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Chapter 2 Chapter 2

The Financial Statements

Business ActivitiesBusiness 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.

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The Balance SheetThe Balance SheetThe 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

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The Balance SheetThe 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.

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AssetsAssets

Definition? Current assets

– Cash– Short-term investments– Accounts receivable– Inventory– Prepaid expenses

Long-term investments Property, plant, and equipment Intangible assets

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LiabilitiesLiabilities

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

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Owners’ (Shareholders’) EquityOwners’ (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.

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The Statement The Statement of Shareholders’ Equity (SSE)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

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The Statement The Statement of Retained Earningsof 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.

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The Income StatementThe 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

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The Statement of Cash FlowsThe 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.

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Classifying Financing, Investing, and Classifying Financing, Investing, and Operating TransactionsOperating Transactions

Financing and Investing Transactions

Operating Transactions

Balance SheetIncome

Statement

1

1. Exchanges with shareholders

2

2. Exchanges of liabilities and shareholders’ equity

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3. Issues and payments of debt

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4. Purchases, sales, and exchanges of assets

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5. Revenues and expenses

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Classifying Operating TransactionsClassifying Operating Transactions

Transitory Persistent

Group CGains and losses due to change in

accounting principles

Group ANormal and recurring operating revenues

and expenses

Group BRevenues and expenses from activities not germane to a

company’s primary activity

Extraordinary items

Disposals of segments

Other revenues and expenses

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Relationships Among the Financial Statements

Statement ofCash Flows

IncomeStatement

Statement ofStockholders’ Equity

EndingBalance Sheet

Assets (Cash)

=

Liabilities

+

Equity

BeginningBalance Sheet

Assets(Cash)

=

Liabilities

+

Equity

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Exercise 2-3Exercise 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

IB

I

BB

B

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Exercise 2-3Exercise 2-3Balance 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

BB

I

BB

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Exercise Exercise Given (in billions): 2010 2009 2008Beginning RE ? 1.3 1.2Revenues 4.4 4.1 3.9Expenses 3.9 ? 3.5Div. 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

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Exercise, 2010Exercise, 2010

Solve for RE(B) using:RE(B) + NI - Div = RE(E)

NI = 4.4 – 3.9 = .5

RE(B) + .5 - .3 = 1.6RE(B) = 1.4

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Exercise, 2009Exercise, 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 = 1.4Exp. = 3.7

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Exercise, 2008Exercise, 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. = 1.3Div. = .3

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