CMA part2-unit2

8/9/2019 CMA part2-unit2

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CMA

FINANCIAL

STATEMENTS

PART 2Unit 2


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Topics covered

A. Balance Sheet

B. Income StatementC. Statement of cash flows

D. Statement of retained earnings


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BALANCE SHEET


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Components of Financial

Statements

Financial statements comprise of:

Balance Sheet (statement of financial position)

Income statement Statement of cash flows

Statement of retained earnings

Notes

Balance Sheet

The balance sheet provides information about an entitys assets,liabilities and their relationships to each other at a moment in time.


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The balance sheet provides information about an entitys assets,liabilities and equity and their relationships to each other at a momentin time.

Balance sheet help users to assess: Entitys liquidity

Financial flexibility and ability

Profitability and risk

Capital structure

The basic financial statements include: Balance sheet (statement of financial position.)

Income statement

Statement of cash flaws

Statement of retained earnings or shareholders equity


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Elements of Financial Statements

Assets - liabilities = equity

Equity = Contribution by owners - Distributions to owners + Comprehensive Income

Comprehensive income = Revenue - Expenses + Gain - Losses


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Balance sheet equation

Assets - liabilities + owners equity

The above equation is based on the proprietary theory. Equity in an

enterprise is what remains after the economic obligations of theenterprise are deducted from its economic resources.

Assets Economic resources that are expected to benefit future cashinflows or help reduce future cash outflows.

Liabilities Economic obligations of the organization to outsiders, orclaims against its assets by outsiders.

Owners equity The residual interest in the organizations assets afterdeducting liabilities.


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Balance Sheet classification

Balance Sheet accounts a re-classified so thatsimilar items are grouped together to arrive at

significant subtotals. Individual items should be reported separately and

in sufficient details to make the balance sheetuseful.

It is not acceptable to report a balance sheet in totalfigures as follows;


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Balance Sheet classification

Current assets XXX

Fixed assets XX

Other assets 1

XXX

Current liabilities XXX

Long-term liabilities XX

Equity XXX


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Also, assets are usually presented in descending order Liquidity.

In the Balance Sheet cash is reported first because it is more moreliquid.

Liabilities are shown in ascending order of time to maturity.

Notes payable is reported first because it should be paid In first.

Accounting payable should be paid reported after notes payable tobanks because it should be paid after notes payable to banks.

Items in the equity section should be reported according to which item

is permanent. The capital account is reported before earning Account.


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Presentation Formats:-

The format of the balance sheet is not standardized, and any methodthat promotes full disclosure method and understandability isacceptable.

The account (or horizontal) form presents assets on the left andliabilities and equity on the right.

The report (or vertical) form is also commonly used. It differs fromthe account form only in that liabilities and equity are presented

below rather than beside assets.


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Classification ofBalance Sheet

Assets

Current assets

Cash, cash equivalent, inventories, receivables, prepaid expenses and held tomaturity securities.

Non current assets

Long term investments and funds, property, plant and equipment, intangibleassets,

Other non current assets

deferred charges

Liabilities

Current liabilities

Obligations whose liquidation is reasonably expected to require theclassifiable as current assets or the creation of other current liability.


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Non current liabilities

Liabilities not qualifying as current are non-current such as:

Pension

deferred revenue deferred tax

advance from affiliated entities

Liabilities under capital lease

Advance for long term commitment

Owners equity

Contributed capital retained earnings

Reserves

Other accumulated comprehensive income

Owners equity is the residual after total are dedicated from total assets.Assets are classified as current if they are reasonably expected to be

realized in cash or consumer during the normal operating cycle.


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Current Assets:-

Current assets are cash and other assets expected to be converted into cash,sold, or consumed either in one year or in the operating cycle, whichever is

longer.Example of operating cycle:

You have $100,000 by.which you purchase inventory of $100,00 and you sell itall to customers.

The operating cycle is the time between purchasing inventory and collectingmoney from customers.

Cash$ 100,000

AccountsReceivable$ 160,000

MerchandiseInventory$ 100,000


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Long-Term Investment:-

Long-term investments, often referred to simply as investments,normally consist of one of four types:

Investments in securities, such as bonds, common stock, or long-termnotes.

Investments in tangible fixed assets not currently used in operations,such as land hold for speculation.

Investments set aside in special funds such as a sinking fund, pensionfund, or plant expansion fund.

Long-term investments are to be held for many years.

Note that if a security can be sold in a short term (e.g six months) butthe company has no intention to sell it then it is reported as investment.However, if the company intend to sell it in theshort run then it isreported as current asset

Also, see how long-term investment is presented in (AB

C Co.)


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Property, Plant and Equipment (P.P & E):-

These assets are tangible items used in operations. They are recordedat cost and are shown net of accumulated depreciation if depreciable

They include:

Land and depletable natural resources, e.g., oil and gas reserves.

Buildings, machinery, equipment, furniture, fixtures, leasehold

improvements, land improvements, leased assets held under capitalleases, and other depreciable assets


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Intangible means not physical e.g. patents, copyrights, trademarks.

These assets are used in operations.

There is uncertainty about their future benefits e.g. the Company hasnot got benefit from its goodwill in future

Intangibles are recorded at cost less accumulated amortization.


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Other Assets:-

Include assets which are - not suitably classified in the above

classifications.

Examples:

Bond issue cost

Long-term prepayments


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The resources Structure

Property, Plant,

and equipment

(PP7E)

Assets

Intangible

Assets

Other noncurrent

Assets

Deferred

Charges

Current

Assets

Non current

Assets


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The Financing Structure Current Liabilities:-

Current liabilities are obligations that are reasonably expected to beliquidated (paid) either through the use of current assets or the creation

of other current liabilities.

Example if liquidation by use of current assets:-

Pay your creditor by cash.

Example of liquidating by creation of current liability

Give your creditor a note payable within one year.

A liability payable next year is not included in the current liabilitysection.


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Long-Term Liabilities:-

Long-term liabilities are obligations that are not reasonably expected tobe liquidated within the normal operating cycle but, instead, are

payable at some date beyond that time.

Examples:

Bond payable

Pension obligations


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Owners' Equity Section include:-

Capital Stock. The par or stated value of the shares issued.

Additional Paid-In Capital. The excess of amounts paid in over

the par or stated value.

Retained Earnings. The corporations' undistributed earnings.

The following illustration demonstrates the owner's equity for differentorganizations


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Owners Equity for Different OrganizationsOwners Equity for a Proprietorship(Assume George Smith is the sole owner)

George Smith, capital $ 400,000Owners Equity for a Partnership(Assume Smith has two partners)

George Smith, capital $ 320,000Alex Handl, capital 40,000Susan Eastma, capital 40,000Total partners capital $ 400,000Owners Equity for a Partnership

Stockholders equity:Paid-in capital

Capital stock, 10,000 shares issued at par value of $ 10 per share $ 100,000paid-in capital in excess of par value of capital stocks 300,000Total paid-in capital $ 400,000


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Most states require stock certificates to have some dollar amount printed on them. Thisamount called par value or stated value.

This amount is determined by the board of directors.

Usually the stock is sold at a price higher than its par value.

The difference between the total amount received and the par value is called paid-in-capitalin excess of par value or additional paid in capital.

In the above illustration the company sold 10000 shares of $ 40 per share. The par value is$ 0 per share.

So, total paid in capital = capital stock at par + paid-in capital in excess of par

or

$ 400,000 = $ 100,000 + $ 300,000


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ABC Company

Balance sheet

Current assets

Cash

Available-for-sale securities-at fair value

Account receivable

Less: Allowance for doubtful accounts

Note receivable

Inventories-at average cost

Supplies on hand

Prepaid expenses

Total current assets

Non-current assets


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Long-term investments

Investment in Warren Co.

Pre-operating expenses

Property, plant, and equipment, net

Intangible assets

Goodwill

Total assets


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Liabilities and stockholders equity

Current liabilities

Notes payable to banks

Accounts payable

Accrued interest on notes payable

Income taxes payable

Accrued salaries, wages, and other liabilities

Deposits received from customers

Total current liabilities

Non-current liabilities

Long-term debt

Twenty-year 12% debentures, due January 1, 2011

Total liabilities


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Stockholders equity

Paid in on capital stock

Preferred, 7%, cumulative

Authorized, issued, and outstanding,

30,000 shares of $ 10 par value

Common-

Authorized, 500,000 shares of $ 1.00 par value;

Issued and outstanding, 400,000 shares

additional paid-in capital

Retained earnings

Total stockholders equity

Total liabilities and stockholders equity


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The basic financial statements include a:

A. Balance sheet, income statement, statement of retained earnings,and statement of retained earnings, and statement of changes in

retained earnings.B .Statement of financial position, income statement, statement of

retained earnings, and statement of changes in retained earnings.

C. balance sheet, statement of financial position, income statement,and statement of changes in retained earnings.

D. Statement of financial position, income statement, statement ofcash flows and statement of retained earnings.


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The correct answer is (D). (CMA,adapted)


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A company decided to sell a line of its business. The assets were soldfor $ 100,000 and had a net book value of $70,000. The applicable taxrate was 20%. The result of this transaction will appear on the:

A. balance sheet as a prior-period adjustment.

B. Income statement as an extraordinary item.

C. Income statement as discontinued operations.

D. Income statement as an accounting change.


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The correct answer is (C). (CIA, adapted)


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Income Statement Format


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The results of operations are reported in the income statement(statement of earnings) on the accrual basis using an approachoriented to historical transaction.

The traditional income statement reports revenue from and expenses ofthe entitys major activities and gains and losses from other activities,incurred over a period.

Revenue - expenses + gains - losses = income or loss

Income is closed to retained earnings at the end of the period


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Earned means revenue will be recorded when the company delivergoods or services to the customer

Realized means that revenue are realized when cash or claims to cash

(credit) are received.If you give a customer a tool for trial then this revenue is not realizedbecause there is no promise from the customer to pay you

Revenue may be earned and realized at the same point of time (yousell and receive cash or credit note at the same time)

Or revenue may have been earned and realized at different times

Example:- The owner of the building receive rent in advance. Thisrevenue is realized but will be earned as the time passed.


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The order of income statements is as follows:

Revenue

Expenses

Income from continuing operations Discontinued operations

Extra ordinary items

Cumulative effect of changes in accounting principles

Net income

Comprehensive income must be displayed in a financial statement but nospecific format is required.

The format of the balance sheet is not standardized and any method thatprovides full disclosure and understandability is acceptable.


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When reporting the discontinuation of a business segment, the gain or loss ondiscontinued operation should be reported net ofTax as a separate item beforeextra ordinary items.

A loss that is material, unusual and infrequent in occurrence should bereported as an extra ordinary item.

The income or loss from operations of a discontinued operations up to themeasurement date and the gain or loss on disposal should both be shownnet of tax.

The measurement date is the date on which management commits itself toa plan to dispose of a segment either by sale or abandonment.

Extraordinary items are those material items that both unusual in nature andinfrequent in the environment in which the entity operates.


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The following items are to be reported separately and in the indicated order onthe face of the income statement:

Pre tax income from continuing operations

The provision for income tax on income from continuing operations Income from continuing operations.

Discounted operations


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The income or loss from operations of a discontinued segment up to themeasurement date and the gain or losses on disposal should both be reportednet of tax.

The gain or loss on disposal is estimated on the measurement date (date on

which management commits itself to a plan to dispose of a segment either by asale or abandonment).

Income before extra ordinary items and cumulative effect of accounting changes (ifany).

Extra ordinary items (material items that are both unusual in nature and infrequent).

Cumulative effect of a change in accounting principle (net of tax)

Net income Income from continuing operations

Discounted operations

Extra ordinary items

Cumulative effect of accounting changes

Net income


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single-step income statements

Only two groupings exist: revenues and expenses.

(Expenses) only a single item is deducted from revenues to arrive at

net income. For that reason it is called (single step) The advantage of asingle-step is that it is simple.

The following illustration shows how a single-step income statement ispresented.


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DAN DEINES COMPANY

Income Statement

For the Year Ended December 31, 2002

Revenue

Net sales $2,972,413

Dividends revenue 98,500

Rental revenue 72,910

Total revenues 3,143,823

Expenses

Cost of goods sold 1,982,541

Selling expenses 453,028 Administrative expenses 350,77

Interest expense 126,060

Income tax expense 66,934

Total expenses 2,979,334

Net income $ 164,489

Earnings per common share $1.74


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Multiple-step income Statement:

This statement separates operating results from non operating.

It classified expenses by functions such as cost of goods sold andselling (e.g. merchandizing or manufacturing) and administrativeexpenses.

So, it permits comparison with previous years.

It also matches expenses with revenues.

The following illustration show how a multiple-step is presented:


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DAN DEINIES COMPANY

Income Statement

For the Year Ended December 31, 2002

Sales revenue

Sales 1972,413

Cost of Goods Sold 1,982,541

Gross profit on Sales 989,872

Operating expenses

Selling expenses 453,028

Administrative expenses 350,771 803,799

Income from operationsOther expenses and Losses 186,073

Interest on bonds and notes 126,060

Income before income tax 231,423

Income tax

Net income for the year $ 164,489

Earnings per com on share $1.74


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Comprehensive income:

Reporting comprehensive income applied to enterprises issuing a full set offinancial statements if they have items ofOther Comprehensive Income, (oa)

but it does not apply to non-for-profit organizations. OCI, is classified separatelyinto:

1. Foreign currency items

2. Minimum pension liability adjustments.

3. Unrealized gain and losses on available for sale securities expect

those that are hedged items in a fair value Hedge.

Comprehensive income and its components use to be displayed in a financialstatement given the same prominence of other statements. The possibilities ofreporting comprehensive income are:

a. Separate statement of comprehensive income

b. Statement of changes in equity

The total of OCI for a period is transferred to a component of equity separate fromretained earnings and additional-paid-in-capital.


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Which one of the following items is included in the determination ofincome from continuing operations?

A. Discontinued operations.

B. Extraordinary loss.

C. Cumulative effect of a change in an accounting principle.

D. Unusual loss from a write-down of inventory.


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The correct answer is (D). (CMA, adapted)


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In a multiple-step income statement for a retail company, all of thefollowing are included in the operating section except.

A. Sale.

B. Cost of goods sold.

C. Dividend revenue.

D. Administrative and selling expenses.


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The correct answer is (C). (CMA, adapted)


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Statement of Cash Flows


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The primary purpose of a statement of cash flow is to provide relevantinformation about the cash receipts and payments of an entity duringthe period The statement of cash flows is required as a part of a full set

of financial statements of all business entities and not for profitorganizations.

The statement of cash flows is to be presented in general purposeexternal financial statements by all business enterprises and not forprofit organization.

The statement of cash flows is intended to help users of financial

statements to evaluate a firms liquidity solvency and financial flexibility.


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The direct method of reporting cash flows from operating activities includesdisclosing the major classes of gross receipts and gross cash payments. FSAS95 encourages use of the direct method of reporting cash receipts andpayments, but indirect method may be used.

Format of statement of cash flow:

+ Cash provided or (used) by operating activities

+ Cash provided by investing activities

+ Cash provided or (used) by financing activities

= Net increase or (decrease) in cash and cash equivalents

+ Beginning balance

= Ending balance

= Operating activities

Direct method

Indirect method


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Operating Activities

Direct Method Indirect Method

+ Interest dividends received + Net income

+ Collection from customers - Non cash revenues

+ Proceeds from sale of trading activities - Non cash expenses

+ Other operating cash inflows - Gain on sale of investment

- Payment for merchandise + Losses on sale of plant assets

- Payment for expenses - Increase in current assets- Payment for interest


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+ Payment for income tax + Decrease in current assets

- Payment to acquire trading securities - Decrease in current liabilities

- Other operating cash flow - Increase in current liability= Cash flow from operating activities + Cash flow from operatingactivity activities

Investing activities:

Principal collections on loans receivable

+ proceeds from sale of investment (except trading securities.)

+ proceeds from sale of plant assets

- Loan made

- Payments to acquire investment (except Trading Securities)

- Payments to acquire plant assets.


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Financing activities

+ Proceeds from borrowing

+ Proceeds from issuing stock- Debit principal payments

- Payments to reacquire stock

- Payments for dividends

= Cash flow from financing activities

-


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Statement of Cash Flows:-

It reports the cash receipts and cash payments of an entity during aparticular period

To make statement of cash flows simply follow these steps:- List the activities that increase cash (cash inflows) and those that

decrease cash (cash outflows)

Place each cash inflow or- outflow in one of the types of activities thatcaused it-

Types of activities are:- Operating activities which include sale and purchase of production of

goods and services.

Investing activities which include acquiring and selling long-termassets, securities held for long-term investment purposes.


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Financing activities which include obtaining resources forowners and creditors and repaying amounts borrowed.

Prepare the Cash Flow Statement.

Now, go back to Biweel example Follow the above steps and prepare cash flows statement as

follows:


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Exhibit 2-4

Biwheels Company

Statement of Cash Flows for the Two Months Ended January 31, 19X2

PART 1: TRANSACTIONS AFECTING CASH

Transaction Amount Type of Activity

(1) Initial investment $400,000 Financing

(2) Loan from bank 100,000 Financing

(3) Acquire inventory for cash (150,000) Operating

(5) Acquire store equipment for cash (150,000) Investment(8) Payments to trade creditors (4,000) Operating

(9) Sale of store equipment 700 Investing

(11) pay rent in cash (6,000) Operating


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Prepare the Cash Flow statement

PART II: STATEMENT OF CASH FLOWS

CASH FLOWS FROM OPERATING ACTIVIGIES

Cash payments to suppliers $ (154,000)

Cash payments for rent (6,000)

Net cash used for operating activities $ (160,000)

CASH FLOWS FROM INVESTING ACTIVITIES

Cash payments for purchases of equipment (4,000)

Cash receipts from sales of equipment 700

CASH FLOWS FROM FINANCING ACTIVITIES

Proceeds from initial investment 400,000Proceeds from bank loan 100,000

Net cash provided by financing activities 500,000

Net increase in cash 336,700

Cash balance, December 1, 19X1 0

Cash balance, January 31, 19X2 336,700


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From the above Cash Flow Statement you can know from where cashcame and where it went.

For example no cash came from operating activity although there is,

net income of $ 57900. You have to note the difference between income statement and

cash flows.

Income statement measure the entity performance in generatingnet assets

Statement of cash flows will be discussed in detail in a separate unit.


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A statement of cash flows is intended to help user of financialstatements.

A. Evaluate a firms liquidity, solvency, and financial flexibility.B. Evaluate a firms economic resources and obligations.

C. Determine a firms components of income from operations.

D. Determine whether insider have sold or purchased the firms stock.


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The correct answer is (A)_. (CMA, adapted)


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Which one of the following transactions should be classified as afinancing activity in a statement of cash flows?

A. Purchase of equipment.B. Purchase of treasury stock.

B. Sale of trademarks.

D. Payment of interest on a mortgage note.


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The correct answer is (B). (CMA, adapted)


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Statement of

Retained Earnings


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The following illustration shows how the statement of retained earning ispresented

TIGERWOODS INC.

Retained Earnings StatementFor the Year Ended December 31, 2002

Balance, January 1, as reported $ 1,050,000

Correction for understatement of net income in prior period

(inventory error) 50,000

Balance, January 1 as adjusted 1,100,000Add: Net income 360,000

1,460,000

Less: Cash dividends $ 100,000

Stock dividends 200,000 300,000

Balance, December 31 $ 1,160,000


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Statement of retained earnings reconciles the beginning balance ofretained earning with the ending balance.

Retained earnings are increased by net income and decreased by net

loss. Both cash and stock dividends decreased retained earnings.

Prior period adjustments may increase retained earnings or decreaseretained earnings.

Prior period adjustment in a correction of an error in the financialstatement of a prior period.

Example: In the year 2000 (prior year) you calculated a depreciation as$ 100,000. In 2001 year concluded that $ 150,000 is the rightdepreciation

So, the 50000 is the prior period adjustment.

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