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Chapter 2: Main Financial Statements An overview

Chapter 2 : Main Financial Statements An overview • “The objective of general purpose financial reporting
Chapter 2 : Main Financial Statements An overview • “The objective of general purpose financial reporting

“The objective of general purpose financial reporting is to provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.”

• International Accounting Standards Board (2010), The Conceptual Framework for Financial Reporting

Three main statements:

i. Balance Sheet (Statement of Financial Position )

ii. Income Statement

iii. Statement of Cash Flows

Balance Sheet

Balance Sheet • Fundamental Structure: Resources Sources of Capital Assets Liabilities Qwner‘s Equity •
Balance Sheet • Fundamental Structure: Resources Sources of Capital Assets Liabilities Qwner‘s Equity •

• Fundamental Structure:

Resources

Sources of Capital

Assets

Liabilities

Qwner‘s Equity

• Asset: Resource

=

– owned or controlled by the accounting entity

– expected to provide future economic benefits to the accounting entity

– ownership or control acquired in a past transaction

• Liability:= obligation to settle a past transaction by transferring resources to an outside party

• Owners’ equity = Residual claims

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The basic accounting equation

The basic accounting equation • Note that the following equation always holds: Assets = Liabilities +
The basic accounting equation • Note that the following equation always holds: Assets = Liabilities +

• Note that the following equation always holds:

Assets = Liabilities + Owner‘s Equity

• The effect of a transaction on the left hand side of the balance sheet always equals the one on the right hand side

• Examples:

– An increase in one asset and a decrease in another asset

– An increase in an asset and an increase in a liability

– An increase in an asset and an increase in owners‘ equity

– An increase in a liability and a decrease in owners‘ equity

• Each transaction affects at least two accounts

Line items on the balance sheet

Line items on the balance sheet • Assets economic resources owned (or controlled) by a business
Line items on the balance sheet • Assets economic resources owned (or controlled) by a business

Assets

economic resources owned (or controlled) by a business as a result of past transactions that are expected to yield future economic benefits and eventually result in cash inflows to the business enterprise.

Examples: property, plant, cash, copyrights, patents, investments

Liabilities claims of those to whom money is owed, i.e. liabilities are existing debts and obligations

Examples: loans payable to a bank, salaries payable to employees

Owner‘s Equity

residual interest in the assets of a business enterprise after deducting its liabilities; also referred to as residual equity or net assets

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Classification of assets

Classification of assets • Assets – current • cash and marketable securities • Receivables • Inventories
Classification of assets • Assets – current • cash and marketable securities • Receivables • Inventories

Assets

– current

• cash and marketable securities

• Receivables

• Inventories

• Prepayments and accrue income

– fixed

• property, plant and equipment

• long-term financial investments

• intangible assets

Classification of liabilities and shareholders‘ equity

Classification of liabilities and shareholders‘ equity • Liabilities – current • short-term debt and current
Classification of liabilities and shareholders‘ equity • Liabilities – current • short-term debt and current

• Liabilities

– current

• short-term debt and current portion of long-term debt

• payables

• accrued expenses and deferred income

– long-term

• long-term debt

• provisions for contingencies and charges

• other long-term liabilities

• Equity

– Common Stocks at par value

– additional paid-in capital (= capital surplus, share premium)

– Reserves

– accumulated other comprehensive income / loss

– retained earnings

– net income for the year

Understanding the basic accounting equation

Understanding the basic accounting equation • The story : Angie has a degree in political science
Understanding the basic accounting equation • The story : Angie has a degree in political science

• The story : Angie has a degree in political science and economics, and decides to start her own business „Vote-Consult“. Some time ago she received € 8.000 from a very good friend, money that she now uses to invest in her enterprise. During the first days of her new enterprise‘s life the following transactions occurred (in chronological order):

1. Angie deposits € 8.000 in a bank account in the name of Vote- Consult.

2. She purchases computers and other office equipment for € 4.000.

3. Angie buys office supply for € 500 on credit.

4. She pays € 300 of the total amount she spent on supplies.

5. She pays the remaining € 200 out of her personal pocket.

What happens to the balance sheet?

What happens to the balance sheet? 1. Angie deposits € 8.000 in a bank account in
What happens to the balance sheet? 1. Angie deposits € 8.000 in a bank account in

1. Angie deposits € 8.000 in a bank account in the name

of Vote-Consult.

[Extension of both assets and liabilities side]

2.

She purchases computers and other office equipment for € 4.000.

[Exchange of assets]

3.

Angie buys computer paper and office supply for € 500 on credit.

[Extension of both assets and liabilities side]

4.

She pays € 300 of the total amount she spent on supplies.

[Contraction of both sides]

5.

She pays the remaining € 200 out of her personal pocket.

[Exchange on the liabilities side]

The Income Statement

The Income Statement Income: – Increase in an entity’s net assets – Resulting from an entity’s
The Income Statement Income: – Increase in an entity’s net assets – Resulting from an entity’s

Income:

– Increase in an entity’s net assets

– Resulting from an entity’s operations

– Over a period of time

• Fundamental balance sheet equation:

Assets = Liabilities + Equity Net Assets = Assets – Liabilities => Net Assets = Equity

Assets

=

Liabilities

+

Owner's Equity

(profits)
(profits)

(profits)(losses)

(losses)
(losses)

(losses)(profits)

Income

Income • Income results only from entity operations – Capital transactions with owners – Gains or
Income • Income results only from entity operations – Capital transactions with owners – Gains or

• Income results only from entity operations

– Capital transactions with owners

– Gains or losses from changes in exchange rates when group accounts are concerned …are not “operations”

• Such transactions do not affect income but equity

• Income is generated over a period of time

– The period between two balance sheet dates

• The income statement provides detailed information about how income was generated

– It adds up revenues and deducts expenses

– Income is the bottom line of the income statement

Income Statement Format

(funcional basis)

Income Statement Format (funcional basis) Net Revenue Cost of goods sold (by product category) Gross margin
Income Statement Format (funcional basis) Net Revenue Cost of goods sold (by product category) Gross margin

Net Revenue Cost of goods sold (by product category) Gross margin Operating expense Operating Income (EBIT) + Financial, Investment & other revenue

– Financial expenses
– expenses from investments and other Income before Taxes

– Income taxes

Income after Tax + Extraordinary Items Net income

Income statement

Income statement • Balance sheet and income statement are interrelated 12
Income statement • Balance sheet and income statement are interrelated 12

• Balance sheet and income statement are interrelated

Income statement • Balance sheet and income statement are interrelated 12

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Clean vs. dirty surplus accounting

Clean vs. dirty surplus accounting Net assets (End of period) – net assets (Beginning of period)
Clean vs. dirty surplus accounting Net assets (End of period) – net assets (Beginning of period)

Net assets (End of period)

– net assets (Beginning of period)

– contributions to equity (receipts from share issues)

+ dividends

+ amount used to redeem shares

= Comprehensive income

• usually not equal to income according to income statement

– difference: change in value of assets and liabilities due to exchange rate changes and other, depending on country‘s accounting regulations

Revenues and Expenses

Revenues and Expenses • Revenues – gross increase in owner‘s equity resulting from operating the business
Revenues and Expenses • Revenues – gross increase in owner‘s equity resulting from operating the business

• Revenues

– gross increase in owner‘s equity resulting from operating the business with the objective of generating profits usually results in an increase in an asset

• Examples: sales; fees, commissions; interest; dividends; rents

• Expenses

– cost of assets consumed or services used resulting from business activities and are, in general, actual or expected cash outflows

• Examples: salaries, wages; interest on loans; insurance premiums; cost of providing fringe benefits to employees; decrease in inventory

Revenues

>

Expenses

Revenues

<

Expenses

to employees; decrease in inventory Revenues > Expenses Revenues < Expenses Net profit Net loss 14
to employees; decrease in inventory Revenues > Expenses Revenues < Expenses Net profit Net loss 14

Net profit

Net loss

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Angie‘s business story continued

Angie‘s business story continued transactions (in chronological order): 6. Invited speech at a regional conference, €
Angie‘s business story continued transactions (in chronological order): 6. Invited speech at a regional conference, €

transactions (in chronological order):

6. Invited speech at a regional conference, € 1000, remitted to the bank account

– This is a revenue:

Accounts affected: Bank; Revenues; Amount: 1.000

7. First rent and utility payment due, charged to bank account, €500.

– This is an expense:

Accounts affected: Cost of office space; Bank

8. Prepayment received for a series of invited speeches, € 4.500.

– This is not yet a revenue, this is unearned revenue Accounts affected: Bank; Unearned revenue.

9. Personal expenses (haircut, groceries, etc.), € 400, paid using the EC card.

– This is a withdrawal Accounts affected: Owner’s equity; Bank.

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Explanations of income statement items

Explanations of income statement items • Net revenue = gross revenue – discounts – returns •
Explanations of income statement items • Net revenue = gross revenue – discounts – returns •

• Net revenue = gross revenue

– discounts

– returns

• Cost of goods sold = cost of goods available for sale – ending product inventory

– Cost of goods available for sale = beginning product inventory + cost of goods manufactured

– Cost of goods manufactured = direct materials

+ direct labour

+ allocated production

overhead cost

– ending product inventory (finished and work in process) value to be determined according to an inventory valuation method, e.g. LIFO, weighted average cost

Cash Flow Statement

Cash Flow Statement • Cash flow statements records cash inflows and cash outflows • Cash inflows
Cash Flow Statement • Cash flow statements records cash inflows and cash outflows • Cash inflows

• Cash flow statements records cash inflows and cash outflows

• Cash inflows e.g., from sales

• Cash outflows e.g., expenses paid

• Easier to manipulate profit than cash flow

Opening Cash

• Easier to manipulate profit than cash flow Opening Cash +- Inflows Outflows = Closing Cash

+- Inflows

Outflows
Outflows

=

Closing Cash
Closing Cash

• All large companies required to prepare a Statement of Cash Flows

using either:

(a)

Direct method

(b)

Indirect method

Relationship Between Cash and Profit

Relationship Between Cash and Profit Cash and profit fundamentally different: Cash Flow Profit = = Cash
Relationship Between Cash and Profit Cash and profit fundamentally different: Cash Flow Profit = = Cash

Cash and profit fundamentally different:

Cash Flow

Profit

=

= Cash Paid Income Earned
=
Cash Paid
Income Earned

Cash Received

Expenses

Incurred

• A business may make a profit, but run out of cash. This is overtrading

• Depreciation is an important non-cash item