Financial Accounting Notes

Introduction to Financial Accounting

Motivation

  • Financial Accounting is the language of business, used to communicate a firm's financial and economic information to external parties.
  • Example: Apple's earnings conference call.
  • Throughout the term, focus will be on:
    • Understanding financial accounting terminology.
    • Understanding accounting principles.
    • Learning to record transactions.
    • Preparing financial statements.
    • Interpreting financial statements for decision making.

Financial Statements

  • Accounting is an information system that:
    • Measures business activities.
    • Processes data into financial statements, and then into a full report.
    • Communicates results to decision makers.
  • A financial report includes business documents that companies use to report the results of their activities to various user groups.
  • Key financial statements include:
    • Income Statement
    • Statement of Retained Earnings
    • Statement of Cash Flow
    • Balance Sheet
  • These statements are accompanied by management discussion and analysis (MD&A) and footnotes.
  • Corporate financials are reported annually and quarterly.
  • Public listed firms file both (unaudited) quarterly and (audited) annual reports to regulatory agencies like the U.S. SEC (U.S. Securities and Exchange Commission).
  • Example: Apple’s annual report in 2021 (2021’s 10-K).

A Glance at Financial Statements

  • EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) stores financial statements for firms required to file annual reports with the U.S. SEC.
  • Since 1996, companies submit annual financial reports to EDGAR.
  • 10-K is the form for annual reports, and 10-Q is for quarterly reports.
  • 10-K/10-Q contains financial statements, business descriptions, management discussion and analysis (MD&A), and footnotes.
  • For financial statements at a highly-aggregated level, finance.yahoo.com can be used.

Access Annual Reports at EDGAR

  • Input ticker or company name.
  • Search for 10-K.
  • Before 2001, 10-K form was in plain text; more recently, it is in HTML.
  • Use Python to parse 10-K HTML files.

EDGAR Usage

  • Financial analysts and institutional investors extensively utilize information on 10-K at EDGAR.
  • Analysts compare financial conditions cross-sectionally (with industry peers) and time-series wise (with the firm’s historical performance).

The 10-K (Annual Report) Parts

  • Part 1
    • Item 1 – Business
    • Item 2 – Properties
    • Item 3 – Legal Proceedings
    • Item 4 – Mine Safety Disclosures
  • Part 2
    • Item 5 – Market
    • Item 6 – Consolidated Financial Data
    • Item 7 – Management's Discussion and Analysis of Financial Condition and Results of Operations
    • Item 8 – Financial Statements
    • Item 9 – Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
  • Part 3
    • Item 10 – Directors, Executive Officers and Corporate Governance
    • Item 11 – Executive Compensation
    • Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    • Item 13 – Certain Relationships and Related Transactions, and Director Independence
    • Item 14 – Principal Accounting Fees and Services
  • Part 4
    • Item 15 – Exhibits, Financial Statement Schedules
    • Signatures

Balance Sheet

  • The balance sheet or statement of financial position reports the company’s assets, liabilities, and owner’s equity as of a specific date.
  • Assets are economic resources that benefit the business now and in the future:
    • Cash/Cash Equivalents
    • Accounts receivable
    • Inventory
    • Notes receivable
    • Prepaid expenses
    • Land
    • Buildings
    • Equipment, furniture, and fixtures
  • Liabilities are the debts of the company, i.e., outsider claims:
    • Accounts payable
    • Notes payable
    • Bank loans
  • Owner’s (shareholders’) equity is the owner’s claim to the corporation, i.e., insider claims:
    • Contributed capital (65%)
    • Equity Debt (35%)

Apple's Balance Sheet

  • Includes items like iPhones, iPads, iPods, iMacs.
  • Lists current assets (Cash and cash equivalents, marketable securities, accounts receivable, inventories, vendor non-trade receivables, other current assets, total current assets).
  • Lists non-current assets (Marketable securities, property, plant and equipment, other non-current assets, total non-current assets).
  • Total assets.
  • Lists current liabilities (Accounts payable, other current liabilities, deferred revenue, commercial paper, term debt, total current liabilities).
  • Lists non-current liabilities (Deferred revenue, term debt, other non-current liabilities, total non-current liabilities).
  • Total liabilities.
  • Commitments and contingencies.
  • Shareholders' equity (Common stock and additional paid-in capital, retained earnings, accumulated other comprehensive income/(loss), total shareholders' equity).
  • Total liabilities and shareholders' equity.

Income Statement: A Performance Report

  • The income statement, statement of operations, or statement of earnings reports the company’s revenues, expenses, and net income (net loss if negative) for a period.
  • Revenues are sales revenue (after subtracting all sales returns).
  • Expenses are the cost of those sales (raw materials, manufacturing costs, HR costs, R&D expenses, etc.).
  • The income statement summarizes the company’s performance during a period.
  • The top-line number is always sales revenue, and the bottom-line number is always net income.
  • Accountants often call net income as bottom-line earnings.
  • Investors pay attention to bottom-line earnings.
  • This is reflected in commonly used performance measures, such as earnings per share (i.e., EPS).

Apple's Income Statement

  • Includes net sales, cost of sales, gross margin.
  • Operating expenses (Research and development, selling, general and administrative, total operating expenses).
  • Operating income.
  • Other income/(expense), net.
  • Income before provision for income taxes.
  • Provision for income taxes.
  • Net income.
  • Earnings per share (Basic and Diluted).
  • Shares used in computing earnings per share (Basic and Diluted).

Statement of Cash Flows

  • This statement details how the company earns/spends cash from three components.
  • The statement of cash flows measures the cash-generating ability of the company during the period.
  • Cash inflows and outflows are from:
    • Cash from Operations (CFO): How the company earns cash through normal operating activities.
    • Cash from Investing (CFI): How the company earns/spends cash through investing activities.
    • Cash from Financing (CFF): How the company finances cash through financing activities (borrowing from creditors/raising cash from investors).
  • Any transaction that affects the cash account in the balance sheet will show an activity in the statement of cash flows.

Apple's Statement of Cash Flows

  • Cash and cash equivalents at the beginning of the year.
  • Operating activities: Net income, adjustments to reconcile net income to cash generated by operating activities (depreciation and amortization, share-based compensation expense, deferred income tax expense/(benefit), other).
  • Changes in operating assets and liabilities: Accounts receivable, net; inventories; vendor non-trade receivables; other current and non-current assets; accounts payable; deferred revenue; other current and non-current liabilities.
  • Cash generated by operating activities.
  • Investing activities: Purchases of marketable securities, proceeds from maturities of marketable securities, proceeds from sales of marketable securities, payments for acquisition of property, plant and equipment, payments made in connection with business acquisitions, net, purchases of non-marketable securities, proceeds from non-marketable securities, other.
  • Cash generated by/(used in) investing activities.
  • Financing activities: Proceeds from issuance of common stock, payments for taxes related to net share settlement of equity awards, payments for dividends and dividend equivalents, repurchases of common stock, proceeds from issuance of term debt, net, repayments of term debt, change in commercial paper, net.
  • Cash used in financing activities.
  • Increase/(Decrease) in cash and cash equivalents.
  • Cash and cash equivalents at the end of the year.
  • Supplemental cash flow disclosure: Cash paid for income taxes, net; cash paid for interest.

Accounting Equation

  • Assets are economic resources of a business expected to produce a benefit in the future.
  • Liabilities are “outsider claims” or economic obligations payable to outsiders.
  • Owners’ equity represents the “insider claims” of a business.
  • For a corporation, shareholders’ equity is divided into contributed capital and retained earnings.
  • Contributed capital is the amount invested in the corporation by its owners, with common shares being the basic component.
  • Retained earnings is the amount earned by income-producing activities and kept for use in the business.
  • Equation: Assets = Liabilities + Owners’ Equity
  • Rationale: Economic Resources = Claims to Economic Resources
  • Assets = Liabilities + Contributed capital + Retained earnings

Retained Earnings

  • Earnings are the net income a company earns over each period.
  • Earnings increase the company's value.
  • Periodically, a company declares and pays dividends to shareholders.
  • Dividends are a payment made by a corporation to its shareholders, rewarding their investment.
  • Dividends decrease the company's value
  • Retained earnings is the amount earned and kept within the company.
  • It is essentially the sum of all prior earnings after subtracting dividends.
  • Statement of Retained Earnings follows the equation:
  • Ending balance of retained earnings = Beginning balance of retained earnings + Net income (or - Net loss) – Dividends declared

Apple's Statement of Shareholders' Equity

  • Balances as of September 26, 2015, including common stock and additional paid-in capital, retained earnings, accumulated other comprehensive income/(loss), and total shareholders' equity.
  • Net income.
  • Other comprehensive income/(loss).
  • Dividends and dividend equivalents declared at $2.18 per share or RSU (Restricted Stock Units).
  • Repurchase of common stock.
  • Share-based compensation.
  • Common stock issued, net of shares withheld for employee taxes.
  • Tax benefit from equity awards, including transfer pricing adjustments.
  • Balances as of September 24, 2016.
  • Net income.
  • Other comprehensive income/(loss).
  • Dividends and dividend equivalents declared at $2.40 per share or RSU.
  • Repurchase of common stock.
  • Share-based compensation.
  • Common stock issued, net of shares withheld for employee taxes.
  • Tax benefit from equity awards, including transfer pricing adjustments.
  • Balances as of September 30, 2017.
  • Cumulative effect of change in accounting principle.
  • Net income.
  • Other comprehensive income/(loss).
  • Dividends and dividend equivalents declared at $2.72 per share or RSU.
  • Repurchase of common stock.
  • Share-based compensation.
  • Common stock issued, net of shares withheld for employee taxes.
  • Balances as of September 29, 2018

A Quick Summary of Financial Statements

  • Income statement
    • Question: How well did the company perform (or operate) during the period?
    • Equation: Revenues – Expenses = Net income
    • If net income is negative, it is called net loss.
  • Statement of Retained Earnings
    • Question: Why did the company’s retained earnings change during the period?
    • Equation: Beginning Retained Earnings +/- Net income (loss) – Dividends = Ending Retained Earnings
  • Balance sheet
    • Question: What is the company’s financial position at the end of the period?
    • Equation: Assets = Liabilities + Owners’ equity
  • Cash flow statement
    • Question: How much cash did the company generate and spend during the period?
    • Equation: Operating cash flows + Investing cash flows + Financing cash flows = Total Δ in cash