Moore Accounting for Financial Reporting Week DB 2

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Peter D. Easton John J. Wild Robert F. Halsey Mary Lea McAnally

for MBAs

Financial Accounting

Eighth Edition

Module Introducing Financial Statements

2

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Learning Objective

Examine and interpret a balance sheet.

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Balance Sheet Basics

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 The balance sheet has three sections:  Assets  Liabilities  Stockholders’ equity

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

 The balance sheet reports the assets, liabilities, and equity at a point in time.  Balance sheet accounts are permanent accounts

because their balance carries over from period to period.

AKA: Owners’ equity Shareholders’ equity

Flow of Costs

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 When a cost creates an immediate benefit, we record the cost in the income statement as an EXPENSE.  When a cost creates a future economic benefit, we

record it on the balance sheet as an ASSET.  As an asset is used up, its cost moves from the balance

sheet to the income statement, where it is recognized as an EXPENSE.

Capitalized: added to the balance sheet as an asset

Assets

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An ASSET confers expected future economic benefits.

An asset must meet the following two conditions to be reported on the balance sheet:

1. It must be owned or controlled by the company. 2. It must arise from a past transaction or event.

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Apple Inc. Balance Sheet―Assets

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Current Assets

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 Cash—currency and bank deposits  Cash equivalents—investments with an original

maturity of 90 days or fewer  Short-term investments—marketable securities the

company expects to sell within the year  Accounts receivable, net—amounts due from

customers arising from the sales on credit

 Inventories—goods purchased or produced for sale to customers  Prepaid expenses—costs paid in advance for rent,

insurance, advertising, and other services

NET: After uncollectible accounts have been subtracted

Long-Term Assets

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 Property, plant, and equipment (PPE), net—land, buildings, and equipment

 Long-term investments—investments the company does not intend to sell within the year  Intangible and other assets—assets without physical

substance such patents, trademarks, franchise rights, and goodwill

NET: After accumulated depreciation has been subtracted

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Measuring Assets

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Most assets are reported at historical cost―the original acquisition cost and NOT at current market value.  If a company cannot value an asset with relative

certainty, it does not recognize an asset on the balance sheet.  This means that significant “assets” are not reflected

on a balance sheet.  Excluded assets often relate to knowledge-based or

intellectual property (IP) assets, such as a strong management team, a solid supply chain, or superior technology.

Effects of “Missing” Assets

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Liabilities

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Liabilities are future economic sacrifices.

A liability has the following two characteristics: 1. It is an unavoidable obligation for the company 2. It must arise from a past transaction or event

A liability represents an amount that must be repaid and can be: 1. Interest bearing―as in a bank loan 2. Non-interest bearing―as to a vendor or partner

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Stockholders’ Equity

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Stockholders’ equity represents capital that has been invested by the stockholders.  Directly via the purchase of stock  Indirectly in the form of retained earnings that reflect

earnings that are reinvested in the business and not paid out as dividends

Apple’s Liabilities and Equity

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Current Liabilities

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 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 (such as wages earned by employees but not yet paid)

 Unearned revenues—cash received from a customer in advance for goods or services to be delivered later

 Short-term debt—short-term loans owing to banks or other lenders

 Current maturities of long-term debt—principal portion of long-term debt that is due to be paid within one year

AKA: Accrued expenses

AKA: Deferred revenues

AKA: Current portion

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Net Working Capital

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 Net working capital Net working capital = Current assets – Current Liabilities

 The net working capital required to conduct business depends on the company’s operating cycle, which is the time between paying cash for goods and receiving cash from customers.

AKA: Working capital

AKA: Cash Cycle Cash Conversion Cycle (CCC)

Operating Cycle

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Operating Cycle

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Companies buy inventory with cash and supplier credit

(accounts payable)

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Operating Cycle

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Companies sell inventory either on credit (accounts

receivable) or for cash

Operating Cycle

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When receivables are collected, a portion of the cash received is used to

repay accounts payable. The remainder goes to the cash

account for the next operating cycle.

Operating Cycle

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Cash Conversion Cycle Apple & 3M

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 Apple’s cash conversion cycle is negative.  Apple can invest the cash it receives from customers

for 73.6 days before paying suppliers.  3M’s cash conversion cycle is positive which is more

typical.

Noncurrent Liabilities

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 Noncurrent liabilities—obligations due after one year  Long-term debt—principal loan amounts that are

scheduled to be repaid more than one year hence  Long-term debt includes bonds, notes, debentures,

mortgages, and other long-term loans  Other long-term liabilities—such as pension liabilities

and long-term tax liabilities, that will be settled a year or more into the future

Stockholders’ Equity Contributed Capital

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 Common stock—par value received from the original sale of common stock to investors

 Additional paid-in capital—amounts received from the original sale of stock to investors in excess of the par value of stock

 Preferred stock—value received from the original sale of preferred stock to investors

 Treasury stock—amount the company paid to reacquire its common stock from shareholders. Treasury shares are “held” by the company for potential resale on the open market.

AKA: Capital in excess of par

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Stockholders’ Equity Earned Capital

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 Retained earnings—cumulative net income that has not been distributed to stockholders via dividends or share repurchases

 Accumulated other comprehensive income or loss— cumulative changes in asset and liability fair values that are not reported in the income statement

Common Size Balance Sheet

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Common Size, aka, Vertical analysis or Right-sizing

 What?  Expresses the balance sheet in % terms  Every line item on the balance sheet (A, L & Eq) divided by

total assets

 WHY?  Compare a company across two or more years  Compare two or more companies―adjusts for size and currency

differences  Compare a company to industry or other benchmark

Book Value vs. Market Value

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 Stockholders’ Equity―the “value” of the company per GAAP

 Market value = Number of common shares outstanding × Company’s stock price

 Book value ≠ Market value  GAAP reports assets and liabilities at historical costs, whereas

the market attempts to estimate fair values.  GAAP excludes assets that cannot be reliably measured.  Market value adjusts for companies’ market characteristics.  GAAP does not consider expected future performance.

AKA: Book Value Book value of equity

AKA: Market capitalization Market cap

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Market Value vs. Book Value

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Learning Objective

Examine and interpret an income statement

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Income Statement

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 The income statement reports  Revenues earned during a period  Expenses incurred to produce those revenues  Net income or loss (Revenue – Expenses)

 The general structure of the income statement: AKA: Net revenue, Sales

AKA: Cost of sales, Cost of revenues

AKA: Earnings before interest and taxes (EBIT)

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Apple’s Income Statement

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Operating Expenses

usual and customary costs a company incurs

to support its operating activities

Nonoperating Income / Expenses

relate to the company’s financing and

investing activities

Accrual Accounting

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 Revenues and expenses recognized on the income statement are NOT determined by the cash received or paid.  Two principles are the foundation of accrual

accounting 1. Revenue recognition principle 2. Expense recognition principle

Expense Recognition Principle

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 Recognize expenses when incurred  Expense recognition may or may not coincide with

cash payment 1. Expense recognized & cash paid simultaneously 2. Cash paid in advance & expense recognized later 3. Expense recognized in current period & cash paid later

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Revenue Recognition Principle

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 Recognize revenue when a performance obligation is satisfied by transferring to a customer a promised good or service.  Good or service is transferred when the customer

obtains control of that good or service.  Revenue is the amount the company expects to

receive.  Revenue recognition may or may not coincide with

cash received. 1. Revenue recognized & cash received simultaneously 2. Revenue recognized in current period & cash received later 3. Cash received in advance & revenue recognized later

Income Statement

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 The income statement reports  Revenues earned during a period  Expenses incurred to produce those revenues  Net income or loss (Revenue – Expenses)

 The general structure of the income statement:

Discontinued Operations

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 Discontinued operations―A disposal of a business unit that represents a strategic shift that has, or will have, a major effect on the company’s financial results  Two components on the income statement (often

combined) 1. Net income / loss from the business prior to sale 2. Any gain or loss on the actual sale of the business

 Segregating Discontinued operations from Continuing operations helps analysts to better isolate the core reoccurring profit and cash flow of the business.

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Common Size Income Statement

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Common Size, aka, Vertical analysis or Right-sizing

 What?  Every line item on the income statement divided by total

revenue  Express the income statement in % terms

 WHY?  Compare a company across two or more years  Compare two or more companies―adjusts for size and currency

differences  Compare a company to industry or other benchmark

Two Important Margins

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 Gross profit margin  Gross profit / Sales  The gross profit margin is influenced by both the selling price of

the company’s products and the cost to make or buy those products.

 Operating expense margins  Operating expense / Sales  Analysis of operating expenses over time and compared with

peer companies

Learning Objective

Examine and interpret a statement of stockholders’ equity.

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Apple’s Liabilities and Equity

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Statement of Stockholders’ Equity

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Statement of stockholders’ equity reconciles the beginning and ending balances of stockholders’ equity accounts.

 Common stock and additional paid-in capital increase by the proceeds from the sale of stock.

 Retained earnings increase by net income and decrease by dividends to shareholders and by stock repurchased and retired.

 Accumulated other comprehensive income increases and decreases by changes in asset and liability fair values that are not reported in the income statement.

Apple’s Statement of Stockholders’ Equity

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Learning Objective

Describe a statement of cash flows.

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Statement of Cash Flows

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 The income statement measures income using GAAP principles and provides information about the economic viability of the company’s products and services.  The statement of cash flows provides information

about the company’s ability to generate cash from those same transactions.

Statement of Cash Flows Format

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 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

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Apple’s Statement of Cash Flows

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AKA: Total cash flow

Learning Objective

Construct and apply linkages among the four financial statements.

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Financial Statement Linkages

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AKA, Financial statement articulation.

 What?  Connections among the four financial statements that link

activity during the period to the balances at the beginning and end of the period

 WHY?  Point out the interconnection among profit, cash flow and the

balance sheet  Help managers and external financial statement users assess

the impact of potential transactions

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Financial Statement Linkages

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Learning Objective

Locate and use additional financial information from public sources.

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Additional SEC Information

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 Form 10-K / 10Q  Annual / quarterly report

 Form 20-F  Non-GAAP or IFRS companies’ annual report, provides a table that

reconciles net income as reported to U.S. GAAP net income.  Form 40-F  Same as 20-F but for Canadian companies

 Form 8-K  Wide range of corporate events, reported within 4 days  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

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Other Information Sources

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 Equity Analyst Reports―sell-side analysts provide clients with:  Objective analysis of company activities  Forecasts for revenues and EPS  Stock price target

 Credit Reports―credit rating agencies provide:  Objective credit analysis that evaluates a company’s creditworthiness  Credit rating (alphanumeric score)

 Data Services―a number of companies supply financial statement data in easy-to-download spreadsheet formats

Global Accounting GAAP vs. IFRS

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 Balance Sheet―the most visible difference is that many IFRS-based balance sheets are presented in reverse order of liquidity.  Income Statement―the most visible differences are:  GAAP requires three years’ of data on the income statement

whereas IFRS requires only two.  IFRS firms can classify expenses by function (cost of sales,

SG&A, R&D, etc.) or by type (raw materials, labor, depreciation, etc.)

Cambridge Business Publishers www.cambridgepub.com

for MBAs

Financial Accounting

Eighth Edition