I will now discuss the five account groups.

ASSETS

Think of assets as anything you own of value. This could be cash, jewelry, cars, cloths, houses, furniture, etc. Several points need to be emphasized. First I stated that YOU owned the asset. If I was talking about a car if it was your car then it would be your asset. This is the “entity” concept of accounting. Applying this to a business setting, if I was talking about a car, or any other asset, owned by Intel then it would be a COPORATE ASSET and not an asset of the stockholder(s). Next, I used the notation of value to further define an asset. Think about your personal situation. If I asked you to list everything you owned I would expect to see a list of your assets. Recognize that you probably have a trash can full of trash at home. You are the owner of the trash; however, it is not of any value. Consider a business such as Albertsons. The corporation owned assets would include such things as cash, buildings, land, furniture and fixtures, trucks, equipment, etc.

LIABILITIES

Liabilities are essentially your financial obligations of which you are liable for. The obligation can be short term or current (in other words it is due within the next 12 months) or it can be of a longer term or duration non-current such as a 5 year car loan or a 30 year mortgage. The distinction between current and non-current is important. If you have a $100,000 30 year mortgage you are not worried that you must come up with $100,000 by the end of the year; rather, you have the next 30 years of cash flows to extinguish this obligation. A corporation will also have current obligations such a payroll taxes withheld from employees that must be remitted to the IRS within a short period of time. Also, the company may have millions or billions of dollars in long term debt such as mortgages or bonds payable.

EQUITY

Equity is essentially the residual or what is left over. The accounting equation stipulates that ASSETS = LIABILITIES + OWNER EQUITY. Reconsider your car. Assume that you have a $10,000 car and with it a $6,000 car loan. You are the owner of the car NOT the bank even though the bank loaned you the proceeds to acquire the car. The bank does not want your car but rather the money loaned with interest. Now consider the accounting equation with respect to your car. You would see $10,000 = $6,000 + $4,000. Your EQUITY in that asset is thus $4,000. Also consider that your “net” equity would be calculated by subtracting or “netting” the liability against the asset. So you would see ASSETS – LIABILITIES = EQUITY or $10,000 - $6,000 = $4,000. Notice that this is an equation and that equations must equal on both sides or be balanced. The Balance Sheet thus is the financial statement that includes the assets, liabilities, and equity account groups. Now if I asked you “What are you worth?” you would need to compile a Balance

Sheet. You would list everything you owned of value, your assets, and this would be offset by all your financial obligations, your liabilities, and the residual would be your equity. In fact if I asked you what your “net worth” was at a particular point in time, you could simply compile ALL your assets and net out ALL your liabilities and what ever remained would be YOUR net worth. If I wanted to know the stockholders’ net worth of Intel (stockholders are the OWNERS of a company), I would want to look at the Balance Sheet of Intel. There I would find ALL the assets of Intel and the offset would be All the liabilities and the remainder would thus be the total stockholders’ equity. Finally recognize that the date is very important. If I want to know the financial worth or financial position of Intel as of December 31, 2003, I would need to look at the Balance Sheet dated at December 31, 2003. The assets and liabilities of companies (just like you) are always changing so the date is very important. Your “net worth” today is different from what it was just even last month; think about it.One more point needs to be addressed regarding the stockholder equity of a corporation. You will notice it is comprised of two primary parts: (1) contributed capital (the stock accounts) and (2) retained earnings (the cumulative net earnings retained in the business). When stockholders originally purchase shares they contribute cash and/or other assets in return for shares of the company, which represents ownership in the company by whoever contributed those assets. On the corporate books we record the receipt of the assets and then a corresponding credit to an account called Common Stock (if it were common shares issued) or Preferred Stock (if it were preferred shares issued). The accounts are thus credited for the par value which is simply the value stated when we incorporated and any excess contributed capital is credited to another equity account called Additional Paid in Capital. For example, if our stock is $2 par value and we issue 10,000 shares of this common stock for $10 per share then we would receive a total of $100,000 of contributed capital but we would credit $20,000 to the Common Stock account (par value x number of shares issued) and the remainder excess to the Additional Paid in Capital account whereby the TOTAL would be the $100,000 of paid in capital. Finally, if our company had net income earned of $500,000 for the year the Retained Earnings account (another stockholder equity account) would be increased. If the company declared and paid $80,000 of dividends to the stockholders then the retained earnings account would be reduced by the dividends. You should note that dividends are simply a return to stockholders and NOT an expense of the business. If dividends were an expense then the net income that increased retained earnings would already include the dividends in arriving at net income.

REVENUE

Revenue is an interesting concept as it does not necessarily mean cash received. For most of us as individuals are revenue is our paycheck. We are simply trading our time for dollars. Businesses such as an attorney or CPA are also service type businesses as they, like us, sell time for dollars. Target or Albertsons on the other hand are merchandisers as they sell product for dollars. Proctor and Gamble or Ford are manufacturers as they purchase raw materials and convert them into finished products that they in turn sell. Let me now clarify a revenue event where there is NO immediate cash. Assume you clean yards for a loving. You come to my house on January 28 and perform the service of cleaning my yard and then present me with the bill for $150. I tell you that I don’t have the money right now but I can pay you next month. If you were to compile your January activity you would include this $150 of revenue earned in your January activity. But what

about the fact that you did not receive cash? Since you recognized the revenue but did not show a corresponding increase in your cash you would instead book the $150 to another current asset known as Accounts Receivable as I am one of your many customer accounts that you expect to receive payment (within the next 12 months which is why it is a current asset) for the services you performed and thus earned the revenue. WHEN did you EARN the revenue, when you performed the service or when you ultimately receive the cash? This is the concept of accrual accounting whereby we book or accrue the revenue in the time period in which we EARN the revenue rather than when we receive the cash payment. Corporations are required to use accrual accounting under Generally Accepted Accounting Principles or GAAP. This provides a better picture of the amount of revenue that was earned in a time period and thus allows the stockholders a better assessment of sales or revenue activities in a given time period. So if I were to look at three years worth of sales for Target I would see the revenues accrued in each year as a representation of revenue earned for that year.

EXPENSES

Expenses can be thought of as ALL the costs incurred to operate and run the business in the same time period as the business was generating sales. Thus expenses are also recognized or accrued in the period in which the expense was incurred NOT when the expense was paid for. For instance, in the yard cleaning example if I were a business I would recognize the $150 of yard cleaning expense in my January activity even though I will not actually pay you the money until February. This matching of revenues and expenses provides for a better measure of net profitability for the respective time period. Thus I would book an expense for $150 and a corresponding current liability known as Accounts Payable or Accrued Liability Payable to reflect the fact that I am liable to pay this amount. Let us now consider an example to put it all together.

Assume you have $40,000 of revenue and $38,000 of total expenses. When you net the $38,000 of expenses against the $40,000 of revenues you are left with Net Income of $2,000. Thus revenues and expenses appear on the Income Statement to properly reflect the net profitability for the business for a period of time (usually on an annual basis). So how does this relate to the Balance sheet? Well if you have $2,000 of Net Income and if Assets = Liabilities + Equity then the total assets are now increased by $2,000 and so the equity is also increased. (If this were a corporation we would increase the stockholder equity account of Retained Earnings for this $2,000). Everyone loves a winner so if this were a company then TOTAL STOCKHOLDERS’ EQUITY would increase and thus more people would buy the stock which would drive the price eventually up. Conversely, if the business had $40,000 of revenues but $43,000 of expenses then rather than Net Income the business would instead have a Net Operating Loss of $3,000. Then the TOTAL STOCKHOLDERS’ EQUITY would go down and rather than folks buying the stock of a winner they would instead sell off the stock which would ultimately drive the price per share down.

THE FINANCIAL STATEMENTS

There are three basic financial statements that we are provided with to understand the financial performance of the company. I need to address one added concept, which is consolidation. A person can own stock in a company and a company such as Home Depot

can own stock in another company such as Ford. When a company owns more than 50% of the total number of shares of stock then the company is essentially controlled by what we refer to as the parent corporation. You have heard of GMAC, a wholly owned subsidiary of General Motors. GMAC is a subsidiary of the parent company General Motors. You cannot acquire shares of stock directly in GMAC but you can acquire shares of stock in General Motors. Remember that if a company such as GM owns a controlling interest in any other corporation then that corporation is a subsidiary of the parent company. Now say you want to invest in GM stock but find out that GM has control of 86 subsidiary companies. Rather than having to review GM’s financial statements as well as the additional 86 subsidiary company’s financial statements, the accounting rules simply require GM to consolidate or combine ALL the entities under its control with its financial statements. The result is disclosed as CONSOLIDATED such that the reader is aware that the group is combined, which provides a more meaningful presentation of the consolidated group.

The common financial statements include (1) the Consolidated Income Statement (sometimes called the Statement of Earnings), (2) the Consolidated Balance Sheet (sometimes referred to as the Statement of Financial Position), and (3) the Consolidated Statement of Cash Flows.

The Consolidated Income Statement provides the reader with the net profitability for the company for a specific period of time. Usually you will see three years of income statements to see the revenues earned and related expenses incurred for the respective time periods.

The Consolidated Balance Sheet will provide the reader a picture of financial position at a specific time period. Here the assets, liabilities and related stockholders’ equity will be shown. The reader can see the composition of the assets as well as the type and amounts of total indebtedness and thus better assess the amount of equity residual that exists.

The Consolidated Statement of Cash Flows is the third financial statement provided. Recall that we use accrual accounting whereby the income statement reflects revenues earned and expenses incurred for a specific time period resulting in net income or net loss. Thus net income is NOT necessarily equal to cash. The utility then of a cash flow statement cannot be overstated. The life blood of a company is cash flow. You can have all the sales in the world but if you don’t collect the cash you will not be able to pay the bills. Think about it! In the previous yard cleaning example, you would record the revenue of $150 as earned in January but if I never paid you, however, you would not be able to pay your bills. Of course other customers would hopefully pay and you would have very little bad debt from uncollectible accounts receivable, but you see my point. Net income from the income statement is very informative in that it is a real good indicator of net profitability for the time period specified but it is not cash earned. So to provide yet further insight into the company, the statement of cash flow exists. Before I discuss the basics of this financial statement I need to state that you do not have to know how to build a watch in order to tell time and you likewise do not need to know how to construct the statement of cash flows in order to read the important information it contains and thus better understand the company you are reviewing.

There are three sections of cash flow that comprise the statement. The cash provided from operating activities is the first and perhaps most important section. It will start with the accrual net income from each year’s income statement and then there will be numerous accounting related adjustments (remember you do not need to know how to build a watch in order to tell time so don’t worry about all these adjustments). The net result will be the first sub-total which will be the net cash provided from operating activities. Stated another way, THIS represents the ACTUAL CASH GENERATED by the company being in business for the time period specified. You will note that it is NOT equal to the net income reported on the income statement because, as you now know, the net income figure is based upon accrual accounting. What you hope to see is that the actual cash generated from operating activities is healthy such that it exceeds the reported net income. Stated another way, consider if it were less. This would mean that you have net overall income recorded but did NOT receive the cash for it (phantom income). A very healthy company will consistently have operating cash flows in excess of reported net income (usually the more the better).

The next section is for investing activities. While ALL the inflows and <outflows> of cash are reported (note that a bracket or negative means cash decrease or outflow and a positive is an increase or cash inflow) it is important to look at the capital expenditures or a classification that means essentially the same thing, such as investments in property plant and equipment. This figure represents the ACTUAL cash dollars spent on capital improvements. Think about it! If a company was in trouble and management was uncertain about the future existence, would they spend large sums on capital expenditures? If I am investing in a company I certainly am concerned about its future.

The final section is cash provided from financing activities. This is where all the cash from stockholders acquiring stock or cash received from loans is recorded, which is why it is called financing cash flows. Accordingly, repayments of loans (remember paying back principal is NOT an expense, only the interest paid is an expense), or repurchases of the company’s own stock from its stockholders (treasury stock because it is reacquired and kept in the company’s treasury until such time that it is reissued), or cash dividends paid (remember dividends paid to stockholders are not expenses of the company and would thus not be included in net income and thus not in the operating cash flow section) constitute some of the main financing activities.

Now put ALL the sections together and the overall result is the net yearly change in total cash of the company. But we must consider the contribution of each section to the whole. In other words, if a company has been increasing their cash balances but upon careful examination of the cash flows statement I see that it is because they are continuously borrowing (the majority of cash inflows is coming from financing activities) then I am not impressed. In fact I would be worried for the future because you cannot keep borrowing. If on the other hand I see the company has strong OPERATING cash flows and with this it pays down debt (negative or outflow of financing cash) or it is using this to repurchase its own stock (treasury stock) or it is seriously investing in capital expenditures then I am impressed. I cannot possibly address every situation, but as you begin to examine these financial statements you will better understand WHAT they are disclosing and HOW they all fit together to provide an insight into the company you are analyzing. One final note, cash IS or IS NOT. This is very important because the statement of cash flows is least susceptible to manipulation. When ALL three financials

are looked at and the information provided by each one is considered, the financial picture of the company comes more into focus. The better you understand the financial statements, the better you will understand the financial position and results of operations for any company you analyze. Furthermore, consider that the ratios we will be using are mostly derived from the financial statements so it should go without saying that the more you understand the accounting financial statements the easier your job will be in performing any financial analysis.

DEPRECIATION

The process of depreciation is fairly straight forward and once you understand WHY we employ this methodology, you will understand a very important accounting concept. Depreciation by definition is a rational cost allocation technique or simply spreading out the cost of a long term asset over its estimated useful life. Assume that a new pizza business started and as a result, a new pizza oven was acquired at a cost of $10,000. Now further assume that this oven is estimated to last for 5 years (it is not uncommon to see equipment, vehicles, etc. with an estimated useful life). If the company treated the $10,000 as say an “oven expense” in year one then the net income would become distorted. Think about it! The oven, which will be around for many years, bakes pizza and thus each year’s income statement should absorb a portion of the pizza oven cost. Thus if I take the $10,000 cost and divide it over the estimated useful life of 5 years, I would record a depreciation expense of $2,000 for each of the next five years even though the $10,000 was all spent in the first year. Remember, accrual accounting attempts to match the revenues earned with the expenses incurred for each period. The fact that this oven is going to help generate revenues for more than one accounting period necessitates that we allocate the cost by attempting to spread it out over some reasonable time period. What if the oven actually lasts for 6 or 7 years? SO WHAT! By spreading the cost out over the estimated useful life we have at least mitigated the effect of bunching it all in year one and in fact have spread it out over 5 years. This clearly complies with GAAP standards and further provides a more meaningful net income for each of the respective years. Now this oven is really a long-term asset and we would see it included in the property, plant and equipment section of the balance sheet but how would we reflect the amount of cost that we are charging off each year? We will show the asset at its historical cost of $10,000 but we will then have an account balance next to it for ALL the depreciation cost accumulated to date. We call this cont-asset account Accumulated Depreciation. So consider the balance sheet after the first year. The Equipment Account would be $10,000 less Accumulated Depreciation of $2,000 yielding a net result of $8,000 (the un-depreciated remaining cost basis). After the second year we would again see Equipment at $10,000 BUT the Accumulated Depreciation would now be $4,000 (reflecting another annual $2,000 amount of depreciation expense) yielding a net book value of $6,000 and so on. At the end of the fifth year the asset would be fully depreciated but it would still be listed on the balance sheet UNTIL it is sold or otherwise disposed of. The balance sheet would show Equipment of $10,000 less Accumulated Depreciation of $10,000 yielding a net book value of zero. Why is this important? Consider that you are going to buy a business and the long term assets are almost all fully depreciated. The asset base you would be acquiring would be older and perhaps in need of serious repairs, etc. Again, the more we understand the financial statement disclosures, the more informed we become.

ADDITIONAL

Lastly, several criticisms of accounting are the use of estimates and historical rather than current values. First, as you now see we must estimate the useful life of assets for example to depreciate the cost of these long term assets. When we first acquired the pizza oven we had no idea how long it would actually last so we based our depreciation on some rational manor. Critics would argue that if the oven ACTUALLY lasted for say 10 years then we would have distorted the net income of the five years in which we expensed $2,000 per year as depreciation expense. I would argue that we do not have a perfect insight into the future and that some depreciation expense is better than none. Given the nature of business and the long term life of various assets we MUST rely on estimates as we do not have perfect future knowledge. You can also see that in cases where we must estimate how much bad debt expense we anticipate or where we must estimate the amount of warranty claims for our products sold, it quickly becomes evident that accounting information routinely relies on the use of estimates.

The assets on the balance sheet are usually at the lower of their historical cost or market value. Consider the Disney Corporation and the vast amount of land it owns in Orlando Florida. Today that land is worth substantially more than it was acquired for back in the 1930s; yet, it is listed on the balance sheet at its historical cost NOT on what it may be worth today. This certainly provides for an understatement of the assets rather than an overstatement. This coincides with the accounting convention known as conservatism. Think about it! How much is that land worth? Given that there is no sure way of determining the true value (appraisals are merely subjective opinions and can vastly differ) the safest bet is to leave the asset on the books at its historical cost. When the asset is ever actually sold THEN the true value will be determined and any gain or loss recognized. Until such time however the asset will stay on the books at cost. The criticism is then given that balance sheets do not really reflect the actual financial position of the company since current values are essentially ignored. This is true but is really a safeguard. When the assets are NOT overstated there is less of a chance for the balance sheet to become inflated with subjective values of assets owned by the company.Note that this is required under GAAP for publicly traded companies and this lower of cost or market value does not apply to individuals. So if you are giving your bank a personal financial statement and you listed your assets at the appraised value (your house listed at the appraised value or the appraised value of that piece of land you bought ten years ago and is now worth twice what you paid for it) you are fine. GAAP does not apply to you. If you are a stockholder of Disney or Intel however, you are better served with a balance sheet under GAAP, which requires a conservative accounting approach. You simply need to be aware of some of these criticisms to better place them into perspective as you begin to understand the financial statement disclosures.

The purpose of this handout is to simplify some of the key concepts that comprise the financial statements. As you continue to familiarize yourself with financial reporting you will become better versed. Just consider when you first learned to drive and how much effort and concentration was required. Today you don’t even think about it. You just get into your car and drive to your destination. Financial statement analysis is similar to driving. As you become more familiar with the rules of the road and practice by reading over and analyzing financial statement content, you will become more proficient at financial statement analysis.