Week 1 (Financial Statement Review)

What does accounting translate?

A company’s diverse activities into a set of objective numbers that provide information about the firm’s performance, problems, & prospects

What are the objectives of external financial reporting?

Provide information

• To be used by investors & creditors

• About the financial health of a business

• About performance (earnings) of a business

• About cash flows of a business

What is the role of external financial reporting?

Facilitate economic transactions & foster efficient allocation of resources

Why do investors demand financial statement information?

Reduces the uncertainty associated w/ opportunities & risks of investing in a particular company

Why do companies supply financial information?

Reduces their cost of capital

What is the Securities & Exchange Commission (SEC)?

Authoritative body responsible for regulating companies whose stock is traded on a US exchange

What is the aim of SEC?

Ensure investors are provided w/ full & fair information about publicly traded companies

What does the SEC require?

Regular filing of annual reports (10-K), quarterly reports (10-Q), & reports highlighting significant events (8-K)

What is Financial Accounting Standards Board (FASB)?

Independent body responsible for promulgating Generally Accepted Accounting Principles (GAAP)

What is the aim of FASB?

Identify & correct financial reporting deficiencies through an open standard-setting process

What are the types of financial statements?

• Income statement

• Balance sheet

• Statement of cash flows

• Statement of changes in stockholders’ equity

What does the income statement report?

Performance of the firm over a period of time

What are the key elements of income statement?

• Revenues

• Expenses

• Gains

• Losses

When are accrual basis revenues recognized in?

Period in which performance obligation (to customer) is satisfied

When are accrual basis expenses recognized in?

Period in which they are incurred (that is, helped generate a benefit)

What are the items on an income statement related to a company’s operations?

• Revenues (Accomplishment)

• Expenses (Effort)

What are the items on an income statement related to secondary (peripheral) activities?

• Gains

• Losses

What is the usefulness of income statements?

• Evaluate past performance

• Predicting future performance

• Help assess risk or uncertainty of achieving future cash flows

What is the limitations of income statements?

• Companies omit items that cannot be measured reliably

• Income is affected by accounting methods employed

• Income measurement involves judgement

What is the performance measure on the income statement?

• Net income

• Gross profit

• Operating income

What is net income?

• Revenues - Expenses + Gains - Losses

• Reflects overall performance of the entity

What is gross profit?

Net Sales - Cost of Goods Sold

What is operating income?

• Net Sales - Cost of Goods Sold - Operating Expenses

• Reflects operating performance of the entity

What are revenues?

Inflows of net assets during a period from delivering or producing goods, rendering services, or other activities that constitute entity’s ongoing major or central operations

What is the earnings process?

• Start production

• Complete production

• Deliver

• Collect money

• Warranty expires

What is the matching principle?

Offset revenue (accomplishment) of a business w/ expenses (effort) that contribute to generating that revenue

What is the result of the matching principle?

Expenses are recognized on income statement in period in which they benefitted the company (incurred) & not necessarily when cash is paid for expenses

What are operating expenses?

Usual & customary costs that a company incurs to support its main business activities

What are examples of operating expenses?

• Cost of goods sold

• Selling expenses

• Depreciation expense

• Research & development expense

What are non operating items?

Relate to company’s financing & investing activities

What are examples of non operating items?

• Interest expense

• Interest or dividend income

• Gains & losses from sale of securities

What is earnings per share?

Amount of net income associated w/ each share of common stock (computed on an equivalent share basis)

What is basic EPS?

Computation based on historical amounts

What is diluted EPS?

Intended to present a worst-case scenario

What is the accounting equation?

Assets = Liabilities + Equity

Investing = non-owner financing + owner financing

What is the balance sheet?

• Reports a company’s resources & claims against those resources at a point in time

• Financial snapshot of business

• Mirrors accounting equation

  • Assets = liabilities + equity

  • Uses of funds = sources of funds

What are assets?

Future economic benefits controlled by a business entity as a result of a past transaction or event

How might we benefit from an asset?

• Convert it to cash (sell it)

• Using it in our every day operations

How are assets measured for balance sheet purposes?

Historical cost concept

• Most assets should be reported at amount paid for them (their historical cost) regardless of increases in market value

What are current assets?

Assets that be converted into cash, or used up, w/in 1 year, or the operating cycle (whichever is longer)

What is the operating cycle?

Average time it takes a business to convert cash to inventory, inventory to accounts receivable, & accounts receivable back to cash

What are current assets usually listed in?

Order of liquidity (most liquid being first)

What are the types of current assets?

• Cash & cash equivalents

• Short-term investments

• Accounts receivable, net

• Merchandise inventory

• Prepaid expenses

What are short-term investments?

Marketable securities & other investments that the company expects to dispose of in the short run

What are accounts receivable, net?

Amounts due to company from customers arising from sale of products & services on credit (“net” refers to subtraction of uncollectible accounts)

What is merchandise inventory?

Goods purchased or produced for sale to customers

What are prepaid expenses?

Costs paid in advance for rent, insurance, advertising, & other services

What are examples of non current assets?

• Long-term investments

• Property, plant, & equipment

• Intangible assets

What are long-term investments?

Marketable securities & other investments that the company DOES NOT expect to dispose of in short term

What are property, plant, & equipment?

Tangible assets that are used in company’s operations which are expected to benefit business for many years

What are intangible assets?

Assets that lack physical substance that are expected to benefit company’s operations for many years

What are liabilities?

• Obligations, or debts, that an entity must pay in money or services at some time in future b/c of past transactions or events

• Accountants focus on “probable sacrifice of future economic benefits”

What are current liabilities?

• Those obligations that are reasonably expected to be paid using current assets or by creating current liabilities

• Typically liabilities that are expected to be paid w/in 12 months or operating cycle, whichever is longer

What are examples of current liabilities?

• Accounts payable

• Accrued liabilities or accrued expenses

• Unearned revenue

• Short-term notes payable

• Current portion of long-term debt

What are accounts payable?

Amounts owed to suppliers for goods & services purchased on credit

What are accrued liabilities or accrued expenses?

Obligations for expenses that have been incurred but not yet paid

• Wages payable or accrued compensation

• Interest payable

• Accrued income taxes or income taxes payable

What is unearned revenue?

Obligations created when company accepts payment in advance for goods or services it will deliver in future

• Advances from customers

• Customer deposits

• Deferred revenues

• Unredeemed gift cards & gift certificates

What are short-term notes payable?

Debt payable to banks or other lenders w/in the next 12 months

What is current portion of long-term debt?

Principal portion of long-term debt that is due to be paid w/in 1 year

What are examples of non current liabilities?

• Long-term debt

• Other long-term liabilities

What is long-term debt?

Amounts borrowed from creditors that are scheduled to be repaid more than 1 year in the future

• Notes payable

• Mortgage payable

• Bonds payable

What are other long-term liabilities?

• Pension liability

• Deferred tax liability

What are the examples of stockholders’ equity?

• Capital stock

  • Common stock

  • Preferred stock

• Additional paid-in capital

  • Additional contributed capital

• Retained earnings

What is book value?

• Total Assets - Total Liabilities

• Stockholders’ Equity

What is market value?

• Market capitalization (market cap)

• Market value/share x # of shares of stock outstanding

What do statement of cash flows provide?

Information about the cash inflows & outflows from operating, financing, & investing activities during an accounting period

What are operating activities?

Transactions that generally involved producing & delivering a good or service

• Inflows: selling goods &/or services

• Outflows: incurring operating costs (salaries, advertising, insurance, etc)

What are investing activities?

Activities involving non-current assets & equity or debt investments in outside entities

• Inflows: sale of property & equipment & investment securities

• Outflows: purchase of property & equipment & investment securities

What are financing activities?

Activities that provide an entity w/ resources from either its owners or creditors

• Inflows: insurance of stock to investors & insurance of debt

• Outflows: repayment of principal on debt, payment of dividends

What are retained earnings?

Total net income earned by a company during its economic life minus any amounts paid out as a dividend (to stockholders) during that same economic life

• Starting + net income - dividends

What is management discussion & analysis?

• Management’s interpretation of the company’s recent performance & financial condition

• Managment’’s “forward-looking” opinions

• Provides information about critical accounting policies & accounting estimates

• Intended to give current & potential investors a candid overall view of the past, present, & future through managment’’s eyes

What is an audit report?

• Financial statements are management’s responsibility. Auditor’s responsibility is to express an opinion on those statements

• Auditing involves a sample of transactions, not investigation of each transaction

• Audit opinion provides reasonable assurance that the statements are free of material misstatements, not a guarantee

• Auditors review accounting policies used by management & estimates used in preparing the statements

• Financial statements are prepared, in all material respects, in conformity w/ GAAP

What do financial statement footnotes contain?

Information about assumptions, estimates, measurement procedures, & details behind summary numbers reported in body to financial statements