2

Chapter 2

The Financial Statements

Business Activities

Business activities are reflected in financial statements; business activities include:

– Operating activities – selling goods and services.

– Investing activities – acquisition and sale of productive assets.

– Financing activities – issue and retirement/repayment of liabilities and equity.

4

The Balance Sheet

The balance sheet reports the financial position at a point in time (end of the quarter or year).

The Balance Sheet is also called:

Statement of Financial Position

The components of the Balance Sheet are:

Assets

Liabilities

Shareholders’ (Owners’) Equity

5

The Balance Sheet

The balance sheet is represented by the

fundamental accounting equation:

Assets = Liabilities + Shareholders’ Equity

A = L + SE

The effects of all business transactions

may be represented in this formula.

6

Assets

Definition?

Current assets – Cash

– Short-term investments

– Accounts receivable

– Inventory

– Prepaid expenses

Long-term investments

Property, plant, and equipment

Intangible assets

7

Liabilities

Definition?

Current liabilities

– Accounts payable

– Wages payable

– Interest payable

– Short-term notes payable

– Current maturities of long-term debt

– Deferred revenues

– Other payables

Long-term liabilities

8

Owners’ (Shareholders’) Equity

Definition?

Contributed capital – Shareholders’ equity (par or stated value)

– Paid-in capital in excess of par value

Earned capital

- Earned Capital has 2 components: Retained Earnings and Other accumulated comprehensive income. We will cover other accumulated comprehensive income in Chapter 13.

– Retained earnings represent the excess earnings retained in the company after dividends have been paid to shareholders. This represents the equity generated by the company for the shareholders.

9

The Statement

of Shareholders’ Equity (SSE)

The following formula represents the

basic SSE:

Beginning shareholders’ equity

Plus: Issuance of stock

Plus: Net income

Less: Dividends

Ending shareholders’ equity

SEBegin + Issue + NI - D = SEEnd

10

The Statement

of Retained Earnings

The statement of retained earnings is a

subset of the SSE, and calculates the

changes in the retained earnings component.

Beginning retained earnings

Plus: Net income

Less: Dividends

Ending retained earnings

REBegin + NI - Div = REEnd

International Perspective – Balance

Sheet

Many non-U.S. firms that publish IFRS-based balance

sheets add shareholder’s equity to non-current liabilities,

referring to the total as capital employed. Consequently,

the balance sheet format looks like:

Non-current assets + Current assets - Current

liabilities = Non-current liabilities + Shareholders’

equity

Under U.S. GAAP balance sheet accounts are listed in order of liquidity. Many non-U.S. firms that publish IFRS-based balance sheets list their assets in the opposite order, starting with non-current assets, followed by current assets.

Many non-U.S. companies, especially in Europe, use the term “turnover” instead of revenue.

12

The Income Statement

Operating revenues – Sales

– Fees earned

– Other revenues

Operating expenses – Cost of goods sold

– Wage expense

– Rent expense

– Selling expense

– Depreciation expense

– Amortization expense

– Other expenses

Operating revenues

and expenses: usual

and frequent

Other revenues and

expenses: unusual

or infrequent

Disposal of a

business segment

Extraordinary items:

unusual and

infrequent

13

The Statement of Cash Flows

Cash flows from operating activities: – Cash flows associated with the acquisition and sale of a

company’s products and services – Collections from sales, rent, interest, etc. – Cash paid to suppliers and employees, and for rent, selling

activities, interest, and taxes etc. Cash flow from investing activities:

– Cash flows associated with the purchase and sale of a company’s investments.

– Proceeds from sale of investment securities, land, buildings, equipment, etc.

– Purchase of investment securities, land, buildings, equipment, etc.

Cash flow from financing activities: – Cash flows associated with a company’s two sources of outside

capital: liabilities and contributed capital. – Proceeds from issuance of notes, debt, sale of equity, etc. – Payments on notes, debt, dividends, etc.

14

Classifying Financing, Investing, and

Operating Transactions

Financing and Investing

Transactions

Operating

Transactions

Balance Sheet Income

Statement

1

1. Exchanges with shareholders

2

2. Exchanges of liabilities and shareholders’ equity

3

3. Issues and payments of debt

4

4. Purchases, sales, and exchanges of assets

5

5. Revenues and expenses

15

Classifying Operating Transactions

Transitory Persistent

Group C

Gains and losses due

to change in

accounting

principles

Group A

Normal and recurring

operating revenues

and expenses

Group B

Revenues and

expenses from

activities not

germane to a

company’s primary

activity

Extraordinary

items

Disposals of

segments

Other revenues

and expenses

16

Relationships Among the Financial Statements

Statement of

Cash Flows

Income

Statement

Statement of Stockholders’ Equity

Ending

Balance Sheet

Assets

(Cash)

=

Liabilities

+

Equity

Beginning

Balance

Sheet Assets

(Cash)

=

Liabilities

+

Equity

18

Exercise 2-3

Balance Sheet (B) or Income Statement (I)

a. Equipment

b. Fees Earned

c. Retained Earnings

d. Wage Expense

e. Patent

f. Cost of Goods Sold

g. Common Stock

h. Dividend Payable

i. Accumulated Depreciation

B

I

B

I

B

I

B

B

B

19

Exercise 2-3

Balance Sheet (B) or Income Statement (I)

j. Prepaid Expense

k. Gain on Sale of Short-term Investment

l. Rent Revenue

m. Supplies Inventory

n. Accounts Receivable

o. Land

p. Insurance Expense

q. Interest Payable

r. Deferred (Unearned) Revenue

B

I

I

B

B

B

I

B

B

20

Exercise Given (in billions): 2010 2009 2008

Beginning RE ? 1.3 1.2

Revenues 4.4 4.1 3.9

Expenses 3.9 ? 3.5

Div. declared .3 .3 ?

Ending RE 1.6 ? ? Now, using the following formulas and relationships, solve for the other missing items:

(1) Rev - Exp = NI

(2) RE(B) + NI - Div = RE(E)

(3) RE(E) becomes RE(B) in the next year

21

Exercise, 2010

Solve for RE(B) using:

RE(B) + NI - Div = RE(E)

NI = 4.4 – 3.9 = .5

RE(B) + .5 - .3 = 1.6

RE(B) = 1.4

22

Exercise, 2009

First, find RE(E):

RE(E) 2009 = RE(B) 2010 = 1.4

Now find Expenses:

RE(B) + Rev. – Exp. - Div = RE(E)

1.3 + 4.1 – Exp - .3 = 1.4

Exp. = 3.7

23

Exercise, 2008

First, find RE(E):

RE(E) 2008 = RE(B) 2009 = 1.3

Now find Div:

RE(B) + Rev – Exp. - Div = RE(E)

1.2 + 3.9 – 3.5 – Div. = 1.3

Div. = .3

24

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