Chapter 7

Preparing Financial Statements and Analyzing Business Transactions

Objectives

Understand financial reporting

Understand four Financial Statements

Understand Notes to Financial Statements

Analyze transactions! –prepare a worksheet

Ratios

Financial Reporting

The Process of preparing and presenting financial information, to include:

The four financial statements:

Income Statement

Statement of Changes in Shareholders’ Equity

Balance Sheet

Statement of Cash Flows

The Financial Accounting Standards Board

Establishes the guidelines for financial statements.

These broad principles are referred to as Generally Accepted Accounting Principles.

The goal is to increase the quality and usefulness of the information

It takes good information

To make good decisions

Is the Information Useful?

It must be capable of making a

difference in the decision making

process

Qualities of Accounting Information

Information is only good if it is:

Relevant

Reliable

Comparable

Consistent

Relevant Information is….

Important to the company Has the potential to

influence decisions

Provided on a timely basis

“I hear that our neighbor is selling

their land”

“We would be able to expand

our operations…”

“Someone else bought it this morning ”

“No longer relevant”

Reliable Information is….

Neutral

Verifiable

And independent of the specific person who prepared it

“Is this information

accurate and free of bias?”

Comparable Information

Each company has prepared its information using the same set of rules

Allows meaningful comparisons of two companies

“Are we doing better or worse than they are?

Why?

Consistent Information

The company uses the same set of rules from year to year

Allows meaningful comparisons of a company’s performance at two points in time

“How are we doing this year

versus last year?

Take a closer look at the Balance Sheet

Adding Subtotals to the Balance Sheet is called Classifying the Balance Sheet

These subtotals allow the reader to make decisions as to the type, amount and the timing of item under review

Current Assets

Current Assets are those that will be converted to cash or used in the next 12 months

Non-Current Assets

Non-Current Assets (also called Plant Assets) are those that will be Not Be converted to cash or used in the next 12 months

Non-Current Assets will not be used in the next 12 months

Current Liabilities

Current Liabilities are those that will be paid off or worked off in the next 12 months

CURRENT RATIO

= Current Assets/Current Liabilities

What does THIS mean????

Non-Current Liabilities

Non-Current Liabilities are those that will Not Be paid off or worked off in the next 12 months

Non-Current Liabilities will not be paid off in the next 12 months

Stockholders’ Equity

Is the Residual Claim on the Net Assets of the Corporation, after the claims of creditors have been satisfied.

Contributed Capital represents the investment by the stockholders

Retained Earnings represents the cumulative (lifetime) profitability of the corporation less dividends

Transaction Analysis – in simplest terms

Is the process of Analyzing the impact a transaction has on the Accounting Equation

1) Did the transaction change the amount of Assets?

2) Did the transaction change the amount of Liabilities?

3) If the change in Assets does not equal the change in Liabilities, evaluate the impact on Equity.

If Shareholder’s Equity changed…

Either the Income Statement or Statement of Shareholders’ Equity will be affected

If the transaction is between the business and non-owners, it is an Income Statement transaction.

If the transaction is between the business and its owners, it is a Statement of Shareholders’ Equity transaction

A really big example. . .

Let’s try it….

This transaction increases Assets and Contributed Capital by $2,000.

$2,000 $2,000

Transactions in January

1) Clint and some of his friends contribute $2,000 to start the business.

This transaction affects the Balance Sheet and the Statement of Changes in Shareholders’ Equity

2) Clint’s Consulting Company borrows $4,000 from a local bank. The loan will be repaid in six months.

This transaction increases Assets and Liabilities by $4,000.

Transactions that don’t change Equity only affect the Balance Sheet

3) The firm spends $1,400 cash for operating expenses.

This transaction decreases Assets and Shareholders’ Equity by $1,400.

Cash will be reduced on the Balance Sheet and Operating Expenses will reduce Income on the Income Statement.

4) Clint’s Consulting acquires office equipment at a cost of $5,000 for cash.

This transaction Increases the Asset – Office Equipment, and decreases another Asset - Cash by $5,000.

This transaction is restricted to the Balance Sheet

5) Clint’s earned $6,000 for service revenue, all paid in cash by clients.

This transaction Increases the Asset – Cash, and increases the Retained Earnings portion of Shareholders’ Equity by $6,000.

This transaction increases Assets on the Balance Sheet, and Net Income on the Income Statement.

6) Clint’s Consulting paid $20 interest to the bank.

This transaction Decreases the Asset – Cash, and decreases the Retained Earnings portion of Shareholders’ Equity by $20.

This transaction decreases Assets on the Balance Sheet, and Net Income on the Income Statement.

The totals are used to create the financial statements.

The Revenues and Expenses will be reported on the Income Statement

Income Statement

Statement of Shareholders’ Equity

Transferred from the Income Statement

This amount is transferred to the Balance Sheet

Balance Sheet

From the Statement of Shareholders’ Equity

Assumptions and Principles underlying financial reporting

Assumptions: Separate Entity Assumption Monetary Unit Assumption Time-period Assumption Going-Concern Assumption

Principles: Historical Cost Principle Revenue Recognition Principle Matching Principle

Separate Entity Assumption

Financial Statements of a business only contain information about that firm

Exclude transactions of the owners

Monetary Unit Assumption

Only items that can be expressed in monetary units (dollars in the United States)

Will be included in the Financial Statements

Time-Period Assumption

The life of a business can be divided into artificial time periods for financial reporting

These time periods are presented at the top of each financial statement

Going-Concern Assumption

A company will remain in business for the foreseeable future

Historical Cost Principle

Assets are recorded on the Balance Sheet at cost

Cost includes all costs necessary to get the asset ready for its intended purpose $5,000

Revenue Recognition Principle

Revenues are recorded on the Income Statement

When the earnings process is complete

And the amount is reasonably assured

Generally at the time the goods or services are provided

$6,000 of consulting work was performed in the month of January

Matching Principle

Expenses are recorded on the Income Statement

In the Same Time Period

As the Revenue they helped Generate

$1,420 of expenses were incurred to generate the $6,000 of revenues

Accrual-Basis Accounting

Revenues and Expenses are recorded on the Income Statement

At the time the economic activity occurs

Regardless of cash flow

$6,000 Revenue = Total work done in January for Cash and Credit Customers

$1,420 Expense = Total costs incurred in January whether paid in Cash or with credit

$4,580 Net Income = growth in total asset base, not necessarily growth in Cash.

EARNINGS PER SHARE

= Net Income/Average Shares of Stock

What does it mean???

End – Chapter 7

Statement of Cash Flows