Chapter 2

Financial Statements and the Annual

Report
Primary Objective of Financial Reporting

 Provide useful information to people

who make
rational investment, credit and similar
decisions

To make informed decisions, users

should have
access to the detailed records of the
business.
(Exp: Mutandis going public in 2018)
Secondary objective of financial reporting
Assess investor/creditor cash receipts

 Provide information to help present and

potential investors and creditors to evaluate
the amounts, timing, and uncertainty of
future cash receipts from dividends or
interest.
Secondary objective of financial reporting
Assess Cash flows to the company

 Provide information to permit users to make

decisions about cash flows of a company
Secondary objective of financial reporting

Reflect resources and claims to them

 Show the effect of transactions on the

company’s accounting equation.
Qualitative Characteristics

 Understandability: Accounting
information must be prepared so that it is
easy to understand by professionals,
students and the business community.
(Normalisation)

 Relevance: Accounting information must

consider all the factors that may affect the
firm’s financial statements and therefore
users decisions (exp: bank loan and
lawsuit)
 Qualitative Characteristics
 Reliability: has three characteristics:
 Verifiability: make sure that information is
free from error.
 Representational Faithfulness: accounting
information must correspond to current and
actual events.
 Neutrality: accounting information should not
hide or change the firm’s position to make it
better or worse than the reality.
Qualitative Characteristics

 Comparability: allows comparisons to be

made between or among companies.

 Consistency: the quality that allows a user

to compare two or more accounting periods for
a single company.
Qualitative Characteristics
 Materiality: deals with the size of an
error in accounting information. Is the
error large enough to affect the decision
made by the user of the information? (Exp :
a $5 pencil to be recorded as expense or
depreciated would not affect the judgment
on the company’s financial statement).

 Conservatism: If there is uncertainty

about how to record a particular item, the
least optimistic estimate is used when two
estimates of amounts are about equally
 Operating Cycle
The length of a company’s operating cycle depends
on its activities:
 Company that sells a product: Operating cycle
begins when cash is invested to buy inventory and
ends when cash is collected by the company from its
customers.
 Company that sells a service: Operating cycle is
determined by the length of time involved in
providing a service and the time required to collect
cash fromcycle
Operating customers.
is the basis for deciding what assets in the balance
sheet are current and which assets are noncurrent.
Classified Balance Sheet

Purpose
The Balance Sheet Heading

1. Name of entity
(the separate-entity assumption)
2. Title of statement
3. Specific date
(financial snapshot at a specific
point in time)
4. Unit measure
(thousands of dollars)
 Classifications

 Current assets
 Noncurrent assets
 Current liabilities
 Long term liabilities
 Stockholders’ equity
Current Assets (Actif Circulant)

 Economic resources that provide benefits over the short

term. They are expected to be realized in cash or sold or
consumed within one year or current operating cycle,
whichever is longer
Examples of Current Assets

 Cash
 Account receivable
 Inventory
 Marketable securities
 Prepaid insurance
 Prepaid rent
 Supplies
Noncurrent Assets (Actif Immobilisé)

 Assets that provide benefits to the firm over the

long term. They are properties that will not be
realized, sold, or consumed within one year or
operating cycle.
 Examples of long-term assets are:
Investments (immobilisations financières)
Property, Plant, and Equipment
(immobilisations corporelles)
Intangibles (immobilisations incorporelles)
Long Term Investments

Long term note receivable

Securities
Property, Plant & Equipment
Land
Buildings
Furniture
Equipment

Less: Accumulated
Depreciation
Intangible Assets
Patents
Trademarks
Copyrights
Goodwill
Assets are listed by their ease of
conversion into cash.
Current Liabilities (Passif Circulant)
 An obligation (debt) that
will be paid the next
operating cycle or within
one year if the cycle is
shorter than one year.
 Examples of current
liabilities are:
 Account payable
 Wages payable
 Income tax payable
 Interest payable
 Short-term notes
payable
Noncurrent Liabilities (Dettes de Financement)

 Obligation that will not be paid or satisfied

within the next operating cycle or one year.

 Examples of long-term debt are:

 Long term notes payable

 Bonds payable
 Mortgage payable
Liabilities are listed by their
maturity (due date).
Accounting for Stockholders’ Equity
Two primary sources of
stockholders’ equity

Contributed capital Earned capital

Capital Stock Retained Earnings
Stockholders’Equity (Capitaux Propres)

 Arises from two sources:

 Contributed capital: appears on the balance
sheet as capital stock, which indicates the
dollar amount invested by the owners
(stockholders).

 Earned capital: takes the form of Retained

Earnings, which represents the accumulated
earnings or net income less any dividends
paid.
 Re
A = L + SE
Top ofaliz the World
one ed, s
Balanceyea olSheet
r o d, or c
ro
per onsu
atin med
A
gc
Assets ycl in
e
Current assets
Cash 400
Marketable securities 500
Accounts receivable 800
Prepaid insurance 100
Supplies 200
Total current assets 2,000
Investments
Land held for future expansion 2,200
Property, plant, and equipment
Land 4,000
Lodge, lifts and equipment 2,600
Less: Accumulated depreciation (200) 2,400
Total property, plant and equipment
6,400
Intangible assets
Patent 400
Total assets
$11,000
 S
ye atis
ar fie
or d w
A = L + SE
Top of the World op ith
e ra i n
Balance Sheet ting one
Liabilities and Stockholders’ cy Equity
cl e
Current liabilities
Accounts payable =L $ 900
Salaries and wages payable 300
Income taxes payable 100
Interest payable
300
Total current liabilities 1,600
Long-term debt
Notes payable 4,000
Total liabilities 5,600

+ SE
Contributed capital
Common stock, $1 par, 500 shares
issued and outstanding 500
Paid-in capital in excess of par value 1,500
Total contributed capital 2,000
Retained earnings 3,400
Total stockholders' equity 5,400

Total liabilities and stockholders’ equity $11,000

Analysis of Liquidity
Bankers and other creditors are
interested in evaluating the liquidity
of a business.

Liquidity is the ability of a company to

pay its debts as they become due.

Two methods to analyze liquidity of a

firm:
Using a Classified Balance Sheet
Working Capital

Current assets less current liabilities

Cushion of liquid assets with which to pay

upcoming current liabilities

Measures ability of company to pay its debts

as they come due
Using a Classified Balance Sheet
Current Ratio

Current assets divided by current liabilities

Allows comparison of companies of various

sizes

Measures short term liquidity

Top of the World’s Liquidity

Current assets $2,000

Current liabilities
What's the
1,600
trend??

Working = Current Assets

Capital – Current Liabilities $ 400

Current = Current Assets

Ratio Current Liabilities 1.25:1
 Life Time’s Liquidity

(in 000’s) 2017 2018

Current assets $ 38,091 $ 46,572
Current liabilities 110,043 61,912
Working capital $ (71,952) $(15,340)

Current ratio = 0.35:1 0.75:1

The Income Statement
The income statement is divided into three major
captions . . .
Earnings from the sale of goods or services.
1. Revenues
The dollar amount of resources used up by the entity
2. Expenses to earn revenues during a period.

3. Net income
Income Statement Heading

1. Name of entity
2. Title of statement
3. Specific date (Unlike the balance sheet, this
statement covers a specified period of time.)
4. Unit measure (thousands of dollars)
The Income Statement: Single Step
Revenues $100
Less: Expenses 75
Net Income $ 25
When revenues exceed expenses,
we report net income.
The Income Statement
Revenues $100
Less: Expenses 125
Net Loss $ (25)
When expenses exceed revenues,
we report net loss.

Don’t tell the School I showed you this net loss stuff!
The Income Statement
Revenues $100
Less: Expenses 100
Breakeven $ 0
When expenses equal revenues,
we operate at breakeven.
Multi-Step Income Statement
Sales
– Cost of goods sold
= Gross profit
Operating expenses:
– Selling expenses
– General and administrative expenses
Four
= Income from operations important
+/–Other revenues and expenses subtotals
= Income before taxes
– Income tax expense
= Net income
Multi-Step Income Statement

 Subdivide the income statement into subtotals:

 Gross profit = Sales – Cost of Goods Sold (CGS)
CGS is the cost of units of inventory sold during the
year.
 Income from operations = Gross profit – selling
expenses – General and administrative expenses
 Income before income taxes = income from
operations + interest revenue – interest expense
 Net income = income before tax – income tax
expense.
 Top of the World
Income Statement

Operating revenues:
For the Year Ended June 30, 2018
Lift tickets $6,500
Equipment rentals 2,500
Total operating revenues $
9,000
Operating expenses:
General and administrative expenses
Salaries and wages $1,400
Depreciation 100
Water, gas, and electricity 1,500
Insurance 1,200
Supplies 100
Total general and administrative expenses $4,300
Selling expenses
Salaries and wages $ 600
Advertising 200
Total selling expenses 800
Total operating expenses 5,100
Income from operations $3,900
Other revenues and expenses:
Interest revenue $ 100
Interest expense 300
Excess of other revenues over other expenses 200
Income before taxes $3,700
Income tax expense 1,000
Net income
$2,700
Analysis of Profitability
 Current and potential investors are interested in evaluating
the profitability of a business.

 Two methods to analyze the profitability of a firm:

 Gross profit ratio = gross profit/sales

How many cents on every $ of sales are left over after covering the
cost of the product

 Profit margin = Net income/sales

How many cents on every $ of sales are left over after covering all
expenses
Top of the World – Profit Margin

Profit Margin % = Net Income

Operating Revenues

Profit Margin % = $2,700 = 30%

$9,000

The amount of every sales dollar that results

in income
 Life Time Fitness, Inc. Profitability

(in 000’s) 2016 2017 2018

Net sales $300,084 $246,427 $188,958

Net income $ 28,908 $ 20,605 $ 7,421

Profit margin % = 9.6% 8.4% 3.9%
Profit Margin % = Net Income
Sales
How many cents on every $ of sales are left
over after
covering all expenses
Statement of Retained Earnings

Income of the enterprise.

ds by Re
en en tain
ivid te ed
rp
D ris
e

Stockholders Retained Earnings

Statement of Retained Earnings

 Shows changes in the components of

owners’ equity
Net income (net loss) and
Dividends
 Provides an
important link Statement of Retained Earnings
between the ……..
income Beginning retained earnings
statement and Add: Net income
the balance
sheet Deduct: Dividends
Ending retained earnings
Statement of Retained Earnings
World, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2018
(in thousands of dollars)

Retained earnings, January 1, 2001 $ 6,805

1. Name
Net incomeof entity
for 1998 3,300
2. Title of statement
Dividends for 1998 (1,000)
3. Specific
Retained date (Like
earnings, the income
December 31,statement, this
2001 $ 9,105
statement covers a specified period of time.)
4. Unit measure (thousands of dollars)
 Basic Format of the
Statement of Cash Flows
Cash flows from operating activities:
$$

Cash flows from investing activities:

$$

Cash flows from financing activities:

$$

Net increase in cash $$

Cash at beginning of year $$
Cash at end of year $$
 Basic Format for the
Statement of Cash Flows
Cash flows from operating activities:
Involve the purchase and sale $$
of products or services
Cash flows from investing activities:
Involve the acquisition and sale $$
of long-term assets
Cash flows from financing activities:
Involve the issuance and payment $$
of long-term liabilities and stock
Net increase in cash $$
Cash at beginning of year $$
Cash at end of year $$
 World, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2018
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,021
Cash at end of the year $ 4,865
 Elements of an Annual Report
 Report of independent accountants
 Management discussion & analysis
 Summary of financial data
 Letter to stockholders
 Financial statements
 Notes to financial statements
End of chapter