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
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The Financial Statements

Balance Sheet – assets, liabilities and equity at one point in time

Income Statement – revenues, expenses, and profit over a
period of time

Statement of Equity – changes in contributed and earned
capital

Statement of Cash Flows – net cash inflows (outflows) form
operating, investing and financing activities
Balance Sheet

Mirrors the Accounting Equation
Assets = Liabilities + Equity
Uses of funds = Sources of funds
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Assets are listed in order of liquidity
Liabilities are listed in order of maturity
Equity consists of Contributed Capital and
Retained Earnings
Balance Sheet
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A balance sheet reports on investing and
financing activities.
It lists amounts for assets, liabilities, and equity
as of a point in time.
The accounting equation (also called the balance
sheet equation) is the basis of the balance sheet:
Assets = Liabilities + Equity
The Accounting Equation
Berkshire Hathaway’s Balance Sheet
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
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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
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Cash—currency, bank deposits, and investments with an
original maturity of 90 days or less (called cash equivalents);
Marketable securities—short-term investments that can be
quickly sold to raise cash;
Accounts receivable, net—amounts due to the company from
customers arising from the sale of products and services on
credit (“net” refers to uncollectible accounts );
Inventory—goods purchased or produced for sale to customers;
Prepaid expenses—costs paid in advance for rent, insurance,
advertising or other services.
Examples of Long-term Assets
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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 subtraction of accumulated
depreciation, the portion of the assets’ cost that has been
transferred from the balance sheet to the income statement);
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.
Apple’s Assets
Cisco Systems, Inc. Assets
Assets are Reported at
Historical Cost
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Historical Cost is
Objective
 Verifiable
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“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
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NOTE: While resources expended for research and
development reflect an 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.]
Disney’s Assets
Where’s Mickey? The
market value of the
Mickey Mouse trademark
does not explicitly show up
here.
Apple’s Liabilities and Equity
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.
Cisco systems, Inc. Current Liabilities
Net Working Capital
Operating Cycle
Examples of Noncurrent Liabilities

Long-term debt—amounts 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 long-term
debt. Long-term debt includes bonds, mortgages, and other long-term
loans.
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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.
Cisco Systems, Inc.
Long-term Liabilities
Statement of Equity

The statement of equity reports on changes in
the accounts that makeup equity
Contributed capital
 Earned capital (retained earnings and accumulated
other comprehensive income)
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This statement is useful in identifying and
analyzing reasons for changes in owners’ claims
on a company’s assets.
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:
Berkshire Hathaway’s
Statement of Stockholders’ Equity
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 addition to the par value of common 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 equity that are not reported in the income statement.
Cisco Systems, Inc.
Stockholders’ Equity
Income Statement
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An income statement reports on operating
activities.
It lists amounts for sales (and revenues) less all
expenses (and costs) over a period of time.
Sales less expenses yield the “bottom-line” net
income amount.
Income Statement
Berkshire Hathaway’s
Income Statement
Apple’s Income Statement
Cisco Systems, Inc.
Income Statement
When are Revenues and Expenses Recognized?
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Revenue Recognition Principle—recognize
revenues when earned
Matching Principle—recognize expenses
when incurred.
Profit vs. Cash
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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
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Operating expenses are the usual and
customary costs that a company incurs to
support its main business activities
Nonoperating expenses relate to the
company’s financing and investing activities
Transitory Items in the
Income Statement
Transitory items
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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
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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

Apple’s Statement of
Stockholders’ Equity
Statement of Cash Flows
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Statement of cash flows (SCF) reports cash inflows
and outflows
Cash flows are reported based on the three business
activities of a company:
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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.
Statement of Cash Flows

The statement of cash flows reports on cash flows for
operating, investing, and financing activities over a period
of time.
Apple’s
Statement
of Cash
Flows
Cisco
Systems,
Inc.
Statement 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
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Financial statements are linked within and
across time – they articulate.
Balance sheet and income statement are
linked via retained earnings.
Apple’s Retained Earnings
Reconciliation
Financial Statements
Information Beyond Financial
Statements
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Management Discussion and Analysis
(MD&A)
Independent Auditor Report
Financial Statement Footnotes
Regulatory Filings and Proxy Statements
Economics of Accounting
Information: Demand & Supply

Demand for financial accounting information
extends to numerous users that include:
Managers and employees
 Creditors and suppliers
 Shareholders and directors
 Customers
 Regulators
 Voters and their representatives

Supply of Accounting Information
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Determined by a company’s estimates of the
benefits and costs of disclosure.
Regulation and bargaining power also play roles
in determining the supply of financial
accounting information.
The SEC requires financial statements, various
note disclosures, and other reports on a regular
basis.
Supply of Accounting Information
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Benefits of disclosure
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lower capital cost from improved transparency
reputation effects enhance labor recruiting
Costs of disclosure
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Information gathering costs
More information to competitors
Potential litigation costs
Potential political costs
Accounting Principles and
Governance Structures
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Information in financial statements enables
company valuation and, by extension, the
valuation of its debt and equity securities.
The importance of financial statements means
that their accuracy is of paramount importance .
To the extent that financial performance and
condition are accurately communicated to
business decision makers, debt and equity
securities will be more accurately priced.
Audit Report
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Financial statements present fairly and in all material respects
company financial condition.
Financial statements are prepared in conformity with GAAP
Financial statements are management’s responsibility. Auditor
responsibility is to express an opinion on those statements
Auditing involves a sampling of transactions, not investigation
of each transaction
Audit opinion provides reasonable assurance that the statements
are free of material misstatements
Auditors review accounting policies used by management and
estimates used in preparing the statements
Sarbanes-Oxley Act
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The SEC requires the CEO and CFO of a company to
personally sign a statement attesting to the accuracy and
completeness of the company’s financial statements.
The statements signed by both the CEO and CFO contain the
following commitments:
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The CEO and CFO have personally reviewed the annual report
There are no untrue statements of a material fact or failure to state a
material fact necessary to make the statements not misleading
The financial statements fairly present in all material respects the financial
condition of the company
All material facts are disclosed to the company’s auditors and Board of
Directors
No changes to the company’s system of internal controls are made unless
properly communicated
Financial Accounting:
not an exact science
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GAAP allows companies choices in preparing
financial statements (inventories, property, and
equipment).
Companies must choose among the alternatives
that are acceptable under GAAP.
Financial statements also depend on countless
estimates.
Financial Accounting in Context
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A company’s financial statements only tell part
of the story.
You must continually keep in mind the world in
which the company operates.
Financial statement analysis must be conducted
within the framework of a thorough
understanding of the broader forces which
impact company performance.
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 GHS90,000 in cash by the owners.
2. Obtained a bank loan and received the proceeds of GHS35,000
on October 2. The cash will be used for operations.
3. Purchased equipment for GHS25,000 cash on October 2.
4. Acquired a building at a cost of GHS80,000. It was financed by
making a GHS20,000 down-payment and obtaining a mortgage
for the balance. The transaction occurred on October 2.
5. On October 2, the President of Ghana publicly declared that he
will eat (and plug) our ice cream while entertaining guests in the
Flagstaff House.
Prepare a transaction analysis of 1. – 5. using the financial statement
effects template:
Balance Sheet
Transaction
1. The Ice Cream Store, Inc.
was formed on October 1,
20XX, with the investment of
GHS90,000 by the owners.
2. Obtained a bank loan and
received the proceeds of
GHS35,000 on October 2. The
cash will be used for operations.
3. Purchased equipment for
GHS25,000 cash on October 2.
4. Acquired a building at a cost
of GHS80,000. It was financed
by making a GHS20,000 downpayment and obtaining a
mortgage for the balance. The
transaction occurred on
October 2.
5. The President agreed to eat
(and plug) our ice cream while
entertaining guests in the
Flagstaff House on Oct. 2.
Cash Asset
+
Noncash
Assets
=
Liabi
-lities
+90
-20
+
Contrib
. capital
+90
+35
N/P
+35
-25
Income Statement
+25
Equip
+80
Bldg.
+60
M/P
+
Retained
Earnings
Revenues
– Expenses
ASSETS
Cash
Ice Cream Shop
Balance Sheet:
GHS80,000
Equipment
25,000
Building
80,000
Total Assets
GHS185,000
LIABILITY AND STOCKHOLDERS' EQUITY
Liabilities:
Note Payable
Mortgage Payable
Total Liabilities
GHS35,000
60,000
95,000
Stockholders Equity:
Capital Stock
90,000
Total Liabilities and
Stockholders Equity
GHS185,000
Ice Cream Shop –
additional transactions
6.
7.
8.
9.
10.
11.
On October 4, purchased merchandise inventory (i.e., ice cream) at a cost of
GHS15,000 by paying GHS5,000 cash and receiving short-term credit for the
remainder from the supplier.
Immediately returned some of the ice cream because some of the flavors
delivered were not ordered. The cost of the inventory returned was GHS3,000.
Sales of ice cream for the month of October, 20XX, totaled GHS8,000. All
sales were for cash. The ice cream cost GHS3,500.
For all of October, total employee wages and salaries earned/paid were
GHS3,000.
As of the end of October, one month's depreciation on the equipment and
building was recognized -- GHS383 for the building and GHS167 for the
equipment.
GHS450 interest expense on the note and mortgage was due and paid on
October 31. Assume that the principal amounts (GHS35,000 + GHS60,000) 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
-3
Wage exp.
-.550
Dep. exp.
-.550
-.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.
Cash (GHS80,000 -5,000 +8,000 -3,000 -450)
Merchandise Inventory (GHS0 + 15,000 -3,000 -3,500)
Equipment (GHS25,000 )
Less: Accumulated Depreciation
Building (GHS80,000)
Less: Accumulated Depreciation
Total Assets
Accounts Payable (GHS0 + 10,000 – 3,000)
GHS79,550
8,500
25,000
(383)
80,000
(167)
GHS192,500
GHS7,000
Note Payable (GHS35,000 principal is unchanged)
35,000
Mortgage Payable (60,000 principal is unchanged)
60,000
102,000
Stockholders' Equity:
Capital Stock
Retained Earnings
90,000
500
90,500
Total Liabilities and Stockholders' Equity
GHS192,500
REVENUES:
Sales of Ice Cream
GHS8,000
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
Note: Assume no income taxes.
GHS500
Preparing
the Financial
Statements
Balance Sheet and Income Statement
Statement of Stockholders’ Equity