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Introduction to FinancialStatement

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Form of Financial Statement

Accounting Equation

The Balance Sheet

The Income Statement

The Cash Flow Statement

The statement of Stockholders’ Equity 

Statement of Retain Earnings

Foot notes and supplement information to financial statement

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Balance Sheet

Mirrors the Accounting Equation

Assets = Liabilities + Equity

Uses of funds = Sources of funds  Assets are listed in order of liquidity

Liabilities are listed in order of maturity

Equity consists of Contributed CapitalandRetained Earnings

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Assets

To be reported on a balance sheet, an asset must

Be owned or controlled by the company

Generally, this means owning title to the asset

Leased assets are recorded under certain circumstances

Must possess expected future benefits

Generally this means cash inflow

Future benefits may mean the receipt of another asset orthe reduction of a liability

When the receipt of future benefits is in doubt, the assetmay become “impaired” and written down of offentirely

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Assets are Reportedin Order of Liquidity

Liquidity refers to the ease of convertinga noncash asset to cash.

Asset portion of the balance sheet isdivided into Current and NoncurrentAssets

Current assets comprise assets that can beconverted to cash within a year

Noncurrent assets (long-term assets) cannot beeasily converted to cash within a year.

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Assets are Reported atHistorical Cost

Historical Cost is◦ Objective

◦ Verifiable

◦ Therefore, not subject to bias

However, historical cost is notparticularly “relevant” to most readers

of the balance sheet “Relevance vs. Reliability” is an

important issue with accountants.

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Liabilities

Liabilities are listed in order of maturity◦ Current Liabilities come due in less than a

year.

◦ Noncurrent liabilities come due after ayear.

Companies desire more current assetsthan current liabilities – this differenceis called net working capital

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Net Working Capital

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Tactics Used to ReduceOperating Cycles

Increase trade credit to minimize thecash invested in inventories

Reduce inventory levels by improvedproduction systems and

management

Decrease accounts receivable by bettercollection procedures

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Equity

Equity consists of:

◦ Contributed Capital (cash raised fromthe issuance of shares)

◦ Earned Capital (retained earnings).Retained Earnings is updated eachperiod as follows:

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Market Value vs. Book Value

Stockholders’ equity = Company bookvalue

Book value is determined using GAAP.

Book value is not the same as MarketValue.

Market Value = # of Shares x Price pershare

On average, the book value is roughlytwo-thirds of market value.

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Income Statement

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Income Statement

Revenues are increases in net assetsas a result of business activities.

Expenses are the outflow or use of

assets to generate revenues, includingcosts of products and services sold,operating costs like wages and

advertising, and nonoperating costslike interest on debt.

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Operating vs. Nonoperating

Operating expenses are the usual andcustomary costs that a company incurs tosupport its main business activities

Nonoperating expenses relate to thecompany’s financing and investing

activities

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Accrual Accounting

Accrual accounting refers tothe recognition of revenuewhen earned (even if notreceived in cash) and thematching of expenses when

incurred (even if not paid incash).

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Accrual Accounting

Accrual accounting rests on twoguiding principles: Revenue Recognition Principle – 

record revenue when

◦ Earned◦ Realized or Realizable

Matching Principle – record expenseswhen◦ Incurred

Neither the recognition of revenue northe recording of expense necessarilyinvolves the receipt or payment of

cash

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Accrual ExampleAssume the following:

• Purchase of $100 of inventory on account• Sale of all of the inventory for $150 on account• Employees earn $20 of wages to be paid next

period

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Transitory vs. Core

Transitory items are one-time events(e.g., not likely to recur)

Core items are likely to recur (persist)

and are, therefore, more relevant forcompany valuation

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Transitory Items

Discontinued operations: net income orloss from business segments that are upfor sale or sold in the current period

Extraordinary items: revenue and

expenses that are both unusual andinfrequent

Changes in accounting principles:cumulative income or loss from changes

in accounting methods (may be reflectedin income from continuing operations inthe future)

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Transitory Items

Income from Continuing Operationsmay still contain transitory items:

◦ Gains (losses) on asset sales

◦ Restructuring expenses

Asset write-downs

Accruals

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Statement of Stockholders’

Equity

Statement of Equity is areconciliation of the beginning and

ending balances of stockholders’equity accounts.

Main equity categories are:◦ Contributed capital

◦ Retained earnings (including OtherComprehensive Income or OCI)

◦ Treasury stock

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Statement of Cash Flows

Statement of cash flows (SCF) reportscash inflows and outflows

Cash flows are reported based on the

three business activities of a company:1. Operating activities: transactions related tothe operations of the business.

2. Investing activities: acquisitions and

divestitures of long-term assets3. Financing activities: issuances and

payments toward equity, borrowings, andlong-term liabilities.