FINANCIAL & MANAGERIAL

ACCOUNTING for MBAs 5e

Peter D. Robert F. Mary Lea Al L. Wayne J.
EASTON HALSEY McANALLY HARTGRAVES MORSE

MODULE 2
Introducing Financial Statements

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 Learning Objective 1

Examine and interpret a balance sheet.

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 Balance Sheet Format

 The balance sheet is divided into three sections.

 Assets
 Liabilities
 Stockholders’ equity
 It reports the assets, liabilities, and equity at a point in time.
 Balance sheet accounts are called permanent accounts in that
they carry over from period to period.

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 Flow of Costs

 When a cost creates an immediate benefit, we record the cost in the

income statement as an expense.
 When a cost creates a future economic benefit, we record it on the
balance sheet as an asset.
 When an asset is used up, the asset’s cost is transferred from the balance
sheet to the income statement, where it is recognized as an expense.
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 Assets

 An asset must possess two characteristics to be reported on the

balance sheet.
1. It must be owned (or controlled) by the company.
2. It must confer expected future economic benefits that result from a
past transaction or event.

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 Apple’s Balance Sheet

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 Current Assets

 Cash—currency, bank deposits, and investments with an original

maturity of 90 days or less (called cash equivalents).
 Short-term investments—marketable securities and other
investments the company expects to dispose of in the short run.
 Accounts receivable, net—amounts due to the company from
customers arising from the sale of products and services on credit
(“net” refers to the subtraction of uncollectible accounts).
 Inventories—goods purchased or produced for sale to customers.
 Prepaid expenses—costs paid in advance for rent, insurance,
advertising, and other services.
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 Long-Term Assets

 Property, plant, and equipment (PPE), net—land, buildings, and

equipment (“net” refers to the subtraction of accumulated
depreciation).
 Long-term investments—investments the company does not
intend to sell in the near future.
 Intangible and other assets—assets without physical substance
(such patents, trademarks, franchise rights, and goodwill).

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 Measuring Assets

 Most assets are reported at their original acquisition costs, or

historical costs, and not at their current market values.
 If a company cannot value an asset with relative certainty, it does not
recognize an asset on the balance sheet.
 This means that sizable “assets” are not reflected on a balance sheet.
 Excluded intangible assets often relate to knowledge-based (intellectual)
assets, such as a strong management team, a well-designed supply
chain, or superior technology.

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 Liabilities and Equity

 Liabilities represent a company’s future economic sacrifices.

 Liabilities are borrowed funds (such as accounts payable and obligations
to lenders).
 They can be interest-bearing or non-interest-bearing.
 Stockholders’ equity represents capital that has been invested by
the stockholders, either
 Directly via the purchase of stock, or
 Indirectly in the form of retained earnings that reflect earnings that are
reinvested in the business and not paid out as dividends.
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 Apple’s Liabilities and Equity

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 Current Liabilities

 Accounts payable—amounts owed to suppliers for goods and

services purchased on credit.
 Accrued liabilities—obligations for expenses that have been incurred
but not yet paid (i.e., wages earned by employees but not yet paid).
 Unearned revenues—obligations created when the company accepts
payment in advance for goods or services it will deliver in the future.
 Short-term notes payable—short-term debt payable to banks or
other creditors.
 Current maturities of long-term debt—principal portion of long-term
debt that is due to be paid within one year.
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 Net Working Capital

 Net working capital, or simply working capital, reflects the

difference between current assets and current liabilities and is
defined as follows.

The net working capital required to conduct business depends on

the company’s operating (or cash) cycle, which is the time between
paying cash for goods and receiving cash from customers.

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 Cash Operating Cycle

 Companies use cash and supplier credit to purchase or manufacture

inventories held for resale.
 Inventories are sold either for cash or on credit (accounts receivable).
 When receivables are collected, a portion of the cash received is used to
repay accounts payable, and the remainder goes to the cash account for
the next operating cycle.
 Our goal is to shorten the cash cycle.
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 Cash Operating Cycle for Apple and 3M

 If a company has a negative cash conversion cycle, it means that the

company needs less time to sell its inventory (or produce it from raw
materials) and receive cash from its customers compared to time in
which it has to pay its suppliers of the inventory (or raw materials).
 The negative cash cycle for Apple implies that it can invest the cash it
receives from sales for 52.7 days before making payment to suppliers.
 3M is a more typical cash operating cycle.
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 Noncurrent Liabilities

 Long-term debt—amounts borrowed from creditors that are

scheduled to be repaid more than one year in the future.
 Long-term debt includes bonds, mortgages, and other long-term loans.
 Other long-term liabilities—like pension liabilities and long-term
tax liabilities, that will be settled a year or more into the future.

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 Stockholders’ Equity
— Contributed Capital —

 Common stock—par value received from the original sale of

common stock to investors.
 Additional paid-in capital—amounts received from the original
sale of stock to investors in excess of the par value of stock.
 Preferred stock—value received from the original sale of
preferred stock to investors.
 Treasury stock—amount the company paid to reacquire its
common stock from shareholders.

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 Stockholders’ Equity
— Earned Capital —

 Retained earnings—accumulated net income (profit) that has not

been distributed to stockholders as dividends.

 Accumulated other comprehensive income or loss—

accumulated changes in asset and liability fair values that are not
reported in the income statement.
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 Market Value vs. Book Value
 Stockholders’ equity is the “value” of the company determined by generally accepted
accounting principles (GAAP) and is commonly referred to as the company’s book value.
 Market value is computed by multiplying the number of outstanding common shares by
the company’s stock price.
 Book value and market value can differ for several reasons.
 GAAP generally reports assets and liabilities at historical costs, whereas the market attempts to estimate
fair market values.
 GAAP excludes resources that cannot be reliably measured.
 GAAP does not consider market differences in which companies operate.
 GAAP does not usually report expected future performance.

 For U.S. companies, median book value is about one-half of market value (yielding a 2.0
market-to-book ratio).
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 Learning Objective 2

Examine and interpret an income statement.

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 Income Statement

 The income statement reports revenues earned during

a period, the expenses incurred to produce those
revenues, and the resulting net income or loss.
 The general structure of the income statement follows.

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 Income Statement
— Apple —

 Operating expenses are the usual and customary costs a

company incurs to support its operating activities.
 Nonoperating expenses relate to the company’s financing and
investing activities.
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 Recognizing Revenues and Expenses
 Revenue recognition principle—recognize revenues for
goods and services provided to customers at an amount
expected to be received.
 Recognizing revenues does not necessarily imply the receipt of
cash.
 Revenue is recognized when the company has done what it is
obligated to do under the sales contract.
 Expense recognition (matching) principle—recognize
expenses when incurred.
 Companies recognize an expense when it is incurred, even if no
cash is paid.
 These two principles are the foundation of accrual
accounting.
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 Discontinued Operations

 Discontinued operations has two components:

1. The net income (loss) from the segment’s business activities prior
to sale, and
2. Any gain or loss on the actual sale of the business.

 To be classified as a discontinued operation, the disposal of

the business unit must represent a strategic shift that has, or
will have, a major effect on the company’s financial results.
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 Analyzing the Income Statement

 Gross profit margin (Gross profit/Sales)

 The gross profit margin is influenced by both the selling price of the
company’s products and the cost to make or buy those products.
 Margins for operating expenses (Operating expense/Sales)
 Analysis of operating expenses focuses on each expense category
reported by the company as a percentage of sales over time and
compared with peer companies.

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 Learning Objective 3

Examine and interpret a statement of stockholders’

equity.

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 Statement of Stockholders’ Equity

 The statement of stockholders’ equity reconciles the

beginning and ending balances of stockholders’ equity
accounts.
 Common stock and additional paid-in capital increase
by the proceeds from the sale of stock.
 Retained earnings increase by the net income reported
in the income statement and decrease by the dividends
to shareholders.
 Accumulated other comprehensive income increases
and decreases by changes in asset and liability fair
values that are not reported in the income statement.
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 Statement of Stockholders’ Equity
— Apple —

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 Learning Objective 4

Describe a statement of cash flows.

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 Statement of Cash Flows

 The income statement provides information about the economic

viability of the company’s products and services.
 The statement of cash flows provides information about the
company’s ability to generate cash from those same transactions.

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 Statement of Cash Flows Format

 Cash flows from operating activities

 Cash flows from the company’s transactions and events that relate to its
operations.
 Cash flows from investing activities
 Cash flows from acquisitions and divestitures of investments and long-
term assets.
 Cash flows from financing activities
 Cash flows from issuances of and payments toward borrowings and
equity.
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 Statement of Cash Flows
— Apple —

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 Learning Objective 5

Construct and apply linkages among the four

financial statements.

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 Retained Earnings Reconciliation

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 Apple’s Financial Statement Linkages

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 Learning Objective 6

Locate and use additional financial information

from public sources.

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 Additional Information Sources

 Form 10-K and Form 10-Q

 Companies with publicly traded securities must file with the SEC a detailed annual report and
discussion of their business activities in their Form 10-K (quarterly reports are filed on Form 10-Q).
 Form 20-F and Form 40-F
 If the company uses accounting standards other than GAAP or IFRS, Form 20-F must discuss major
differences between the accounting principles used and GAAP and provide a table that reconciles net
income as reported to U.S. GAAP net income.
 Form 8-K
 Outsiders typically use Form 8-K to monitor for material adverse changes in the company.

continued
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 Additional Information Sources

 Analyst Reports
 Sell-side analysts provide their clients with objective analyses of company operating activities.
 Credit Services
 Several firms provide credit analysis that assists us in evaluating a company’s creditworthiness and
future financial viability.
 Data Services
 A number of companies supply financial statement data in easy-to-download spreadsheet formats.

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 Global Accounting

 Balance Sheet
 The most visible difference is that many IFRS-based balance sheets are presented in
reverse order of liquidity.
 Income Statement
 The most visible difference is that GAAP requires three years’ of data on the income
statement whereas IFRS requires only two.

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The End