PART ONE BASIC FINANCIAL ACCOUNTING As an introduction to financial accounting, this section of the course is designed to familiarize managers with the content, limitations and uses of general-purpose financial statements of profit-oriented business firms. Previous training or experience in financial accounting is not required of participants. The primary learning objective is for participants to be able to interpret and use the basic financial statements prepared for a business entity. The course is not designed to emphasize the procedural aspects of statement preparation. However, you will have the opportunity to prepare some basic financial statements; you will also analyze and interpret financial statements. Methods of instruction will include lecture, illustrative cases, group discussion and assigned cases which provide an opportunity for hands-on experience with financial statements and their use. The technical notes and case material in this workbook will be used during our class sessions and for selected reading assignments. The daily course schedule includes references to specific sections of this course manual. PART ONE BASIC FINANCIAL ACCOUNTING Page I. COMPONENTS OF FINANCIAL STATEMENTS - THE BALANCE SHEET ........................... 1 II. COMPONENTS OF FINANCIAL STATEMENTS - THE INCOME STATEMENT ........................ 5 III. THE ABC'S OF FINANCIAL ACCOUNTING ........... 9 IV. ACCOUNTING CONCEPTS AND PRINCIPLES .......... 18 V. ALTERNATIVE ACCOUNTING METHODS .............. 21 VI. ACCOUNTING FOR INCOME TAXES ................. 29 VII. CASH FLOW ANALYSIS .......................... 32 VIII. WORKING CAPITAL ANALYSIS .................... 41 IX. FINANCIAL STATEMENT ANALYSIS ................ 49 BASIC FINANCIAL ACCOUNTING A primary function of management is to acquire and utilize economic resources in order to accomplish the various goals and objectives of the business enterprise. Accordingly, the ability to 2 understand financial statements and their information content is an important skill of successful managers. The basic elements used to prepare financial statements of a business enterprise are assets, liabilities, owners' equity, revenues and expenses. I. COMPONENTS OF FINANCIAL STATEMENTS - THE BALANCE SHEET A. ASSETS - Assets are the physical properties, property rights, claims and other resources owned or controlled by the business entity. 1. Assets are classified as current or non-current. a. Current Assets are expected to be converted to cash, sold or used in business operations within one year of the balance sheet date. Current asset examples include: cash, accounts receivable, marketable securities & inventory. b. Non-current Assets are assets that are not held for the purpose of resale to customers. Examples of non- current assets include: land, buildings and equipment. 2. Valuation of Assets (Measurement in $) a. Cash - actual cash balances. b. Marketable Securities - primarily at current market value. c. Accounts Receivable - net realizable value, which is the amount of cash expected to be received. d. Inventories - historical cost (FIFO, LIFO or average cost method). e. Prepaid Expenses - amount paid in advance for services to be received in the future. f. Land - historical cost to acquire the properties. g. Buildings and Equipment - historical cost less accumulated depreciation. B. LIABILITIES - Liabilities are debts and obligations of the business arising from completed transactions in which the firm acquired either assets or services. Most liabilities require the payment of cash at some future point in time. 1. Liabilities are classified as current or noncurrent. 3 a. Current Liabilities require payment within one year from the balance sheet date. Examples of current liabilities include accounts payable, notes payable and accrued liabilities. b. Non-current Liabilities are obligations and debts that will mature beyond one year from the balance sheet date. Examples of non-current liabilities include long-term notes payable, bonds payable, or mortgage notes payable. 2. Valuation of Liabilities (Measurement in $) a. Accounts Payable - amount of cash to be paid in the future for supplies and materials that the firm acquired on a credit basis. b. Accrued Liabilities - amount of cash to be paid in the future for services the firm has already utilized in its operations (salaries, royalties, commissions). c. Notes Payable - the unpaid principal amount due to creditors such as commercial banks. C. STOCKHOLDERS' EQUITY - Stockholders' equity (or owners' equity) is the difference between total assets and total liabilities. This difference represents the residual claims of owners against the firm's assets. Equity is also called net worth or net assets. 1. The principal sources of stockholders' equity are: a. Contributed Capital - This consists of common stock, preferred stock and other sources of 4 paid-in capital (for a corporation). b. Retained Earnings - Retained Earnings is the cumulative amount of net income reported by the firm since its formation, less any dividends paid to stockholders. 2. Valuation of Stockholder Equity (Measurement in $) a. Contributed capital is measured by the value of assets or services that the company received in exchange for shares of stock that were issued to the owners (investors). b. Retained Earnings is measured by total net income of all previous years less dividends paid during these years. The net income or net profit for a period is added to the Retained Earnings element of owners' equity. D. THE BALANCE SHEET - The purpose of the balance sheet is to show the financial position of a business at a particular date. The fundamental balance sheet relationship is: ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY As an illustration of the balance sheet, examine the comparative balance sheets of Alamo Distributing Company shown in Exhibit 1. EXHIBIT 1 ALAMO DISTRIBUTING COMPANY BALANCE SHEETS December 31, 20X1 and 20X2 ASSETS Current Assets: 20X1 20X2 Cash $ 70,000 $ 38,000 Accounts Receivable (net) 65,000 105,000 Inventories (at FIFO Cost) 31,000 52,000 Prepaid Expenses 6,000 4,500 5 Total Current Assets $172,000 $199,500 Noncurrent Assets (at cost): Land $208,000 $237,000 Buildings 150,000 150,000 Equipment 460,000 681,000 Less: Accumulated Depreciation (240,000) (338,000) Total Noncurrent Assets $578,000 $730,000 Total Assets $750,000 $929,500 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts Payable $ 22,000 $ 47,000 Notes Payable 60,000 32,000 Accrued Liabilities 18,000 24,000 Total Current Liabilities $100,000 $103,000 Notes Payable - Long Term 312,000 400,500 Total Liabilities $412,000 $503,500 Stockholders' Equity: Common Stock (no par value) $200,000 $220,000 Retained Earnings 138,000 206,000 Total Stockholders' Equity $338,000 $426,000 Total Liabilities & Stockholder Equity $750,000 $929,500 ======== ======== II. COMPONENTS OF FINANCIAL STATEMENTS - THE INCOME STATEMENT A. REVENUE - Revenue is gross income such as sales or contract fees resulting from an exchange transaction in which the company provided goods or services to outside parties. B. EXPENSES - Cost of goods, services and other resources used by the business during a particular time period. 1. Cost of Goods Sold - cost of inventory delivered to customers. 2. Depreciation - systematic allocation of the cost of buildings and equipment to specific time periods. 6 3. Salaries and Wages - costs incurred for services that are not expected to benefit future periods (the cost relates to services used in the current period). C. MEASUREMENT OF REVENUES AND EXPENSES 1. With the accrual method of accounting, revenues are recognized when earned, which is usually at the point in time that a sale is completed or services are rendered. The recording of revenues is not dependent upon cash collections. 2. Expenses represent the cost of goods, services and/or other resources that are utilized during a period of time. The recording of expenses is not dependent upon cash payments. The matching concept requires that expenses must be associated with revenues of the same time period. Expenses are deducted from revenues to measure net income (profit or earnings) for a given time period. D. THE INCOME STATEMENT - The income statement of a business entity presents the revenues earned and expenses resulting from operations of the business for a period of time. The comparative income statements of Alamo Distributing Company for the years ending December 31, 20X1 and 20X2 are presented in Exhibit 2. The difference between the revenues and expenses is the amount of net income for each year, which represents an increase in the stockholders' equity of the firm. EXHIBIT 2 ALAMO DISTRIBUTING COMPANY INCOME STATEMENTS For Years Ending December 31, 20X1 and 20X2 20X1 20X2 7 Sales $900,000 $1,200,000 Cost of Goods Sold (350,000) (580,000) Gross Profit on Sales $550,000 $ 620,000 Selling Expenses (110,000) (133,500) Administrative Expenses (238,000) (250,000) Income from Operations $202,000 $ 236,500 Interest Expense (52,000) (65,000) Income before Taxes $150,000 $ 171,500 Income Tax Expense (60,000) (63,500) Net Income $ 90,000 $ 108,000 ======== ========== Earnings per Common Share* $1.80 $1.96 Total Depreciation Expense included above ..... $ 82,000 $ 98,000 * Based on 50,000 and 55,000 average common shares outstanding in 20X1 and 20X2, respectively. E. STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - a statement of changes in stockholders' equity summarizes all changes directly affecting account balances in the stockholders' equity section of the balance sheet. Such changes include net income, cash and stock dividends, issues of common or preferred stock and treasury stock transactions. Comparative Statements of Changes in Stockholders' Equity for Alamo Distributing Company are presented in Exhibit 3. Ending account balances on December 31 of each year are the amounts appearing in the balance sheets in Exhibit 1. EXHIBIT 3 ALAMO DISTRIBUTING COMPANY * STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY For Years Ending December 31, 20X1 and 20X2 STOCKHOLDERS' EQUITY 8 Common Retained Stock Earnings Total Balances on January 1, 20X1 $200,000 $ 78,000 $278,000 Net Income for 20X1 90,000 90,000 Cash Dividends Declared (30,000) (30,000) Balances on December 31, 20X1 $200,000 $138,000 $338,000 Net Income for 20X2 108,000 108,000 Cash Dividends Declared (40,000) (40,000) Common Shares Issued for Cash 20,000 20,000 Balances on December 31, 20X2 $220,000 $206,000 $426,000 ======== ======== ======== * If there are no significant changes in common stock or other elements of contributed capital, only a Statement of Retained Earnings may be presented, as shown in the Retained Earnings column above.