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Note 2

The document provides an overview of key concepts in accounting and finance covered in Chapter 3, including: 1) The four main financial statements - balance sheet, income statement, statement of retained earnings, and statement of cash flows - and what each reports. 2) The balance sheet lists a company's assets, liabilities, and equity. It provides a snapshot of the company's financial position at a point in time. 3) The income statement captures a company's revenues, expenses, and profits over a period of time, showing how much it earned. 4) While profits and cash flows are related, they differ because profits are calculated on an accrual basis while cash flows consider actual cash inflows

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140 views

Note 2

The document provides an overview of key concepts in accounting and finance covered in Chapter 3, including: 1) The four main financial statements - balance sheet, income statement, statement of retained earnings, and statement of cash flows - and what each reports. 2) The balance sheet lists a company's assets, liabilities, and equity. It provides a snapshot of the company's financial position at a point in time. 3) The income statement captures a company's revenues, expenses, and profits over a period of time, showing how much it earned. 4) While profits and cash flows are related, they differ because profits are calculated on an accrual basis while cash flows consider actual cash inflows

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faizool
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© © All Rights Reserved
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FIN 301

Class Notes

Chapter 3: Accounting and Finance


INTRODUCTION
Accounting Function: Gathering, processing, and reporting data.
End result is a set of four financial statements
1- Balance sheet
2-Income statement
3-Statement of retained earnings
4-Statement of cash flow
Annual Report includes:
Financial highlights: include key figures such as sales, net income, and EPS.
Letter to stockholders from CEO: assessment of the firm performance and future
plan.
Management Discussion & Analysis
Financial performance : Summary of financial ratios, Balance sheet, Income
statement, Statement of retained earnings, Statement of cash flows, Report from
the independent auditor
Members of the management team and board of directors

BALANCE SHEET
Provides a snapshot of a firms financial condition as of a particular date.

Major Components of the Balance Sheet


Total assets =Current assets + Fixed assets
Total liabilities =Current liabilities + Long term liabilities
Total Stockholders equity = Preferred and Common stocks at par value + paid in
Capital + retained earnings +Accumulated other
comprehensive income treasury stocks at cost.
Total assets = Total liabilities + Total Stockholders equity
Current Assets: includes,
Cash
Cash equivalents: T-bills, commercial paper, and other
Accounts receivable
Inventory: FIFO vs. LIFO. In inflationary setting firms use LIFO for tax purposes.
Prepaid expenses
Other current assets: for example, deferred income taxes
Deferred income tax asset happen when income reported to stockholders is less than the
income reported to tax authority.
Deferred income tax liability happen when income reported to stockholders is more than the
income reported to tax authority.

The difference between the two reported incomes occur for many reasons, but one major source is the
use of accelerated depreciation methods for tax purposes and straight-line method for reporting
purposes.
2

Fixed Assets: includes


Property, plant, and equipment accumulated depreciation
Straight-line depreciation Expenses = (cost salvage value) / economic life of assets
Straight-line or Accelerated depreciation: firms use accelerated dep. To reduce taxes in early years.
Asset

Straight-Line Method
Year 1 Year2 Year3

Original Cost
Depreciation Expenses
Accumulated Depreciation
Net Book Value

$300

$300

$300

Accelerated Method
Year1 Year2
Year3
$300
$300
$300

$100

$100

$100

$150

$100

$50

$100

$200

$300

$150

$250

$300

$0

$150

$50

$0

$200

$100

Intangible and Other Assets


Intangible: examples: Trademarks, Patents, Goodwill.
Other Assets: Long-term assets that do not fit into other categories
Current liabilities: includes Accounts payable, Notes payable, and Accrued liabilities,
current portion due from long term debt.
Long-term liabilities: includes long term bank loan, Mortgage bonds, Debentures,
pension liabilities, and deferred taxes owed to the government.
Accrued liabilities happen because of accrual basis of accounting. This means that revenue
and expenses are recognized when they are incurred rather than when cash is received or paid.
Usually, wages payable and tax payable.

Total Stockholders equity = Preferred and Common stocks at par value + paid in
Capital + retained earnings +Accumulated other
comprehensive income treasury stocks at cost.
* Accumulated other comprehensive income includes currency translation
gains or losses, deficit or surplus in pension fund liability, hedging transactions losses and gains.

INCOME STATEMENT
Captures the operating results of the firm over a period of time .Details the earnings generated by the
firm after all expenses have been subtracted from the revenues.
Components of the Income Statement
Sales
- Cost of sales: direct cost of producing the merchandize (raw materials and labor)
= Gross profit margin
- Operating expenses:
Selling, general, and administrative expenses: marketing expenses, managers salary.
Depreciation expenses, R & D expenses
= Operating profit or Earning before Interest and tax (EBIT)
- Non-operating expenses: interest expenses and other expenses
= Earnings before income tax and extraordinary items
- Income tax
- Extraordinary items: nonrecurring items
= Earnings after taxes (EAT)
- Preferred stock dividends
= Earnings available to common stockholders (Net Income)

Book Values and Market Values

Assets and liabilities are usually booked at their historical or original cost value.
Shareholders and managers are concerned about the market value of their stock, so their
focus is on a market value driven balance sheet. While book values are oriented to original
cost, market value is oriented to value in use or economic value: the ability to generate
future cash flows.
The market value of assets minus the market value of liabilities is the market value of
shareholders equity.

Profits versus Cash Flow


*

Shareholders and managers are concerned about maximizing shareholder value,


which is oriented toward estimating and generating cash flows.

Certain non-cash expenses, such as depreciation and amortization, are allocated


to a specific period to measure accounting profit. These non-cash expenses
cause profit to be less than what operating cash flow actually is and thus non4

cash expenses (non-cash revenues) must be added back to (subtracted from)


profit to estimate cash flow in a period. In addition capital expenditures, which are
capitalized and depreciated or expensed over future periods, incur cash outlays
when purchased.

Another reason why profits and cash flow differ is explained by comparing cash
accounting versus accrual accounting. Accrual accounting emphasizes profit
measurement in a period: the revenue earned in the period; the expenses
incurred in the period. Cash flow is oriented to cash collected versus disbursed in
a period. Adjusting entries, accruals, receivable, prepaid expenses, and payable
liabilities cause accounting profits measured in a period to differ from cash flow in
the same period.

Example: Cash flow versus profit


Suppose a firm pays $100 to produce some goods. It sells those goods in year 2 for $150 but did not
collect it is money until year 3. Ignoring interest and taxes and other operating expenses, its income
and cash flow will be as follows:

Sales
-COGS
Net Income
-Change in AR
-Change in Inventory
Net Operating Cash Flow

Year 1 Year 2 Year 3


0
150
0
0
100
0
0
50
0
0
100
-100

How much is the Net income over the 3 years?


How much is the Operating cash flow over the 3 years?

150
-100
0

-150
0
150

STATEMENT OF CASH FLOWS


Purpose is to provide relevant information about a companys cash receipts and cash payments during
a particular accounting period.
It is different from the net income statement because it involves only cash based activities.
Shows the affects of a companys operating, investing, and financing activities on its cash balance

Cash flows from Operating Activities


The cash inflow and outflow from direct operation like sales, payments for raw materials and labor,
interest paid or received, and taxes paid.
Two methods: 1- Direct and 2-Indirect
Direct method
Firm reports cash flows and cash out flows from operating activities

Indirect method
Convert net income to cash flow from operating activities
Adjust for transactions that affect income but did not affect the cash balance
OCF = Net Income
Add
Depreciation expense
Subtract Change in Account receivable, inventory, prepaid expanses
Add
Change in account payable, accrued liabilities, net deferred tax liabilities

Cash flows from Investing Activities


Refer to the cash received or paid when the firm tries to buy or sell long term fixed assets.
Cash flows from financing Activities
Refer to the issuance and the retirement of stocks and bonds, payment of dividends Interest expenses
paid are not included here. Interest expenses are considered part of the operating activities.
Example1:
The Ragin Cajun had an operating income (EBIT) of $260,000 last year.
The firm had $18,000 in depreciation expenses, $15,000 in interest expenses,
and $60,000 in selling, general, and administrative expenses.
If the Cajun has a marginal tax rate of 40 percent, what was its after-tax
cash flow for last year?
EBT = $260,000 - $15,000 = $245,000
EAT = $245,000(1 - 0.40) = $147,000
ATCF = $147,000 + $18,000 = $165,000

Example2:
Triangle Systems had earnings after tax of $1,000,000 last year.
Included in its expenses were $50,000 of interest, $100,000 of prepaid expenses,
and $150,000 of depreciation. In addition, the company paid dividends
of $200,000 to its stockholders last year.
What was Triangle's after-tax cash flow last year?

ATCF = $1,000,000 + $150,000 - $100,000 = $1,050,000

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