Module 2:

Introducing Financial Statements and

Transaction Analysis

Flow of Costs

Four Main Financial Statements

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

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

Assets
To be reported on a balance sheet, an asset
must
1. Be owned (or controlled) by the company
2. Must possess expected future economic
benefits

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.

Examples of Current Assets

Cashcurrency, bank deposits, and investments

with an original maturity of 90 days or less (called
cash equivalents);
Marketable securitiesshort-term investments
that can be quickly sold to raise cash;
Accounts receivable, netamounts due to the
company from customers arising from the sale of
products and services on credit (net refers to
uncollectible accounts explained in Module 6);
Inventorygoods purchased or produced for sale
to customers;
Prepaid expensescosts paid in advance for rent,
insurance, advertising or other services.

Examples of Long-term Assets

Property, plant and equipment (PPE), netland,

factory buildings, warehouses, office buildings,
machinery, motor vehicles, office equipment and
other items used in operating activities (net refers
to subtraction of accumulated depreciation, the
portion of the assets cost that has been transferred
from the balance sheet to the income statement,
which is explained in Module 6);
Long-term investmentsinvestments that the
company does not intend to sell in the near future;
Intangible and other assetsassets without
physical substance, including patents, trademarks,
franchise rights, goodwill and other costs the
company incurred that provide future benefits.

Apples Assets

Cisco Systems, Inc. Assets

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
Strong management team, a well-designed
supply chain, or superior technology

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 have
assets reflecting the full amount of money that
they have spent developing drugs. These
amounts, for the most part, have been expensed
in the past and serve to reduce retained
earnings. Internally developed trade marks are
also economic assets, but may not show up on
the balance sheet. [The purchase of externally
developed trademarks are treated as assets.]

Disneys Assets
Wheres Mickey? The
market value of the Mickey
Mouse trademark does not
explicitly show up here.

Apples Liabilities and Equity

Examples of Current Liabilities

Accounts payableamounts owed to suppliers for goods

and services purchased on credit.

Accrued liabilitiesobligations 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 revenuesobligations 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 payableshort-term debt payable to

banks or other creditors.

Current maturities of long-term debtprincipal

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

Cisco systems, Inc. Current

Liabilities

Net Working Capital

Operating Cycle

Examples of Noncurrent
Liabilities

Long-term debtamounts borrowed from

creditors that are scheduled to be repaid more than
one year in the future; any portion of long-term debt
that is due within one year is reclassified as a
current liability called current maturities of longterm debt. 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. We discuss these items in later modules.

Cisco Systems, Inc.

Long-term Liabilities

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:

Examples of Equity Accounts

Common stockpar value received from the original

sale of common stock to investors.

Preferred stockvalue received from the original sale

of preferred stock to investors; preferred stock has fewer
ownership rights compared to common stock.

Additional paid-in capitalamounts received from

the original sale of stock to investors in addition to the par
value of common stock.

Treasury stockamount the company paid to reacquire

its common stock from shareholders.

Retained earningsaccumulated net income (profit)

that has not been distributed to stockholders as dividends.

Accumulated other comprehensive income or

lossaccumulated changes in equity that are not
reported in the income statement (explained in Module 9).

Cisco Systems, Inc.

Stockholders Equity

Income Statement

Apples Income Statement

Cisco Systems, Inc.

Income Statement

When are Revenues and Expenses

Recognized?

Revenue Recognition Principle

recognize revenues when earned
Matching Principlerecognize
expenses when incurred

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:

Operating vs. Nonoperating

Operating expenses are the usual and

customary costs that a company incurs to
support its main business activities
Nonoperating expenses relate to the
companys financing and investing
activities

Transitory Items in the

Income Statement

Transitory Items

Discontinued 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.

Accrual Accounting
Accrual accounting refers to the
recognition of revenue when
earned (even if not received in
cash) and the matching of
expenses when incurred (even if
not paid in cash).

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

Apples Statement of
Stockholders Equity

Statement of Cash Flows

Statement of cash flows (SCF) 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 companys 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.

Apples
Statem
ent of
Cash
Flows

Cisco
Systems
Stateme
nt of
Cash
Flows

Relation of SCF to Income

Statement and Balance Sheet

General Coding of
Balance sheet Changes

Working Capital Accounts

Articulation of Financial
Statements

Financial statements are linked

within and across time they
articulate.
Balance sheet and income
statement are linked via retained
earnings.

Apples Retained Earnings

Reconciliation

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.

Adjusting Accounts

Prepaid Rent

Unearned Revenue

Accrual of Wages

Accrual of Revenue

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:

Income Statement

Balance Sheet
Transaction

Cash Asset

1. The Ice Cream Store, Inc. was

formed on October 1, 20XX, with
the investment of $90,000 by the
owners.

+90

2. Obtained a bank loan and

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

+35

3. Purchased equipment for

$25,000 cash on October 2.

-25

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. The President of the United

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

-20

Noncash
Assets

Liabilities

Contrib.
+
capital

+90

+35
N/P

+25
Equip

+80
Bldg.

+60
M/P

Retained
Earnings

Revenues

Expenses

ASSETS
Cash

Ice Cream
Shop
Balance
Sheet:

$80,000

Equipment

25,000

Building

80,000

Total Assets

$185,000

LIABILITY AND STOCKHOLDERS' EQUITY

Liabilities:
Note Payable
Mortgage Payable
Total Liabilities

$35,000
60,000
95,000

Ice Cream Shop

additional transactions
6. On

October 4, purchased merchandise inventory (i.e., ice cream)

at a cost of $15,000 by paying $5,000 cash and receiving shortterm 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 presented above:

Income Statement

Balance Sheet
Transaction

6.

Cash
Asset

-5

7.
8.
9.

Noncash Assets

Liabilities

+15
Inv.

+10
A/P

-3
Inv.

-3
A/P

Contrib.
capital

Retained
Earnings

Revenues

Expenses

+8
Sales

-3.5
COGS

+8

-3.5
Inv.

+4.5

-3

-3

10.

11.

- .383
Bldg., net
-.167
Equip., net
-.450

-.550

-.450

-3
Wage exp.
-.550
Dep. exp.

-.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.

Cash ($80,000 -5,000 +8,000 -3,000 -450)

Merchandise Inventory ($0 + 15,000 -3,000 -3,500)
Equipment ($25,000 )
Less: Accumulated Depreciation
Building ($80,000)
Less: Accumulated Depreciation
Total Assets

$79,550
8,500
25,000
(383)
80,000
(167)
$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:

REVENUES:
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

Preparing
the
Financial
Statements

Balance Sheet and Income

Statement

Statement of Cash Flows

Statement of Stockholders
Equity

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 Registrants Common Equity and Related
Stockholder Matters;
Item 6, Selected Financial Data;
Item 7, Managements 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.

Additional Sources of
Information

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 companys certified public
accounting firm
Change in control of the company
Departure of the companys executive officers
Changes in the companys articles of
incorporation or bylaws

Global Accounting

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
n. Classify interest expense and dividends paid as financing cash
flows, and interest revenue and dividend revenue as investing
cash flows.

Analyst Reports

Credit and Data Services

Credit Analysis

Standard & Poors

(StandardAndPoors.com)
Moodys Investors Service (Moodys.com)
Fitch Ratings (FitchRatings.com)

Data Services

Thomson Corporation (Thomson.com)

First Call - summary of analysts earnings

forecasts
Compustat database - individual data items for all
publicly traded companies or for any specified
subset of companies.