Module 2: Overview of Business Activities and Financial Statements

Four Main Financial Statements Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows

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 Retained Earnings

Assets Assets are listed in order of liquidity 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 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. Do these Assets get USED UP to generate REVENUES or CONVERTED into CASH?

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. Do these Assets get USED UP to generate REVENUES or CONVERTED into CASH?

Apple’s Assets Which Assets get USED UP to generate REVENUES / CONVERTED into CASH?

Cisco Systems, Inc. Assets What is Goodwill? How is it an Asset? How did it get on the Balance Sheet?

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.] Why do you think R&D is accounted for as it is?

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

Apple’s Liabilities and Equity

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. Which ones are used to operate the business? Which ones are used to finance the business?

Cisco systems, Inc. Current Liabilities Which ones are used to operate the business? Which ones are used to finance the business?

Net Working Capital Working Capital is a measure of short-term liquidity. Can I pay by bills in the short-run? What is the rationale for using this relationship to assess short-term liquidity?

Operating Cycle

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. Which Non current Liabilities are used to OPERATE the business? Finance the business?

Cisco Systems, Inc. Long-term Liabilities Which Non current Liabilities are used to OPERATE the business? Finance the business?

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: What choices does an owner have once profits are made? Which one is usually the best possible choice? Why?

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 8).

Cisco Systems, Inc. Stockholders’ Equity

Income Statement Which line item is the most important number used by analysts to determine a valuation for a corporation?

Apple’s Income Statement Is Apple profitable? What is Apple’s Profit Margin? Is that good or bad? What other information would we want to know?

Cisco Systems, Inc. Income Statement Which items are most likely not to continue in the future?

When are Revenues and Expenses Recognized? Revenue Recognition Principle—recognize revenues when earned Matching Principle—recognize expenses when incurred. The idea is to measure: Rewards---REVENUES against Efforts---EXPENSES This will provide a good look at long-run profitability! Research shows this has a better predictive value for valuation

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:

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.

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

Apple’s Statement of 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.

Apple’s Statement of Cash Flows Would you want Operating Cash Flows to be an inflow/outflow? Investing activities? Financing activities?

Cisco Systems, Inc. Statement of Cash Flows

Relation of SCF to Income Statement and Balance Sheet

General Coding of Balance sheet Changes

Working Capital Accounts

Articulation of Financial Statements Financial statements are linked within and across time – they articulate. Balance sheet and income statement are linked via retained earnings.

Apple’s Retained Earnings Reconciliation

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

Unearned Revenue

Accrual of Wages

Accrual of Revenue

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 Income Statement Transaction Cash Asset + Noncash Assets = Liabi-lities Contrib. capital Retained Earnings Revenues – Expenses 1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 by the owners. +90 2. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash 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 transaction occurred on October 2. -20 +80 Bldg. +60 M/P 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.

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

Ice Cream Shop – additional transactions 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. 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. Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales were for cash. The ice cream cost $3,500. For all of October, total employee wages and salaries earned/paid were $3,000. 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. $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:

Balance Sheet Income Statement Transaction Cash Asset + Noncash Assets = Liabi-lities Contrib. capital Retained Earnings Revenues – Expenses 6. -5 +15 Inv. +10 A/P 7. -3 8. +8 -3.5 +4.5 Sales COGS 9. . Wage exp. 10. - .383 Bldg., net -.167 Equip., net -.550 Dep. exp. 11. -.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.

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 (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

  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.

Preparing the Financial Statements

Balance Sheet and Income Statement

Statement of Stockholders’ Equity

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

Analyst Reports

Credit and Data Services 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.