Module 2:
Overview of Business
Activities and
Financial Statements
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





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 explained in
Module 6);
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



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,
which is explained in Module 6);
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

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.]
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.

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 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 (explained
in Module 8).
Cisco Systems, Inc.
Stockholders’ Equity
Income Statement
Apple’s Income Statement
Cisco Systems, Inc.
Income Statement
When are Revenues and Expenses Recognized?


Revenue Recognition Principle—recognize
revenues when earned
Matching Principle—recognize 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
company’s 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

Apple’s 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 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.
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


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
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:
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
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
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
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 ($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
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.
Preparing
the Financial
Statements
Balance Sheet and Income Statement
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 Registrant’s Common Equity and Related Stockholder Matters;
 Item 6, Selected Financial Data;
 Item 7, Management’s 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 company’s certified public accounting
firm
 Change in control of the company
 Departure of the company’s executive officers
 Changes in the company’s articles of incorporation
or bylaws

Analyst Reports
Credit and Data Services

Credit Analysis
Standard & Poor’s (StandardAndPoors.com)
 Moody’s 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.
