2 Review of Business Activities and Financial Statements

MODULE 2
Review of
Business Activities
and Financial
Statements
© Cambridge Business Publishers, 2021

Learning Objective 1
LO1
Examine and interpret
a balance sheet.
© Cambridge Business Publishers, 2021 2

Balance Sheet Basics
 The balance sheet has three sections:

 Assets
AKA: Owners’ equity
 Liabilities Shareholders’ equity
 Stockholders’ equity
ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

 The balance sheet reports the assets, liabilities, and
equity at a point in time
 Balance sheet accounts are permanent accounts
because their balance carries over from period to
period
Assets
An ASSET confers expected future economic benefits
An asset must meet the following two conditions to be

reported on the balance sheet
1. It must be owned or controlled by the company
2. It must arise from a past transaction or event

Apple, Inc. Balance Sheet: Assets

Current Assets
 Cash—currency and bank deposits

 Cash equivalents—investments with an original maturity of 90
days or fewer
 Short-term investments—marketable securities the company
expects to sell within the year
 Accounts receivable, net—amounts due from customers arising
from the sales on credit NET: after uncollectible accounts
 Inventories—goods purchased or have been subtracted
produced for sale to customers

 Prepaid expenses—costs paid in advance for rent, insurance,
advertising, and other services

Long-Term Assets
 Property, plant, and equipment (PPE), net—land, buildings, and

equipment NET: after accumulated
 Long-term investments— depreciation has been subtracted
investments the company does not intend to sell within the year
 Intangible and other assets—assets without physical substance
such patents, trademarks, franchise rights, and goodwill

Measuring Assets
Most assets are reported at historical cost – the original

acquisition cost and NOT at current market value
 If a company cannot value an asset with relative certainty, it
does not recognize an asset on the balance sheet
 This means that significant “assets” are not reflected on a
balance sheet
 Excluded assets often relate to knowledge-based or intellectual
property (IP) assets, such as a strong management team, a solid
supply chain, or superior technology

Effects of “Missing” Assets

Liabilities
Liabilities are future economic sacrifices
A liability has the following two characteristics:

1. It is an unavoidable obligation for the company
2. It must arise from a past transaction or event
A liability represents an amount that must be repaid

and can be:
3. Interest bearing – as in a bank loan
4. Non-interest bearing – as to a vendor or partner

Stockholders’ Equity
Stockholders’ equity represents capital that has been

invested by the stockholders
 Directly via the purchase of stock
 Indirectly in the form of retained earnings that reflect earnings
that are reinvested in the business and not paid out as
dividends

Apple’s Liabilities and Equity

Current Liabilities
 Accounts payable—amounts owed to suppliers for goods

and services purchased on credit AKA: Accrued expenses
 Accrued liabilities—obligations for expenses that have
been incurred but not yet paid (such as wages earned by
employees but not yet paid) AKA: Deferred revenues
 Unearned revenues—cash received from a customer in
advance for goods or services to be delivered later
 Short-term debt—short-term loans owing to banks or
other lenders AKA: Current portion
 Current maturities of long-term debt—principal portion of

long-term debt that is due to be paid within one year

Net Working Capital
 Net working capital AKA: Working capital
 The net working capital required to conduct business

depends on the company’s operating cycle, which is
the time between paying cash for goods and receiving
cash from customers AKA: Cash cycle
Cash Conversion Cycle (CCC)

Operating Cycle

Operating Cycle
Companies buy
inventory with cash and
supplier credit
(accounts payable)

Operating Cycle
Companies sell
inventory either on
credit (accounts
receivable) or for cash

Operating Cycle
When receivables are collected,

a portion of the cash received is
used to repay accounts
payable. The remainder goes to
the cash account for the next
operating cycle.

Operating Cycle

Cash Conversion Cycle
Apple & 3M
 Apple’s cash conversion cycle is negative

 Apple can invest the cash it receives from customers
for 73.6 days before paying suppliers
 3M’s cash conversion cycle is positive which is more
typical

Noncurrent Liabilities
 Noncurrent liabilities—obligations due after one year

 Long-term debt—principal loan amounts that are
scheduled to be repaid more than one year hence
 Long-term debt includes bonds, notes, debentures,
mortgages, and other long-term loans
 Other long-term liabilities—such as pension liabilities
and long-term tax liabilities, that will be settled a year
or more into the future

Contributed Capital
 Common stock—par value received from the original
sale of common stock to investors
 Additional paid-in capital—amounts received from the
original sale of stock to investors in excess of the par
value of stock AKA: Capital in excess of par
 Preferred stock—value received from the original sale

of preferred stock to investors
 Treasury stock—amount the company paid to
reacquire its common stock from shareholders.
Treasury shares are “held” by the company for
potential resale on the open market.
Earned Capital
 Retained earnings—cumulative net income that has
not been distributed to stockholders via dividends or
share repurchases
 Accumulated other comprehensive income or loss—

cumulative changes in asset and liability fair values
that are not reported in the income statement

Analyst Adjustments 2.1

Common Size Balance Sheet
AKA: Vertical analysis

 WHAT? Right-sizing
 Expresses the balance sheet in % terms
 Every line item on the balance sheet (A, L & Eq)
divided by total assets
 WHY?
 Compare a company across two or more years
 Compare two or more companies – adjusts for size and
currency differences
 Compare a company to industry or other benchmark

Boston Scientific
Common-Size Balance Sheet

Book Value v. Market Value
 Stockholders’ equity—the “value” of the company per

GAAP AKA: Book value
Book value of equity
 Market value = Number of common shares outstanding
× Company’s stock price
AKA: Market capitalization
 Book value ≠ Market value Market cap
 GAAP reports assets and liabilities at historical costs,
whereas the market attempts to estimate fair values
 GAAP excludes assets that cannot be reliably measured
 Market value adjusts for companies’ market characteristics
 GAAP does not consider expected future performance

Market Value vs. Book Value

LO2
Examine and interpret
an income statement.

Income Statement
 The income statement reports
 Revenues earned during a period
 Expenses incurred to produce those revenues
 Net income or loss (Revenue – Expenses)
 The general structure of the income statement:
AKA: Net revenue
Sales
AKA: Cost of sales

Cost of revenues
AKA: Earnings before interest and taxes (EBIT)

Apple’s Income Statement
Operating Expenses:
usual and customary costs a
company incurs to support its
operating activities
Nonoperating Income /
Expenses: relate to the
company’s financing and
investing activities

Accrual Accounting
 Revenues and expenses recognized on the income

statement are NOT determined by the cash received
or paid
 Two principles are the foundation of accrual
accounting
1. Revenue recognition principle
2. Expense recognition principle

Revenue Recognition Principle
 Recognize revenue when a performance obligation is

satisfied by transferring to a customer a promised good
or service
 Good or service is transferred when the customer
obtains control of that good or service
 Revenue is the amount the company expects to receive
 Revenue recognition may or may not coincide with cash
received
1. Revenue recognized & cash received simultaneously
2. Revenue recognized in current period & cash received later
3. Cash received in advance & revenue recognized later

Expense Recognition Principle
 Recognize expenses when incurred

 Expense recognition may or may not coincide with cash
payment
1. Expense recognized & cash paid simultaneously
2. Cash paid in advance & expense recognized later
3. Expense recognized in current period & cash paid later

Income Statement
 The income statement reports
 Revenues earned during a period
 Expenses incurred to produce those revenues
 Net income or loss (Revenue – Expenses)
 The general structure of the income statement:

Reporting of Transitory Items
 Discontinued operations: A disposal of a business unit

that represents a strategic shift that has, or will have,
a major effect on the company’s financial results
 Two components on the income statement (often
combined)
1. Net income / loss from the business prior to sale
2. Any gain or loss on the actual sale of the business
 Segregating Discontinued operations from Continuing
operations helps analysts to better isolate the core
reoccurring profit and cash flow of the business

Analyst Adjustments

Adjusting for Discontinued Operations
Should we treat these items as OPERATING or NONOPERATING?

 “Operating”
 The subsidiary has historically been treated as an operating asset
 Any income, gain, or loss should also be treated as operating
 “Nonoperating”
 The subsidiary ceases to be part of the company’s operations once
the decision is made to dispose of it
 Any income, gain, or loss is not core operating income
 Cash flow from the discontinued operations will not persist into the
future

Analyst Adjustments
 Discontinued operations at Eli Lilly in 2018 and 2019
 Analysts would NOT expect the huge 2019 gain to recur

 Would treat the entire amount as nonoperating

Two Important Margins
 Gross profit margin (Gross profit / Sales)

 The gross profit margin is influenced by both the selling price
of the company’s products and the cost to make or buy those
products
 Operating expense margins (Operating expense/Sales)

 Analysis of operating expenses over time and compared with
peer companies

Analyst Adjustments

Common Size Income Statement
AKA: Vertical analysis

Right-sizing
 WHAT?
 Every line item on the income statement divided by total
revenue
 Expresses the income statement in % terms
 WHY?
 Compare a company across two or more years
 Compare two or more companies – adjusts for size and
currency differences
 Compare a company to industry or other benchmark

Boston Scientific
Common-Size Income Statements

LO3
Examine and interpret a
statement of stockholders’ equity.

Statement of Stockholders’ Equity
Statement of stockholders’ equity reconciles the

beginning and ending balances of stockholders’ equity
accounts
 Common stock and additional paid-in capital increase by the
proceeds from the sale of stock
 Retained earnings increase by net income and decrease by
dividends to shareholders and by stock repurchased and retired
 Accumulated other comprehensive income increases and
decreases by changes in asset and liability fair values that are
not reported in the income statement

Apple’s Liabilities and Equity

Apple’s Statement of

LO4
Describe a
statement of cash flows.

Statement of Cash Flows
 The income statement measures income using GAAP

principles and provides information about the
economic viability of the company’s products and
services
 The statement of cash flows provides information
about the company’s ability to generate cash from
those same transactions

Statement of Cash Flows Format
 Cash flows from operating activities - Cash flows from

the company’s transactions and events that relate to its
operations
 Cash flows from investing activities - Cash flows from
acquisitions and divestitures of investments and long-
term assets
 Cash flows from financing activities - Cash flows from
issuances of and payments toward borrowings and
equity

Apple’s Statement of Cash Flows
AKA: Total cash flow

LO5
Apply linkages among the
four financial statements.

Financial Statement Linkages
AKA: Financial Statement

Articulation
 WHAT?
 Connections among the four financial statements that link
activity during the period to the balances at the beginning
and end of the period
 SO WHAT?
 Point out the interconnection among profit, cash flow and
the balance sheet
 Help managers and external financial statement users assess
the impact of potential transactions

Financial Statement Linkages

LO6
Explain the accounting cycle and
apply the financial statement
effects template to analyze
accounting transactions.

Four-Step Accounting Cycle
 Step 1 Record transactions in the accounting records

 Step 2 Prepare accounting adjustments to recognize
a number of events that have occurred but that have
not yet been recorded
 Step 3 Construct the financial statements
 Step 4 Close the books in anticipation of the start of
a new accounting cycle

Financial Statement Effects Template
(FSET)
 Simple way to capture transactions

 Template captures all four financial statements
 Powerful way to consider potential (“what-if”)
transactions and the effect on financial reports

Apple FSET 2017–2018
For each transaction, we ask these three questions:

 What accounts are affected?
 What is the direction of the effect?
 What is the amount of the effect?

LO7
Prepare and explain
accounting adjustments and
their financial statement effects.

Accounting Adjustments
Companies make accounting adjustments so that

financial statements are accurate and complete
 For example, employees might have earned wages during an
accounting period but not been paid before the end of the
period
 Failure to recognize the wages owed would understate
liabilities (because wages payable would be too low) and
would overstate net income for the period
(because wages expense would be too low)
 Both the balance sheet and the income statement
would be inaccurate
 SO, the company makes an accounting adjustment
Four Types of Accounting Adjustments
 Prepaid (deferred) expenses:  Accrued expenses: Expenses

Advance cash payments that will incurred and recognized on the
ultimately become expenses income statement even though
cash has not been paid yet
 Unearned (deferred) revenues: Cash
received from customers before any  Accrued revenues: Revenues
services or goods are provided earned and recognized on the
income statement even though
cash is not received yet
Prepaid (Deferred) Expenses

Unearned (Deferred ) Revenues

Accrued Expenses

Accrued Revenues

Four Types of Accounting Adjustments
 Prepaid (deferred) expenses:  Accrued expenses: Expenses

Advance cash payments that will incurred and recognized on the
ultimately become expenses income statement even though
cash has not been paid yet
 Unearned (deferred) revenues: Cash
received from customers before any  Accrued revenues: Revenues
services or goods are provided earned and recognized on the
income statement even though
cash is not received yet
LO8
Construct financial statements
from the accounting records.

Constructing the Financial Statements
 When all transactions and adjustments have been

recorded in the FSET, sum each column to obtain
ending balances
 Prepare financial statements in this order:
1. Income statement
2. Statement of stockholders’ equity – including the retained
earnings reconciliation
3. Balance sheet
4. Statement of cash flows

Apple’s Income Statement
 Apple’s income statement accounts are in the last
three columns of the FSET
 We use the data from those columns to prepare the
income statement

Apple’s Retained Earnings Reconciliation
Update the retained earnings balance:

 Add net income
 Subtract dividends
 Subtract any stock repurchased and retired

Apple’s Statement of Stockholders’ Equity
We use the information from the contributed capital and

earned capital columns in the FSET to prepare the
statement of stockholders’ equity

Apple’s Balance Sheet
 Use the ending balances from the last row in the

FSET
 Balance sheet accounts are called permanent
accounts because their respective balances carry
over from one period to the next

LO9
Explain and apply
the closing process.

The Closing Process
AKA: Closing the books
 The closing process: “zeroing out” of the temporary

accounts by transferring their ending balances to
retained earnings
 Revenues, expenses, and dividends are temporary
accounts because the balance at the start of each
accounting period is $0 so that only the current
period’s activities are included in the total amount
 Balance sheet accounts are permanent accounts and
do NOT CLOSE each period

The Closing Process: FSET v Practice
Closing Process: FSET
 The FSET and T-accounts are pedagogical tools that represent
transactions’ effects on financial statements
 The FSET is highly stylized, but its simplicity is instructive
 Each transaction and adjustment is automatically transferred to
retained earnings – no additional closing process
Closing Process: Practice

 Journal entries capture transactions and adjustments
 Retained earnings are not continuously updated
 Companies use a formal “closing process” at the end of each
reporting period
Journal Entries

1. Close Revenue and Gain Accounts

2. Close Expense and Loss Accounts

3. Close Dividend Account

LO10
Locate and use additional
financial information
from public sources.

Additional SEC Information
 Form 10-K / 10Q Annual / quarterly report

 Form 20-F Non-GAAP or IFRS companies’ annual report, provides
a table that reconciles net income as reported to U.S. GAAP net
income
 Form 40-F Same as 20-F but for Canadian companies
 Form 8-K Wide range of corporate events, reported within 4 days
 Entry into or termination of a material definitive agreement (including
petition for bankruptcy)
 Exit from a line of business or impairment of assets
 Change in the company’s certified public accounting firm
 Change in control of the company
 Departure of the company’s executive officers
 Changes in the company’s articles of incorporation or bylaws

Other Information Sources
 Equity Analyst Reports Sell-side analysts provide clients with:

 Objective analysis of company activities
 Forecasts for revenues and EPS
 Stock price target
 Credit Reports Credit rating agencies provide:
 Objective credit analysis that evaluates a company’s creditworthiness
 Credit rating (alphanumeric score)
 Data Services A number of companies supply financial
statement data in easy-to-download spreadsheet formats

Global Accounting: GAAP v IFRS
 Balance Sheet. The most visible difference is that many

IFRS-based balance sheets are presented in reverse
order of liquidity.
 Income Statement. The most visible differences are:
 GAAP requires three years’ of data on the income
statement whereas IFRS requires only two
 IFRS firms can classify expenses by function (cost of
sales, SG&A, R&D, etc.) or by type (raw materials,
labor, depreciation, etc.)

Cambridge Business Publishers
www.cambridgepub.com

2 Review of Business Activities and Financial Statements

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2 Review of Business Activities and Financial Statements

Uploaded by

Copyright:

Available Formats

MODULE 2

© Cambridge Business Publishers, 2021

© Cambridge Business Publishers, 2021 2

 The balance sheet has three sections:

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

An ASSET confers expected future economic benefits

An asset must meet the following two conditions to be

© Cambridge Business Publishers, 2021 4

© Cambridge Business Publishers, 2021 5

 Cash—currency and bank deposits

produced for sale to customers

© Cambridge Business Publishers, 2021 6

 Property, plant, and equipment (PPE), net—land, buildings, and

© Cambridge Business Publishers, 2021 7

Most assets are reported at historical cost – the original

© Cambridge Business Publishers, 2021 8

© Cambridge Business Publishers, 2021 9

Liabilities are future economic sacrifices

A liability has the following two characteristics:

A liability represents an amount that must be repaid

© Cambridge Business Publishers, 2021 10

Stockholders’ equity represents capital that has been

© Cambridge Business Publishers, 2021 11

© Cambridge Business Publishers, 2021 12

 Accounts payable—amounts owed to suppliers for goods

 Current maturities of long-term debt—principal portion of

© Cambridge Business Publishers, 2021 13

 Net working capital AKA: Working capital

 The net working capital required to conduct business

© Cambridge Business Publishers, 2021 14

© Cambridge Business Publishers, 2021 15

© Cambridge Business Publishers, 2021 16

© Cambridge Business Publishers, 2021 17

When receivables are collected,

© Cambridge Business Publishers, 2021 18

© Cambridge Business Publishers, 2021 19

 Apple’s cash conversion cycle is negative

© Cambridge Business Publishers, 2021 20

 Noncurrent liabilities—obligations due after one year

© Cambridge Business Publishers, 2021 21

 Preferred stock—value received from the original sale

 Accumulated other comprehensive income or loss—

© Cambridge Business Publishers, 2021 23

© Cambridge Business Publishers, 2021 24

AKA: Vertical analysis

© Cambridge Business Publishers, 2021 25

© Cambridge Business Publishers, 2021 26

 Stockholders’ equity—the “value” of the company per

© Cambridge Business Publishers, 2021 27

© Cambridge Business Publishers, 2021 28

© Cambridge Business Publishers, 2021 29

AKA: Cost of sales

AKA: Earnings before interest and taxes (EBIT)

© Cambridge Business Publishers, 2021 30

© Cambridge Business Publishers, 2021 31

 Revenues and expenses recognized on the income

© Cambridge Business Publishers, 2021 32

 Recognize revenue when a performance obligation is

© Cambridge Business Publishers, 2021 33

 Recognize expenses when incurred

© Cambridge Business Publishers, 2021 34

© Cambridge Business Publishers, 2021 35

 Discontinued operations: A disposal of a business unit

© Cambridge Business Publishers, 2021 36