Session 1 Definitions and Elements of Financial StatementsYou will need to learn these underlined terms for the midterm!I.Income statement–“video” of revenues, expenses, gains, losses over aperiod of timea.Basic definitions:Revenue–increase in equity (and associated increase in assets and/ordecrease in liabilities) earned from the sale of goods or provision of servicesto customers; it is measured on a gross basis as the amount of assets to bereceived.Expense– decrease in equity (and associated decrease in assets and/orincrease in liabilities) created by sale of goods, rendering of services orpassage of time; it is measured on a gross basis as the amount of assetsconsumed.Gain – increase in equity resulting from selling assets or recognizing theincrease in value of assets (or decrease in value of liabilities); it is measuredon a net basis as the positive difference between current value and amountrecorded on the balance sheet.Loss – decrease in equity resulting from selling assets or decrease in valueof assets (or increase in value of liabilities); it is measured on a net basis asthe negative difference between current value and amount recorded on thebalance sheet.Accounting period - the time period between consecutive balance sheets forwhich a firm prepares an income statement and statement of cash flows(e.g., an annual report has a 12-month accounting period and a quarterlystatement has a 3-month accounting period).b.Elements:Sales - revenue from selling goods or providing services to customers,which is reported as the top line on the income statement.Cost of Goods Sold or Cost of Sales labor, material, and overhead costsdirectly related to providing goods or services.Gross Profit is the difference between Sales Revenue and Cost of GoodsSold, which represents the profit that is available to cover all of the otherexpenses on the income statement.Operating Expenses are expenses related to the ordinary operatingactivities of the firm of providing goods or services to customers or gainsand losses related to operating assets like PPE.Operating Profit or Income equals gross profit minus operating expenses.Other Nonoperating Revenue and Expense are items related toFINANCING activities (i.e., interest expense) and INVESTING activities(i.e., interest income and gains and losses on investments).Income Before Tax equals operating profit minus other income andexpense.Tax expense equals a GAAP based measure of the government charges onincome.Net Income equals income before tax minus tax expense.c.Income statement accounts are called TEMPORARY ACCOUNTSbecause amounts accumulate for a defined period of time and are thenzeroed out when the balance is transferred to retained earnings.Annual income statement amounts represent the total revenues orexpenses for a 12 month period called the fiscal year.II.Balance sheet–“snapshot”of assets, liabilities, stockholders’ equity at a point in timea.Basic DefinitionsOperating cycle - average time it takes to go from cash to goods andservices sold to customers and then back to cash collected from customers.b.Elements:Asset: resource the firm controls because of a past transaction or event thatprovides expected future benefits.Current asset: asset a firm expects to convert to cash, sell, orconsume within the longer of one year or an operating cycle.Noncurrent asset: asset not classified as current.Liability: creditor’s claims or obligation that represents a probablefuture economic sacrifice of assets or services based on a past transaction orevent.Current liability: obligation a firm expects to pay within thelonger of one year or an operating cycle.Noncurrent liability: liability not classified as current.Shareholders’ equity: measure of financing provided by owners of the firm that captures owners’residual claim on assets of the firm after satisfying liabilities.Retained earnings: cumulative net income minus dividends overthe life of the firm.Retained earnings are a source of financing. When earnings exceedthe dividends paid out to shareholders, it increases equity or theowner’s claim on the firm.There is NOT a corresponding “cash fund” in the asset section equalto the balance in retained earnings. Changes in retained earnings area function of net income and dividends declared, which may or maynot correspond to changes in cash.Dividends: distribution of cash to the owners of the firm.c.Balance sheet accounts are called PERMANENT ACCOUNTS becausethe amounts accumulate year after year. The ending balance from the previous year becomes the beginning balance for the next year.For example, ending cash amount in 2011 will be the beginning cash amount in 2014, that is then adjusted for 2014 inflows and outflows to determine the 2014 cash amount.d.Basic accounting equation:ASSETS = LIABILITIES + STOCKHOLDERS' EQUITYThe powerful implication is investments in assets can be financed witheither DEBT or EQUITY!Assets are resources and liabilities and equity represent the claims on thoseresources.III.Statement of Retained Earnings (included in Statement of Shareholders’ Equity) presents a“video” of the change in retained earnings from net income and dividends during the period.IV.Statement of Cash Flows–“video” of the sources and uses of cash over a period of time that explains the change in the cash balance on the balance sheet.a.Operating – core operations and items related to measurement of net incomeb.Investing- firms INVEST in assets so includes asset transactions:i.buy and sell property plant and equipmentii.buy and sell investmentsc.Financing - firms FINANCE with debt and equity so includes debt andequity transactionsi.borrow and pay back nonoperating debtii.issue and repurchase stockiii.pay dividendsd.Format+Net Operating Cash Flow+ Net Investing Cash Flow+ Net Financing Cash Flow= Change in Cash for the PeriodBeginning Cash from Last Year+/- Change in Cash for the Period= Ending Cash for This YearBalance Sheet Account Name DefinitionsAn account accumulates the increases and decreases that occur for a single item. GAAP does not provide an all-inclusive list of acceptable account names so their usagevaries by firm.Separate accounts are reported if they are “material” or crucial to understanding firm performance. For example, some firms divide interest revenue and interest expense into separate accounts while other firms combine them into one net account.You will receive credit in exams as long as the name is potentially used in practice and accurately describes and correctly classifies an account as asset, liability, or shareholders’equity. It is acceptable, but not required, to use more specific account names like prepaid rent for prepaid expense.The following list of account names are commonly used.Assets:Cash – currency or balances in checking accounts, CDs, or money market accounts available to meet current obligations. Highly liquid short-term investments with less than90 days to maturity and little risk of value changes are called "cash equivalents" and included in the cash account.Short-term investment or marketable securities –current value of investments in another firm’s debt or equity securities that can be quickly sold for cash.Accounts receivable – amount due from customers for goods and services already delivered. Gross accounts receivable is the amount owed. Net accounts receivable is the amount expected to be collected after subtracting an allowance for uncollectible accounts.Notes receivable – amount to be received from an outside entity formalized with a note or lending agreement that specifies interest and payment terms.Inventory – raw materials, work in process (products started but not finished), and finished goods available for sale to customers.Prepaid expenses –asset recognized when cash paid in advance of when futureexpenses will be incurred.Long-term investments–investments in bonds or equity securities expected to be held for the long-term.Property, plant, and equipment (gross) – original cost to obtain and put into service buildings, land, and equipment.Accumulated depreciation – a contra or offsetting account with the cumulative amount of the cost of property, plant and equipment assigned to depreciation expense.Property, plant and equipment (net) –original cost minus accumulated depreciation.Intangible assets – items like patents and copyrights that provide future benefit but do not have physical substance. Intangible assets are only recognized when they are purchased from an outside source. For example, if a firm purchases a patent from another company the cost is shown as an asset. However, if a firm does research that results in a patent, those research costs are included in R&D expense and an asset is only recognized for the legal and registration fees to obtain the patent.Goodwill – purchase price of an acquired company minus the market value of the identifiable assets minus liabilities of that company. The market values of both tangible and intangible assets are considered in the calculation of identifiable assets. Goodwill is ONLY recognized when one company purchases another company at a premium for things like future potential, market power, and quality of workforce that are not considered “i dentifiable assets.”Liabilities:Accounts payable – amount owed to suppliers for inventory or other goods or services purchased on credit.Other payables or accrued expenses– amounts owed for expenses that have already been recognized like interest, taxes, salaries, and rent.Short-term loans payable or notes payable–obligations formalized with a note or lending agreement that specify interest and payment terms and are due within the next year.Current maturities of long-term debt- the portion of long-term debt expected to be paid within the next year.Unearned revenue or advances from customer–liability incurred because cash was received from customers in advance of when revenue is earned so the firm has an obligation to deliver goods or services to the customer.Long-term debt (Notes, Loans Bonds, or Mortgage Payable) –obligations formalized witha note or lending agreement expected to be paid more than 1 year later.Shareholders’ Equity:Common stock at par –par or stated value of total stock issued over the life of the firm. Common stock has voting rights. Note that par value has legal significance but no real economic significance. For example, in some legal jurisdictions par value can play a role in distributions to stockholders in the case of liquidation. However, par value does not relate to the market value of the stock. Some legal jurisdictions, including Texas, allow no par value stock.Additional paid in capital - total amount of cash received above par value when the stock was issued, aggregated over the life of the firm. Note that some firms include the par value and additional paid in capital in one “common stock” account. Also, note that additional paid in capital is reduced for certain stock option and treasury stock transactions.Example: Issue 10,000 shares of $1 par value common stock for $5 pershare. The shareholders' equity section will appear asfollows: Common stock at par $10,000Additional paid in capital $40,000Preferred stock - amount of cash the firm received for stock giving the holder a preference relative to common shareholders in terms of dividends and cash received if the firm is liquidated.Treasury stock - repurchase price of stock that was issued and then repurchased by the firm and held internally. Notice that treasury stock reduces shareholders’equity because it reduces the equity claimed by OUTSIDE shareholders.Retained earnings – cumulative net income minus dividends over the life of the firm.Accumulated Other Comprehensive Income - gains and losses that bypass the income statement and flow directly to the shareholders’ equity, accumulated over the life of the firm.Income Statement Account Name DefinitionsRevenueInterest income– interest earned on debt investments.ExpensesCost of goods sold or cost of sales revenue– labor, material and overhead costs directly related to providing goods and services. It is recognized only for the goods or services delivered during the period. For example, a manufacturing firm includes manufacturing salaries and depreciation on manufacturing equipment in the inventory account and then in cost of goods sold when the inventory is sold to customers.Assume TI has 20 inventory items available for sale that cost $1000 each, and they sell 5 of these items for $1600 each. The income statement would show sales revenue of $8,000 (5 * $1,600) and cost of goods sold of $5,000 (5 * $1,000). It is not appropriate to show revenues minus cost of goods sold as one net amount on the income statement. With this example, the inventory asset account on the balance sheet contain $15,000 (15 * $1,000).Now assume, you know that beginning inventory is $12,000, purchases were $8,000, and ending inventory is $15,000. Calculate Cost of Goods Sold with the following equation: Beginning Inventory 12,000+ Purchases +8,000= Cost of Goods Available for Sale $20,000- Ending Inventory -$15,000= Cost of Goods Sold =$5,000Depreciation expense– cost of PPE allocated to expense during the current period.Wage or salary expense– amount of wages employees have earned during the period.Rent expense– amount of rent incurred during the period.Advertising expense– amount of advertising costs incurred during the period.Interest expense–cost incurred during the period for money borrowed.Insurance expense– amount of insurance used during the period.Tax expense– federal, state, and local taxes measured on income.Selling, general, and administrative expense– all costs to sell and manage a firm (includes sales and management salaries and depreciation related to headquarters building).Research and development–all costs to create and develop new products (includes R&D salaries and depreciation on research facilities and equipment).。