UNDERSTANDING FINANCIAL STATEMENTS

1. UNDERSTANDING FINANCIAL STATEMENTS • BALANCE SHEET – Liabilities & Stockholders’ Equity

2. LIABILITIES • Liabilities- probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future, as a result of past transactions or events. • May be CURRENT or LONG-TERM -- same criteria of “one-year or operating cycle, whichever is longer”

3. Current Liabilities • Accounts Payable • Short-term Notes Payable • Accrued Liabilities • Unearned Revenues (Deferred Credits) • Current Maturity Portion of Long-term Debt • Deferred Taxes

4. Long-Term Liabilities • Notes or Mortgages Payables • Bonds Payable • Leases Payable (capital leases) • Pension Obligations • Post-retirement benefits other than pensions • Deferred Taxes • Warranty Obligations • Contingencies Payable

5. Accounts Payable • Usually defined as obligations arising from purchases of merchandise for resale or of raw materials • Few valuation or reporting issues • Significant changes from period to period often result from changes in sales volume

6. Short-Term Notes Payable • Promissory notes due within a year (or operating cycle if more appropriate) • Usually are interest-bearing • Usually reported at face value because of short-term nature

7. Accrued Liabilities • Result from accrual basis of accounting • Represent expenses that have been INCURRED and thus ACCRUED, but have NOT BEEN PAID in cash • Examples are Interest Payable and Wages Payable

8. Unearned Revenue • Examples: Unearned rent revenue Advances from customers • Sometimes called “deferred credits” • Results from a prepayment received in advance for services or products • Under accrual accounting, revenue is recognized when EARNED, not when received in cash -- in this case, cash flow precedes revenue recognition

9. Current Maturities - LT Debt • Represent principal payments (not interest) on debt that are due within one year • Includes principal payments on notes, mortgages, bonds, leases

10. Long-term Liabilities • Notes or Mortgages Payable • Bonds Payable • Leases Payable (Capital Leases Payable) - recorded at the present value of expected future cash outflows starting when the lease begins (PPE will also be recorded) (Operating leases are recorded as lease expense and no liability nor PPE are recorded) • Pension Obligations - reported at the present value of expected future cash outflows • Warranty Obligations - Represent estimated liability of a firm to repair or replace merchandise that it sells

11. Long-term Liabilities • Postretirement benefits other than pensions An estimate of the obligation for paying medical insurance premiums or medical expenses of retired employees and spouses. These future benefits are accrued as the employees are working for the company.

12. Long-term Liabilities • Contingencies – potential liabilities such as possible losses assessed in a lawsuit If the loss is probable, then record the liability and loss and disclose in a footnote. If the loss is not estimable, then do not record the liability and loss, but must disclose in a footnote. If the loss reasonably possible, then do not record the liability and loss, but must disclose in a footnote. If remote, then do not record, must not disclose.

13. Deferred Income Taxes • Taxes paid are based on taxable income on Tax Return • Tax expense reported on income statement is based on FINANCIAL Income Statement • Deferred Income Taxes result from TIMING (temporary) differences in taxable and financial statement income • Classification may be current or long-term depending on the asset or liability underlying the temporary difference • Examples: • depreciation • pension expense • installment sale accounting

14. OWNERS’ EQUITY • Forms of business contrasted as to owners’ equity section. • a. Proprietorship: report owners’ equity as a single capital account. • b. Partnership: report separate capital account for each partner. • c. Capital account reflects all changes: investments, withdrawals, earnings, and losses. d. Corporations report stockholders’ equity, including contributed capital and retained earnings.

15. STOCKHOLDERS’ EQUITY Common stock, at par value Preferred stock Additional Paid-in Capital (also called Paid- in Capital in Excess of Par) Retained Earnings Accumulated Other Comprehensive Income Less: Treasury Stock (at cost) Total Stockholders’ Equity

16. Common Stock and Additional Paid-In Capital • Common stock represents ownership of the company • Voting privileges • No fixed return (no required dividend rate) But over the company’s lifetime the common stock dividends should be higher than the preferred stock dividends • Must disclose par value and number shares: • Authorized • Issued • Outstanding

17. Preferred Stock • No voting privileges • If company terminates, then their investment is returned before the common stockholders • Stated dividend rate (i.e., 8%) • Usually annual dividend is not required, but when dividends are declared by B of D, then the current year preferred stock dividends would be paid before the common stock dividends. • If “cumulative preferred stock”, then missed dividends (called dividends in arrears) would be paid first when dividends are declared by B of D. • If “redeemable preferred stock” (preferred stkhlders are repaid their investment after a stated period, like bonds), then the company is not allowed to show in SE section (show between liabilities and SE section.

18. Retained Earnings • Represents the cumulative undistributed earnings of the business since its inception • Accumulated net income (net loss) less dividends declared since inception • Current year detail is shown in Statement of Retained Earnings (Beg. RE+Net Income-Dividends declared= Ending RE) • Only Ending RE balance is shown on BS

19. Treasury Stock • Repurchased shares of stock to be retained and possibly reissued later is called Treasury Stock. • The stock may be repurchased: To distribute the stock to employees under stock option plans or retirement plans. To prevent a hostile takeover.

20. Treasury Stock • The repurchase of a company’s own stock can be accounted for by one of two methods: (1) At Cost Method (the amount paid to repurchase the stock is shown as a separate line item as a subtraction from stockholders’ equity) (2) Par Value Method (the amount paid to repurchase the stock reduces Common Stock and Additional Paid-In Capital)