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Statement
Lecture # 01
By: Faisal Dhedhi
40%
Financial Statements
Accounting
Cycle
Adjusted Trial Balance
Periodical Adjustments
Ledger Posting
Trial Balance
Introduction
Financial statements are a snapshot of a company's well being at a
specific point in time.
The length of time (the accounting period) that these financial
statements represent varies;
The timing and the methodology used to record revenues and
expenses may also impact the analysis and comparability of financial
statements across companies.
Accounting statements are prepared in most cases on the basis of
these three basic premises:
1.
The company will continue to operate (going-concern
assumptions).
2.
Revenues are reported as they are earned within the specified
accounting period (revenues-recognition principle).
3.
Expenses should match generated revenues within the
specified accounting period (matching principle).
Business Strategy
Labor Markets
Capital Markets
Product Markets:
Suppliers
Customers
Competitors
Business Regulations
Scope of Business:
Degree of Diversification
Type of Diversification
Competitive Positioning:
Cost Leadership
Differentiation
Key Success Factors & Risks
Business Activities
Operating
Investment
Financing
Accounting Environment
Accounting Strategy
Choice of:
Accounting Policies
Accounting Estimates
Reporting Formats
Supplementary
Disclosures
Accounting System
Measure & Report
Economic
Consequences of
Business Activities
Financial Statements
Sales These are defined as total sales (revenues) during the accounting
period. Remember these sales are net of returns, allowances and discounts
Cost of goods sold (COGS) These are all the direct costs related to the
product or rendered service sold and recorded during the accounting period.
(Reminder: matching principle.)
Operating expenses These include all other expenses that are not
included in COGS but are related to the operation of the business during the
specified accounting period. This account is most commonly referred to as
"SG&A" (sales general and administrative) and includes expenses such as
selling, marketing, administrative salaries, sales salaries, maintenance,
administrative office expenses (rent, computers, accounting fees, legal fees),
research and development (R&D), depreciation and amortization, etc.
Other revenues & expenses These are all non-operating expenses such
as interest earned on cash or interest paid on loans.
Income taxes This account is a provision for income taxes for reporting
purposes.
Non-Recurring Items
Discontinued operations, extraordinary items and accounting
changes are all reported as separate items in the income statement.
They are all reported net of taxes and below the tax line, and are not
included in income from continuing operations. In some cases,
earlier income statements and balance sheets have to be adjusted to
reflect changes.
Investments These are investments that management does not expect to sell
within the year. These investments can include bonds, common stock, long-term
notes, investments in tangible fixed assets not currently used in operations (such
as land held for speculation) and investments set aside in special funds, such as
sinking funds, pension funds and plan-expansion funds. These long-term
investments are reported at their historical cost or market value on the balance
sheet.
Fixed assets These are durable physical properties used in operations that
have a useful life longer than one year. This includes:
Machinery and equipment This category represents the total machinery,
equipment and furniture used in the company's operations. These assets are
reported at their historical cost less accumulated depreciation.
Buildings (plants) These are buildings that the company uses for its
operations. These assets are depreciated and are reported at historical cost
less accumulated depreciation.
Land The land owned by the company on which the company's buildings or
plants are sitting on. Land is valued at historical cost and is not depreciable
under U.S. GAAP
Other assets This is a special classification for unusual items that cannot be
included in one of the other asset categories. Examples include deferred charges
(long-term prepaid expenses), non-current receivables and advances to
subsidiaries.
Intangible assets These are assets that lack physical substance but
provide economic rights and advantages: patents, franchises, copyrights,
goodwill, trademarks and organization costs. These assets have a high
degree of uncertainty in regard to whether future benefits will be realized.
They are reported at historical cost net of accumulated depreciation.
Liabilities:
Liabilities have the same classifications as assets: current and long-term.
3. Current liabilities These are debts that are due to be paid within one
year or the operating cycle, whichever is longer; further, such obligations will
typically involve the use of current assets, the creation of another current
liability or the providing of some service.
Usually included in this section are:
Bank indebtedness This amount is owed to the bank in the short term,
such as a bank line of credit.
Accounts payable This amount is owed to suppliers for products and
services that are delivered but not paid for.
Wages payable (salaries), rent, tax and utilities This amount is payable
to employees, landlords, government and others
Preferred stock
Common stock
Issue of par value stock
Additional paid-in capital
Treasury stock repurchase
Retained earning
Contributed Capital
Contributed capital is the total legal capital of the corporation (par value of
preferred and common stock) plus the paid-in capital.
Par value This is a value of preferred and common stock that is arbitral
(artificial); it is set by management on a per share basis. This artificial value
has no relation or impact on the market value of the shares.
Legal capital of the corporation This is par value per share multiplied
by the total number of shares issued.
Example:
Company XYZ issued 15,000 preferred shares to investors for
$300,000.
Company XYZ issued 30,000 common shares to investors for
$600,000.
Par value of preferred shares is $20 per share.
Par value of common shares is $15 per share.
Legal capital:
Preferred shares: $300,000(15,000 x $20)
Common shares: $450,000(30,000 x $15)
Legal capital
$750,000
Paid-in capital:
Preferred shares: $
0 ($300,000-$300,000)
Common shares: $150,000($600,000-$450,000)
Paid-in capital $150,000
Legal capital + Paid-in capital = Contributed Capital
There are two basic dividend forms:
Cash dividends These are cash payments made to stockholders of
record. Retained earnings are reduced when dividends are declared.
Stock dividends These are dividends paid in the form of additional stock
of the issuing company to shareholders of record in proportion to their
current holdings. A stock dividend does not increase the wealth of the
recipient nor does it reduce the net assets of the firm. It is a permanent
capitalization of retained earnings to contributed capital.
Dividend Terminology
Date of Declaration: This is the date the board approved and declared a
dividend.
Date of record: This is the date set by the issuer that determines who is eligible
to receive a declared dividend or capital-gains distribution.
Ex-dividend date: This is the first day of trading when the selling shareholder is
entitled to the recently announced dividend payment. Shares purchased as of the
ex-dividend date will not receive the previously declared dividend.
Date of payment: This is the date on which the company will pay the declared
dividend to its stockholders of record as of the date of record.
Stock Split
Stock splits are events that increase the number of shares outstanding and
reduce the par or stated value per share of the companys stock. For example, a
two-for-one stock split means that the company stockholders will receive two
shares for every share they currently own. This will double the number of shares
outstanding and reduce by half the par value per share. Existing shareholders will
see their shareholdings double in quantity, but there will be no change in the
proportional ownership represented by the shares (i.e. a shareholder owning
2,000 shares out of 100,000 would then own 4,000 shares out of 200,000).
Most importantly, the total par value of shares outstanding is not affected by
a stock split (i.e. the number of shares times par value per share does not
change). Therefore, no journal entry is needed to account for a stock split. A
memorandum notation in the accounting records indicates the decreased par
value and increased number of shares.
Stocks that are trading on the exchange will normally be re-priced in
accordance to the stock split. For example, if XYZ stock was trading at $90
and the company did a 3-for-1 stock split, the stock would open at $30 a
share.
Stock splits are usually done to increase the liquidity of the stock (more
shares outstanding) and to make it more affordable for investors to buy
regular lots (regular lot = 100 shares).
The statement of cash flow reports the impact of a firm's operating, investing
and financial activities on cash flows over an accounting period. The cash
flow statement is designed to convert the accrual basis of accounting used in
the income statement and balance sheet back to a cash basis.
Audit: An audit is a process for testing the accuracy and completeness of information
presented in an organization's financial statements. This testing process enables an
independent Certified Public Accountant (CPA) to issue what is referred to as "an
opinion" on how fairly a company's financial statements represent its financial position
and whether it has complied with generally accepted accounting principles.
The audit report is addressed to the board of directors as the trustees of the
organization. The report usually includes the following:
a cover letter, signed by the auditor, stating the opinion.
the financial statements, including the balance sheet, income statement and statement
of cash flows
notes to the financial statements
In addition to the materials included in the audit report, the auditor often prepares what
is called a "management letter" or "management report" to the board of directors. This
report cites areas in the organization's internal accounting control system that the
auditor evaluates as weak.
What Does the Auditor Do?
The auditor will request information from individuals and institutions to confirm:
bank balances
contribution amounts
conditions and restrictions
contractual obligations
Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are
recorded correctly. They are required only to express an opinion as to
whether the financial statements, taken as a whole, give a fair representation
of the organization's financial picture. In addition, audits are not intended to
discover embezzlements or other illegal acts. Therefore, a "clean" or
unqualified opinion should not be interpreted as assurance that such
problems do not exist.
They are to provide information to help present and potential investors and
creditors and other users in assessing the amounts, timing and uncertainty
of prospective cash receipts from dividends or interest and the proceeds
from the sale, redemption or maturity of securities or loans. (Emphasize the
difference between the cash basis and the accrual basis of accounting.)
Accounting Qualities:
1) Primary qualities of useful accounting information:
- Relevance - Accounting information is relevant if it is capable of making a
difference in a decision.
Relevant information has:
(a) Predictive value
(b) Feedback value
(c) Timeliness
- Reliability - Accounting information is reliable to the extent that users can
depend on it to represent the economic conditions or events that it
purports to represent.
Reliable information has:
(a) Verifiability
(b) Representational faithfulness
(c) Neutrality
2) Secondary qualities of useful accounting information:
Comparability - Accounting information that has been measured and
reported in a similar manner for different enterprises is considered
comparable.
Consistency - Accounting information is consistent when an entity applies
the same accounting treatment to similar accountable events from period
to period.
Financial Ratio:
Where:
Annual purchases = cost of goods sold + ending inventory beginning
inventory
Average payables = (previously reported accounts payable + current accounts
payable) / 2
10. Average Number of Days Payables Outstanding (Average Age of Payables)
This ratio provides the same information as payable turnover except that it indicates it
by number of days.
Average number of days payables outstanding =
365_____
payable turnover
II. Other Internal-Liquidity Ratios
11.Cash Conversion Cycle
This ratio will indicate how much time it takes for the company to convert collection or
their investment into cash. A high conversion cycle indicates that the company has a
large amount of money invested in sales in process.
Cash conversion cycle = average collection period + average number of days in
stock - average age of payables
Cash conversion cycle = average collection period + average number of days in
stock - average age of payables
12.Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the
company has to maintain its current operations without any additional sales.
Where:
Projected expenditures = projected outflow needed to operate the company
7.3 - Operating Profitability Ratios
Operating Profitability can be divided into measurements of return on sales and
return on investment
Return on Sales
1. Gross Profit Margin
This shows the average amount of profit considering only sales and the cost of the
items sold. This tells how much profit the product or service is making without overhead
considerations. As such, it indicates the efficiency of operations as well as how products
are priced. Wide variations occur from industry to industry.
Gross profit margin = gross profit / net sales
Gross profit = net sales cost of goods sold
DuPont System
A system of analysis has been developed that focuses the attention on all three
critical elements of the financial condition of a company: the operating
management, management of assets and the capital structure. This analysis
technique is called the "DuPont Formula". The DuPont Formula shows the
interrelationship between key financial ratios. It can be presented in several
ways.
The first is:
Return on equity (ROE) = net income / total equity
If we multiply ROE by sales, we get:
Return on equity = (net income / sales) * (sales / total equity)
Said differently:
ROE = net profit margin * return on equity
The second is:
Return on equity (ROE) = net income / total equity
If in a second instance we multiply ROE by assets, we get:
ROE = (net income / sales) * (sales / assets) * (assets / equity)
Said differently:
ROE = net profit margin * asset turnover * equity multiplier
Many large firms operate different divisions in different industries. For these
companies it is difficult to find a meaningful set of industry-average ratios.
Inflation may have badly distorted a company's balance sheet. In this case,
profits will also be affected. Thus a ratio analysis of one company over time or
a comparative analysis of companies of different ages must be interpreted with
judgment.
Different accounting practices can distort comparisons even within the same
company (leasing versus buying equipment, LIFO versus FIFO, etc.).
It is difficult to generalize about whether a ratio is good or not. A high cash ratio
in a historically classified growth company may be interpreted as a good sign,
but could also be seen as a sign that the company is no longer a growth
company and should command lower valuations.
A company may have some good and some bad ratios, making it difficult to tell
if it's a good or weak company.
Dilutive Securities
Dilutive Securities are securities that are not common stock in form, but allow the
owner to obtain common stock upon exercise of an option or a conversion privilege.
The most common examples of dilutive securities are: stock options, warrants,
convertible debt and convertible preferred stock. These securities would decrease
EPS if exercised or if they were converted common stock. In other words, a dilutive
security is any securities that could increase the weighted number of shares
outstanding.
If a security after conversion causes the EPS figure to increase rather than decrease,
such a security is an anti-dilutive security, and it should be excluded from the
computation of the dilutive EPS.
For example, assume that the company XYZ has a convertible bond issue: 100
bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each
bond can be converted into 50 shares of the common stock. The tax rate is 30%.
XYZs weighted average number of shares, used to compute basic EPS, is 10,000.
XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.
What is the basic EPS? What is the diluted EPS?