Basic financial reporting & statements
- 1. PAPER TWO: BASIC FINANCIAL REPORTING & STATEMENT Paper Delivered By Dr. Tunde Adeyemi 1
- 2. The Preparation of The Financial Statements- Basics for Beginners 2
- 3. Financial Statements This Area covers the basic preparation of a Financial Statement for those that are new to accounting o a financial statement; as a prelude to studying the financial statement of a business: The Income Statement 3
- 4. Financial Statements This Area covers the basic preparation of a Financial Statement for those that are new to accounting o a financial statement; as a prelude to studying the financial statement of a business: The Income Statement The Statement of Retained Earnings 4
- 5. Financial Statements This Area covers the basic preparation of a Financial Statement for those that are new to accounting o a financial statement; as a prelude to studying the financial statement of a business: The Income Statement The Statement of Retained Earnings The Balance Sheet 5
- 6. Financial Statements This Are covers the basic preparation of a Financial Statement for those that are new to accounting o a financial statement; as a prelude to studying the financial statement of a business: The Income Statement The Statement of Retained Earnings The Balance Sheet The purpose of these statements is to help users make better decisions.6
- 8. Income Statement The first statement prepared is the Income Statement. 8
- 9. Income Statement The first statement prepared is the Income Statement. The Income Statement reports a business’ performance for the period. 9
- 10. Income Statement A simple format for an income statement is: 10
- 11. Income Statement A simple format for an income statement is: Revenues – Expenses = Net Income 11
- 12. Income Statement A simple format for an income statement is: Revenues – Expenses = Net Income We will look at a more complex format later. 12
- 13. Income Statement Revenues are earned for the sale of goods or services. Note that revenues occur when the sale is made. The payment may or may not have been received. 13
- 14. Income Statement Revenues are earned for the sale of goods or services. Note that revenues occur when the sale is made. The payment may or may not have been received. Examples of revenues include sales, service revenue and interest revenue. 14
- 15. Income Statement Expenses are incurred when a business receives goods and services. Like revenues, payment may or may not have been made. 15
- 16. Income Statement Expenses are incurred when a business receives goods and services. Like revenues, payment may or may not have been made. Examples of expenses include salaries expense, utility expense and interest expense. 16
- 17. Income Statement Most businesses require more information from their businesses than a simple income statement can provide. Therefore, they use a multi-step income statement format. 17
- 18. Income Statement Most businesses require more information from their businesses than a simple income statement can provide. Therefore, they use a multi-step income statement format. A format for a multi-step income statement is: 18
- 19. Income Statement Sales revenue - Cost of goods sold Gross profit - Operating expenses Income from operations +/- Non-operating items Income before taxes - Income taxes Net income 19
- 20. Income Statement Cost of goods sold represents the expense a business incurred to buy or make a product for resale. 20
- 21. Income Statement Cost of goods sold represents the expense a business incurred to buy or make a product for resale. 21
- 22. Income Statement Operating expenses are the usual expenses incurred in operating a business. 22
- 23. Income Statement Operating expenses are the usual expenses incurred in operating a business. Accounts such as salaries expense, utility expense, and depreciation expenses are all shown in this section. 23
- 24. Income Statement Non-operating items are revenue, expenses, gains and losses that do not relate to the company’s primary operations. 24
- 25. Income Statement Non-operating items are revenue, expenses, gains and losses that do not relate to the company’s primary operations. Accounts include interest expense and gains and losses of the sale of equipment and investments. 25
- 26. Income Statement Income taxes are computed by multiplying Income before taxes by the income tax rate. 26
- 27. Income Statement Income taxes are computed by multiplying Income before taxes by the income tax rate. 27
- 28. The Statement of Retained Earnings 28
- 29. Statement of Retained Earnings The Statement of Retained Earnings reports how net income and dividends affected a company’s financial position during the period. 29
- 30. Statement of Retained Earnings The format of the statement is: 30
- 31. Statement of Retained Earnings The format of the statement is: Beg. balance, retained earnings + Net income - Dividends End. balance, retained earnings 31
- 32. Statement of Retained Earnings Note that the Income Statement must be prepared before the Statement of Retained Earnings. 32
- 33. Statement of Retained Earnings Note that the Income Statement must be prepared before the Statement of Retained Earnings. This is because you have to know the amount of net income in order to compute the ending balance of retained earnings. 33
- 35. Balance Sheet The purpose of the balance sheet is to report the financial position of an accounting entity at a particular point in time. 35
- 36. Balance Sheet The purpose of the balance sheet is to report the financial position of an accounting entity at a particular point in time. The basic format for the balance sheet is: Assets = Liabilities + Equity 36
- 37. Balance Sheet Assets are economic resources owned by a company. 37
- 38. Balance Sheet Assets are economic resources owned by a company. Examples include cash, accounts receivable, supplies, buildings and equipment. 38
- 39. Balance Sheet Liabilities are the company’s debt or obligations. 39
- 40. Balance Sheet Liabilities are the company’s debt or obligations. Examples are accounts payable, unearned revenues and bonds payable. 40
- 41. Balance Sheet Equity is the residual balance. Assets – liabilities = equity. Equity is commonly called stockholders’ equity if the business is a corporation as it represents the financing provided by the stockholders along with the earnings from the business not paid out as dividends. 41
- 42. Balance Sheet There are two different types of assets shown on a balance sheet. These are current assets and non-current assets. 42
- 43. Balance Sheet There are two different types of assets shown on a balance sheet. These are current assets and non-current assets. Current assets + Non-current assets Total assets 43
- 44. Balance Sheet Current assets are assets that will be used or turned into cash within one year. 44
- 45. Balance Sheet Current assets are assets that will be used or turned into cash within one year. Examples include cash, accounts receivable, inventory, short-term investments, supplies and prepaids. 45
- 46. Balance Sheet Non-current assets comprise the remainder of the assets. 46
- 47. Balance Sheet Non-current assets comprise the remainder of the assets. These include accounts such as: long-term investments, land, building, equipment and patents. 47
- 48. Balance Sheet There are two different types of liabilities shown on a balance sheet – current liabilities and long-term liabilities. 48
- 49. Balance Sheet There are two different types of liabilities shown on a balance sheet – current liabilities and long-term liabilities. Current liabilities + Long-term liabilities Total liabilities 49
- 50. Balance Sheet Current liabilities are obligations that will be paid in cash (or other services) or satisfied by providing service within the coming year. 50
- 51. Balance Sheet Current liabilities are obligations that will be paid in cash (or other services) or satisfied by providing service within the coming year. Examples include accounts payable, short- term notes payable, and taxes payable. 51
- 52. Balance Sheet Long-term liabilities are obligations that will not be paid or satisfied within the year. 52
- 53. Balance Sheet Long-term liabilities are obligations that will not be paid or satisfied within the year. Examples include mortgage payable and bonds payable. 53
- 54. Balance Sheet Stockholders’ Equity is divided into two categories: contributed capital and retained earnings. Contributed capital + Retained earnings Total stockholders’ equity 54
- 55. Balance Sheet Contributed capital is the amount of cash (or other assets) provided by the shareholders. 55
- 56. Balance Sheet Contributed capital is the amount of cash (or other assets) provided by the shareholders. Common Stock and Additional Paid in Capital are accounts in this section. 56
- 57. Balance Sheet Retained earnings is the total earnings that have not been distributed to owners as dividends. 57
- 58. The Balance Sheet Current assets + Non-current assets Total assets Current liabilities + Long-term liabilities + Stockholders’ equity Total liabilities and stockholders’ equity 58
- 59. Balance Sheet The Balance Sheet must be prepared after the Statement of Retained Earnings in order to have calculated the ending balance of Retained Earnings. 59
- 60. Income Statement Net income Statement of Retained Earnings Beginning Retained Earnings + Net income – Dividends Ending retained earnings Balance Sheet Ending Balance Retained Earnings Order of Preparation 60
- 61. Income statement—A summary of the revenue and expenses for a specific period of time. Statement of retained earnings – a summary of the changes in the retained earnings that have occurred during a specific period of time. Balance sheet—A list of the assets, liabilities, and owner’s equity as of a specific date. Review 61
- 62. Assets = Liabilities + Equity Most important equation in business So, what does it mean? It means you can get assets through liabilities or equity. So, what does that mean? That means you can get assets (like cash, factories or land) through taking on debt (loans from the bank, issuing bonds) or equity (relinquishing partial ownership interest in your company) 62
- 63. What Exactly are Assets? Simplified Definition of an Asset: Cash or anything that will produce cash in the future. More exact definition: is anything owned by an individual or a business, which has commercial or exchange value. Assets may consist of specific property or claims against others, in contrast to obligations due others. Exact definition: Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Let’s keep it simple! For instance, if you had a factory that made computers, then it would be considered an asset. Why? Because the factory would produce cars that would be sold in the market for cash. Examples of assets include: cash, machinery, inventory, factory, land or anything else that will produce cash in the future. 63
- 64. What are Liabilities? Simplified definition of liabilities: Anything that will reduce an asset (such as cash) in the future. More exact definition: a loan, expense, or any other form of claim on the assets of an entity that must be paid or otherwise honored by that entity. Exact definition: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Let’s keep it simple! For instance, if you owe your suppliers money for inventory then you would need to pay them at some point. Thus, you have liability until cash (an asset) was used to payoff the money owed. Example of liabilities include: Accounts payable, Loans outstanding, Unearned Services (occurs when you receive cash before performing your service) 64
- 65. What is Equity? Simplified definition of Equity: The value of your company after you payoff all the money you owe. More exact definition: ownership or percentage of ownership in a company or items of value. Exact definition: Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Let’s keep it simple! For instance, you have a truck worth $20,000 (an asset), a factory worth $140,000 (an asset) and $30,000 of cash in the bank (an asset). If you sold the truck and the factory you would have $190,000 in cash and that would be your equity. However, you owe the bank $80,000 because you bought the car and part of the factory on a loan. Thus your equity after paying off your loan (liabilities), would only be $110,000. Examples of equity include common stock or simply one’s ownership of a private company (e.g. I own 28% of Mike’s Hard Lemonade Stand, while my other partners own the other 72%) 65
- 66. An additional financial statement that identifies changes in retained earnings from one accounting period to the next. Statement of Retained Earnings Beginning retained earnings + Net income – Dividends paid = Ending retained earnings Net income results in: Increase in net assets Increase in retained earnings Increase in owners’ equity Dividends result in: Decrease in net assets Decrease in retained earnings Decrease in owners’ equity 66
- 67. Statement of Cash Flows Reports the amount of cash collected and paid out by a company in operating, investing and financing activities for a period of time. How did the company receive cash? How did the company use its cash? Complementary to the income statement. Indicates ability of a company to generate income in the future. 67
- 68. Statement of Cash Flows Cash inflows Sell goods or services Sell other assets or by borrowing Receive cash from investments by owners Cash outflows Pay operating expenses Expand operations, repay loans Pay owners a return on investment 68
- 69. Match Classification of Cash Flows Operating activities – Transactions and events that enter into the determination of net income. Investing activities – Transactions and events that involve the purchase and sale of securities, property, plant, equipment, and other assets not generally held for resale, and the making and collecting of loans. Financing activities – Transactions and events whereby resources and obtained from, or repaid to, owners and creditors. 69
- 70. Operating Activities Cash Inflow Sale of goods or services Sale of investments in trading securities Interest revenue Dividend revenue Cash Outflow Inventory payments Interest payments Wages Utilities, rent Taxes 70
- 71. Investing Activities Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans to other entities 71
- 72. Financing Activities Cash Inflow Issuance of own stock Borrowing Cash Outflow Dividend payments Repaying principal on borrowing Treasury stock purchase 72
- 74. Statement of Cash Flows Analysis Operating Investing Financing General Explanation Building up pile of cash, Possibly looking for Acquisition Operating cash flow being Used to buy fixed assets And pay down debt Operating cash flow and sale of fixed assets being used to pay down debt. Operating cash flow and borrowed money being used to expand 1. 2. 3. 4. + + + + + ─ + ─ + ─ ─ + 74
- 75. Statement of Cash Flows Analysis Operating Investing Financing General Explanation Operating cash flow problems covered by sale of fixed assets, borrowing and owner contributions. Rapid growth, short falls in operating cash flow; purchase of fixed assets. Sale of fixed assets is financing operating cash flow shortages. Company is using reserves to finance cash flow short falls. 5. 6. 7. 8. ─ ─ ─ ─ + ─ + ─ + + ─ ─ 75
- 76. Notes to the Financial Statements Notes are used to convey information required by GAAP or to provide further explanation. 76
- 77. Notes to the Financial Statements Four general types of notes: Summary of significant accounting policies: assumptions and estimates. Additional information about the summary totals. Disclosure of important information that is not recognized in the financial statements. Supplementary information required by the IFRS and or the SEC. 77
- 78. Separate Entity Concept Arm’s-Length Transactions Cost Principle Monetary Measurement Concept Going Concern Assumption What Are The Fundamental Concepts and Assumptions? 78
- 79. Entity ─ The organizational unit for which accounting records are maintained. Separate entity concept ─ The activities of an entity are to be separate from those of its individual owners. Proprietorship Partnership Corporation Separate Entity Concept 79
- 80. The Cost Principle All transactions are recorded at historical cost. Historical cost is assumed to represent the fair market value of the item at the date of the transaction because it reflects the actual use of resources by independent parties. 80
- 81. The Monetary Measurement Concept Accountants measure only those economic activities that can be measured in monetary terms. Listed values may not be the same as actual market values: Inflation Measurement issues 81
- 82. The Going Concern Assumption An entity will have a continuing existence for the foreseeable future. 82
- 83. Why Use Accrual Accounting? GAAP – Generally Accepted Accounting Principles Business requires periodic, timely reporting Accrual-basis accounting better measures a firm’s performance than does cash flow data. 83
- 84. The Time Period Concept The life of a business is divided into distinct and relatively short time periods so the accounting information can be timely, generally 12 months or less. 84
- 85. Define Accrual Accounting A system of accounting in which revenues and expenses are recorded as they are earned and incurred, not necessarily when cash is received or paid. Provides a more accurate picture of a company’s profitability. Statement users can make more informed judgments concerning the company’s earnings potential. 85
- 86. Revenue Recognition Revenues are recorded when two main criteria are met: Cash has either been collected or collection is reasonably assured. The earning process is substantially complete 86
- 87. The Matching Principle All costs and expenses incurred in generating revenues must be recognized in the same reporting period as the related revenues. This process of matching expenses with recognized revenues determines the amount of net income reported on the income statement. costs and expenses related revenues 87
- 88. Cash-Basis Accounting Revenues and expenses are recognized only when cash is received or payments are made. Mainly used by small businesses. Not an accurate picture of true profitability. 88
- 89. During 2010, Crown Consulting billed its client for $48,000. On December 31, 2010, it had received $41,000, with the remaining $7,000 to be received in 2011. Total expenses during 2010 were $31,000 with $3,000 of these costs not yet paid at December 31. Determine net income under both methods. Cash-Basis Accounting Cash receipts $41,000 Cash disbursement 28,000 Income $13,000 Accrual-Basis Accounting Revenues earned $48,000 Expenses incurred $31,000 Income $17,000 Accrual vs. Cash-Basis Accounting 89
- 90. Purpose of Analysis Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers Financial statement analysis helps users make better decisions. 90
- 91. Liquidity and Efficiency Solvency Profitability Market Ability to meet short-term obligations and to efficiently generate revenues Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations Ability to provide financial rewards sufficient to attract and retain financing Building Blocks of Analysis 91
- 92. Tools of Analysis Horizontal Analysis Comparing a company’s financial condition and performance across time. 92
- 93. Tools of Analysis Vertical Analysis Comparing a company’s financial condition and performance to a base amount. 93
- 94. Debt Ratio and its Purpose Measure of leverage Varies from industry to industry, but should be around 50% Total liabilities Total assets = 94
- 95. Current Ratio and its Purpose Measure of liquidity Also called Working Capital Ratio Some successful companies have current ratios less than 1.0 Total current assets Total current liabilities = 95
- 96. Asset Turnover and its Purpose Measure of company efficiency The higher the asset turnover ratio, the more efficient the company is using its assets to generate sales. Sales Total assets= 96
- 97. Return on Sales and its Purpose Measure of the amount of profit earned per dollar of sales. Evaluated within the appropriate industry. Net income Sales= McGraw-Hill/Irwin, 2003 97
- 98. Return on Equity and its Purpose Overall measure of performance─profit earned per dollar of investment. Typically between 15% and 25%. Net income Owners’ equity = 98
- 100. Overview of IFRSs IFRS is a globally-accepted set of accounting standards and interpretations established by: International Accounting Standards Board (IASB) International Financial Reporting Interpretations Committee (IFRIC). IFRS assist preparers of financial statements produce and present: high quality transparent and, comparable financial information IFRSs are designed for use by profit oriented entities. However, entities engaged in not-for-profit activities may find IFRSs useful, and may follow them if considered appropriate 100
- 101. Global adoption of IFRSs 101 •China •Hong Kong •Russia •EU countries •Africa - Kenya - Zimbabwe - South Africa - Zambia - Ghana - Sierra Leone. - Canada – 2012 -Nigeria- 2012 Countries that require or permit IFRS or have fixed dates to implement Countries seeking convergence with the IASB or pursuing adoption of IFRS
- 102. Global adoption of IFRSs Cont. Having a single set of high-quality globally accepted accounting standards is important especially in increasingly global capital markets. In fact, “the need for a single-set of highly quality globally accepted accounting standards has been highlighted by the global financial crisis, which has demonstrated how interconnected the world’s capital markets are.” Additionally, using one set of standards globally would have the “potential to improve financial-statement comparability102
- 103. Global adoption of IFRSs Cont. Over 12,000 companies in over 100 countries have already adopted IFRS. In the European Union, member states whose securities are listed on EU regulated stock exchanges prepare Consolidated Financial Statements as per IFRS. In Israel, Australia and New Zealand, IFRS has been adopted as national accounting standards. China has formulated local GAAP which are IFRS based, although some differences still exist. Other countries like Canada, India and South Korea are attempting to complete the transition to IFRS by 2011 while Mexico and Japan are working towards convergence by 2012, which would eliminate major differences between their current standards and IFRS. 103
- 104. Concerns/Implications As with many benefits, there also comes challenges and concerns. For one thing, the first time cost of implementing a new accounting system and training of employees will be quite significant. Other concerns about the conversion to IFRS are caused by the nature of IFRS. Because IFRS is more principles-based, there is a fear that the companies may apply the same rules differently thereby causing varying results. 104
- 105. The IFRS Clouds (Challenges) 105 Cash Flow projection Data availability Financial reporting Business impact Recognition & Measurement IFRS adoption Analysis & Disclosures Systems & processes Credit rating
- 106. 106 106 Objective of financial reporting Provide financial 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. The information provided about financial performance helps existing and potential investors, lenders and other creditors to understand the return the entity has produced on its economic resources.
- 107. 107 107 Objective of financial reporting continued Decisions by investors about buying, selling or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments, eg dividends, principal and interest payments or market price increases. Decisions by lenders about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect. Information must reflect the effect on performance of changes in market prices and/or interest rates.
- 108. 108 Objective of financial reporting continued Information about an entity’s financial performance in a period, reflected by changes in economic resources (other than by obtaining additional resources directly from investors or creditors) is useful in assessing the entity’s past and future ability to generate net cash inflows
- 109. 109Elements Asset resource controlled by the entity result of past event expected inflow of economic benefits Liability present obligation arising from past event expected outflow of economic benefits Income recognised increase in asset/decrease in liability in current reporting period that result in increased equity except… Expense recognised decrease in asset/increase in liability in current reporting period that result in decreased equity except… 109 109
- 110. THE END QUESTION AND ANSWERS- CLASS WORK (CASE STUDIES) 110