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Agenda

This lecture contains the following:

• A brief review of the four financial statements
• Examples of how financial statements are prepared
• The articulation of reformulated financial statements

I-2
 Objectives

Ø Explain business activities and their relation to financial statements.

Ø Describe the purpose of each financial statement and linkages between them.

Ø Identify the accounting relations that govern the financial statements.

Ø Understand how reformulated statements tie together as a set of stocks and flows.

I-3
 The Four Financial Statements

Income Statement (called

Balance Sheet (called “statement of profit and
“Statement of Financial loss and other
Position” by IAS 1) comprehensive income
for the period” by IAS 1)
Notes to
the
Accounts
Statement of
Cash Flow Statement ( Shareholders’ Equity
called “Statement of (called «statement of
Cash Flows” by IAS 7) changes in equity» by
IAS 1)

2-4
 The Balance Sheet:
Nike, Inc., 2010

The balance sheet reports the

assets of the firm at a point in
time and the claims against
those resources. The claims
are broken up into liabilities
and shareholders’ equity.

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 Balance Sheet Equation

Shareholders’
Equity

Assets

Liabilities
 The Form of the Balance Sheet

1) Assets = Liabilities + Shareholders’ Equity; or

2) Shareholders’ Equity = Assets – Liabilities

• Assets are economic resources that produce future earnings.

• Liabilities are obligations to transfer assets or provide
services to parties other than the owners.
• Equity is the owners’ residual interest in the assets of an
entity that remains after deducting the liabilities.

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 The Form of the Balance Sheet
ASSETS LIABILITIES AND EQUITY
Current assets $ Current liabilities $
Cash X Accounts payable X
Accounts receivable X Interest payable X
Inventory X ... X
… X … X
Total current assets XXX Total current liabilities XXX

Non current assets Long-term liabilities

Property, plant and equipment Long term loan from bank X
Land X Bonds payable X
Buildings (Less acc. Depreciation) X …. X
Equipment (Less acc. depreciation) X Total liabilities XXX
Total Property, plant and equipment XXX
Intangible assets Stockholders’ equity
Goodwill X Capital stock X
Patent X Preferred stock X
Total Intangible assets XXX Common stock X
Other non-current assets Retained earnings X
… Total stockholders’ equity XXX
Total assets XXXX Total liabilities and stockholders’ equity XXXX

I-8
 Example - Balance Sheet Preparation
• Presented below are selected accounts of Biking Corporation at December 31, 2018:
Accounts receivable 143,000 Accounts payable 283,000
Building 1,200,000 Accumulated depreciation – building 450,000
Cash 360,000 Accumulated depreciation – equipment 232,000
Equipment 950,000 Bonds payable 425,000
Inventory 242,000 Common stock, $5 par value 400,000
Land 520,000 Income taxes payable 93,000
Patent 150,000 Interest payable 30,000
Prepaid insurance 89,000 Long-term loan from bank 640,000
Refundable federal and state income taxes 97,630 Notes payable (short-term) 264,000
Trading securities 117,000 Preferred stock, $10 par value 150,000
Rent payable 45,000
Retained earnings ?

Required: Prepare a classified balance sheet.

I-9
 Solution
Current assets $
Cash 360,000
Trading securities 117,000
Accounts receivable 143,000
Inventory 242,000
Prepaid insurance 89,000
Refundable federal and state income taxes 97,630
Total current assets 1,048,630

I-10
 Solution
Current assets $
Cash 360,000
Trading securities 117,000
Accounts receivable 143,000
Inventory 242,000
Prepaid insurance 89,000
Refundable federal and state income taxes 97,630
Total current assets 1,048,630

Property, plant and equipment

Land 520,000
Buildings 1,200,000
Less acc. depreciation -450,000 750,000
Equipment 950,000
Less acc. depreciation -232,000 718,000
Total Property, plant and equipment 1,988,000

I-11
 Solution
Current assets $
Cash 360,000
Trading securities 117,000
Accounts receivable 143,000
Inventory 242,000
Prepaid insurance 89,000
Refundable federal and state income taxes 97,630
Total current assets 1,048,630

Property, plant and equipment

Land 520,000
Buildings 1,200,000
Less acc. depreciation -450,000 750,000
Equipment 950,000
Less acc. depreciation -232,000 718,000
Total Property, plant and equipment 1,988,000

Intangible assets
Patent 150,000
Total Intangible assets 150,000
Total assets 3,186,630

I-12
 Solution
Current assets $ Current liabilities $
Cash 360,000 Accounts payable 283,000
Trading securities 117,000 Notes payable 264,000
Accounts receivable 143,000 Interest payable 30,000
Inventory 242,000 Income taxes payable 93,000
Prepaid insurance 89,000 Rent payable 45,000
Refundable federal and state income taxes 97,630 Total current liabilities 715,000
Total current assets 1,048,630

Property, plant and equipment

Land 520,000
Buildings 1,200,000
Less acc. depreciation -450,000 750,000
Equipment 950,000
Less acc. depreciation -232,000 718,000
Total Property, plant and equipment 1,988,000

Intangible assets
Patent 150,000
Total Intangible assets 150,000
Total assets 3,186,630

I-13
 Solution
Current assets $ Current liabilities $
Cash 360,000 Accounts payable 283,000
Trading securities 117,000 Notes payable 264,000
Accounts receivable 143,000 Interest payable 30,000
Inventory 242,000 Income taxes payable 93,000
Prepaid insurance 89,000 Rent payable 45,000
Refundable federal and state income taxes 97,630 Total current liabilities 715,000
Total current assets 1,048,630
Long-term liabilities
Property, plant and equipment Long term loan from bank 640,000
Land 520,000 Bonds payable 425,000
Buildings 1,200,000 Total long term liabilities 1,065,000
Less acc. depreciation -450,000 750,000 Total liabilities 1,780,000
Equipment 950,000
Less acc. depreciation -232,000 718,000
Total Property, plant and equipment 1,988,000

Intangible assets
Patent 150,000
Total Intangible assets 150,000
Total assets 3,186,630

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 Solution
Current assets $ Current liabilities $
Cash 360,000 Accounts payable 283,000
Trading securities 117,000 Notes payable 264,000
Accounts receivable 143,000 Interest payable 30,000
Inventory 242,000 Income taxes payable 93,000
Prepaid insurance 89,000 Rent payable 45,000
Refundable federal and state income taxes 97,630 Total current liabilities 715,000
Total current assets 1,048,630
Long-term liabilities
Property, plant and equipment Long term loan from bank 640,000
Land 520,000 Bonds payable 425,000
Buildings 1,200,000 Total long term liabilities 1,065,000
Less acc. depreciation -450,000 750,000 Total liabilities 1,780,000
Equipment 950,000
Less acc. depreciation -232,000 718,000 Stockholders’ equity
Total Property, plant and equipment 1,988,000 Capital stock
Preferred stock, $10 par; 150,000
Intangible assets Common stock, $5 par 400,000 550,000
Patent 150,000 Retained earnings 856,630
Total Intangible assets 150,000 Total stockholders’ equity 1,406,630
Total assets 3,186,630 Total liabilities and stockholders’ equity 3,186,630

Retained earnings are calculated as a plug number.

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 The Income Statement

The income statement

reports revenues less
expenses (earnings)
that increase owners’
equity between two
balance sheet dates.

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 The Form of the Income Statement

Net Revenue
– Cost of Goods Sold (or “cost of sales”)
= Gross Margin
– Operating Expenses
= Operating Income before Tax (EBIT)
– Interest Expense
= Income before Taxes
– Income Taxes
= Income after Taxes (and before Extraordinary Items)
+ Extraordinary Items
= Net Income
– Preferred Dividends
= Net Income Available to Common shareholders

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 Cost of Goods Sold: An Application of Matching
• Cost of goods sold is an accrual concept, calculated in the following way:

Inventory, beginning XXX

+ Purchases XXX
= Goods available for sale XXX
– Inventory, ending (XXX)
= Cost of Goods Sold XXX

• The beginning balance of inventory and purchases of goods during the year
sum up to the total goods that the firm could have sold during the year.
• The ending balance of inventory (usually available from physical count) is
subtracted to get the cost of the goods actually sold.
 Calculation of Cost of Goods Sold
• In the income statement preparation example total purchases were
2,598,000 (after adding shipment and subtracting discounts).

• The beginning of inventory was 409,000 and the ending of

inventory was 547,000.

How much is it the Cost of Goods Sold?

Inventory, beginning 409,000
+ Purchases 2,598,000
= Goods available for sale 3,007,000
– Inventory, ending (547,000)
= Cost of Goods Sold 2,460,000
 Example - Income Statement Preparation
• Below are selected ledger accounts of Grant Corporation at December 31, 2018:
Accounting and legal services 24,000 Merchandise inventory ending 547,000
Advertising 108,000 Purchase discounts 31,000
Depreciation of office 62,000 Sales 5,000,000
Depreciation of sales equipment 58,000
Extraordinary loss (before tax) 96,000
Insurance expense 26,000
Interest expense 176,000
Merchandise inventory beginning 409,000
Office salaries 282,000
Purchases 2,548,000
Sales commission 76,000
Sales returns 42,000
Sales salaries 257,000
Shipment-in 81,000

• Assume a tax rate of 35%.

Required: Prepare the income statement
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 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000

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 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000
Merchandise inventory beginning 409,000
Purchases 2,548,000
Shipment–in 81,000
Purchase discounts –31,000
Merchandise inventory ending –547,000
Cost of goods sold –2,460,000

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 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000
Merchandise inventory beginning 409,000
Purchases 2,548,000
Shipment–in 81,000
Purchase discounts –31,000
Merchandise inventory ending –547,000
Cost of goods sold –2,460,000
Gross profit 2,498,000

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 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000
Merchandise inventory beginning 409,000
Purchases 2,548,000
Shipment–in 81,000
Purchase discounts –31,000
Merchandise inventory ending –547,000
Cost of goods sold –2,460,000
Gross profit 2,498,000
Sales salaries 257,000
Sales commission 76,000
Advertising 108,000
Depreciation of sales equipment 58,000
Selling expense –499,000

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 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000
Merchandise inventory beginning 409,000
Purchases 2,548,000
Shipment–in 81,000
Purchase discounts –31,000
Merchandise inventory ending –547,000
Cost of goods sold –2,460,000
Gross profit 2,498,000
Sales salaries 257,000
Sales commission 76,000
Advertising 108,000
Depreciation of sales equipment 58,000
Selling expense –499,000
Office salaries 282,000
Insurance expense 26,000
Accounting and legal services 24,000
Depreciation of office 62,000
Administrative expense –394,000

I-25
 Solution
Sales 5,000,000
Sales returns –42,000
Net Sales 4,958,000
Merchandise inventory beginning 409,000
Purchases 2,548,000
Shipment–in 81,000
Purchase discounts –31,000
Merchandise inventory ending –547,000
Cost of goods sold –2,460,000
Gross profit 2,498,000
Sales salaries 257,000
Sales commission 76,000
Advertising 108,000
Depreciation of sales equipment 58,000
Selling expense –499,000
Office salaries 282,000
Insurance expense 26,000
Accounting and legal services 24,000
Depreciation of office 62,000
Administrative expense –394,000
Income from operations 1,605,000
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 Solution

…
Income from operations 1,605,000
Interest expense –176,000
Income before taxes 1,429,000
Income taxes –500,150
Income before extraordinary item 928,850
Extraordinary loss, net of $33,600 taxes –62,400
Net income 866,450

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 Solution: Condensed Income Statement
Net Sales (1) 4,958,000
Cost of goods sold (2) –2,460,000
Gross profit 2,498,000
Selling expense (3) 499,000
Administrative expense (4) 394,000 –893,000
Income from operations 1,605,000
Interest expense –176,000
Income before taxes 1,429,000
Income taxes –500,150
Income before extraordinary item 928,850
Extraordinary loss, net of $33,600 taxes –62,400
Net income 866,450

(1) 5,000,000-42,000
(2) 409,000+(2,548,000+81,000-31,000)-547,000
(3) 257,000+76,000+108,000+58,000
(4) 282,000+26,000+24,000+62,000
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 Comprehensive Income

• Comprehensive income is net income (from the income

statement) plus “other comprehensive income”;

• To avoid earnings fluctuations some of the unrealized

gains/losses are reported in “other comprehensive income”
(OCI) and not included in net income.
• Examples of OCI are:
• Unrealized gains or losses on intangible assets and property, plant and equipment
• Unrealized gains or losses on derivatives used in hedging
• Unrealized gains or losses on pension and postretirement liabilities
• Foreign currency translation adjustments
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 Shareholder’s Equity

• Has two primary components:

üContributed capital which represents stockholders’ investment – common
stock (par value) and additional paid in capital, and

üRetained earnings which equals cumulative net income minus cumulative

dividends since the formation of the company. (Dividends are distributions
of assets to stockholders.)

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 The Components of the Equity Statement

The Stocks and Flow Equation:

Ending equity =
Beginning equity + Comprehensive income – Net payout to shareholders

Comprehensive income =
Net income + Other comprehensive income (OCI)

Net payout to shareholders =

Dividends + Share repurchases – Share issues

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The Statement of
Shareholders’
Equity:
Nike, Inc., 2010

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Comprehensive Income

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 The Statement of Stockholders’ Equity

The statement of
stockholders’ equity
documents changes
in the balance sheet
equity accounts

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 The Statement of Cash Flows

The Cash Flow

Statement :
Nike, Inc., 2010

The statement of cash flows explains the

change in cash during the period in terms
of cash provided by or used for operating,
investing and financing activities.

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The Form of the Cash Flow Statement
Change in Cash
=
Cash from Operations

+ Cash from Investing

+ Cash from Financing

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The Articulation of the Financial Statements: How They Fit Together

Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations
Beginning Balance Sheet Cash from investing Ending Balance Sheet
Cash from financing
Cash Net change in cash
Cash
+ Other Assets Statement of + Other Assets
Shareholders’ Equity
Total Assets Total Assets
Investment/disinvestment by owners
– Liabilities Net income and OCI – Liabilities

Owners’ equity Net change in owners’ equity Owners’ equity

Income Statement
+ Revenues
– Expenses
Net income
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 A Summary of the Accounting Relations
The Balance Sheet The Income Statement
+ Assets + Net Revenue
- Liabilities - Cost of Goods Sold
= Shareholders’ Equity = Gross Margin
– Operating Expenses
= Operating Income before Taxes (EBIT)
– Net Interest Expense
Cash Flow Statement = Income Before Taxes
+ Cash Flow from Operations – Income Taxes
+ Cash Flow from Investing = Income After Tax and before Extraordinary Items
+ Cash Flow from Financing + Extraordinary Items
= Change in Cash = Net Income
– Preferred Dividends
= Net Income Available to Common Shares

Statement of Shareholders’ Equity

+ Dividends
+ Net Income + Share Repurchases
+ Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income ¬¾¾ = Comprehensive Income - Share Issues
- Net Payout to Shareholders ¬¾¾¾¾¾¾¾¾¾¾¾¾¾¾¾ = Net Payout
= Ending Equity I-38
 Accounting for a Savings Account
• Amount invested: $100
• Earnings rate: 5%

BALANCE SHEET INCOME STATEMENT

Assets $100 Owners’ equity $100 Revenue $5

Expenses 0

Earnings $5

STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY

Cash from operations $5 Balance, end of Year 0 $100

Cash investment 0 Earnings, Year 1 5

Cash in financing activities: Dividends (withdrawals), Year 1 (5)

Dividends (5) Balance, end of Year 1 $100

Change in cash $0
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 Measurement in the Balance Sheet

• Historical Cost Accounting

• Fair Value Accounting

Box 2.3 in text explains how each item of assets

and liabilities is measured.

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 Principles of Earnings Measurement

• Recognize value added only when you have a customer

ü Revenue recognition principles

Add value when it has been earned
(usually when a sale is made).

ü Matching principle
Match expenses against revenue for which they
are incurred.

• Accounting value added (earnings) = Revenue – Expenses

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 Good Matching: Examples

• Only costs of good sold are matched to sales revenue, not the full
costs of producing or buying inventory during the period. Thus,
gross margin (Revenue – Cost of good sold) measures value added
from trading with customers. Costs for goods not sold are
reported in the balance sheet, as inventory, to be matched with
revenue in future periods when the inventory is sold.

• Costs of buying plant are not expensed when incurred. Rather,

the cost is “capitalized” on the balance sheet and depreciated over
years when the plant produces revenues. Depreciation is a
method of matching the cost of plant to the revenues the plant
generates.

• Employee pension costs are recorded as an expense in the period

that employees generate revenues, not when they are paid (in
retirement).

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 Bad Matching: Examples

• Research and development expenditures are expensed when

incurred, rather than matched to (subsequent) revenues they
generate.

• Advertising and promotion costs are expensed when incurred,

rather than matched to (subsequent) revenues they generate.

• Estimating useful lives for plant assets that are too long:
Depreciation is understated.

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