Financial Statements PDF

7. Financial Statements This week we shall discuss four financial statements used by pharmacies: the income statement, balance sheet, capital statement, and sources and uses of these statements. This is followed by a brief explanation of a concept that is fundamental to understandi...

7. Financial Statements This week we shall discuss four financial statements used by pharmacies: the income statement, balance sheet, capital statement, and sources and uses of these statements. This is followed by a brief explanation of a concept that is fundamental to understanding financial statements - The accrual method of accounting. Finally we will present the concept and methods of depreciation and ratios. BALANCE SHEET The balance sheet, which may also be called a statement of final position, reports the financial status of the business. It tells what a business owns (its assets), what it owes (its liabilities), and how much is left over (owner equity), at a specific point in time. The fundamental balance sheet equation is: ASSETS = LIABILITIES + OWNERS’ EQUITY This equation states that assets must always be equal to the sum of liabilities plus owners equity. If assets decrease, there must be a corresponding decrease in either liabilities or owners’ equity (or their sum). If liabilities increase, either assets must be increased or owners’ equity must decrease. COMPONENTS OF THE BALANCE SHEET Below we see an example of a balance sheet. The balance sheet consists of three major sections: assets,liabilities and owners’ equity.  Bulldog Pharmacy Balance Sheet 31-12-20xx Assets Current Assets Cash $ 71,600 Accounts Receivables $ 92,400 Inventory $191,600 Total Current Assets $355,600 Non-Current Assets Fixtures & Equipment $ 80,000 Less Accumulated Depreciation $ 35,600 Net Fixtures and Equipment $ 44,400 Total Assets $400,000 Liabilities Current Liabilities Accounts Payable $ 64,800 Notes Payable (Current) $ 12,000 Accrued Tax Payable $ 23,600 Total Liabilities $100,400 Noncurrent Liabilities Mortgage $ 52,800 Total Liabilities $153,200 Owners’ Equity Capital Stock $ 25,000 Retained Earnings $221,800 Total Owners’ Equity $246,800 Total Liabilities and owners’ equity $400,00 ASSETS Assets are defined as valuable resources that are owned or controlled by the business and were acquired at a measurable cost. Examples include cash, accounts receivable, delivery cars, and computers. Assets are categorized as either current or non current. Current assets are those that will be sold, consumed or converted to cash within the current operating cycle of the business (which is usually one year). Current assets are listed on the balance sheet in order of liquidity, or the ease with which they can be converted to cash. The current assets commonly appearing in the balance sheet of pharmacies include cash, account receivable, inventories, prepaid expenses, and short term investments. Cash refers to coin, currency and other items, such as personal checks, charge card receipts, and travelers checks, which banks will accept for deposit cash of course is the most liquid asset. Accounts receivable are amounts owed to the pharmacy by its customer as a result of the ordinary extension of credit; in other words, accounts receivables are customers promise to pay for merchandise that they purchase on credit from the pharmacy. Conceptually, accounts receivable may be divided into those arising from credit sales and those arising from third party sales. Credit sales are charge sales made to the customers who themselves pay for the merchandise they have purchased on credit. This is a normal situation of a customer charging merchandise and then paying for it once he or she has been billed. Third party sales are charge sales made to a customer of the pharmacy but are paid for by a third party - Usually an insurance company or managed care organization. Most third-party sales are for prescriptions, Two different types of inventories may appear on the balance sheet: merchandise inventories and supplies inventories. The merchandise inventory is, by far, the largest and most important. In many cases, the balance sheet of a pharmacy will have only one entry labeled “inventory”. When this occurs, the notation refers to merchandise inventory. Merchandise inventory consists of goods that the pharmacy has purchased for resale. Examples of merchandise inventory in a pharmacy include OTC medication, prescription drugs, cosmetics and first aid supplies. Supplies inventory consists of goods that were purchased for use in the business rather than for resale. Supplies that have low unit value and will be consumed within the year. Examples of supplies include bags, pens and prescription labels and vials. At certain times during the year, a pharmacy may have more cash than it needs to conduct its business. Rather than simply leaving the cash in a checking account, which draws little to no interest, the pharmacy may invest its excess cash in money market accounts, stocks, bonds, and certificates of deposit with even higher rates of interest. When management intends to sell these inventories within the current operating cycle of the business because the business will need cash. The Investments are called short term investments, temporary investments, or marketable securities. Prepaid expenses arise from payments made for a good or service in an accounting period prior to one during which a good or service is actually used for example, if a pharmacy is required to prepaid its rent. Non current assets are those but under normal conditions are not sold, consumed, or converted to cash within the normal operating cycle of a business, or 1 year. They are assets that have been purchased for use in the business, which usually have high unit cost, and which are expected to last for several years. Examples include land, buildings, fixtures, cars, and computers. Non-current assets are also referred to as fixed assets or fixtures and equipment. Note in the balance sheet shown, non-current assets are described in three separate lines: The first line states the acquisition cost of non-current assets. This is what the business paid for the assets when they were initially purchased. The second line since the amount of accumulated depreciation. This is an accountant's estimate of the amount of the assets’ value that has been lost, or used up, as of the date on the balance sheet. The third line gives a net value of the non current assets. This is calculated as the acquisition cost less accumulated depreciation. (The net value of non current assets is only a rough estimate of their market value, or the amount for which they can be sold.) Frequently,a balance sheet will show only the net value of non current assets. LIABILITIES Liabilities are the business’s debts. They arise from purchasing goods or services on credit or from borrowing money to finance the business’s operations. As with assets, they are classified as either current or non-current. Current liabilities consist of those debts that will come due during the current operating cycle of a business. For a pharmacy, the most common occurring current liability include accounts payable, short term notes, occurred expenses, and the current portion of long-term debt. Accounts payable are debts that arise from purchase of goods or services on credit. For example, purchasing of accounting or janitorial services on credit would lead to an account payable. For a pharmacy, a vast majority of accounts payable come from purchase of merchandise inventory. Accounts payable that arise from purchase of inventory may also be called “trade payables.” Current or short-term notes payable are debts evidenced by formal, signed agreements called promissory notes. Notes payable arise when the pharmacy borrows money. When it does so, it must sign a written agreement that specifies when repayment must be made are not worth rate of interest When the pharmacy orders inventory from a wholesaler, no formal signed agreement is necessary. Thus, the resulting payable is an account payable. However, when the pharmacy gets a short-term loan from a bank, a promissory note is signed, and consequently, this is a note payable. The two are also different in that interest must be paid on a note payable but, assuming payment is made on time, no interest is paid on account payable. Accrued expenses are amounts owed for goods and services that have been used during the accounting period but for which payment has not been made. For example, as of the end of the accounting period, the pharmacy may owe its employees for salaries that will not be paid until sometime in the next accounting period. This might occur if the end of the accounting fell in the middle of a 2 week pay period. In this situation, the balance sheet for the period should show an accrued expense called accrued salaries payable to recognize that the pharmacy owed salaries as of the end of the period. On many long-term debt, such as a 5-year car loan or 20-year mortgage, some portion may be due in the current year. The portion of the long term debt that is due the current year is, consequently, a current liability and is called the current portion of long-term debt. As an example, the amount of a pharmacy’s mortgage that must be paid in the current accounting period may be listed as a current liability (the amount due in later periods would be listed as a non-current liability). Non-current liabilities are debts that will come due after the current operating cycle of the business. Examples include car loans that are paid off over 5 years and mortgages that are paid off over 20 years. Non-current liabilities may also be recorded as note payable (long term), mortgage or long term debt. OWNERS’ EQUITY Owners Equity is the amount left over after liabilities are subtracted from the assets. Owners Equity may also be called net worth, stockholders equity, or capital. It arises from two sources - invested capital or retained earnings. Invested Capital consists of cash invested into a business by its owners. For a corporation, it is called common or capital stock. Accountants make a strict distinction between the finances of the business and the finances of the owners of the business. They consider them two separate and distinct entities. This is true even when the business is a sole proprietorship (a business owned by one person). Hence, the transfer of cash from the owner's personal account to the business account is considered an investment into the business. Owners may also withdraw cash from the business. For a sole proprietorship or partnership, such withdrawals are referred to as owner withdrawals. For a corporation, they are called dividends paid. Dividends paid or owner withdrawals decrease invested capital and, consequently, owner equity. Retained earnings are profits (or losses) that the business has made during its years of operation and that have been left in the business. Profits increase retained earnings, while losses decrease them. For a corporation, the owner's equity section of the balance sheet has separate entries for both invested capital and retained earnings. A proprietorship has only one entry that includes both. This entry is written as “owners name, Capital”. For example, if I owned a business, my owner's equity section would be entitled “J Seelal, Capital.” INCOME STATEMENT The income statement, which is also called the profit and loss statement, reports the net income of a business for a specific period of time. This period may be a month, a quarter, or a year. A pharmacy will have an income statement made at least once per year. Many pharmacies generate income statements monthly to allow them to more closely monitor sales and expenses. The basic income statement equation is: Revenues - Expenses = Net Income Revenues are sales of merchandise normally sold by the business. For a pharmacy, all sales of prescription and OTC drugs, health and beauty aids, and sundries would be considered revenues. However, the sale of a delivery car would not be a revenue. This is because the pharmacy does not, as a normal part of its business, sell delivery cars. Nor would cash invested in the business by its owners be considered a revenue. Again, it is because the money coming in is not a result of the normal operation of the business. For most pharmacies revenues include both cash and credit sales. Expenses are costs at the business incurs to make sales or earn revenues. Expenses include all costs of operating the business. Examples are the cost of merchandise sold, salaries, utilities and interest payments. Repayment of the principal amount of a loan would not be an expense, nor would owner withdrawals from the business. One expense requires a special note. The depreciation expense is an estimate of the amount of noncurrent assets’ value that has been used up during the current operating cycle. Unlike other expenses, no direct cash payments are made for the depreciation expense. Net income is defined as the difference between revenues and expenses for a specific period of time. Net income is also called net profit or earnings. INCOME STATEMENT FOR A MERCHANDISING FIRM A merchandising firm is one that sells a tangible product. Examples include supermarkets, hardware stores, automobile dealerships, and pharmacies. An income statement for a merchandising firm is shown below. The major difference between the income statements of service and merchandising firms is the cost of goods sold. Because a merchandising firm generates revenues through sales of a tangible product, the cost to the firm of the products that it sells must be included on the income statement as an expense. This expense is referred to as the cost of goods sold. Cost of goods is not the same as merchandise inventory. Inventory consists of all goods that the pharmacy holds for resale in the normal course of its business. Inventory is an asset. When a pharmacy purchases inventory, it does not incur an expense. It simply exchanges assets - cash for inventory. The expense is incurred when the inventory is sold to a customer. When it is sold, the pharmacy incurs an expense. This expense is called the cost of goods sold. So, when merchandise is purchased, it is an asset called inventory: when merchandise is sold, it becomes an expense called cost of goods sold. As shown in the example, the cost of goods sold (COGS) may be determined in the following manner. The amount of inventory that the pharmacy has at the beginning of the year is referred to as the beginning inventory (BI). To the beginning inventory is added all purchases (P) that the pharmacy made during the year. Purchases consist of all merchandise that the pharmacy bought for resale to its customers. The sum of BI and P is known as cost of goods available for sale (COGAS). This is the total amount of merchandise that the pharmacy had available to sell over the entire year. The ending inventory (EI) is the amount of merchandise inventory on hand at the end of the year. Cost of goods sold is calculated by subtracting ending inventory from cost of goods available for sale. So, to summarize, COGS = B + P - EI. STATEMENT OF RETAINED EARNINGS The statement of retained earnings reports how the business’ retained earnings have changed over some period. The statement lists the amount of retained earnings at the beginning of the period and major changes to retained earnings over the period. These include dividend payments or net losses, which decrease retained earnings, and net income and additional owner investment, which increase retained earnings. For sole proprietorships and partnerships, a comparable statement is the capital statement. It shows how owners’ equity (which is also called capital) has changed over some period. Net income and owner investment increase owner equity (or capital), whereas net losses and owner withdrawals decrease it. SOURCES AND USES STATEMENT A pharmacy's revenues and expenses for a period of time are not the same as the amounts of cash taken in and paid out during that period. For this reason, the pharmacy needs one financial statement to report its revenues and expenses and another to report its cash flows. The income statement reports revenues and expenses for the year (or operating period). The sources and uses statement shows how a pharmacy obtained cash during the year (or operating period) and how it used that cash. The sources and uses statement may also be called a cash flow statement or a statement of changes in financial position. An example of a sources and uses statement is presented below in the example. It shows that the pharmacy’s largest sources of cash for 20 x 1 were profitable operations of the pharmacy (net income plus depreciation) and an increase in accounts payable. The largest uses included purchase of noncurrent assets and dividend paid. CASH VERSUS ACCRUAL ACCOUNTING Accountants must divide the life of the business into discrete accounting periods. For a pharmacy, an accounting period is usually 1 year. One of the major problems that accountants face is that of recording and matching revenues and expenses in the proper accounting periods. If revenues and expenses are not recognized in the proper accounting periods, then net income will be measured incorrectly. There are two common methods of detailing the time period in which a revenue or expense should be recorded. These are the cash and the accrual methods of accounting. In the cash method, revenues are recognized (that is, recorded as revenues) in the period during which cash is received and expenses are recognized in the period during which cash is paid out. For example, assume that the pharmacy dispenses the prescription for Mrs. Jones in December of 2015. If she pays for the prescription when she receives it the pharmacy will recognize revenue for the 2015 period. If she charges it and does not pay until January 2016, the revenue will be recognized in the 2016 accounting period. The cash method, while simple to understand and use, is not commonly used by pharmacies. The accrual method is more commonly used. In the accrual system, revenues are recognized in the period during which goods are delivered or services rendered. This is not necessarily the same period that cash is received. To continue the example used earlier under the accrual system, the pharmacy would recognize a revenue in the period during which the prescription was delivered to Mrs. Jones in 2015 regardless of when payment was made. Thus in the accrual system, both cash and credit sales are recognized as revenues at the time the sale is made, not necessarily when payment is received. There are two ways of determining when expenses are recognized in the accrual system. First, expenses are recognized in the same accounting period as the associated revenue. Thus, all the costs of making sales in 2015 are recognized as expenses in 2015, regardless of when payment was made. For example property taxes for 2015 are considered expenses of 2015 even though they may not be paid until 2016 or even though they may have been paid in 2014. Why? Because the property on which taxes are due was used to generate revenues in 2015. A second way of defining expense recognition in the accrual system is that expenses are recognized in the period when the associated good or service is used. Thus, all utilities used in 2015 are recognized as expenses in 2015 even if the bill for December’s utilities is not paid until January 2016. Or, the cost of merchandise that a pharmacy sells is not recognised as an expense until the merchandise is actually sold. So if a bottle of Maalox is purchased and paid for in December of 1994 and sold in January of 1995, the year in which it was sold. (When merchandise is purchased it is a current asset inventory. It only becomes an expense - cost of goods sold - when it has been sold.) Pharmacies use the accrual system because it allows for the accurate matching og the revenues of an accounting period with the expenses required to generate those revenues. In other words, they use this method because it allows for the accurate measurement of net income. DEPRECIATION Non-current assets are assets that are purchased for use in operation of the pharmacy and are expected to last longer than 1 year. Non-current assets are also known as fixed assets, operating assets, plant and equipment, and fixtures and equipment. Examples of fixed assets include delivery cars, computers, Unit dose carts, buildings and fixtures. Pharmacies purchase non-current assets because they need them to generate revenues. Pharmacies purchase, for example, computers to process prescription orders and store prescription records. These functions are necessary parts of the process of generating revenue from the sale of prescription. Over the period of its useful life, a non-current asset is used up, is worn out, or otherwise loses its value in the process of generating revenues. Because it is used to generate revenues, its cost must be recognized as an expense. And, because it is used to generate revenues over several years, its total cost cannot be recognized as an expense in the year during which it was purchased. Rather, part of its total cost must be recognized as an expense in each of the years of its useful life. This expense is called a depreciation expense. Depreciation is the process of systematically and rationally determining how much of a non-current asset’s initial cost is recognized as an expense in each year of its life. (Land is an exception, as it may be used to generate revenue, but it does not lose its value over time). CALCULATING DEPRECIATION DATA Three amounts must be known or estimated before the annual depreciation expense can be calculated. First, the asset’s acquisition cost must be determined. This is the amount of Pharmacy paid for the asset. In addition, acquisition cost includes any reasonable cost at the pharmacy incurred in acquiring the asset and putting it into operation. Thus, transportation, taxes, and set up costs are recorded as part of the acquisition cost of a fixed asset. Any costs of renovating or overhauling the asset data incurred before putting it into use are also considered part of the acquisition cost. For example, if a pharmacy purchased a building and had to renovate before using it, both the purchase price and the cost of the renovation would be included in the acquisition cost. Next, the asset’s useful life must be estimated. This is the length of time that the pharmacy intends to use the asset. A pharmacy might, for example, estimate the useful life of a computer at 5 years and the useful life of its building at 30 years. Finally, the asset’s estimated residual or salvage value must be estimated. This is an estimate of what the asset will be with at the end of its useful life. In making this estimate, the pharmacy must consider what the asset could be sold for, less any cost of disposing of the asset. The estimated useful life and residual value of a fixed asset vary depending on the pharmacy’s policies. For example, Bulldog Pharmacy may replace delivery cars every 3 years, whereas Tiger’s Pharmacy may replace them every 5 years. The annual depreciation expense for each pharmacy will be similar, despite the difference in useful lives, because the residual value for Bulldog Pharmacy’s cars will be substantially higher than that of Tigers Pharmacy’s cars. Once these quantities are determined, the pharmacy must select a depreciation method. METHODS OF DEPRECIATION Pharmacies must select either of three methods for calculating the annual depreciation expense. STRAIGHT LINE METHOD The straight line method of depreciation is the simplest and most straightforward of the three methods. It assumes that non-current assets wear out or are used up at a constant rate. As a result, the depreciation expense is the same each year of the asset’s life. As a result, the depreciation expense is calculated by multiplying the asset’s acquisition cost less residual value by the straight line rate of depreciation. The straight line rate of depreciation is equal to 1 divided by the asset’s useful life. Hence: In the example below, the calculation of the straight line depreciation for the sample data is shown. In each year, the annual depreciation expense is calculated as cost minus residual value ($30,000) multiplies by the straight line rate (1/N) of ⅕. Thus, the depreciation expense is $6000 in each of the years of the computer’s useful life. ACCELERATED METHODS The other two methods are called accelerated methods because they take off proportionally more of an asset’s value in the early years of its life and proportionally less in later years. These methods are based on the assumptions that the asset is more efficient or that it loses more of its value in the early years of its life. This is a reasonable assumption for many non-current assets. Cars, for example, lose much more of their value in the first year after their purchase than in later years. The two accelerated methods most commonly used are the sum of years digits and double declining balance methods. SUM OF YEARS DIGITS To calculate the annual depreciation expense by the sum of years digits method, the asset’s cost minus its residual value is multiplied by a fraction that decreases each year. The numerator of the fraction is the number of years of life the asset had remaining at the beginning of the current year. The denominator is the sum of years digits. The calculation of this method is shown in the above example. At the beginning of the first year during which the pharmacy used the computer, it had 5 years of useful life remaining. The sum of digits is 5+4+3+2+1=15. The depreciation expense for the first year is calculated as cost minus residual value ($30,000) multiplied by 5/15. This yields a first year depreciation expense of $10,000. The annual depreciation expense declines each year. At the beginning of the 5th year, only 1 year of useful life remains. The sum of years digits remains 15, and the cost minus residual remains $30,0000. Thus, the depreciation expense for the last year of the computer's life is $30,000 x 1/15= $2000. DOUBLE DECLINING BALANCE METHOD The annual depreciation expense is calculated in the double declining balance method by multiplying the book value of the asset by twice (or double) the straight line rate of depreciation. The book value of an asset is its acquisition cost minus its accumulated depreciation. Two things to note about this method: 1. Book value, the amount that is depreciated, declines each year. 2. The total amount of depreciation recognized over the life of the asset cannot exceed the asset’s acquisition cost less its residual value. This example shows the calculation of the annual depreciation expense using this method. In the first year of the computer’s use, no depreciation has accumulated. Thus, the computer’s book value is the same as its cost: $35,000. This amount is multiplied by double the straight line rate - or ⅖ - to give the first year depreciation expense of $14,000. In the second year of the computer’s life, $14,000 of depreciation has been accumulated. Thus, the book value for the second year is $35,000 - $14,000 = $21,000. This amount is multiplied by ⅖ to yield the second-year depreciation expense of $8400. This process is continued each year. However, in the fourth year, the calculated amount of depreciation would depreciate the asset below its residual value. Because this is not allowable, the amount of depreciation expense actually recognized in this year is the amount necessary to reduce the asset’s book value to its residual value. There is no depreciation expense in the fifth year of the asset’s life because the full amount of allowable depreciation has been recognized in the first 4 years. COMPARISON OF DEPRECIATION METHODS In this comparison, we can see that the accelerated methods do, in fact, recognize more of the asset’s value as an expense in its early years of life compared to its later years. However, the total amount of depreciation expense recognized over the life of the asset is the same for all methods.