When Pat arrived home, she carefully reviewed the projected financial statements, then made notes about what she had learned.

1. The basic form of the balance sheet is Assets = Liabilities + Owner Equity.

2. Assets are the expenditures made for items, such as Inventory and Equipment, that are needed to operate the business. The Liabilities and Owner Equity reflect the funds that financed the expenditures for the Assets.

3. Balance sheets show the financial position of a business at a given moment in time.

4. Balance sheets change as transactions are recorded.

5. Every transaction is an exchange, and both sides of each transaction are recorded. For example, when a company obtains a bank loan, there is an increase in the asset cash that is matched by an increase in a liability entitled “Bank Loan.” When the loan is repaid, there is a decrease in cash which is matched by a decrease in the Bank Loan liability. After every transaction, the balance sheet stays in balance.

6. Income increases Owner Equity, and Drawings decrease Owner Equity.

7. The income statement shows how income for the period was earned.

8. The basic form of the income statement is:
a. Sales − Cost of Goods Sold = Gross Income.
b. Gross Income − Expenses = Net Income.

9. The income statement is simply a detailed explanation of the increase in Owner Equity represented by Net Income. It shows how the Owner Equity increased from the beginning of the year to the end of the year because of the Net Income.

10. Net Income contributes to Cash from Operations after it has been adjusted to a cash basis.

11. Not all expenses are cash outflows—for instance, Depreciation.

12. Changes in Current Assets (except Cash) and Current Liabilities are not cash outflows nor inflows in the period under consideration. They represent future, not present, cash flows.

13. Cash can be generated internally by operations or externally from sources such as lenders or equity investors.

14. The Cash Flow Statement is simply a detailed explanation of how cash at the start developed into cash at the end by virtue of cash inflows, generated internally and externally, less cash outflows.

15. As previously noted:
a. The Income Statement is an elaboration of the change in Owner Equity in the Balance Sheet caused by earning income.
b. The Cash Flow Statement is an elaboration of the Balance-Sheet change in beginning and ending Cash.
Therefore, all three financial statements are interrelated or, to use the technical term, “articulated.” They are mutually consistent, and that is why they are referred to as a “set” of financial statements. The three piece set consists of a balance sheet, income statement, and cash flow statement.

16. A set of financial statements can convey much valuable information about the enterprise to anyone who knows how to analyze them. This information goes to the core of the organization’s business strategy and the effectiveness of its management.

While Pat was making her notes, Kim was carefully analyzing the Nutrivite projected financial statements in order to make her recommendation to the bank’s loan committee about Nutrivite’s loan application. She paid special attention to the Cash Flow Statement, keeping handy the bank’s guidelines on cash flow analysis, which included the following issues:

• Is cash from operations positive? Is it growing over time? Is it keeping pace with growth in sales? If not, why not?

• Are cash withdrawals by owners only a small portion of cash from operations? If owners’ cash withdrawals are a large share of cash from operations, then the business is conceivably being milked of cash and may not be able to finance its future growth.

• Of the total sources of cash, how much is being internally generated by operations versus obtained from outside sources? Normally wise businesses rely more on internally generated cash for growth than on external financing.

• Of the outside financing, how much is derived from equity investors and how much is borrowed? Normally, a business should rely more on equity than debt financing.

• What kind of assets is the company acquiring with the cash being expended? Are these asset expenditures likely to be profitable? How long will it take for these assets to repay their cost and then to earn a reasonable return?

Kim reflected carefully on these issues and then finalized her recommendation, which was to approve the loan. The bank’s loan committee accepted Kim’s recommendation and even went further. They authorized Kim to tell Pat that—if she met all her responsibilities in regard to the loan throughout the year—the bank would renew the loan at the end of the year and even increase the amount. Kim called Pat with the good news. Their conversation included the following dialogue:

Kim: To renew the loan, the bank will ask you for new projected financial statements for the subsequent year. Also, the loan agreement will require you to submit financial statements for the year just past—that is, not projected but actual financial statements. The bank will require that these actual financial statements be reviewed by an independent CPA before you submit them.

Pat: Let me be sure I understand: Projected financial statements are forwardlooking, whereas actual financial statements are backward looking, is that correct?

Kim: Yes, that’s right.

Pat: Next, what is an independent CPA?

Kim: As you probably know, a CPA is a certified public accountant, a professional trained in finance and accounting and licensed by the state. Independent means a CPA who is not an employee of yours or a relative. It means someone in public practice in a CPA firm, someone who will likely make an objective and unbiased evaluation of your financial statements.

Pat: And what does reviewed mean?

Kim: Good question. CPAs offer three levels of service relating to financial statements:

• An audit is a thorough, in-depth examination of the financial statements and test of the supporting records. The result is an audit report, which states whether the financial statements are free of material misstatements (whether caused by error or fraud). A “clean” audit report provides assurance that the financial statements are free of material misstatements. A “modified” report gives no such assurance and is cause for concern. Financial professionals always read the auditor’s report first, even before looking at any financial statement, to see if the report is clean. The auditor is a watchdog, and this watchdog barks by issuing a modified audit report. By law all companies that have publicly traded securities must have their financial statements audited as a protection to investors, creditors, and other financial statement users. Private companies are not required by law to have audits, but sometimes particular investors or creditors demand them. An audit provides the highest level of assurance that a CPA can provide and is the most expensive level of service. Less expensive and less thorough levels of service include the following.

• A review is a less extensive and less expensive level of financial statement inspection by a CPA. It provides a lower level of assurance that the financial statements are free of material misstatements.

• Finally, the lowest level of service is called a compilation, where the outside CPA puts together the financial statements from the client company’s books and records without examining them in much depth. A compilation provides the least assurance and is the least expensive level of service. So the bank is asking you for the middle level of assurance when it requires a review by an independent CPA. Banks usually require a review from borrowers that are smaller private businesses.

Pat: Thanks. That makes it very clear.

We now leave Pat and Kim to their successful loan transaction and move on.

Frequently Asked Questions

Ans: Pat was applying for a bank loan to start her new business, Nutrivite, a retail store selling nutritional supplements, vitamins, and herbal remedies. She de- scribed her concept to Kim, a loan officer at the bank view more..
Ans: When Pat arrived home, she carefully reviewed the projected financial statements, then made notes about what she had learned. 1. The basic form of the balance sheet is Assets = Liabilities + Owner Equity. 2. Assets are the expenditures made for items, such as Inventory and Equipment, that are needed to operate the business. The Liabilities and Owner Equity reflect the funds that financed the expenditures for the Assets. view more..
Ans: Here is a brief list of who uses financial statements and why. This list gives only a few examples and is by no means complete. 1. Existing equity investors and lenders, to monitor their investments and to evaluate the performance of management. 2. Prospective equity investors and lenders, to decide whether or not to invest. 3. Investment analysts, money managers, and stockbrokers, to make buy/sell/hold recommendations to their clients. view more..
Ans: Financial statements have a standard format whether an enterprise is as small as Nutrivite or as large as a major corporation. For example, a recent set of financial statements for Microsoft Corporation can be summarized in millions of dollars as follows: view more..
Ans: We check the financial health of a company in much the same fashion by analyzing the financial statements. The vital signs are tested mostly by various financial ratios that are calculated from the financial statements. These vital signs can be classified into three main categories: view more..
Ans: Some important points to keep in mind when using financial ratios are: • Whereas all balance sheet numbers are end-of-period numbers, all income statement numbers relate to the entire period. For example, when calculating the ratio for Accounts Receivable Turnover, we use a numerator of Credit Sales, which is an entire-period number from the income statement, and a denominator of Accounts Receivable, which is an end-ofperiod number from the balance sheet. view more..
Ans: Up to this point we have considered financial ratios one at a time. However, there is a useful method for combining financial ratios known as Dupont1 analysis. To explain it, we first need to define some financial ratios, together with their abbreviations, as follows: view more..
Ans: Financial ratios are useful not only to assess the past or present condition of an enterprise, but also to reliably predict its future solvency or bankruptcy. This type of information is of critical importance to present and potential creditors and investors. There are several different methods of analysis for obtaining this predictive information. view more..
Ans: A special committee of the American Institute of Certified Public Accountants (AICPA) concluded the following about earnings and the needs of those who use financial statements: Users want information about the portion of a company’s reported earnings that is stable or recurring and that provides a basis for estimating sustainable earnings. view more..
Ans: Defining nonrecurring items is difficult. Writers often begin with phrases like “unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in their popular intermediate accounting text use the term irregular to describe what most statement users would consider nonrecurring items. view more..
Ans: Careful analysis of past financial performance aimed at removing the effects of nonrecurring items is a more formidable task than one might suspect. This task would be fairly simple if (1) there was general agreement on just what constitutes a nonrecurring item and (2) if most nonrecurring items were prominently displayed on the face of the income statement. view more..
Ans: An examination of the income statement, the first step in the search sequence, requires an understanding of the design and content of contemporary income statements. This knowledge will aid in the location and analysis of nonrecurring view more..
Ans: After the income statement, the operating activities section of the statement of cash flows is an excellent secondary source to use in locating nonrecurring items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of this section of the statement of cash flows results from two factors. First, gains and losses on the sale of investments and fixed assets must be removed from net income in arriving at cash flow from operating activities. Second, noncash items of revenue or gain and expense or loss must also be removed from net income. view more..
Ans: The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17. view more..
Ans: Income tax notes are among the more challenging of the disclosures found in annual reports. They can, however, be a rich source of information on nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires a focus on a single key schedule found in the standard income tax note. The goal is simply to identify nonrecurring tax increases and decreases in this schedule. view more..
Ans: An “other income (expense), net,” or equivalent line item is commonly found in both the single- and multistep income statement. In the case of the multistep format, the composition of other income and expenses is sometimes detailed on the face of the income statement. In both the multi- and single-step formats, the most typical presentation is a single line item with a supporting note. Even though a note detailing the contents of other income and expense may exist, companies typically do not specify its location. Other income and expense notes tend to be listed close to the end of the notes to the financial statements view more..

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