Module 2:

Introducing Financial Statements

and Transaction Analysis
Flow of Costs
 Four Main Financial Statements

• Balance Sheet
• Income Statement
• Statement of Stockholders’ Equity
• Statement of Cash Flows
 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
Retained Earnings
 Assets
To be reported on a balance sheet, an asset must
1. Be owned (or controlled) by the company
2. Must possess expected future economic benefits

 Assets are listed in order of liquidity

 Current assets comprise assets that can be
converted to cash within a year
 Long-term assets cannot be easily converted to cash
within a year.
 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 uncollectible accounts explained in
Module 6);
• Inventory—goods purchased or produced for sale to
customers;
• Prepaid expenses—costs paid in advance for rent, insurance,
advertising or other services.
 Examples of Long-term Assets
• Property, plant and equipment (PPE), net—land, factory
buildings, warehouses, office buildings, machinery, motor
vehicles, office equipment and other items used in operating
activities (“ net” refers to subtraction of accumulated
depreciation, the portion of the assets’ cost that has been
transferred from the balance sheet to the income statement,
which is explained in Module 6);
• 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.
Apple’s Assets
Cisco Systems, Inc. Assets
 Assets are Reported at
Historical Cost
• Historical Cost is
– Objective
– Verifiable
• “Relevance vs. Reliability”
• Only include items that can be reliably
measured.
– Considerable amount of “ assets” may not be
reflected on a balance sheet
– Strong management team, a well-designed supply
chain, or superior technology
Knowledge Based Assets are not Reflected
on the Balance Sheet
• NOTE: While resources expended for research and
development reflect and economic asset, they
generally are expensed as incurred.
• INSIGHT: 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.]
Disney’s Assets

Where’s Mickey? The

market value of the
Mickey Mouse trademark
does not explicitly show up
here.
Apple’s Liabilities and Equity
 Examples of Current Liabilities
• Accounts payable—amounts owed to suppliers for goods and
services purchased on credit.
• Accrued liabilities—obligations for expenses that have been
incurred but not yet paid; examples are accrued wages payable
(wages earned by employees but not yet paid), accrued interest
payable (interest that is owing but has not been paid), and accrued
income taxes (taxes due).
• Unearned revenues—obligations created when the company
accepts payment in advance for goods or services it will deliver in
the future; also called advances from customers, customer deposits,
or deferred revenues.
• 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.
Cisco systems, Inc. Current Liabilities
Net Working Capital
Operating Cycle
 Examples of Noncurrent Liabilities
• Long-term debt—amounts borrowed from creditors that are
scheduled to be repaid more than one year in the future; any
portion of long-term debt that is due within one year is
reclassified as a current liability called current maturities of
long-term debt. Long-term debt includes bonds, mortgages,
and other long-term loans.
• 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.
Cisco Systems, Inc.
Long-term Liabilities
 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:
 Examples of Equity Accounts
• Common stock—par value received from the original sale of
common stock to investors.
• Preferred stock—value received from the original sale of preferred
stock to investors; preferred stock has fewer ownership rights compared
to common stock.
• Additional paid-in capital—amounts received from the original sale
of stock to investors in addition to the par value of common stock.
• Treasury stock—amount the company paid to reacquire its common
stock from shareholders.
• Retained earnings—accumulated net income (profit) that has not
been distributed to stockholders as dividends.
• Accumulated other comprehensive income or loss—
accumulated changes in equity that are not reported in the income
statement (explained in Module 9).
Cisco Systems, Inc.
Stockholders’ Equity
Income Statement
Apple’s Income Statement
Cisco Systems, Inc.
Income Statement
When are Revenues and Expenses Recognized?

• Revenue Recognition Principle—recognize

revenues when earned
• Matching Principle—recognize expenses
when incurred
 Profit vs. Cash
• Net Income does not necessarily correspond to a net cash
flow. A firm could have “ good income” but “ poor cash flow”
or vice versa (i.e., there are two dimensions to consider).
• We have previously summarized the mechanics of the balance
sheet with the expanded accounting equation:
 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 compan
y’s financing and investing activities
Transitory Items in the
Income Statement
 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.
 Accrual Accounting

Accrual accounting refers to the

recognition of revenue when earned
(even if not received in cash) and
the matching of expenses when
incurred (even if not paid in cash).
 Statement of Stockholders’ Equity

• Statement of Equity is a reconciliation of

the beginning and ending balances of
stockholders’ equity accounts.
• Main equity categories are:
– Contributed capital
– Retained earnings (including Other
Comprehensive Income or OCI)
– Treasury stock
Apple’s Statement of
Stockholders’ Equity
 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.
 Apple’s
Statement
of Cash
Flows
 Cisco
Systems

Statement
of Cash
Flows
Relation of SCF to Income Statement
and Balance Sheet
 General Coding of
Balance sheet Changes
Working Capital Accounts
 Articulation of Financial Statements
• Financial statements are linked within and
across time – they articulate.
• Balance sheet and income statement are
linked via retained earnings.
Apple’s Retained Earnings Reconciliation
 Recording transactions –
Pay $100 Wages in Cash

• Cash assets are reduced by $100, and wage expense of $100 is

reflected in the income statement, which reduces income and
retained earnings by that amount.
• All transactions incurred by the company during the
accounting period are recorded similarly.
Adjusting Accounts
Prepaid Rent
Unearned Revenue
Accrual of Wages
Accrual of Revenue
 Exercise: The Ice Cream Store, Inc.
The Ice Cream Store, Inc. incurred the following start-up costs:
1. The Ice Cream Store, Inc. was formed on October 1, 20XX,
with the investment of $90,000 in cash by the owners.
2. Obtained a bank loan and received the proceeds of $35,000
on October 2. The cash will be used for operations.
3. Purchased equipment for $25,000 cash on October 2.
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.
5. 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:
 Balance Sheet Income Statement
Noncash Liabi- Contrib. Retained
Transaction Cash Asset +
Assets
=
lities
+
capital
+
Earnings
Revenues – Expenses

1. The Ice Cream Store,

Inc. was formed on
October 1, 20XX, with the
+90 +90
investment of $90,000 by
the owners.

2. Obtained a bank loan

and received the proceeds
of $35,000 on October 2. +35
+35
The cash will be used for N/P
operations.

3. Purchased equipment
+25
for $25,000 cash on -25
October 2. Equip
4. Acquired a building at a
cost of $80,000. It was
financed by making a
$20,000 down-payment and +80 +60
obtaining a mortgage for -20
the balance. The
Bldg. M/P
transaction occurred on
October 2.

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.
 ASSETS  
Cash  $80,000
Equipment  25,000
Ice Cream Shop Building  80,000
   
Balance Sheet:
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  $185,000
 Ice Cream Shop –
additional transactions
6. On October 4, purchased merchandise inventory (i.e., ice cream) at a cost of
$15,000 by paying $5,000 cash and receiving short-term credit for the
remainder from the supplier.
7. Immediately returned some of the ice cream because some of the flavors
delivered were not ordered. The cost of the inventory returned was $3,000.
8. Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales
were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries earned/paid were
$3,000.
10. As of the end of October, one month's depreciation on the equipment and
building was recognized -- $383 for the building and $167 for the
equipment.
11. $450 interest expense on the note and mortgage was due and paid on
October 31. Assume that the principal amounts ($35,000 + $60,000) of the
note and mortgage remain unchanged.

Prepare a transaction analysis of 6. -11. using the balance sheet/income

statement template presented above:
 Balance Sheet Income Statement

Cash Liabi- Contrib. Retained

Transaction + Noncash Assets = + + Revenues – Expenses
Asset lities capital Earnings

6. +15 +10
-5
Inv. A/P
7. -3 -3
Inv. A/P
8. -3.5 +8 -3.5
+8 +4.5
Inv. Sales COGS
9. -3
-3 . -3
Wage exp.
10. - .383 -.550
Bldg., net Dep. exp.
-.550
-.167
Equip., net

11. -.450
-.450 -.450 Int. Exp.

Prepare the following financial statements (ignore income taxes): (i) an updated Balance
Sheet as of October 31, 20XX; and (ii) an Income Statement for the month of October
20XX.
Cash ($80,000 -5,000 +8,000 -3,000 -450)  $79,550
Merchandise Inventory ($0 + 15,000 -3,000 -3,500)  8,500
Equipment ($25,000 )  25,000
Less: Accumulated Depreciation  (383)
Building ($80,000)  80,000
Less: Accumulated Depreciation (167)
Total Assets  $192,500

Accounts Payable ($0 + 10,000 – 3,000)  $7,000

Note Payable ($35,000 principal is unchanged)  35,000
Mortgage Payable (60,000 principal is unchanged)  60,000
   102,000
Stockholders' Equity:  
Capital Stock  90,000
Retained Earnings  500
   90,500
Total Liabilities and Stockholders' Equity  $192,500
   

REVENUES:
Sales of Ice Cream  $8,000
Cost of Sales  3,500
GROSS PROFIT: 4,500
Payroll Expense  3,000
Depreciation Expense 550
INCOME FROM OPERATIONS 950
Interest Expense 450
NET INCOME $500
   
Note: Assume no income taxes.  
Preparing the
Financial
Statements
Balance Sheet and Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity
 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.
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
 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:
1. Classify interest expense, dividends paid, interest revenue, and
dividend revenue as operating cash flows, or
2. Classify interest expense and dividends paid as financing cash flows,
and interest revenue and dividend revenue as investing cash flows.
Analyst Reports
 Credit and Data Services
• Credit Analysis
– Standard & Poor’s (StandardAndPoors.com)
– Moody’s Investors Service (Moodys.com)
– Fitch Ratings (FitchRatings.com)
• Data Services
– Thomson Corporation (Thomson.com)
• First Call - summary of analysts’ earnings forecasts
• Compustat database - individual data items for all
publicly traded companies or for any specified subset of
companies.