©Cambridge Business Publishers, 2015 Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang M ODULE 2 Review of Business Activities and Financial Statements

©Cambridge Business Publishers, Learning Objective 1 Describe and interpret the elements of and the information conveyed by financial statements.

Four Main Financial Statements  Balance Sheet  Income Statement  Statement of Stockholders’ Equity  Statement of Cash Flows ©Cambridge Business Publishers,

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 ©Cambridge Business Publishers,

Assets To be reported on a balance sheet, an asset must 1.Be owned (or controlled) by the company 2.It must confer expected future economic benefits that result from a past transaction or event. 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. ©Cambridge Business Publishers,

Examples of Current Assets  Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents)  Short-term investments—marketable securities and other investments that the company expects to dispose of in the short run  Accounts receivable, net—amounts due to the company from customers arising from the sale of products and services on credit (“net” refers to the subtraction of uncollectible accounts)  Inventories—goods purchased or produced for sale to customers  Prepaid expenses—costs paid in advance for rent, insurance, advertising and other services ©Cambridge Business Publishers,

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 the subtraction of accumulated depreciation, the portion of the assets’ cost that has been expensed);  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. ©Cambridge Business Publishers,

Apple’s Assets 8 ©Cambridge Business Publishers, 2015

Cisco Systems, Inc. Assets 9 ©Cambridge Business Publishers, 2015

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, such as  Strong management team, a well-designed supply chain, or superior technology ©Cambridge Business Publishers,

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 report assets reflecting the full cost that they have expended in developing drugs. These costs, for the most part, have been expensed in the income statement as R&D expense. ©Cambridge Business Publishers,

Disney’s Assets 12 ©Cambridge Business Publishers, 2015 Where’s Mickey? The market value of the Mickey Mouse trademark does not explicitly show up here.

Apple’s Liabilities and Equity 13 ©Cambridge Business Publishers, 2015

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. ©Cambridge Business Publishers,

Cisco Systems, Inc. Current Liabilities 15 ©Cambridge Business Publishers, 2015

Net Working Capital 16 ©Cambridge Business Publishers, 2015

Operating Cycle 17 ©Cambridge Business Publishers, 2015

Examples of Noncurrent Liabilities  Long-term debt—amounts borrowed from creditors that are scheduled to be repaid more than one year in the future. 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. ©Cambridge Business Publishers,

Cisco Systems, Inc. Long-Term Liabilities 19 ©Cambridge Business Publishers, 2015

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: ©Cambridge Business Publishers,

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 excess of the par value of 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 asset and liability fair values that are not reported in the income statement. ©Cambridge Business Publishers,

Cisco Systems, Inc. Stockholders’ Equity 22 ©Cambridge Business Publishers, 2015

Income Statement 23 ©Cambridge Business Publishers, 2015

Apple’s Income Statement 24 ©Cambridge Business Publishers, 2015

Operating vs. Nonoperating  Operating expenses are the usual and customary costs that a company incurs to support its main business activities  Cost of goods sold  Selling expenses  Depreciation expense, and  Research and development expense  Nonoperating expenses relate to the company’s financing and investing activities  Interest expense  Interest or dividend income, and  Gains and losses from the sale of securities ©Cambridge Business Publishers,

Cisco Systems, Inc. Income Statement 26 ©Cambridge Business Publishers, 2015

When are Revenues and Expenses Recognized?  Revenue Recognition Principle—recognize revenues when earned  Expense Recognition (Matching) Principle— recognize expenses when incurred  These two principles are the foundation of accrual accounting  First, recognize revenues in the time period they are earned;  Then, record all expenses incurred to generate those revenues during that same time period (this is called matching expenses to revenues).  Net income is, then, correctly reported for that period. ©Cambridge Business Publishers,

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: ©Cambridge Business Publishers,

Transitory Items in the Income Statement 29 ©Cambridge Business Publishers, 2015

Transitory Items  Discounted 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 ©Cambridge Business Publishers,

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 ©Cambridge Business Publishers,

Apple’s Statement of Stockholders’ Equity 32 ©Cambridge Business Publishers, 2015

Statement of Cash Flows  Statement of cash flows 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. ©Cambridge Business Publishers,

Apple’s Statement of Cash Flows 34 ©Cambridge Business Publishers, 2015

Cisco Systems Statement of Cash Flows 35 ©Cambridge Business Publishers, 2015

Relation of SCF to Income Statement and Balance Sheet 36 ©Cambridge Business Publishers, 2015

General Coding of Balance Sheet Changes 37 ©Cambridge Business Publishers, 2015

Working Capital Accounts 38 ©Cambridge Business Publishers, 2015

39 Learning Objective 2 Analyze and interpret transactions using the financial statement effects template.

Articulation of Financial Statements  Financial statements are linked within and across time – they articulate.  Balance sheet and income statement are linked via retained earnings. ©Cambridge Business Publishers,

Apple’s Retained Earnings Reconciliation 41 ©Cambridge Business Publishers, 2015

Articulation of Apple’s Financial Statements 42 ©Cambridge Business Publishers, 2015

Accounting Cycle 43 ©Cambridge Business Publishers, 2015

44 Learning Objective 3 Analyze and interpret accounting adjustments and their financial statement effects.

Financial Statement Effects Template 45 ©Cambridge Business Publishers, 2015

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. ©Cambridge Business Publishers,

Adjusting Accounts  Prepaid expenses - Prepaid expenses reflect advance cash payments that will ultimately become expenses; an example is the payment of radio advertising that will not be aired until sometime in the future.  Unearned revenues - Unearned revenues reflect cash received from customers before any services or goods are provided; an example is cash received from patrons for tickets to an upcoming concert. ©Cambridge Business Publishers,

Prepaid Rent 48 ©Cambridge Business Publishers, 2015

Unearned Revenue 49 ©Cambridge Business Publishers, 2015

Adjusting Accounts  Accrued expenses - Accrued expenses are expenses incurred and recognized on the income statement, even though they are not yet paid in cash; an example is wages owed to employees who performed work but who have not yet been paid.  Accrued revenues - Accrued revenues are revenues earned and recognized on the income statement, even though cash is not yet received; examples include accounts receivable and revenue earned under a long-term contract. ©Cambridge Business Publishers,

Accrual of Wages 51 ©Cambridge Business Publishers, 2015

Accrual of Revenues 52 ©Cambridge Business Publishers, 2015

53 Learning Objective 4 Construct financial statements from account balances.

Exercise: The Ice Cream Store, Inc. The Ice Cream Store, Inc. incurred the following start-up costs: 1.The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 in cash by the owners. 2.Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. 3.Purchased equipment for $25,000 cash on October 2. 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. 5.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. ©Cambridge Business Publishers,

Financial Statement Effects Template 55 ©Cambridge Business Publishers, 2015 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 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 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 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 Store Balance Sheet 56 ©Cambridge Business Publishers, 2015 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 $185,000

The Ice Cream Store, Inc. 6.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. 7.Immediately returned some of the ice cream because some of the flavors delivered were not ordered. The cost of the inventory returned was $3, Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales were for cash. The ice cream cost $3, For all of October, total employee wages and salaries earned/paid were $3, 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. 11.$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. ©Cambridge Business Publishers,

Template 58 ©Cambridge Business Publishers, 2015 Balance Sheet Income Statement Transaction Cash Asset + Noncash Assets = Liabi- lities + Contrib. capital + Retained Earnings Revenues– Expenses Inv. +10 A/P Inv. -3 A/P Inv Sales -3.5 COGS Wage exp Bldg., net Equip., net Dep. exp 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.

Balance Sheet 59 ©Cambridge Business Publishers, 2015 Cash ($80,000 -5,000 +8,000 -3, ) $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 Less: Accumulated Depreciation(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 Stockholders' Equity: Capital Stock 90,000 Retained Earnings ,500 Total Liabilities and Stockholders' Equity $192,500

Income Statement 60 ©Cambridge Business Publishers, 2015 REVENUES: Sales of Ice Cream $8,000 Cost of Sales 3,500 GROSS PROFIT:4,500 Payroll Expense 3,000 Depreciation Expense550 INCOME FROM OPERATIONS950 Interest Expense450 NET INCOME$500 Note: Assume no income taxes.

Apple’s Transactions 61 ©Cambridge Business Publishers, 2015

Apple’s Balance Sheet and Income Statement 62 ©Cambridge Business Publishers, 2015

Apple’s Statement of Cash Flows 63 ©Cambridge Business Publishers, 2015

Apple’s Statement of Stockholders’ Equity 64 ©Cambridge Business Publishers, 2015

Analyzing Global Reports  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: 1.Classify interest expense, dividends paid, interest revenue, and dividend revenue as operating cash flows, or 2.Classify interest expense and dividends paid as financing cash flows, and interest revenue and dividend revenue as investing cash flows. ©Cambridge Business Publishers,

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.  Item 10, Directors, Executive Officers and Corporate Governance; Item 11, Executive Compensation;  Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters;  Item 13, Certain Relationships and Related Transactions, and Director Independence; Item 14, Principal Accountant Fees and Services. ©Cambridge Business Publishers,

Additional Sources of Information Form 20-F and Form 40-F  Non-U.S. companies that are publicly traded in the U.S. also file annual reports with the SEC.  The filing, labeled Form 20-F, requires financial statements prepared according to U.S. GAAP or IFRS.  The company must provide a table that reconciles net income as reported to U.S. GAAP net income.  Canadian companies file their annual reports, prepared under IFRS, using Form 40-F. 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 ©Cambridge Business Publishers,

Analyst Reports 68 ©Cambridge Business Publishers, 2015

Credit and Data Services  Credit Analysis  Standard & Poor’s (StandardAndPoors.com)  Moody’s Investors Service (Moodys.com)  Fitch Ratings (FitchRatings.com)  Data Services  Thomson Reuters Corporation (Thomson.com)  Capital IQ (CapitalIQ.com) ©Cambridge Business Publishers,

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