Chapter

1. Review of Accounting 2 Chapter

2. Three Basic Financial Statements • Income Statement • Balance Sheet • Statement of Cash Flows

3. The Income Statement • An Income Statement shows profitability for a time period (ex: 1 year) • Revenues from customers for services or merchandise. • Expenses from vendorsfor merchandise, production, services or supplies. • Can be prepared in steps Revenues Less: Expenses Equals: Net Income

4. Classifications on the Income Statement Sales – Cost of Goods Sold Step 1 = Gross Profit – Operating Expenses Step 2 = Operating Profit (EBIT) – Interest Expense Step 3 = Earnings Before Taxes – Income Taxes Step 4 = Earnings After taxes

5. Income statementTable 2-1 KRAMER CORPORATION Income Statement For the Year Ended December 31, 2010 1. Sales . . . . . . . . . . . . . . . . . $2,000,000 2. Cost of goods sold . . . . . . . . . . . (1,500,000) 3. Gross profits . . . . . . . . . . . . . 500,000 4. Selling and administrative expense . . . . (220,000) 5. Depreciation expense . . . . . . . . . . (50,000) 6. Operating profit (EBIT)* . . . . . . . . 230,000 7. Interest expense . . . . . . . . . . . . (20,000) 8. Earnings before taxes (EBT) . . . . . . . 210,000 9. Taxes . . . . . . . . . . . . . . . . . (99,500) 10. Earnings after taxes (EAT) . . . . . . . . 110,500 11. Preferred stock dividends . . . . . . . . 10,500 12. Earnings available to common shareholders. $ 100,000 13. Shares outstanding . . . . . . . . . . . 100,000 14. Earnings per share . . . . . . . . . . . $1.00 *Earnings before interest and taxes.

6. Return to Capital • Three sources of capital: • bondholders, • preferred stockholders, and • common stockholders. • After paying interest to bondholders and dividends to preferred shareholders, the remaining amount are available for the common stockholders. However, the firm may or may not disburse this amount as dividends to common stockholders. The firm may retain the whole/part of the profit as Retained Earnings for future investment.

7. The Balance Sheet A Balance Sheet (B/S) shows what a firm owns and how it is financed at a point in time (ex.; December 31) Remember the ALOE! Assets = Liabilities + Owners’ Equity

8. Classifications on the Balance Sheet Assets: what a business owns Current Assets • Ex: Accounts receivable, Inventory • Will be sold or used up within 1 year Capital Assets • Ex: Building, Plants, Lands Liabilities: what a business owes Current Liabilities • Ex: Accounts payable • Dues within 1 year Long-term Liabilities • Due some time after 1 year Equity: what the owner(s) haveinvestedin the business Shareholders’ Equity • Capital stock • Retained earnings

9. Balance Sheet Items • Liquidity: Asset accounts are listed in order of liquidity • Current assets: • Items that can be converted to cash within 12 months • Marketable securities • Temporary investments of excess cash • Accounts receivable • Allowance for bad debts to determine their anticipated collection value • Inventory • Includes raw materials, goods in progress, or finished goods • Prepaid expenses • Represent future expense items that are already paid for

10. Balance Sheet Items (cont’d) • Investments • Long-term commitment of funds • Includes stocks, bonds, or investments in other companies • Plant and equipment • Carried at original cost minus accumulated depreciation • Accumulated depreciation • Sum of past and present depreciation charges on currently owned assets

11. Concept of Net Worth/book value • There is nearly always a disparity between book value and market value, since the first is a recorded historical cost, and the second is based on the perceived supply and demand for an asset, which can vary constantly. • For example, a company buys a machine for $100,000 and subsequently records depreciation of $20,000 for that machine, resulting in net book value of $80,000. If the company were to then sell the machine at its current market price of $90,000, the business would record a gain on the sale of $10,000. • Market value is of primary concern to the: • Financial manager • Security analyst • Stockholders

12. Concept of net Worth/book value • Total Asset..................................................... $1,000,000 • Total Liabilities................................................ (300,000) • Stockholders’ equity...................................... 700,000 • Preferred Stock* obligation.......................... (50,000) • Net worth assigned to common.................... 650,000 • Common shares outstanding........................ 100,000 • Net worth, or book value per share.............. $6.50 preferred share represents neither a debt claim nor an ownership interest in the firm. It is a hybrid, or intermediate type of security. It will be further discussed in chapter 17.

13. Book Value Vs Market Value • There are situations when the market value of a fixed asset is much higher than book value, such as when the market value of an office building sky rockets due to increased demand. • Market value is of primary concern to the: • Financial manager • Security analyst • Stockholders

14. TABLE 2-5 Comparison of market value to book value per share in January 2003

15. Limitations of Financial Statements • Based on past transactions rather than future forecasts • May not recognize important economic changes as they occur • increase in property values • new competition • Variety of accounting policies and methods are used • depreciation • inventory valuation

16. Statement of Cash flows • The purpose of the statement of cash flows is to emphasize the critical nature of cash flow to the operations of the firm. • Cash flow represents cash or cash equivalent items that can easily be converted into cash within 90 days. • The IS & BS are based on accrual method of accounting, in which revenues and expenses are recognized as they occur rather than when cash actually changes hands.

17. Statement of Cash flows • The cash flow statement represents the actual cash flow position of a firm. • The three primary sections of the cash flow statement: 1. Cash flows from operating activities. 2. Cash flows from investing activities. 3. Cash flows from financing activities.

18. Depreciation and Funds Flow • Depreciation • Attempt to allocate the initial cost of an asset over its useful life. • Charging of depreciation does not directly influence the movement of funds.

19. Depreciation as a Tax Shield • Not a new source of fund • Provides tax shield benefits measurable as depreciation times the tax rate Corporation A Corporation B Earnings before depreciation and taxes…… $400,000 $400,000 Depreciation……………………………………… 100,000 0 _________ _________ Earnings before taxed………………………… 300,000 400,000 Taxes (40%)……………………………………… 120,000 160,000 _________ _________ Earnings after taxes…………………………… 180,000 240,000 +Depreciation charged without cash outlay… 100,000 0 _________ _________ Cash flow………………………………………… $280,000 $240,000 Difference………………………………………… $40,000

20. The 3 basic financial statements are the income statement, the balance sheet, and the statement of cash flows The price-earnings ratio relates the net income per the financial statements to the market value of the company’s shares There are inherent limitations in the income statement and balance sheet as to reporting current values and economic events Cash flows after tax are essential information for business decision-making Summary and Conclusions NOW, TO REVIEW . . .