Introduction

Topic 1
ACCT 642 – Financial Statement Analysis 1

• Instructor: Young Jun CHO

– Email: yjcho@smu.edu.sg
– Room 4019, SOA
– Office Hours: by Appointment (or Walk-in)

• Course Website
– https://elearn.smu.edu.sg
– ACCT 642-Financial Statement Analysis 1-G5
Course Objective
• ACCT642, Financial Statement Analysis 1, aims to provide an
understanding of (1) how financial statements are prepared and (2)
the various financial statement analysis techniques.
– Designed as an introductory course: No prerequisites are
required.

• The focus of this course will be on training you to be a

knowledgeable consumer of accounting information, rather than a
producer of such information.

• Hopefully, this course will help you to understand the financial

reports - what they tell us and what they do not tell us about a
business - and identify significant issues in assessing a firm’s
financial position and financial performance.
Course Schedule
Readings
Week
Timetable Topic (Chapter
No.
Nos.)

1 Oct. 8, Monday, 11:45am to 3:15pm Introduction 21

2 Oct. 15, Monday, 11:45am to 3:15pm Financial Reporting Mechanics 22

Financial Reporting Standards 23

3 Oct. 22, Monday, 11:45am to 3:15pm
Analysis of Income 24

4 Oct. 26, Friday, 3:30pm to 7pm Analysis of Inventories 25, 28

5 Oct. 29, Monday, 11:45am to 3:15pm Analysis of Long-Lived Assets 25, 29

6 Nov. 5, Monday, 11:45am to 3:15pm Analysis of Non-Current Liabilities 25, 31

7 Nov. 12, Monday, 11:45am to 3:15pm Analysis of Cash Flow Statement 26

Analysis of Income Taxes

30
8 Nov. 19, Monday, 11:45am to 3:15pm Financial Analysis Techniques (if time
27, 32, 33
allows)
Assessment Components
• Participation and Class Behavior (10%)
– Don’t be shy to ask question! However, please limit your in-class questions to
today’s topic.
– No Cellphone (including SMS)
– No Use of Notebook Computer
– Bring your name card every class

• Progress Assessment (30%)

– Closed-book midterm exam: Tuesday, 30 October, 2018 (10am-11:30am)
– The exam venue is to be announced.
– The exam covers topics from Week 1 to Week 4.

• Final Exam (60%): During the week of 3 Dec. to 9 Dec. 2018

– Closed-book final exam: the date, time, and venue are to be announced.
– The exam covers topics from the entire course.
Four Basic Financial Statements
• “Information” is the form of financial statements
(and the accompanying notes to the accounts)

Balance Sheet (“Statement of Financial Position”):

Reports the financial position of an entity at a specific point in time

Income Statement or Profit and Loss Statement

(“Statement of Comprehensive Income”):
Reports the economic earning activities of an entity over a period of time

Statement of Changes in Equity:

Reports the owner-related transactions that result in changes in
equity from one period to another

Statement of Cash Flows:

Reports the cash flows in and out of an entity, classified into
operating, investing and financing activities
The Balance Sheet
• Also called the Statement of Financial Position
• Reports (at a particular point in time)
– Assets
– Liabilities
– Shareholders’ equity
• Basic Accounting Equation (Balance Sheet
Equation)
Assets = Liabilities + Shareholder’s Equity
Economic Sources of Financing for Economic Resources
Resources
 MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars)
Assets
Cash $ 4,895
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets $ 27,261
Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000
Total liabilities $ 16,156
Stockholders' Equity
Capital $ 3,000
Retained earnings 8,105
Total stockholders' equity 11,105
10/7/2018 equity
Total liabilities and stockholders' $ 27,261
 MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars)
Assets are Assets
economic resources Cash $ 4,895
controlled by the Accounts receivable 5,714
entity which are Inventories 8,517
expected to produce Plant and equipment 7,154
future economic Land 981
benefits to the entity. Total assets Amount of cash in the company’s $bank
27,261
Cash and Stockholders' Equity
Liabilities
accounts.
Liabilities
Accounts
Accounts Amounts owed by customers
payable from prior
$ 7,156
receivable
Notes payable sales. 9,000
Assets are listed by Parts and completed but unsold $ 16,156
Total liabilities
their ease of Inventories
Stockholders' Equity
conversion into
products.
Contributed capital $ 3,000
cash. Plant and
Retained earnings 8,105
Factories and production machinery.
equipment
Total stockholders' equity 11,105
Total liabilities 10/7/2018
and stockholders' equity
Land Land on which factories are built. $ 27,261
 MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars)
Assets
Liabilities are present Cash $ 4,895
obligations of the Accounts receivable 5,714
entity which are Inventories 8,517
expected to result in Plant and equipment 7,154
an outflow of Land 981
economic benefits Total assets $ 27,261
form the entity. Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000
Total liabilities $ 16,156
Accounts Amounts owed to Stockholders'
suppliers for prior
Equity
payable purchases.Contributed capital $ 3,000
Retained earnings 8,105
Notes Amounts owed on written debt
Total stockholders' equity 11,105
payable contracts.
Total liabilities and stockholders' equity
10/7/2018 $ 27,261
Presentation Title
 MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
Equity is the residual (in thousands of dollars)
interest in the entity’s Assets
assets after deducting Cash $ 4,895
the entity’s liabilities Accounts receivable 5,714
and represents Inventories 8,517
shareholders’ residual Plant and equipment 7,154
claim to the entity’s Land 981
assets. Total assets $ 27,261
Liabilities and Stockholders' Equity
Amounts invested in the Liabilities
business by
Capital
Accounts payable
stockholders. $ 7,156
Retained Notesnot
Past earnings payable
distributed to 9,000
earnings stockholders.Total liabilities $ 16,156
Stockholders' Equity
Capital $ 3,000
Retained earnings 8,105
Total stockholders' equity 11,105
10/7/2018
Total liabilities and stockholders' equity Presentation Title
$ 27,261
Retained Earnings
• Retained earnings is the B/S item that links I/S (net
income) to B/S (Shareholders’ equity).

• Retained earnings is the accumulated past earnings

which have not been paid as dividends to shareholders

• Ending Balance of Retained Earnings = Beginning

Balance of Retained Earnings + Net Income – Dividend
Beginning Balance of Ending Balance of
Net Income Dividend
Retained Earnings Retained Earnings
2001 0 1,000 500 500
2002 500 2,000 1,000 1,500
2003 1,500 1,500 2,000 ?
1,000
 MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars)
Assets
Cash $ 4,895
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets $ 27,261
Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000
Assets = Liabilities Total
+ Stockholders’
liabilities Equity $ 16,156
Stockholders' Equity
Capital $ 3,000
Retained earnings 8,105
Total stockholders' equity 11,105
10/7/2018
Total liabilities and stockholders' equity Presentation Title
$ 27,261
Assets on the Balance Sheet
Current Non-current
• Expected to be converted to • Will be held longer than one
cash, sold or consumed in year
the next 12 months or within
the business’ operating • Include
cycle – Property, plant and
equipment (PP&E)
• Include
• Land
– Cash
• Buildings
– Short-term investments
• Computers
– Accounts receivable
• Equipment
– Inventory
– Intangibles
– Prepaid expenses
– Long-term investments
Liabilities on the Balance Sheet
Current Non-current
• Obligations or debts • Debts payable more than
payable in the one year or one year from balance
within the business’s sheet date
operating cycle • Include
• Include – Long-term notes payable
– Accounts payable – Bonds payable
– Taxes payable
– Short-term notes payable
– Salaries/wages payable
Shareholders’ Equity on the Balance
Sheet
• Represents shareholders ownership of the
business assets
• Consists of:
– Paid-in capital (sometimes labeled Share
Capital or simply, Capital)
– Additional paid-in capital (depends on
jurisdictions)
– Retained earnings
The Income Statement
• part of Statement of Comprehensive Income
• Reports two main categories
– Revenues and gains
– Expenses and losses
• Shows the “bottom line”
– Net income or net loss for the period
– Earnings performance during the accounting period
(how the company improved (harmed) its financial
position over a period of time)
• Net Income = Revenues - Expenses
 MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
10/7/2018
Net income $ 3,300
 MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

Revenues
Sales revenue
Revenues are earnings from the sale of goods $ 37,436
or
Expenses
services to customers. Revenues are recognized in
theCost of goods sold
period $ 26,980
in which goods and services are sold,
Selling, general and administrative 3,624
not necessarily the period in which cash is
Research and development 1,982
received.
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
10/7/2018
Net income $ 3,300
Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made Cash from sale

on May 25th. collected on June 10th.
X X
May 2009 June 2009
Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made

on May 25th.
X
May 2009
 MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Expenses are the dollar amount of resources used up by
Selling, general and administrative 3,624
the entity to earn revenues during a period. Expenses are
Research and development 1,982
recognized in the period in which they are matched with the
Interest expense 450
revenues they helped create, not necessarily the period in
Total expenses 33,036
which cash is paid.
Pretax income $ 4,400
Income tax expense 1,100
10/7/2018
Net income $ 3,300
Expenses
The dollar amount of resources used
up by the entity to earn revenues
during a period.

When will the expense for this

transaction be recognized?

Dec. 1, 2008 paid $1,000 cash Insurance is effective

for next year’s insurance in 2009

2008 2009
Expenses
The dollar amount of resources used
up by the entity to earn revenues
during a period.

When will the expense for this

transaction be recognized?

Insurance expense
Recorded in 2009

2009
 MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

Revenues Cost of The cost to produce products sold this

goods sold period.
Sales revenue $ 37,436
Selling,
Expenses Operating expenses not directly related
general and
to production.
Cost of goods sold $ 26,980
administrative

Selling, general and administrative Research

3,624and Expenses incurred to develop new
development products.
Research and development 1,982
Interest
Interest expense 450 The cost of using borrowed funds.
expense
Total expenses Income tax Income
33,036taxes on current period’s pretax
expense income.
Pretax income $ 4,400
Income tax expense 1,100
Net25income 10/7/2018 $ 3,300
 MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
If expenses exceed revenues,
Pretax income $ 4,400
we report net loss.
Income tax expense 1,100
Net income 10/7/2018 $ 3,300
Link between I/S and B/S
• Retained Earnings:
– The “link” between I/S and B/S explains the
changes that took place in the SE during the
reporting period

Revenues Expenses
for the – for the
period period

Beginning Ending
Net Income Dividends
Balance + Balance of
of Retained – (Loss) – for the = Retained
for the period period
Earnings Earnings
Statement of comprehensive income
Statement of Changes in Equity
• The Statement of Changes in Equity
shows a company’s transactions with its
owners.
• Net income (or net loss) flows from the
Income Statement to the Statement of
Changes in Equity.
 MAXIDRIVE CORP.
Statement of Changes in Equity
For the Year Ended December 31, 2009
(in thousands of dollars)

Stockholder equity, January 1, 2009 $ 8,805

Net income for 2009 3,300
Dividends for 2009 (2,000)
Share Issuance for 2009 1,000
Stockholder equity, December 31, 2009 $ 11,105
Review – Shareholders’ Equity
• Shareholders’ Equity (SE) = Capital + Retained Earnings (RE)
• Ending Balance of SE
= Beginning Balance of SE + ΔSE
= Beginning Balance of SE + ΔCapital + ΔRE
= Beginning Balance of SE + ΔCapital + (NI – Div)

• Exercises: ABC Corp. issued $10M of shares, earned $5M of NI,

and paid $1M of dividends during 2011. At the end of 2010, the
balance of SE was $100M, including $50M of RE.
– Compute the balance of RE in 2011.
– Compute the balance of SE in 2011.
– Compute the balance of Capital in 2010 and 2011.
The Statement of Cash Flows

• Reports changes in cash over the accounting

period

• Cash Flows + Accruals = Earnings (Income)

• On a statement of cash flows, cash means more

than just cash in the bank
– It includes cash equivalents, which are highly liquid
short-term investments
Cash Flow Categories

Cash Flow from Operating Activities

Cash Flow from Investing Activities

Cash Flow from Financing Activities

Net Cash Flow

Classifications of Cash Flows
• Cash flows from operating activities
– generally involve the producing and delivering goods and providing services. Often
defined as whatever isn’t an investing or financing flow. e.g., customers,
interest/dividends received, employees, suppliers, for interest, for taxes

• Cash flows from investing activities

– acquiring and disposing of Property Plant & Equipment, Intangibles & Natural
Resources for cash
– acquiring and disposing of Investments (companies and securities) for cash

• Cash flows from financing activities

– issuing and retiring short-term and long-term 3rd-party debt (principal only) for cash
– issuing and retiring stock for cash
– payment of cash dividends (interest expense is part of operating cash flows)
3rd-party debt is debt to other than to suppliers, employees, for interest, for taxes. It
usually includes Notes Payable (Short-term Debt) depending on who they are
payable to (mostly financial institutions and debt investors), Current Maturities of
Long-term Debt, and Long-term Debt.
 Cash Flows from Operating Activities

Two Formats for Reporting Operating Activities

• Direct Method reports cash flows as gross receipts and gross
payments (who paid or received cash; e.g., customers, employees,
suppliers, bank for interest, government for taxes)

• Indirect Method adjusts net income to compute cash flows from

operating activities (eliminate non-cash items included in net income,
and add cash items excluded in net income).

Note that no matter which format is used, the same amount of

net cash flows from operating activities is generated.
Cash Flow from Operating Activities

Direct Method

The direct method reports the components of cash flows from operating
activities as gross receipts and gross payments
Cash Flow from Operating Activities
Indirect Method

The indirect method starts with net income from the income statement and then
eliminates non-cash items to arrive at net cash inflow (outflow) from operating
activities.
Cash Flow from Investing Activities
Only direct method is allowed!

• Acquisition and Disposal of Property Plant &

Equipment, Intangibles & Natural Resources for
cash

• Acquisition and Disposal of Investments

(companies and securities) for cash
Cash Flow from Financing Activities
Only direct method is allowed!
• Issuance and retirement of short-term and long-
term 3rd-party debt (principal only) for cash

• Issuance and retirement of stock for cash

• payment of cash dividends (note: interest

expense is part of operating cash flows)
3rd-party debt is debt to other than to suppliers, employees, for interest, for taxes. It
usually includes Notes Payable (Short-term Debt) depending on who they are
payable to (mostly financial institutions and debt investors), Current Maturities of
Long-term Debt, and Long-term Debt.
Noncash Investing and Financing Activities
• Certain transactions are important investing and
financing activities but have no cash flow effects.

• If debt or stock is issued for long-term assets, it is not

included in the section of cash flow from investing or
financing activities.

• However, supplemental disclosure is required for

noncash investing and financing activities.
The Statement of Cash Flows reports the inflows and outflows
of cash during the period in the categories of operating,
MAXIDRIVE CORP.
investing, and financing.
Statement of Cash Flows
For the Year Ended December 31, 2009
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (2,000)
Cash received from share issuance 1,000
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
Notes (or Footnotes)
• Required to accompany the four basic financial
statements

• Provide information that is essential to understanding the

information provided in the primary statements
– Disclose information about the accounting policies, methods,
and estimates used to prepare the financial statements.
– Provide explanatory information about almost every line item on
the balance sheet and income statement.
Relationship Among the Financial Statements

MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars) Net income from the income
Revenues statement increases ending
stockholders’ equity on the
Sales revenue $ 37,436
Expenses
Cost of goods sold
Selling, general and administrative
$ 26,980
3,624
statement of changes in equity.
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100 MAXIDRIVE CORP.
Net income $ 3,300 Statement of Changes in Equity
For the Year Ended December 31, 2009
(in thousands of dollars)

Stockholder equity, January 1, 2009 $ 8,805

Net income for 2009 3,300
Dividends for 2009 (2,000)
Share Issuance for 2009 1,000
Stockholder equity, DecemberPresentation Title
31, 2009 $ 11,105
Relationship Among the Financial Statements

MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars) Ending stockholders’ equity from
Assets
Cash $ 4,895 the statement of changes in
Accounts receivable 5,714
Inventories 8,517 equity is one of the components
Plant and equipment 7,154
Land 981 of the balance sheet.
Total assets $ 27,261
Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000 MAXIDRIVE CORP.
Total liabilities $ 16,156
Statement of Changes in Equity
Stockholders' Equity
For the Year Ended December 31, 2009
Contributed capital $ 3,000
Retained earnings 8,105 (in thousands of dollars)
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261 Stockholder equity, January 1, 2009 $ 8,805
Net income for 2009 3,300
Dividends for 2009 (2,000)
Share Issuance for 2009 1,000
Stockholder equity, December 31, 2009 $ 11,105
 Relationship Among the Financial Statements
MAXIDRIVE CORP.
MAXIDRIVE CORP. Statement of Cash Flows
Balance Sheet For the Year Ended December 31, 2009
At December 31, 2009 (in thousands of dollars)
(in thousands of dollars)
Assets Cash flows from operating activities:
Cash $ 4,895 Cash collected from customers $ 33,563
Accounts receivable 5,714 Cash paid to suppliers and employees (30,854)
Inventories 8,517 Cash paid for interest (450)
Plant and equipment 7,154 Cash paid for taxes (1,190)
Land 981 Net cash flow from operating activities $ 1,069
Total assets $ 27,261 Cash flow from investing activities:
Liabilities and Stockholders' Equity Cash paid to purchase equipment $ (1,625)
Liabilities Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Accounts payable $ 7,156
Cash received from bank loan $ 1,400
Notes payable 9,000 Cash paid for dividends (2,000)
Total liabilities $ 16,156 Cash received from share issuance 1,000
Stockholders' Equity Net cash flow from financing activities 400
Contributed capital $ 3,000 Net decrease in cash during the year $ (156)
Retained earnings 8,105 Cash at beginning of the year 5,051
Total stockholders' equity 11,105 Cash at end of the year $ 4,895
Total liabilities and stockholders' equity $ 27,261

The balance in cash on the balance sheet equals the change in cash
added to the beginning of the year balance in cash on the statement of
cash flows
 Exercise: Consider Target, a large retailer. Classify the
following items as an Asset (A), a Liability (L), or
Shareholders’ Equity (SE) for Target:

• a. Accounts payable • g. Accounts receivable

• b. Share capital • h. Long-term debt

• c. Supplies • i. Merchandise inventory

• d. Retained earnings • j. Notes payable

• e. Land • k. Expenses payable

• f. Prepaid expenses • l. Equipment

Exercise: Assume Facebook is expanding into Ireland. The company
must decide where to locate and how to finance the expansion. Identify
the financial statement where these decision makers can find the
following information about Facebook, Inc. In some cases, more than
one statement will report the needed data.

a. Share capital i. Cash spent to acquire the

building
b. Income tax payable
j. Selling, general, and
c. Dividends
administrative expenses
d. Income tax expense
k. Adjustments to reconcile
e. Ending balance of retained net income to net cash
earnings provided by operations
f. Total assets l. Ending cash balance
g. Long-term debt m. Current liabilities
h. Revenue n. Net income
Exercise: Compute the missing amount in the accounting
equation for each company (amounts in billions)

Assets Liabilities Owners’ Equity

Fresh Produce $ ? $ 9 $ 17
Hudson Bank 29 ? 15
Pet Lovers 21 10 ?
Exercise: Sennett Designs (SD) sells furniture on a retail basis. SD
began operations during December 2009 and sold furniture for
$250,000 in cash. The furniture sold by SD was purchased on credit for
$150,000 and delivered by the supplier during December. The credit
terms granted by the supplier required SD to pay the $150,000 in
January next year for the furniture it received during December. In
addition to the purchase and sale of furniture, in December, SD paid
$20,000 in cash for rent and salaries.

1) How much is SD’s profit for December 2009 if no other transactions

occurred?

2) How much is SD’s cash flow for December 2009?

3) If SD purchases and sells exactly the same amount in January 2010 as

it did in December and under the same terms (receiving cash for the
sales and making purchases on credit that will be due in February),
how much will the company’s profit and cash flow be for the month of
January?
Exercise: Nelson, Inc.’s comparative balance sheet at
January 31, 2011, and 2010, reports (in millions):

2011 2010
Total assets $ 39 $ 31
Total liabilities 10 9

Three situations about Nelson’s issuance of shares and payment of

dividends during the year ended January 31, 2011, follow. For each
situation, use the accounting changes in equity to compute the amount
of Nelson’s net income or net loss during the year ended January 31,
2011.
1) Nelson issued $11 million of shares and paid no dividends.
2) Nelson issued no shares but paid dividends of $11 million.
3) Nelson issued $55 million of shares and paid dividends of $32
million.
Exercise: Amounts of the assets and liabilities of Ellen Samuel Banking
Company, as of January 31, 2010, are given as follows. Also included
are revenue and expense figures for the year ended on the date
(amounts in millions).

Total revenue ……...............................…$ 37.8

Receivables ……..................................... 0.9
1) What is the amount of retained
earnings at January 31, 2010?
Current liabilities ………………………….. 151.1
Share capital ………………………………. 14
2) What is the amount of net
Interest expense ………………………….. 0.8
income for the year ended at
Salary and other employee expenses … 17.7 January 31, 2010?
Long-term liabilities………………………. 2.8
Investment assets……............................ 169.6 3) What is the amount of
Property and equipment, net.................... 1.9 dividend declared during the
Other expenses………………………….. . 6.9 year ended at January 31,
Retained earnings, beginning….…………. 8.6 2010?
Retained earnings, ending ….….………... ?
Cash………………………………..……….. 2.1
Other assets…………………………...…. 14.4