Understanding Basic

Financial Statements
…make better use of the information in financial statements
 Primary Financial Statements
Basic financial statements:
 Balance Sheet
 Income Statement
 Statement of Retained Earnings
 Statement of Cash Flows
 Primary Financial Statements
• Primary financial statements answer basic questions
including:
– What is the company’s current financial status?
– What was the company’s operating results for the period?
– How did the company obtain and use cash during the period?
 Statement of financial position
• Summary of the financial position of a company at a
particular date
• Assets: cash, accounts receivable, inventory, land,
buildings, equipment and intangible items
• Liabilities: accounts payable, notes payable and
mortgages payable
• Owners’ Equity: net assets after all obligations have
been satisfied
 Statement of financial position
• What are the resources of the company?
• What are the company’s existing obligations?
• What are the company’s net assets?
 Accounting Equation
Assets = Liabilities + Owners’ Equity

Resources Sources of Funding

Resources Creditors’ Owners’

to use to claims claims
generate = against
+ against
revenues resources resources
 Balance Sheet Limitations
 Assets recorded at historical value
 Only recognizes assets that can be expressed in monetary terms
 Owners’ equity is usually less than the company’s market value
 Statement of profit or loss
• Shows the results of a company’s operations over a
period of time.
• What goods were sold, or services performed that
provided revenue for the company?
• What costs were incurred in normal operations to
generate these revenues?
• What are the earnings or company profit?
 Statement of profit or loss
Revenues
• Assets (cash or AR) created through business
operations
Expenses
• Assets (cash or AP) consumed through business
operations
Net Income or (Net Loss)
• Revenues - Expenses
 Statement of changes in equity
An additional financial
Beginning retained earnings
statement that identifies
+ Net income changes in retained
earnings from one
– Dividends paid accounting period to the
next.
= Ending retained earnings

Net income results in: Dividends result in:

Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained
Increase in owners’ equity earnings
Decrease in owners’ equity
 Statement of Cash Flows
• Reports the amount of cash collected and paid out by a company in
operating, investing and financing activities for a period of time.
• How did the company receive cash?
• How did the company use its cash?
• Complementary to the income statement.
• Indicates ability of a company to generate income in the future.
 Statement of Cash Flows
Cash inflows
• Sell goods or services
• Sell other assets or by borrowing
• Receive cash from investments by owners
Cash outflows
• Pay operating expenses
• Expand operations, repay loans
• Pay owners a return on investment
 Match Classification of
Cash Flows
• Operating activities – Transactions and events
that enter into the determination of net income.
• Investing activities – Transactions and events that
involve the purchase and sale of securities,
property, plant, equipment, and other assets not
generally held for resale, and the making and
collecting of loans.
• Financing activities – Transactions and events
whereby resources and obtained from, or
repaid to, owners and creditors.
 Operating Activities
Cash Inflow Cash Outflow
• Sale of goods or • Inventory payments
services • Interest payments
• Sale of investments • Wages
in trading securities • Utilities, rent
• Interest revenue
• Taxes
• Dividend revenue
 Investing Activities
Cash Inflow Cash Outflow
• Sale of plant assets • Purchase of plant assets
• Sale of securities, • Purchase of securities,
other than trading other than trading
securities securities
• Collection of principal
• Making of loans to
on loans
other entities
 Financing Activities
Cash Inflow Cash Outflow
• Issuance of own stock • Dividend payments
• Borrowing • Repaying principal on
borrowing
• Treasury stock
purchase
 Statement of Cash Flows
Operating Investing Financing
CASH Activities Activities Activities
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
 Statement of Cash Flows Analysis
Operating Investing Financing General Explanation
Building up pile of cash,
1. + + + Possibly looking for
Acquisition

2. + ─ ─ Operating cash flow being

Used to buy fixed assets
And pay down debt

3. + + ─ Operating cash flow and sale of fixed assets

being used to pay down debt.

Operating cash flow and borrowed

4. + ─ + money being used
to expand
 Statement of Cash Flows Analysis
Operating Investing Financing General Explanation

Operating cash flow problems covered by sale

5. ─ + + of fixed assets, borrowing and owner
contributions.

6. Rapid growth, short falls in operating cash

─ ─ +
flow; purchase of fixed assets.

Sale of fixed assets is financing operating cash

7. flow shortages.

─ + ─
Company is using reserves
to finance cash flow
8. ─ ─ ─ short falls.
 Notes to the Financial Statements
• Notes are used to convey information required
by GAAP or to provide further explanation.
 Notes to the Financial Statements
Four general types of notes:
 Summary of significant accounting policies:
assumptions and estimates.
 Additional information about the summary totals.
 Disclosure of important information that is not
recognized in the financial statements.
 Supplementary information required by the FASB or
the SEC.
 What Are The Fundamental
Concepts and Assumptions?
• Separate Entity Concept
• Arm’s-Length Transactions
• Cost Principle
• Monetary Measurement Concept
• Going Concern Assumption
 Separate Entity Concept
Entity ─ The organizational unit for which
accounting records are maintained.

Separate entity concept ─ The activities of an

entity are to be separate from those of its individual
owners.
• Proprietorship
• Partnership
• Corporation
 The Cost Principle
• All transactions are recorded at historical cost.
• Historical cost is assumed to represent the fair
market value of the item at the date of the transaction
because it reflects the actual use of resources by
independent parties.
 The Monetary Measurement
Concept
• Accountants measure only those economic activities
that can be measured in monetary terms.
• Listed values may not be the same as actual market
values:
– Inflation
– Measurement issues
 The Going Concern Assumption
• An entity will have a continuing existence for the
foreseeable future.
 Why Use Accrual Accounting?
• GAAP – Generally Accepted Accounting
Principles
• Business requires periodic, timely reporting
• Accrual-basis accounting better measures a firm’s
performance than does cash flow data.
 The Time Period Concept
The life of a business is divided into distinct and
relatively short time periods so the accounting
information can be timely, generally 12 months or
less.
 Define Accrual Accounting
• A system of accounting in which revenues and
expenses are recorded as they are earned and
incurred, not necessarily when cash is received
or paid.
• Provides a more accurate picture of a
company’s profitability.
• Statement users can make more informed judgments
concerning the company’s earnings
potential.
 Revenue Recognition
Revenues are recorded when two main criteria are met:
The earning process is
 substantially complete

Cash has either been collected

 or collection is reasonably
assured.
 The Matching Principle
costs and expenses
• All costs and expenses incurred in generating
revenues must be recognized in the same
reporting period as the related revenues.
• This process of matching expenses with
recognized revenues determines the amount of net
income reported on the income statement.
related revenues
 Cash-Basis Accounting
• Revenues and expenses are recognized only when
cash is received or payments are made.
• Mainly used by small businesses.
• Not an accurate picture of true profitability.
 Accrual vs. Cash-Basis Accounting
During 2010, Crown Consulting billed its client for $48,000. On
December 31, 2010, it had received $41,000, with the remaining
$7,000 to be received in 2011. Total expenses during 2010 were
$31,000 with $3,000 of these costs not yet paid at December 31.
Determine net income under both methods.
Cash-Basis Accounting Accrual-Basis Accounting
Cash receipts $41,000 Revenues earned $48,000
Cash disbursement 28,000 Expenses incurred $31,000
Income $13,000 Income $17,000
 Purpose of Analysis
Financial statement analysis helps users make
better decisions.

Internal Users External Users

• Managers • Shareholders
• Officers • Lenders
• Internal Auditors • Customers
 Building Blocks of Analysis
Ability to meet Ability to
short-term generate future
obligations and to revenues and
efficiently generate Liquidity meet long-term
revenues Solvency obligations
and
Efficiency
Ability to
Ability to provide generate
financial rewards positive market
sufficient to attract expectations
and retain
financing Profitability Market
 Standards for Comparison
 Intra-company
 Competitor
 Industry
 Guidelines
 Tools of Analysis
Horizontal Analysis
• Comparing a company’s financial condition and
performance across time.
 Tools of Analysis
Vertical Analysis
• Comparing a company’s financial condition and performance to a
base amount.