NC STATE UNIVERSITY
ACC 580: Financial Accounting1
Note on Financial Statements
I.
Review of Financial Statements
The Balance Sheet
Financial reporting is based on the following accounting equation, which summarizes the balance sheet:
Assets = Liabilities
⇓
⇓
Productive Creditor
capacity
claims
+
Shareholders equity
⇓
Owner claims
(contributed capital plus
undistributed earnings)
Note: Shareholders equity is also sometimes called book value [of equity] or owners’ equity.
The Balance Sheet is an arithmetic equality. In accounting, it is always true that the assets are equal to the sum
of the liabilities and shareholders equity.
Assets are future economic benefits that the firm controls because of a past event or transaction. Examples
include: cash, accounts receivable (these are amounts owed to the firm by its customers), inventories, land,
investments in other firms, factories.
Liabilities are obligations to sacrifice resources. For the most part, accounting liabilities are also legal
obligations. Examples include: accounts payable (amounts owed by the firm to its suppliers), bank loans
payable (amounts owed to banks).
Shareholders equity is the residual, defined as Assets - Liabilities. Shareholders equity includes capital
contributed by owners (common stock) plus the entire cumulative earnings of the firm that has not been
distributed as dividends.
The Balance Sheet lists specific items of Assets, Liabilities and Owners Equity. There are totals (arithmetic
sums of the values listed for the various items) displayed as well.
The Income Statement
Income, net income, earnings (often used interchangeably). Negative income = loss or net loss
Revenues
–
⇓
Asset inflows from
selling goods and
services
Expenses
+
Gains – Losses
⇓
⇓
⇓
Expired costs Other asset Other expired
associated with inflows
costs
revenues
Income not declared as dividends increases retained earnings—this concept links the income statement
(statement of operations) to the balance sheet
Losses (negative income) decrease retained earnings (or increase accumulated deficit). Losses occur
when expenses exceed revenues.
1
Based on note written by Professors Jennifer Francis and Per Olsson.
1
Income can be calculated using two balance sheets and knowledge of dividends declared.
Beginning balance in Retained earnings + income (or – loss) - dividends = Ending balance in retained
earnings. (Capital contributions are treated as negative dividends.) This is called the clean surplus
relation. It means that all changes in book values flow through income. Violations of clean surplus are
called dirty surplus items. The clean surplus relation links the Balance Sheet and the Income Statement.
The Statement of Cash Flows
Shows the sources (inflows) and uses (outflows) of cash during a fiscal period. Arithmetically, this equals the
change in cash balances between two successive balance sheets.
Cash inflows and outflows are shown in three categories: cash flows from operations, cash flows from investing
and cash flows from financing.
Focuses on cash inflows and outflows only. Any transactions which do not involve cash are not included (e.g.,
acquiring land, property, plant or equipment by assumption of a liability). Such transactions (if material) must
be separately disclosed.
The Statement of Owners’ Equity
Shows the breakdown of items affecting the stockholders’ equity accounts during the period.
This statement is often used to show comprehensive income (Statement of Financial Accounting Standards No.
130). Comprehensive income reflects all changes in owners’ equity in a period, except those resulting from
owners (primarily stock issuances) and distributions to owners (primarily dividends and stock repurchases). The
intent of SFAS No. 130’s requirement that firms report comprehensive income was to include gains and losses
that are not reflected in the income statement (and therefore, not included in net income), but which are reflected
as charges to owners’ equity.
The most common adjustments to owners’ equity are:
Foreign currency translation gains (losses)
Excess of additional pension liability over unrecognized prior service cost (“minimum pension
liability” adjustment)
Unrealized holding gains (losses) for available-for-sale securities
Deferred or unearned compensation related to employee stock option plans
Guarantees of employee stock option debt
These adjustments are also referred to as dirty surplus items because they violate the clean surplus
relation: Beginning balance in Retained earnings + income (or – loss) - dividends = Ending balance in
retained earnings.
2
Financial statement data for Sparkle Company follow, for the years 2000-2003:
Sparkle Company Balance Sheets
2000
2001
2002
2003
Assets
Cash
Accounts receivable
Inventories
Total current assets
Gross property, plant & equipment
Accumulated depreciation
Total assets
$100
260
140
500
2,400
(400)
$2,500
$76
360
300
736
3,720
(520)
$3,936
$40
460
460
960
4,860
(660)
$5,160
$170
760
830
1,760
5,630
(840)
$6,550
Liabilities and shareholders' equity
Accounts payable
Short term borrowings
Salaries payable
Total current liabilities
Bonds payable
Common stock, par value $1
Additional paid in capital
Retained earnings
Total liabilities & shareholders' equity
$250
50
100
400
500
1,000
200
400
$2,500
$300
70
130
500
500
1,500
1,000
436
$3,936
$350
100
150
600
1,000
1,600
1,200
760
$5,160
$500
200
200
900
1,500
1,600
1,200
1,350
$6,550
2001
$2,760
(1,573)
(510)
(120)
557
(500)
57
(17)
$40
$4
2002
$3,100
(1,798)
(590)
(140)
572
(100)
472
(142)
$330
$6
2003
$4,750
(2,803)
(750)
(180)
1,018
(160)
858
(257)
$600
$10
Sparkle Company Income Statements
Sales
Cost of goods sold
Selling, general and administrative
Depreciation expense
Operating income
Interest expense
Pretax income
Income tax expense
Net income
Dividends
Important relations:
Assets = Liabilities + Owners' Equity. This relation links the two sides of the balance sheet. For example, in
2000, total assets of $2,500 equal total liabilities ($900 = $400 + $500) plus shareholders’ equity ($1,600 =
$1,000 + $200 + $400).
Book value at time t = Book value at time t-1 + Net income in year t – Net dividends in year t. See the Statement
of Owners’ Equity.
3
Sparkle Company Statements of Cash Flows
2001
2002
2003
$40
120
(100)
(160)
50
30
(20)
$330
140
(100)
(160)
50
20
280
600
180
(300)
(370)
150
50
310
(1,320)
(1,320)
(1,140)
(1,140)
(770)
(770)
Cash flows from financing
Increase (decrease) in short term borrowings
Issuance (payments) of bonds payable
Issuance of common stock
Dividends paid
Cash flows from financing
20
0
1,300
(4)
1,316
30
500
300
(6)
824
100
500
0
(10)
590
Net increase (decrease) in cash
Beginning cash balance
Ending cash balance
(24)
100
76
(36)
76
40
130
40
170
Cash flows from operations
Net income
Depreciation expense
(Increase) decrease in accounts receivable
(Increase) decrease in inventories
Increase (decrease) in accounts payable
Increase (decrease) in salaries payable
Cash flows from operations
Cash flows from investments
Additions to PP&E
Cash flows from investing
Important relation:
Net change in cash (per the ending balances in two consecutive balance sheets) = Cash flow from operations +
Cash flow from investing + Cash flow from financing (all reported in the Statement of Cash Flows). This
relation links the Balance Sheet with the Statement of Cash Flows. For example, in 2001, the change in cash per
the balance sheet was -$24. Cash flow from operations in 2001 was -$20, cash flow from investment in 2001
was -$1,320 and cash flow from financing was $1,316; the aggregate of the three cash flows is $-24 (the change
in the cash balances between 2000 and 2001).
4
Sparkle Company Statements of Owners’ Equity
Balance at Dec. 31, 2000
Net income
Foreign currency translation
Minimum pension liability
Unrealized holding gains
Comprehensive income
Cash dividends
Repurchase common stock
Issued common stock
Balance at Dec. 31, 2001
Net income
Foreign currency translation
Minimum pension liability
Unrealized holding gains
Comprehensive income
Cash dividends
Repurchase common stock
Issued common stock
Balance at Dec. 31, 2002
Net income
Foreign currency translation
Minimum pension liability
Unrealized holding gains
Comprehensive income
Cash dividends
Repurchase common stock
Issued common stock
Balance at Dec. 31, 2003
Common stock
Shares Amount
1,000
$1,000
Additional
paid in capital
$200
Retained
earnings
$400
$40
$40
($4)
500
$500
Accumulated other
comprehensive income
Total owners'
equity
$1,600
$0
$0
$0
$0
$40
($4)
$800
$1,300
$2,936
$330
$330
($6)
100
$100
$0
$0
$0
$0
$330
($6)
$200
$300
$3,560
$600
$600
($10)
$0
$0
$0
$0
$600
($10)
$4,150
Important relation:
Book value at time t = Book value at time t-1 + Net income in year t – Net dividends in year t. There are no dirty
surplus items for Sparkle Company. Hence the clean surplus relation should hold. For example, the book value
of equity in 2001 ($2,936) equals book value of equity in 2000 ($1,600) plus net income in 2001 ($40) less net
dividends paid in 2001 (-$1,296 = $4 - $500 (additional c/s) - $800 (additional paid in capital)).2
2
Note that we use the term net dividends. By that we mean cash paid to or received from equity holders. This
will include cash dividends as well as share issuances and share repurchases.
5
II.
Comparing Financial Statements and Ratios Across and Within Firms
Common size financial statements express the components of the financial statements in terms of a common
variable for each statement. For the balance sheet, it is common to use total assets as the scale variable, while
for the income statement, total sales revenue is typically used. The sizing is done each year, using the value of
the scale variable that year. By expressing each component of the balance sheet and the income statement as a
percentage (of assets and revenues, respectively), one can compare firms of varying sizes. The common size
financial statements for Sparkle Company looks as follows:
Assets
Cash
Accounts receivable
Inventories
Total current assets
Gross property, plant & equipment
Accumulated depreciation
Total assets
2000
100
260
140
500
2,400
(400)
2,500
4.00%
10.40%
5.60%
20.00%
96.00%
-16.00%
100.00%
2001
76
360
300
736
3,720
(520)
3,936
1.92%
9.15%
7.62%
18.69%
94.52%
-13.21%
100.00%
2002
40
460
460
960
4,860
(660)
5,160
0.78%
8.91%
8.91%
18.61%
94.18%
-12.79%
100.00%
2003
170
760
830
1,760
5,630
(840)
6,550
2.60%
11.60%
12.67%
26.87%
85.95%
-12.82%
100.00%
Liabilities and shareholders' equity
Accounts payable
Short term borrowings
Salaries payable
Total current liabilities
Bonds payable
Common stock at par
Additional paid in capital
Retained earnings
Total liabilities & shareholders' equity
250
50
100
400
500
1,000
200
400
2,500
10.00%
2.00%
4.00%
16.00%
20.00%
40.00%
8.00%
16.00%
100.00%
300
70
130
500
500
1,500
1,000
436
3,936
7.62%
1.78%
3.30%
12.70%
12.70%
38.11%
25.41%
11.07%
100.00%
350
100
150
600
1,000
1,600
1,200
760
5,160
6.78%
1.94%
2.91%
11.63%
19.38%
31.01%
23.26%
14.73%
100.00%
500
200
200
900
1,500
1,600
1,200
1,350
6,550
7.63%
3.05%
3.05%
13.74%
22.90%
24.43%
18.32%
20.62%
100.00%
Sales
Cost of goods sold
Selling, general and administrative
Depreciation expense
Operating income
Interest expense
Pretax income
Income tax expense
Net income
2001
2002
2003
2,760 100.00% 3,100 100.00% 4,750 100.00%
(1,573) -57.00% (1,798) -58.00% (2,803) -59.00%
(510) -18.48% (590) -19.03% (750) -15.79%
-4.35%
(140)
-4.52%
(180)
-3.79%
(120)
20.17%
572
18.45%
1,018
21.42%
557
-3.23%
(160)
-3.37%
(500) -18.12% (100)
2.06%
472
15.23%
858
18.05%
57
-0.62%
(142)
-4.57%
(257)
-5.42%
(17)
1.44%
330
10.66%
600
12.64%
40
6
Trend analysis expresses the change in the value of a period t+1 financial statement component measured
relative to its value in period t as a percentage of its period t value. Negative values indicate declines in the item
being measured (good if the variable is an expense, bad if it is revenue). Whereas common size financial
statements permit cross-sectional (i.e., across firm) comparisons controlling for size, trend analysis permits
within-firm comparisons of the firm over time. Trend analysis obviously controls for firm-specific features by
using the same firm each year as its control in the next year. Whereas the point of common size financial
statement is to assess how a firm is performing relative to its peers, the point of trend analysis is to assess how
the firm is doing relative to its past. A trend analysis for Sparkle Company would show the following:
Assets
Cash
Accounts receivable
Inventories
Total current assets
Gross property, plant & equipment
Accumulated depreciation
Total assets
2000
100
260
140
500
2,400
(400)
2,500
2001
76
360
300
736
3,720
(520)
3,936
-24.24%
38.46%
114.29%
47.15%
55.00%
30.00%
57.43%
2002
40
460
460
960
4,860
(660)
5,160
-46.99%
27.78%
53.33%
30.50%
30.65%
26.92%
31.11%
2003
170
760
830
1,760
5,630
(840)
6,550
324.33%
65.22%
80.43%
83.35%
15.84%
27.27%
26.94%
Liabilities and shareholders' equity
Accounts payable
Short term borrowings
Salaries payable
Total current liabilities
Bonds payable
Common stock at par
Additional paid in capital
Retained earnings
Total liabilities & shareholders' equity
250
50
100
400
500
1,000
200
400
2,500
300
70
130
500
500
1,500
1,000
436
3,936
20.00%
40.00%
30.00%
25.00%
0.00%
50.00%
400.00%
8.94%
57.43%
350
100
150
600
1,000
1,600
1,200
760
5,160
16.67%
42.86%
15.38%
20.00%
100.00%
6.67%
20.00%
74.44%
31.11%
500
200
200
900
1,500
1,600
1,200
1,350
6,550
42.86%
100.00%
33.33%
50.00%
50.00%
0.00%
0.00%
77.65%
26.94%
2002
3,100
(1,798)
(590)
(140)
572
(100)
472
(142)
330
12.32%
14.29%
15.69%
16.67%
2.73%
-80.00%
730.99%
730.99%
730.99%
2003
4,750
(2,803)
(750)
(180)
1,018
(160)
858
(257)
600
53.23%
55.87%
27.12%
28.57%
77.88%
60.00%
81.67%
81.67%
81.67%
Sales
Cost of goods sold
Selling, general and administrative
Depreciation expense
Operating income
Interest expense
Pretax income
Income tax expense
Net income
2001
2,760
(1,573)
(510)
(120)
557
(500)
57
(17)
40
7