Module 2 Introducing the Fin Statements, and Transaction analysis.

Start by looking at Flow of Costs

And what are the four main financial statements?

Balance Sheet
Income Statement
Statement of Stockholders Equity
Statement of Cash flows
 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 Capital
and
Retained Earnings
 Assets
To be reported on a balance sheet, an asset must
1. Be owned (or controlled) by the company
2. Must possess expected future economic
benefits

 Assets are listed in order of liquidity

• Current assets comprise assets that can be
converted to cash within a year
• Long-term assets cannot be easily converted
to cash within a year.
 Examples of Current Assets
• Cash—currency, bank deposits, and investments with an
original maturity of 90 days or less (called cash
equivalents);
• Marketable securities—short-term investments that can
be quickly sold to raise cash;
• Accounts receivable, net—amounts due to the
company from customers arising from the sale of
products and services on credit (“net” refers to
uncollectible accounts explained in Module 6);
• Inventory—goods purchased or produced for sale to
customers;
• Prepaid expenses—costs paid in advance for rent,
insurance, advertising or other services.
 Examples of Long-term Assets
• Property, plant and equipment (PPE), net—land,
factory buildings, warehouses, office buildings,
machinery, motor vehicles, office equipment and other
items used in operating activities (“net” refers to
subtraction of accumulated depreciation, the portion of
the assets’ cost that has been transferred from the
balance sheet to the income statement, which is
explained in Module 6);
• Long-term investments—investments that the
company does not intend to sell in the near future;
• Intangible and other assets—assets without physical
substance, including patents, trademarks, franchise
rights, goodwill and other costs the company incurred
that provide future benefits.
 Assets are Reported at
Historical Cost
• Historical Cost is
– Objective
– Verifiable
• “Relevance vs. Reliability”
• Only include items that can be reliably
measured.
– Considerable amount of “assets” may not be
reflected on a balance sheet
– Strong management team, a well-designed
supply chain, or superior technology.
 Knowledge Based Assets are not
Reflected on the Balance Sheet
• NOTE: While resources expended for research
and development reflect and economic asset,
they generally are expensed as incurred.
• INSIGHT: Pharmaceutical firms do not have
assets reflecting the full amount of money that
they have spent developing drugs. These
amounts, for the most part, have been expensed
in the past and serve to reduce retained
earnings. Internally developed trade marks are
also economic assets, but may not show up on
the balance sheet. [The purchase of externally
developed trademarks are treated as assets.]
 Examples of Current Liabilities
• Accounts payable—amounts owed to suppliers for goods and
services purchased on credit.
• Accrued liabilities—obligations for expenses that have been
incurred but not yet paid; examples are accrued wages payable
(wages earned by employees but not yet paid), accrued interest
payable (interest that is owing but has not been paid), and accrued
income taxes (taxes due).
• Unearned revenues—obligations created when the company
accepts payment in advance for goods or services it will deliver in
the future; also called advances from customers, customer deposits,
or deferred revenues.
• Short-term notes payable—short-term debt payable to banks or
other creditors.
• Current maturities of long-term debt—principal portion of long-
term debt that is due to be paid within one year.
NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIAB
 Operating cycle
• Cashpurchases of (on acct??)
• Inventorysales (acct receivable)
• Collect and pay cash
 Examples of Noncurrent Liabilities
• Long-term debt—amounts borrowed from creditors
that are scheduled to be repaid more than one year in
the future; any portion of long-term debt that is due
within one year is reclassified as a current liability called
current maturities of long-term debt. Long-term debt
includes bonds, mortgages, and other long-term loans.
• Other long-term liabilities—various obligations, such
as pension liabilities and long-term tax liabilities, that will
be settled a year or more into the future. We discuss
these items in later modules.
 Equity
Equity consists of:
– Contributed Capital (cash raised from the
issuance of shares)
– Earned Capital (retained earnings).
Retained Earnings is updated each period
as follows:
 Examples of Equity Accounts
• Common stock—par value received from the original sale of
common stock to investors.
• Preferred stock—value received from the original sale of
preferred stock to investors; preferred stock has fewer ownership
rights compared to common stock.
• Additional paid-in capital—amounts received from the
original sale of stock to investors in addition to the par value of
common stock.
• Treasury stock—amount the company paid to reacquire its
common stock from shareholders.
• Retained earnings—accumulated net income (profit) that has
not been distributed to stockholders as dividends.
• Accumulated other comprehensive income or loss—
accumulated changes in equity that are not reported in the
income statement (explained in Module 9).
Income Statement
 When are Revenues and Expenses
Recognized?
• Revenue Recognition Principle—
recognize revenues when earned
• Matching Principle—recognize expenses
when incurred.
 Profit vs. Cash
• Net Income does not necessarily correspond to a net
cash flow. A firm could have “good income” but “poor
cash flow” or vice versa (i.e., there are two dimensions to
consider).
• We have previously summarized the mechanics of the
balance sheet with the expanded accounting equation:
 Permanent: Operating vs. Nonoperating and
Transitory Income items

Permanent
• Operating expenses are the usual and customary costs
that a company incurs to support its main business
activities
• Nonoperating expenses relate to the company’s
financing and investing activities
Transitory
• Discontinued operations Gains or losses (and net
income or loss) from business segments that are being
sold or have been sold in the current period.
• Extraordinary items Gains or losses from events that
are both unusual and infrequent.
 Accrual Accounting

Accrual accounting refers to

the recognition of revenue
when earned (even if not
received in cash) and the
matching of expenses when
incurred (even if not paid in
cash).
 Statement of Stockholders’ Equity

• Statement of Equity is a reconciliation

of the beginning and ending balances
of stockholders’ equity accounts.
• Main equity categories are:
– Contributed capital
– Retained earnings (including Other
Comprehensive Income or OCI)
– Treasury stock
 Statement of Cash Flows
• Statement of cash flows (SCF) reports cash
inflows and outflows
• Cash flows are reported based on the three
business activities of a company:
– Cash flows from operating activities - Cash flows
from the company’s transactions and events that
relate to its operations.
– Cash flows from investing activities - Cash flows
from acquisitions and divestitures of investments and
long-term assets.
– Cash flows from financing activities- Cash flows
from issuances of and payments toward borrowings
and equity.
 Relation of SCF to Income
Statement and Balance Sheet
 General Coding of
Balance sheet Changes
Articulation of Financial Statements
• Financial statements are linked within
and across time – they articulate.
• Balance sheet and income statement
are linked via retained earnings.
 Recording transactions –
Pay $100 Wages in Cash

• Cash assets are reduced by $100, and wage expense of $100 is

reflected in the income statement, which reduces income and
retained earnings by that amount.
• All transactions incurred by the company during the
accounting period are recorded similarly.
Adjusting Accounts
Prepaid Rent; wage accrual
Accrual of Revenue
Exercise: The Ice Cream Store, Inc.
The Ice Cream Store, Inc. incurred the following start-up
costs:
1. The Ice Cream Store, Inc. was formed on October 1,
20XX, with the investment of $90,000 in cash by the
owners.
2. Obtained a bank loan and received the proceeds of
$35,000 on October 2. The cash will be used for
operations.
3. Purchased equipment for $25,000 cash on October 2.
4. Acquired a building at a cost of $80,000. It was
financed by making a $20,000 down-payment and
obtaining a mortgage for the balance. The transaction
occurred on October 2.
5. On October 2, the President of the United States
publicly declared that she will eat (and plug) our ice
cream while entertaining guests in the White House.
 Balance Sheet Income Statement
Noncash Liabi Contrib Retained
Transaction Cash Asset + = + + Revenues – Expenses
Assets -lities . capital Earnings
1. The Ice Cream Store, Inc.
was formed on October 1,
20XX, with the investment of
$90,000 by the owners. +90 +90

2. Obtained a bank loan and

received the proceeds of
$35,000 on October 2. The cash +35
will be used for operations. +35
N/P

3. Purchased equipment for

$25,000 cash on October 2. +25
-25
Equip

4. Acquired a building at a cost

of $80,000. It was financed by
making a $20,000 down-
payment and obtaining a
mortgage for the balance. The +80 +60
-20
transaction occurred on Bldg. M/P
October 2.

5. The President of the United

States agreed to eat (and plug)
our ice cream while
entertaining guests in the White
House on Oct. 2.
 ASSETS  
Cash  $80,000
Equipment  25,000
Ice Cream Shop Building  80,000
   
Balance Sheet: Total Assets  $185,000
   
LIABILITY AND STOCKHOLDERS' EQUITY
 
Liabilities:  
Note Payable  $35,000
Mortgage Payable  60,000
Total Liabilities  95,000
   
Stockholders Equity:  
Capital Stock  90,000
Total Liabilities and  
Stockholders Equity  $185,000
 Balance Sheet Income Statement
Cash Liabi- Contrib. Retained
Transaction + Noncash Assets = + + Revenues – Expenses
Asset lities capital Earnings
6. +15 +10
-5
Inv. A/P
7. -3 -3
Inv. A/P
8. -3.5 +8 -3.5
+8 +4.5
Inv. Sales COGS
9. -3
-3 . -3
Wage exp.
10. - .383 -.550
Bldg., net Dep. exp.
-.550
-.167
Equip., net
11. -.450
-.450 -.450
Int. Exp.

Prepare the following financial statements (ignore income taxes): (i) an updated Balance
Sheet as of October 31, 20XX; and (ii) an Income Statement for the month of October
20XX.
 Ice Cream Shop –
additional transactions
6. On October 4, purchased merchandise inventory (i.e., ice cream) at
a cost of $15,000 by paying $5,000 cash and receiving short-term
credit for the remainder from the supplier.
7. Immediately returned some of the ice cream because some of the
flavors delivered were not ordered. The cost of the inventory
returned was $3,000.
8. Sales of ice cream for the month of October, 20XX, totaled $8,000.
All sales were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries earned/paid
were $3,000.
10.As of the end of October, one month's depreciation on the
equipment and building was recognized -- $383 for the building and
$167 for the equipment.
11.$450 interest expense on the note and mortgage was due and paid
on October 31. Assume that the principal amounts ($35,000 +
$60,000) of the note and mortgage remain unchanged.

Prepare a transaction analysis of 6. -11. using the balance

sheet/income statement template presented above:
Cash ($80,000 -5,000 +8,000 -3,000 -450)  $79,550
Merchandise Inventory ($0 + 15,000 -3,000 -3,500)  8,500
Equipment ($25,000 )  25,000
Less: Accumulated Depreciation  (383)
Building ($80,000)  80,000
Less: Accumulated Depreciation (167)
Total Assets  $192,500

Accounts Payable ($0 + 10,000 – 3,000)  $7,000

Note Payable ($35,000 principal is unchanged)  35,000
Mortgage Payable (60,000 principal is unchanged)  60,000
   102,000
Stockholders' Equity:  
Capital Stock  90,000
Retained Earnings  500
   90,500
Total Liabilities and Stockholders' Equity  $192,500
   
REVENUES:
Sales of Ice Cream  $8,000
Cost of Sales  3,500
GROSS PROFIT: 4,500
Payroll Expense  3,000
Depreciation Expense 550
INCOME FROM OPERATIONS 950
Interest Expense 450
NET INCOME $500
   
Note: Assume no income taxes.  
 Additional Sources of
Information
• Form 10-K
– Item 1, Business; Item 1A. Risk Factors;
– Item 2, Properties;
– Item 3, Legal Proceedings;
– Item 4, Submission of Matters to a Vote of Security Holders;
– Item 5, Market for Registrant’s Common Equity and Related
Stockholder Matters;
– Item 6, Selected Financial Data;
– Item 7, Management’s Discussion and Analysis of Financial
Condition and Results of Operations;
– Item 7A, Quantitative and Qualitative Disclosures About Market
Risk;
– Item 8, Financial Statements and Supplementary Data;
– Item 9, Changes in and Disagreements With Accountants on
Accounting and Financial Disclosure;
– Item 9A, Controls and Procedures.
 Additional Sources of
Information
• Form 8-K
– Entry into or termination of a material
definitive agreement (including petition for
bankruptcy)
– Exit from a line of business or impairment of
assets
– Change in the company’s certified public
accounting firm
– Change in control of the company
– Departure of the company’s executive officers
– Changes in the company’s articles of
 Credit and Data Services
• Analyst reports – on line or in person
– Yahoo and google et
– If you have an on-line or in person trading firm like
Ameritrade or Charles Schwa b
• Credit Analysis
– Standard & Poor’s (StandardAndPoors.com)
– Moody’s Investors Service (Moodys.com)
– Fitch Ratings (FitchRatings.com)
• Data Services
– Thomson Corporation (Thomson.com)
• First Call - summary of analysts’ earnings forecasts
• Compustat database - individual data items for all publicly
traded companies or for any specified subset of companies.