Understanding Financial Statements and Concepts

1. THE FINANCIAL STATEMENTS Chapter 3

2. CHAPTER 3 OBJECTIVES • Describe the composition and objectives of each of the four financial statements. • Show how the economic entity, periodicity, monetary unit, stable dollar, and going concern assumptions, and the revenue recognition, matching, and historical cost principles, influence financial statement disclosures.

3. CHAPTER 3 OBJECTIVES (CONT.) • Distinguish between cash flow reporting and the accrual basis of accounting. • Articulate the importance of cash flows from operating activities. • Explain and give examples of financial statement articulation.

4. FINANCIAL STATEMENT CONCEPTS • Objectives—all analysts, regardless of specific objectives, desire knowledge about • Cash flows • Resources • Claims against those resources • Wealth and changes in it

5. FINANCIAL STATEMENT CONCEPTS (CONT.) • Corporate objective—maximize shareholder wealth, which equals share price maximization

6. FINANCIAL STATEMENT CONCEPTS (CONT.) • Assumptions—characteristics embedded in the financial reporting system • Economic entity—business is distinct from owners • Periodicity—companies disclose financial statements at regular time intervals • Monetary unit—economic activity measured and reported in dollars • Stable dollar—financial statements are not inflation adjusted • Nominal dollar capital maintenance—sum of monetary unit and stable dollar assumptions

7. FINANCIAL STATEMENT CONCEPTS (CONT.) • Principles—core concepts of GAAP • Historical cost—asset and liability attribute most commonly used to measure and report accounts; historical exchange price • Revenue realization principle—report revenues when realized (or realizable) and earned • Usually occurs at point of sale or service • Independent of cash receipt

8. FINANCIAL STATEMENT CONCEPTS (CONT.) • Principles—core concepts of GAAP (cont.) • Matching principle—costs incurred in generating revenues • subtracted in revenue realization period • independent of cash outflows • Accrual accounting—sum of revenue realization and matching principles

9. FINANCIAL STATEMENT CONCEPTS (CONT.) • Cash accounting—equates cash received for goods and services to revenues and cash paid to earn them as expenses; not GAAP

10. FINANCIAL STATEMENT CONCEPTS (CONT.) • Financial statement interrelationships • Articulation—logical relationships among financial statements’ accounts as the four financial statements work as an integrated reporting system to convey financial information

11. FINANCIAL STATEMENT ORIENTATION • eSTUFF.com—hypothetical Internet retailer; introduces students to financial statements; used to illustrate concepts throughout the text • eSTUFF’s financial statements—Exhibit 3-1 (pp. 67-69 of the text)

12. FINANCIAL STATEMENT CONCEPTS (CONT.) • Additional financial statement disclosures—strengthen articulation • Notes to the financial statements—amplify and clarify financial statements; also called notes or footnotes • Supplementary information—additional disclosures that add insight to financial statements

13. INCOME STATEMENT (CONT.) • Measures change in wealth during a reporting period • Equation: revenues – expense = net income (loss)

14. INCOME STATEMENT (CONT.) • Revenues—asset increases from providing services or delivering goods • Gains—asset increases from peripheral transactions • Expenses—asset decreases; costs of doing business; matched against revenues • Losses—asset decreases from peripheral transactions

15. INCOME STATEMENT (CONT.) • Cost of goods sold—difference between the historical cost and selling price of inventory that is sold • Selling, general, and administrative expenses (S,G&A expenses; operating expenses)—costs incurred in running a business; matched against revenues • Income—difference between revenues (gains) and expenses (losses) • Earnings per share (EPS)—profit (loss) per share of common stock

16. INCOME STATEMENT (CONT.) • All-inclusive income—results from reporting all revenues (gains) and expenses (losses) in a reporting period • Multiple step format—separates central business activities’ revenues and expenses from peripheral gains and losses • Single step format—combines core and peripheral revenues and subtracts core and peripheral expenses from them

18. STATEMENT OF SHAREHOLDERS’ EQUITY • Measures change in owners’ wealth during the reporting period • Equation: Beginning shareholders’ equity + net income – dividends = ending shareholders’ equity

19. SHAREHOLDERS’ EQUITY (CONT.) • Contributed capital—resources invested in the business by its owners • Common stock—most prevalent stock type issued; risk capital • Preferred stock—dividend preference over common stock; less risky investment than common stock • Par value—minimum selling price of stock

20. SHAREHOLDERS’ EQUITY (CONT.) • Additional paid in capital—difference between stock’s selling price and its par value • Retained earnings—income kept within the business • Dividends—cash paid to shareholders as a return on investment

21. BALANCE SHEET • Measures wealth at one point in time (usually the end of the reporting period) • Equation: assets = liabilities + shareholders’ equity • Remains in balance after every transaction

22. BALANCE SHEET (CONT.) • Liquidity—cash or items convertible into cash that can be used to pay obligations in the near term • Assets—future economic benefits, controlled by an entity, resulting from a past transaction

23. BALANCE SHEET (CONT.) • Current asset—liquid resource; usually converted into cash within one year • Long-term asset—illiquid resource; used to generate revenues and cash flows; includes long-term investments, property, plant, equipment, and intangible assets

24. BALANCE SHEET (CONT.) • Liabilities—future economic obligations, owed by an entity, resulting from a past transaction • Current liabilities—pending obligations; usually payable within one year • Long-term liabilities—non-current obligations

27. STATEMENT OF CASH FLOWS • Measures change in cash during a reporting period • Equation: cash flows from operating activities + cash flows from investing activities + cash flows from financing activities = net change in cash

28. STATEMENT OF CASH FLOWS(CONT.) • Cash flows from operating activities—cash provided by or used for central business activities; most important section of the statement • Direct cash flows—method of disclosure for reporting operating cash flows; reports received from sales and services and paid to suppliers, employees, and other short-term creditors • Indirect cash flows—alternative operating cash flow reporting method; reconciles net income to operating cash flow to report operating cash flows

29. STATEMENT OF CASH FLOWS(CONT.) • Cash flows from investing activities—cash provided or used by the disposal and acquisition of long-term assets • Cash flows from financing activities—cash provided or used by issuing and retiring stocks and bonds and paying dividends