Ch. 2 Overview of Business Activities and Financial Statements Learning objectives Understand Elements of financial statements Use Financial Statement Effects Template Understand period-end adjustments and their financial statement effects Construct Financial Statements from account balances

Four Main Financial Statements Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows M2-20, Ongoing Analysis Project (Apple, SEC)

Assets = Liabilities + Equity 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 (Earned) Capital

Assets To be reported on a balance sheet, an asset must Be ( owned) or controlled by the company Must possess expected (future)(economic)(benefits) Assets are listed in order of liquidity Current assets comprise assets that can be converted to (cash) within (one year) Long-term assets cannot be easily converted to (cash ) within (one 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 net of (uncollectible) (receivables); Inventory—goods (purchased) or (manufactured) 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 etc. used in ( operating) activities (“net” refers to subtraction of ( accumulated)(depreciation)) 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.

Cisco Systems, Inc. Assets

At what amount an asset is reported in the balance sheet? Rule: Historical Cost (= original acquisition cost) is Objective Verifiable Knowledge Based Assets such as ( patents) ( research & development or R&D) are not Reflected on the Balance Sheet. 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.]

Disney’s Assets Where’s Mickey? The market value of the Mickey Mouse trademark does not explicitly show up here.

Examples of Current Liabilities Accounts payable: Cash to be paid in the future Accrued liabilities: Cash to be paid in the future Unearned revenues: Cash received in the past 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. example: mortgage loan

Examples of Noncurrent Liabilities Long-term debt 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: M2-23, D2-53

Income Statement

Cisco Systems, Inc. Income Statement

Income Statement When are Revenues and Expenses Recognized? Revenue Recognition Principle—recognize revenues when earned Matching Principle—recognize expenses when incurred

Profit (accrual accounting) vs Profit (accrual accounting) vs. Operating Cash Flow (cash-basis accounting) Net Income ≠ Operating Cash Flow. Net Income = (revenues ) – (expenses) Operating CF = (cash received from operations) – ( cash paid for operations ) A firm could have “good income” but “poor operating cash flow” or vice versa (i.e., there are two dimensions to consider). M2-25, P2-45 (Financial Statement Effects Template)

Operating vs. Nonoperating 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 Items in the Income Statement

Transitory Items 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 (Eliminated from income statement since 2015).

Exercise: The Ice Cream Store, Inc. The Ice Cream Store, Inc. incurred the following start-up costs: The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 in cash by the owners. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. Purchased equipment for $25,000 cash on October 2. 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. 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. Prepare a transaction analysis of 1 – 5 using the financial statement effects template.

Balance Sheet (beginning balances are ‘0” Income Statement Transaction Cash Asset + Noncash Assets = Liabi-lities Contrib. capital Retained Earnings Rev – Expenses The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 by the owners. (Financing) 90,000 2. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. 35,000 3. Purchased equipment for $25,000 cash on October 2. (Investing) -25,000 25,000 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. (Financing and Investing) -20,000 80,000 60,000 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. (No transaction to be recorded) Balance 105,000 95,000

Ice Cream Shop Balance Sheet: ASSETS   Cash  $80,000 Equipment  25,000 Building  80,000 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

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.

Articulation of Financial Statements Financial statements are linked within and across time – they articulate. Balance Sheet and Income Statement are linked via (retained)(earnings)

Adjusting Accounts

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 incorporation or bylaws

Global Accounting Balance Sheet The most visible difference is that the typical IFRS-based balance sheet is presented in reverse order of liquidity. Income Statement The most visible difference is that GAAP requires three years’ data on the income statement whereas IFRS requires only two. Statement of Cash Flows One of the more apparent differences between GAAP and IFRS is that a GAAP-based statement of cash flows classifies interest expense, interest revenue, and dividend revenue as operating cash flows, and dividends paid as financing cash flows. IFRS allows firms to choose from between the following two options: Classify interest expense, dividends paid, interest revenue, and dividend revenue as operating cash flows, or Classify interest expense and dividends paid as financing cash flows, and interest revenue and dividend revenue as investing cash flows.