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Chapter 8
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Financial Reporting
James M. Reeve A User's Perspective
Deloitte & Touche
Professor of Accounting
University of Tennessee

As we go through life, it is important to 3. Cash flows -by reporting the sources

manage our own personal financial affairs. and uses of cash for operating, invest-
We must be careful to spend within our ing, and financing activities during a
limits, use our credit cards wisely, pay our period of time.
taxes, and save enough to meet future In this chapter, we will develop a basic
needs. Accomplishing these objectives often understanding of the three major nancial
requires us to monitor our nances. For statements: the balance sheet, the income
many of us, monitoring them may be as statement, and the statement of cash ows.
simple as recording checks and deposits in Before we describe the statements them-
our checkbooks. Recording transactions in selves, the next section will discuss the
a checkbook is an example of accounting. financial reporting environment.
Accounting is defined as an information
system that provides reports to various indi-
FINANCIAL REPORTING
viduals or groups about economic activities
of an individual, family, organization, or ENVIRONMENT
other entity. Regulatory Environment
Not only must individuals manage their The financial statements of publicly traded
financial affairs; so must businesses. Account- companies are required to be submitted and
ing is used by corporations to provide filed annually with the Securities Exchange
information about business events. You may Commission (SEC), a governmental agency
think of accounting as the "language of busi- that was established by Congress in the
ness" because it is the means by which most early 1930s to regulate the stock markets
business information is communicated. and the financial statement disclosures of
Assume you inherited $10,000 and companies that list their stock on the public
wished to invest this money in the stock stock exchanges. The financial statements
market (the common stock of public com-
are required disclosures in order to serve the
panies). Which stocks would you select? needs of external decision makers, such as
How would you know which stocks were stock investors, creditors, financial analysts,
good potential investments, and which employees, vendors, and customers. For
ones were not? One way would be to use example, if you were considering: job offer
the information provided in corporate
from a public company, you might wish to
financial statements to assess the financial
evaluate its financial statements before
performance of your prospective invest- accepting the job. After all, you may not
ments. The financial statements compose a wish to be hired by a company that has
set of reports identifying the financial posi- weak financial position.
tion, results of operations, and cash flows
By law, the SEC is responsible for regu-
for an organization. The financial state-
lating the actual content of the financial
ments provide information about the:
statements. However, the SEC has tradi-
1. Financial position -by reporting the tionally allowed an independent body of
wealth of a business at a point in time. accounting experts to perform this func-
2. Results of operations by reporting tion. The independent body that develops
how well the company performed dur- the standards or "rules" for financial report-
ing the most recent period of time. ing iS the Financial Accounting Standards

Chapter 8: Financial Reporting: A Users' Perspective 191

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Board (FASB). These rules are the guide- Corporation? Would it also surprise you
lines used by accountants in reporting that you would not find this asset on Dis-
Marketplace various business events to external users. ney's financial statements? The reason is
http://www.marketplace-simulation.com The FASB does not determine the report- that the rules established by the accounting
ing rules for federal corporate income taxes. standard setters allow a company to record
BEST-USE CORRELATIONS These rules are determined by Congress trademark assets at cost, not at market
and enforced by the Internal Revenue Ser- value. The cost to establish Mickey Mouse
This chapter reviews how to track,
vice. Thus, corporate tax reporting and as a trademark was incurred decades ago as
and thus manage, your business per-
nancial reporting are two completely dif- mere legal fees. These costs are insigni -
formance. The focus is on measuring
ferent areas. We will not discuss corporate cant. Thus, while Mickey Mouse is
wealth, measuring the change in
tax reporting in this chapter. The term used significant economic asset of Disney, he
wealth, and measuring the change in for the financial reporting standards is gen- does not show up on its financial state-
cash.
erally accepted accounting principles (GAAP). ments because of the nature of GAAP.
All public companies must report their Taking a more contemporary example,
Financial Statements
financial performance according to GAAP. are the stock options awarded to employees
In Marketplace, after receiving your
The annual disclosure required by the a form of compensation expense to be
quarterly results, rst check your SEC is termed a 10-K report. The 10-K reported on the income statement, and if so,
cash flow statement (did you have includes information about the company's what is the compensation expense to be
enough cash?), then your income performance for the year, including the reported? Under many circumstances no
statement (how much did you lose or
nancial statements. The SEC maintains compensation expense is recorded. However,
earn?), and then your balance sheet
electronic versions of the 10-K report in when they should be reported the amount of
(are you solvent?). In Q5, venture
database, Electronic Data Gathering Analy- iS expense is determined by a set of rules estab-
capitalists will evaluate your actual
sis and Retrieval (EDGAR) system. Using lished by the FASB. The actual rules are
performance through Q4 and your the Internet, you can download without established by the FASB in Statements of
pro forma projections through Q8.
charge any public company's 10-K report Financial Accounting Standards (SFAS),
You can see how every choice
from EDGAR via a number of Internet ser- which are issued periodically to address new
made affects cash ow, income
vices. We recommend the free Edgarscan reporting rules and requirements.
statements, and balance sheets.
service provided by Pricewaterhouse- Exhibit 8.1 illustrates the role of GAAP
As teams make decisions, nancial
Coopers at www.edgarscan.pwcglobal.com/ in financial reporting. The "real world"
statements are updated so that you servlets/edgarscan/. consists of thousands of business events
can immediately see their impact on
required to conduct business. This underly-
accounts and rm pro tability. ing economic reality must be measured in
Generally Accepted order for external users of nancial state-
Cash Is King, or Is It Profit? Accounting Principles ments to be able to evaluate business
Starting in Q5, rms may borrow What could be controversial about report- performance. The "lens" used to measure
money and have lots of cash. But
ing business events? Is it not obvious how these economic events is provided by gener-
remember, investments in R&D and
an event should be recorded? Sometimes ally accepted accounting principles. In
new sales of ces are current period
this is true, but often there is : great deal of other words, we see the underlying events
expenses. They register on income
controversy on how business events should of an organization through the lens of
statements as losses. The losses
be recorded. To take a simple example, how accounting measurement. The results of the
reduce your retained earnings on the
should Walt Disney Corporation account measurement process are the financial state-
balance sheet, causing owners' for the trademark value of Mickey ments. Thus, what we see is strongly
equity to shrink. At this point, the
Mouse®? Would you agree that Mickey in uenced by the measurement system
auditors step in and limit current
Mouse is valuable asset of the Disney itself (the lens, if you will). If the lens is
period expenses. Thus, pro t and
the need to add to owners' equity
take on significant importance after
Exhibit 8.1: Measurement "Lens": Generally Accepted Accounting Principles
Q5.
GAAP
The Loan Shark Is Waiting
If you experience a cash shortfall in The Real World
Marketplace, the bank will call in a
loan shark to pay your bills. To avoid
the loan shark, project your cash Lens Financial Statement
ows every quarter by using Market-
place's easy-to-use pro forma tools.
See what could happen if sales fall
short of expectations; consider a
drop in revenue by 30 to 50%.
distorted, then So will be the likely interpre- granted, the entity's financial statements We shall discuss each of these categories
tation of the real world. will also be used to monitor the business. separately, referring to the example balance
As a (future) manager, you must keep Other people using financial statements are sheet of Martinez Company in Exhibit 8.2.
this important point in mind: What you management, financial analysts, investors,
see in financial statements reflects the customers, suppliers, and employees. The Assets
underlying transactions of a business and next sections of this chapter describe the The balance sheet assets of a business enter-
how they are measured. To illustrate, one of financial statements. prise are the items that meet the following
the requirements of GAAP is to record all four conditions:
long-term assets at original purchase cost Measuring Wealth: The Balance Sheet 1. Will result in future benefits (cash
less accumulated depreciation from the If you were asked "What is your wealth?" inflows).
purchase date. How well do you think this how would you respond? The first thing to 2. Are estimable in money terms.
rule measures
ties of Marriottthe value of the
International? Allhotel proper- notice is that you can answer the question 3. Are the result of a past transaction.
the hotel only by referring to a specific point in time,
properties of Marriott have market value as in 'What is your wealth right now?" The 4. Are owned by the enterprise.
that likely exceeds their original cost less components of wealth are assets and liabili- First, all assets must be able to generate
accumulated depreciation. Thus, the hotel ties. Assets represent items that confer future future cash flows. This is a core definition
assets measured under GAP likely under- economic benefits to the owner. Examples of an asset. Second, only assets that can be
state their "true" market values. of assets to an individual are cash, invest- measured are placed on the balance sheet.
ments, car, and house. Liabilities are items
There must be some reference point for
that obligate the owner to provide future measurement. Thus, for example, a busi-
FINANCIAL STATEMENTS
economic benefits to someone else. Exam- ness's good reputation would not be an
The financial statements and their relation-
ship to the objectives of financial ples of liabilities to an individual are accounting assetand
Third, assets because it isarise
liabilities not estimable.
if one side
student loans, credit card balances, auto
accounting can be summarized here with
note, and house mortgage. The wealth of or the other to a transaction performs its
the objective in bold followed by the appro- side of the agreement. This is termed a par-
priate statement: an entity can be measured as follows:
tially executed agreement, which iS how a
Measuring wealth--balance sheet. Assets Liabilities = Net wealth
past transaction is defined. For example, if I
Measuring change in wealth-income As with an individual, the financial condi- agree to paint your house and you agree to
statement. tion of a business at a point in time is pay me, this is just a mutual promise. In
snapshot of its wealth. Thus, businesses also a such a case, there are no accounting assets
Measuring change in cash--statement
have assets and liabilities. In addition, a or liabilities because there is no partial exe-
of cash flows.
business has claims by owners. The owners cution. On the other hand, if I paint your
Each of the major financial statements can have invested in the business and have house before you pay me, then there is par-
be defined as follows:
right to a portion in the financial success of tial execution. I have performed my side of
Balance sheet. A list of the assets, liabili- the business. We term the claim of the own-
the agreement, and I have an asset--termed
ties, and stockholders' equity as of a as ers stockholders' equity. an account receivable. Lastly, the asset must
specific date, usually at the close of the The wealth of a business is measured at be owned and under control of the enter-
last day of a month or year. a point in time using the balance sheet. As prise to be included as an asset on the
• Income statement. A summary of the we shall see, the balance sheet is the starting balance sheet.
revenue and the expenses for a specific place for all of the financial statements. Assets can be separated into current
period of time, such as month or a year. This is so because the balance sheet mea- assets and fixed assets. Current assets are
Statement of cash flows. A summary of sures wealth, and it is wealth and what those that will be converted into cash with-
the cash receipts and cash payments from happens to wealth that drive our financial in the next year or operating cycle of the
operating, investing, and financing trans- interest. business, whichever is longer. Fixed assets
actions for a specific period of time, such The balance sheet measures the assets, represent benefits that will accrue to the
as a month or year. liabilities, and net worth of a business at : business over a longer-term time horizon.
All financial statements should be identified point in time using the following equation:

by the name of the business, the title of the Assets = Liabilities + Stockholders' equity Cash and Marketable Securities
statement, and the date or period of time. Unlike you or me, a business enterprise has The typical current assets of a business
The data presented in the balance sheet are assets and liabilities for a business purpose. enterprise are cash and marketable securities,
for a specific date. The data presented in the Thus, it should not be surprising to observe accounts receivable, and inventory. The cash
income statement and the statement of cash assets and liabilities on the balance sheet of and marketable securities of a business
flows are for a period of time. a business that may at first appear unfamil- enterprise would be determined much like
Financial statements are used to evaluate iar. Examples of assets of a business they would be for an individual. They rep-
the current financial condition of a business enterprise are cash, accounts receivable, resent the sum total of all cash accounts,
and to predict its future operating results inventory, and property, plant, equipment. checking accounts, and current investments
and cash flows. For example, bank loan Examples of liabilities of a business enter- used by the enterprise for operating needs.
officers use an entity's financial statements prise are accounts payable as well as Management will invest excess cash bal-
in deciding whether to grant it a loan. Once short-term and long-term notes payable. ances into marketable securities, such as

Chapter 8: Financial Reporting: A Users' Perspective 193

 accounts receivable by the allowance for
Exhibit 8.2: Martinez Company- Balance Sheet, December 31, 200X doubtful accounts values the accounts
receivable at the estimated amount of cash
Assets
that the company actually believes will be
Current Assets
realized in the future. The allowance is
Cash and Marketable Securities $120,000
determined from historical experience.
Accounts Receivable (net of allowance
340,000 The accounts receivable balance should
for doubtful accounts)
be carefully managed. If the accounts
Inventory (valued at LIFO) 570,000
Total Current Assets $1,030,000
receivable become too large relative to the
Non-Current Investments 430,000 underlying sales, this might indicate overly
liberal credit terms. The size of the accounts
Property, Plant, and Equipment (net of
$800,000 accumulated depreciation) 3,000,000 receivable can be measured by the average
Total Assets $4,460,000
collection period. This ratio is calculated as
follows:

Liabilities and Stockholders' Equity Average collection period =

Current Liabilities
Sales
Accounts Payable $360,000 365 days ÷ Average accounts receivable/
Short-term Notes Payable 120,000
Total Current Liabilities $480,000 Average accounts receivable is the sum of
Notes Payable 1,500,000 the beginning and ending balance divided
Total Liabilities $1,980,000 by 2. The smaller the accounts receivable
Stockholders' Equity: balance relative to the sales, the shorter the
Preferred Stock 200,000 collection period, and vice versa. The collec-
Common Stock (no par), 50,000 shares tion period should be compared across time
issued and outstanding 1,400,000 for the same firm or across industry com-
Less: Treasury Stock 5,000 shares (160,000) petitors at a particular point in time. To
Retained Earnings 1,040,000 illustrate, Best Buy Co. has an average col-
Total Stockholders' Equity 2,480,000 lection period of only five days. Best Buy
Total Liabilities and Stockholders' Equity $4,460,000 has a small accounts receivable balance rela-
tive to its sales because most of its sales are
done on a cash a or credit card basis. Thus,
stocks and bonds of other companies, or an invoice. A sale has occurred because the the company does not provide credit to cus-
money market funds, in order to capture product has been shipped, yet cash has not tomers (the credit card company pays Best
investment returns. Management must yet been received from Customer Compa- Buy immediately for credit card sales). In
plan cash requirements for future growth, ny. Thus, Selling Company has an account contrast, General Electric Co. has an aver-
operating seasonalities, investment, and receivable from Customer Company repre- age collection period of 25 days. This is so
other operating needs. senting the total sales price of the shipped because General Electric does not sell items
goods. Customer Company processes the to its customers on a cash basis but instead
Accounts Receivable invoice and remits a check to Selling Com- provides credit to customers. GE is collect-
The accounts receivable represent the pany on February 26. At this time the ing its accounts within 25 days, on average,
amount owed to the firm for sales already accounts receivable held by Selling Compa- which would be viewed as acceptable.
made to customers. This needs some expla- ny is eliminated because cash is received The collection period helps manage-
nation. Unlike individuals, firms do not from Customer Company. The time separa- ment maintain the accounts receivable
conduct transactions with other businesses tion between the shipment of the goods balances consistent with its credit policies.
on a cash basis. The reason is fairly straight- (sale) and the collection of the cash gives If the collection period is growing, this can
forward. When you or I purchase rise to accounting accruals. An accrual is indicate a problem with collections, which
something, we can take out checkbook merely an account that connects an co- can result in possible future write-downs.
and pay for it right then. It is our money; nomic event that occurs at one point in Collection periods stretching beyond 60
we can do with it what we wish. Companies time to its cash flow at another point in days would be considered too long for
cannot do this because all employees that time. Thus, accounts receivable represent many industries.
wish to purchase something for the firm an accrual account that links the sale with
cannot be given a checkbook! It is not their the eventual cash receipt. Inventory
money; it is it is the firm's money. Thus, firmsThe accounts receivable balance at a A very important current asset of manufac-
separate the decision to purchase something point in time will be disclosed on the bal- turing and merchandising enterprises is
from the paying for it. This is termed inter- ance sheet, net of the allowance for inventory. Inventory for a retailer or whole-
nal control by separation of duties. doubtful accounts. The allowance for doubt- saler represents purchased goods for resale.
Exhibit 8.3 illustrates the transaction ful accounts represents the estimated For example, the merchandise inventory of
sequence. On February 6 Selling Company amount of the accounts receivable that is Toys 'R' Us would include board games sit-
ships product to Customer Company with expected to be uncollected. Reducing the ting on the shelf for sale. The retailer

194 Part 2: Getting Started in Business

 Property, Plant, and Equipment
Exhibit 8.3: Separation of Economic Event from Cash Flows (Fixed Assets)
The property, plant, and equipment (PPE)
Selling Company Customer Company Calendar include all of the physical assets required to
Time deliver products and services. The property
Sales Ship product with invoice Purchasing Feb. 6 (or land) is valued on the balance sheet at
Department Department original acquisition cost. The balance sheet
value is not adjusted for changes in market
value unless the market value has been
permanently impaired. The plant and
equipment are valued at original acquisi-
Accounts Accounts
Pay invoice with check tion cost less accumulated depreciation.
Receivable Payable
Department Department The accumulated depreciation measures the
Feb. 26
amount of the original acquisition cost that
has been depreciated since the asset was
acquired. Depreciation expense is the
purchases goods from suppliers. These and finished goods inventories required for amount of acquisition cost allocated to a
goods are added to the inventory balances. production. particular period. The most common
When customers purchase the inventory, it How much inventory is enough? The method of depreciation is the straight-line
leaves the firm and is recorded as cost of inventory efficiency is measured by the method, which is determined as
goods sold. The cost of goods sold is an inventory turnover ratio calculated as Annual depreciation expense
income statement item representing the Cost of goods sold Acquisition cost Residual value
cost of sold items matched against the sales Inventory turnover
Average inventory Useful life in Years
revenue. Whatever product is left at the end
of the period is the inventory shown on the The average inventory is the sum of the Exhibit 8. 4 illustrates accumulated depre-
balance sheet of the firm. beginning and ending inventory balance ciation and depreciation expense.
divided by 2. The higher the inventory Depreciation does not attempt to measure
A manufacturer is different than retail-
er or wholesaler. A manufacturer does not turnover number, the more quickly inven- the decline in property and equipment
tory is being turned into sales (which is value. Depreciation only matches the ser-
purchase goods for resale but instead makes
goods for sale. In making goods for sale, a favorable). The inventory turnover ratio vice benefits of plant and equipment to

manufacturer uses three inventory cate- can be compared for a single company over accounting periods that benefit from those
time to identify inventory turnover trends assets. The property, plant, and equipment
gories: materials, work in process, and
or with other companies in an industry to are shown on the balance sheet at net book
finished goods. These inventory categories
are defined as follows: compare a company with competitors. Dif- value. Net book value (or net fixed assets) is
ferent industries will have very different the difference between acquisition cost
• Materials inventory. These are the costs
inventory turnover ratios. For example, and accumulated depreciation at a point
of materials that have not yet entered the
manufacturing process. For example,
McDonald's will have a much higher inven- in time.
tory turnover (40 turns) than will Zale's The efficiency of property, plant, and
purchased steel for an automobile manu-
Jewelers (1.53 turns) because food products equipment can be evaluated by measuring
facturer would be included in materials
inventory.
are more perishable than diamonds. the sales earned per dollar of fixed assets
(property, plant, and equipment). This is
Work in process inventory. These are the Noncurrent Investments termed the fixed asset turnover ratio and is
manufacturing costs associated with prod- Noncurrent assets are those that are held and calculated as
ucts that have not completed production. provide benefits longer than a year. The
The cost of the incomplete cars in the fac- most common noncurrent assets are non- Sales
Fixed asset turnover =
tory would be work in process inventory Fixed assets
current investments and property, plant,
for an automobile manufacturer. and equipment. Noncurrent investments
The higher this ratio, the more efficient are
Finished goods inventory. These are the include sinking funds and minority invest- the fixed assets of the business. In a sense,
accumulated manufacturing costs associ- this measure provides insight as to how well
ments in subsidiary companies. A sinking
ated with the completed products that fund is an investment used to repay bor- a company uses its fixed capacity. For exam-
have not been sold. For example, the total rowed funds. Often sinking funds require ple, a hotel experiencing only 60 percent
manufactured cost of completed cars that periodic contributions until the fund is occupancy (i.e., 60 percent of the room
have not been shipped to dealers would large enough to retire debt. Investments are nights are occupied by guests) will have a
be used to value the finished goods inven- made in subsidiary companies for the pur-
poorer fixed asset turnover than similar
tory of an automobile manufacturer. pose of developing business relationships.
hotel with 85 percent occupancy.
Many manufacturers are using just-in-time For example, Ford Motor Company has
principles in order to improve their manu- minority investment in Mazda Motors of Liabilities
facturing operations. One of the results of Japan. This investment provides Ford an The liabilities of business enterprise
these efforts is to dramatically reduce the opportunity to participate in and learn are the items that meet the following four
amount of raw material, work in process, about the Japanese automobile market. conditions:

Chapter 8: Financial Reporting: A Users' Perspective 195

 ties, called a current ratio, for several
Exhibit 8.4: Annual Depreciation Expense and Accumulated Depreciation, retailers:
$5,000 Asset Depreciated (Straight Line) over Five Years Wal-Mart, 0.92
Accumulated Depreciation Kmart, 2.00
$
JCPenney, 1.71
Sears, 1.82
$5,000 Toys 'R' Us, 1.24
Amazon.com, 1.40
$4,000
As you can see, there is wide variation in the
current ratio across the various retailers. A
$3,000 closer examination of the financial state-
ments helps the reader interpret the ratios.
$2,000 For example, Wal-Mart had an unusually
large debt installment payment due within
Annual Depreciation Expense
the next year, which increased current liabil-
$1,000
ities and brought its current ratio below 1.0.

2 3 Year Long-Term Liabilities

Life of Machinery Organizations may acquire funds through
long-term borrowings, such as mortgages,
bonds, and bank notes. These instruments
1. Will result in future sacrifices (cash out- The balance of the accounts payable repre- require the company to repay a fixed
flows). sents the total amount owed to suppliers at amount of principal at some date in the
2. Are estimable in money terms. a point in time. Cash is remitted to satisfy future. In addition, the company is obligat-
3. Are results of a past transaction. accounts payable within the time terms of ed to pay a contracted return on the debt.
the supplier (generally within a month). This contracted return, termed interest
4. Are owned by the enterprise.
Accrued expenses payable are amounts of expense, is accrued and paid over the time
The liabilities of a business enterprise are cash owed various suppliers for services period that the debt is outstanding. Gener-
defined much like the assets except that lia- received but not yet paid. An example ally, the outstanding debt is paid back in
bilities represent future cash outflows. The would be utilities expense for power con- installments, much like a home mortgage or
liabilities of a business enterprise are used to sumed but not yet paid. At the end of the auto note. The notes to the financial state-
finance operations much like an auto loan month, when financial statements are pre- ments will provide detailed information
is used to finance the purchase of an auto- pared, the monthly power bill may not yet about the amount, terms, and interest rates
mobile. Companies use liabilities to provide have been paid, yet a month's worth of of outstanding debt. From a financial man-
money to acquire assets, such as inventory power has been consumed. The accrued agement perspective, the firm should refund
and property, plant, and equipment. Liabil- utilities payable will be satisfied when the high interest cost debt as market interest
ities, like assets, are divided into current company receives and pays the power bill rates fall. Management uses the money
and noncurrent categories. during the beginning of the next month. from long-term debt to make investments
Current liabilities are obligations that are
Other accrued expenses payable are related that will provide a return that exceeds the
expected to be paid within the next year or to wages, advertising, rentals, interest, and interest expense. When the investment
operating cycle, whichever is longer. The contract billings. return exceeds the cost of the debt, this is
most common current liabilities are Noncurrent notes payable are the termed positive financial leverage.
accounts payable, accrued expenses, and short- amounts of cash owed to bank for a short- A company must be careful not to be
term notes payable. term loan. Often banks provide companies overly indebted. As with individuals, too
short-term loans to meet the cash needs much debt can cause interest and principal
Current Liabilities within the operating cycle. For example, a payments to become too burdensome. One
Accounts payable are generated from pur- toy manufacturer may a need a short-term measure of debt load is the ratio of total lia- is
chases made on credit. To illustrate, a credit loan to manufacture toys for the Christmas bilities to total assets. The following are
card balance is an accounts payable for an season. After the season when the revenues some companies and the ratio of total lia-
individual. As discussed in the accounts are collected, the bank loan can be paid. bilities to total assets for each:
receivable section, when businesses conduct A rule of thumb for many companies is Adolph Coors, 43%
transactions with each other, it is usually on that the current assets should at least be Sprint Corp, 66%
a credit basis. When a company sells on maintained at 150 percent of the level of
Procter & Gamble, 64%
credit, an account receivable is established the is current liabilities. This ensures that
by the selling company for the purchase there are sufficient funds on hand to meet American Airlines, 72%
price, while a complementary account current obligations when they come due. eBay, 12%
payable is established on the purchasing To illustrate, the following shows the ratio As you can see, it is not uncommon for the
company's books for the purchase price. of current assets divided by current liabili- total debt to exceed 50 percent of total assets.

196 Part 2: Getting Started in Business

 In some capital-intensive industries, such as Retained Earnings
airlines, the ratio can be much higher. Retained earnings are the earnings of the firm Exhibit 8.5: Martinez Company
that have been reinvested since the firm's Retained Earnings
Stockholders' Equity inception. The income of profitable firm Balance
The stockholders' equity section of the balance can be either reinvested into the business or Retained earnings,
sheet measures the owners' claims on the paid out as a dividend to the stockholders. beginning of period $ 840,000
assets of the firm. The common elements of The earnings that have been reinvested into Net income for
this section are common stock, preferred stock, the assets of the firm are added to the the period 200,000
treasury stock, and retained earnings. retained earnings to reflect the amount of
Less: dividends
capital retained by the firm. Likewise, if the for the period 0
Common Stock company experiences losses, the retained
Retained earnings,
earnings will go down by the amount of the end of period
The common stock of the firm represents $1,040,000
loss. Thus, the balance sheet stays in balance
the stockholders' original investment in the
because the increase in net assets from earn-
firm. For Martinez Company, common
ings retained by the business is "balanced" by
stockholders have invested $1,400,000 into
the Retained Earnings account. es of the business exceed the revenue, the
the firm. This investment could have been
It is not unusual for the retained earn- excess is a net loss. For this reason the
an original investment to start the firm or
ings balance for a young company to be income statement is sometimes referred to
several investments over a period of time.
negative because there have only been loss- as a profit and loss statement, or P&L. It is
The average price paid by investors was $28
es. As the company matures and is able to impractical to determine the exact amount
per share ($1,400,000 ÷ 50,000 common
earn profits, the retained earnings will of expense for each revenue transaction.
shares). It should be pointed out that the
Therefore, the net income or the net loss is
common stock amount shown on the bal- begin to become positive.
See Exhibit 8.5 for the calculation of reported for a period of time, such as a
ance sheet iS not the market value of the
the end-of-period retained earnings balance month or a year, rather than for each rev-
firm as determined by the stock price on a
for Martinez Company. enue transaction.
stock exchange. The market value of the
The retained earnings are in the stock- The net income (or net loss) is deter-
firm is not reflected on the balance sheet.
holders' equity section of the balance sheet mined using a matching process involving
1t because it represents the owners' increase in two steps. First, revenue is recorded during
Preferred Stock the book value of the firm after dividends. the period. Second, expenses used in gener-
Companies will often issue a class of stock The retained earnings should not be con- ating the revenue are matched against the
that has a preference right over the com- sidered as a "pool of cash" or a "rainy day revenue to determine the net income or the
mon shareholders. This type of stock is fund." Retained earnings are no such thing. net loss. Generally, the revenue for provid-
termed a preferred stock. Preference rights The retained earnings have already been ing a service is recorded after the service has
include preference to dividends. This reinvested in the firm and represent the been provided to the customer. The expens-
means that the preferred stockholders will increase in the net assets of the firm since its es incurred in generating revenue during a
receive a dividend before the common inception. period are then recorded and are thus
stockholders. However, this dividend is matched against the revenue.
usually stated as a fixed percent of original The net income is an important indica-
selling price, or par value, of the stock. Measuring Changes in Wealth: tor of a firm's financial performance for a
Thus, for example, 9 percent preferred The Income Statement period of time. Often the net income is

dividend
stock thatofa $9
hasper share.par value will pay a The
a $100 incomefor
in wealth statement measures the
the organization change
over an expressed as aequity
stockholders' percentage of to
in order total
aidassets or
compar-
accounting period. The two major compo- isons across firms. For example, the net

Treasury Stock income as a percent of total assets and

nents of the income statement are revenues
Treasury stock represents common stock that and expenses. Revenues represent increases stockholders' equity is shown in Exhibit
has been repurchased by the firm. The firm in wealth from providing goods and ser- 8.6 for Wal-Mart and Kmart.
cannot be considered an owner in itself; vices. The corresponding increase in wealth
thus, it is inappropriate to disclose the trea- is shown on the balance sheet as increases in
sury stock as an asset. Instead, the treasury assets (e.g., cash or accounts receivable) or
Exhibit 8.6: Net Income Informa-
1S stock is more like common stock that has reductions of liabilities. Expenses represent
tion for Wal-Mart
been temporarily retired from the stock reductions in wealth from using goods and
and Kmart
market. For Martinez, the treasury stock services provided by others. The corre-
was repurchased at an average price of $32 sponding decrease in wealth is shown on Wal-Mart Kmart
per share ($160,000 5,000 shares). The the balance sheet as reductions in assets Net income as a
treasury stock is disclosed as a reduction in (e.g., cash) or increases in liabilities (e.g., percent of total assets 8% 2.7%
stockholders' equity. The treasury stock accounts payable). Net income as a
may be reissued to the market at a later date The excess of the revenue over the percent of
or granted to senior executives as part of the expenses incurred in earning the revenue is
stockholders' equity 20% 6.4%
executive stock option plans. called net income or net profit. If the expens-

Chapter 8: Financial Reporting: A Users' Perspective 197

fi
Exhibit 8.7: Martinez Company Exhibit 8.8: Inventory Relationships for a Manufacturer
Income Statement for
the Year Ended 200X Raw Materials

Sales $6,200,000
Beginning Inventory
Cost of Goods Sold 3,600,000 Raw Materials
Gross Profit $2,600,000
Plus: Raw Material
Sales, General, and Purchases Work in Process
Administrative
Expenses 2,000,000 Less: Ending Inventory
Raw Materials Beginning Inventory
Operating Profit $ 600,000 Work in Process
Other Income and Raw Materials Raw Materials
Expenses (250,000) Used in Production Used in Production
Income before Taxes $ 350,000
Plus: Production Costs
Income Taxes 150,000 (direct labor
Finished Goods
Net Income $ 200,000 and overhead)
Less: Ending Inventory Beginning Inventory
Earnings per share Work in Process Finished Goods
($200,000/50,000 shares) $4.00
Cost of Goods Cost of Goods
Manufactured Manufactured

Less: Ending Inventory

As you can see, Wal-Mart's nancial per- Finished Goods
formance was much better than Kmart's.
Wal-Mart stockholders are receiving a rate Cost of Goods Sold
of return nearly 20 percent on their invest-
ment, while Kmart stockholders are
receiving only a little more than 6 percent
return on their investment. Cost of Goods Sold overhead, in order to build product. The
The income statement for Martinez forThe cost of goods sold for a manufacturer is the inventory of partially completed product is
the year ended 200X is shown in Exhibit accumulated cost to make a product for sale. termed work in process inventory. The cost of
8.7. Unlike the balance sheet, which These costs include the direct materials, goods manufactured during a period is the
shows the financial position of a firm at direct labor, and factory overhead. Direct sum of all production and material cost
point in time, the income statement materials are the materials used to make inputs, plus the beginning work in process
shows the results of operations for a product. For example, electrical components inventory, less the ending work in process
period of time, such as for a quarter or for would be direct materials for a personal com- inventory. The cost of goods manufactured
a year. Martinez Company earned puter. Direct labor refers to the employee is added to the finished goods inventory.
$200,000 in net income during the peri- costs associated with fabricating and assem- The cost of goods sold during the period is
od, which is the change in net assets for bling products. For example, the assembly the beginning finished goods inventory, plus
the period. wages would be direct labor for a personal the cost of goods manufactured, less the
computer. Factory overhead, sometimes ending finished goods inventory, to yield
Revenues (Sales) termed burden, represents all remaining costs the cost of goods sold.
Revenues are earned by firm for providing incurred in production that are not direct The difference between the revenues
goods and services to customers. Often the materials or labor. Examples of factory over- and the cost of goods sold is termed the
terms revenues and sales are used inter- head include power, plant manager salaries, gross margin (or gross profit). The gross mar-
changeably. For example, if a firm sold maintenance, and factory depreciation. The gin ratio, which is gross margin divided by
$3,000 worth of goods to customer, the direct labor, direct materials, and factory sales, can be used to compare companies in
revenues would increase by $3,000 as overhead are frequently termed product costs an industry. Companies with a high gross a
would the cash (or accounts receivable) on since they are costs directly associated with margin ratio compared to the industry
the balance sheet. The amount of revenue is producing the product. either control their costs or price their
determined by multiplying the quantity of Exhibit 8.8 illustrates the inventory rela- products better than the competition.
goods and services sold by the price charged tionships in a manufacturer. A manufacturer
the customer. The revenue is accumulated must purchase the raw materials for produc- Sales, General, and
in the revenue account until the end of the tion. The beginning raw material inventory Administrative Expenses
accounting period. At the end of the plus current period purchases, less the end- The sales, general, and administrative ex-
accounting period, all of the income state- ing inventory, yield the raw material placed penses (SG&A expenses) are the costs of
ment accounts, including the revenue into production. The raw materials placed nonmanufacturing services purchased by a
account, are "zeroed out" in order to begin in in production are added with other pro- firm. Examples of SG&A costs include
a new period. duction inputs, direct labor and factory advertising, research and development

198 Part 2: Getting Started in Business

 Operating Activities
fi
Exhibit 8.9: Dell Computer and Apple Computer Operating Pro t Information The cash flow from operating activities rep-
resents the amount of cash generated from
Dell Computer Apple Computer
(All numbers in thousands, except the ratios) providing goods and services to customers.
Consolidated net sales $7,983,000
This amount is determined by subtracting
$31,888,000
cash disbursed for operating activities from
Cost of sales $25,445,000 $5,817,000
Gross margin $2,166,000 cash received from operations. The major
$6,443,000
SG&A expenses $3,780,000 $1,644,000 sources of cash from operations are, of
Operating profit $2,663,000 $ 522,000 course, sales. Notice that the $6,200,000
Gross margin ratio 20.2% 27.1% sales amount shown on the income state-
ment is also the amount received in cash
Operating profit ratio 8.3% 6.5%
shown on the statement of cash flows.
Although these two numbers are equal in
(R&D), shipping, office depreciation, line as other income and expenses. Gains this example, this will often not be the case
office salaries, sales office, and sales force and losses for disposing of assets are deter- for most companies. This is so because sales
expenses. SG&A expenses are frequently mined by comparing the proceeds upon sale are recorded on the income statement when
termed period costs since they are incurred with the book value of the assets. The book goods are shipped. However, cash is collect-
in and benefit a particular accounting peri- value is the original cost of the asset less ed at a later point in time. Recording sales in
od. Some SG&A expenses, such as R&D, accumulated depreciation. Thus, if an asset this way, termed accrual accounting, causes
may actually benefit more than one period; that originally cost $10,000 with $4,000 of timing difference between sales recognition
however, accounting practices require that accumulated depreciation was sold for (on the income statement) and cash collec-
they are expensed in the period incurred $8,000, a $2,000 ($8,000 - $6,000) gain tion (on the statement of cash flows).
rather than deferred and matched with would be recognized as "other income." Cash is disbursed for operations to sup-
future periods benefited. port items related to production, selling,
The difference between the gross margin Income Taxes administrative, and taxes during the period.
and the SG&A expenses is termed the oper- The federal tax code requires most corpora- Each of these items corresponds to operat-
ating profit. Analysts will often evaluate a tions to pay income taxes on their earnings. ing expenses on the income statement. The
company's performance using the operating The tax is calculated using tax methods, cash disbursed for production is related to
profit ratio, which is the operating profit which frequently differ from financial cost of goods sold. The cost of goods sold
divided by the sales. To illustrate, consider reporting approaches. The statutory rate means the costs matched against sales.
the gross margin and operating profit ratios can reach as high as 45 percent of earnings. However, the cash associated with produc-
of Dell Computer and Apple Computer A company that a has a loss may elect to ing the products may have occurred in
companies for a recent year (see Exhibit 8.9). carry the loss forward to years in which pos- prior periods. Thus, the cash outflow for
The gross margin ratio of Apple Com- itive earnings occur. In this way, the loss production will often not be equal to the
puter is 27.1 percent, while that of Dell can offset earnings in future periods and cost of goods sold in any one period. If
Computer is only 20.2 percent. Note, how- reduce the amount of taxes owed in those inventories are building up, the cash out-
ever, that the operating profit ratio for Dell years. The net effect is to provide a tax ben- flow for production will exceed cost of
Computer is actually higher than Apple's efit from years with losses to years in which goods sold. If the inventories are being
ratio. Dell Computer has smaller selling there are positive earnings. depleted, the cash outflow for production
and R&D expenses; thus, it is able to oper- will be less than the cost of goods sold.
ate profitably on smaller gross profit The cash disbursed for advertising, sales
margins. Apple Computer, on the other Measuring Changes in Liquidity: expenses, and R&D is related to the sales,
hand, invests much more in selling and The Statement of Cash Flows general, and administrative expenses.
R&D; thus, it must sell its computers at The last major financial statement is the Notice that the total of these amounts,
higher gross profit margins in order to statement of cash flows. The statement of $2,000,000, is equal to the total sales, gen-
remain profitable. Even so, Apple is not cash flows explains the change in a firm's eral, and administrative expenses in the
able to sell its computers at a price high a balance sheet cash balance from the begin- income statement. The cash disbursed for
enough to generate operating profit as a ning of the period to the end of the period. interest is related to other income and
percent of sales equal to that of Dell. Thus, the statement of cash flows shows expenses, and the cash disbursed for taxes 1S
how a firm acquires and uses cash during an related to the tax expense. Again, the cash
Other Income and Expenses operating year. So, like the income state- disbursement numbers may not necessarily
The other income and expenses include ment, the statement of cash flows provides be identical to the corresponding income
gains and losses from the disposition of disclosure for period of time rather than statement expense numbers due to accrual
assets and interest income and expenses. at a point in time. The statement of cash accounting. Additionally, depreciation
Some companies may also include income flows is divided into three sections: operat- expense is a noncash expense on the income
and expenses that are incidental to the prin- ing activities, investing activities, and statement and should not be included on
cipal line of business. For example, licensing financing activities. An example of the cash the statement of cash flows. For this reason
income, fines, and litigation gains or losses flow from operations for Martinez Compa- the cash flow from operations is frequently
may be disclosed below the operating profit ny is shown in Exhibit 8.10. greater that the net income for most firms.

Chapter 8: Financial Reporting: A Users' Perspective 199

 notes payable, which required a use of
Exhibit 8.10: Martinez Company Statement of Cash Flows for Year Ended 200X $900,000 cash, and issued new notes for
$130,000
$600,000, which provided cash of
Cash Balance, Beginning of period
$600,000. Why would Martinez retire a
Operating Activities note only to turn around and reissue anoth-
Receipts from operating activities: er note to the bank? One likely reason
Sales $6,200,000 would be to refinance a loan at a lower
Interest and other income 50,000 interest rate.
Total cash receipts from In addition, Martinez engaged in some
operating activities $6,250,000 transactions with its stockholders. Martinez
Disbursements for operating activities received $100,000 in cash from issuing new
Production 3,300,000 stock to owners and used $160,000 in cash to
Advertising 700,000 repurchase common stock for the treasury.
Sales expenses 900,000
Research and development 400,000
Interest 300,000 SUMMARY
Taxes 150,000 In this chapter, we have introduced the basic
Total disbursements for operating activities 5,750,000 financial reporting environment and finan-
Cash flow from operations 500,000 cial statements used by public companies.
Exhibit 8.11 provides a summary of the
Investing Activities
financial statement relationships. To review,
Purchase of plant capacity (270,000)
the balance sheet measures the wealth (net
Sale of subsidiary investment 120,000 assets) of an enterprise at a point in time.
Cash flow from investing activities (150,000)
The income statement explains how wealth
Financing Activities changed over a period of time between two
Issue note payable to bank 600,000 balance sheet dates. Thus, the income state-
Retire note payable to bank (900,000) ment measures the operating performance
Sell stock to owners 100,000 of a firm for a period of time. The statement
Purchase treasury shares (160,000) of cash flows provides information about
Cash flow from financing activities (360,000) the sources and uses of cash over period of
Change in cash flow (10,000) time. The statement of cash flows provides a
Cash Balance, End of period $120,000 complete explanation for the change in the
cash balance between two balance sheet
dates. Thus, all three statements are said to
Investing Activities stockholders' equity are a use of cash articulate: All three statements are linked
The investing activities of a firm originate because the firm must use cash to retire together.
from the changes in noncurrent assets that debt or repurchase stock, as treasury stock, Managers often need to read financial
occur over the period. Increases in noncur- from the market. Martinez had a number of information from financial statements. As
rent assets are a use (disbursement) of cash, financing transactions. you play Marketplace, you should be able to
while decreases are a source (receipt) of cash. Martinez had both a receipt and dis- learn how financial statements reflect the
For Martinez in Exhibit 8.10 there were two bursement in cash from long-term notes business events of organizations.
noncurrent asset transactions. Martinez payable transactions with the bank. In
used cash to increase plant capacity, which Exhibit 8.10, Martinez retired $900,000 of
increases the noncurrent asset, plant and
equipment. Martinez received cash through
the sale of a long-term investment in a sub-
sidiary. The cash received from this sale is Exhibit 8.11: Articulation between Financial Statements
shown as a positive cash flow from investing
activities. On Martinez's balance sheet, the Change in Wealth
subsidiary investment would be reduced to Income Statement
the present balance of $430,000.

Financing Activities Balance Sheet Balance Sheet

The financing activities of a firm originate period t period t + 1

from changes in long-term liabilities and

stockholders' equity over the period.
Change in Liquidity
Increases in long-term liabilities or stock-
Statement of Cash Flows
holders' equity are a source of cash. Issuing
bonds or stock results in cash inflows to the
firm. Decreases in long-term liabilities or

200 Part 2: Getting Started in Business