Chapter 3

1. Chapter 3 Introduction to Financial Statements

2. Objectives of Financial Accounting • Generally accepted accounting principles (GAAP) • Objective: present fairly the financial position of a company to current and potential stockholders, creditors, security analysts, and other interested parties • Certified public accountant (CPA): audits financial statements according to GAAP and renders opinions on whether the statements present fairly the financial condition of firm

3. Objectives of Financial Accounting • GAAP • No single, universally-accepted definition • Varying interpretations and applications • Working definition: set of objectives, conventions, and principles that have evolved over the years to govern the preparation and presentation of financial statements

4. Objectives of Financial Accounting • Depreciation accounting: a means of allocating cost of long-lived assets to number of accounting periods in which asset is expected to be used

5. Objectives of Financial Accounting • Sources of financial accounting “rules” • Securities and Exchange Commission (SEC) Accounting Series Releases • American Institute of Certified Public Accountants (AICPA) Accounting Research Bulletins (ARBs) • AICPA Accounting Principles Board (APB) • Statements of the Public Company Accounting Oversight Board • Releases of the Emerging Issue Task Force (EITF)

6. Objectives of Financial Accounting • Sources of financial accounting “rules” (continued) • Financial Accounting Standards Board (FASB) • Currently most important source of authoritative pronouncements on accounting principles • Appointed by Financial Accounting Foundation, an independent, nonprofit organization • Issues Statements of the FASB • Established Governmental Accounting Standards Board (GASB) to establish accounting standards for state and municipal governments

7. Objectives of Financial Accounting • GAAP apply only to field of financial accounting and not to other major fields of accounting such as tax, managerial, and cost accounting • Objectives • Tax accounting: minimize a firm’s tax liability within the constraints imposed by current income tax laws • Managerial accounting: collect, report, and interpret information needed for managerial decision making • Cost accounting: identify and assign relevant costs in a business organization

8. Objectives of Financial Accounting The Auditor’s Opinion A complete audit of every single transaction in a large corporation cannot be done in a reasonable time or at a reasonable cost. • The same transaction may be accounted for in different ways according to different systems.

9. The Auditor’s Opinion • Clean Opinion of Financial Statements • Scope: indicates which statements were audited and informs the reader that generally accepted auditing standards were followed and that tests considered necessary by the auditors were undertaken • Opinion (not certification): statements “present fairly” the financial condition of firm in “conformity with [GAAP]”

10. The Auditor’s Opinion • Qualified opinion: indicates some lack of conformity with GAAP • Footnotes are an integral part of financial statements and provide an important and useful summary of the firm’s accounting policies.

11. The Balance Sheet • Balance sheet • A “snapshot” of the financial condition of a company at a given moment in time • A stock statement that represents the stock of assets, liabilities, and equities as of a given instant • Three major sections • Assets: total resources of the firm in dollar terms • Liabilities: claims of various classes of creditors against assets • Equities: includes net worth account, or excess of assets over creditors

12. The Balance Sheet • “Basic accounting equation” • Assets = Liabilities + Equities • Total Business Resources = Creditor’s Claims and Owner’s Claims * Two sides balance, or equal, each other!

13. The Balance Sheet • Assets • Current assets: cash and other assets that are normally converted into cash within a year or within one operating cycle • Marketable securities: short-term investments of cash in highly liquid, low-risk securities (i.e. U.S. Treasury bills, prime commercial paper) • Accounts receivable: amount due the company for goods that have been shipped (or services rendered), but for which the company has not yet been paid • Allowance for bad debts: company’s estimate of total dollar amount of current receivables that will eventually become uncollectible. • Inventories: raw materials, goods in process, and finished goods • Valued at cost or market value

14. The Balance Sheet • Assets (continued) • Fixed Assets • i.e. property, plant, and equipment • Highly illiquid • Used over long periods of time • Value: historical cost less accumulated depreciation • Accumulated depreciation: cumulative total dollars of depreciation that have been “charged off” against the historical cost of company’s current fixed asset base

15. The Balance Sheet • Liabilities and Equities • Current liabilities: debts that will fall due within one year or one operating cycle • Accounts payable to the firm’s suppliers, short-term notes payable, the currently due portion of any long-term debt, and various categories of accrued expenses • Accrued expenses: expenses that have been incurred as of the balance sheet date, but that have not yet been paid in cash (i.e. salaries and wages due to employees, interest due on loans, accrued utilities expenses) • Long-term liabilities: long-term debt owed to banks or other creditors and any obligations under capital leases

16. The Balance Sheet 2. Liabilities and Equities (continued) • Equities: owners’ interest in company represented by various classes of shares of stock • Preferred stock: if dividends are not paid in a given year they are considered in arrears and must be paid in full before dividends can be paid on common stock • Par value of the common stock: when stock is sold, it must be entered on the books of the corporation at an assigned or “legal value” • Some states elect to have no par value • “Paid-in capital” or “amounts contributed in excess of par value”: amount for which stock is sold over and above its par value

17. The Balance Sheet • Liabilities and Equities (continued) • Equities • Retained earnings: firm’s reinvested earnings over the years that have not been paid out in dividends • “Belong” entirely to common stockholders • Represent buildup of their equity interest over time

18. The Balance Sheet • The relationship between current assets to current liabilities is important! • Short-term liquidity: ability of firm to meet its current obligations as they fall due Net working capital Circulating capital Current assets Current liabilities

19. The Balance Sheet • Margin of safety: Current assets should be approximately twice as large as current liabilities • Lags in conversion of inventories to receivables and then to cash • Marketable securities: subject to possible temporary or even permanent declines in market value • Accounts receivable: subject to bad-debt losses • Inventories: subject to physical deterioration, unsalability, declines in market value

20. The Balance Sheet • Preferred stock vs. Common stock • Preferred Stock • Benefit: P.S. has a priority claim to its annual dividend and preference as to distribution of asset values in event of a liquidation • But: P.S. relinquishes any claims to earnings above the annual dividend • Common stock • Benefit: earnings above annual dividend are distributed among C.S. holders • But: C.S. accepts risk of variable dividends (not guaranteed) and risk of charging stock values in response to changing fortunes of company

21. Book Value of Securities • Book value: value at which an asset is carried on the company’s balance sheet (“books”) • Assuming that all assets could be sold at book value and all current liabilities paid off, the net book value (or net asset value) represents the dollar value of the remaining assets that would be available to pay off each class of security in order of its preference in liquidation Bonds Preferred stock Common Stock

22. Books Value of Securities • Keep in mind… • “Going concern” assumption: there is no imminent danger of liquidation and therefore liquidation value is not the most relevant variable in determining the value of its securities • Assets may be sold at more or less than book value. • Market values are determined by market forces that may be only marginally related to book values

23. The Income Statement Stock of financial resources on December 31, 2007 Flow of revenues and expenses during calendar year 2008 Stock of financial resources on December 31, 2008 • Balance Sheet vs. Income Statement • The balance sheet represents the financial position of the firm at a given instant, whereas the income statement portrays the results of operations for a period of time. Balance sheet December 31, 2007 Income Statement Calendar year 2008 Balance sheet December 31, 2008

24. The Income Statement • Components of the Income Statement • Current and retained earnings: annual sales revenue, various categories of costs and expenses, net earnings before/after tax, earnings per share of common stock • Sales figure: total sales revenue for the year, net of any sales return or discounts allowed • Cost of goods sold: material costs, direct factory labor, factory overhead costs • Depreciation: total dollar amount of plant and equipment depreciation for year • Selling and administrative expenses: all other categories of operating expenses

25. The Income Statement • Components of the Income Statement (continued) • Operating profit: sales less total operating expenses, or amount of gross profit earned from normal operations • Other income: miscellaneous income from sources other than normal operation (i.e. interest on notes receivable, capital gains and losses) • Interest expense account: normally listed separately since it represents a financing expense • Deducting interest expense: net income for the year on a per share basis • Conversion calculation: deduct preferred-stock dividends paid from net income, then divide remainder by average number of shares of common stock outstanding during the year.

26. The Income Statement • Supplemental “pro forma” or “operating” earnings present the “core” operating earnings of the company independent of the impact of what the company may consider to be nonrecurring, unusual transactions.

27. The Income Statement • The statement of accumulated and retained earnings illustrates a key relationship between the balance sheet and income sheet. Retained earnings* December 31, 2007 Net income 2008 Dividends Paid 2008 Retained earnings December 31, 2008 *Occasionally distributions of losses may be deducted from retained earnings.

28. Statement of Cash Flows • Statement of cash flows: shows all of the sources and uses of cash during the year and details the overall change in total of cash and marketable securities (“cash equivalents”) during the year • Three major sources for cash flows: • Operating activities • Investing activities • Financing activities

29. Statement of Cash Flows • Cash flow statement provides important information about the company’s management of stockholders’ resources and a useful picture of how cash flows through the business.

30. Sarbanes-Oxley and Financial Statements • Sarbanes-Oxley Act • Public company CEOs and CFOs are required to “certify” the company’s quarterly and annual financial statements, stating that the financial statements are accurate. • Public companies and their accountants are required to review the company’s “internal controls” and provide a public statement as to the effectiveness of those controls • Accounting firms have become much more proactive in requiring corporate executives to certify themselves the quality of the information provided to the accounting firms. • Public companies are required to minutely detail the firm’s processes under Section 404 of the Act.