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~ Chapter 2 ~
Financial Background
 Learning Objectives

• Understand the information

provided by financial
statements
• Know the four basic financial
statements
• Know the difference between
book value and market value
 Accounting Function
• Gathering, processing, and reporting data
• End result is a set of financial statements
• A complete set of financial statements should
include:

– Statement of Financial Position

– Statement of Comprehensive Income
– Statement of Changes in Equity
– Statement of Cash Flows
– Notes to Financial Statements
 Annual Report

• Financial highlights • Financial

performance
• Letter to
stockholders from • Members of the
CEO management team
– Communication and board of
with stockholders directors

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 Financial Performance
• Summary of financial ratios
• Statement of Financial Position
• Statement of Comprehensive Income
• Statement of Changes in Equity
• Statement of Cash Flows
• Report from the independent auditor
 Statement of Financial Position
(Balance Sheet)

• The SFP is a snapshot of the firm’s assets and

liabilities at a given point in time.

• It shows what the firm owns (assets) and how

they were financed between liabilities and
stockholders’ equity.

• Assets = Liabilities + Stockholders’ Equity

 Major Components of the SFP
• Fixed Assets • Stockholders’ Equity
• + Other Assets • + Long Term Liabilities
• + Current Assets • + Current Liabilities
• = Total Assets • = Total Liabilities &
Stockholders’ Equity
SFP - Figure 2.1

The SFP:
 Fixed Assets

• Property, plant, and equipment

• Carried at cost – accumulated depreciation

 Intangible and Other Assets
• Intangible
– Trademarks
– Patents
– Goodwill

• Other
– Long-term assets that do not fit into other
categories
A trademark is a word, phrase, symbol or design or a
combination of words, phrases, symbols or designs
that identifies the goods and services of one party and
distinguishes them from those of another.

Examples of trademarks
 Patent
• An exclusive right granted to anyone who
makes a new or useful invention or
improvement of a product or a process that
provides a new way of doing something.
• It prevents anyone from making, using, selling,
offering for sale or importing the invention
 Goodwill

Goodwill reflects that an ongoing business had some

"prudent value" beyond its assets, such as the
reputation the firm enjoyed with its clients.

For example, a company may have net assets valued at

$1 million, but the company's overall value (including
brand, customers, intellectual capital) is valued at
$10 million. Anybody buying that company would
book $10 million in total assets acquired, comprising
$1 million physical assets, and $9 million in goodwill.
 Current Assets
• Cash & cash equivalents

• Accounts receivable

• Inventory

• Other current assets

- Prepaid expenses
 Shareholders’ Equity
• Share capital
– Funds raised by issuing shares (preferred shares
and common shares)
• Retained earnings
– Net income retained in the firm net of all
dividends paid
 Liabilities
• Long-term liabilities
– Mortgage loans
– Debentures

• Current liabilities
– Accounts payable
– Bank o/d
– Accrued expenses
 Liquidity
• Refers to the ease and quickness
with which assets can be converted
to cash without a significant loss in value.
• Current assets are the most liquid.
• The more liquid a firm’s assets, the less likely the
firm is to experience problems meeting short-
term obligations.
• Liquid assets frequently have lower rates of
return than fixed assets.
 Which asset is more liquid?

Inventories?

Cash in hand?

Debtors?

Cash at bank?
 Market Vs. Book Value
• Book value is the price paid for a particular asset.
– This price never changes so long as you own the asset.
• Market value is the current price at which you can
sell an asset.

For example, if you bought a house 10 years ago for

$300,000, its book value for your entire period of
ownership will remain $300,000. If you can sell the
house today for $500,000, this would be the market
value.
 Market Vs. Book Value
• The SFP provides the book value of the
assets, liabilities and equity.

• Market value is the price at which the

assets, liabilities or equity can actually be
bought or sold.
 Lecture Exercise
• Construct a Statement of Financial Position for ABC from
the following entries. Find the shareholders’ equity.

RM
• Cash = 10,000
• Inventory = 165,000
• Land = 210,000
• A/c Receivable = 22,000
• A/c Payable = 27,000
• Short term loan = 40,000
• Mortgage loan = 100,000
 Statement of Comprehensive Income
(Income Statement)
• Captures the operating results of the firm over
a period of time.
• Details the earnings generated by the firm
after all expenses have been subtracted from
the revenues

The accounting definition of income is:

Revenue – Expenses ≡ Income
 Components of the SCI
Sales
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Operating Profit / Earnings before interest and tax
(EBIT)
Less: Interest expense
Earnings before tax (EBT)
Less: Taxes
Net profit / Earnings after tax (EAT) / Earnings
available to common shareholders
Less: Dividends
Example: SCI
 Lecture Exercise
Given the following information,
prepare a Statement of
Comprehensive Income for
Goodman Software, Inc.
$
Selling and administrative expense 50,000
Depreciation expense 80,000
Sales 400,000
Interest expense 30,000
Cost of goods sold 150,000
Taxes 18,550
 Lecture Exercise
• ElectroWiz Company produces a popular video game
called Destructo which sells for $32.
• Last year ElectroWiz sold 50,000 Destructo games, each of
which costs $6 to produce.
• ElectroWiz incurred selling and administrative expenses of
$80,000 and depreciation expense of $10,000.
• In addition, ElectroWiz has a $100,000 loan outstanding at
12%. Their tax rate is 40%. There are 100,000 common
shares outstanding.
Prepare a Statement of Comprehensive Income for
ElectroWiz (include EPS).
Note: Earnings per Share (EPS) = Net Income/ no. of shares outstanding
Statement of Changes in Equity
• shows how much of the firm’s earnings were
retained, rather than paid out as dividends.
• the purpose is to reconcile the retained
earnings number in the SFP with the net
income figure from the SCI.
Statement of Changes in Equity
Changes in
Equity
 Lecture Exercise

Assuming Mabor Bhd.’s net income for the year ended 2008 is RM845
million, calculate the amount of dividends that Mabor Bhd. has paid to
its shareholders in 2008.
 Statement of Cash Flows

The cash flow statement provides

information about:
• cash receipts (cash inflows)
• uses of cash (cash outflows)
• during a period of time
 Non-cash Items
• A primary reason why accounting income differs
from cash flow is that an income statement
contains non-cash items.

• E.g. Depreciation

• Cash flow is the difference between the dollars that

came in and the dollars that went out.

• Deduction of depreciation as an expense does not

involve any cash flows.
 Sources and Uses
• Sources
– Cash inflow – occurs when we “sell” something
– Decrease in asset account
– Increase in liability or equity account

• Uses
– Cash outflow – occurs when we “buy” something
– Increase in asset account
– Decrease in liability or equity account
 Basic Organization of the
Statement of Cash Flows
• A business may be evaluated in terms of
three types of business activities:
1. Operating activities
2. Investing activities
3. Financing activities
 Statement of Cash Flows

– Operating Activity – includes net income and

changes in current assets & current liabilities.

– Investing Activity – includes changes in fixed

assets

– Financing Activity – includes changes in long-

term debt and equity accounts as well as
dividends
Statement of Cash Flows
 Lecture Exercise
Identify each of the following as increasing (+) or decreasing (-) in
cash flows from operating activities (O), investing activities (I) or
financing activities (F). (EXAMPLE: increase in inventory would
decrease cash flows from operating activities, and the correct
answer would be “-O”)
1. Increase in accounts payable
2. Decrease in inventory
3. income from operations
4. Payment of dividends
5. Sale of preferred stock
6. Increase in accrued expenses
7. Purchase of new equipment
8. Decrease in income tax payable
"I hear and I forget.
I see and I remember.
I do and I understand."
-- Confucius