Chapter 2•Understating Financial

Statements•Understating Financial

Statements

Key Concepts and Skills

• Know the difference type of financial statement

• Know the meaning of each financial statement• Understand the definition of each account• Understand how to prepare financial

statement• Know how to determine a firm’s cash flow

from its financial statements

Type of Financial Statement

• Income Statement• Statement of Equities• Balance Sheet• Statement of Cash Flow

Users of Financial Statement

• Managers• Shareholders• Creditors• Suppliers• Potential Investors• Tax Authority

Balance Sheet

• The balance sheet is a snapshot of the firm’s assets (owns) and liabilities (owes) at a given point in time. In Cambodia, an annual balance sheet is normally prepared as at 31 December of each year.

• Balance Sheet Identity• Assets = Liabilities + Stockholders’ Equity

The Balance Sheet

Balance SheetAssets Liabilities (Debt) & Equity

Current Assets Cash Marketable Securities Accounts Receivable Inventories

Prepaid ExpensesFixed Assets Machinery & Equipment Buildings and LandInvestmentIntangible Assets

Goodwill, Patent, Brand Name, Brand Mark

Current Liabilities Accounts PayableShort-term Notes PayableAccrued LiabilitiesUnearned Revenues Current Maturity Portion of

Long-term DebtDeferred Taxes Long-Term Liabilities Long-term notes MortgagesEquity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings

Assets

• An asset is an item of value owned by the business.

Assets

• Current Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.• Cash, marketable securities, accounts receivable,

inventories, prepaid expenses.

• Property Plant, and Equipment: machinery and equipment, buildings, and land.

• Investment• Intangible Assets such as patents and

copyrights.

Cash

• The most liquid of assets• Generally includes currency, coin, balances

in checking and other demand or “near demand” accounts

Marketable Securities

• Refers to short-term investments that the firm INTENDS to hold for less than one year (thus a “current” asset)

• Generally reported on balance sheet at market value

• May include t-bills, CDs, stocks, bonds• Sometimes combined with cash and reported

as Cash Equivalents

Accounts Receivable

• Arise from credit-sale transactions• Reported on the balance sheet at NET

REALIZABLE VALUE• Accounts Receivable 20000• Less Allowance for Doubtful Accounts (500)• Net Accounts Receivable 19500

Or Account Receivable, net 19500

Inventory

• Consist of items held for sale or used in manufacture of goods for sale

• Merchandising Company• one type of inventory (finished goods)

• Manufacturing Company• three types of inventories (raw materials, work-

in-process, finished goods)

Prepaid Expenses

• Represent expenses paid in advance -- included in current assets if they expire within one year or operating cycle

• Usually not a material item• Present few or no reporting or valuation

issues

• ON TO NONCURRENT ASSETS…….

Property, Plant & Equipment (PP&E)

• Often called “fixed assets”• Represent major resource commitments

which benefit a firm for more than one year• Recorded at HISTORICAL cost; cost allocated

over asset’s useful life through DEPRECIATION (exception: land is not depreciated)

• PP&E is reported on balance sheet at historical cost less accumulated depreciation to date

Investment

• Investments of a business represent assets of a permanent nature that will yield benefits a year or more after the date of the financial statement. These may include: investments in related companies such as affiliates (partly owned) and subsidiaries (owned and controlled); stocks and bonds maturing later than one year; securities placed in special funds; and fixed assets not used in production. The value of these items should be shown at cost.

Intangible Assets

• Resources with expected future economic benefits but lacking a physical substance

• Some examples are patents, copyrights, goodwill

• Goodwill can be material if firm is heavily involved in acquisition activity

LIABILITIES & EQUITIES

REPRESENT CLAIMS TO ASSETS• LIABILITIES: Creditor Claims• EQUITIES: Owner Claims

Constitute the “right” side of equation

LIABILITIES

• May be CURRENT or LONG-TERM -- same criteria of “one-year or operating cycle, whichever is longer” applies here as well

• Represent claims by creditors of the firm

A Look at Current Liabilities

• Accounts Payable• Short-term Notes Payable• Accrued Liabilities• Unearned Revenues (Deferred Credits)• Current Maturity Portion of Long-term Debt• Deferred Taxes (some, not all or even

most…)

…and Long-Term Liabilities?

• Notes or Mortgages Payables• Bonds Payable• Pension and Lease Obligations

Accounts Payable

• Usually defined as obligations arising from purchases of merchandise for resale or of raw materials

• Few valuation or reporting issues• Significant changes from period to period

often result from changes in sales volume

Short-Term Notes Payable

• Promissory notes due within a year (or operating cycle if more appropriate)

• Usually are interest-bearing• Usually reported at face value because of

short-term nature

Accrued Liabilities

• Result from accrual basis of accounting• Represent expenses that have been

INCURRED and thus ACCRUED, but have NOT BEEN PAID in cash

• Examples are Interest Payable and Wages Payable

• In this case, cash flow follows expense recognition

Unearned Revenue

• Sometimes called “deferred credits”• Results from a prepayment received in

advance for services or products• Under accrual accounting, revenue is

recognized when EARNED, not when received in cash -- in this case, cash flow precedes revenue recognition

Current Maturities - LT Debt

• Represent principal payments on debt that are due within one year

• Confirms the old adage that nothing is long-term forever -- eventually it has to be paid as a current item!

• Now, how about those items that are STILL LONG-TERM LIABILITIES

Notes or Mortgages Payable

• Represent any mortgages or notes payable that do not have any principal repayment requirements during the coming year

Bonds Payable

• Once again, represent items that do not have any principal payment requirements within the next year

Pension & Lease Obligations

• Generally reported at the present value of expected future cash outflows

• Can represent MAJOR liabilities for many firms and have a significant impact on the balance sheet

Stockholders’ Equity

• Represent claims to assets by OWNERS, i.e. stockholders

• Is often referred to as a RESIDUAL; this flows from a restatement of the basic equation:

ASSETS - LIABILITIES = EQUITIES

More on Stockholders’ Equity

• Usually consists of STOCK ACCOUNTS AND ADDITIONAL PAID-IN CAPITAL and RETAINED EARNINGS -- may have other equity accounts

• May have more than one “class” of stock: common stock and one or more issues of preferred stock

• Shares of common stock represent ownership of the firm

• Stock usually has a PAR VALUE

STOCK AND ADDITIONAL PAID-IN CAPITAL

• Common and Preferred Stock accounts often carry balances representing “par value” of outstanding shares

• Preferred Stockholders: received fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.

• Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

• Additional paid-in Capital accounts reflect balances over and above par value (from original sales of stock)

Retained Earnings

• In simplest terms, represents the cumulative undistributed earnings of the business since its inception

• Represent funds the company has chosen to “retain” and reinvest in the business

• RETAINED EARNINGS DOES NOT REPRESENT A PILE OF CASH!!!!!!!

Income Statement

• The income statement is more like a video of the firm’s operations for a specified period of time – “between balance sheets” (IS Equation: Rev-Expenses=Income).

• In Cambodia, the normal accounting period is the year ended 31 December.

• You generally report revenues first and then deduct any expenses for the period

• Matching principle – GAAP say to show revenue when it accrues (not necessarily when the cash comes in) and match the expenses required to generate the revenue

SALES

Less: Cost of Goods Sold

GROSS PROFIT

Less: Operating Expenses

OPERATING PROFIT (EBIT)

Less: Interest Expense

EARNINGS BEFORE TAXES (EBT)

Less: Income Taxes

EARNINGS AFTER TAXES (EAT)

Less: Preferred Stock Dividends

NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Income Statement

Major Categories

• NET SALES: A firm’s sales are usually reported as Sales less Sales Returns less Sales Allowances• the major source of revenue for most companies• trends are important

Major Categories (continued)

• Cost of Goods Sold (CGS)• cost to seller of products sold to customers• relationship between CGS and sales is an

important one

• Gross Profit (first step of profit determination)• difference between net sales and CGS

Major Categories (continued)

• Operating Expenses• Selling Expenses: Advertising Exp, Salary for Sale

Staff, Commission…………• Administrative Expenses: Depreciation,

Amortization, Repairs and Maintenance,……….

Major Categories (continued)

• Operating Profit (second step of profit determination) -- also called EBIT• measures overall performance of company’s

operations: sales revenue less expenses.

• Interest Expense:

Major Categories (continued)

• Earnings before income taxes• profit recognized before deduction of income tax

expense

• Income Tax Expense:• Earning After Taxes or Net Income

• “bottom line” -- firm’s profit after consideration of ALL revenues & expenses

Major Categories (continued)

• Preferred Stock Dividend:• Net Income Available to Common

Stockholders:• Earnings per Common Share

• Determined by dividing earnings available to common shareholders (earnings less any preferred dividend requirements) by average number of common shares outstanding during the period

Chapter

•End of Chapter•End of Chapter