Components Of Financial Statements

Components of Financial Statements

Assets, Liabilities, Owner's Equity, Revenues, Expenses, Gains, Losses Financial Statements Overview Accounting Equation Assets = Liabilities + Equity Equity = Assets - Liabilities

--->

Assets = Liabilities + Equity

[Example] Company A has $800,000 liabilities and $1,200,000 equity. How much assets does the Company A have? Assets = Liabilities + Equity = $800,000 - $1,200,000 = $2,000,000 Assets = Liabilities + Equity Liabilities = Assets - Equity Equity = Assets - Liabilities From any balance sheet, --> it can be verified that --> Total Assets = Total Liabilities + Total Stockholders' Equity. Assets Assets are --> probable future economic benefits --> obtained or controlled by an entity --> as a result of past transactions or events. [SFAC No. 6., Para. 25] Essential characteristics of assets Probable future economics benefits Obtained or controlled by an entity Result of past transactions or events. Common characteristic of all assets --> is service potential or future economic benefits [SFAC No. 6., Para. 28] Liabilities Liabilities are --> probable future sacrifices of economic benefits --> arising from present obligations of an entity --> to transfer assets or provide services to other entities in the future --> as a result of past transactions or events. [SFAC No. 6., Para. 35] Essential characteristics of liabilities Probable future sacrifices of economic benefits Present obligations to transfer assets or provide services in the future Result of past transactions or events. Equity Equity (or net assets) is --> residual interests in the assets of an entity --> that remains after deducting its liabilities. [SFAC No. 6., Para. 49] Essential characteristics of equity Equity is residual interests in the assets after deducting liabilities Equity = Assets - Liabilities [Example] Company A has $2,000,000 assets and $800,000 liabilities. How much equity does the Company A have? Equity = Assets - Liabilities = $2,000,000 - $800,000 = $1,200,000 Revenues

Revenues are --> inflows of assets of an entity or --> settlements of its liabilities (or a combination of both) --> from delivering or producing goods, rendering services. [SFAC No. 6., Para. 78] Essential characteristics of revenues Inflows of assets or settlements of liabilities From delivering goods or rendering services Expenses Expenses are --> outflows or other using up of assets or --> incurrences of liabilities (or a combination of both) | --> from delivering or producing goods, rendering services. [SFAC No. 6., Para. 80] Essential characteristics of expenses Outflows of assets or incurrences of liabilities from delivering goods or rendering services Gains Gains are --> increases in equity (net assets) --> except those from revenues or investments by owners. [SFAC No. 6., Para. 82] Essential characteristics of gains Increases in equity from transactions or events Except those that result from revenues or investments by owners. Losses Losses are --> decreases in equity (net assets) --> except those from expenses or distributions to owners. [SFAC No. 6., Para. 83] Essential characteristics of losses Decreases in equity from transactions or events Except those that result from expenses or distributions to owners. Net Income and Owner's Equity Assets = Liabilities + Equity Assets = Liabilities + Equity + Revenues - Expenses Assets = Liabilities + Equity + Revenues - Expenses + Gains - Losses Ending Assets = Ending Liabilities + Ending Owner's Equity Ending Owner's Equity = Beginning Owner's Equity + Investment by Owner + Net Income Net Income = Revenues - Expenses + Gains - Losses Ending Owner's Equity = Beginning Owner's Equity + Investment by Owner + Revenues - Expenses + Gains - Losses Ending Assets = Ending Liabilities + Ending Owner's Equity = Ending Liabilities + Beginning Owner's Equity + Investment by Owner + Net Income = Ending Liabilities + Beginning Owner's Equity + Investment by Owner + Revenues - Expenses + Gains - Losses If Investment by Owner = 0, Gains = 0, Losses = 0, then Ending Assets = Ending Liabilities + Beginning Owner's Equity + Revenues - Expenses Ending Assets = Ending Liabilities + Ending Owner's Equity Assets = Liabilities + Owner's Equity

Assets are reported on the balance sheet. Asset accounts have normal balances on the debit side. Increase in assets is reported on the debit side of a journal entry. Decrease in assets is reported on the credit side of a journal entry. Liabilities are reported on the balance sheet. Liability accounts have normal balances on the credit side. Increase in liabilities is reported on the credit side of a journal entry. Decrease in liabilities is reported on the debit side of a journal entry. Owner's Equity is reported on the balance sheet. Owner's equity accounts have normal balances on the credit side. Increase in owner's equity is reported on the credit side of a journal entry. Decrease in owner's equity is reported on the debit side of a journal entry. Revenues are reported on the income statement. Revenue accounts have normal balances on the credit side. Increase in revenues is reported on the credit side of a journal entry. Decrease in revenues is reported on the debit side of a journal entry. Expenses are reported on the income statement. Expense accounts have normal balances on the debit side. Increase in expenses is reported on the debit side of a journal entry. Decrease in expenses is reported on the credit side of a journal entry. Gains are reported on the income statement. Gain accounts have normal balances on the credit side. Increase in gains is reported on the credit side of a journal entry. Decrease in gains is reported on the debit side of a journal entry. Losses are reported on the income statement. Loss accounts have normal balances on the debit side. Increase in losses is reported on the debit side of a journal entry. Decrease in losses is reported on the credit side of a journal entry. An Example of Detailed Balance Sheet Sample Technology Corporation Balance Sheet December 31, 2006

Assets Current Assets Cash Marketable Securities Accounts and Notes Receivable Less: Allowance for Doubtful Accounts Inventories Other Current Assets Total Current Assets Investments Long-Term Investments in Bonds

Property, Plant, and Equipment Land Buildings Less: Accumulated Depreciation Equipment Less: Accumulated Depreciation Total Property, Plant, and Equipment Intangible Assets Other Noncurrent Assets Total Assets

Liabilities and Stockholders' Equity Current Liabilities Notes Payable Accounts Payable Income Taxes Payable Accrued Expenses Current Portion of Long-Term Debt Total Current Liabilities Long-Term Liabilities Long-Term Notes Payable Long-Term Borrowings Bonds Payable Deferred Income Tax Liabilities Total Long-Term Liabilities Total Liabilities

Contributed Capital Preferred Stock, $5 par value (authorized 10,000 shares, issued and outstanding 7,000 shares) Common Stock, $2 par value (authorized 2,000,000 shares, issued 1,200,000 shares, outstanding 1,150,000 shares) Additional Paid-in Capital Total Contributed Capital Retained Earnings Total Contributed Capital and Retained Earnings Less: Treasury Stock, at cost (50,000 shares) Total Stockholders' Equity

Total Liabilities and Stockholders' Equity

Example of Detailed Income Statement Financial Statements Overview

Sample Technology Corporation Income Statement For the Year Ended December 31, 2006

Net Sales Sales Less: Sales returns and allowances Cost of Goods Sold Gross Profit

Selling, General and Administrative Expenses Salaries Advertising expenses Taxes and insurance Depreciation and amortization expense Bad debts expense Other selling, general and administrative expenses Operating Income (Loss)

Other Revenues and Gains Interest income

Gain on sale of investment Other Expenses and Losses Interest expense Loss on sale of equipment Income (Loss) from Continuing Operations before Income Taxes

Income Taxes Expense Income (Loss) from Continuing Operations

Discontinued Operations: Gain (Loss) from operations of discontinued business segment (Net of income tax effect of $ ) Gain (Loss) on disposal of business segment (Net of income tax effect of $ ) Extraordinary Gain (Loss) from Early Extinguishment of Debts (Net of income taxes effect of $ ) Net Income (Loss)

Earnings per Common Share: Income from Continuing Operations Discontinued Operations Extraordinary Gain (Loss) Net Income (Loss)

Revenue Recognition Principle U.S. GAAP Codification, Accounting Standards ASC, International Financial Reporting Standards (IFRS) U.S. GAAP by Topic, Accounting by Topic

Revenue Recognition Principle

U.S. GAAP Codification Topic 600: Revenue

Revenues are recognized when (a) realized or realizable and (b) earned. [SFAC No. 5, Para. 83] Revenues --> not recognized until realized or realizable. --> not recognized until earned. Revenues are realized --> when products are exchanged for cash or claims to cash. Revenues are realizable

--> when related assets received are readily convertible to cash or claims to cash. Revenues are earned --> when the products are delivered or --> services are performed. Recognition is the process of --> recording an item in the financial statements. Realization is the process of --> converting non-cash resources into cash. Revenues are --> inflows of assets or settlements of liabilities (or both) --> from activities of the entity's central operations. Gains are --> increases in net assets --> from peripheral or incidental transactions of an entity. ARB No. 43, Chapter 1A Accounting Research Bulleting (ARB) No. 43 a. Chapter 1A b. Issued in June 1953 Unrealized Profit --> should not be credited to income. Profit is deemed to be realized --> when a sale (in the ordinary course of business) is effected. --> unless the collection of sale price is not reasonably assured. Profit is NOT deemed to be realized --> if the collection of sale price is not reasonably assured.

Examples of Revenues and Gains Operating Revenues Operating revenues include --> revenue accounts generated from the primary operations of the company. Sales Nonoperating Revenues and Gains Nonoperating revenues and gains include --> revenue and gain accounts generated from --> other than the primary operations of the company. Interest revenue (or interest income) Gain on sale of securities Gain on sale of buildings Gain on sale of machinery Gain on sale of equipment Interest revenue (or interest income) account --> may be classified as operating revenues --> for banks and other financial corporations --> whose primary operations are lending money to earn interest income. Gains from Discontinued Operations Gains from discontinued operations are --> due to the disposal of business segment. Gain from operations of discontinued business segment Gain on disposal of business segment Extraordinary Gains Extraordinary gains include

--> gains that unusual and infrequent. Gain on early extinguishment of debt

Examples of Expense and Loss Accounts Financial Statements Overview Expenses and Losses Operating Expenses Operating expenses include expense accounts that are necessary to earn operating revenues. Cost of sales (or cost of goods sold) Selling, General and Administrative Expenses (SG&A Expenses) Selling, General and Administrative Expenses include the following accounts. Salaries expense Sales salaries expense (Salaries expense for sales personnel) Insurance expense Property tax expense Rent expense Utilities expense Nonoperating Expenses and Losses Nonoperating expenses and losses include expense and loss accounts that are due to the transactions other than the primary operations of the company. Interest expense Loss on sale of securities Loss on sale of buildings Loss on sale of machinery Loss on sale of equipment Interest expense account may be classified as operating expenses for banks and other financial corporations, whose primary operations are lending money to earn interest income. Losses from Discontinued Operations Losses from discontinued operations are due to the disposal of business segment. Loss from operations of discontinued business segment Loss on disposal of business segment Extraordinary Losses Extraordinary losses include losses that unusual and infrequent. Loss on early extinguishment of debt Loss from fire Loss from flood Loss from earthquake Losses due to Changes in Accounting Method Cumulative effect of changes in accounting method is reported as either gain or loss in the income statement of the current period. Cumulative effect of changes in depreciation method

An Example of Detailed Statement of Cash Flows Financial Statements Overview

Sample Technology Corporation

Statement of Cash Flows

For the Year Ended December 31, 2006

Cash Flows from Operating Activities Net Income Adjustments

Depreciation Expense Amortization Expense Gain on Sale of Equipment Increase in Accounts Receivable Decrease in Unearned Rent Revenue Decrease in Inventories Increase in Accounts Payable Increase in Prepaid Expenses Increase in Income Taxes Payable Net Cash Provided by Operating Activities

Cash Flows from Investing Activities Purchase of Available-for-sale Securities Sale of Equipment Purchase of Buildings Net Cash Used in Investing Activities

Cash Flows from Financing Activities Borrowings from Banks Issuance of Common Stock Payment of Cash Dividends Net Cash Used in Financing Activities

Net Increase/Decrease in Cash and Cash Equivalents Cash and Cash Equivalents, January 1, 2006 Cash and Cash Equivalents, December 31, 2006

Examples of Asset Accounts Financial Statements Overview Assets and Contra-Asset Accounts Current Assets Current Assets include assets that are expected to be converted into cash within a year from the balance sheet date. Cash Bank deposits Accounts receivable (due within a year from the balance sheet date) Notes receivable (due within a year from the balance sheet date) Marketable securities Short-term loans Prepaid expenses Other current assets Inventories Inventories include merchandise or goods that are ready to be sold, and other assets that are in the process of producing goods. Merchandise Raw materials Work-in-process (WIP) Finished goods Property, Plant, and Equipment (PP&E) PP&E include tangible fixed assets that are used for the primary business operations. Land Buildings Machinery Equipment Vehicles Leasehold improvements Accumulated Depreciation Accumulated depreciation is a contra-asset account which is subtracted from asset accounts. Land does not have accumulated depreciation, because land account is not depreciated. Accumulated depreciation, buildings Accumulated depreciation, machinery Accumulated depreciation, equipment Accumulated depreciation, vehicles Intangible Assets Intangible assets include assets that do not have physical substance, but provide future economic benefits. Trademark Copyright Patent Goodwill The amortization of intangible assets is directly subtracted from the balance of related intangible assets. Accounts such as "accumulated amortization" are not used.

Other Assets Other assets include noncurrent assets that are not classified as one of the above accounts. Long-term notes receivable (due after a year from the balance sheet date) Long-term loans related companies

Examples of Liability Accounts Financial Statements Overview Liabilities Current Liabilities Current liabilities include liabilities that are expected to be paid within a year from the balance sheet date. Accounts payable (due within a year from the balance sheet date) Notes payable (due within a year from the balance sheet date) Short-term borrowings Salaries payable Income taxes payable Sales taxes payable Current maturities of long-term debt (due within a year from the balance sheet date) Other current liabilities Long-Term Liabilities Long-term liabilities include liabilities that are expected to be paid after a year from the balance sheet date. Bonds payable Long-term notes payable (due after a year from the balance sheet date) Long-term borrowings

Stockholders' Equity Financial Statements Overview Stockholders' Equity Contributed Capital Contributed capital includes the amounts that are transferred from stockholders to the company. Preferred stock (par value x number of preferred shares issued) Common stock (par value x number of common shares issued) Additional paid in capital, preferred stock ( [issue price - par value] x number of preferred shares issued ) Additional paid in capital, common stock ( [issue price - par value] x number of common shares issued ) Additional paid in capital is also called as "Paid-in capital in excess of par value". Retained Earnings Retained earnings represent the amount of the company's past net income retained inside the company (not paid as dividend to stockholders.) Retained earnings Accumulated deficit (if the amount of retained earnings is negative, it is called as "accumulated deficit".) Treasury Stock Treasury stock represents the company's common or preferred stock currently owned by the company it self, as a result of stock repurchase in the past. The amount of treasury stock is subtracted from stockholders' equity. Treasury stock (the amount of treasury stock is determined by either cost method or par value method.)

Shareholders' Equity SFAS No. 129 Statement of Financial Accounting Standards (SFAS) No. 129 a. Disclosure of Information about Capital Structure b. Issued in February 1997 SFAS No. 129 --> Consolidates capital structure related disclosures required by APB Opinion No. 10, 15 and SFAS No. 47. Required Disclosures about Securities a. Dividend and liquidation preferences b. Participation rights c. Call prices and dates d. Conversion rates and dates e. Exercise prices and dates f. Sinking-fund requirements g. Unusual voting rights h. Contracts to issue additional shares i. Number of shares issued on conversion or exercise j. Changes in the number of shares of stock

k. l. m. n. o.

Liquidation preference for preferred stock Amounts at which preferred stock may be called Amounts at which preferred stock is subject to redemption Amounts of arrearages in cumulative preferred dividends Amount of redemption requirements for redeemable stock

Preferred Stock --> A security with preferential rights (compared to common stock) Participation Rights --> Rights to receive dividends or returns APB Opinion No. 12 Disclosures of Changes in Capital Accounts a. Changes in the accounts comprising stockholders' equity b. Changes in the number of shares of stock ARB No. 43, Chapter 1A Stock Issued for Property --> It is not permissible to treat the par value of stock issued as the cost of property acquired. APB Opinion No. 14 Debt with stock detachable purchase warrants --> Proceeds are allocated to the two components. a. debt security b. warrants Allocation is based on --> a. fair value of debt securities without warrants b. fair value of warrants Portion of proceeds allocated to debt security --> recorded as liability. Portion of proceeds allocated to warrants --> recorded as additional paid-in capital. APB Opinion No. 29 Cost of an asset acquired = Fair value of the asset surrendered + Cash (boot) paid - Cash (boot) received Dividend-in-kind --> recorded at the fair value of the asset transferred --> gain or loss is recognized on the disposition of the asset. ARB No. 43, Chapter 7B Stock Dividend --> Issuance of its own stock to shareholders without consideration --> to distribute retained earnings to shareholders. Accounting for Stock Dividend --> Retained earnings is transferred to capital stock and additional paid-in capital --> for the amount of fair value of additional shares issued Stock Split

--> Issuance of its own stock to shareholders without consideration --> to reduce per share price by increasing number of outstanding shares. Accounting for Stock Split --> Retained earnings is not transferred to capital stock. Issuance of additional shares of more than 25 percent --> Recorded as stock splits. APB Opinion No. 6 Treasury Stock --> Capital stock acquired (and held) by the entity that issued such stock. Treasury stock is --> reported separately as a deduction from the total of (capital stock, additional paid-in capital, and retained earnings.) Gains on Sales of Treasury stock --> credited to additional paid-in capital. Losses on Sales of Treasury stock --> charged to additional paid-in capital (up to previous gains on sales of same class of stock) --> remaining losses are charged to retained earnings. Retirement of Treasury Stock An excess of purchase price over par (or stated) value --> charged to additional paid-in capital (limited to pro rata portion) and retained earnings. Alternatively, --> may be charged (entirely) to retained earnings.

Examples of Balance Sheet Financial Statements Overview Example 1 Balance sheet has three major components. Assets = Liabilities + Stockholders' Equity Precision Technology Corporation Balance Sheet December 31, 2006 Liabilities Assets Stockholders' Equity Total Assets

Total Liabilities and Stockholders' Equity

Example 2 Assets = Current Assets + Investments + Property, Plant, and Equipment + Intangible Assets Liabilities = Current Liabilities + Long-term Liabilities Stockholders' Equity = Common Stock + Preferred Stock + Retained Earnings

Precision Technology Corporation Balance Sheet December 31, 2006 Current Liabilities Long-term Liabilities

Current Assets Investments Property, Plant, and Equipment Intangible Assets

Preferred Stock Common Stock Retained Earnings

Total Assets

Total Liabilities and Stockholders' Equity

Example 3

Precision Technology Corporation Balance Sheet December 31, 2006 Current Assets Cash Marketable Securities Inventories

Current Liabilities Accounts Payable Notes Payable Salaries Payable Interest Payable Income Taxes Payable Current Portion of Long-term Debt

Investments in other companies Property, Plant, and Equipment Land Buildings Less: Accumulated Depreciation Equipment Less: Accumulated Depreciation

Long-term Liabilities Long-term Notes Payable Long-term Borrowings Bonds Payable Stockholders' Equity Preferred Stock Common Stock Additional Paid-in Capital, Preferred Stock Additional Paid-in Capital, Common Stock Retained Earnings

Intangible Assets Patents Trademarks Goodwill Total Assets

Total Liabilities and Stockholders' Equity

Accounting Ratios for Financial Statement Analysis

U.S. GAAP Codification, Accounting Textbooks Financial Accounting, Intermediate Accounting, Advanced Accounting U.S. GAAP by Topic, Accounting by Topic

Liquidity Analysis Ratios Current Ratio Current Ratio =

Quick Ratio

Current Assets -----------------------Current Liabilities

Quick Assets

Quick Ratio =

---------------------Current Liabilities

Quick Assets = Current Assets - Inventories Net Working Capital Ratio Net Working Capital Ratio =

Net Working Capital -------------------------Total Assets

Net Working Capital = Current Assets - Current Liabilities

Profitability Analysis Ratios Return on Assets (ROA) Return on Assets (ROA) =

Net Income ---------------------------------Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Return on Equity (ROE) Return on Equity (ROE) =

Net Income -------------------------------------------Average Stockholders' Equity

Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2 Return on Common Equity (ROCE) Return on Common Equity (ROCE) =

Net Income -------------------------------------------Average Common Stockholders' Equity

Average Common Stockholders' Equity = (Beginning Common Stockholders' Equity + Ending Common Stockholders' Equity) / 2 Profit Margin Profit Margin =

Net Income ----------------Sales

Earnings Per Share (EPS) Earnings Per Share (EPS) =

Net Income --------------------------------------------Number of Common Shares Outstanding

Activity Analysis Ratios Assets Turnover Ratio Assets Turnover Ratio =

Sales ---------------------------Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio =

Sales ----------------------------------Average Accounts Receivable

Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 Inventory Turnover Ratio Inventory Turnover Ratio =

Cost of Goods Sold --------------------------Average Inventories

Average Inventories = (Beginning Inventories + Ending Inventories) / 2

Capital Structure Analysis Ratios Debt to Equity Ratio

Total Liabilities ---------------------------------Total Stockholders' Equity

Debt to Equity Ratio =

Interest Coverage Ratio

Income Before Interest and Income Tax Expenses ------------------------------------------------------Interest Expense

Interest Coverage Ratio =

Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense

Capital Market Analysis Ratios Price Earnings (PE) Ratio

Market Price of Common Stock Per Share -----------------------------------------------------Earnings Per Share

Price Earnings (PE) Ratio =

Market to Book Ratio Market to Book Ratio =

Market Price of Common Stock Per Share ------------------------------------------------------Book Value of Equity Per Common Share

Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Yield Dividend Yield =

Annual Dividends Per Common Share -----------------------------------------------Market Price of Common Stock Per Share

Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Payout Ratio Dividend Payout Ratio =

Cash Dividends -------------------Net Income

ROA = Profit Margin X Assets Turnover Ratio ROA = Profit Margin X Assets Turnover Ratio Net Income ROA = ------------------------ = Average Total Assets Profit Margin = Net Income / Sales Assets Turnover Ratio = Sales / Averages Total Assets

Net Income -------------- X Sales

Sales -----------------------Average Total Assets