Chapter 3, Financial Statements and Ratio Analysis
3.1 The Stockholders’ Report:
Generally Accepted Accounting Principles (GAAP): Guidelines to prepare and maintain financial
reports
Financial Accounting Standards Board (FASB): Body that authorizes these principles
Public Company Accounting Oversight Board (PCAOB): non-profit corporation that oversees auditors
of public corporations
Stockholders’ report: summarizes and documents the firm’s financial activities during the past year
The letter to stockholders: Primary communication from management in the annual report, which
describes the events that managers believe had the greatest effect on the firm during the year
Accounting: A series of activities (or an information system) collecting, processing and
communicating financial information about an economic entity.”
Basic terms:
For simplicity, a business can be set up as a:
Proprietorship
Partnership
Corporation
Most businesses will have two objectives:
1. Profitability: The ability to generate enough profit to satisfy shareholders/owners’ needs;
2. Liquidity: The ability to pay debts when they are due
Looking only at the business entity, one needs to
Record
Process
Communicate
… the financial transactions over a period of time, and state the value of the business entities assets,
liabilities and equity at the end date of that period of time.
Record: Will happen as first, to recognize that a business transaction has occurred and to record it in
the form of a journal. Accountants use the accounting system: double-entry bookkeeping, i.e. every
financial transaction will affect two or more accounts.
Accounts: the records in which this information is recorded
Keeping the most basic records and processing is described as “bookkeeping,” whereas
processing and communicating the financial information is described as “accounting.”
Process: Post these journals to the General Ledger, recording the balance of each account. Each
account will be listed on the trial balance, showing the balance of that account. Here total debits will
equal total debits.
The General Ledger is the same as T-Accounts, but with additional information such as dates,
journal reference, analysis, balance etc.
Communicate: To rearrange the account names and balances as listed in the trial balance into:
“Financial Statements” that are easy to understand for the user. Financial Statements must show the
relevant information and be a faithful representation of business entity.
,Four key financial statements:
1. Income statement
2. Balance sheet
3. Statement of stockholders’ equity
4. Statement of cash flows
Income Statement:
Provides a financial summary of the firm’s operating results during a specified period.
Revenue – expenses = profit
Revenues:
Revenue: Amounts earned from services being provided or goods being sold. The effect of increasing
revenue is to increase equity. Can also be found in different words: Income, Sales, Fees Earned,
Earned Revenue, Revenue Income etc.
Income: Income = Revenue, but can be used in different ways:
Interchangeably with Revenue
Money or money equivalent that an individual or business receives in exchange for providing
goods or services or through investing capital
(Net amounts) e.g. Income from operations
Sales: Amounts charged to customers for merchandise sold (can be cash sales, or sales on account)
Fees Earned: Amounts charged to customers for services provided
Consultancy Fees Earned: Amounts charged to customers for consultancy services provided
Rent Revenue: Revenue earned for renting property (regarding multi-step income statement, be
careful. This is the main source of income for this business, or an added extra).
Interest Received: Amounts received, or due to be received due to money lent out
Expenses:
Expenses: Cost amounts incurred in order to carry on the business, e.g. cost of selling goods, cost of
providing services etc. These costs should be matched to the revenues on the income statement. The
effect of increasing expenses is to decrease equity
Cost of Goods Sold (COGS): Cost amounts a merchandiser pays for the goods sold, or a manufacturer
pays to manufacture the goods sold. 2 definitions depending on the accounting system used:
1. Perpetual Inventory System: COGS = General Ledger Account, stating the costs of goods sold
2. Periodic Inventory System: Group of general ledger accounts, also stating the costs of the
goods sold, however calculated as beginning inventory + purchases – ending inventory
Sales Expense: Cost amounts incurred in order to sell merchandise
Advertising Expense: Cost amounts incurred associated with advertising used
Freight in: Cost amounts incurred by the buyer of merchandise for the transportation/shipping costs.
Usually associated with FOB Shipping (Free On Board)
,Freight Out: Cost amounts incurred by the seller of merchandise for the transportation/shipping
costs. Usually associated with FOB Destination (Free On Board)
Wages Expenses: Cost amounts incurred to compensate employees, normally based on hours
worked.
Salaries Expenses: Cost amounts incurred to compensate employees, normally based on months
worked
Utilities Expenses: Cost amounts incurred due to electricity, gas, heat, water, and sewer used
Telephone Expenses: Cost amounts incurred due to telephone services used
Rent Expenses: Cost amounts incurred due to occupying space (usually property) rented and used
Insurance Expenses: Cost amounts incurred due to insurance used/expired
Office Supplies Expenses: Cost amounts incurred due to pens, paper, stationary etc.
Depreciation Expenses – Equipment: Expense account to record the decrease in value of equipment
for the accounting period concerned
Miscellaneous Expenses: Other expenses that do not fall into the other accounts being used
Interest Expenses: Amounts paid, or due to be paid due to money borrowed
Other items:
Preferred stock dividends: Fixed cash payment from the company to preferred shareholders
Preferred equity: Financial capital (like interest-bearing debt or common equity)
Earnings per share: Profit per 1 common share outstanding
Dividend per share: Dividend per 1 common share outstanding
Dividends: Payment from the company to common shareholders, a part of earnings available for the
common shareholders
Retained earnings: A part of earnings available for common shareholders NOT paid out, but retained
for future investment.
Steps of creating the Income Statement
1. Income Statement begins with sales revenue and subtracts the cost of goods sold to obtain
the gross profit, which represents the amount remaining to pay operating, financial, and tax
costs.
2. Then deduct operating expenses (selling expense, general and administrative expense,
lease expense, and depreciation expense), to obtain the operating profits.
3. Then deduct the cost of any debt financing (interest expense) to obtain the net profits
before taxes
4. Then calculate the taxes based on the appropriate tax rates, and deduct the taxes from the
net profits before taxes to obtain the net profits, also referred to as net income
, 5. Deduct preferred stock dividends (if the firm has preferred stock) to obtain earnings
available for common stockholders, which is the amount earned by the firm on behalf of its
common stockholders
6. Dividing earnings available for common stockholders by the number of shares of common
stock outstanding gives earnings per share (EPS), the number of dollars earned during the
period on behalf of each outstanding share of common stock.
7. Companies are not legally required to pay dividends to shareholders, and when they do pay
dividends, the management will determine the size of payments. Dividing this chosen
amount by the amount of shares gives the dividend per share.
Balance Sheet:
A summary statement of the firm’s financial position at a given time.
Balances assets against its financing, which can be either liability (debt) or equity (what owners
provided).
Assets = liability + stockholders’ equity
Book value: The value of any item listed on the balance sheet
Balance sheet makes a distinction between short-term and long-term assets and liabilities.
Current assets and current liabilities are short-term, which means that the firm will convert
them into cash within 1 year.
All other assets and liabilities, along with stockholders’ equity, are long-term or fixed,
because they will most likely remain on the firms books for more than 1 year.
An item on the balance sheet is liquid if the item is easy to convert into cash quickly without much
loss in value.
Items on the balance sheet are sorted:
Assets are sorted from the most liquid (cash) down to the least liquid
Liabilities and equity accounts are sorted from short-term (current) to long-term (non-
current)
A balance sheet looks as follows:
Assets:
1. Current assets: converted into cash within 1 year
2. Fixed assets: part of the business for more than 1 year
Liabilities
1. Current liabilities: obligations that need to be met within 1 year
2. Long-term liabilities: obligations more than 1 year into the future
Stockholders’ equity:
1. Preferred stock
2. Common stock
3. Paid-in capital in excess of par
4. Retained earnings
