FINANCIAL REPORTING
MF 713
FINANCIAL REPORTING
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Introduction
• My name – Chima Mbagwu
• Your name ?
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Teaching philosophy (Blending research and teaching
and office hours)
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Your Expectations from this class – Very important.
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My expectations from you
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What is this class about?
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My emphasis is on learning
What my role will be
What your role will be
What happens if we both perform our
roles, :); if not :(
The learning environment
Questions….
Role of Financial Statement Analysis
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Accounting is the language of business
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Accounting is a system of analyzing, recording
and summarizing the results of a business’s
activities and then reporting the results to
decision makers.
What is the purpose of Financial Statement
Analysis
 The role of FSA is to make predictions about a
company’s ability to earn profits and generate
cash flows into the future based on its past
performance and current financial health.
Four Main Financial Statements
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Balance Sheet
Income Statement
Statement of owners’ Equity/Retained earnings
Statement of Cash Flows
All four statements are interconnected.
Key Financial Statements
1. Balance sheet—statement of affairs at a point in time
 Mirrors the accounting equation:
 Assets = liabilities + owners’ equity
 Use of funds = sources of funds
 Assets are the resources controlled by the firm
and are listed in order of liquidity
 Liabilities are amounts owed to lenders and other
creditors
 Owners’ equity is the residual interest in the net
assets of an entity that remains after deducting its
liabilities
Assets
For an item to be an asset, it must
1.
possess expected future economic benefits
2.
Be owned (or controlled) by the company
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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.
Ordering is different between US GAAP and IFRS
Examples of Assets
Current Assets:
 Cash
 Marketable securities
 Accounts receivable, net
 Inventory
 Prepaid expenses
Referred to as current because they can easily be
converted to cash
Long Term Assets
 Long-term investments
 Intangible and other assets
 Property, plant and equipment (PPE), net
Liabilities
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These are amounts that the company owes to
others
They are either short term – current or;
Long term
Liabilities have to be paid eventually otherwise,
the company becomes bankrupt
Some liabilities are interest bearing
Examples of Current Liabilities
Current liabilities (operate the business)
 Accounts payable
 Accrued liabilities
 Unearned revenues
 Short-term notes payable
 Current maturities of long-term debt
Long term liabilities (finance the business)
 Long-term debt
 Other long-term liabilities
Equity
Equity consists of:
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Contributed Capital (cash raised from the
issuance of shares)
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Earned Capital (retained earnings). Retained
Earnings is updated each period as follows:
Examples of Equity Accounts
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Common stock.
Preferred stock
Additional paid-in capital
Treasury stock
Retained earnings
Accumulated other comprehensive income or loss
Even though equity shows the net assets or net worth
of a company, it is wrong to view this as the value of a
company because of the historical cost assumption.
Balance Sheet Format
Liquidity
 For a company overall, its ability to pay for short-term
obligations
 For a particular asset or liability, its “nearness to cash”
Balance sheet ordering according to liquidity:
 Companies using U.S. GAAP (e.g., Apple, Hershey)
order items on the balance sheet from most liquid to
least liquid.
 Companies using IFRS order balance sheet
information from least liquid to most liquid.
Key Financial Statements
2. Income Statement
 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 or profit.
Key Financial Statements
3. Statement of changes in owners’
equity/Retained Earnings—amounts and sources of
changes in shareholders’ equity over the period
4. Cash flow statement reconciles beginning and
ending cash balance, splitting changes into three
categories:
 Operating cash flows (CFO)
 Investing cash flows (CFI)
 Financing cash flows (CFF)
Key Financial Statements
The order of preparation
1. The income statement
2. The statement of retained earnings
3. The balance sheet
4. The Cash flow statement
This is also the order that you will follow when you
are attempting to create a forecast financial
statement.
Other sources of information
In addition to the key financial statements, there are
other sources of information that a company
discloses or other financial intermediaries disclose
which is helpful in analyzing the financial statements.
1.
Footnotes and supplementary disclosures
2.
Management discussion and analysis
3.
Audit report
Footnotes and Supplementary Schedules
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Basis of presentation
Accounting methods and assumptions
Further information on amounts in primary statements
Business acquisitions/disposals
Contingencies
Legal proceedings
Stock options and benefit plans
Significant customers
Segment data
Quarterly data
Related-party transactions
Management Discussion and Analysis
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Nature of the business
Results from operations, business overview
Trends in sales and expenses
Capital resources and liquidity
Cash flow trends
Discussion of critical accounting choices
Effects of inflation, price changes, and
uncertainties on future results
The Audit Report
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Audit: Independent review of company’s financial
statements
Reasonable assurance that financial statements are
free of material errors
Audit opinion:
Unqualified: “Clean” opinion
Qualified: Exceptions to accounting principles
Adverse: Statements not presented fairly
Disclaimer of opinion: Unable to form an opinion
Must provide opinion on company’s internal controls
under U.S. GAAP
Audit Report
1. Responsibility of management to prepare
accounts
 Independence of auditors
2. Properly prepared in accordance with relevant
GAAP
 Reasonable assurance that the statements are
free from material misstatement
3. Accounting principles and estimates chosen are
reasonable
Financial Statements – Problem
Regarding the report of independent auditors
under GAAP, the audit report:
A. is unqualified if the auditors disagree with
the firm on the treatment of some items.
B. must provide an opinion on the firm’s
internal controls.
C. does not apply to the footnotes to the
financial statements.
Financial Statement Analysis
Framework
1.
2.
3.
4.
5.
6.
Purpose and context of analysis
Collect data
Process data
Analyze/interpret data
Conclusions and recommendations
Update analysis periodically
Accounting Equations
Revenue – Expenses = Net income
Assets = Liabilities + Owners’ equity
Assets – Liabilities = Owners’ equity
Owners’ equity = Contributed capital +
Retained earnings
Closing RE = Opening RE + NI - Dividend
Financial Reporting – Problem
Which of the following would be most likely to
change equity?
A. Collecting receivables.
B. Selling a 5-year-old machine.
C. Declaring a dividend.
Financial Reporting – Problem
Which of the following would be most likely to
change equity?
A. Collecting receivables.
B. Selling a 5-year-old machine.
C. Declaring a dividend.
Declaring a dividend will always decrease
equity, as it increases a liability (dividends
payable).
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:
Balance Sheet
Transaction
1. The Ice Cream Store, Inc.
was formed on October 1,
20XX, with the investment of
$90,000 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 downpayment 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.
Cash Asset
+
Noncash
Assets
=
Liabi
-lities
Income Statement
+
Contrib
. capital
+
Retained
Earnings
Revenues
– Expenses
Balance Sheet
Transaction
1. The Ice Cream Store, Inc.
was formed on October 1,
20XX, with the investment of
$90,000 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 downpayment 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.
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
$80,000
Equipment
25,000
Ice Cream
Shop
Building
80,000
Balance Sheet:
Total Assets
$185,000
LIABILITY AND STOCKHOLDERS' EQUITY
Liabilities:
Note Payable
Mortgage Payable
Total Liabilities
$35,000
60,000
95,000
Stockholders Equity:
Capital Stock
90,000
Total Liabilities and
Stockholders Equity
$185,000
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 $15,000 by paying $5,000 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 $3,000.
Sales of ice cream for the month of October, 20XX, totaled $8,000. All
sales were for cash. The ice cream cost $3,500.
For all of October, total employee wages and salaries earned/paid
were $3,000.
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.
$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
Cash
Asset
+
Noncash Assets
=
Liabilities
+
Contrib.
capital
+
Retained
Earnings
Revenues
– Expenses
6.
7.
8.
9.
10.
11.
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.
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.
+
Income Statement
- .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.
Income Statement for the period
ended:
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
Note: Assume no income taxes.
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:
Capital Stock
Retained Earnings
90,000
500
90,500
Total Liabilities and Stockholders' Equity
$192,500
Cashflow Statement
36
Business Activities and Cash
Flows
The Statement of Cash Flows shows each
major type of business activity that caused a
company's cash to increase or decrease.
Operating
Activities
Investing
Activities
Financing
Activities
Classifying Cash Flows
Statement of Cash Flows
Cash flows related to dayto-day activities
Cash flows related to long
term assets
Cash flows with lenders
and investors
Beginning and ending
cash balance
Operating Activities
Cash flows from operating activities are
related to components of net income.
Investing Activities
Cash flows from investing activities are
related to the sale or purchase of
investments and long-lived assets.
Financing Activities
Cash flows from financing activities are
related to external financing sources
(owners and lenders).
Relationships to Other Financial Statements
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To prepare a Statement of Cash
Flows, information is needed from:
Comparative
Balance Sheets
A complete
Income
Statement
Additional Data
The basic balance sheet equation is:
Assets = Liabilities + Shareholders' Equity
Split Assets into Cash and Noncash Assets:
Cash + Noncash Assets = Liabilities + Shareholders' Equity
Move Noncash Assets to the Right:
Cash = Liabilities + Shareholders' Equity – Noncash Assets
Changes to Cash must be:
Changes in Cash = Changes in (Liabilities + Shareholders' Equity –
Noncash Assets)
This equation says that changes in cash must be equal to changes
in liabilities, shareholders’ equity and noncash assets.
Preparing the Statement of Cash Flows
1
Determine the change in each balance sheet
account.
2
Identify the cash flow category or categories
for each account.
3
Create schedules that summarize operating,
investing, and financing cash flows.
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Two methods for preparing the Statement
Both yield identical results. Only difference is in the
operating section
The Direct Method reports components of cash flows
from operating activities as gross receipts and
payments.
The Indirect Method present the operating activities
sections of the cash flow statement by adjusting net
income to compute cash flows from operating
activities.
The result will be the same.
Cash Flow Statement Preparation
Consider the following information to be used to prepare a Cash Flow Statement:
1
2
Determine the
change in each
Balance Sheet
Account
Determine the related
Cash Flow section;
Operating, Investing
or Financing
Operating Cash Flows
Indirect Method
Net Income
+/- Items included in net income that do not involve cash
+ Amortization
+ Losses on disposal of long-term assets or retirement of long-term debt
– Gains on disposal of long-term assets or retirement of long-term debt
+/- Changes in current assets and current liabilities
+ Decreases in current assets
– Increases in current assets
– Decreases in current liabilities
+ Increases in current liabilities
= Net Cash Flow provided by (used in) Operating Activities
Free Cash Flow (FCF)
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FCF is cash available for discretionary uses
Frequently used to value firms
FCFF = CFO + Int (1 – T) – FCInv
FCFE = CFO – FCInv + Net debt increase
Operating Activities
presented using the
Direct Method
There is no change
in the presentation
of Investing and
Financing Activities