Financial Statements(Quick Test #4 with Coaching)

To comply with the reporting requirements of the U.S. Securities and Exchange Commission (SEC) and U.S. generally accepted accounting principles (US GAAP), the following financial statements of corporations with publicly traded shares of stock must present the amounts for each of the most recent 3 years:

• Income statement
• Statement of comprehensive income
• Statement of cash flows
• Statement of stockholders’ equity

The balance sheet must present the amounts at the final moment of the most recent 2 years.

The amount spent on capital expenditures during each accounting year is reported in the investing activities section of the statement of cash flows (SCF). The amount of the capital expenditures (often referred to as capex) is shown in parentheses to indicate it is an outflow of cash or that it has a negative effect on the company’s cash.

To optimize its cash flows (by delaying some cash outflows for income taxes until a later year), a profitable corporation will use accelerated depreciation expense (150% declining balance, 200% declining balance, sum of the years' digits, etc.) on its U.S. income tax return. This is allowed even though the corporation uses the straight-line depreciation expense on its external financial statements.

Having greater depreciation expense in the early years of an asset's life and less depreciation expense in the later years means lower taxable income and lower income tax payments in the early years and higher tax payments in later years.

This delay in the tax payments is valuable because of the time value of money where current dollars are more valuable than future dollars.

A comparative financial statement is one that shows multiple columns of amounts. For example, a comparative income statement will present the amounts for the most recent accounting year plus the amounts for the two previous years. The following image shows a comparative income statement:

Corporations with publicly traded shares of stock are required to present three columns of amounts for these financial statements:

• Income statement
• Statement of comprehensive income
• Statement of cash flows
• Statement of stockholders' equity

The reporting requirement for the balance sheet is to present two columns of amounts. The amounts are the balances as of the final moment of the most recent two years.

Consolidated financial statements are required when a corporation owns/controls several legal entities. For example, RSTCorp whose stock is publicly traded owns/controls three additional corporations. RSTCorp is referred to as the parent company and the other three corporations are referred to as subsidiaries. The combination or group of the four corporations is referred to as the economic entity.

It is typical for the parent company to buy, use or sell some of the products from its subsidiaries. In addition, each subsidiary often buys, uses, or sells products from the other subsidiaries and the parent company. These transactions are referred to as intercompany sales, purchases, expenses, etc.

Since RSTCorp’s stockholders benefit from the successful operations of all four corporations, the parent company issues consolidated financial statements. The financial statements exclude the intercompany transactions and reports only the sales, expenses, etc. occurring with customers outside of the economic entity.

If a company develops its brand names and trademarks over time through product research and development, effective marketing, etc. (as opposed to having purchased brands and/or trademarks from other companies), the amounts spent are reported as expenses when they occur. The costs are not recorded nor reported as an asset on its balance sheet.

As a result, a trademark/logo developed over time could be a company’s most valuable asset but will not be reported as an asset on the company’s balance sheet.

LIFO is the acronym for last-in, first-out. It is a cost flow assumption used in determining the amounts reported as inventory and the cost of goods sold.

LIFO means that the most recent costs of goods purchased (or produced) are the first costs out of inventory and reported as the cost of goods sold. The cost of goods sold is an expense that is matched with the sales reported on the income statement.

With inflation (costs increasing), the recent higher costs will be the first costs reported as the cost of goods sold expense, thereby reporting less gross profit, net income, taxable income, and income tax expense.

LIFO also means that the balance sheet asset inventory will report the older lower costs.

Property, plant and equipment – net is the long-term asset section of the balance sheet which reports a company’s assets that are in use in the business. These assets are also referred to as fixed assets or plant assets. The amounts reported include the historical costs of the land, buildings, equipment, fixtures, vehicles, etc.

Property, plant and equipment – net also includes a subtraction for the accumulated depreciation as of the date of the balance sheet. Accumulated depreciation is the sum of the assets’ depreciation expense that was reported from the time the assets were acquired until the date of the balance sheet.

The cost of an asset minus its accumulated depreciation is the asset’s book value or carrying value.

When a corporation purchases its own shares of common stock and has not retired the shares, these repurchased shares are known as treasury stock. Typically, the amount paid to purchase the treasury stock is reported as a subtraction within (and near the end of) the stockholders’ equity section of the balance sheet.

When a corporation purchases treasury stock, there is a reduction in the corporation's:

• Liquidity
• Stockholders' equity
• Number of shares of stock outstanding (which can cause earnings per share to increase)

The statement of cash flows (SCF) has three main sections for reporting its cash flows:

• Operating activities (involves net income and the changes in the working capital accounts)
• Investing activities (involves noncurrent asset accounts)
• Financing activities (involves noncurrent liability and stockholders' equity accounts and short-term debt)

Another component of SCF is supplementary information such as noncash changes involving investing and financing activities, and disclosing the amounts paid for income taxes and interest.

The notes to the financial statements are an integral part of all financial statements including SCF.

Since DMCI does not manufacture or sell products, it is unlikely to have inventory and will have only a minimal amount of equipment. Further, it distributes most of its cash for employees' salaries, rent, and dividends. This means that the corporation’s book value, which is the reported amount of stockholders’ equity, will be relatively small.

Since DMCI is highly profitable and its book value is small, DMCI's market value is greater due to its high profitability and the high amount of cash distributed to its stockholders.

In some industries (such as meat packing) the cost of the processing equipment is significant, but the profit margins are slim at best. In that situation, it is possible that the book value (cost minus accumulated depreciation) of the equipment will not be recovered.

If that is the case, the book value of the equipment must be reduced. The amount by which the book value is reduced is reported on the income statement as an impairment loss.

Since GRR owns a relatively small percentage of other corporations' stock that is actively traded, GRR is required to report these investments at the quoted market prices as of the balance sheet's date.

Since ARCO owns a relatively small percentage of the common stock of large publicly traded corporations, ARCO's balance sheet will report the investment at its market value as of the balance sheet date.

Any positive or negative adjustment to the balance sheet amount is reported as part of net income on the accounting period's income statement. The net income amount is typically the dominant component of a company’s comprehensive income.

A payment for insurance coverage for a future accounting period is a current asset such as prepaid insurance (or prepaid expenses). As the insurance expires, the balance in the account Prepaid Insurance should be decreased and the amount of the decrease should be reported as insurance expense on the income statement.

In this question, none of the $6,000 payment made on December 28 will expire until January 1. Therefore, on December 31, the entire $6,000 should be reported as the current asset Prepaid Insurance. As of December 31, none of the $6,000 should be reported as insurance expense.

The $100,000 received by the insurance company on December 29 will be earned by the insurance company during the six-month period starting on January 1 and ending on June 30. Therefore, as of December 31, none of the $100,000 will be earned and cannot be reported on the December income statement.

Accountants will say that prior to January 1, the entire $100,000 must be deferred from being reported on December's income statement. It is deferred by reporting the $100,000 on the December 31 balance sheet as the current liability deferred revenues. (It is a liability because on December 31, the insurance company has an obligation/liability to provide $100,000 of insurance protection after December 31 or to return the $100,000.)

As the insurance company begins earning the insurance premiums after December 31, it will reduce the amount of deferred revenues and report the reduction on the income statement as revenues.

The dividends a corporation paid to stockholders is reported on the statement of cash flows (SCF) as an outflow of cash in the section with the heading of cash flows from financing activities.

Outflows of cash are shown in parentheses on the SCF. You can also think of the amounts shown in parentheses on the SCF as having a negative effect on the corporation’s cash balance.

The statement of cash flows (SCF) is typically prepared using the indirect method. This means that the section operating activities will begin with the company's net income from the income statement. Since the income statement was prepared using the accrual method of accounting, the accrual amounts must be converted/adjusted to cash amounts.

As an example, assume that XLCorp purchased equipment two years earlier and is depreciating the asset over seven years. In the most recent year, the company reported Depreciation Expense of $35,000 on its income statement. That expense resulted from the company debiting Depreciation Expense for $35,000 and crediting Accumulated Depreciation for $35,000. No cash was involved in the most recent year. (The cash outlay/payment occurred when the equipment was purchased two years earlier.)

Another adjustment involves accounts receivable. Assume XLCorp’s income statement reported revenues of $1,000,000. The information given in the question stated that accounts receivable increased by $30,000 (from $150,000 to $180,000). Therefore, the company must have collected only $970,000 of the $1,000,000 of revenues reported on the income statement. Therefore, the net income of $200,000 must be reduced by $30,000.

The question also states that accounts payable increased by $50,000 (from $90,000 to $140,000). This means XLCorp did not fully pay for the expenses included in the income statement. Since holding back $50,000 in payments was positive for the company's cash balance, there will be a positive adjustment to the net income in the operating activities section of the SCF.

The following image shows the adjustments and the resulting net cash from operating activities of $255,000.

The current ratio is the company's current assets divided by its current liabilities.
Working capital is the company's current assets minus its current liabilities.

The amounts of the current assets and current liabilities are both reported on the company's balance sheet.

The requirements for a U.S. corporation’s statement of cash flows (SCF) include disclosing the amount paid for income taxes and the amount paid for interest on its debt.

These disclosures are required because the corporation’s income statement reports income tax expense and interest expense based on the accrual method of accounting.

The disclosure of the amount paid is to accommodate users of the financial statements whose financial models use the cash amounts paid in the period of the SCF.

The U.S. Securities and Exchange Commission’s Form 10-K is an annual report filed by corporations with publicly traded shares of stock. SEC Form 10-K includes a complete set of financial statements (5 main statements plus the notes to the financial statements), Management’s Discussion and Analysis, and other information.

Form 941, Form 1040, and Form 1120 are U.S. Internal Revenue Service forms.

The amount of the corporation’s retained earnings at the end of the year is calculated as follows:

Beginning balance $783,000 + net income after taxes $100,000 – dividends to stockholders $40,000 = $843,000.

The other amounts listed in the question will affect the total amount of the corporation's stockholders' equity, but do not affect the amount of retained earnings.

At the time when ELCO sold the equipment for $10,000, the equipment had a book value of $12,000 (cost of $40,000 – accumulated depreciation of $28,000).

Both the cost of $40,000 and the accumulated depreciation of $28,000 must be removed from the company’s long-term/noncurrent assets, and the $10,000 of cash received will be added to the company’s current assets.

The difference between the $10,000 received and the $12,000 of book value that is removed = a loss of $2,000. This $2,000 will be reported on ELCO’s income statement as Loss on Sale of Assets Used in Business $2,000.

Key points:

• Due to double-entry accounting and the accounting equation, if a sole proprietorship's ending inventory (an asset) is overstated (reported at more than the correct amount), the owner's equity will also be overstated.

• If a corporation's ending inventory is overstated, the retained earnings (which is part of stockholders' equity) will be overstated.

• The ending inventory at the end of Year 1 becomes the beginning inventory for Year 2. Therefore, if the inventory at the end of Year 1 is incorrect, the income statements for both Year 1 and Year 2 will be incorrect. Specifically, the amounts for the cost of goods sold, gross profit, and net income will be incorrect.

• If the ending inventory at the end of Year 2 is accurate, Year 2’s balance sheet will be correct.

• The combined total net income for Year 1 and Year 2 will be correct since the errors are offsetting.

The following image with hypothetical amounts illustrates the effects of an incorrect inventory at the end of Year 1:

Accumulated other comprehensive income (AOCI) is part of the stockholders' equity section of a corporation's balance sheet.

AOCI accumulates the other comprehensive income (OCI) amounts reported on each accounting period's statement of other comprehensive income (or in a financial statement that shows both the net income and the other comprehensive income).

The following image illustrates:

• Net income becoming part of retained earnings, which is another line item in the stockholders' equity section of the balance sheet.

• Other comprehensive income becoming part of accumulated other comprehensive income, which is a line item in the stockholders’ equity section of the balance sheet.

The inventory turnover ratio is the cost of goods sold for the year divided by the average inventory cost during the same year.

The cost of goods sold is reported on the income statement for the year. The cost of goods sold is used because inventory is reported at cost.

The average inventory must be computed using the balance sheets from throughout the year of the sales. The average inventory is best because the balance sheet reports the cost of inventory only for the final moment of the accounting year whereas the cost of goods sold is the cumulative amount for 365 days.

Jay's compensation for working in his sole proprietorship is not reported on Jay Company's income statement. Therefore, the net income represents Jay's compensation for working in the business and Jay's return on his investment in the business.

Kay's compensation for working in her regular corporation is reported as salary expense on the corporation's income statement. Therefore, the net income on Kay Corporation's income statement shows the amount Kay earned on her corporation’s capital.

The following image shows that Jay Company's net income before tax is $120,000, while Kay Corporation's net income before tax is $50,000.

The dividends declared/paid to a corporation's stockholders are a distribution of the corporation's earnings (after-tax net income). Dividends are not an expense of the corporation, not a reduction of net income, and are not a liability until the board of directors declares the dividend.

Dividends are recorded as a decrease in the corporation’s retained earnings. (Retained earnings is often a significant component of a profitable corporation’s stockholders’ equity).

The delivery truck purchased by ZZCO six years ago is fully depreciated after its 5 years of use. ZZCO must have assumed $0 salvage value when calculating its annual depreciation of $40,000 for 5 years. Since the truck remains in use, both its cost and accumulated depreciation continue to be reported on ZZCO's balance sheet.

Depreciation involves allocating the asset's cost to expense over the truck's estimated useful life. Since the cost of $200,000 was allocated over the asset’s estimated useful life of 5 years, nothing remains to be allocated after the truck’s fifth year. This means $0 depreciation expense in the current year.

TOPCO is using FIFO, the acronym for first in, first out. This means the first costs in inventory are the first costs out of inventory and are the first costs reported as the cost of goods sold. When using FIFO, the accounting rule is to report inventory on the balance sheet at the lower of cost or net realizable value.

Net realizable value (NRV) is the amount expected to be received in the ordinary course of business minus the estimated costs to complete, sell, and ship the inventory items.

Since the NRV of $270,000 is less than the cost of $290,000, the $20,000 difference will affect TOPCO’s financial statements as follows:

• Inventory will be reported on the balance sheet as $270,000 (not the cost of $290,000)
• The period's net income will be reduced by $20,000

The historical cost principle (or cost principle) in accounting requires a company to report its property, plant and equipment at an amount not higher than its cost.

Since the land is not being sold, there is no gain that is recorded, recognized, or reported.