THE FINANCIAL STATEMENTS Chapter 3

CHAPTER 3 OBJECTIVES Describe the composition and objectives of each of the four financial statements. Describe the composition and objectives of each of the four financial statements. Show how the economic entity, periodicity, monetary unit, stable dollar, and going concern assumptions, and the revenue recognition, matching, and historical cost principles, influence financial statement disclosures. Show how the economic entity, periodicity, monetary unit, stable dollar, and going concern assumptions, and the revenue recognition, matching, and historical cost principles, influence financial statement disclosures.

CHAPTER 3 OBJECTIVES (CONT.) Distinguish between cash flow reporting and the accrual basis of accounting. Distinguish between cash flow reporting and the accrual basis of accounting. Articulate the importance of cash flows from operating activities. Articulate the importance of cash flows from operating activities. Explain and give examples of financial statement articulation. Explain and give examples of financial statement articulation.

FINANCIAL STATEMENT CONCEPTS Objectives—all analysts, regardless of specific objectives, desire knowledge about Objectives—all analysts, regardless of specific objectives, desire knowledge about Cash flows Cash flows Resources Resources Claims against those resources Claims against those resources Wealth and changes in it Wealth and changes in it

FINANCIAL STATEMENT CONCEPTS (CONT.) Corporate objective—maximize shareholder wealth, which equals share price maximization Corporate objective—maximize shareholder wealth, which equals share price maximization

FINANCIAL STATEMENT CONCEPTS (CONT.) Assumptions—characteristics embedded in the financial reporting system Assumptions—characteristics embedded in the financial reporting system Economic entity—business is distinct from owners Economic entity—business is distinct from owners Periodicity—companies disclose financial statements at regular time intervals Periodicity—companies disclose financial statements at regular time intervals Monetary unit—economic activity measured and reported in dollars Monetary unit—economic activity measured and reported in dollars Stable dollar—financial statements are not inflation adjusted Stable dollar—financial statements are not inflation adjusted Nominal dollar capital maintenance—sum of monetary unit and stable dollar assumptions Nominal dollar capital maintenance—sum of monetary unit and stable dollar assumptions

FINANCIAL STATEMENT CONCEPTS (CONT.) Principles—core concepts of GAAP Principles—core concepts of GAAP Historical cost—asset and liability attribute most commonly used to measure and report accounts; historical exchange price Historical cost—asset and liability attribute most commonly used to measure and report accounts; historical exchange price Revenue realization principle—report revenues when realized (or realizable) and earned Revenue realization principle—report revenues when realized (or realizable) and earned Usually occurs at point of sale or service Usually occurs at point of sale or service Independent of cash receipt Independent of cash receipt

FINANCIAL STATEMENT CONCEPTS (CONT.) Principles—core concepts of GAAP (cont.) Principles—core concepts of GAAP (cont.) Matching principle—costs incurred in generating revenues Matching principle—costs incurred in generating revenues subtracted in revenue realization period subtracted in revenue realization period independent of cash outflows independent of cash outflows Accrual accounting—sum of revenue realization and matching principles Accrual accounting—sum of revenue realization and matching principles

FINANCIAL STATEMENT CONCEPTS (CONT.) Cash accounting—equates cash received for goods and services to revenues and cash paid to earn them as expenses; not GAAP Cash accounting—equates cash received for goods and services to revenues and cash paid to earn them as expenses; not GAAP

FINANCIAL STATEMENT CONCEPTS (CONT.) Financial statement interrelationships Financial statement interrelationships Articulation—logical relationships among financial statements’ accounts as the four financial statements work as an integrated reporting system to convey financial information Articulation—logical relationships among financial statements’ accounts as the four financial statements work as an integrated reporting system to convey financial information

FINANCIAL STATEMENT ORIENTATION eSTUFF.com—hypothetical Internet retailer; introduces students to financial statements; used to illustrate concepts throughout the text eSTUFF.com—hypothetical Internet retailer; introduces students to financial statements; used to illustrate concepts throughout the text eSTUFF’s financial statements—Exhibit 3-1 (pp of the text) eSTUFF’s financial statements—Exhibit 3-1 (pp of the text)

FINANCIAL STATEMENT CONCEPTS (CONT.) Additional financial statement disclosures—strengthen articulation Additional financial statement disclosures—strengthen articulation Notes to the financial statements—amplify and clarify financial statements; also called notes or footnotes Notes to the financial statements—amplify and clarify financial statements; also called notes or footnotes Supplementary information—additional disclosures that add insight to financial statements Supplementary information—additional disclosures that add insight to financial statements

INCOME STATEMENT (CONT.) Measures change in wealth during a reporting period Measures change in wealth during a reporting period Equation: revenues – expense = net income (loss) Equation: revenues – expense = net income (loss)

INCOME STATEMENT (CONT.) Revenues—asset increases from providing services or delivering goods Revenues—asset increases from providing services or delivering goods Gains—asset increases from peripheral transactions Gains—asset increases from peripheral transactions Expenses—asset decreases; costs of doing business; matched against revenues Expenses—asset decreases; costs of doing business; matched against revenues Losses—asset decreases from peripheral transactions Losses—asset decreases from peripheral transactions

INCOME STATEMENT (CONT.) Cost of goods sold—difference between the historical cost and selling price of inventory that is sold Cost of goods sold—difference between the historical cost and selling price of inventory that is sold Selling, general, and administrative expenses (S,G&A expenses; operating expenses)—costs incurred in running a business; matched against revenues Selling, general, and administrative expenses (S,G&A expenses; operating expenses)—costs incurred in running a business; matched against revenues Income—difference between revenues (gains) and expenses (losses) Income—difference between revenues (gains) and expenses (losses) Earnings per share (EPS)—profit (loss) per share of common stock Earnings per share (EPS)—profit (loss) per share of common stock

INCOME STATEMENT (CONT.) All-inclusive income—results from reporting all revenues (gains) and expenses (losses) in a reporting period All-inclusive income—results from reporting all revenues (gains) and expenses (losses) in a reporting period Multiple step format—separates central business activities’ revenues and expenses from peripheral gains and losses Multiple step format—separates central business activities’ revenues and expenses from peripheral gains and losses Single step format—combines core and peripheral revenues and subtracts core and peripheral expenses from them Single step format—combines core and peripheral revenues and subtracts core and peripheral expenses from them

STATEMENT OF SHAREHOLDERS’ EQUITY Measures change in owners’ wealth during the reporting period Measures change in owners’ wealth during the reporting period Equation: Beginning shareholders’ equity + net income – dividends = ending shareholders’ equity Equation: Beginning shareholders’ equity + net income – dividends = ending shareholders’ equity

SHAREHOLDERS’ EQUITY (CONT.) Contributed capital—resources invested in the business by its owners Contributed capital—resources invested in the business by its owners Common stock—most prevalent stock type issued; risk capital Common stock—most prevalent stock type issued; risk capital Preferred stock—dividend preference over common stock; less risky investment than common stock Preferred stock—dividend preference over common stock; less risky investment than common stock Par value—minimum selling price of stock Par value—minimum selling price of stock

SHAREHOLDERS’ EQUITY (CONT.) Additional paid in capital—difference between stock’s selling price and its par value Additional paid in capital—difference between stock’s selling price and its par value Retained earnings—income kept within the business Retained earnings—income kept within the business Dividends—cash paid to shareholders as a return on investment Dividends—cash paid to shareholders as a return on investment

BALANCE SHEET Measures wealth at one point in time (usually the end of the reporting period) Measures wealth at one point in time (usually the end of the reporting period) Equation: assets = liabilities + shareholders’ equity Equation: assets = liabilities + shareholders’ equity Remains in balance after every transaction Remains in balance after every transaction

BALANCE SHEET (CONT.) Liquidity—cash or items convertible into cash that can be used to pay obligations in the near term Liquidity—cash or items convertible into cash that can be used to pay obligations in the near term Assets—future economic benefits, controlled by an entity, resulting from a past transaction Assets—future economic benefits, controlled by an entity, resulting from a past transaction

BALANCE SHEET (CONT.) Current asset—liquid resource; usually converted into cash within one year Current asset—liquid resource; usually converted into cash within one year Long-term asset—illiquid resource; used to generate revenues and cash flows; includes long-term investments, property, plant, equipment, and intangible assets Long-term asset—illiquid resource; used to generate revenues and cash flows; includes long-term investments, property, plant, equipment, and intangible assets

BALANCE SHEET (CONT.) Liabilities—future economic obligations, owed by an entity, resulting from a past transaction Liabilities—future economic obligations, owed by an entity, resulting from a past transaction Current liabilities—pending obligations; usually payable within one year Current liabilities—pending obligations; usually payable within one year Long-term liabilities—non-current obligations Long-term liabilities—non-current obligations

STATEMENT OF CASH FLOWS Measures change in cash during a reporting period Measures change in cash during a reporting period Equation: cash flows from operating activities + cash flows from investing activities + cash flows from financing activities = net change in cash Equation: cash flows from operating activities + cash flows from investing activities + cash flows from financing activities = net change in cash

STATEMENT OF CASH FLOWS (CONT.) Cash flows from operating activities—cash provided by or used for central business activities; most important section of the statement Cash flows from operating activities—cash provided by or used for central business activities; most important section of the statement Direct cash flows—method of disclosure for reporting operating cash flows; reports received from sales and services and paid to suppliers, employees, and other short-term creditors Direct cash flows—method of disclosure for reporting operating cash flows; reports received from sales and services and paid to suppliers, employees, and other short-term creditors Indirect cash flows—alternative operating cash flow reporting method; reconciles net income to operating cash flow to report operating cash flows Indirect cash flows—alternative operating cash flow reporting method; reconciles net income to operating cash flow to report operating cash flows

STATEMENT OF CASH FLOWS (CONT.) Cash flows from investing activities— cash provided or used by the disposal and acquisition of long-term assets Cash flows from investing activities— cash provided or used by the disposal and acquisition of long-term assets Cash flows from financing activities— cash provided or used by issuing and retiring stocks and bonds and paying dividends Cash flows from financing activities— cash provided or used by issuing and retiring stocks and bonds and paying dividends