Module 2 Introduction To F/S & Transaction Analysis

1. Module 2Introduction To F/S &Transaction Analysis

2. Four Main Financial Statements • Balance Sheet • Income Statement • Statement of Stockholders’ Equity • Statement of Cash Flows

3. 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

4. Assets To be reported on a balance sheet, an asset must • Be owned or controlled by the company • Must possess expected future 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.

5. Examples of Current Assets • Cash • Marketable securities • Accounts receivable • Inventory • Prepaid expenses

6. Examples of Long-term Assets • Property, plant and equipment (PPE) • Long-term investments • Intangible and other assets

7. Apple’s Assets

8. General Mills, Inc. Assets

9. Assets are Reported at Historical Cost • Historical Cost is • Objective • Verifiable • “Relevance vs. Reliability”

10. 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.]

11. Disney’s Assets Where’s Mickey? The market value of the Mickey Mouse trademark does not explicitly show up here.

12. Apple’s Liabilities and Equity

13. Liabilities • Liabilities are listed in order of maturity • Current Liabilities come due in less than a year. • Noncurrent liabilities come due after a year.

14. Examples of Current Liabilities • Accounts payable • Accrued liabilities • Unearned revenues • Short-term notes payable • Current maturities of long-term debt

15. General Mills, Inc. Current Liabilities

16. Net Working Capital

17. Operating Cycle

18. Examples of Noncurrent Liabilities • Long-term debt • Other long-term liabilities • pension liabilities • long-term tax liabilities

19. General Mills, Inc. Long-term Liabilities

20. 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:

21. Examples of Equity Accounts • Common stock • Preferred stock • Additional paid-in capital • Treasury stock • Retained earnings • Accumulated other comprehensive income or loss

22. General Mills, Inc. Stockholders’ Equity

23. Income Statement

24. Apple’s Income Statement

25. General Mills, Inc. Income Statement

26. When are Revenues and Expenses Recognized? • Revenue Recognition Principle—recognize revenues when earned • Matching Principle—recognize expenses when incurred.

27. 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:

28. 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 company’s financing and investing activities

29. Transitory Items in the Income Statement

30. Transitory items • Discontinued operationsGains or losses (and net income or loss) from business segments that are being sold or have been sold in the current period. • Extraordinary itemsGains or losses from events that are both unusual and infrequent.

31. 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). Accrual Accounting

32. 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

33. Apple’s Statement of Stockholders’ Equity

34. 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 investing activities • Cash flows from financing activities

35. Apple’s Statement of Cash Flows

36. General Mills, Inc. Statement of Cash Flows

37. Articulation of Financial Statements • Financial statements are linked within and across time – they articulate. • Balance sheet and income statement are linked via retained earnings.

38. Apple’s Retained Earnings Reconciliation

40. Recording transactions • 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.

41. Adjusting Accounts

42. Accrual of Wages

43. Exercise: The Ice Cream Store, Inc. The Ice Cream Store, Inc. incurred the following start-up costs: • The Ice Cream Store, Inc. was formed on October 1, 20XX, with the investment of $90,000 in cash by the owners. • Obtained a bank loan and received the proceeds of $35,000 on October 2. The cash will be used for operations. • Purchased equipment for $25,000 cash on October 2. • 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. • 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:

45. Ice Cream Shop Balance Sheet:

46. Ice Cream Shop – additional transactions • 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. • 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. • Sales of ice cream for the month of October, 20XX, totaled $8,000. All sales were for cash. The ice cream cost $3,500. • For all of October, total employee wages and salaries earned/paid were $3,000. • 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. • $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:

47. 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.

50. Preparing the Financial Statements