2 • C H A P T E R Financial Statements: An Overview
Learning Objective 1 • Understand 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?
Summary of the financial position of a company at a particular date. Sometimes referred to as a Statement of Financial Position 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. • What are the resources of the company? • What are the company’s existing obligations? • What are the company’s net assets?
Define double-entry accounting What Is the Accounting Equation? • Assets = Liabilities + Owners’ Equity A system of recording transactions in a way that maintains the equality of the accounting equation.
Creditors’ claims against resources Owners’ claims against resources Resources to use to generate revenues = + Accounting Equation • Assets = Liabilities + Owners’ Equity Resources Sources of Funding
Must Equal Sample Balance Sheet Assets Cash $ 40 Accounts receivable 100 Land 200 Total assets $340 Liabilities Accounts payable $ 50 Notes payable 150 $200 Owners’ Equity Capital stock $100 Retained earnings 40 $140 Total liabilities and owners’ equity $340
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.
Describe Three Balance Sheet Limitations. 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.
Revenues Assets (cash or AR) created through business operations • Expenses Assets (cash or AP) consumed through business operations • Net Income or (Net Loss) Revenues - Expenses Shows the results of a company’s operations over a period of time. Sometimes referred to as a Statement of Earnings The Income Statement • 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?
Sample Income Statement • The Example Company • Income Statement • For the Years Ended December 31, 2003 and 2002 • 2003 2002 • Revenues: • Sales $100 $ 85 • Other revenue 30 15 • Total revenues $130 $100 • Expenses: • Cost of goods sold $ 62 $ 58 • Operating & admin. 16 12 • Income tax 20 18 • Total expenses $ 98$ 88 • Net Income $ 32 $ 12
Earnings per share (EPS): Net Income (Net Loss) # of Shares of Stock Outstanding 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.
Beginning retained earnings + Net income – Dividends paid = Ending retained earnings An additional financial statement that identifies changes in retained earnings from one accounting period to the next. Dividends result in: Decrease in net assets Decrease in retained earnings Decrease in owners’ equity Net income results in: Increase in net assets Increase in retained earnings Increase in owners’ equity Statement of Retained Earnings
Statement of Cash Flows • Cash inflows Sell goods or services. Sell other assets or by borrowing. Receive cash from investments by owners. • Cash outflows Pay operating expenses. Expand operations, repay loans. Pay owners a return on investment. Reports the amount of cash collected and paid out by a company in operating, investing, and financing activities. Statement of Cash Flows How did the company receive cash? How did the company use its cash?
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.
Financing Activities Operating Activities Investing Activities Financing Activities Investing Activities Operating Activities Statement of Cash Flows CASH INFLOWS CASH OUTFLOWS
Sample Statement of Cash Flows The Example Company Statement 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
Articulation--the relationship between an operating statement (the income statement or the statement of cash flows) and comparative balance sheets. How the Financial Statements Tie Together Is Called?
Cash Flow Statement 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 Balance Sheet 12/31/03 Balance Sheet 12/31/02 Income Statement Cash $ 80,000 Other 4,550,000 Total $4,630,000 Liabilities $2,970,000 Cap. stock 900,000 R/E 760,000 Total $4,630,000 Cash $ 110,000 Other 4,975,000 Total $5,085,000 Liabilities $2,860,400 Cap. stock 1,000,000 R/E 1,224,600 Total $5,085,000 Revenues $12,443,000 Expenses 11,578,400 Net income $ 864,600 Stmt of Retained Earnings R/E 12/31/02 $ 760,000 Net income 864,600 Dividends (400,000) R/E 12/31/03 $1,224,600 Financial Statement Articulation
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 • CPA firms have economic incentives to perform credible audits. • Reputation • Lawsuits • Owners and managers want the most favorable results possible. • Bank credit • Bonuses • Public stock price
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
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. Total current assets Total current liabilities
Sales Total assets 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.
Net income Sales What IsReturn on Salesand Its Purpose? • Measure of the amount of profit earned per dollar of sales. • Evaluated within the appropriate industry.
Net income Owners’ equity What IsReturn on Equityand Its Purpose? • Overall measure of performance--profit earned per dollar of investment. • Typically between 15% and 25%.
Market price per share Earnings per share What Is thePrice-Earnings Ratioand Its Purpose? • Measure of growth potential, earnings stability, and management capabilities. • In the U.S., typically between 5 and 30.
Debt ratio Current ratio Asset turnover Return on sales Return on equity Price-earnings ratio Financial Ratios Total liabilities Total assets Current assets Current liabilities Sales Total assets Net income Sales Net income Owners’ equity Market price per share Earnings per share
Learning Objective 5 • Explain the fundamental concepts and assumptions that underlie financial accounting.
Accounting Model • The basic accounting assumptions, concepts, principles, and procedures that determine the manner of recording, measuring, and reporting a company’s transactions.
What Are The Fundamental Concepts and Assumptions? • Separate Entity Concept • Arm’s-Length Transactions • Cost Principle • Monetary Measurement Concept • Going Concern Assumption
Describe the Separate Entity Concept. 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
What Is An Arm’s-Length Transaction? The exchange of goods or services between independent and rational parties, each looking out for their company’s best interests.
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