1. Financial Statements: An Overview Financial Statements: An Overview C H A P T E R 2

2. Learning Objective 1 Understand the basic elements and formats of the three primary financial statements. ÊBalance Sheet ËIncome Statement ÌStatement of Cash Flows What are the three basic financial statements?

3. Primary Financial Statements These financial statements answer basic questions: What is the company’s current financial status? What were the company’s operating results for the period? How did the company obtain and use cash during the period?

4. Sometimes referred to as a Statement of Financial Position What are the resources of the company? What are the company’s existing obligations? What are the company’s net assets? Summary of the financial position of a company at a particular date. The Balance Sheet Assets: cash, accounts receivable, inventory, land, buildings, equipment, and intangible items. Liabilities: accounts payable, notes payable, and mortgages payable. Owners’ Equity: net assets after all obligations have been satisfied. Assets: cash, accounts receivable, inventory, land, buildings, equipment, and intangible items. Liabilities: accounts payable, notes payable, and mortgages payable. Owners’ Equity: net assets after all obligations have been satisfied.

5. What Is the Accounting Equation? Assets = Liabilities + Owners’ Equity Define double-entry accounting A system of recording transactions in a way that maintains the equality of the accounting equation.

6. Accounting Equation Assets = Liabilities + Owners’ Equity Sources of Funding Creditors’ claims against resources =+ Owners’ claims against resources Resources to use to generate revenues

7. Assets Cash $ 40 Accounts receivable 100 Land 200 Total assets$340 Liabilities Accounts payable $ 50 Notes payable 150 $200 Owners’ Equity Capital stock $100 Retained earnings 40 $140 Total liabilities and owners’ equity $340 Sample Balance Sheet Must Equal

8. What Are Classified and Comparative Balance Sheets? They distinguish between current and long-term assets. current and long-term liabilities. Listed in decreasing order of liquidity. Comparative so financial statement users can identify significant changes over time. They have more than one year on the Balance Sheet.

9. Assets recorded at historical value. Only recognizes assets that can be expressed in monetary terms. Owners’ equity is usually less than the company’s market value. Describe Three Balance Sheet Limitations.

10. Sometimes referred to as a Statement of Earnings What goods were sold or services performed that provided revenue for the company? What costs were incurred in normal operations to generate these revenues? What are the earnings or company profit? Shows the results of a company’s operations over a period of time. The Income Statement Revenues Assets (cash or AR) created through business operations Expenses Assets (cash or AP) consumed through business operations Net Income or (Net Loss) Revenues - Expenses

11. Sample Income Statement The Example Company Income Statement For the Years Ended December 31, 2003 and 2002 20032002 Revenues: Sales$100$ 85 Other revenue 30 15 Total revenues$130$100 Expenses: Cost of goods sold$ 62$ 58 Operating & admin.1612 Income tax 20 18 Total expenses$ 98$ 88 Net Income$ 32$ 12

12. How Do You Calculate Earnings Per Share? Tells the owner of a single share of stock how much of the net income for the year belongs to him or her. Earnings per share (EPS): Net Income (Net Loss) # of Shares of Stock Outstanding

13. An additional financial statement that identifies changes in retained earnings from one accounting period to the next. Statement of Retained Earnings Beginning retained earnings +Net income –Dividends paid =Ending retained earnings Beginning retained earnings +Net income –Dividends paid =Ending retained earnings Net income results in: Increase in net assets Increase in retained earnings Increase in owners’ equity Dividends result in: Decrease in net assets Decrease in retained earnings Decrease in owners’ equity

14. Reports the amount of cash collected and paid out by a company in operating, investing, and financing activities. How did the company receive cash? How did the company use its cash? Statement of Cash Flows Cash inflows Sell goods or services. Sell other assets or by borrowing. Receive cash from investments by owners. Cash outflows Pay operating expenses. Expand operations, repay loans. Pay owners a return on investment.

15. What Are The Three Primary Types Of Activities On A Statement Of Cash Flows? Operating Activities: A company’s day-to-day activities. Major operating cash inflow—cash receipts from selling goods or from providing services. Major operating cash outflow—payments to purchase inventory and to pay operating expenses. Investing Activities: Buying and selling long-term assets. Financing Activities: Cash is obtained from or repaid to owners and creditors.

16. Statement of Cash Flows CASH OUTFLOWS Operating Activities Financing Activities Investing Activities CASH INFLOWS Financing Activities Operating Activities Investing Activities

17. The Example Company Statement of Cash Flows December 31, 2003 Cash Flows From Operating Activities: Receipts 48 Payments (43)5 Cash Flows From Investing Activities: Receipts0 Payments(4)(4) Cash Flows Used By Financing Activities: Receipts10 Payments (6) 4 Net Cash Flow5 Sample Statement of Cash Flows

18. How the Financial Statements Tie Together Is Called? Articulation--the relationship between an operating statement (the income statement or the statement of cash flows) and comparative balance sheets.

19. Financial Statement Articulation Balance Sheet 12/31/02 Cash $ 80,000 Other 4,550,000 Total $4,630,000 Liabilities $2,970,000 Cap. stock 900,000 R/E 760,000 Total $4,630,000 Revenues $12,443,000 Expenses 11,578,400 Net income $ 864,600 Income Statement Cash $ 110,000 Other 4,975,000 Total $5,085,000 Liabilities $2,860,400 Cap. stock 1,000,000 R/E 1,224,600 Total $5,085,000 Balance Sheet 12/31/03 Cash--Op. Act. $ 973,000 Cash--Inv. Act. (1,188,000) Cash--Fin. Act. 245,000 Net increase $ 30,000 Beg. cash 80,000 End. cash $ 110,000 Cash Flow Statement R/E 12/31/02 $ 760,000 Net income 864,600 Dividends (400,000) R/E 12/31/03 $1,224,600 Stmt of Retained Earnings

20. Learning Objective 2 Recognize the need for financial statement notes and identify the types of information included in the notes.

21. Notes to the Financial Statements What are the four general types? Summary of significant accounting policies: assumptions, estimates, and judgments. Additional information about the summary totals. Disclosure of important information that is not recognized in the financial statements. Supplementary information required by the FASB or the SEC. Notes are an acceptable way to convey information to users when the information is too uncertain or needs further explanation.

22. Learning Objective 3 Describe the purpose of an audit report and the incentives the auditor has to perform a good audit.

23. The Audit Report Owners and managers want the most favorable results possible. Bank credit Bonuses Public stock price CPA firms have economic incentives to perform credible audits. Reputation Lawsuits

24. The Audit Report.Issued by independent CPA firms..CPAs attest to conformity with GAAP..Financial statements are the responsibility of the company’s management and not the CPA.

25. Learning Objective 4 Use financial ratios to identify a company’s strengths and weaknesses and to forecast its future performance.

26. What Is the Debt Ratio and Its Purpose? Measure of leverage. Varies from industry to industry, but should be around 50%. Total liabilities Total assets

27. Total current assets Total current liabilities What Is the Current Ratio and Its Purpose? Measure of liquidity. Also called Working Capital Ratio. Some successful companies have current ratios less than 1.0.

28. What Is Asset Turnover and Its Purpose? Measure of company efficiency. The higher the asset turnover ratio, the more efficient the company is using its assets to generate sales. Sales Total assets

29. What Is Return on Sales and Its Purpose? Measure of the amount of profit earned per dollar of sales. Evaluated within the appropriate industry. Net income Sales

30. What Is Return on Equity and Its Purpose? Overall measure of performance--profit earned per dollar of investment. Typically between 15% and 25%. Net income Owners’ equity

31. What Is the Price-Earnings Ratio and Its Purpose? Measure of growth potential, earnings stability, and management capabilities. In the U.S., typically between 5 and 30. Market price per share Earnings per share

32. Financial Ratios Debt ratio Current ratio Asset turnover Return on sales Return on equity Price-earnings ratio Total liabilities Total assets Current assets Current liabilities Sales Total assets Net income Sales Net income Owners’ equity Market price per share Earnings per share

33. Learning Objective 5 Explain the fundamental concepts and assumptions that underlie financial accounting.

34. The basic accounting assumptions, concepts, principles, and procedures that determine the manner of recording, measuring, and reporting a company’s transactions. Accounting Model

35. Separate Entity Concept Arm’s-Length Transactions Cost Principle Monetary Measurement Concept Going Concern Assumption What Are The Fundamental Concepts and Assumptions?

36. Entity--The organizational unit for which accounting records are maintained. Separate entity concept--The activities of an entity are to be separate from those of its individual owners. Proprietorship Partnership Corporation Describe the Separate Entity Concept.

37. The exchange of goods or services between independent and rational parties, each looking out for their company’s best interests. What Is An Arm’s-Length Transaction?

38. What Is Meant By The Cost Principle? All transactions are recorded at historical cost. Historical cost is assumed to represent the fair market value of the item at the date of the transaction because it reflects the actual use of resources by independent parties.

39. What Is The Monetary Measurement Concept? Accountants measure only those economic activities that can be measured in monetary terms. Listed values may not be the same as actual market values: Inflation. Measurement issues.

40. What Do We Mean By The Going Concern Assumption? An entity will have a continuing existence for the foreseeable future.

41. “If You Always Do What You Always Did, You Always Get What You Always Got.” W. Edward Deming End Chapter 2