Chapter 2: The Financial Statements

Business Activities Business activities are reflected in financial statements; business activities include: Operating activities – selling goods and services. Investing activities – acquisition and sale of productive assets. Financing activities – issue and retirement/repayment of liabilities and equity.

Financial Statements Financial statements report the company activity during the year and the financial condition of the company at the end of the year. The required financial statements are: Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows

The Balance Sheet The balance sheet reports the financial position at a point in time (end of the quarter or year). The balance sheet is divided into three major categories: Assets Liabilities Stockholders’ equity

The Balance Sheet The balance sheet is represented by the fundamental accounting equation: Assets = Liabilities + Stockholders’ Equity A = L + SE The effects of all described business transactions may be represented in this formula.

The Balance Sheet (B/S) Assets - represent future benefit to the company, and are classified in order of liquidity (current assets; property, plant and equipment; long-term investments) Liabilities - represent obligations of the company, and are classified according to payment date (current liabilities, long-term liabilities) Stockholders’ equity - represents the residual claims of the owners, and is classified based on source (contributed capital and retained earnings)

B/S Assets: Current Assets Current assets include Cash: checking and savings accounts; petty cash. Short-term investments: investments in stocks and bonds of other companies. Accounts receivable: amounts owed to a company from its customers. Inventory: products on hand designated for sale to customers. Prepaid expenses: amounts paid for future expenses.

B/S Assets: Property, Plant and Equipment Property, plant, and equipment are assets that are used in the production of goods and services. These productive assets are long-term in nature, and include the following: Land: property upon which the productive facilities are located. Building: the physical structure of the company’s operations. Machinery and Equipment: include operating machinery, vehicles, computers, copy machines, etc.

B/S Assets: Long-term Investments Long-term investments are assets acquired by the company to provide long-term benefits to the company. Long-term investments include: Long-term notes receivable owed to the company (from customers or others). Investments in stock of other companies: held for expectation of dividends and/or stock price increase. Investment in bonds of other companies: held for expectation of dividends and/or stock price increase. Other assets, like land, held for the long term.

B/S Assets: Intangible Assets Intangible assets are long-lived assets that have no physical substance. Examples include: Patents: legal claim to produce and sell a product. Copyrights: legal claims to books, art, music and other created works. Goodwill: recognized when one company buys another company, and the purchase price is greater than the fair value of the identifiable net assets.

B/S Liabilities: Current Liabilities Current liabilities are obligations expected to be paid (or services expected to be performed) within the next year or operating cycle. The elimination of the current liabilities requires the use of current assets (most commonly cash). Examples include: Accounts payable Wages payable Interest payable Short-term notes payable Current maturities of long-term debt Deferred (unearned) revenues

B/S Liabilities: Long-term Liabilities Long-term liabilities are obligations expected to require payments beyond the current year. Examples of long-term liabilities include: Notes payable: amounts owed to banks and other creditors beyond the current year. Mortgage payable: amounts owed to mortgage company beyond the current year. Bonds payable: amounts owed to investors holding bond investments issued by the company, where payments of principal and interest are beyond the current year.

B/S Stockholders’ Equity: Contributed Capital Contributed capital is generated when owners (shareholders) of the company contribute cash and other assets into the company. Components of contributed capital include Common stock: shares of stock issued to owners to to reflect ownership. Additional paid in capital: excess amounts contributed by shareholders for various activities.

B/S Stockholders’ Equity: Retained Earnings Retained earnings represent the excess earnings retained in the company after dividends have been paid to shareholders. This represents the equity generated by the company for the shareholders.

The Statement of Stockholders’ Equity (SSE) Explains the changes in contributed capital and retained earnings during the year. A basic version of the SSE is represented in the following schedule (Figure 2-5): Contributed Retained Capital Earnings Total Dec. 31, 2004 $ 6,450 $ 500 $ 6,950 Net income 1,085 1,085 Less: dividends (200) (200) Issue of stock 3,100 3,100 Dec. 31, 2005 $ 9,550 $ 1,385 $10,935

The Statement of Stockholders’ Equity (SSE) The following formula represents the basic SSE: Beginning stockholders’ equity Plus: Issuance of stock Plus: Net income Less: Dividends Ending stockholders’ equity SEBegin + Issue + NI - D = SEEnd

The Statement of Retained Earnings The statement of retained earnings is a subset of the SSE, and calculates the changes in the retained earnings component. Beginning retained earnings Plus: Net income Less: Dividends Ending retained earnings REBegin + NI - Div = REEnd

The Income Statement (I/S) The income statement shows the components of net income in detail. Revenues represent the inflow of assets (or decrease in liabilities) due to a company’s operating activities. Expenses represent the outflow of assets (or increases in liabilities) due to a company’s operating activities. The general formula for the I/S is: Revenues - Expenses = Net Income

The Income Statement Format Operating revenues Sales Fees earned Other revenues Less: Operating expenses Cost of goods sold Wage expense Rent expense Selling expense Depreciation expense Other expenses Net Income

The Statement of Cash Flows Cash flows from operating activities: Collections from sales, rent, interest, etc. Cash paid to suppliers and employees, and for rent, selling activities, interest, and taxes etc. Cash flow from investing activities: Proceeds from sale of investment securities, land, buildings, equipment, etc. Purchase of investment securities, land, buildings, equipment, etc. Cash flow from financing activities: Proceeds from issuance of notes, debt, sale of equity, etc. Payments on notes, debt, dividends, etc.

Relationships Among the Financial Statements Beginning Balance Sheet Ending Balance Sheet Statement of Cash Flows Assets (Cash) Assets (Cash) Income Statement = = Liabilities Liabilities + + Equity Statement of Stockholders’ Equity Equity

Problem 2-1 Presented below are the main section headings of the balance sheet: a. Current assets b. Long-term investments c. Property, plant, and equipment d. Intangible assets e. Current liabilities f. Long-term liabilities g. Contributed capital h. Retained earnings

Problem 2-1 1. Dividend Payable 2. Payments Received in Advance 3. Allowance for Uncollectible Accounts 4. Inventories 5. Capital Stock 6. Accumulated Depreciation - Building 7. Bonds Payable 8. Machinery and Equipment

Problem 2-1 9. Accounts Receivable 10. Short-term Investments 11. Buildings 12. Patents 13. Property 14. Investment Fund for Plant Expansion 15. Wages Payable 16. Cash

Problem 2-1 17. Accumulated Depreciation - Equip 18. Prepaid Rent 19. Trademarks 20. Land Held for Investment 21. Current Portion of Long-Term Debt 22. Accounts Payable 23. Short-term Notes Payable

Exercise 2-3 Balance Sheet (B) or Income Statement (I) a. Equipment b. Fees Earned c. Retained Earnings d. Wage Expense e. Patent f. Cost of Goods Sold g. Common Stock h. Dividend Payable i. Accumulated Depreciation

Exercise 2-3 Balance Sheet (B) or Income Statement (I) j. Prepaid Expense k. Gain on Sale of Short-term Investment l. Rent Revenue m.Supplies Inventory n. Accounts Receivable o. Land p. Insurance Expense q. Interest Payable r. Deferred (Unearned) Revenue

Exercise 2-4 Given (in billions): 2003 2002 2001 Beginning RE ? 1.3 1.2 Revenues 4.4 4.1 3.9 Expenses 3.9 ? 3.5 Div. declared .3 .3 ? Ending RE 1.6 ? ? Now, using the following formulas and relationships, solve for the other missing items: (1) Rev - Exp = NI (2) RE(B) + NI - Div = RE(E) (3) RE(E) becomes RE(B) in the next year

Exercise 2-4, 2003 Solution for 2003:

Exercise 2-4, 2002 Solution for 2002:

Exercise 2-4, 2001 Solution for 2001: