Lecture Engineering economics - Chapter 2: Introduction to financial statements and the accounting equation

Upon completion of this chapter you should understand: Basic concepts associated with the Income Statement, basic concepts associated with the Balance Sheet, cash flow and cash flow statements, financial statement generation and the accounting equation, other types of financial statements.

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IET 35000 Engineering Economics

Chapter 2 – Unit 1

Introduction to Financial Statements

and the Accounting Equation

Learning Objectives – Chapter 2

Upon completion of this chapter you should understand:

 Basic concepts associated with the Income Statement

 Basic concepts associated with the Balance Sheet

 Cash flow and cash flow statements

 Financial statement generation and the accounting

equation

 Other types of financial statements

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Learning Objectives – Unit 1

Upon completion of this unit you should understand:

equation

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Financial statements:

 Represent the financial history of the organization – both

successes and failures

 Assist in planning, budgeting and investment analysis

 Based on techniques over 300 years old

Importance:

 Provide essential information for managers and

administrators

 Serve as the required external reporting method for

publicly held organizations.

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Income Statement

 Reports the financial activities over a period of time

Annual corporate reports include an Income Statement

covering the financial activities during the firm’s fiscal year

Income Statements covering less than a year time period

are used for internal reporting, budgeting and planning

purposes

 Amounts reported are in units of $/time period

Annual reports = $/year

 Income Statements are also known as Profit and Loss

Statements

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Income Statement

Typical Income Statement format includes three sections:

Section 1: Income from the sale of products or services less the cost

to produce and deliver the products or services. Result is the gross

profit

Section 2: Expenses associated with general administrative

functions, depreciations and income or costs of a nonrecurring

nature are subtracted from the gross profit yielding the net

income before taxes

Section 3: Taxes are based on the net income. Subtracting taxed

from net income before taxes yields net income. If dividends are

paid by the organization, they are subtracted from net income

which yields retained earnings 6

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 Typical format:

Revenue or Sales

 Operating Expenses or Cost of Good Sold

Gross Profit

 Selling, General and Administrative Costs

Net Income Before Taxes

 Taxes Net Profit After Tax

 Dividends Retained Earnings

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Income Statement

 Example:

http://www.investopedia.com/articles/04/022504.asp

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Income Statement Components

Revenue or Sales – income from an organization’s core business; income from sale of products or services after returns and adjustments.

Includes both cash transactions and credit transactions

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Cost of Goods Sold – expenses directly associated with the

manufacturing of the product or providing the service.

Includes material, labor and overhead

Gross Income = Net Sales – Cost of Goods Sold

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 Material Costs

Direct material cost can be associated with the product

or service. Direct Material is included in the cost of

goods sold

Indirect material cost is required to produce the product

or provide the service, but cannot be directly associated

with the product or service. Indirect material cost is

frequently assigned to overhead which is included in the

cost of goods sold

Cost of supplies used for administrative and selling

purposes is included in operating expenses in the SG&A

 Labor Costs

Direct labor cost can be associated directly with the

product or service. Direct labor is included in the cost of

goods sold

Indirect labor cost is required to produce the product or

provide the service, but cannot be directly associated

with the product or service. Indirect labor cost is

frequently assigned to overhead which is included in the

cost of goods sold

Labor cost associated with administrative and selling

purposes is included in operating expenses in the SG&A

 Overhead or Burden Expense

Manufacturing overhead includes indirect labor and

indirect material expense along with any other expense

that is required to keep the core function of the business

in operation

Administrative overhead includes all of the costs

associated with operating the ‘office’ function of the

organization that is not assigned to SG&A labor or

supplies expense

Sometimes it is difficult to separate some expenses such

as electricity into manufacturing and administrative

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Operating Expense or Selling and Administrative Expense – includes all expense and cost which cannot be assigned to the product or service, but are required to keep the organization operating. Includes non‐

income taxes such as property tax

 Operating Income = Gross Income – Operating Expenses

 Operating expenses generally include depreciation which is

the decrease in value of fixed assets due to age and technical

obsolescence. Not a cash flow but is an expense

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Other Income – income from sources other than an organization’s core business. Include income from:

 Subsidiaries

 Sale of used or surplus equipment

 Investment securities

 Extraordinary expenses or revenues which will typically occur

only one time are frequently separated out to clarify the

performance of the organization.

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 Interest expense is frequently separated from operating expenses which are termed selling, general and administrative (SG&A). Includes interest payments on bonds and loans.

 Net Income (Profit) before Taxes is the Gross Income minus

all other expenses, and plus any other income to the firm.

This amount is the amount used to determine the income

taxes paid by the organization.

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 Corporations pay income taxes to local, state and federal governments based on the net income of organization at a corporate tax rate

 Funds left after taxes represent the funds available for reinvestment or dividends

 Proprietorships and partnerships don’t pay income tax. The

Net Income before Taxes amount passes to the owner(s) who

then are responsible for the tax liability.

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 Dividends – as discussed in the previous chapter, dividends

can be paid to owner’s (shareholders). The board of directors

for the corporation determines if dividends are to be paid on

common stock and the amount. Remember that dividends on

preferred stock may be mandatory if the firm is profitable

 Retained Earnings – after all the bills (expenses and taxes) are

paid and profits are shared with the owner’s (dividends),

retained earnings are ‘retained’ by the firm for expansion,

reinvestment or as a buffer for fluctuations in revenue

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End Unit 1 Material

Additional Reading  Understanding the Income

Statement: http://www.investopedia.com/articles/04/022504.asp

Go to Unit 2 The Balance Sheet

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The Balance Sheet

equation

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Balance Sheet

 Reports the financial activities at a point in time

Annual corporate reports include a Balance Sheet

showing the firm’s financial position at the end of the

firm’s fiscal year

 Balance Sheets have three sections:

Assets – anything of value owned by the firm

Liabilities – any debt owed by the firm which has not

been paid

Net Worth or Owner’s Equity – difference between assets

and liabilities

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 Typical format:

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Assets

Current Assets

Fixed Assets

Total Assets

Liabilities Current Liabilities Long Term Debt Total Liabilities Owner’s Equity Retained Earnings Total Owner’s Equity Total Liabilities and Owner’s Equity

Always Equal

Balance Sheet

 Example:

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Balance Sheet Components

 Assets are something owned by the organization that have value listed in order of liquidity

 Current Assets include cash and other items that can be converted into cash within one year

 Fixed Assets have a life greater than one year

 Intangible assets include patents, trademarks and goodwill

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 Liabilities are debts owed to suppliers, employees and for taxes. Liabilities is anything that has not been paid when the snapshot of the firm’s financial condition is taken.

 Current liabilities are debts that will

be paid within one year

 Term liabilities are debts such as bonds that are payable in more than a year

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Balance Sheet Components

 Owner’s Equity is money owed to the shareholders

 Common and preferred stock represents money that has been paid

by the shareholders to the firm. The value is listed at the stock’s par value

 Excess capital is the amount paid for the stock at the initial offering over the par value

 Accumulated retained earnings are profits retained by the corporation

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End Unit 2 Material

Additional Reading  Reading the Balance Sheet:

Go to Unit 3 Cash Flow and the Cash Flow Statement

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Cash Flow and the Cash Flow

Statement

equation

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Cash Flow

 Cash flow is the inflow and outflow from a cash account

 Important dis nc on: Cash Flow ≠ Income

Cash flow includes only cash transactions

Income includes non‐cash flow items including accounts

payable, accounts receivable and depreciation

 Cash flow is typically grouped into three sections related to

the source of funds. Cash flow from:

Operations – core business activities

Investing – fixed assets

Financing – debt, loans and dividends

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 Cash can be increased (sources of funds) by:

Profits from operations

Selling stock

Obtaining loans or increasing liabilities

Reducing fixed assets or decreasing current assets

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Cash Flow

 Cash is decreased (uses of funds) by:

Losses from operations

Buying back stock from shareholders

Paying off loans or decreasing liabilities

Investing in fixed assets or increasing current assets

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Calculating Cash Flow

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Net Profit After Tax + Depreciation and Amortization

+ Deferred Taxes + Decrease/‐ Increase in Asset Accounts 1

+ Increase/‐ Decrease in Liability Accounts 2

Operating Cash Flow

1 Inventory, Accounts Receivable

2 Accounts Payable, Taxes Payable

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 Reports the cash flow over a period of time

Annual corporate reports include a Cash Flow Statement

covering the financial activities during the firm’s fiscal year

Statements covering less than a year time period are used

for internal reporting, budgeting and planning purposes

 Groups interested in Cash Flow Statements include:

Accounting – ability to cover payroll and other expenses

Potential lenders– picture of a company's ability to repay

Potential investors – evaluate the company financial

soundness

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Cash Flow Statement

 Example:

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Cash Flow Statement Components

Net Earnings is based on the cash flow created by the firm’s core business and is taken from the income statement.

Adjustments are made to the net earnings for non‐cash entries on the Income Statement. Example – depreciation is added since it is a non‐cash flow item.

Changes to receivable and payable accounts from the prior reporting period are also included 36

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Additional adjustments to the net earnings include changes to the inventory value from the prior reporting period

Purchase or sale of fixed assets such as land, buildings and equipment is included in the Investing section

Investing cash in fixed assets such

as equipment is shown as a negative value

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Cash Flow Statement Components

Transactions related to debt, loans and dividend are included in the Investing section

An increase in debt would be shown as a positive value since it represents a positive cash flow to the firm

Note that the example cash flow statement format does differ from the example in the Bowman text

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End Unit 3 Material

Additional Reading  What is a Cash Flow Statement?

Go to Unit 4 Financial Statement Generation

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Financial Statement Generation

equation

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Accounting System

 Accounting system is responsible for:

Collecting and recording financial events

Organizing financial data into usable information

Preparing internal financial reports and statements

 Journal – chronological listing of financial events

 General Ledger – collection of the firm’s accounts

 Ledger Accounts – individual accounts for each category of

revenue, expense, asset, liability, owners’ equity, etc.

Accounts are usually assigned an account number.

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 Accounting equation is a combination of the Income

Statement and Balance Sheet:

 Equation must always be kept in balance

 Transactions can be accumulated under the five categories.

At the end of the financial period, each column can be

accumulated and entered into the appropriate financial

statement

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

 



 







Statement

Income

Costs

‐ Revenue et

BalanceShe

Equity Owners' s

Liabilitie

Accounting System

 Double‐Entry System – for every financial transaction, a

minimum of two entries are made into the Accounting

Equation. Examples of simple ledger account entries:

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Transaction 1 st Account Entry 2 nd Account Entry

Purchase materials for cash ‐ Cash + Inventory

Purchase equipment on credit + Equipment + Accounts Payable

Sell common stock + Cash + Owners’ Equity

Pay wages ‐ Cash + 1 Wages Paid

1 Wages Paid is a cost which is a negative term in the Accounting Equation,

therefore the net effect is subtracting from both sides of the equal side.

Accounting System

 Double‐Entry System – some transactions require more than

two entries in the Accounting Equation. Example:

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Sale of product for cash:

1 + Cash (asset account/balance sheet)

2 + Revenue (revenue account/income statement)

3 ‐ Inventory (asset account/balance sheet)

4 + 1Cost of Goods Sold (cost account/income statement)

1 Cost of Goods Sold is a cost which is a negative term in the Accounting Equation,

therefore the net effect is subtracting from both sides of the equal side.

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