Upon completion of this chapter you should understand: Basic concepts associated with the Income Statement, basic concepts associated with the Balance Sheet, cash flow and cash flow statements, financial statement generation and the accounting equation, other types of financial statements.
Chapter 2 – Unit 1 Introduction to Financial Statements and the Accounting Equation IET 35000 Engineering Economics Learning Objectives – Chapter 2 Upon completion of this chapter you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements Financial statement generation and the accounting equation Other types of financial statements Learning Objectives – Unit 1 Upon completion of this unit you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements Financial statement generation and the accounting equation Other types of financial statements Financial Statements Financial statements: Represent the financial history of the organization – both successes and failures Assist in planning, budgeting and investment analysis Based on techniques over 300 years old Importance: Provide essential information for managers and administrators Serve as the required external reporting method for publicly held organizations. Income Statement Reports the financial activities over a period of time Annual corporate reports include an Income Statement covering the financial activities during the firm’s fiscal year Income Statements covering less than a year time period are used for internal reporting, budgeting and planning purposes Amounts reported are in units of $/time period Annual reports = $/year Income Statements are also known as Profit and Loss Statements Income Statement Typical Income Statement format includes three sections: Section 1: Income from the sale of products or services less the cost to produce and deliver the products or services. Result is the gross profit Section 2: Expenses associated with general administrative functions, depreciations and income or costs of a nonrecurring nature are subtracted from the gross profit yielding the net income before taxes Section 3: Taxes are based on the net income. Subtracting taxed from net income before taxes yields net income. If dividends are paid by the organization, they are subtracted from net income which yields retained earnings Income Statement Typical format: Revenue or Sales Operating Expenses or Cost of Good Sold Gross Profit Selling, General and Administrative Costs Net Income Before Taxes Taxes Net Profit After Tax Dividends Retained Earnings Income Statement Example: http://www.investopedia.com/articles/04/022504.asp Income Statement Components Revenue or Sales – income from an organization’s core business; income from sale of products or services after returns and adjustments. Includes both cash transactions and credit transactions Cost of Goods Sold – expenses directly associated with the manufacturing of the product or providing the service. Includes material, labor and overhead Gross Income = Net Sales – Cost of Goods Sold Income Statement Components Material Costs Direct material cost can be associated with the product or service. Direct Material is included in the cost of goods sold Indirect material cost is required to produce the product or provide the service, but cannot be directly associated with the product or service. Indirect material cost is frequently assigned to overhead which is included in the cost of goods sold Cost of supplies used for administrative and selling purposes is included in operating expenses in the SG&A section of the income statement. 10 Income Statement Components Labor Costs Direct labor cost can be associated directly with the product or service. Direct labor is included in the cost of goods sold Indirect labor cost is required to produce the product or provide the service, but cannot be directly associated with the product or service. Indirect labor cost is frequently assigned to overhead which is included in the cost of goods sold Labor cost associated with administrative and selling purposes is included in operating expenses in the SG&A section of the income statement. 11 Income Statement Components Overhead or Burden Expense Manufacturing overhead includes indirect labor and indirect material expense along with any other expense that is required to keep the core function of the business in operation Administrative overhead includes all of the costs associated with operating the ‘office’ function of the organization that is not assigned to SG&A labor or supplies expense Sometimes it is difficult to separate some expenses such as electricity into manufacturing and administrative overhead accounts 12 Income Statement Components Operating Expense or Selling and Administrative Expense – includes all expense and cost which cannot be assigned to the product or service, but are required to keep the organization operating. Includes non‐ income taxes such as property tax Operating Income = Gross Income – Operating Expenses Operating expenses generally include depreciation which is the decrease in value of fixed assets due to age and technical obsolescence. Not a cash flow but is an expense 13 Income Statement Components Other Income – income from sources other than an organization’s core business. Include income from: Subsidiaries Sale of used or surplus equipment Investment securities Extraordinary expenses or revenues which will typically occur only one time are frequently separated out to clarify the performance of the organization. 14 Income Statement Components Interest expense is frequently separated from operating expenses which are termed selling, general and administrative (SG&A). Includes interest payments on bonds and loans. Net Income (Profit) before Taxes is the Gross Income minus all other expenses, and plus any other income to the firm. This amount is the amount used to determine the income taxes paid by the organization. 15 Income Statement Components Corporations pay income taxes to local, state and federal governments based on the net income of organization at a corporate tax rate Funds left after taxes represent the funds available for reinvestment or dividends Proprietorships and partnerships don’t pay income tax. The Net Income before Taxes amount passes to the owner(s) who then are responsible for the tax liability. 16 Income Statement Components Dividends – as discussed in the previous chapter, dividends can be paid to owner’s (shareholders). The board of directors for the corporation determines if dividends are to be paid on common stock and the amount. Remember that dividends on preferred stock may be mandatory if the firm is profitable Retained Earnings – after all the bills (expenses and taxes) are paid and profits are shared with the owner’s (dividends), retained earnings are ‘retained’ by the firm for expansion, reinvestment or as a buffer for fluctuations in revenue 17 End Unit 1 Material Additional Reading Understanding the Income Statement: http://www.investopedia.com/articles/04/022504.asp Go to Unit 2 The Balance Sheet 18 Chapter 2 – Unit 2 The Balance Sheet IET 35000 Engineering Economics Learning Objectives – Unit 2 Upon completion of this unit you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements Financial statement generation and the accounting equation Other types of financial statements 20 Balance Sheet Reports the financial activities at a point in time Annual corporate reports include a Balance Sheet showing the firm’s financial position at the end of the firm’s fiscal year Balance Sheets have three sections: Assets – anything of value owned by the firm Liabilities – any debt owed by the firm which has not been paid Net Worth or Owner’s Equity – difference between assets and liabilities 21 Balance Sheet Typical format: Assets Liabilities Current Assets Fixed Assets Current Liabilities Long Term Debt Total Liabilities Owner’s Equity Retained Earnings Total Owner’s Equity Total Assets Always Equal Total Liabilities and Owner’s Equity 22 Balance Sheet Example: http://www.investopedia.com/articles/04/031004.asp 23 Balance Sheet Components Assets are something owned by the organization that have value listed in order of liquidity Current Assets include cash and other items that can be converted into cash within one year Fixed Assets have a life greater than one year Intangible assets include patents, trademarks and goodwill 24 Balance Sheet Components Liabilities are debts owed to suppliers, employees and for taxes. Liabilities is anything that has not been paid when the snapshot of the firm’s financial condition is taken. Current liabilities are debts that will be paid within one year Term liabilities are debts such as bonds that are payable in more than a year 25 Balance Sheet Components Owner’s Equity is money owed to the shareholders Common and preferred stock represents money that has been paid by the shareholders to the firm. The value is listed at the stock’s par value Excess capital is the amount paid for the stock at the initial offering over the par value Accumulated retained earnings are profits retained by the corporation 26 End Unit 2 Material Additional Reading Reading the Balance Sheet: http://www.investopedia.com/articles/04/031004.asp Go to Unit 3 Cash Flow and the Cash Flow Statement 27 Chapter 2 – Unit 3 Cash Flow and the Cash Flow Statement IET 35000 Engineering Economics Learning Objectives – Unit 3 Upon completion of this unit you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements Financial statement generation and the accounting equation Other types of financial statements 29 Cash Flow Cash flow is the inflow and outflow from a cash account Important dis nc on: Cash Flow ≠ Income Cash flow includes only cash transactions Income includes non‐cash flow items including accounts payable, accounts receivable and depreciation Cash flow is typically grouped into three sections related to the source of funds. Cash flow from: Operations – core business activities Investing – fixed assets Financing – debt, loans and dividends 30 10 Cash Flow Cash can be increased (sources of funds) by: Profits from operations Selling stock Obtaining loans or increasing liabilities Reducing fixed assets or decreasing current assets 31 Cash Flow Cash is decreased (uses of funds) by: Losses from operations Buying back stock from shareholders Paying off loans or decreasing liabilities Investing in fixed assets or increasing current assets 32 Calculating Cash Flow Net Profit After Tax + Depreciation and Amortization + Deferred Taxes + Decrease/‐ Increase in Asset Accounts1 + Increase/‐ Decrease in Liability Accounts2 Operating Cash Flow 1Inventory, Accounts Receivable 2Accounts Payable, Taxes Payable 33 11 Cash Flow Statement Reports the cash flow over a period of time Annual corporate reports include a Cash Flow Statement covering the financial activities during the firm’s fiscal year Statements covering less than a year time period are used for internal reporting, budgeting and planning purposes Groups interested in Cash Flow Statements include: Accounting – ability to cover payroll and other expenses Potential lenders– picture of a company's ability to repay Potential investors – evaluate the company financial soundness 34 Cash Flow Statement Example: http://www.investopedia.com/articles/04/033104.asp 35 Cash Flow Statement Components Net Earnings is based on the cash flow created by the firm’s core business and is taken from the income statement. Adjustments are made to the net earnings for non‐cash entries on the Income Statement. Example – depreciation is added since it is a non‐cash flow item. Changes to receivable and payable accounts from the prior reporting 36 period are also included 12 Cash Flow Statement Components Additional adjustments to the net earnings include changes to the inventory value from the prior reporting period Purchase or sale of fixed assets such as land, buildings and equipment is included in the Investing section Investing cash in fixed assets such as equipment is shown as a negative value 37 Cash Flow Statement Components Transactions related to debt, loans and dividend are included in the Investing section An increase in debt would be shown as a positive value since it represents a positive cash flow to the firm Note that the example cash flow statement format does differ from the example in the Bowman text 38 End Unit 3 Material Additional Reading What is a Cash Flow Statement? http://www.investopedia.com/articles/04/033104.asp Go to Unit 4 Financial Statement Generation 39 13 Chapter 2 – Unit 4 Financial Statement Generation IET 35000 Engineering Economics Learning Objectives – Unit 4 Upon completion of this unit you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements Financial statement generation and the accounting equation Other types of financial statements 41 Accounting System Accounting system is responsible for: Collecting and recording financial events Organizing financial data into usable information Preparing internal financial reports and statements Journal – chronological listing of financial events General Ledger – collection of the firm’s accounts Ledger Accounts – individual accounts for each category of revenue, expense, asset, liability, owners’ equity, etc. Accounts are usually assigned an account number. 42 14 Accounting Equation Accounting equation is a combination of the Income Statement and Balance Sheet: Assets s Owners' Equity ‐ Costs Liabilitie Revenue Income Statement BalanceSheet Equation must always be kept in balance Transactions can be accumulated under the five categories. At the end of the financial period, each column can be accumulated and entered into the appropriate financial statement 43 Accounting System Double‐Entry System – for every financial transaction, a minimum of two entries are made into the Accounting Equation. Examples of simple ledger account entries: Transaction Purchase materials for cash 1st Account Entry 2nd Account Entry ‐ Cash + Inventory + Equipment + Accounts Payable Sell common stock + Cash + Owners’ Equity Pay wages ‐ Cash + 1Wages Paid Purchase equipment on credit 1Wages Paid is a cost which is a negative term in the Accounting Equation, therefore the net effect is subtracting from both sides of the equal side 44 Accounting System Double‐Entry System – some transactions require more than two entries in the Accounting Equation. Example: Sale of product for cash: + Cash (asset account/balance sheet) + Revenue (revenue account/income statement) ‐ Inventory (asset account/balance sheet) + 1Cost of Goods Sold (cost account/income statement) 1Cost of Goods Sold is a cost which is a negative term in the Accounting Equation, therefore the net effect is subtracting from both sides of the equal side 45 15 Example Problem 2.1 Example Problem 2.1 Solution 46 End Unit 4 Material Additional Reading Double entry accounting systems: http://simplestudies.com/double‐entry‐accounting‐system.html Go to Unit 5 Other Financial Statements 47 Chapter 2 – Unit 5 Other Financial Statements IET 35000 Engineering Economics 16 Learning Objectives – Unit 5 Upon completion of this unit you should understand: Basic concepts associated with the Income Statement Basic concepts associated with the Balance Sheet Cash flow and cash flow statements. Financial statement generation and the accounting equation Other types of financial statements 49 Other Financial Statements The Income Statement, Balance Sheet and Cash Flow Statement are financial statements are mandatory reports for publically held corporations Issued on an annual basis Prepared by the ‘Financial Accounting’ functional area Good management practice requires ongoing financial information. Internal reports are prepared frequently to meet the needs of the organization. Formats depend on the need Prepared by the ‘Managerial Accounting’ functional area 50 Other Financial Statements Examples Cost of goods sold statement with detail such as: Material costs and variance to standards Labor costs and variance to standards Overhead costs and variance to standards Product inventory with detail such as: Raw material quantity and cost In‐process material quantity, %completion and value Finished goods quantity and value 51 17 Other Financial Statements Examples Accounts receivable with detail such as: Who owes and due date Who is past due and possible bad accounts Sales information with detail such as: Customer and product type Asset inventory with detail such as: Acquisition cost Planned life, depreciation and salvage value. 52 Standards Corporations and accountants use what is known as Generally Accepted Accounting Principles (GAAP) GAAP are set by policy boards associated with accounting profession and are periodically reviewed and updated Corporations are expected to follow GAAP standard to insure consistent, accurate and honest financial reporting. http://www.fasab.gov/index.html 53 End Chapter 2 Material Student Study Guide Chapter 2 Homework Assignment Problem Set 2 54 18 ... Basic concepts associated with the Balance Sheet Cash flow and cash flow statements. Financial statement generation and the accounting equation Other types of financial statements 49 Other Financial Statements The Income Statement, Balance Sheet and Cash Flow ... Double entry accounting systems: http://simplestudies.com/double‐entry accounting system.html Go to Unit 5 Other Financial Statements 47 Chapter 2 – Unit 5 Other Financial Statements IET 35000 Engineering Economics. .. Owner’s Equity is money owed to the shareholders Common and preferred stock represents money that has been paid by the shareholders to the firm. The value is listed at the stock’s par value Excess capital is the amount paid for