Module 1: Basics of Financial Statements

Balance Sheet Equation Assets: companies own cash, receivables, inventories, real estate, equipment, securities, and intangibles—must have future value to the company Liabilities: Companies’ obligations to employees, suppliers, governments, bankers, lenders, bondholders Equity: The owners’ remaining investment in the company

Balance Sheet Equation Balance Sheet: Everything a company owns was purchased with money from creditors or owners. Who owns what? Company owns the assets Investors (owners) purchase shares of stock in the company, including a share of earnings Creditors own promises of future payment from companies

Financial Statements FINANCIAL STATEMENTS INCLUDE: Balance Sheet: List of assets, obligations, and owners’ equity on a date. Income Statement: Change in owners’ equity due to operating the business. Revenues, expenses, profits, and losses=net income Cash Flows: Change in cash balance due to (1) operating the business, (2) buying or selling long-term assets, and (3) financing the company (cash flows to/from lenders and owners). Stockholders’ Equity: Change in owners’ accounts from beginning of the period to end of the period.

Financial Accounting Information DEMAND: Who needs to know about the finances of companies? Almost everyone! DEMAND: Who needs to know about the finances of companies? Almost everyone! Managers, employees, investment analysts, shareholders and directors, customers, regulators and tax agencies, voters and their representatives… Managers, employees, investment analysts, shareholders and directors, customers, regulators and tax agencies, voters and their representatives… However, readers must be knowledgeable before they can understand financial reports because they are written in the language of business. However, readers must be knowledgeable before they can understand financial reports because they are written in the language of business. Accounting provides the language. Accounting provides the language.

Supply of Accounting Information SEC filing requirements: SEC filing requirements: Form 10-K: annual report Form 10-Q: quarterly Form 8-K: additional Benefits of disclosure. Benefits of disclosure. Lower costs of funds because reliable information supports trust in the company Lower costs of funds because reliable information supports trust in the company Increases stock prices overall, reduces risk Increases stock prices overall, reduces risk Costs of disclosure. Costs of disclosure. Preparation and dissemination, competitive disadvantages, litigation potential, and political costs Preparation and dissemination, competitive disadvantages, litigation potential, and political costs

Berkshire Hathaway’s Balance Sheet

Berkshire Hathaway’s Income Statement

Berkshire Hathaway’s Statement of Stockholders’ Equity

Statement of Cash Flows The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time. The statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time.

Information Related to Financial Statements Management Discussion and Analysis Management Discussion and Analysis Independent Auditor’s Report Independent Auditor’s Report Financial Statement Footnotes Financial Statement Footnotes Report on Internal Controls Report on Internal Controls

Profitability Analysis

Oversight of Financial Accounting SEC oversees all publicly traded companies SEC oversees all publicly traded companies Financial Accounting Standards Board (FASB) and has delegated authority from SEC Financial Accounting Standards Board (FASB) and has delegated authority from SEC Congress and federal courts can overrule the SEC or the FASB Congress and federal courts can overrule the SEC or the FASB

Module 2: Introducing Financial Statements and Transaction Analysis

Balance Sheet Reflects the Accounting Equation Reflects the Accounting Equation Assets = Liabilities + Equity Assets = Liabilities + Equity Uses of funds = Sources of funds Uses of funds = Sources of funds Assets are listed in order of liquidity Assets are listed in order of liquidity Liabilities are listed in order of maturity Liabilities are listed in order of maturity Equity consists of Contributed Capital and Equity consists of Contributed Capital and Retained Earnings Retained Earnings

Assets To be reported on a balance sheet, an asset must 1. Be owned (or controlled) by the company 2. Must possess expected future economic benefits

Examples of Current Assets Cash Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents); Marketable securities Marketable securities—short-term investments that can be quickly sold to raise cash; Accounts receivable, net 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 Inventory—goods purchased or produced for sale to customers; Prepaid expenses 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 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); 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; 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. Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits.

Examples of Current Liabilities Accounts payable Accounts payable —amounts owed to suppliers for goods and services purchased on credit. Accrued liabilities 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 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 notes payable —short-term debt payable to banks or other creditors. Current maturities of long-term debt Current maturities of long-term debt —principal portion of long-term debt that is due to be paid within one year.

Net Working Capital

Examples of Noncurrent Liabilities Long-term debt 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 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) Contributed Capital (cash raised from the issuance of shares) Earned Capital (retained earnings). Retained Earnings is updated each period as follows: Earned Capital (retained earnings). Retained Earnings is updated each period as follows:

Examples of Equity Accounts Common stock Common stock —par value received from the original sale of common stock to investors. Preferred stock 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 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 Treasury stock —amount the company paid to reacquire its common stock from shareholders. Retained earnings Retained earnings —accumulated net income (profit) that has not been distributed to stockholders as dividends. Accumulated other comprehensive income or loss Accumulated other comprehensive income or loss —accumulated changes in equity that are not reported in the income statement (explained in Module 9).

Income Statement

When are Revenues and Expenses Recognized? Accrual Accounting: Revenue Recognition Principle—recognize revenues when earned Matching Principle—recognize expenses when incurred

Operating vs. Nonoperating Operating expenses are the usual and customary costs that a company incurs to support its main business activities 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 Nonoperating expenses relate to the company’s financing and investing activities

Statement of Cash Flows Statement of cash flows (SCF) reports cash inflows and outflows 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 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 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 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. Cash flows from financing activities - Cash flows from issuances of and payments toward borrowings and equity.

Cash Flow from Operations

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

Recording transactions Understand basic recording of 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. Wages Expense$100 Cash$100 All transactions incurred by the company during the accounting period are recorded similarly.

Adjusting Accounts

Global Accounting Balance Sheet The most visible difference is that the typical IFRS-based balance sheet is presented in reverse order of liquidity. 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. Income Statement The most visible difference is that GAAP requires three years’ data on the income statement whereas IFRS requires only two.

Module 3: Accounting Adjustments and Constructing Financial Statements

The Accounting Cycle

T-Accounts and Journal Entries

Capital Investment

Asset (Inventory) Transaction

Cash Dividends All transactions between the company and its shareholders are considered financing transactions. This includes payment of dividends, the issuance of stock, and any subsequent stock repurchase. Financing transactions affect only the balance sheet; they do not affect the income statement.

Adjusting Accounts

Types of Adjustments Cash received or paid before recognition of revenue or expense: Prepaid expenses Prepaid expenses Unearned revenues Unearned revenues Cash received or paid after recognition of revenue or expense Accrued expenses Accrued expenses Accrued revenues Accrued revenues

Prepaid Expenses (Assets) Assume that Apple pays $200 to purchase time on MTV for future i ads. Apple’s cash account decreases by $200, and an asset called prepaid advertising increases by the same amount. When the ad is aired, the prepaid asset is “used up” and is removed from the balance sheet and recognizing the cost as an expense.

Unearned Revenues (Liabilities) Assume that Apple receives $400 cash from a customer as advance payment on a multi-unit iPod sale to be delivered next month.

Recognition of Unearned Revenue as Earned Revenue Assume that Apple delivers the iPods a month later (but still within the fiscal quarter).

Accrued Expenses (Liabilities) Assume that Apple’s sales staff earns $100 of sales commissions this period that will not be paid until next period. When paid, the liability is reduced as is cash.

Accrued Revenues (Assets) Assume that Apple delivers iPods to a customer in Germany who will pay next quarter. The sales price for those units is $500 and the cost is $400.

Trial Balance trial balance The trial balance is a listing of all accounts and their balances at a point in time. Its purpose is to prove the mathematical equality of debits and credits, provide a useful tool to uncover any accounting errors, and help prepare the financial statements.

Adjusted Trial Balance For Apple

Preparation of the Financial Statements Income Statement Income Statement

Preparation of the Financial Statements Retained Earnings Computation Retained Earnings Computation

Preparation of the Financial Statements Balance Sheet Balance Sheet

Preparation of the Financial Statements Statement of Stockholders’ Equity Statement of Stockholders’ Equity

Statement of Cash Flows – Indirect Method Operating cash flows Operating cash flows

Changes to Working Capital Accounts

Formal Presentation of Apple’s SCF

Closing Process closing process The closing process refers to the ‘zeroing out’ of revenue and expense accounts (the temporary accounts) by transferring their ending balances to retained earnings. Balance sheet accounts carry over from period to period and are called permanent accounts.) The result is that all income statement accounts begin the next period with zero balances.

Closing Process Journal Entries