Financial Management – Winter 2005 – 1 February to 3 March The accounting environment The rules of financial accounting:

Financial Management – Winter 2005 – 1 February to 3 March The accounting environment: Corporation Financial statements Auditor (Certified Public Accountant - CPA) SEC (Securities and Exchange Comission) AICPA (American Institute of Certified Public Accountants) FASB (Financial Accounting Standards Board) GAAP (Generally accepted accounting principles

Financial Management – Winter 2005 – 1 February to 3 March Securities and Exchange Commission (SEC) In 1934 the U.S. Congress created the SEC, which was commissioned to implement and enforce the Securities Act of 1933 and the Securities Exchange Act of 1934, both responses to the stock market crash in Among other things these acts state that companies with publicly traded securities need to register with the SEC (Form S-10) annually file audited financial reports with the SEC (Form 10-K) file quarterly financial statements with the SEC (Form 10-Q) annually provide audited financial reports to the stockholders The SEC was given broad powers by Congress to prescribe the accounting practices and standards to be used by companies with its jurisdiction. American Institute of Certified Public Accountants (AICPA) In 1938 the SEC elected to delegate its responsibility to prescribe accounting principles and procedures to the private sector, i.e. the accounting profession. It has allowed and encouraged the AICPA to take an active role. The AICPA responded by establishing standard-setting bodies. The current body is called Financial Accounting Standards Board (FASB)

Financial Management – Winter 2005 – 1 February to 3 March Financial Accounting Standards Board (FASB) Since 1973, the FASB has been the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports. They are officially recognized as authoritative by the SEC (Financial Reporting Release No. 1, Section 101) and the AICPA (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information. Generally Accepted Accounting Principles (GAAP) The US GAAP are used by companies based or listed in the USA. They comprise a massive volume of standards, interpretations, opinions and bulletins and are developed by the FASB. The US GAAP are a combination of authoritative standards and accepted ways of accounting.

Financial Management – Winter 2005 – 1 February to 3 March The 3 basic business activities The subject of financial accounting & reporting:

Financial Management – Winter 2005 – 1 February to 3 March Equity Financing Debt Financing Investment in Producing Assets Goods & Services Net Earnings Operating Activities Investing Activities Financing Activities Reinvested Debt Payment Dividends Businesses are like Fruit Trees… Roots Branches Trunk & Fruit

Financial Management – Winter 2005 – 1 February to 3 March The 3 basic activities involved in conducting a business are: Financing activities (Roots): Financing activities (Roots): - Owners contribute cash and receive equity shares in return. - Creditors loan cash in return for the promise of interest and principal payments. Investing activities (Trunk and branches): Investing activities (Trunk and branches): Once the capital is collected it is invested in producing assets, like buildings, equipment, machinery and vehicles. Operating activities (Fruit): Operating activities (Fruit): The assets are operated to produce goods & services which are sold to customers. Net Income The Net Income of these sales can be used in three ways: 1.Reinvested in the producing assets 2.Returned to the creditors in the form of debt payments 3.Returned to the owners in the form of dividends

Financial Management – Winter 2005 – 1 February to 3 March The three basic activities of businesses and their financial flows: Operating revenues Operating costs Sale of assets Purchase of assets Operating activities Investing activities Financing activities Equity, debt Dividends, debt payments Financial boundaries of the corporation

Financial Management – Winter 2005 – 1 February to 3 March The three basic activities of businesses and their environmental flows: Emissions to air Materials Energy Operating activities Investing activities Financing activities Solid waste Other resources Environmental boundaries of the corporation Emissions to water

Financial Management – Winter 2005 – 1 February to 3 March What information is contained in the 4 financial statements What information is contained in the 4 financial statements How are the financial flows of the 3 basic business activities reflected in the 4 financial statements? How are the financial flows of the 3 basic business activities reflected in the 4 financial statements? The 4 Financial Statements:

Financial Management – Winter 2005 – 1 February to 3 March The Financial Statements are designed to measure different aspects of the business (the fruit tree): The Balance Sheet: The Balance Sheet: Is a picture of the tree (fruit, branches, trunk & roots) at a certain point in time. It includes assets (inventory of goods and producing assets) and financing sources (equity, debt and reinvestments from net income) of the business. The Income Statement: The Income Statement: Accounts for all activities involved in the operation of the business (growing and selling the fruit) over a period of time. It contains a list of all operating expenses and revenues of the business. The Statement of Retained Earnings The Statement of Retained Earnings Reports how much of the net income from the operating activities are retained by the business and how much paid as dividends. The Statement of Cash Flows The Statement of Cash Flows Details all the cash inflows and outflows that occurred over a period of time associated with the operating (fruit), investing (trunk and branch) and financing (roots) activities of the business.

Financial Management – Winter 2005 – 1 February to 3 March The Income Statement measures operating performance over a particular period of time. Operating Revenues − Operating Expenses = Operating Income + Other Revenues − Other Expenses = Net Income before Taxes − Income Taxes = Net Income after Taxes / Number of Shares = Income per Share Net income Net income is the most important number disclosed on the financial statements.

Financial Management – Winter 2005 – 1 February to 3 March The three basic activities of businesses and the financial flows of the income statement: Operating revenues Operating costs Sale of assets Purchase of assets Operating activities Investing activities Financing activities Equity, debt Dividends, debt payments Financial boundaries of the corporation

Financial Management – Winter 2005 – 1 February to 3 March The Statement of Retained Earnings Beginning retained earnings balance + Net Income − Dividends = Ending retained earnings balance tells us how much of the net income has been retained by the company and how much has been paid out to the shareholders. Companies retain profits to finance operations and capital expenditures and to pay off debt. The rest is usually returned to the shareholders in the form of dividends. Retained earnings Retained earnings is a cumulative measure of the amount of company assets that comes from profitable operations rather than fund raising (debt or equity).

Financial Management – Winter 2005 – 1 February to 3 March The three basic activities of businesses and the financial flows of the statement of retained earnings: Operating revenues Operating costs Sale of assets Purchase of assets Operating activities Investing activities Financing activities Equity, debt Dividends Financial boundaries of the corporation

Financial Management – Winter 2005 – 1 February to 3 March The Statement of Cash Flows The statement of cash flows is a summary of the financial flows into and out of a company’s cash account. (Note that accounting flows are not necessarily cash flows) Operating activities + Cash collection − Cash paid = Net cash increase (decrease) from operating activities (1) Investing activities− Purchases of securities or property + Sales of securities or property = Net cash increase (decrease) from investing activities (2) Financing activities+ raised capital from issuing equity or entering debt − Dividends or debt payments = Net cash increase (decrease) from financing activities (3) (1) + (2) + (3) = Increase (decrease) in cash balance + Beginning cash balance = Ending cash balance The cash balance provides important information on a company’s solvency.

Financial Management – Winter 2005 – 1 February to 3 March The three basic activities of businesses and the financial flows of the statement of cash flows: Operating revenues Operating costs Sale of assets Purchase of assets Operating activities Investing activities Financing activities Equity, debt Dividends, debt payments Financial boundaries of the corporation (Cash flows only)

Financial Management – Winter 2005 – 1 February to 3 March The balance sheet provides a picture of the company’s financial situation at one point in time. It is based on the fundamental accounting equation: Assets = Liabilities + Equity The fundamental accounting equation states that net worth of a company equals the amount that is owned by all shareholders: (Assets – Liabilities) = Equity Assets: Items and right acquired through objectively measurable transactions that can be used in the future to generate economic benefits. Liabilities: Primarily a firm’s debt and payables. The total amount of liabilities is the portion of assets that a firm has borrowed and must repay. Stockholders’ Equity consists of contributed capital and retained earnings. classified consolidated The balance sheet is called classified if assets and liabilities are grouped into classifications, and consolidated if it contains all divisions and subsidiaries of the firm. The Balance Sheet

Financial Management – Winter 2005 – 1 February to 3 March Assets Current assets Cash Short-term investments Accounts receivable Inventory Prepaid expenses Long-term investments Notes receivable Land Debt securities Equity securities Property, plant equipment Intangible assetsLiabilities Current liabilities Accounts payable Other payables Current maturities of long-term debt Deferred revenues Long-term liabilities Notes payable Bonds payables Mortgage payableEquity Contributed capital Retained earnings Balance Sheet Classifications

Financial Management – Winter 2005 – 1 February to 3 March The Relationships between the Financial Statements Balance Sheet–12/31/03 Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings Balance Sheet–12/31/04 Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings Statement of Cash Flows–1/1/04–12/31/04 Net cash flow from operating activities Net cash used by investing activities Net cash provided by financing activities Change in cash balance Beginning cash balance (12/31/03) Ending cash balance (12/31/04) Income Statement–1/1/04–12/31/04 Revenues − Expenses = Net income Statement of Retained Earnings 1/1/04–12/31/04 Beginning retained earnings balance + Net income − Dividends Ending retained earnings balance