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Financial Statements

C.H. ChengDepartment of

Systems Engineering & Engineering ManagementThe Chinese University of Hong Kong

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Accounting

Accounting measures the results of business activities and communicates those measurements to interested readers.

Engineers need to develop understanding of accounting concepts to use accounting data effectively.

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Financial accounting deals with preparing general purpose reports for people outside an organisation to use.

Managerial accounting deals with providing information for managers inside the organisation to use.

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Financial Statements

Balance Sheet Income Statement Statement of Cash Flows

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The balance sheet represents a snapshot of the investments of a firm (assets) and financing on those investment (liabilities and owners’ equities) as of a specific date.

Assets = Liabilities + Shareholders’ equity.

Balance Sheet

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ABC Company Comparative Balance Sheets for December 31, Year 1 and Year 2 December 31 December 31 Year 1 Year 2

Assets Current Assets Cash $30,000 $ 3,000 Account Receivable 20,000 55,000 Merchandise Inventory 40,000 50,000 Total Current Assets $90,000 $108,000 Noncurrent Assets Buildings and Equipment (costs) $100,000 $225,000 Accumulative Depreciation (30,000) (40,000) Total Noncurrent Assets $ 70,000 $185,000 Total Assets $160,000 $293,000

Equities Current Liabilities Account Payable - Merchandise Suppliers $ 30,000 $ 50,000 Account Payable - Other Suppliers 10,000 12,000 Salaries Payable 5,000 6,000 Total Current Liabilities $ 45,000 $ 68,000 Noncurrent Liabilities Bonds Payable 0 100,000 Total Liabilities $ 45,000 $168,000 Shareholders’ Equity Capital Stock ($10 par value) $100,000 $100,000 Retained Earnings 15,000 25,000 Total Shareholders’ Equity 115,000 125,000 Total Equity $160,000 $293,000

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Asset recognition

Assets are resources with the potential for providing a firm with a future economic benefit.

Accounting recognises the resources as assets when the firm has acquired rights to their use in the

future as a result of a past transaction or exchange, and

the firm can measure or quantify the future benefits with a reasonable degree of precision.

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All assets are future benefits; not all future benefits, however, are assets. Asset recognition is not always easy.

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Asset valuation bases

Acquisition or historical cost is the amount of cash payment (or cash equivalent value of other forms of payment) made in acquiring an asset.

Present value of future net cash flows is a measure of the ability of an asset either to generate future net cash receipts or to reduce future cash expenditures.

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Generally accepted accounting asset valuation bases

Monetary assets such as cash and account receivable appear on the balance sheet at their net present value.

Nonmonetary assets such as merchandise inventory, land, buildings and equipment appear at acquisition cost.

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Asset classification

Current assets (1 year) Long-term assets (more than 1

year).

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Liability recognition

A liability arises when a firm receives benefits or services and in exchange promises to pay the provider of those goods or services a reasonably definite amount at a reasonably definite future time.

All liabilities are obligations but not all obligations are liabilities.

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Liability valuation

Most liabilities are monetary.

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Liability classification

Current liabilities (1 year)Long-term liabilities (more than 1

year)

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Shareholders’ equity

The shareholders’ equity in a firm is a residual interest.

The owners have a claim on all assets not required to meet the claims of creditors.

The valuation of the assets and liabilities included in the balanced sheet therefore determines the valuation of total shareholders’ equity.

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The net increase in stockholders’ equity that results from business operations and is accumulated in the Retained Earnings account.

R.E.t = R.E.t-1 + N.I.t - Dividendt

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Income statement

The income statement provides information about the operating performance of a firm for some particular period of time.

Net income = Revenues - Expenses

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ABC Corporation Income Statement for Year 2 Sales Revenue $125,000 Less Expenses: Cost of Good Sold $ 60,000 Salaries 19,667 Depreciation 10,000 Interest 2,000 Income Taxes 13,333 Total Expense $105,000 Net Income $ 20,000

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Illustrative Example

Ace Hardware Store: Donald and Joanne Ace open a hardware store on January 1, Year 1. The firm receives $20,000 in cash from the Aces and borrows $12,000 from a local bank. The firm must repay the loan on June 30, Year 1, with interest at the rate of 12 percent per year. The firm rents a store building on January 1, and pays 2 months’ rent of $4,000 in advance. On January 1, it also pays the premium of $2,400 for property and liability insurance coverage for the year ending December 31, Year 1. During January it acquires merchandise costing $40,000, of which it purchases $26,000 for cash and $14,000 on account. Sales to customers during January total $50,000, of which $34,000 is for cash and $16,000 is on account. The acquisition cost of the merchandise sold during January is $32,000, and various employees receive $5,000 in salaries.

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Accrual basis of accounting

It recognises revenue when a firm sells goods or renders services.

Cost incurred lead to expenses in the period when the firm recognises the revenues that the cost helped produces.

Costs incurred that a firm cannot closely identify with specific revenue streams become expense of the period in which the firm consumes the services of an asset and the future benefits of the asset disappear.

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Ace Hardware Store Income Statement for January, Year 1 Sales Revenue $50,000 Less Expenses: Cost of Goods Sold $32,000 Salaries Expense 5,000 Rent Expense 2,000 Insurance Expense 200 Interest Expense 120 Total Expense 39,320 Net Income $10,680

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The accrual basis of accounting provides a better measure of operating performance because: revenues more accurately reflect the

results of sales activity in an accounting period, and

expenses more closely match reported revenues.

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Timing and Measurement principles

Under the accrual accounting, we must consider when a firm recognises revenues and expenses (timing) and how much it recognises (measurement).

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Timing & measurement of revenues

A firm recognises revenues when it has performed all, or a substantial portion, of

the services it expects to provide, and it has received either cash, a receivable, or

some other asset susceptible to reasonably precise measurement.

A firm measures the amount of revenues by the cash or cash-equivalent value of other assets it receives from customers.

Adjustments are made for uncollectible accounts, sales discounts and allowance, and delayed payments.

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Timing & measurement of expenses

Asset expirations become expenses as follows: Asset expirations associated directly with

particular type of revenues are expenses in the period when a firm recognises revenues. This treatment, called matching convention, matches cost expirations with revenues.

Asset expirations not clearly associated with revenues become expenses of the period when a firm consumes services in operations.

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Product costs are assets; they become expenses only when a firm sells the products. In a merchandising firm, the inventory is

evaluated at acquisition cost in the balance sheet. The same amount of acquisition cost is stated as the cost of goods sold in the income statement when the products are sold.

In a manufacturing firm, there are two types of inventory: work-in-process and finished goods inventory.

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Three types of costs are reported: direct labour, direct material, and manufacturing overhead.

Selling costs are period expenses. Accounting reports selling costs (advertising costs, marketing costs, etc.) as expenses in the period when a firm uses their services.

Administrative costs are also period expenses. The amount of an expense is the cost of the expired asset.

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Statement of cash flows

This statement reports the net cash flows relating to operating, investing, and financial activities for a period of time.

Remember that not all revenues result in immediate increase in cash and that not all expenses result in an immediate decrease in cash.

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Factors Cash flow statement shows the actual cash flow generated by the firm for the year. The primary categories for this statement include: Cash flow from operations: collections from

customers, payments to suppliers, other operating cash outflows and interest payments, tax payments.

Cash flow from investment activities: amount of cash used for investments by the firm.

Cash flow from financing transactions: cash inflows or outflows to or from the firm’s leanders and owners.

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ABC Corporation Statement of cash flow for year 2 Operations: Net Income $ 20,000 Plus Expenses Not Using Cash: Depreciation 10,000 Plus Increase in Current Liabilities: Accounts Payable – Merchandise Suppliers 20,000 Accounts Payable – Other Suppliers 2,000 Salaries Payable 1,000 Less Increases in Current Assets Other than Cash: Accounts Receivable (35,000) Merchandise Inventory (10,000) Cash Flow from Operations $ 8,000 Investing: Acquisition of Equipment (125,000) Financing: Issue of Long-term Bonds $100,000 Dividends (10,000) Cash Flow from Financing 90,000 Net Change in Cash $(27,000)

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Cash Flow PatternsCF from

operations CF from

Investment CF from Financin

g

Observations

+ - + Firm is using its cash flows from operations and new financing to expand operations

+ + - Firm is using its cash flow from operations and selling off assets to pay down debt and pay owners

+ - - Firm is using cash flow from operations to expand the business and to pay down debt and pay owners

- + + Firm is encountering cash flow problems from operations which are being covered by selling assets and borrowing more and/or acquiring more equity financing