Financial Statements, Ratios, and Internal Controls: Comprehensive Guide for Students

Purpose of SCF

Shows cash inflows/outflows from Operating, Investing, and Financing activities.

Operating Activities

Cash from day-to-day business (revenues, expenses, working capital changes).

Investing Activities

Cash from long-term assets (buy/sell equipment, buildings, investments).

Financing Activities

Cash from owners & creditors (borrowings, stock, dividends).

Non-cash activities

Reported at bottom of SCF (ex: issuing stock to buy equipment).

Indirect Method

Starts with Net Income → adjusts for non-cash items → adjusts for changes in current assets & liabilities.

Add-backs (Indirect Method)

Add depreciation, losses, decreases in current assets, increases in current liabilities.

Subtractions (Indirect Method)

Subtract gains, increases in current assets, decreases in current liabilities.

Current Ratio

Current Assets ÷ Current Liabilities.

Debt-to-Equity Ratio

Total Liabilities ÷ Total Equity.

Return on Equity (ROE)

Net Income ÷ Average Equity.

Net Profit Margin

Net Income ÷ Sales.

Horizontal Analysis

% change from one period to the next → (New-Old)/Old.

Vertical Analysis

% of a base line (e.g., % of total assets or % of net sales).

Liquidity

Ability to pay short-term obligations.

Solvency

Ability to survive long-term, manage debt.

Net Income flows to...

Ending Retained Earnings (via the Statement of Retained Earnings).

Ending Retained Earnings flows to...

Balance Sheet under Stockholders' Equity.

Cash on SCF flows to...

Ending cash on the Balance Sheet.

Balance Sheet equation

Assets = Liabilities + Equity.

Retained Earnings equation

Beginning RE + Net Income - Dividends = Ending RE.

Income Statement → RE → Balance Sheet

Shows how profit becomes equity.

Relevant Revenues

Revenues that change between alternatives.

Relevant Expenses

Costs that change between alternatives.

Differential Income

Difference in expected net income between two choices.

Sunk Costs

Already incurred → NOT relevant.

Opportunity Cost

Benefit lost by choosing one alternative over another.

Current vs. Proposed

Proposed - Current = Financial impact of decision.

Objective of Internal Controls

Protect assets, ensure reliable accounting, promote efficiency, follow laws/regulations.

Establish Responsibility

Only one person is responsible for each task.

Segregation of Duties

Split recordkeeping, custody, and authorization.

Documentation Procedures

Use invoices, receipts, prenumbered documents.

Physical Controls

Safes, locks, passwords.

Independent Internal Verification

Reconcile records, audits, reviews.

Human Resource Controls

Background checks, mandatory vacations.

Effective Governance & Oversight

Tone at the top, strong leadership accountability.

Monsanto Fraud

Failed to record rebate expense/payable → overstated net income & understated liabilities.

Proper Rebate Entry

Dr Rebate Expense; Cr Rebate Payable.

Worldcom Fraud

Capitalized expenses as PP&E → overstated assets & net income.

Correct Worldcom Entry

Dr Expense; Cr Cash/AP (NOT PP&E).

Accounting Equation

Assets = Liabilities + Equity.

Journal Entry

Debits on left, credits on right; must balance.

Ledger

Collection of all T-accounts.

Trial Balance

List of all accounts and balances → ensures debits = credits.

Adjusting Entries

Required at end of period to update accounts (accruals & deferrals).

Closing Entries

Close revenues, expenses, and dividends into Retained Earnings.

Accrual Accounting

Record revenues when earned & expenses when incurred.

Revenue Recognition Principle

Record revenue when the company provides goods/services.

Matching Principle

Record expenses in same period as related revenue.

Depreciation

Allocation of cost of long-term assets over useful life.

Contra-Asset

Offsets an asset (ex: Accumulated Depreciation).

FOB Shipping Point

Buyer owns goods during transit.

FOB Destination

Seller owns goods during transit.

Assets

Resources owned providing future benefit.

Liabilities

Obligations owed to creditors.

Equity

Owners' claim on assets.

Revenue

Earnings from operations.

Expense

Costs incurred to generate revenue.

Dividends

Distributions of earnings to shareholders.

GAAP

Rules companies must follow for financial reporting.