Accounting & Finance

Financial statements are prepared in most cases on the basis of three basic premises:

1. The company will continue to operate (going-concern assumptions).

2. Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle).

3. Expenses should match generated revenues within the specified accounting period (matching principle).

Furthermore, financial statements are prepared using one of two basic accounting methods:

1. Cash-basis accounting - This method consists of recognizing revenue (income) and expenses when payments are made (when checks are issued) or when cash is received (and deposited in the bank).

2. Accrual accounting - This method consists of recognizing revenue in the accounting period in which it is earned, that is, when the company provides a product or service to a customer, regardless of when the company gets paid. Expenses are recorded when they are incurred instead of when they are paid for.

Financial Statements - The Balance Sheet

The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. It's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity).

• Assets are economic resources that are expected to produce economic benefits for their owner
• Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees.
• Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.

The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders\' Equity

Total Assets
Total assets on the balance sheet are composed of the following:

Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:

• Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. Different cash denominations are converted at the market conversion rate.
• Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exists. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.
• Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts. Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced by allowance for doubtful accounts).
• Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short-term loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (the amount that will be collected).
• Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means, including at cost or current market value, and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.
• Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original (or historical) cost.

Long-Term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are considered long-term assets. These are:

• Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.
• Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes:
• Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation.
• Buildings or Plants - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation.
• Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP.
• Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.
• Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.

Total Liabilities
Liabilities have the same classifications as assets: current and long term.

Current liabilities - These are debts that are due to be paid within one year or the operating cycle, whichever is longer. Such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service.

Usually included in this section are:

• Bank indebtedness - This amount is owed to the bank in the short term, such as a bank line of credit.
• Accounts payable - This amount is owed to suppliers for products and services that are delivered but not paid for.
• Wages payable (salaries), rent, tax and utilities - This amount is payable to employees, landlords, government and others.
• Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that includes customer prepayments, dividends payables and wages payables, among others.
• Notes payable (short-term loans) - This is an amount that the company owes to a creditor, and it usually carries an interest expense.
• Unearned revenues (customer prepayments) - These are payments received by customers for products and services the company has not delivered or for which the company has not yet started to incur any cost for delivery.
• Dividends payable - This occurs as a company declares a dividend but has not yet paid it out to its owners.
• Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability.
• Current portion of capital-lease obligation - This is the portion of a long-term capital lease that is due within the next year.

Long-term Liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are:

• Notes payables - This is an amount the company owes to a creditor, which usually carries an interest expense.
• Long-term debt (bonds payable) - This is long-term debt net of current portion.
• Deferred income tax liability - GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings to the IRS. Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later due to the timing difference. If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset).
• Pension fund liability - This is a company's obligation to pay its past and current employees' post-retirement benefits; they are expected to materialize when the employees take their retirement for structures like a defined-benefit plan. This amount is valued by actuaries and represents the estimated present value of future pension expense, compared to the current value of the pension fund. The pension fund liability represents the additional amount the company will have to contribute to the current pension fund to meet future obligations.
• Long-term capital-lease obligation - This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of time. Long-term capital-lease obligations are net of current portion.

Financial Statements - The Income Statement

The income statement measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. The income statement is also known as the "profit and loss statement" or "statement of revenue and expense."

Income statements can be presented in one of two ways: multi-step and single-step. The two formats are illustrated below in two simplistic examples:

Multi-Step Format	Single-Step Format
Net Sales	Net Sales
Cost of Sales	Materials and Production
Gross Income*	Marketing and Administrative
Selling, General and Administrative Expenses (SG&A)	Research and Development Expenses (R&D)
Operating Income*	Other Income & Expenses
Other Income & Expenses	Pretax Income
Pretax Income*	Taxes
Taxes	Net Income
Net Income (after tax)*	--

Sample Income Statement
Now let's take a look at a sample income statement for company XYZ for Fiscal Year (FY) ending 2008 and 2009. Expenses are in parentheses.

Income Statement For Company XYZ FY 2008 and 2009
(Figures USD)	2008	2009
Net Sales	1,500,000	2,000,000
Cost of Sales	(350,000)	(375,000)
Gross Income	1,150,000	1,625,000
Operating Expenses (SG&A)	(235,000)	(260,000)
Operating Income	915,000	1,365,000
Other Income (Expense)	40,000	60,000
Extraordinary Gain (Loss)	-	(15,000)
Interest Expense	(50,000)	(50,000)
Net Profit Before Taxes (Pretax Income)	905,000	1,360,000
Taxes	(300,000)	(475,000)
Net Income	605,000	885,000

Here are some of the different entries that may be found on the income statement and what each one means.

• Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts.
• Cost of Goods Sold (COGS) - These are all the direct costs that are related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)
• Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.
• Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans.
• Income taxes - This account is a provision for income taxes for reporting purposes.

The Components of Net Income:

• Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.
• Recurring income before interest and taxes from continuing operations - In addition to operating income from continuing operations, this component includes all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earnings. However, non-cash expenses such as depreciation and amortization are not assumed to be good indicators of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.
• Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses.
• Pre-tax earnings from continuing operations - Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.
• Net income from continuing operations - This component takes into account the impact of taxes from continuing operations.

Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes.

• Income (or expense) from discontinued operations - This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).
• Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation.
• Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.

• Unusual or Infrequent Items
  Included in this category are items that are either unusual or infrequent in nature but they cannot be both.

Examples of unusual or infrequent items:

• Gains (or losses) as a result of the disposition of a company's business segment including:
• Plant shutdown costs
• Lease-breaking fees
• Employee-separation costs
• Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including:
• Plant shut-down costs
• Lease-breaking fees
• Gains (or losses) as a result of a lawsuit
• Losses of operations due to an earthquake
• Impairments, write-offs, write-downs and restructuring costs
• Integration expenses related to the acquisition of a business

• Extraordinary Items
  Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.

Example of extraordinary items:

• Losses from expropriation of assets
• Gain (or losses) from early retirement of debt

Discontinued Operations
Sometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Keep in mind these basic definitions:

• Measurement date – This is the date when the company develops a formal plan for disposing.
• Phase-out period – This is the time between the measurement date and the actual disposal date.

The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations.
On the measurement date, the company will accrue any estimated loss during the phase-out period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (the same rule applies to the sale of a portion of a business segment).

Accounting Changes
Accounting changes occur for two reasons:

1. As a result of a change in an accounting principle.
2. As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

• Inventory accounting methods (LIFO to FIFO)
• Change to or from full-cost method (This is used in oil and gas exploration. The successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.)
• Change from or to percentage-of-completion method (see revenue-recognition methods)
• All changes just prior to a company's IPO

Prior Period Adjustments
These adjustments are related to accounting errors. These errors are typically not reported in the income statement but are reported in retained earnings (found in changes in retained earnings). These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

Financial Statements - Cash Flow

The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period.

The cash flow statement shows the following:

• How the company obtains and spends cash
• Why there may be differences between net income and cash flows
• If the company generates enough cash from operation to sustain the business
• If the company generates enough cash to pay off existing debts as they mature
• If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows
The statement of cash flows is segregated into three sections:

• Operating activities
• Investing activities
• Financing activities

1. Cash Flow from Operating Activities (CFO)
CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes:

• Cash inflow (+)
1. Revenue from sale of goods and services
2. Interest (from debt instruments of other entities)
3. Dividends (from equities of other entities)
• Cash outflow (-)
1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders
5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)
CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.

This includes:

• Cash inflow (+)
1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities
• Cash outflow (-)
1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities

3. Cash flow from financing activities (CFF)
CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, or through short-term or long-term debt for the company's operations. This includes:

• Cash inflow (+)
1. Sale of equity securities
2. Issuance of debt securities
• Cash outflow (-)
1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock

A cash flow statement looks like this:

Reporting Non-Cash Investing and Financing Transactions
Information for the preparation of the statement of cash flow is derived from three sources:

1. Comparative balance sheets
2. Current income statements
3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash.

Examples Include:

• Conversion of debt to equity
• Conversion of preferred equity to common equity
• Acquisition of assets through capital leases
• Acquisition of long-term assets by issuing notes payable
• Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.