NC STATE UNIVERSITY ACC 580: Financial Accounting 1

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1 NC STATE UNIVERSITY ACC 580: Financial Accounting 1 Note on Financial Statements I. Review of Financial Statements The Balance Sheet Financial reporting is based on the following accounting equation, which summarizes the balance sheet: Assets = Liabilities + Shareholders equity Productive Creditor Owner claims capacity claims (contributed capital plus undistributed earnings) Note: Shareholders equity is also sometimes called book value [of equity] or owners equity. The Balance Sheet is an arithmetic equality. In accounting, it is always true that the assets are equal to the sum of the liabilities and shareholders equity. Assets are future economic benefits that the firm controls because of a past event or transaction. Examples include: cash, accounts receivable (these are amounts owed to the firm by its customers), inventories, land, investments in other firms, factories. Liabilities are obligations to sacrifice resources. For the most part, accounting liabilities are also legal obligations. Examples include: accounts payable (amounts owed by the firm to its suppliers), bank loans payable (amounts owed to banks). Shareholders equity is the residual, defined as Assets - Liabilities. Shareholders equity includes capital contributed by owners (common stock) plus the entire cumulative earnings of the firm that has not been distributed as dividends. The Balance Sheet lists specific items of Assets, Liabilities and Owners Equity. There are totals (arithmetic sums of the values listed for the various items) displayed as well. The Income Statement Income, net income, earnings (often used interchangeably). Negative income = loss or net loss Revenues Expenses + Gains Losses Asset inflows from Expired costs Other asset Other expired selling goods and associated with inflows costs services revenues Income not declared as dividends increases retained earnings this concept links the income statement (statement of operations) to the balance sheet Losses (negative income) decrease retained earnings (or increase accumulated deficit). Losses occur when expenses exceed revenues. 1 Based on note written by Professors Jennifer Francis and Per Olsson. 1

2 Income can be calculated using two balance sheets and knowledge of dividends declared. Beginning balance in Retained earnings + income (or loss) - dividends = Ending balance in retained earnings. (Capital contributions are treated as negative dividends.) This is called the clean surplus relation. It means that all changes in book values flow through income. Violations of clean surplus are called dirty surplus items. The clean surplus relation links the Balance Sheet and the Income Statement. The Statement of Cash Flows Shows the sources (inflows) and uses (outflows) of cash during a fiscal period. Arithmetically, this equals the change in cash balances between two successive balance sheets. Cash inflows and outflows are shown in three categories: cash flows from operations, cash flows from investing and cash flows from financing. Focuses on cash inflows and outflows only. Any transactions which do not involve cash are not included (e.g., acquiring land, property, plant or equipment by assumption of a liability). Such transactions (if material) must be separately disclosed. The Statement of Owners Equity Shows the breakdown of items affecting the stockholders equity accounts during the period. This statement is often used to show comprehensive income (Statement of Financial Accounting Standards No. 130). Comprehensive income reflects all changes in owners equity in a period, except those resulting from owners (primarily stock issuances) and distributions to owners (primarily dividends and stock repurchases). The intent of SFAS No. 130 s requirement that firms report comprehensive income was to include gains and losses that are not reflected in the income statement (and therefore, not included in net income), but which are reflected as charges to owners equity. The most common adjustments to owners equity are: Foreign currency translation gains (losses) Excess of additional pension liability over unrecognized prior service cost ( minimum pension liability adjustment) Unrealized holding gains (losses) for available-for-sale securities Deferred or unearned compensation related to employee stock option plans Guarantees of employee stock option debt These adjustments are also referred to as dirty surplus items because they violate the clean surplus relation: Beginning balance in Retained earnings + income (or loss) - dividends = Ending balance in retained earnings. 2

3 Financial statement data for Sparkle Company follow, for the years : Sparkle Company Balance Sheets 2000 Assets Cash $100 $76 $40 $170 Accounts receivable Inventories Total current assets ,760 Gross property, plant & equipment 2,400 3,720 4,860 5,630 Accumulated depreciation (400) (520) (660) (840) Total assets $2,500 $3,936 $5,160 $6,550 Liabilities and shareholders' equity Accounts payable $250 $300 $350 $500 Short term borrowings Salaries payable Total current liabilities Bonds payable ,000 1,500 Common stock, par value $1 1,000 1,500 1,600 1,600 Additional paid in capital 200 1,000 1,200 1,200 Retained earnings ,350 Total liabilities & shareholders' equity $2,500 $3,936 $5,160 $6,550 Sparkle Company Income Statements Sales $2,760 $3,100 $4,750 Cost of goods sold (1,573) (1,798) (2,803) Selling, general and administrative (510) (590) (750) Depreciation expense (120) (140) (180) Operating income ,018 Interest expense (500) (100) (160) Pretax income Income tax expense (17) (142) (257) Net income $40 $330 $600 Dividends $4 $6 $10 Important relations: Assets = Liabilities + Owners' Equity. This relation links the two sides of the balance sheet. For example, in 2000, total assets of $2,500 equal total liabilities ($900 = $400 + $500) plus shareholders equity ($1,600 = $1,000 + $200 + $400). Book value at time t = Book value at time t-1 + Net income in year t Net dividends in year t. See the Statement of Owners Equity. 3

4 Sparkle Company Statements of Cash Flows Cash flows from operations Net income $40 $ Depreciation expense (Increase) decrease in accounts receivable (100) (100) (300) (Increase) decrease in inventories (160) (160) (370) Increase (decrease) in accounts payable Increase (decrease) in salaries payable Cash flows from operations (20) Cash flows from investments Additions to PP&E (1,320) (1,140) (770) Cash flows from investing (1,320) (1,140) (770) Cash flows from financing Increase (decrease) in short term borrowings Issuance (payments) of bonds payable Issuance of common stock 1, Dividends paid (4) (6) (10) Cash flows from financing 1, Net increase (decrease) in cash (24) (36) 130 Beginning cash balance Ending cash balance Important relation: Net change in cash (per the ending balances in two consecutive balance sheets) = Cash flow from operations + Cash flow from investing + Cash flow from financing (all reported in the Statement of Cash Flows). This relation links the Balance Sheet with the Statement of Cash Flows. For example, in 2001, the change in cash per the balance sheet was -$24. Cash flow from operations in 2001 was -$20, cash flow from investment in 2001 was -$1,320 and cash flow from financing was $1,316; the aggregate of the three cash flows is $-24 (the change in the cash balances between 2000 and 2001). 4

5 Sparkle Company Statements of Owners Equity Common stock Additional Retained Accumulated other Total owners' Shares Amount paid in capital earnings comprehensive income equity Balance at Dec. 31, ,000 $1,000 $200 $400 $1,600 Net income $40 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $40 $0 $40 Cash dividends ($4) ($4) Repurchase common stock Issued common stock 500 $500 $800 $1,300 Balance at Dec. 31, 2001 $2,936 Net income $330 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $330 $0 $330 Cash dividends ($6) ($6) Repurchase common stock Issued common stock 100 $100 $200 $300 Balance at Dec. 31, 2002 $3,560 Net income $600 Foreign currency translation $0 Minimum pension liability $0 Unrealized holding gains $0 Comprehensive income $600 $0 $600 Cash dividends ($10) ($10) Repurchase common stock Issued common stock Balance at Dec. 31, 2003 $4,150 Important relation: Book value at time t = Book value at time t-1 + Net income in year t Net dividends in year t. There are no dirty surplus items for Sparkle Company. Hence the clean surplus relation should hold. For example, the book value of equity in 2001 ($2,936) equals book value of equity in 2000 ($1,600) plus net income in 2001 ($40) less net dividends paid in 2001 (-$1,296 = $4 - $500 (additional c/s) - $800 (additional paid in capital)). 2 2 Note that we use the term net dividends. By that we mean cash paid to or received from equity holders. This will include cash dividends as well as share issuances and share repurchases. 5

6 II. Comparing Financial Statements and Ratios Across and Within Firms Common size financial statements express the components of the financial statements in terms of a common variable for each statement. For the balance sheet, it is common to use total assets as the scale variable, while for the income statement, total sales revenue is typically used. The sizing is done each year, using the value of the scale variable that year. By expressing each component of the balance sheet and the income statement as a percentage (of assets and revenues, respectively), one can compare firms of varying sizes. The common size financial statements for Sparkle Company looks as follows: Assets 2000 Cash % % % % Accounts receivable % % % % Inventories % % % % Total current assets % % % 1, % Gross property, plant & equipment 2, % 3, % 4, % 5, % Accumulated depreciation (400) % (520) % (660) % (840) % Total assets 2, % 3, % 5, % 6, % Liabilities and shareholders' equity Accounts payable % % % % Short term borrowings % % % % Salaries payable % % % % Total current liabilities % % % % Bonds payable % % 1, % 1, % Common stock at par 1, % 1, % 1, % 1, % Additional paid in capital % 1, % 1, % 1, % Retained earnings % % % 1, % Total liabilities & shareholders' equity 2, % 3, % 5, % 6, % Sales 2, % 3, % 4, % Cost of goods sold (1,573) % (1,798) % (2,803) % Selling, general and administrative (510) % (590) % (750) % Depreciation expense (120) -4.35% (140) -4.52% (180) -3.79% Operating income % % 1, % Interest expense (500) % (100) -3.23% (160) -3.37% Pretax income % % % Income tax expense (17) -0.62% (142) -4.57% (257) -5.42% Net income % % % 6

7 Trend analysis expresses the change in the value of a period t+1 financial statement component measured relative to its value in period t as a percentage of its period t value. Negative values indicate declines in the item being measured (good if the variable is an expense, bad if it is revenue). Whereas common size financial statements permit cross-sectional (i.e., across firm) comparisons controlling for size, trend analysis permits within-firm comparisons of the firm over time. Trend analysis obviously controls for firm-specific features by using the same firm each year as its control in the next year. Whereas the point of common size financial statement is to assess how a firm is performing relative to its peers, the point of trend analysis is to assess how the firm is doing relative to its past. A trend analysis for Sparkle Company would show the following: Assets 2000 Cash % % % Accounts receivable % % % Inventories % % % Total current assets % % 1, % Gross property, plant & equipment 2,400 3, % 4, % 5, % Accumulated depreciation (400) (520) 30.00% (660) 26.92% (840) 27.27% Total assets 2,500 3, % 5, % 6, % Liabilities and shareholders' equity Accounts payable % % % Short term borrowings % % % Salaries payable % % % Total current liabilities % % % Bonds payable % 1, % 1, % Common stock at par 1,000 1, % 1, % 1, % Additional paid in capital 200 1, % 1, % 1, % Retained earnings % % 1, % Total liabilities & shareholders' equity 2,500 3, % 5, % 6, % Sales 2,760 3, % 4, % Cost of goods sold (1,573) (1,798) 14.29% (2,803) 55.87% Selling, general and administrative (510) (590) 15.69% (750) 27.12% Depreciation expense (120) (140) 16.67% (180) 28.57% Operating income % 1, % Interest expense (500) (100) % (160) 60.00% Pretax income % % Income tax expense (17) (142) % (257) 81.67% Net income % % 7