Chapter 3
Financial
Statements
Chapter 3 Outline
3.1 Accounting
Principles
• Generally accepted
accounting principles
• Auditors
• Accounting conventions
• Measuring costs and value
• Recognition principles
• Managing financial
statements
• The effect of recent
accounting scandals
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3.2 Financial
Statements
• The balance sheet
• The income statement
• The statement of cash flows
3.3 The Tax System
• Interest and dividends
received
• Depreciation
• Capital gains
• Tax rates
3.2 Financial Statements

Financial statements provide a summary of the transactions
of a company.
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The balance sheet provides a snapshot of the company’s assets,
liabilities, and equity at a point in time.
The income statement and statement of cash flows summarize
activity over the fiscal period, whether that be a quarter or a year.
The statement of cash flows provides summaries of cash flows by
operations, investing, and financing activities over a period of time.
Key to understanding financial statements is appreciating
that the balance sheet, income statement, and statement of
cash flows are all interconnected.
The Balance Sheet
 The balance
sheet, which we also refer to as
the statement of financial condition, is a
snapshot of the company’s financial position,
listing assets, liabilities, and equity.
 Because of double-entry bookkeeping, assets
must be equal to the sum of liabilities and
equity.
 Balance sheets are as of a particular date,
such as the end of the fiscal year or fiscal
quarter.
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Balance sheet example
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Balance sheet example, cont.
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The structure of the balance sheet
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The order of the assets is by
liquidity, with the most liquid
listed first, and so on. This is
different than what we see for
companies reporting based on
IFRS.
According to IFRS, unless there is
a compelling reason to do
otherwise, the asset accounts are
listed in two groups: current and
noncurrent.

SAP AG, a German computer
company, reports the following
in its 2010 balance sheet:
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The income statement


The income statement, or the statement of earnings, is a summary
of the company’s performance over a period of time, typically a
fiscal quarter or a fiscal year.
The basic structure is as follows:
Revenues
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Subtract
Cost of goods sold
Equals
Gross profit
Subtract
Selling, general, and administrative expenses
Equals
Earnings before interest and taxes (EBIT)
Subtract
Interest expenses
Equals
Earnings before taxes (EBT)
Subtract
Taxes
Equals
Net income
Income statement:
variations in terminology
You will find variations of this basic structure as you examine the
income statements of actual companies:
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Revenues may be referred to as net revenues, sales, or net sales
The cost of goods sold may be referred to as the cost of sales or direct costs
If the company mines or extracts minerals, gas, or oil, it may have depletion,
which is similar to depreciation and amortization
The company may have research and development or other operating
expenses that are deducted to arrive at EBITDA
The company may have other income or other expenses that may be added
or deducted before or after EBIT, depending on the nature of the income or
expense
If the company has preferred stock, net income may be presented before and
after preferred stock dividends are subtracted, in which case the bottom-line
net income may be referred to as net income available to common
shareholders
Income statement example
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Depreciation
 “Wear and tear” has traditionally been referred
to
by accountants as depreciation because an asset is
depreciating or reducing in value through time.
 The depreciation expense is the estimate of the loss
of value of a long-lived tangible asset over a
specified period of time, such as a year or a quarter.
 A similar concept is amortization, in which
amortization expense is the loss of value of an
intangible asset over time. For financial reporting
purposes, the company is allowed to use any
reasonable method for calculating depreciation or
amortization.
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Depreciation
Financial reporting
purposes
Tax purposes
Straight-line
Declining balance
(e.g., 150 DB, DDB)
Sum-of-years-digits
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Modified
accelerated cost
recovery
Straight-line
 The
most common method of depreciation for
financial reporting purposes is straight-line
depreciation.
 Depreciation using the straight-line method is the
same each year of the asset’s life, calculated as
the depreciable asset’s cost, less an estimated
salvage value, divided by its estimated useful life:
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Depreciation
Example: Consider an asset that has a cost of
$100,000 and a useful life of 5 years. If the asset’s
salvage value—that is, what the company expects to
sell the asset for when the asset is at the end of its
useful life—is $10,000, the depreciation each year is
$18,000 per year:
In other words, 20% of the asset’s cost (less salvage
value) is depreciated each year.
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Other depreciation methods
 Whereas straight-line depreciation results in
the same depreciation expense each period,
accelerated methods result in more
depreciation in earlier years of the asset’s life
and less in the later years.
 One group of accelerated methods is the
declining balance methods of depreciation.
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In the declining balance methods, we apply a fixed
percentage against the carrying value of the asset,
which declines each year with the depreciation. The
result is a declining depreciation expense through
time.
Other depreciation methods
 Example: applying the 150% declining method
(which is known as 150 DB) in our example is 150%
of the straight-line rate, or 1.5 × 20% = 30%.
year, the asset’s depreciation is 30% ×
$90,000, or $27,000. In the second year, there is $90,000
- 27,000 = $63,000 remaining to be depreciated. Twenty
percent applied against this value produces $18,900 for
the second year’s depreciation.
 For the first
 Another declining balance method, the
doubledeclining balance (DDB) method, follows a similar
process, but the rate is twice that of straight-line.
We often refer to the DDB method as the 200DB
method because the rate is 200% of the straightline rate.
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Earnings per share

Basic earnings per share (basic EPS) are the earnings per
share based on the weighted average of the number of
common shares outstanding during the fiscal period:
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Companies are also required to report diluted earnings per
share (diluted EPS), which is simply the adjusted net income
divided by the total possible number of shares that could be
outstanding if all potentially dilutive securities outstanding
were converted into common shares:
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The statement of cash flows


The statement of cash flows is a summary of the sources
and uses of cash in the company over a period of time,
such as a fiscal quarter or a fiscal year. The statement of
cash flows begins with net income from the income
statement.
There are three major parts:
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Cash flow for/from operations (CFO) - cash flow from the dayto-day operations of the business; the result of subtracting the
increase in net working capital from traditional cash flow
Cash flow for/from investing (CFI) - cash flow, on net, from
investing activities
Cash flow for/from financing (CFF) - cash flow, on net, from
financing activities
Statement of cash flows example
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Statement of cash flows example
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Cash flows summary
Cash flow
from
operations
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Cash flow
from
investing
Cash flow
from
financing
Net
change in
cash flow
Up next …Taxation
Problem 1
Which of the following statements has
accounts reported as of a specific date?
A. Balance sheet
B. Income statement
C. Statement of cash flows
D. Statement of owners equity
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Problem 2
On which of the following statements will
you find comprehensive income?
A. Balance sheet
B. Income statement
C. Statement of cash flows
D. Statement of owners equity
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Problem 3: Complete the following
Item
Dividends paid
Capital expenditures
Deferred tax liability
Intangibles
Owners’ equity
Cash and cash equivalents
Interest income
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Statement where we find
account