Financial Statements and Reporting

Created by David Moore, PhD

Reference Material: Wall Street Prep Accounting Crash Course

Key Concepts

Note: This lesson is largely a review of key accounting concepts.

  1. Fundamentals of Accounting
  2. Financial Reporting
  3. Financial Statements
    • Income statement
    • Balance Sheet
    • Cash Flow Statement

Fundamentals of Accounting

What is Accounting?

Accounting is the standard language of business. i.e. must speak business

  • Set of rules for measuring a firm's financial performance
  • GAAP: Generally Accepted Accounting Principles
  • FASB: Financial Accounting Standards Board
  • Accounting is used to make corporate and investment decisions

Accounting Assumptions

  1. Accounting entity: a company is a separate "living" entity
  2. Going concern: a company is assumed to remain in existence indefinitely
  3. Measurement: must be quantifiable in a monetary unit
  4. Periodicity: in US must file one(1) annual(10K) and three(3) quarterly(10Q) reports

Accounting Principles

  1. Historical Cost
  2. Revenue Recognition
  3. Matching Principle
  4. Full Disclosure

Accrual Exercise

  • 4/15/2019: "Ain't First Your Last"(AFYL) purchases running shoes from Nike
  • 8/20/2019: AFYL receives online credit card order for the shoes
  • 8/29/2019: Shoes are shipped to customer
  • 10/20/2019: AFYL receives cash for selling shoes


When should you record revenue? Expense?

Constraints

  1. Estimate and Judgment
  2. Materiality
  3. Consistency
  4. Conservatism

Financial Reporting

Overview

"The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it.
To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company's securities are a good investment.
Only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions."
-SEC

Periodic Reports

10K
  • Filed Annually
  • Much more detail
  • Audited
  • Primary document for analyst
10Q
  • Filed Quarterly
  • Less detail
  • Reviewed but not audited

More on the 10K


See Example

  1. General Business Info
  2. MD&A, financial info
  3. Disclosure
  4. Exhibit

Other Reporting

  • 8k: Disclosure of material event ex. acquisition
  • Form 14A (DEF 14A): Known as proxy statement. Filed before annual meeting. Details on board members and executives.
  • S-1: Registration statement prior to IPO
  • S-4: Registration of securities, business combinations


Full list of SEC forms

Sources of Financial Information

Library Resources

Library Business Databases
  • Business Insights Global:news and company's background information.
  • Business Source Complete: good resource for company's background information and industry
  • Lexis Nexis Company Dossier: news and company's background information.
  • Mergent Online: industry ratios and company financials
  • Morningstar Investment Research Center: company financials

Financial Statements

Income Statement (I/S)

Financial statement depicting operating performance of a company over a specified period of time

  • Analyst use:components and drivers of performance
  • Tells us about: growth prospects, cost structure, profitability
  • Other names: Consolidated statement of earnings, Profit & Loss Statement, Statement of Revenue and Expenses

Simplified I/S

Revenue  
Sales +
Expenses  
Cost of Goods Sold -
Gross Profit Revenue - COGS
Selling, General, and Administrative -
Research and Development -
Depreciation (and amortization) -
Earnings Before Interest and Taxes (EBIT) Revenue - Operating Expenses
Net Interest Expense -
Taxable Income EBIT - Net Interest Expense
Taxes Taxable Income $\times$ Tax Rate
Net Income (NI) Taxable Income - Taxes
Disney Example          Other Income Statement Items

Revenue

Proceeds from the sale of goods and services produced or offered by the company.

  • Must be from operations (excludes interest income, legal settlement)
  • Revenue recognition: WHEN EARNED and MEASURABLE
    • Multiple deliverables: iPhone example
    • Long Term Projects: Percentage of Completion or Completed Contract ex. Boeing

Extra: When should expenses be recorded? Why?

Why accrual?

  • More accurate description of a company's operating results

What's problem though? Does not reflect cash!!

Revenue Manipulation

  • Allocation of revenue can be subjective; "Wiggle room"
  • Footnotes become important
  • TSAI example
Back to I/S

Cost of Goods Sold (COGS)

Direct cost of manufacture or procurement of a good or service that the company sells to generate revenue

  • Includes: inventory (merchandise or manufactured), shipping/delivery, depreciation
  • DOES NOT include: overhead, marketing and admin, R&D
  • Don't forget Matching Principle


Back to I/S

Selling, General & Administrative

Operating expenses not included in cost of goods sold

  • "Support" (Indirect) Expense: anything that supports goods and service but not directly related
  • Store lease for retail space, sales people/cashiers, IT and office support, selling equipment, exec salaries, legal expenses
Back to I/S

Research & Development

Expenses from activities directed at developing new products or procedures.

  • Can be included in SG&A
  • Separate line item if large
    • Research-intensive industries: healthcare, technology, energy
Back to I/S

Depreciation

Allocating the cost of a tangible asset over its useful life and is used to account for declines in (book/historical) value.

  • Matching Principle!
  • Ex. Plant, buildings, machinery, computer software and hardware. (Land is NOT depreciated)
  • Depreciation usually included in COGS or SG&A (direct or indirect to revenue)
    • Identified on Cash-flow statement
  • Non-cash expense

Methods of Depreciation

  1. Straight-line
    • Asset depreciated evenly over useful life
    • Used by majority of companies

      • Annual Depreciation Expense=$\frac{Original Cost- Salvage Value}{Useful Life}$

  2. Accelerated
    • Declining balance, Sum of years digits, Units of production
Back to I/S

Amortization

Allocation of the cost of intangible assets over the number of years that these assets are expected to help generate revenue for the company

  • Similar to depreciation (often lumped together)
  • Applies to acquired intangible assets
  • Internally generated intangible assets are expensed as they are incurred
  • Remember: historical costs! Does Coke recognize/amortize trademark?
  • Non-cash expense
Back to I/S

D&A Ask Yourself

  1. Is useful life indefinite? (Yes=Stop)
  2. Is it less than one year? (Yes = expense)
  3. Is it tangible? (Yes= Depreciate)
  4. Is it internally generated? (Yes= Expense as incurred No=Amortize)

Net Interest Expense

Payments made on company's outstanding debt net any income received from interest on cash holdings and investments.

  • Interest is a financing (not operating) expense.
  • Reduces tax burden


Back to I/S

Tax Expense

Tax liability reported on income statement.

  • Tax expense DOES NOT EQUAL actual cash taxes paid
  • Tax expense: GAAP ("book rules")
  • Taxes paid: Country's tax code ("tax rules")


Back to I/S

Net Income

Final measure of profitability. "Bottom line"

  • AKA: Net earnings or Net profit


Back to I/S

Other Expenses

  • Stock Based Compensation(SBC):Recognized as expense.
  • Other operating expenses/income: Identified when large, otherwise embedded. ex. Gain/loss on sale or legal settlement, restructuring, inventory write-down
  • Other non-operating expense/income: Usually netted together. Ex. gain/loss in value on investment (not related to operations)

Shares Outstanding

$Shares Outstanding= Shares Issued - Treasury Stock$

  • Outstanding: Unit of ownership.
    • Basic: Includes only the actual shareholders
    • Diluted: includes the impact of dilutive securities (can be converted into common stock, ex., options, convertible stock/debt)
  • Treasury: Issued but subsequently repurchased, no longer outstanding.

Items Below NI

  1. EPS
    • Common profitability ratio: how much of total current period profits belong to each shareholder
    • Shares outstanding: Use basic or diluted. Weighted average throughout period.
    • Diluted EPS favored. More "real"

    $EPS=\frac{NI}{Shares Outstanding}$

  2. Dividends
    • Distribution of profits to shareholders

EBIT and EBITDA

EBIT
  • Earnings before interest and taxes
  • "Operating income"
  • Tied to core operations of business
  • Listed on I/S
EBITDA
  • Earnings before interest, taxes, depreciation, and amortization
  • Adds back in non-cash expense
  • More "real" depiction of core profits
  • EBITDA not directly on I/S

Balance Sheet B/S

Reports a company's assets (resources) and liabilities and shareholder's equity (how resources were funded) at a particular point in time.

Assets=Liabilities+Equity

  • Historical costs and Conservatism!
  • B/S reflects book value(BV): can differ from Market value (MV)

Double Entry Accounting

Every transaction can be viewed as having two sides: 1) Use of funds and 2) Source of funds

Debit (Use of Funds) Credit (Sources of Funds)
Increases in Assets Decrease in Assets
Decreases in Liabilities and Equity Increases in Liabilities and Equity


How we track movements on B/S

D(ebit)U(se)C(redit)S(ource)

About_me

Link between I/S and B/S

Retained Earnings is the link:
  • Income(revenue) increases retained earnings on B/S.
  • Expenses decrease retained earnings on B/S

Simplified B/S

Assets Liabilities and Equity
Cash and Marketable Securities Accounts Payable
Accounts Receivable Accrued Expenses
Inventory Short-term Debt
Prepaid Expenses Deferred (unearned) Revenue
Total Current Assets Total Current Liabilities
Property Plant and Equipment Long-term Debt
Intangible Assets & Goodwill Common stock and paid-in surplus
  Retained Earnings
Total Assets            = Total Liabilities + Shareholders' Equity
Disney Example              Leases              Other Equity

Assets

Companies resources or use of funds

To qualify as an asset:

  1. A company must own the resource
  2. The resource must be of value
  3. The resource must have quantifiable, measurable cost


Back to B/S

Liabilities and Equity

Companies sources of funds

What the company owes to others(liabilities)

  1. Must be measurable
  2. Its occurrence must be probable
  3. Transaction from which obligation arises has taken place

Equity is sourced through:

  1. Equity investment (think stock)
  2. Retained Earnings


Back to B/S

Cash and Marketable Securities

  • Extremely liquid assets
  • Cash equivalents. Example U.S. Treasury bills
  • Marketable securities: debt or equity investment. Can be separate line item


Back to B/S

Accounts Receivable

Cash owed, but not yet received, to the company from a completed (delivered) sale

  • Example: Credit card sales.


Schrute farm sold $1000 worth of beets at the local farmer's market. They collected $600 in cash and the remainder is on credit card (to be collected in 30 days). What accounts are effected and how?

Back to B/S

Inventory

Direct costs associated with production and procurement of goods waiting to be sold.

  • Inventory cycles out of B/S into I/S as COGS
  • Hits income statement when revenue is recognized (matching!)

Beginning Inventory
+Purchases of New Inventory
-Cost of Goods Sold
=Ending Inventory

Inventory costing

  1. FIFO: First in, First Out
  2. LIFO: Last in, First out
    • Must disclose LIFO reserve if using LIFO
    • LIFO Inventory (COGS) +LIFO Reserve = FIFO Inventory (COGS)
  3. Average cost

Write down

  • Remember can't mark up!
  • Must mark down if if MV falls below historical cost
  • Loss recognized as "other (non)operating expense"
  • Example: Food goes bad in a restaurant


Back to B/S

Prepaid Expenses

Prepaid for a service that has not been received.

  • Example: Insurance, rent, utilities
  • Asset created due to right for future service
  • Not recognized on I/S until received.


Back to B/S

Plant Property & Equipment (Fixed Assets)

Long-term, tangible, assets vital to business operations and not easily converted into cash.

  • New purchases of PP&E called capital expenditures (CAPEX)
  • PP&E cycles out of B/S into I/S as depreciation
  • PP&E is reported net of accumulated depreciation
  • Must be written down
  • Gain/loss on asset sale recorded on I/S
$Beg. PP&E+Capex-Depreciation-Sales/Write offs=End PP&E$
Back to B/S

Intangible assets & Goodwill

Intangible Asset
  • Non-physical and acquired
  • Link to I/S through amortization
  • Similar to PP&E
  • Examples: Customer lists, licenses, franchises, patents, trademarks
Goodwill
  • Amount by which purchase price exceeds fair market value in an acquisition
  • Accounting plug
  • Not amortized but rather tested annually
  • Loss of value (impairment) expensed on I/S
  • Time Warner write down


Back to B/S

Accounts Payable

Amounts owed by the company to suppliers for prior purchases or services

What happens to B/S if Schrute farm purchases $10,000 worth of phosphorus on credit to be paid in 90 days. Was cash impacted?

Back to B/S

Accrued Expenses

Expenses that have already been incurred but not yet paid.

  • Are accrued expenses recognized on I/S?
  • Examples: Wages, Insurance, taxes, dividends, litigation costs
Back to B/S

Deferred (unearned) Revenue

Revenue received for services (goods) not yet provided.

  • Long-term liability if revenue expected to be recognized in more than a year.
  • Unwind when revenue earned
  • Examples: Gift cards, sports/theater tickets, iPhone
Back to B/S

Short-term Debt

  • Debt obligations owed within 12-months
  • Includes portion of long-term debt which is due within the year
Back to B/S

Long-term Debt

  • Debt with a maturity greater than one-year
  • Often sizeable


Back to B/S

Common Stock (APIC)

Book value of equity

Two components (due to old conventions)

  1. Common stock par value: Nominal value to issued share
  2. Additional paid in capital (APIC): Excess value of share issued over par value
  3. Reported together.
  4. Example Google par value $0.01 and APIC is $84.99


Back to B/S

Retained Earnings

Cumulative earnings over a companies entire existence.

$Beg.RE+NI-Dividends=EndRE$

Back to B/S
Finance leases
  • Economic Ownership
  • Lease treats underlying asset as PP&E and lease as debt obligation
  • Lease value/liability is PV of lease payments
  • Asset is depreciated; Lease liability accrues interest; Reduce liability with lease payment
  • I/S reduced by depreciation and interest expense(decreases over life of lease)
Operating Lease
  • No economic ownership
  • Initial impact the same
  • I/S reduced by lease payment
  • Loss of value (impairment) expensed on I/S



Excel Example

Other Equity

  • Preferred stock: special rights and priority over common stock
  • Treasury stock; Issued common stock that has been reacquired by the company. Contra equity account
  • Other comprehensive income(loss): Income(loss) not directly recognized on I/S. Ex. foreign currency transactions


Lastly! What does B/S tell us about 3 major corporate finance questions?

Issue with I/S and B/S

About_me

I/S Cash issues

  1. Revenue and Expenses are accrued
  2. Depreciation(and amortization) are non-cash expense (so are Stock based compensation and write-downs)
  3. Cash spent on investments only appears on B/S
  4. Cash cost of financing for debt on I/S but not for equity

Cash Flow Statement (CFS)

Summarizes sources and uses of cash over a specified period

  • Reconciles NI to a company's actual change in cash
  • Most companies follow the indirect method: accrual based
  • Identifies period-over-period change for every B/S line item that affects cash
  • Not perfect; we will use I/S to estimate Free cash flow

Three sections of CFS

  1. Cash flow from Operations: captures CA, CL, and D&A
  2. Cash flow from Investing: captures Long-term assets
  3. Cash flow from Financing: captures long term liabilities and equities

Cash Flow from Operations

Adjust NI for non-cash items, working capital and cash from non-operating activities

Working Capital (CA and CL)
A L
+ Cash Out Cash In
- Cash In Cash Out

Non-cash items include D&A, impairment, SBC
Disney Example

Cash Flow from Investing (CFI)

Tracks additions and reductions to fixed assets.

-CAPEX
-Purchases of Intangibles
+Asset sales
+(-)Sale(Purchase) of debt/equity security$

Disney Example

Cash Flow from Financing (CFF)

Tracks changes in companies sources of debt and equity.

+(-) Issuance (repayment) of debt
+(-) Common stock issued (repurchased)
- Dividends

Disney Example

Lemonade Stand

Key Learning Outcomes

  • Accounting principles, assumptions, and constraints
  • Financial reporting (when, why, and how)
  • Three financial statements
  • How they are made and interact with each other

Next time

Basic Example Modeling