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SM299-Management as a System
Financial Accounting I
Balance Sheet,
Income Statement

Professor J. Robb Dixon

building on earlier
presentations by Professors
Eng Wu and Peter Arnold
There are 417 companies represented
here in the auditorium.
• Who has the best company?
• How do you answer this question?
• Who cares?
Lots of people
Prospective employees
Suppliers
Managers/employees
Customers
Investors
Government…
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 What is Accounting?
Two Basic Forms
Managerial:
Accounting info for internal decision making on:
Marketing - product, place, price and promotion
Operations - outsourcing, capital investment, inventory
Control and performance measurement
No formalized accounting reports

AIG
Financial:
General Motors
Accounting info for external users on:
Lehman Bros.
Financial status of companies
Madoff Securities
Performance and profitability
Banks?
Financial soundness or otherwise
To afford comparability, formal accounting rules
Very formal accounting reports
 Learning Financial Accounting
Formal structure – like learning a new language
Some Misconceptions/Barriers
1. Accounting is merely a number crunching exercise.
2. Computers are making accountants obsolete.
3. I am a [non-accounting] major; who needs accounting?

Guidelines for learning success:

1. Persevere – lots of practice - do not give up!!
2. Reason rather than memorize – there is logic embedded here.

Some Important Fundamentals

1. Companies like to make money – showing profits good
2. Companies do not like to pay taxes – showing profits bad
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 What is Financial Accounting?

 is only recording data (in the right columns)

Bookkeeping?
vs. presentation & interpretation

Precise & objective  almost all accounting numbers are

measurement? influenced by estimates

 use historical concept, record costs

Report market value of (assets, equity); liabilities (mixed). Book
companies? Value.

 provide economic information to

Primary objective?
external users.

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 Characteristics

Relevance  timely & has predictive value

Reliability  accurate, unbiased, verifiable

Comparability  across companies

 across time
Consistency

 Accounting Rules (GAAP) - SEC, FASB, AICPA

Soon, maybe, IFRS – International Financial Reporting
Standards – Accounting majors rejoice!
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 Financial Statements

 Snapshot of Business
Balance Sheet

Income Statement  Profit/Loss over a period

Statement of Retained  Undistributed income

Statement of Cash Flows

Earnings  Where $ comes from / goes to

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 Quiz #1

• Which of the four primary financial

statements provides a snapshot at a
particular point in time of a company’s
financial condition?
A. Income statement
B. Balance sheet
C. Statement of retained earnings
D. Statement of cash flows
E. More than one of the above
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 Income Statement

Answers Basic Question = Is business profitable?

How do we measure profit?

Fundamental equation:
Revenues - Expenses = Profit

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 Income Statement: Basis of the
Accounting
• Cash Basis Accounting
 Performance measured as difference
between cash received & cash paid
• Accrual Basis Accounting
 Performance measured as difference
between revenues & expenses

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 Income Statement
- Accrual Basis Accounting
Under GAAP -
Rules for recognizing revenues & expenses

Revenue Recognition
 Goods delivered / Services completed
 Reasonably assured to receive payments

Expense Recognition [Matching Principle]

 Recognizing expenses when revenue recognized
 Matching expenses with revenue
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 Example of Accrual v Cash
A small business opens and offers customers credit even
though its suppliers insist on cash payment on delivery.
Suppose during the first month of business $1000 is sold
on account (the customer agrees to pay in thirty days).
Total cash expenses for the month are $800. What is the
profit? a.$1000 b. $800 c. $200 d. ($200) e. ($800)
 Cash based would show ($800) - no money in!

Accrual based shows $200

Which do you think is a better reflection of
the first month’s performance?
a. Cash-based b.Accrual-based
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 Easy Company
Statement of Profit and Loss
For the Year Ended December 31, 2009

Net Sales 10000 Gross Margin

Gross Margin
Cost of Goods Sold 7000
Gross Profit 3000

Operating Expenses
Selling General and Adminstrative 1600
Operating Profit
Depreciation 200 Operating Profit
Profit from Operations 1200

Interest Expense 200

Income before Taxes 1000

Income Tax Expense 400

Net Profit 600

Bottom Line
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Bottom Line
 Some Important Concepts

What’s Cash?
1. Growth requires cash
2. Inventory requires cash – inventory purchase is not an expense
3. Debt Servicing requires cash.
4. Dividends may require cash, but dividend is never an expense

What’s not cash?

1. Profit is not the same as cash
2. Revenue is accounts receivable, not cash
3. Expense is not necessarily cash

4. Depreciation is an expense, but never cash

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 The Balance Sheet
The Easy Company
Statement of Financial Position
(December 31)

2008 2009 2008 2009

Assets Liabilities and Owner's Equity
Current Assets Liabilities
Cash $ 2,000 $ 900 Current Liabilities
Marketable Securities 1,000 1,000 Accounts Payable $ 300 $ 500
Accounts Receivable 2,000 2,500 Accrued Expenses 1,300 1,200
Inventory 2,000 2,300 Current Portion of long-term debt 200 200
Prepaid Expenses 100 100 Total Current Liabilities 1,800 1,900
Total Current Assets 7,100 6,800 Non-Current Liabilities
Long-term Debt 2,000 1,800
Investment in Affiliated Co. 200 200 Total Liabilities 3,800 3,700

Non-Current Assets Owner's Equity

Property Plant and Equipment Capital Stock 2,000 2,000
Cost 5,000 6,000 Retained Earnings 3,700 4,300
Accumulated Depreciation 3,000 3,200 Total Owner's Equity 5,700 6,300
et Property Plant and Equipment 2,000 2,800

Other Assets 200 200

Total Assets $ 9,500 $ 10,000 Total Liabilities and Owner's Equity $ 9,500 $ 10,000
 Balance Sheet
Sources of Funds
Uses of Funds Assets Liabilities and Owner’s Equity

Cash Accounts payable

Marketable securities Wages payable
Accounts receivable Accrued expenses
Inventories Unearned revenues
Prepaid expenses Notes payable
Property Plant & Equip. Long term debt
Accumulated depreciation
Net PPE Capital Stock
Intangible assets Paid-in capital
Other assets Contributed Capital
Retained earnings
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 Quiz #2

• Unearned revenues are called a

A. Liability
B. Asset
C. Owners’ Equity
D. Revenue
E. Expense

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 Quiz #3

• Prepaid expenses are called a

A. Liability
B. Asset
C. Owners’ Equity
D. Revenues
E. Expenses

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 The Balance Sheet
What are Assets? What are Liabilities? What is Owner’s Equity? Why is it
called a Balance Sheet?

Think of assets as uses of funds

acquire inventory, build factories, provide credit to customers,
pay for expenses in advance.
Think of Liabilities and Owners’ Equity as sources of funds
money for assets has to come from somewhere:
liabilities entail a contractual obligation to repay;
owners’ equity is an exchange of money for influence

Firms hold assets to generate revenues. Some assets are more flexible than
others. Cash is the most flexible asset because it is capable of becoming any
other asset (with a time lag of course).
 Quiz #4

Who is Rory McIlroy?

A. 2011 U.S. Open & 2012 PGA champion.
B. A Venetian mathematician.
C. A Franciscan monk.
D. The father of accounting.
E. B, C, and D are all correct.
 Quiz #4

Who is Luca Pacioli?

A. 2011 U.S. Open & 2012 PGA champion.
B. A Venetian mathematician.
C. A Franciscan monk.
D. The father of accounting.
E. B, C, and D are all correct.
 Organizing Principles for the Balance
Sheet
• Entity Principle
• Duality of Effects Luca Pacioli 1494
“A person should not sleep at night until the
debits equal the credits”
• Assets / Sources of Assets (Liabilities and
Owners Equity)
• Listing of Assets Liquidity
• Listing of Liabilities Maturity

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 Quiz #5

• In the listing of liabilities on the balance

sheet, bonds due to mature in 20 years
would appear
A. Near the top of the list
B. Near the bottom of the list
C. It would depend on their rating
D. It’s liquidity, not maturity, that matters.

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 The Easy Company
Statement of Financial Posit
(December 31)

Liquidity
2010 2011
Assets
Current Assets
Cash $ 2,000 $ 900
Marketable Securities 1,000 1,000
Accounts Receivable 2,000 2,500
Inventory 2,000 2,300
Prepaid Expenses 100 100
Total Current Assets 7,100 6,800

Investment in Affiliated Co. 200 200

Non-Current Assets
Property Plant and Equipment
Cost 5,000 6,000
Accumulated Depreciation 3,000 3,200
Net Property Plant and Equipment 2,000 2,800
 2010 2011
Liabilities and Owner's Equity
Liabilities
Current Liabilities
Accounts Payable $ 300 $ 500

Maturity
Accrued Expenses 1,300 1,200
Current Portion of long-term debt 200 200
Total Current Liabilities 1,800 1,900
Non-Current Liabilities
Long-term Debt 2,000 1,800
Total Liabilities 3,800 3,700

Owner's Equity
Capital Stock 2,000 2,000
Retained Earnings 3,700 4,300
Total Owner's Equity 5,700 6,300

Total Liabilities and Owner's Equity $ 9,500 $ 10,000

 Concept Check:
Assets = Liabilities + Owner’s Equity
Total Assets $ 9,500 $ 10,000

Total Liabilities 3,800 3,700

Total Owner's Equity 5,700

Total Liabilities and Owner's Equity $ 9,500

What is Total Liabilities and Owners’ Equity in

the second year?

What is Total Owners’ Equity in the second

year?
Capitalization

Funds for asset acquisition come from two sources – Debt

(Liabilities) and Equity

Leverage - the extent to which assets are funded through liabilities

relative to owners’ equity.
In general greater leverage brings more risk.
Greater leverage can bring greater return to owners.
Quiz

1. True or False - The total value of a

firm’s assets is how much the firm is worth.
False
2. True or False - The total value of the
firm’s owner’s equity is what the firm is worth.

False
 The Easy Company
Statement of Financial Position
(December 31)

2010 2011 2010 2011

Assets Liabilities and Owner's Equity
Current Assets Liabilities
Cash $ 2,000 $ 900 Current Liabilities
Marketable Securities 1,000 1,000 Accounts Payable $ 300 $ 500
Accounts Receivable 2,000 2,500 Accrued Expenses 1,300 1,200
Inventory 2,000 2,300 Current Portion of long-term debt 200 200
Prepaid Expenses 100 100 Total Current Liabilities 1,800 1,900
Total Current Assets 7,100 6,800 Non-Current Liabilities
Long-term Debt 2,000 1,800
Investment in Affiliated Co. 200 200 Total Liabilities 3,800 3,700

Non-Current Assets Owner's Equity

Property Plant and Equipment Capital Stock 2,000 2,000
Cost 5,000 6,000 Retained Earnings 3,700 4,300
Accumulated Depreciation 3,000 3,200 Total Owner's Equity 5,700 6,300
Net Property Plant and Equipment 2,000 2,800

Other Assets 200 200

Total Assets $ 9,500 $ 10,000 Total Liabilities and Owner's Equity $ 9,500 $ 10,000
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 The Balance Sheet Equation

The Balance Sheet can be represented by the equation:

Assets (A) = Liabilities (L) + Owners Equity (OE)

A =  L +  OE { =  L +  Cap +  RE }

=  L + {  Cap + NI - Div } Statement

StatementofofRetained
Retained
Earnings
Earnings

=  L + {  Cap + Rev - Expenses - Div }

Income
IncomeStatement
Statement
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 Have you got your balance now?

Good! We’ll continue next time.

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