FINANCIAL STATEMENT

Analysis & Valuation

Fourth Edition

Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang

MODULE 2

Review of
Business Activities and
Financial Statements

©Cambridge Business Publishers, 2015

 Learning Objective 1

Describe and interpret the elements of

and the information conveyed by
financial statements.

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 Four Main Financial Statements

 Balance Sheet
 Income Statement
 Statement of Stockholders’ Equity
 Statement of Cash Flows

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 Balance Sheet

 Mirrors the Accounting Equation

Assets = Liabilities + Equity
Uses of funds = Sources of funds

 Assets are listed in order of liquidity

 Liabilities are listed in order of maturity
 Equity consists of Contributed Capital and
Retained Earnings

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 Assets

To be reported on a balance sheet, an asset must

1. Be owned (or controlled) by the company
2. It must confer expected future economic benefits
that result from a past transaction or event.

Assets are listed in order of liquidity

 Current assets comprise assets that can be
converted to cash within a year
 Long-term assets cannot be easily converted to
cash within a year.
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 Examples of Current Assets
 Cash—currency, bank deposits, and investments with an
original maturity of 90 days or less (called cash equivalents)
 Short-term investments—marketable securities and other
investments that the company expects to dispose of in the
short run
 Accounts receivable, net—amounts due to the company from
customers arising from the sale of products and services on
credit (“net” refers to the subtraction of uncollectible accounts)
 Inventories—goods purchased or produced for sale to
customers
 Prepaid expenses—costs paid in advance for rent, insurance,
advertising and other services
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 Examples of Long-Term Assets

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

buildings, warehouses, office buildings, machinery, motor
vehicles, office equipment and other items used in
operating activities (“net” refers to the subtraction of
accumulated depreciation, the portion of the assets’ cost
that has been expensed);
 Long-term investments—investments that the company
does not intend to sell in the near future;
 Intangible and other assets—assets without physical
substance, including patents, trademarks, franchise rights,
goodwill and other costs the company incurred that
provide future benefits.
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 Apple’s Assets

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 Cisco Systems, Inc.
Assets

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 Assets are Reported at Historical Cost

 Historical Cost is
 Objective
 Verifiable
 “Relevance vs. Reliability”
 Only include items that can be reliably measured
 Considerable amount of “assets” may not be
reflected on a balance sheet, such as
 Strong management team, a well-designed supply
chain, or superior technology

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 Knowledge Based Assets are not
Reflected on the Balance Sheet

 NOTE: While resources expended for research and

development reflect and economic asset, they generally
are expensed as incurred.
 INSIGHT: Pharmaceutical firms do not report assets
reflecting the full cost that they have expended in
developing drugs. These costs, for the most part, have
been expensed in the income statement as R&D
expense.

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 Disney’s Assets

Where’s Mickey?
The market value
of the Mickey Mouse
trademark does
not explicitly
show up here.

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 Apple’s Liabilities and Equity

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 Examples of Current Liabilities
 Accounts payable—amounts owed to suppliers for goods and services
purchased on credit.
 Accrued liabilities—obligations for expenses that have been incurred
but not yet paid; examples are accrued wages payable (wages earned by
employees but not yet paid), accrued interest payable (interest that is
owing but has not been paid), and accrued income taxes (taxes due).
 Unearned revenues—obligations created when the company accepts
payment in advance for goods or services it will deliver in the future;
also called advances from customers, customer deposits, or deferred
revenues.
 Short-term notes payable—short-term debt payable to banks or other
creditors.
 Current maturities of long-term debt—principal portion of long-term
debt that is due to be paid within one year.

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 Cisco Systems, Inc.
Current Liabilities

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 Net Working Capital

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 Operating Cycle

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 Examples of Noncurrent Liabilities

 Long-term debt—amounts borrowed from

creditors that are scheduled to be repaid more
than one year in the future. Long-term debt
includes bonds, mortgages, and other long-term
loans.
 Other long-term liabilities—various obligations,
such as pension liabilities and long-term tax
liabilities, that will be settled a year or more into
the future.

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 Cisco Systems, Inc.
Long-Term Liabilities

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 Equity

Equity consists of:

 Contributed Capital (cash raised from the issuance of
shares)
 Earned Capital (retained earnings). Retained Earnings
is updated each period as follows:

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 Examples of Equity Accounts
 Common stock—par value received from the original sale of
common stock to investors.
 Preferred stock—value received from the original sale of preferred
stock to investors; preferred stock has fewer ownership rights
compared to common stock.
 Additional paid-in capital—amounts received from the original sale
of stock to investors in excess of the par value of stock.
 Treasury stock—amount the company paid to reacquire its common
stock from shareholders.
 Retained earnings—accumulated net income (profit) that has not
been distributed to stockholders as dividends.
 Accumulated other comprehensive income or loss—accumulated
changes in asset and liability fair values that are not reported in the
income statement.
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 Cisco Systems, Inc.
Stockholders’ Equity

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 Income Statement

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 Apple’s Income Statement

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 Operating vs. Nonoperating
 Operating expenses are the usual and customary costs that
a company incurs to support its main business activities
 Cost of goods sold
 Selling expenses
 Depreciation expense, and
 Research and development expense
 Nonoperating expenses relate to the company’s financing
and investing activities
 Interest expense
 Interest or dividend income, and
 Gains and losses from the sale of securities
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 Cisco Systems, Inc.
Income Statement

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 When are Revenues
and Expenses Recognized?
 Revenue Recognition Principle—recognize revenues
when earned
 Expense Recognition (Matching) Principle—recognize
expenses when incurred
 These two principles are the foundation of accrual
accounting
 First, recognize revenues in the time period they are earned;
 Then, record all expenses incurred to generate those
revenues during that same time period (this is called
matching expenses to revenues).
 Net income is, then, correctly reported for that period.
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 Profit vs. Cash

 Net Income does not necessarily correspond to a net cash

flow. A firm could have “good income” but “poor cash flow”
or vice versa (i.e., there are two dimensions to consider).
 We have previously summarized the mechanics of the
balance sheet with the expanded accounting equation:

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 Transitory Items
in the Income Statement

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 Transitory Items

 Discounted operations—Gains or losses (and

net income or loss) from business segments
that are being sold or have been sold in the
current period

 Extraordinary items—Gains or losses from

events that are both unusual and infrequent

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 Statement of Stockholders’ Equity

 Statement of Equity is a reconciliation of the

beginning and ending balances of stockholders’
equity accounts.
 Main equity categories are:
 Contributed capital
 Retained earnings (including Other Comprehensive
Income or OCI)
 Treasury stock

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 Apple’s Statement
of Stockholders’ Equity

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 Statement of Cash Flows

 Statement of cash flows reports cash inflows and

outflows
 Cash flows are reported based on the three business
activities of a company:
 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.
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 Apple’s
Statement
of
Cash Flows

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 Cisco
Systems

Statement
of
Cash Flows

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 Relation of SCF to
Income Statement and Balance Sheet

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 General Coding
of Balance Sheet Changes

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 Working Capital Accounts

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 Learning Objective 2

Analyze and interpret transactions

using the financial statement effects
template.

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 Articulation of Financial Statements

 Financial statements are linked within and across

time – they articulate.
 Balance sheet and income statement are linked
via retained earnings.

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 Apple’s Retained Earnings
Reconciliation

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 Articulation
of Apple’s
Financial
Statements

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 Accounting Cycle

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 Learning Objective 3

Analyze and interpret

accounting adjustments and their
financial statement effects.

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 Financial Statement Effects Template

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 Recording Transactions –
Pay $100 Wages in Cash

 Cash assets are reduced by $100, and wage expense

of $100 is reflected in the income statement, which
reduces income and retained earnings by that
amount.
 All transactions incurred by the company during the
accounting period are recorded similarly.
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 Adjusting Accounts

 Prepaid expenses - Prepaid expenses reflect advance cash

payments that will ultimately become expenses; an example is
the payment of radio advertising that will not be aired until
sometime in the future.
 Unearned revenues - Unearned revenues reflect cash received
from customers before any services or goods are provided; an
example is cash received from patrons for tickets to an upcoming
concert.
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 Prepaid Rent

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 Unearned Revenue

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 Adjusting Accounts

 Accrued expenses - Accrued expenses are expenses incurred and

recognized on the income statement, even though they are not yet
paid in cash; an example is wages owed to employees who performed
work but who have not yet been paid.
 Accrued revenues - Accrued revenues are revenues earned and
recognized on the income statement, even though cash is not yet
received; examples include accounts receivable and revenue earned
under a long-term contract.
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 Accrual of Wages

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 Accrual of Revenues

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 Learning Objective 4

Construct financial statements from

account balances.

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 Exercise: The Ice Cream Store, Inc.
The Ice Cream Store, Inc. incurred the following start-up costs:
1. The Ice Cream Store, Inc. was formed on October 1, 20XX, with the
investment of $90,000 in cash by the owners.
2. Obtained a bank loan and received the proceeds of $35,000 on
October 2. The cash will be used for operations.
3. Purchased equipment for $25,000 cash on October 2.
4. Acquired a building at a cost of $80,000. It was financed by making a
$20,000 down-payment and obtaining a mortgage for the balance.
The transaction occurred on October 2.
5. On October 2, the President of the United States publicly declared that
she will eat (and plug) our ice cream while entertaining guests in the
White House.
Prepare a transaction analysis of 1. – 5. using the financial
statement effects template.
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 Financial Statement Effects Template
Balance Sheet Income Statement
Cash Noncash Liabi Contrib. Retained
Transaction + = + + Revenues – Expenses
Asset Assets -lities capital Earnings
1. The Ice Cream Store, Inc. was
formed on October 1, 20XX,
with the investment of $90,000
by the owners. +90 +90

2. Obtained a bank loan and

received the proceeds of $35,000
on October 2. The cash will be +35
used for operations. +35
N/P

3. Purchased equipment for

$25,000 cash on October 2. +25
-25
Equip

4. Acquired a building at a cost

of $80,000. It was financed by
making a $20,000 down-
payment and obtaining a
mortgage for the balance. The +80 +60
transaction occurred on October -20
Bldg. M/P
2.

5. The President of the United

States agreed to eat (and plug)
our ice cream while entertaining
guests in the White House on
Oct. 2.

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 Ice Cream Store ASSETS  
Cash  $80,000
Equipment  25,000
Balance Sheet Building  80,000
   
Total Assets  $185,000

LIABILITY AND STOCKHOLDERS' EQUITY 

Liabilities:  
Note Payable  $35,000
Mortgage Payable  60,000
Total Liabilities  95,000
   
Stockholders Equity:  
Capital Stock  90,000
Total Liabilities and  
Stockholders Equity  $185,000

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 The Ice Cream Store, Inc.
6. On October 4, purchased merchandise inventory (i.e., ice cream) at a
cost of $15,000 by paying $5,000 cash and receiving short-term credit
for the remainder from the supplier.
7. Immediately returned some of the ice cream because some of the
flavors delivered were not ordered. The cost of the inventory returned
was $3,000.
8. Sales of ice cream for the month of October, 20XX, totaled $8,000. All
sales were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries earned/paid
were $3,000.
10. As of the end of October, one month's depreciation on the equipment
and building was recognized -- $383 for the building and $167 for the
equipment.
11. $450 interest expense on the note and mortgage was due and paid on
October 31. Assume that the principal amounts ($35,000 + $60,000) of
the note and mortgage remain unchanged.
Prepare a transaction analysis of 6. – 11. using the balance
sheet/income statement template.
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 Template
Balance Sheet Income Statement

Cash Noncash Liabi- Contrib. Retained

Transaction + = + + Revenues – Expenses
Asset Assets lities capital Earnings
6. +15 +10
-5
Inv. A/P
7. -3 -3
Inv. A/P
8. -3.5 +8 -3.5
+8 +4.5
Inv. Sales COGS
9. -3
-3 . -3
Wage exp.
10.
- .383
Bldg., net -.550
-.550
-.167 Dep. exp.
Equip., net

11. -.450
-.450 -.450
Int. Exp.

Prepare the following financial statements (ignore income taxes):

(i) an updated Balance Sheet as of October 31, 20XX; and (ii) an
Income Statement for the month of October 20XX.
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 Balance Cash ($80,000 -5,000 +8,000 -3,000 -450)  $79,550
Merchandise Inventory ($0 + 15,000 -3,000 -3,500)  8,500
Sheet Equipment ($25,000 )  25,000
Less: Accumulated Depreciation  (383)
Building ($80,000)  80,000
Less: Accumulated Depreciation (167)
Total Assets  $192,500

Accounts Payable ($0 + 10,000 – 3,000)  $7,000

Note Payable ($35,000 principal is unchanged)  35,000
Mortgage Payable (60,000 principal is unchanged)  60,000
   102,000
Stockholders' Equity:  
Capital Stock  90,000
Retained Earnings  500
   90,500
Total Liabilities and Stockholders' Equity  $192,500

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 Income REVENUES:
Statement Sales of Ice Cream  $8,000
Cost of Sales  3,500
GROSS PROFIT: 4,500
Payroll Expense  3,000
Depreciation Expense 550
INCOME FROM OPERATIONS 950
Interest Expense 450
NET INCOME $500
   
Note: Assume no income taxes.  

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 Apple’s Transactions

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 Apple’s Balance Sheet
and Income Statement

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 Apple’s Statement of Cash Flows

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 Apple’s Statement
of Stockholders’ Equity

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 Analyzing Global Reports
 Balance Sheet - The most visible difference is that the typical IFRS-based
balance sheet is presented in reverse order of liquidity.
 Income Statement - The most visible difference is that GAAP requires
three years’ data on the income statement whereas IFRS requires only
two.
 Statement of Cash Flows - One of the more apparent differences
between GAAP and IFRS is that a GAAP-based statement of cash flows
classifies interest expense, interest revenue, and dividend revenue as
operating cash flows, and dividends paid as financing cash flows. IFRS
allows firms to choose from between the following two options:
1. Classify interest expense, dividends paid, interest revenue, and dividend revenue as
operating cash flows, or
2. Classify interest expense and dividends paid as financing cash flows, and interest
revenue and dividend revenue as investing cash flows.
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 Additional Sources of Information
Form 10-K
 Item 1, Business; Item 1A. Risk Factors;
 Item 2, Properties;
 Item 3, Legal Proceedings;
 Item 4, Submission of Matters to a Vote of Security Holders;
 Item 5, Market for Registrant’s Common Equity and Related Stockholder Matters;
 Item 6, Selected Financial Data;
 Item 7, Management’s Discussion and Analysis of Financial Condition and Results of
Operations;
 Item 7A, Quantitative and Qualitative Disclosures About Market Risk;
 Item 8, Financial Statements and Supplementary Data;
 Item 9, Changes in and Disagreements With Accountants on Accounting and Financial
Disclosure;
 Item 9A, Controls and Procedures.
 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 Accountant Fees and Services.
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 Additional Sources of Information
Form 20-F and Form 40-F
 Non-U.S. companies that are publicly traded in the U.S. also file annual reports with
the SEC.
 The filing, labeled Form 20-F, requires financial statements prepared according to U.S.
GAAP or IFRS.
 The company must provide a table that reconciles net income as reported to U.S.
GAAP net income.
 Canadian companies file their annual reports, prepared under IFRS, using Form 40-F.

Form 8-K
 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

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 Analyst
Reports

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 Credit and Data Services

 Credit Analysis
 Standard & Poor’s (StandardAndPoors.com)
 Moody’s Investors Service (Moodys.com)
 Fitch Ratings (FitchRatings.com)
 Data Services
 Thomson Reuters Corporation (Thomson.com)
 Capital IQ (CapitalIQ.com)

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The End