1. Ch. 2 Overview of Business Activities and Financial Statements
Learning objectives
Understand Elements of financial statements
Use Financial Statement Effects Template
Understand period-end adjustments and their financial statement effects
Construct Financial Statements from account balances

2. Four Main Financial Statements
Balance Sheet
Income Statement
Statement of Stockholders’ Equity
Statement of Cash Flows
M2-20, Ongoing Analysis Project (Apple, SEC)

3. 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 (Earned) Capital

4. Assets 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 (one year)
Long-term assets cannot be easily converted to (cash ) within (one year).

5. 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 net of (uncollectible) (receivables);
Inventory—goods (purchased) or (manufactured) for sale to customers;
Prepaid expenses—costs paid in advance for rent, insurance, advertising or other services.

6. Examples of Long-term Assets
Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment etc. used in ( operating) activities (“net” refers to subtraction of ( accumulated)(depreciation))
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.

7. Cisco Systems, Inc. Assets

8. At what amount an asset is reported in the balance sheet?
Rule: Historical Cost (= original acquisition cost) is
Objective
Verifiable
Knowledge Based Assets such as ( patents)
( research & development or R&D) are not Reflected on the Balance Sheet.
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.]

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

10. Examples of Current Liabilities
Accounts payable: Cash to be paid in the future
Accrued liabilities: Cash to be paid in the future
Unearned revenues: Cash received in the past
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.
example: mortgage loan

11. Examples of Noncurrent Liabilities
Long-term debt
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.

12. 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:
M2-23, D2-53

13. Income Statement

14. Cisco Systems, Inc. Income Statement

15. Income Statement When are Revenues and Expenses Recognized?
Revenue Recognition Principle—recognize revenues when earned
Matching Principle—recognize expenses when incurred

16. Profit (accrual accounting) vs
Profit (accrual accounting) vs. Operating Cash Flow (cash-basis accounting)
Net Income ≠ Operating Cash Flow.
Net Income = (revenues ) – (expenses)
Operating CF = (cash received from operations) –
( cash paid for operations )
A firm could have “good income” but “poor operating cash flow” or vice versa (i.e., there are two dimensions to consider).
M2-25, P2-45 (Financial Statement Effects Template)

17. 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

18. Transitory Items in the Income Statement

19. 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
(Eliminated from income statement since 2015).

20. 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.

21. Balance Sheet (beginning balances are ‘0”
Income Statement
Transaction
Cash Asset +
Noncash Assets =
Liabi-lities
Contrib. capital
Retained Earnings
Rev
– Expenses
The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 by the owners.
(Financing)
90,000
2. Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations.
35,000
3. Purchased equipment for $25,000 cash on October 2.
(Investing)
-25,000
25,000
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.
(Financing and Investing)
-20,000
80,000
60,000
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.
(No transaction to be recorded)
Balance
105,000
95,000

22. Ice Cream Shop Balance Sheet:
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

23. 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.

24. Articulation of Financial Statements
Financial statements are linked within and across time – they articulate.
Balance Sheet and Income Statement are linked via (retained)(earnings)

25. Adjusting Accounts

26. 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.

27. 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

28. Global Accounting
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:
Classify interest expense, dividends paid, interest revenue, and dividend revenue as operating cash flows, or
Classify interest expense and dividends paid as financing cash flows, and interest revenue and dividend revenue as investing cash flows.