FINANCIALACCOUNTING

BASICS

Part One

A. IntroductionB. Business ActivitiesC. Financial StatementsD. Balance SheetE. Balance Sheet ElementsF. Balance Sheet Equation

A. INTRODUCTION

1. Accounting is a language – the language ofbusiness

2. The purpose of any language is to conveyinformation

3. Accounting conveys information about businessactivities to interested parties

4. Accounting information is communicated tointerested parties outside the company viafinancial statements• Most important outside users of accounting

information are investors and creditors5. Financial statements also provide information to

managers inside the company

B. BUSINESS ACTIVITIES

There are three primary activities conducted by businessenterprises:

1. Financing – obtaining cash to be able to (a) makeinvestments and (b) conduct operating activities –

2. Investing – using cash to (a) purchase capital assets (e.g.,buildings, machinery, equipment, land) needed to conductoperating activities, (b) purchase capital stock of othercompanies for strategic purposes (e.g., purchase ofsubsidiary), and (c) invest in income producing financialinvestments (e.g., government bonds or bonds of othercompanies) (cash management activity)

3. Operating – producing and selling goods and services –includes using cash to purchase operating assets (such asinventories) and pay operating expenses (such as wages,utilities, and taxes)

Two sources of financing: (a) equity financing (sale of capitalstock) and (b) debt financing (bank loans, issuance of bonds)

C. FINANCIAL STATEMENTS

Companies summarize the results of theirbusiness activities in four financial statements:

1. Balance sheet2. Income statement3. Retained earnings statement (or statement of

stockholders’ equity)4. Statement of cash flows (statement of changes

in financial position)

Balance sheet and income statement are primaryRetained earnings statement and statement of cashflows are derived from the balance sheet and theincome statement

D. BALANCE SHEET

TYPICAL COMPANYBalance Sheet

December 31, Year 1(in thousands)

ASSETS LIABILITIES AND STOCKHOLDERS’ EQUITYCURRENT ASSETS CURRENT LIABILITIESCash $ 1,449 Accounts payable $ 5,602Marketable securities 246 Bank loan payable

1,000Accounts receivable, net 9,944 Accrued liabilities

876Inventories 10,623 Estimated tax liability

1,541Prepaid expenses 389 Current portion of long-term debt

500Total current assets 22,651 Total current liabilities

9,519NONCURRENT ASSETS NONCURRENT LIABILITIESProperty, plant & equipment 26,946 Long-term debt 2,000less: Accumulated depreciation (13,534) Deferred income taxes 824Property, plant & equipment-net 13,412 Total liabilities

12,343Investments 1,110 STOCKHOLDERS’ EQUITYIntangible assets 403 Common stock 1,000Goodwill 663 Additional paid-in capital 11,256Total noncurrent assets 15,588 Total paid-in capital 12,256

D. BALANCE SHEET

The previous slide shows an example of a typicalbalance sheet.The balance sheet reports a company’s assets,liabilities, and stockholders’ equity at a particularpoint in time.The heading indicates:Name of companyName of statement (Balance sheet)Balance sheet date (the date at which thecompany’s “photograph” is being taken)Measurement unit (e.g., in thousands of dollars)

E. BALANCE SHEET ELEMENTS

1.Assetsa. Resources owned (or controlled) by the

companyb. Assets can be acquired in the following ways:

1. Incurring a liability2. Selling company stock3. Earning money through profitable

operationsc. Total Assets = Current Assets + NoncurrentAssets

Current assets – cash and other assets expectedto be converted into cash or used up within oneyear from the balance sheet dateNoncurrent assets – also known as Long-termAssets

E. BALANCE SHEET ELEMENTS (cont)

2. Liabilitiesa. Obligations to outside parties who haveprovided resources to the company

b. Total Liabilities = Current Liabilities +Noncurrent (or Long-term) Liabilities

Current liabilities – obligations that must be paidwithin one year from the balance sheet dateLong-term liabilities – obligations that will bepaid after one year from the balance sheet date

Example – on December 31, Year 1, a bankloan to be repaid on December 15, Year 2 is acurrent liability, but a bank loan to be repaidon January 5, Year 3 is long-term

E. BALANCE SHEET ELEMENTS (cont)

3. Equitya. Owners’ investment in the company (e.g., stockholders’ equity)b. Includes amount invested through the purchase of stock (paid-in

capital) and earnings reinvested in the company (retainedearnings)

c. Total Equity = Paid-in Capital + Retained Earningsd. Paid-in Capital – usually divided between the par value of stock

(Common Stock account) and the amount at which stock was soldabove par value (Additional Paid-in Capital account); for example,100 shares of $5 par stock is sold for $30 per share:

Common Stock (100 x $5) $500

Additional Paid-in Capital (100 x $25) 2,500Total Paid-in Capital $3,000

e. Retained Earnings – the amount of income that has beengenerated by the company since its formation that has notbeen paid out to the stockholders as dividends:

Cumulative net incomeLess: Cumulative dividends paid to stockholdersEquals: Retained Earnings

E. BALANCE SHEET ELEMENTS (cont)

Summary of a balance sheet:Balance Sheet

Assets LiabilitiesCurrent assets Current liabilitiesNoncurrent assets Long-term liabilities

Total Stockholders’ equityPaid-in capitalRetained earningsTotal

E. BALANCE SHEET ELEMENTS (cont)

The balance sheet summarizes the resources(assets) in which a company has invested onthe left side andHow the money was raised to acquire theresources on the right sideDebt financing (liabilities)Equity financing (stockholders’ equity)

The left side of the balance sheet summarizesthe company’s investing activitiesThe right side of the balance sheetsummarizes the company’s financing activities

(Operating activities are summarized on the income statement)

F. BALANCE SHEET EQUATION

1. Assets = Liabilities + Equity (A = L + E)a. This equation is fundamental – after accounting

for each transaction, the equation must remainin balance

2. Balance sheet equation can be rearranged as:Assets – Liabilities = Equity

a. Creditors can sue the company if amounts duearenot paid

b. Equity investors have only a residual claim toassets after liabilities have been paid

c. Assets – Liabilities also is referred to as netassets