Financial statements are directed primarily towards investors and creditors. Outsiders to the firm.
Insiders to the firm use managerial accounting which may overlap with financial accounting but is a separate topic.
Government and labor are also interested in financial statements. Gov't for taxes and oversight. Labor to make sure they're being paid in accordance with the profit level that the company is earning.
A side note: Depaul faculty and staff used to receive the school's annual financial statements. They noticed that operating funds were transferred to the endowment. Usually it's the opposite. Faculty and staff raised the issue and it was dealt with.
Financial annual reports are available from http://www.annualreports.com/. SEC also has the info at edgar.sec.com. (EDGAR = Electronic Data-Gathering, Analysis, and Retrieval) It's not packaged very nicely though.
Another good, free site is finance.yahoo.com. Search/filtering capabilities are excellent.
Earnings.com informs you of key events (dividends, stock splits, etc) on a daily basis.
The Accounting Equation
Assets = Liabilities + Owners' Equity
- This equation underlies the preparation of the balance sheet.
- Basis for the "double entry" system
Balance of assets, liabilities and owners' equity at a specified point in time.
Business assets and liabilities are kept separate from those of the owners.
Assets
Resources owned by the entity.
Is a very talented employee (for instance, a major league baseball player) under contract for 5 years an asset that would go on the balance sheet? It's an asset, but it doesn't go on the balance sheet. By convention, human resources are not on the balance sheet as an asset.
Goodwill is a complex topic and is not covered in this course.
Assets can be categorized as monetary (liquid), non-monetary (designated in monetary terms, but not as liquid) and non-physical.
Some facts about the firm (e.g. president is ill) may be important, but they do not appear on the balance sheet at all.
Liabilities
Commitments requiring future resources, usually cash.
Some liabilities are satisfied in other ways. For instance, if you receive payment for a prepaid subscription. This incurs a liability that is satisfied by delivering the product.
Owners' Equity
In a way, it's a residual: the difference between assets and liabilities. However, we don't calculate it like that.
Two components: Contributed capital (what investors have put into the business) and retained earnings (profit that the company has made but not returned to the stockholders).
The Double Entry Bookkeeping System
Analyze how accounting events affect the accounting equation.
- Issue stock for $100k - Asset ($100k cash) and Equity increase.
- Buy car for $20k - No change - Just a transfer from one type of asset (cash) to another (vehicles).
- Purchase truck for $10k to be paid in the future - Assets (vehicles) and Liabilities (amount owed) both increase.
- Pay for the truck - Assets (cash) and liability (amount owed) both decrease.
- Sell services for $15k in cash - Assets (cash) and Equity (retained earnings) both increase by $15k.
- Sell services for $25k to be received in the future - Assets (accounts receivable) and Equity (retained earnings) by $25k.
- Collect the $25k - No change - Cash increases, accounts receivable decreases. Both are offsetting assets.
- Pay rent of $5k - Both Assets (cash) and Equity (retained earnings) decreases by $5k.
- Pay dividend of $7k - Both Assets (cash) and Equity (dividends) decrease by $7k.
Financial Statements
Balance Sheet
Implements the accounting equation A = L + OE at a given point in time.
Statement of Retained Earnings
Beginning Balance (from last year's balance sheet)
+Net Income
-Dividends
=Ending Balance (should match this year's balance sheet)
Income Statement
Record all items of revenue and all expenses to compute a net income. That net income is used in the statement of retained earnings, so it must be prepared first.
Statement of Cash Flows
This is complex. It'll be covered in the last class. For now: It focuses on the change in cash over the year. When looking at the statement of cash flows, analysts and others focus on where the cash came from: operating activities, investing activities, financing activities (borrowing).
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