Introduction to Financial Statements
Course KRF21SE
March 25-26, 2003
Glenn Booker
Accounting provides relevant information to stakeholders (users).
Distinguish internal versus external stakeholders.
 External stakeholders include customers, stockholders, creditors, the government (federal
and state), and suppliers. They need accounting info to analyze their involvement with
the business. Mostly look for past performance data.
Stockholders and creditors get the annual report. Compliance data goes to regulatory
agencies, tax data goes to the government, and transaction data goes to suppliers and
customers.
 Internal stakeholders include employees and managers – those who run the business.
Internal users use accounting info to plan and execute future business operations. Might
include financial analysts, market research, and production managers. Managers need to
determine product cost, budget to plan operations, conduct purchasing and determine
pricing, and assess business performance.
An accounting information system includes four parts
 Financial accounting subsystem – provides info to external users, stockholders, and
creditors
 Management accounting subsystem – provides info to internal users – managers and
employees
 Taxation accounting subsystem – gives state and federal government info, particularly
about corporate, owner, and employee income tax.
 Regulatory accounting subsystem – gives the SEC financial statements and business
data
Service organizations (e.g. banks, hotels, insurance) primarily need to determine costs and
pricing.
Capital to support a business comes from stockholders and creditors (e.g. investors). They want
to know if their investment is safe.
The annual report typically includes business and financial performance data for the year, as well
as plans for the future of the business. Financial statements focus on present finanacial
performance. Comparative financial statements compare current performance to previous years.
Consolidated financial statements give financial statements for more than one company.
The annual report includes:
 Summary of financial highlights
 Letter to stockholders
 Current state of the business
 Auditor’s report
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

List of company directors and officers
Financial statements
Government needs include tax and regulatory data. Taxes include taxes paid, owed, and
employee taxes paid. Corporations pay state and federal income tax.
Form 1120 is a corporate tax return document, based on the Internal Revenue Code defined by
Congress (see IRS link).
Form 941 describes employee tax information.
Businesses must submit financial statements at regular intervals, and notify when changes in
ownership or board of directors occur.
Form 10K is a financial statement to the SEC (regulatory).
Suppliers and customers get more frequent accounting info than other stakeholders, since they
conduct more transactions with the business.
Documents for them include:
 Purchase orders, which are sent to suppliers to request goods or services from them.
 Invoices, which are sent to customers to request payment for goods or services received.
 Remittance advice slips, which are part of the supplier’s invoice, sent back to the supplier
with payment.
 Sales slips are given to the customer to record cash sales, and provide a customer receipt.
Major financial statements
Accounting follows Generally Accepted Accounting Principles (GAAP). There are four major
financial statements.
 Income statement
 Statement of owner’s equity
 Balance sheet
 Statement of cash flows
Income statement summarizes revenue, expenses, and net income (or loss) over some time
period. This determines whether the business has been profitable. Gets the revenues and
expenses from the adjusted trial balance.
Net income = revenue - expenses
Statement of owner’s equity shows changes in the equity (capital) of a business owner over some
time period. Corporations give a statement of retained earnings instead. Doesn’t show changes
in contributed capital. Shows both increases and decreases in equity. Can be negative for a
poorly performing company. Is obtained from the adjusted trial balance.
Balance sheet shows financial position of the business as of one date (a snapshot). Lists assets,
liabilities, and owner’s equity. Also called a “statement of financial position.” Gets cash assets
from the statement of cash flows, and equity info from the statement of owner’s equity. Is a
general overview of the company’s financial status. Is obtained from the adjusted trial balance.
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Statement of cash flows shows the liquidity of the business during some time period. Shows cash
inflows and outflows, and hence the net change in cash balance. Sections within it are the
operating activities, investing activities, and financing activities. The operating activities gets the
net income from the income statement, and the balance sheet item changes. Is derived from more
than the adjusted trial balance; it takes input from all cash accounts.
The adjusted trial balance provides all data for the income statement, statement of owner’s
equity, and balance sheet.
Statements are generated in order:
1) income statement
2) statement of owner’s equity
3) balance sheet
4) statement of cash flows
The statement of cash flows is too messy to describe in this course.
Compiling financial statements
The income statement includes all revenues (such as sales revenue), expenses (such as wages,
rent, utilities, insurance, supplies, and depreciation expenses), and calculates the net income.
The statement of owner’s equity (capital) gets the owner’s equity data from the adjusted trial
balance; and the net income from the income statement.
Balance sheet: Assets include all debits. Liabilities include accounts payable (AP), wages
payable, accumulated depreciation, and owner’s equity.
Assets = Liabilities + Owner’s Equity
Get data from the adjusted trial balance and from the statement of owner’s equity.
The two-column accounting format shows debits on the left, and credits on the right.
Debits are generally assets, and count negative. Include cash, accounts receivable (AR),
inventory, and all expenses.
Credits are generally liabilities, and count positive. Liabilities include sales revenue, accounts
payable (AP), wages payable, accumulated depreciation, and owner’s equity.
Who gets what
Accounting info goes to internal and external stakeholders.
 Internal get internal financial reports, such as payroll and inventory.
 External get financial statements, such as the annual report.
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Income statement reports expenses, offset by revenue during some time period.
Balance sheet lists assets and liabilities as of one day. Assets include the inventory ending
balance on that day; the inventory costing method must be stated (such as LIFO).
Balance sheet includes current and long term assets (inventory vs. property).
Statement of cash flows describes the cash flow associated with events in the income statement
and other operating activities of the business.
Income statement shows sales, cost of goods, expenses, taxes, etc to get operating income post
tax.
Statement of cash flow
Liquidity means the ability to pay obligations on time. More cash on hand means more liquidity.
Is based on opening and closing balances for every operating activity. Cash flow in includes
sales. Cash flow out includes purchases, advertising, wages, payroll, insurance, taxes.
Net cash = cash flow in – cash flow out
Investing and financing cash flows are also possible categories.
Inventory cash flow = cost of goods sold + previous ending inventory balance –
inventory beginning balance
Cash paid for inventory = amount owed for inventory during this period – AP on
inventory yet to be paid.
Part 4 was supposed to be a balance sheet simulation, but showed a profit & loss statement
instead. Plotted revenue, expenses, and profit over time, based on setting price per unit,
advertising cost per day, credit terms for customer, supplier payment period, and the amount of
short term debt outsourcing. Credit terms and payment period adjustable from 0-90 days.
Demand was made constant in most cases. Tool not very helpful! No test.
Price per unit is the wholesale amount charged for the product. Low price should raise demand,
but reduce revenue.
Web References
FASB (Financial Accounting Standards Board) – define GAAP
IRS – define taxation requirements
SEC – define regulatory requirements
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Reading and Analyzing Financial Statements
Course KRF22SE
March 26-28, 2003
Glenn Booker
Revenue and Gain
Revenue and gains affect business income.
A business incurs costs associated with purchase of goods & services. By using those goods &
services, the business increases its net worth and earns income through revenue and gains.
The FASB defines revenue as the inflow or enhancement of assets which constitute the entity’s
major operations.
Revenue = increase in assets and/or decrease in liabilities as a result of the business’
primary activities.
Hence revenues 1) increase the net worth of the business, 2) result from an earnings process, and
3) result from activities that are ongoing central operation for the business.
Recall that
Assets = Liabilities + owner’s equity
The net worth of a business is its owner’s equity, hence
Net worth = assets – liabilities
For example, sale of a book in a bookstore generates revenue, increases the assets of the
business, and hence increases their net worth. But the net worth increase is the price of the book
minus the costs of selling the book.
Sale of a gift certificate increases both assets and liabilities for the business, but the net worth
still goes up the same amount.
When the gift certificate is used, the store loses the liability, and hence earns revenue at that
moment.
Revenue must be from some action or process by the business; often selling goods or services.
Hence the gift certificate earns revenue when it is used, not when it is purchased.
Revenue is not earned from investments, unless that’s your primary business.
Revenue and gain are only recognized when realized and earned. The date of recognition is
reflected in financial statements.
If stocks earn value in the stock market, that gain doesn’t exist (isn’t recognized) until they are
sold. But the value of the stocks may be noted at the end of an accounting period; this is called
“mark-to-market.”
The FASB says revenue is earned when the entity (business) has substantially accomplished
what must be done to entitle the benefit of its revenue. Hence revenue is earned when goods are
sold or services are provided.
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Revenue is earned when the goods and services are provided, but revenue is realized when
payment or good promise of payment is received.
Payment can be a cash or non-cash asset. Noncash assets must be ‘of measurable value’ and
convertible to cash.
A gain is an increase in net worth from “peripheral or incidental transactions.” Hence any
increase in net worth due to something which isn’t revenue, is a gain. For example, a toy
company selling an outlet at a profit would be a gain, since their main business is selling toys.
Gains are typically rare events compared to revenue, hence revenue is more important.
Gains must be earned and realized before they can be recognized. The definitions of earned
and realized are the same as for revenues.
Operating Activities
Operating activities are broken into three cycles:
 Expenditure cycle – exchange company assets for goods and services from suppliers.
Suppliers includes vendors and employees. Vendors supply raw materials, or goods for
resale. Employees supply labor.
 Revenue cycle – sells goods and services to customers for payment.
 Conversion cycle – combines raw materials, labor, and resources to produce products.
Occurs only within a single company – no external parties are involved.
The expenditure and revenue cycles occur in service, manufacturing, and merchandising (retail)
companies. The conversion cycle only applies to manufacturing companies.
In a service company, the expenditure cycle pays for labor and materials.
In a manufacturing company, the expenditure cycle pays for labor, skills and knowledge,
employee benefits, and materials used in business.
In a merchandising company, the expenditure cycle pays for labor, goods and services for resale.
The paper trail for operating activities records and communicates information about business
transactions.
Expenditure Cycle
The expenditure cycle occurs between a business and its suppliers. Typically involves a lot of
money; payroll is often the biggest ongoing expense for a company.
The expenditure cycle involves four steps
 Determine business needs
 Select vendors and order goods
 Receive and store goods
 Pay for goods
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Big businesses typically have complex expenditure processes, but the same sequence of events
occurs for everyone.
Determine business needs
Determine business needs by those who use them daily. Could involve many people, so one
person often the authorized purchaser for a group (e.g. department). The authorized purchaser
fills out a purchase requisition (PR) to tell the purchasing department what they want. The PR
describes the items, their quantity, and the date they’re needed. The PR must be signed off by the
authorized purchaser, and has a serial number for tracking.
Select vendors and order goods
The purchasing department receives the PR and starts the ordering process. A supplier is chosen,
hopefully to get the best quality, at the lowest price, within the time allowed. Then the
purchasing department sends a purchase order (PO) to the vendor. The PO specifies the
quantity, description, and price of each item, the PO number, shipping location, delivery date,
and credit terms (which are specified by the supplier).
The PO is also a legally binding commitment between the company and the supplier.
Receive and store goods
When the goods are received, need to make sure the contents are correct and in proper condition.
Goods delivered are now assets of the company, and they must be inspected, secured, and stored.
The receiving department inspects the delivery and prepares a receiving report to convey their
findings. Need inspection to avoid low quality, incorrect, or incomplete shipments; and to avoid
causing manufacturing delays.
Then the goods are secured and stored appropriately. Some goods, such as chemicals, have
specific temperature storage needs.
Pay for goods
Then the goods can be paid for after satisfactory receipt. The supplier sends a bill requesting
payment; this is the invoice. The invoice lists the type, quantity, and price of the goods and
services delivered.
The accounting department pays the vendor, but payment is issued only after checking the
invoice, receiving report, and PO against each other for consistency.
Employees are also suppliers in the expenditure cycle. Payment for services rendered is handled
by the payroll department. Contract or freelance labor sends an invoice for their labor cost.
Vendors offer discounts for speedy payment. Terms of, for example, “2/10 n/30” mean the
“payment is due in 30 days, but if you pay within 10 days you get a 2% discount.” Such
discounts can be thousands of dollars for large purchases, so policies are often created to take
advantage of them.
A summary of the expenditure cycle, as described above, is shown in Figure 1.
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Figure 1. Expenditure Cycle
Shipment
Employee or
Subcontractor
PR
Invoice
Purchasing
Dept
Payroll Dept
PO
Vendor
Co
p
PO y of
Invoice
Invoice
Shipment
Accounting
Dept
Payment
Receiving
Dept
Payment
End User
(dept)
Shipment
Storage
Receiving Report
Company boundary
Depreciation
Depreciation is the portion of the cost of an asset used to generate revenue.
All assets except land have limited useful life. Need to capture capital costs of each asset over
its useful life.
Part of the cost of an asset is charged to Depreciation Expense account every accounting period.
The amount debited to the DE account is also credited to Accumulated Depreciation account,
which is a contra-asset account. The DE account is closed at the end of every accounting period,
but the AD account keeps open for the life of the asset.
Depreciation is not a loss of value of the asset – since some assets may gain value over time.
Depreciation refers to the cost of using that asset to generate revenue.
The un-depreciated part of asset cost = the carrying value or book value
The carrying value is NOT the fair market value. For example, a building may depreciate (and
hence have decreasing carrying value) even though its fair market value goes up.
To find depreciation, need
 Acquisition cost of the asset (‘cost’)
 Extent of ‘useful life’ of the asset
 ‘Salvage value’ of the asset (also called the ‘residual value’)
The useful life is how long you get economic benefit from the asset.
Land has infinite useful life. (But be careful – an office building on that land has finite useful life,
and is called ‘real estate’.)
Useful life is limited by deterioration or wear, or time, or obsolescence. Obsolescence may occur
due to technology, trends, or preferences. Replaced assets are considered obsolete.
Useful life can be given in time (years), or expected output (miles on a car).
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Salvage value = the fair market value after the useful life is over.
Salvage value is estimated at the start of the useful life. Waiting until useful life is over would
violate the ‘matching principle’ during its lifetime.
Depreciation cost = acquisition cost – salvage cost
Depreciation cost is the amount of value depreciated over the useful life of the asset.
Values for depreciation are often guesswork.
Calculating Depreciation
There are three types of depreciation methods
 Straight-line method
 Units-of-production method
 Accelerated method
Straight line method
Straight line method assumes a constant, even, equal benefit from the asset every year of its
useful life. Hence its annual depreciation expense is:
Annual DE = (cost – salvage value)/(useful life)
Then
Accumulated depreciation expense = the previous years accumulated depreciation +
annual depreciation expense.
Carrying value = cost – accumulated depreciation
At the end of the useful life, FOR ANY DEPRECIATION METHOD, the final carrying value
equals the salvage value.
[Carrying value = Salvage value] @ end of useful life
For a $40k car, with $10k salvage value and a five-year useful life, would get:
Annual depreciation expense = ($40k - $10k)/(5 yr) = $6,000/year
At end Annual Depreciation Accumulated
Carrying Value
of Year
Expense
Depre. Expense
1
$6,000
$6,000
[Cost = $40k] - $6k = $34k
2
$6,000
$12,000
$40k - $12k = $28k
3
$6,000
$18,000
$40k - $18k = $22k
4
$6,000
$24,000
$40k - $24k = $16k
5
$6,000
$30,000
$40k - $30k = $10k = salvage value
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Units-of-production method
The Units-of-production method prorates the depreciation based on how much value was
obtained from the asset during each accounting period. This is better when the asset’s usage
varies a lot from year to year.
Annual depreciation expense = (cost – salvage value)*(# of units produced this year)/
(total production life)
For the same car example, given its actual history of mileage driven and assuming a 50,000 mile
useful life:
At end Miles Driven
of Year
that Year
1
8,000
2
11,000
3
12,000
4
7,000
5
12,000
Annual Depreciation
Accumulated
Expense
Depre. Expense
($30k)*8/50 = $4,800
$4,800
($30k)*11/50 = $6,600
$11,400
($30k)*12/50 = $7,200
$18,600
($30k)*7/50 = $4,200
$22,800
($30k)*12/50 = $7,200
$30,000
Carrying Value
$40k - 4800 = $35,200
$40k – 11,400 = $28,600
$40k – 18,600 = $21,400
$40k – 22,800 = $17,200
$40k – 30,000 = $10k
Notice again, that the final carrying value is equal to the salvage value.
Accelerated methods
Some kinds of equipment may age quickly, and require more maintenance as they age, so an
accelerated depreciation schedule is needed. There are many varieties of accelerated
depreciation methods.
The double-declining balance method is common. It starts with twice the straight line
depreciation rate, applied to the acquisition cost (not to the depreciable cost), then applied to the
carrying value after the first year.
So for a five year depreciation, the straight line would depreciate 20% every year. For the
double-declining balance method, use 40% as the depreciation rate like this
At end Annual Depreciation
Accumulated
Carrying Value
of Year
Expense
Depre. Expense
1
40%($40k) = $16,000
$16,000
$40k - $16,000 = $24,000
2
40%($24k) = $9600
$25,600
$40k - $25,600 = $14,400
3
40%($14,400) = $5760
$31,360
$40k - $31,360 = $8640
But wait! The final carrying value has dropped below the salvage value, so fix the third year’s
depreciation to get to the salvage value.
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At end
Annual Depreciation
Accumulated
Carrying Value
of Year
Expense
Depre. Expense
1
40%($40k) = $16,000
$16,000
$40k - $16,000 = $24,000
2
40%($24k) = $9,600
$25,600
$40k - $25,600 = $14,400
3
40%($14,400) = $5760 $4400
$30,000
$40k - $30,000 = $10,000
Partial Year Depreciation
If an asset is put into service, or disposed of, partway through the year, must use some
convention for calculating partial year depreciation. Common ones are:
 Mid-year convention
 Mid-month convention
Mid-year convention means to find depreciation as though every asset were obtained exactly
halfway through the year. This averages out nicely for large numbers of assets.
The mid-month convention records depreciation based on the actual months in service that year.
For partial months, that month counts for depreciation if the asset was purchased before the 15th,
or disposed of after the 15th.
Taxes and Depreciation
The IRS sets rules for depreciation as far as taxation is concerned. Oddly enough,
different rules may be used for financial records than are used for calculating taxes!
And so most companies do so.
The tax method for depreciation is the Modified Accelerated Cost Recovery System (MACRS).
The IRS defines the useful life of most things:
 Cars and trucks are 5 years
 Furniture is 7 years
 Residential property (as in a building, not its land) is 27.5 years
 And so on…
The allowable depreciation methods are based on the useful life of the asset.
 Use 200% declining-balance depreciation for 3, 5, 7, and 10-year useful life assets.
[Is this the same as double-declining balance?]
 Use 150% declining-balance depreciation for 15 and 20-year useful life assets.
 Use straight-line method for real estate buildings
For partial year depreciation:
 Use the mid-year convention for everything except real estate
 Use the mid-month convention for real estate
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Instead of using MACRS, can use predefined depreciation tables by the IRS. They give the
depreciation rate (% of carrying value) for each asset for each year.
For that car example ($40k cost, $10k salvage value, 5-year life) the depreciation looks like this:
At end Depreciation
Annual Depreciation
of Year
Percent
Expense
1
20
20%*$40k = $8000
2
32
32%*$32k = $21,760
3
19.2
19.2%*$10,240 = $1966.08
4
11.52
11.52%*$8273.92 = $953.16
5
11.52
11.52%*$7320.76 = $843.35
6
5.76
5.76%*$6477.41 = $373.10
Carrying Value
$40k - $8k = $32k
$32k - $21,760 = $10,240
$10,240 - $1966.08 = $8273.92
$8273.92 - $953.16 = $7320.76
$7320.76 - $843.35 = $6477.41
$6477.41 - $373.10 = $6104.31
[But this goes below the salvage value after the third year…do we fix it like the earlier
accelerated example? Cumulative depreciation for the above schedule is ($40k – 6104.31)/$40k
= 84.74%. What happens if the salvage value is only 5% or 10% of the initial cost?]
Debt financing
Debt financing is an alternative to equity-based financing, or diluting ownership of the company.
It’s done based on assessment of long term risks and rewards.
Debt financing = acquiring goods and services in exchange for liability to pay more than
their current cost.
The borrower accepts interest expense (the cost of borrowing), and the lender gets revenue or
return on investment to justify making the loan.
The financial risk is the risk of the borrower defaulting on the debt by failing to make payments.
If the company defaults, the lender can force them to liquidate assets to meet payments.
Debt financing can be rewarding. The company can benefit if the return on borrowed funds
exceeds the cost of borrowing. The excess income belongs to the borrower, increasing their
return on investment.
Financial leveraging increases the rate of return by securing return on investment more than the
cost of borrowing.
Return on owner’s equity (ROE) = net income / (owner’s equity)
The ROE measures the success of using financial leveraging.
Debt-to-equity (D to E) ratio = total debt / (stockholder’s equity)
The debt-to-equity ratio measures debt financing risk. If more than one, then debts exceed
equity, and risk of defaulting is higher. Higher debt requires more income to meet payments.
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Financial risk also depends on sales volatility. If high D to E ratio, a sales decline reduces the
return on equity, and can lead to defaulting. But companies with steady sales (e.g. utilities) can
handle high D to E ratio.
Daily operations are financed by short term or current liabilities, such as accounts payable,
salaries payable, and notes payable.
Long term liabilities are used to get land, buildings, equipment, and patents. These assets
generate revenue to meet debt obligations.
More References
AICPA – The American Institute of Certified Public Accountants
ABFM – Association For Budgeting and Financial Management; part of the American Society
for Public Administration
GAO – General Accounting Office, an oversight branch of Congress
IASC - International Accounting Standards Board
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