Download Financial Statements Basics - Duke`s Fuqua School of Business

Fuqua School of Business, Duke University
ACCOUNTG 510: Foundations of Financial Accounting
Lecture Note: Financial Statement Basics, Transaction Recording, and Terminology
I. The Financial Reporting Package (the Annual Report)
A.
Description of what the company does, pictures of employees and products
B.
Analytic material supplied by the company
1. 5 or 10 year Financial Summary
2. Management Discussion and Analysis
3. Unwarranted optimism (“it wasn't our fault”) and other self-serving discussion
4. Report by Management and Auditor
C.
Financial statements
1. Income Statement - usually (but not always) is presented first
2. Balance Sheet
3. Statement of Cash Flows
4. Statement of Shareholders’ Equity
5. Footnotes and other required disclosures
D.
Signatures by CFO and CEO attesting to the Annual Report.
II. Balance Sheet
A.
Describes the financial “status” of a business entity at a particular point in time, usually the end of
a time period called fiscal year or fiscal quarter. 1
B.
Financial reporting is based on the following accounting equation, which summarizes the balance
sheet:
Assets

Productive
capacity
=
Liabilities

Creditor
claims
+
Shareholders’ equity

Owner claims
(contributed capital plus undistributed earnings)
Note: Shareholders’ equity is also sometimes called book value (of equity) or owners’ equity.
The balance sheet is an arithmetic equality. In accounting, it is always true that the assets are equal
to the sum of the liabilities and shareholders’ equity.
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Fiscal just refers to the fact that not all firms have a December year end. By the way, the convention is to describe
a firm’s financial statement as pertaining to “fiscal year T” if their fiscal year end is between June and December
inclusive. If the fiscal year end is January through May, we say the fiscal year pertains to “fiscal year T-1.” So, for
example, a financial statement dated January 31, 2003 would commonly be interpreted as applying to fiscal 2002.
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Assets are future economic benefits that the firm controls because of a past event or transaction.
Examples include: cash, accounts receivable (these are amounts owed to the firm by its customers),
inventories, land, investments in other firms, factories.
Liabilities are obligations to sacrifice resources. For the most part, accounting liabilities are also
legal obligations. Examples include: accounts payable (amounts owed by the firm to its suppliers),
bank loans payable (amounts owed to banks).
Shareholders’ equity is the residual, defined as Assets minus Liabilities. Shareholders’ equity
includes capital contributed by owners (common stock) plus the entire cumulative earnings of the
firm that has not been distributed as dividends (retained earnings).
The balance sheet lists specific items of Assets, Liabilities, and Owners’ Equity. There are totals
(arithmetic sums of the values listed for the various items) displayed as well.
C.
Assets - economic resources that are expected to generate future cash flows
1. Typically ordered by liquidity or “closeness to turning into cash.” So, the most liquid assets are
listed first, followed by next most liquid, etc.
2. Short Term (or “current”) – expected to turn into cash within the firm’s operating cycle; most
firms have operating cycles of one year or less.
a. Cash
b. Marketable Securities or Short Term Investments
c. Accounts Receivable
d. Inventories
3. Long Term (or “non-current”) –expected to turn into cash sometime after one operating cycle.
a. Investments
b. Property, Plant and Equipment (“PP&E”)
c. Intangible Assets
d. Other
D.
Liabilities - economic obligations to outsiders or claims against assets by outsiders
1. Short Term (“current” – due within one year)
2. Long Term (“non-current” – due after one year)
E.
Owners’ Equity - the residual interest in assets after deducting liabilities
1. Common stock at par value
2. Contributed capital (also called additional paid in capital, “APIC”)
3. Retained earnings (earnings not paid out in the form of dividends, but reinvested within the
firm)
4. Treasury shares (shares that are bought back)
5. Noncontrolling Interests
6. Accumulated other comprehensive income
F.
Note that we have not said anything yet about how assets are valued (historical cost, market value,
fair value, inflation-adjusted, etc.).
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III. Income Statement
A.
A measure of performance during a period of time.
Income, net income, earnings (often used interchangeably). Negative income = loss or net loss
B.
Net Income = Revenues - Expenses + Gains/Losses
Revenues
–

Asset inflows from
selling goods and
services
Expenses
+

Expired costs
associated with
revenues
Gains
– Losses


Other asset
Other expired
inflows
costs
Revenues = sales prices times quantities generated in the normal ongoing course of business
Expenses = all costs associated with normal ongoing operations
Gains/Losses = sources of revenue and expense which are not associated with ongoing business
operations. Examples include: gains and losses on sales of assets (if not part of normal business) or
sale of a business segment.
C.
Income not declared as dividends increases retained earnings. This concept links the income
statement (statement of operations) to the balance sheet:
RetainedEarningst  RetainedEarningst 1  NetIncomet  Dividendst
t represents the time subscript. If dividends exceed the net income, retained earnings will
decrease. Moreover, losses (negative income) decrease retained earnings (or increase
accumulated deficit). Losses occur when expenses exceed revenues.
1. Since the balance sheet equation must hold at both the beginning and the end of the period, it
also holds for changes in account balances (denoted by ).
Assets  Liabilities
= Owners’ Equity
= Retained Earnings + Contributed Capital
= Net Income  Dividends + Contributed Capital
2. This reconciliation of the income statement and the change in the shareholders’ equity account
is done in the statement of shareholders’ equity.
D.
In the United States, accounting income that you report to shareholders is not the same thing as the
income you report to the Internal Revenue Service (IRS) for tax purposes. Stated differently, firms
have two sets of books: one for financial reporting (i.e., the financial statements that are filed with
the SEC and which form the basis for investors’ and creditors’ assessments of value and financial
health), and another for tax purposes. We often refer to the first set as the financial reporting books
while the other set of books is the tax books. In many other countries, taxable income and book
income are much closer than they are in the United States.
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E.
Earnings per share
1. Net income is calculated on a total (dollar, in the US) basis as well as on a per share basis. The
earnings per share number is calculated by dividing net income by the weighted average
number of shares outstanding for the period. So, for example, if the firm had 100 shares
outstanding for 10 months of the year and 200 shares outstanding for the other two months, the
weighted average number of shares outstanding is:
10
2
(100)  (200)  116.667
12
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2. We also distinguish between “basic” and “diluted” shares outstanding. While this topic is
beyond the scope of the course, we briefly comment on it here for those who are exceptionally
eager. Some firms have instruments (like stock options, convertible debt, warrants) which,
while not currently common stock, have the ability to convert into common stock at either the
firm’s discretion or the holder’s discretion. The “diluted” number of shares outstanding shows
the number of common shares that would be outstanding if all these instruments were to
convert into common shares at the date of the balance sheet.2 The “basic” number shows the
number of common shares without these conversions.
IV. Cash Flow Statement
A.
At the most simplistic level, the statement of cash flows can be viewed as reconciling the beginning
and ending balance of the cash account (or cash and cash equivalents).
B.
More importantly, it separates the effects of operating, investing, and financing activities of the firm
on cash flow.
C.
Sometimes cash inflows and outflows are shown directly on the face of the statement. This is called
the “direct method.”
D.
Firms more commonly use the “indirect method.” We investigate both approaches in a later lecture
note. Briefly, the indirect method starts with net income and “backs into” cash flow.
E.
Note that the cash flow statement totally ignores the future; it looks only at events and transactions
that resulted in cash this period.
V. Statement of Shareholders’ Equity
A.
Provides a summary of what has happened to each of the major shareholders’ equity accounts
during the period.
B.
For common stock, the firm shows both the number of shares and the dollar value attached to those
shares.
2
Note that in calculating diluted Earnings per share, it may be necessary to make adjustments to net income as well.
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VI. Preparation of Financial Statements
A.
Management is responsible for preparing financial statements and for the fairness of the
representation of the financial statements.
B.
The auditor's role is to examine the financial statements that have been prepared by management
and to express an opinion regarding their “reliability.”
C.
Accounting statements are constructed according to Generally Accepted Accounting Principles
(GAAP). Congress granted the Securities and Exchange Commission (SEC) the authority to decide
on the appropriate accounting principles. The SEC has delegated this job to the Financial
Accounting Standards Board (FASB), a private rule-setting body. The accounting standard setting
process is influenced by political considerations, not just “accounting logic.”
D.
Accounting is not just backward looking; the definitions of assets and liabilities are based on future
cash flows.
E.
Because accounting is forward looking (at least somewhat), there is considerable room for
judgment in the accounting.
F.
Management is the most knowledgeable about the firm’s financial position, its future plans, what
the long term impact of past and current actions is likely to be, etc.
G.
Management often has the most to gain from misrepresenting the financial statements (i.e., the
financial position of the firm and/or the firm’s performance for the year).
H.
Accounting is moving from a mixed attribute (historical cost and fair values) framework toward a
fair value framework.
VII. Basic Bookkeeping
A.
Journal entries - Debits and Credits
Journal entries represented by debits and credits are mechanisms that accountants use to ensure that
the balance sheet maintains its “balance.” By balance we mean that assets always equal the sum of
liabilities plus equity. We can ensure this balance by making sure that whenever we add (or
subtract) an asset from the balance sheet, we add (subtract) something else to make sure we stay in
balance. Journal entries achieve this by showing (usually in the top lines, and those not indented)
the “debits” with the other lines (usually below, and usually indented) showing the “credits.”
Debits and credits have no meaning outside of accounting, so don’t impute a meaning to them that
you think they should have. A debit is used to indicate an increase in an asset account and a
decrease in a liability or equity account. A credit implies the opposite: a decrease to an asset
account and an increase in a liability or equity account. So, for example, if you debit Cash and
credit Bank borrowings, what does this mean you did?
Journal entry:
Cash (Dr)
Bank borrowings (Cr)
XXX
XXX
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It means you borrowed money from the bank (thus increasing your liabilities) and increased your
assets by the amount of cash received. Notice that we use (Dr) and (Cr) as short forms for debits
and credits in the journal entry. However, it is not necessary to parenthetically indicate which one is
a debit or credit because the indentation and placing the credit amounts in an adjacent column is
sufficient to indicate which of the accounts is being debited and credited.
What if you then took the cash you borrowed and then bought some equipment: what would your
journal entry look like?
Journal entry:
Equipment (Dr)
Cash (Cr)
XXX
XXX
You would debit Equipment and credit Cash, as shown above. Note that in the first case you
increased an asset account (Cash) and increased a liability account (Bank borrowings) to keep the
balance sheet in balance. In the second journal entry, you decreased one asset account (Cash) and
increased another asset account (Equipment) to maintain balance.
B.
T-accounts
A t-account is just a picture illustrating the activity in a given account. Consider the asset account
for Cash:
Cash (A)
Dr.
Cr.
XXX
YYY
In a t-account, the convention is that the debited amounts are entered on the left and credits are
entered on the right. While we will discard indicating the Dr. and Cr. in future t-accounts, it is a
useful practice to write Dr. and Cr. each time you open a t-account.
Asset accounts typically have a debit balance while liabilities and equity accounts have a credit
balance. Because cash is an asset account, debits to it (the XXX’s) increase the account, while
credits to it (the YYY’s) decrease it. Cash would be expected to have, on net, a debit balance at any
point in time. We show the ending balance, pictorially, by drawing a line across the bottom and
reporting the net debit or credit. For example, suppose the beginning balance in cash is AAA. Then
the ending balance in cash, given the transactions that generated an increase in cash of XXX and a
decrease in cash of YYY, must be ZZZ = AAA + XXX – YYY.
Beg. Bal.
Cash (A)
AAA
XXX
End. Bal.
ZZZ
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YYY
Liability and equity t-accounts work the same way, except that the natural3 beginning and ending
balances in these accounts are credits not debits (as was the case for asset accounts). For example,
let us consider the liability account for Bank Borrowings:
Bank Borrowings (L)
AAA
Beg. Bal.
YYY
XXX
ZZZ
End. Bal.
Unlike the cash account, the beginning balance for Bank Borrowings is a credit balance as it
represents a liability. Given the transactions that generated an increase in bank borrowings of XXX
and a decrease in borrowings of YYY, the ending balance must be ZZZ = AAA + XXX – YYY.
C.
Examples of common transactions (and their t-account journal entries)
Transaction
Issued debt
Balance Sheet Accounts Affected:
Cash (A)
Bonds Payable (L)
XXX
Purchased inventory with cash
XXX
Cash (A)
XXX
Purchased inventory on credit
Accounts Payable (L)
XXX
Paid suppliers
Cash (A)
XXX
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Inventory (A)
XXX
Inventory (A)
XXX
Accounts Payable (L)
XXX
By this we mean that generally Liability (Asset) Accounts will have Credit (Debit) balances. But, on occasion
these accounts will have opposite balances. During the course, we will come across some of these unnatural
balances in these accounts.
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Purchased PP&E
Cash (A)
PP&E (A)
XXX
Sold products for cash
(1) Record revenues
Cash (A)
XXX
(2) Record costs
Cost of Goods Sold (RE)
Accounts Receivable (A)
Cost of Goods Sold (RE)
Cash (A)
Accts Receivable (A)
XXX
Operating Expenses (RE)
XXX
Declared a dividend
Inventory (A)
XXX
XXX
Incurred operating expenses
Sales revenues (RE)
XXX
XXX
Collected receivables
Inventory (A)
XXX
XXX
(2) Record costs
Sales revenues (RE)
XXX
XXX
Sold products on credit
(1) Record revenues
XXX
Accounts Payable (L)
XXX
Dividends Declared (RE)
XXX
Dividend Payable (L)
XXX
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Paid the dividend
Cash (A)
Dividend Payable (L)
XXX
Recognized depreciation
Expense
Deprn. Expense (RE)
XXX
PP&E (A)
XXX
Accrued interest expense
XXX
Interest Expense (RE)
Interest Payable (L)
XXX
Paid the interest
XXX
Cash (A)
Interest Payable (L)
XXX
XXX
The above transactions use the notation RE to refer to an item that affects the balance sheet through
its effect on retained earnings (which is part of the equity section of the balance sheet). Items affect
RE because they affect net income, which comes from the income statement. This is because of the
relation (noted earlier) which links the balance sheet and the income statement:
RetainedEarningst  RetainedEarningst 1  NetIncomet  Dividendst
RE labeled accounts are “temporary” accounts because they are always “closed” to retained
earnings at the end of the reporting period. By “closed” we mean that the account is zeroed out, by
charging any amount in it to retained earnings. Here is an example closing of sales revenues of
$245,000 at the end of the reporting period. For purposes of this example, assume that all of the
sales were on credit (just so you can see the entire cycle of journal entries and charges to taccounts):
Revenue earned on credit
Sales
Sales revenues
245,000
Cash collected on some A/R
Cash
200,000
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Accounts
Receivable
245,000
Accounts
Receivable
245,000
200,000
Reporting period ends
(transfer revenues to retained
earnings)
Balances in accounts
Sales revenues
Retained Earnings
245,000
245,000
Sales revenues
245,000
Retained Earnings
245,000
245,000
0
Cash
245,000
Accounts
Receivable
200,000
245,000
200,000
45,000
200,000
Does the Balance Sheet balance? Yes! Note that total assets = Cash of $200,000 plus AR of
$45,000, or $245,000. What about the sum of liabilities plus equity? There are no liability accounts
here and the only equity account is retained earnings and it has a balance of $245,000.
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