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pay in advance of taking delivery of products, so cash collections occur
before the sales are recorded at the time products are delivered to the cus-
tomers.

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FINANCIAL REPORTING


cash flow picture you have to consider other cash flows during
the year for expenses recorded last year or for expenses that
won™t be recorded until next year. To complete the accrual-
basis expenses picture for the year you have to consider
expenses recorded during the year for which cash was not
paid during the year. In summary (see Figure 2.1 for data):
• Accrual-basis expenses for year: $14.9 million expenses
recorded and paid in cash during year + $8.9 million
expenses recorded but cash was not paid during year =
$23.8 million expenses
• Expense-driven cash flows during year: $14.9 million
expenses recorded and paid in cash during year + $7.5 mil-
lion paid during year for last year™s expenses or for next
year™s expenses = $22.4 million cash flow for expenses


Net Profit and Net Cash Flow for Year

Net profit for the year is $2.2 million, equal to $26
million sales revenue less $23.8 million expenses. In
contrast, the net cash flow of revenue and expenses is $3.3
million for the year. Both figures are correct. The $2.2 million
figure is the correct measure of profit for the year according
to proper accounting methods for recording sales revenue and
expenses to the year. The $3.3 million net cash flow figure is
correct, but keep in mind that cash flows related to revenue
and expenses of the previous year and the following year are
intermingled with the cash flows of revenue and expenses of
the year just ended.


THE INCOME STATEMENT
Figure 2.2 presents the basic format of the business™s income
statement for the year just ended. The income statement
starts with sales revenue for the year and ends with the net
income for the year. Between the top line and the bottom
line a business reports several expenses and subtotals for
intermediate measures of profit. A company that sell products
discloses the amount of its cost-of-goods-sold expense imme-
diately below sales revenue, which is deducted to get the first
profit line, called gross margin. The word gross implies that

16
I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S




Note: Amounts are in millions of dollars.

Sales revenue $26.0
Cost-of-goods-sold expense XX.X
Gross margin XX.X
Operating expenses XX.X
Earnings before interest and income tax X.X
Interest expense .X
Earnings before income tax X.X
Income tax expense X.X
Net income $ 2.2
FIGURE 2.2 Format of external income statement for year.




other expenses have to be deducted from sales revenue to
arrive at the final, or bottom-line profit.
One or more classes of operating expenses are disclosed in
external financial statements. How many and which specific
types of operating expenses? The disclosure of operating
expenses varies from business to business; financial reporting
rules are lax in this regard. Few businesses disclose the
amounts of advertising expenses, for example, or the amounts
of top-management compensation. Many businesses lump a
variety of different operating expenses into a conglomerate
account called sales, administrative, and general expenses. In
most external income statements, total operating expenses are
deducted from gross margin to arrive at the profit figure
labeled earnings before interest and income tax expenses (see
Figure 2.2).
I™m sure you™ve noticed that instead of dollar amounts for
expenses and the intermediate profit lines between the top
line and the bottom line in Figure 2.2 I show only placehold-
ers (e.g., XX.X). Showing the dollar amounts for these items
would serve no particular purpose here. I wish to emphasize
the basic format of the externally reported income statement,
not the data in this financial statement. In Chapter 3 I develop
an internal profit report for managers that is a much different
format than the external income statement, which is more
useful for decision-making analysis.

17
FINANCIAL REPORTING


THE BALANCE SHEET
The usual explanation of the balance sheet is that it is the
financial statement that summarizes a business™s assets and
liabilities. Well, yes and no. If you have in mind a complete
reckoning of all the assets of the business at their current
market or replacement values you are off the mark. The bal-
ance sheet does not list all assets at current values. On the
other hand, the balance sheet comes close to listing all the lia-
bilities of a business. You may find these opening comments
about the balance sheet rather unusual, and I don™t blame you
if you think so.

The accounts, or basic elements presented in a balance sheet
are the result of accrual-basis accounting methods for record-
ing the revenue and expenses of the business. A balance sheet
in large part consists of the remains of the profit accounting
process. A balance sheet is not based on a complete survey of
all the tangible and intangible assets of the business at their
current values. For example, a business may have developed
a well known and trusted brand name and have a well trained
and dedicated workforce. But these two “assets” are not
reported in its balance sheet. Having these two assets should
be reflected in above-average profit performance, which is
reported in the income statement of the business. The chief
executive can brag about these two assets in the company™s
financial reports to shareowners and lenders, but don™t look
for them in the company™s balance sheet.
The balance sheet at the start and end of the year for the
business is presented in Figure 2.3. Cash usually is shown
first in a balance sheet, as you see in Figure 2.3. Cash
includes coin and currency on hand, balances in demand
deposit checking accounts with banks, and often cash equiva-
lents such as short-term, marketable securities that can be liq-
uidated at a moment™s notice. The dollar amounts reported in
the balance sheet for assets other than cash and for liabilities
and owners™ equity accounts are called book values, because
these are the amounts recorded in the books, or accounts,
kept by the business.
Generally, the book values of the liabilities of a business are
the amounts of cash owed to creditors and lenders that will be
paid later. The book value of the asset accounts receivable is
the amount of cash that should be received from customers,

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I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S




Note: Amounts are in millions of dollars.

Assets
Beginning End
of Year of Year
Cash $ 1.6 $ 2.0
Accounts receivable $ 2.0 $ 2.5
Inventories $ 3.9 $ 4.7
Prepaid expenses $ 0.5 $ 0.6
Subtotal of current assets $ 8.0 $ 9.8
Property, plant, and equipment $15.5 $19.1
Accumulated depreciation ($ 6.5) $ 9.0 ($ 8.2) $10.9
Total assets $17.0 $20.7

Liabilities and Owners™ Equity
Advance payments from customers $1.0 $1.2
Accounts payable $1.6 $2.0
Accrued expenses payable $0.6 $0.8
Short-term notes payable $1.5 $2.0
Subtotal of current liabilities $ 4.7 $ 6.0
Long-term notes payable $ 3.5 $ 4.0
Owners™ equity”invested capital $4.0 $4.2
Owners™ equity”retained earnings $4.8 $ 8.8 $6.5 $10.7
Total liabilities and owners™ equity $17.0 $20.7

Note: The amounts reported at the beginning of the year are the carryover balances at the
end of the preceding year; the amounts continue seamlessly from the end of the preceding
year to the start of the following year.
FIGURE 2.3 Format of external balance sheet.




usually within a month or so. The book value of inventories
(products held for sale) and property, plant, and equipment
are the costs of the assets. The cost of inventories is relatively
recent under one method of accounting or, alternatively, rela-
tively old under another. (Accountants can™t agree on just one
method for this particular asset.)
The total cost of property, plant, and equipment is relatively
old unless most of these long-lived operating resources were
recently acquired by the business. Their cost is spread over

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FINANCIAL REPORTING


the estimated years of their use; the amount of cost that is
recorded as depreciation expense is recorded in the accumu-
lated depreciation offset account, which is deducted from the
original cost of the assets (see Figure 2.3)
When the shareowners invest capital in the business, the
appropriate owners™ equity account is increased. At the end of
the year the amount of profit for the year less the amount of
profit distributed to the shareowners is recorded as an
increase in the second owners™ equity account, which is called
retained earnings (see Figure 2.3).
The balance sheet assets and liabilities that are directly
connected with the sales revenue and expenses of the busi-
ness are summarized as follows:
• Accounts receivable. Receivables from sales made on
credit to customers.
• Inventories. Products manufactured or purchased that
have not yet been sold.
• Prepaid expenses. Costs paid ahead for next year™s
expenses.
• Property, plant, and equipment less accumulated deprecia-
tion. The original cost of long-term operating resources
less the cumulative amount of the cost that has been
recorded as depreciation expense so far.
• Advance payments from customers. Just what the account
title implies”cash received in advance from customers for
future delivery of products, so sales revenue has not yet
been recorded.
• Accounts payable. Amounts owed to creditors for pur-
chases on credit and for expenses that had not yet been
paid to vendors and suppliers at balance sheet date.
• Accrued expenses payable. Cumulative amounts owed for
certain expenses of period that had not been paid at bal-
ance sheet date.
These are called operating assets and liabilities because they
are generated in the operations of making sales and incurring
expenses. Operating liabilities are non-interest-bearing, which
sets them apart from the interest-bearing notes owed by the
business. Notes payable arise from borrowing money, not
from the revenue and expense operations of the business. The
operating assets and liabilities of a business constitute a good

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I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S


part of its balance sheet, as illustrated in Figure 2.3. This is
typical for most businesses.
The beginning and ending balances in the balance sheet
shown in Figure 2.3 are the sources of the data in Figure 2.1
for the cash flow and accrual-basis amounts of revenue and
expenses. The derivation of the amounts are summarized as
follows (amounts in millions of dollars):


$2.00 beginning balance of accounts receivable
$1.20 ending balance of advance payments from customers
$3.20 cash flow from last year™s sales or for next year™s sales

$2.50 ending balance of accounts receivable
$1.00 beginning balance of advance payments from customers
$3.50 sales made during the year but cash not collected during the year

$1.60 beginning balance of accounts payable
$0.60 beginning balance of accrued expenses payable
$4.70 ending balance of inventories
$0.60 ending balance of prepaid expenses
$7.50 cash payments during year of last year™s or for next year™s expenses

$1.70 depreciation expense for year (increase in accumulated depreciation)
$2.00 ending balance of accounts payable
$0.80 ending balance of accrued expenses payable
$3.90 beginning balance of inventories

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