The Relationships between the Financial Statements

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The Relationships between the Financial Statements
Statement of Cash Flows1/1/0412/31/04
Net cash flow from operating activities Net cash
used by investing activities Net cash provided by
financing activities Change in cash
balance Beginning cash balance (12/31/03) Ending
cash balance (12/31/04)
Balance Sheet12/31/04
Balance Sheet12/31/03
Assets Cash Other current assets Long-term
investments Long-lived assets Intangible
assets Liabilities and Stockholders Equity
Current liabilities Long-term liabilities
Contributed capital Retained earnings
Assets Cash Other current assets Long-term
investments Long-lived assets Intangible
assets Liabilities and Stockholders Equity
Current liabilities Long-term liabilities
Contributed capital Retained earnings
Income Statement1/1/0412/31/04
Revenues - Expenses Net income
Statement of Retained Earnings 1/1/0412/31/04
Beginning retained earnings balance Net
income - Dividends Ending retained earnings
balance
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Todays topics

• The 4 basic assumptions of financial accounting
• The 4 valuation bases of financial accountings
• The 4 basic principles of financial accounting
• Capitalizing versus expensing cost
• Environmental information in financial statements

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Investing
Liability Accounts
Asset Accounts
Operating Revenues
Operating Expenses
Credit
Interest Principal
Equity
Dividends
Financing
Accounting is about measurements of stocks within
well-defined boundariesand flows across these
boundaries, using a well-defined measure.
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Four basic assumptions of financial accounting
The first 2 basic accounting assumptions
establish the boundaries of the accounting
object (economic entity)

• Economic entity assumption (financial boundary)
  Profit-seeking entities, which are separate and
  distinct from their owners and other entities,
  can be identified and measured. (holding
  company, subsidiary, consolidated statements)
• Fiscal period assumption (temporal boundaries)
  The life of the economic entity can be divided
  into fiscal periods, and the performance and
  financial position of the entity can be measured
  during those periods. (10-Q, 10-K, calendar
  versus fiscal year, e.g. retailers often use
  January 31)

Financial flows and stock changes are temporal
phenomena
Question What is the difference between the
financial performance and position of a company?
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Four basic assumptions of financial accounting,
cont.

• Going concern The life of the economic entity
  will extend beyond the current fiscal period.
  (related to the definition of an asset something
  creating future economic benefits)
• Stable dollar The performance and financial
  position of the entity can be measured in terms
  of a monetary unit that maintains constant
  purchasing power across fiscal periods.

The fourth basic accounting assumption assures
that the accounting measure,i.e. the dollar, is
a well-defined unit of measurement. What does
it not account for?
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Financial boundaries

• Measurement of flows (e.g. market transactions)
  are based on transaction value

• Measurement of stocks is more difficult, since
  no market transaction takes place ? Need for
  valuation methods

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Four valuations on the Balance Sheet

• Present value (PV)
• Fair market value (FMV)
• Original cost (OC)
• Replacement cost (RC)

• Present value Method Calculate sum of all
  discounted future cash flows Problem
  Subjectivity associated with cash flow
  predictions Used for Contractual agreements
  like notes receivable or payable, mortgages,
  bonds, leases, pensions
• Fair market value (or sales price) Method
  Current value of the item in the output market
  Problem Calculating market value can be
  difficult and too subjective for
  financial accounting Used for Short-term
  investments Special case of FMV Face value (or
  current cash flows) Used for Cash and all
  current liabilities Special case of FMV Net
  realizable value (expected cash
  collection from outstanding accounts) Used for
  Accounts receivable

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Four valuations on the Balance Sheet, cont.

• Original cost
• Method Use the historical cost paid in the
  input market
• Advantage Supported by documented evidence,
  thus objectively verifiable Used for
  Prepaid expenses, land, securities, property,
  plant, equipment,
  intangible assets
• Is typically reduced by accumulated
  amortization or depreciation (net book value)
• Replacement cost Method Current cost that
  would have to be paid in input market Used in
  The conservative lower-of-cost-or-market rule for
  inventory Reason To avoid overstatement of
  the actual dollar value of this account

Now we have valuation bases for all asset and
liability accounts. Stockholders equity is not
is not valued but calculated as the difference
betweenthe value of total assets and the value
of total liabilities. This is also called the
book value of the company.
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Four basic principles of financial accounting
Managerial accounting The economic value of an
entity, an asset or a liability is its present
value, i.e. the sum of all discounted future
cash flows. Problem How to predict future
interest rate and future cash flows? Result
PV in many cases not suitable for financial
accounting.
The appropriate valuation basis for each account
is determined by the principle of objectivity.
The Principle of Objectivity (of flow and stock
measurements) Financial accounting information
must be verifiable and reliable. The values of
transaction and the assets and liabilities
created by them must beobjectively determined
and backed by documented evidence. Plus
Disclosed dollar amounts are reasonably
reliable. Minus Much relevant and useful
information will not appear on the financial
statements. (Example Potential environmental
liability)
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Four basic principles of financial accounting,
cont.

• The Principle of Matching (Coordination of in-
  and outflows)
• In order to correctly measure operating
  performance, the companys efforts
• of a given period should be matched against the
  benefits that result from them.
• This principle matches the timing of the cost
  item (e.g. wages, equipment purchases, security
  investment) against the benefits it generates,
  i.e. usually revenues.
• If revenues are generated immediately - Treat
  cost item as expense - Cost appears on the
  income statement of the current period.
• If revenues are realized in future periods -
  Treat cost item as asset, i.e. capitalize it. -
  Cost appears on the balance sheet. - Convert the
  asset into an expense in the periods when the
  related revenues are realized, i.e. amortize
  / depreciate it.

Definitions Amortization Systematic allocation
of a capitalized (deferred) cost item over its
life. Depreciation Amortization of fixed assets,
i.e. property, plant and equipment
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Cost is expensed when related revenue occurs in
same period.
Revenues
ExpensedCost
Period 1
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Cost is capitalized in period 1
Initial value of asset (cost)
Period 1
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and amortized in the periods
Initial value minus accumulated depreciation
Revenues
DepreciationExpense 1
Period 2
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in which related revenues are generated.
Initial value minus accumulated depreciation
Revenues
DepreciationExpense 2
Period 3
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Four basic principles of financial accounting,
cont.

• The Principle of Revenue Recognition (Timing of
  the flows)
• Four criteria must be met before revenue can be
  included in the income statement
• The company has completed a significant portion
  of the production and sales effort
• The amount of revenue can be objectively
  measured
• The major portion of the costs has been
  occurred, and the remaining costs can be
  reasonably estimated
• The eventual collection of the cash is
  reasonably assured

To understand the principle of revenue
recognition consider a complete production /
sales cycle
1. Order
2. Production
3. Transfer
4. Payment
The most common point of revenue recognition is
Step 3, when the good or service is transferred
to the buyer.
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Relationship between matching and revenue
recognition
Income Statement Future Period
Income Statement Current Period
Principles of Revenue recognition
Revenue
Revenue
Expense cost onincome statement
3a.
1.
2.
Expense
Incur cost in current period forthepurpose
of generatingrevenue
Decidein what periodthe revenueis to
begenerated
Capitalize cost onbalance sheet
Expense
3b.
Net Income
Net Income
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Four basic principles of financial accounting,
cont.

• The Principle of Consistency (between all stock
  and flow measurements)
• Companies should choose a set of methods und use
  them from one period to
• Another. However, companies do change accounting
  methods occasionally.
• Why is consistency an issue?
• GAAP allow a number of different, acceptable
  methods to measure assets,
• liabilities, revenues, expenses and dividends.
• There are two reasons for this
• No method is general enough to apply to all
  companies in all situations
• GAAP are the result of a political process with
  many interested parties facing widely different
  situations, not a natural science

• Summary of the Four Basic Accounting Principles
• Objectivity
• Matching
• Revenue recognition
• Consistency

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Two exceptions to the four basic principles

• 2 Exceptions to the 4 Basic Principles
• Materiality The principles of financial
  accounting measurement can be violated if the
  transactions involve dollar amounts that are too
  small to affect the decisions of the users of
  financial statements. Example No need to
  capitalize the purchase of a wastepaper basket.
  Q Why should it be capitalized
  in theory? Q Why is it not
  necessary in practice?
• Conservatism When in doubt about the
  objective value of an item - Understate
  assets - Overstate liabilities - Accelerate
  the recognition of losses - Delay the
  recognition of gains Main reason Liability
  associated with overstating incorrectly the
  financial condition and performance of a
  company. Example Lower-of-cost-or-market
  rule However, does not mean to intentionally
  understate financial statements