1. Review of Accounting 2
Chapter

2. Three Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows

3. The Income Statement
An Income Statement shows profitability for a time period (ex: 1 year)
Revenues from customers for services or merchandise.
Expenses from vendors for merchandise, production, services or supplies.
Can be prepared in steps
Revenues
Less: Expenses
Equals: Net Income

4. Classifications on the Income Statement
Sales – Cost of Goods Sold Step 1 = Gross Profit – Operating Expenses Step 2 = Operating Profit (EBIT) – Interest Expense Step 3 = Earnings Before Taxes – Income Taxes Step 4 = Earnings After taxes

5. Income statement Table 2-1
KRAMER CORPORATION
Income Statement
For the Year Ended December 31, 2010
1. Sales $2,000,000
2. Cost of goods sold (1,500,000)
3. Gross profits ,000
4. Selling and administrative expense (220,000)
5. Depreciation expense (50,000)
6. Operating profit (EBIT)* ,000
7. Interest expense (20,000)
8. Earnings before taxes (EBT) ,000
9. Taxes (99,500)
10. Earnings after taxes (EAT) ,500
11. Preferred stock dividends ,500
12. Earnings available to common shareholders. $ 100,000
13. Shares outstanding ,000
14. Earnings per share $1.00
*Earnings before interest and taxes.

6. Return to Capital Three sources of capital:
bondholders,
preferred stockholders, and
common stockholders.
After paying interest to bondholders and dividends to preferred shareholders, the remaining amount are available for the common stockholders. However, the firm may or may not disburse this amount as dividends to common stockholders. The firm may retain the whole/part of the profit as Retained Earnings for future investment.

7. Assets = Liabilities + Owners’ Equity
The Balance Sheet
A Balance Sheet (B/S) shows what a firm owns and how it is financed at a point in time (ex.; December 31)
Remember the ALOE!
Assets = Liabilities + Owners’ Equity

8. Classifications on the Balance Sheet
Assets: what a business owns
Current Assets
Ex: Accounts receivable, Inventory
Will be sold or used up within 1 year
Capital Assets
Ex: Building, Plants, Lands
Liabilities: what a business owes
Current Liabilities
Ex: Accounts payable
Dues within 1 year
Long-term Liabilities
Due some time after 1 year
Equity: what the owner(s) have invested in the business
Shareholders’ Equity
Capital stock
Retained earnings

9. Balance Sheet Items
Liquidity: Asset accounts are listed in order of liquidity
Current assets:
Items that can be converted to cash within 12 months
Marketable securities
Temporary investments of excess cash
Accounts receivable
Allowance for bad debts to determine their anticipated collection value
Inventory
Includes raw materials, goods in progress, or finished goods
Prepaid expenses
Represent future expense items that are already paid for

10. Balance Sheet Items (cont’d)
Investments
Long-term commitment of funds
Includes stocks, bonds, or investments in other companies
Plant and equipment
Carried at original cost minus accumulated depreciation
Accumulated depreciation
Sum of past and present depreciation charges on currently owned assets

11. Concept of Net Worth/book value
There is nearly always a disparity between book value and market value, since the first is a recorded historical cost, and the second is based on the perceived supply and demand for an asset, which can vary constantly.
For example, a company buys a machine for $100,000 and subsequently records depreciation of $20,000 for that machine, resulting in net book value of $80,000. If the company were to then sell the machine at its current market price of $90,000, the business would record a gain on the sale of $10,000.
Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

12. Concept of net Worth/book value
Total Asset $1,000,000
Total Liabilities (300,000)
Stockholders’ equity ,000
Preferred Stock* obligation (50,000)
Net worth assigned to common ,000
Common shares outstanding ,000
Net worth, or book value per share $6.50
preferred share represents neither a debt claim nor an ownership interest in the firm. It is a hybrid, or intermediate type of security. It will be further discussed in chapter 17.

13. Book Value Vs Market Value
There are situations when the market value of a fixed asset is much higher than book value, such as when the market value of an office building sky rockets due to increased demand.
Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

14. TABLE 2-5 Comparison of market value to book value per share in January 2003

15. Limitations of Financial Statements
Based on past transactions rather than future forecasts
May not recognize important economic changes as they occur
increase in property values
new competition
Variety of accounting policies and methods are used
depreciation
inventory valuation

16. Statement of Cash flows
The purpose of the statement of cash flows is to emphasize the critical nature of cash flow to the operations of the firm.
Cash flow represents cash or cash equivalent items that can easily be converted into cash within 90 days.
The IS & BS are based on accrual method of accounting, in which revenues and expenses are recognized as they occur rather than when cash actually changes hands.

17. Statement of Cash flows
The cash flow statement represents the actual cash flow position of a firm.
The three primary sections of the cash flow statement:
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.

18. Depreciation and Funds Flow
Attempt to allocate the initial cost of an asset over its useful life.
Charging of depreciation does not directly influence the movement of funds.

19. Depreciation as a Tax Shield
Not a new source of fund
Provides tax shield benefits measurable as depreciation times the tax rate
Corporation A Corporation B
Earnings before depreciation and taxes…… $400,000 $400,000
Depreciation……………………………………… 100,
_________ _________
Earnings before taxed………………………… 300, ,000
Taxes (40%)……………………………………… 120, ,000
Earnings after taxes…………………………… 180, ,000
+Depreciation charged without cash outlay… ,
Cash flow………………………………………… $280,000 $240,000
Difference………………………………………… $40,000

20. Summary and Conclusions
NOW, TO REVIEW . . .
The 3 basic financial statements are the income statement, the balance sheet, and the statement of cash flows
The price-earnings ratio relates the net income per the financial statements to the market value of the company’s shares
There are inherent limitations in the income statement and balance sheet as to reporting current values and economic events
Cash flows after tax are essential information for business decision-making