Chapter 2: Financial Statements and the Accounting Process

1
Chapter 2 Financial Statements and the
Accounting Process
2
Financial Accounting
GAAP (Generally Accepted Accounting Principles)
The Accounting Information System
Financial Statements
Parties involved in Standard Setting
Conceptual framework
Objectives
Qualitative Characteristics or Fundamental
Concepts
Assumptions
Recognition and Measurement Concepts
Principles
Constraints
3
Financial Accounting
GAAP (Generally Accepted Accounting Principles)
The Accounting Information System
Financial Statements
Financial Statements
Parties involved in Standard Setting
Conceptual framework
Transaction Analysis
Objectives
Qualitative Characteristics or Fundamental
Concepts
Assumptions
Recognition and Measurement Concepts
Principles
Constraints
4
Todays class objectives
Financial Statements
Point in Time
Period of Time
Statement of Stockholders Equity
Balance Sheet
Statement of Cash Flows
Income Statement
Contributed Capital
Retained Earnings
Assets
Liabilities
Stock
Statement of Retained Earnings
Net Income
Equity
Dividends
Transaction Analysis
5
The Balance Sheet (B/S)

• Based on the relationship
• Assets Sources of Assets
• Assets Claims to Assets
• Assets Liabilities Equity
• The Balance Sheet (or Accounting) Equation
• Assets Liabilities Stockholders Equity
• A L SE

Point in Time
6
The B/S Assets

• Assets are
• probable future economic benefits
• obtained or controlled by an entity
• result of past transactions or events.
• On B/S, classified in order of liquidity current
  and non-current.
• Current assets are expected to be converted to
  cash, sold, or used up within the next accounting
  period (usually defined as a year).

7
The B/S Assets

• Current assets (CA)
• Cash
• Short-term marketable securities
• Accounts receivable
• Inventory
• Prepaid expenses
• Property, plant, and equipment (PPE)
• Long-term investments
• Intangible assets
• Patents
• Goodwill

8
The B/S Liabilities

• Liabilities are claims by creditors against the
  assets of a company.
• The creditors have a priority claim (before the
  owners) to the assets in liquidation.
• Liabilities are classified in terms of due dates
  current liabilities and non-current liabilities.
• Current liabilities will require the use of
  current assets or the creation of other current
  liabilities at maturity.

9
The B/S Liabilities

• Current liabilities (CL)
• Accounts payable
• Wages payable
• Interest payable
• Short-term notes payable
• Unearned revenues
• Other payables
• Long-term liabilities (LTL)
• Bonds payable
• Mortgage payable
• Long-term notes payable

10
The B/S Equity

• Equity represents the claims of the owners
  against the assets of a company.
• Corporations have a different form of ownership
  than proprietorships (individual owner), but the
  concept is the same.
• Most of the applications in this course will be
  for corporations, but some of the early material
  deals with proprietorships.

11
The B/S Equity for Single Owner
(Proprietorship)

• Owners equity account consists of
• contributions by owner
• withdrawals by owner
• earnings of the proprietorship
• Ex John Smith, Capital 150,000

12
The B/S Equity for Corporation

• Stockholders equity (SE) consists of
• Contributed capital (CC)
• Common Stock
• Preferred Stock (see Chapter 9)
• Additional paid in capital (see Chapter 9)
• Retained earnings (RE)
• Net income
• Dividends
• SE CC RE

13
The B/S Equity for Corporation Ex Stockholders
equity

• Common stock (5,000 shares
• at 2 par value) 10,000
• Paid-in capital in excess of par 90,000
• Total paid-in capital 100,000
• Retained Earnings 50,000
• Total Stockholders equity 150,000

14
Ex. 2-14

• Indicate CA, PE, OA, CL, LTL, SE
• ___ Cash
• ___ Common Stock
• ___ Notes Payable
• ___ Prepaid Insurance
• ___ Accounts Receivable
• ___ Machinery
• ___ Investments
• ___ Patents

CA
SE
CL/LTL
CA/OA
CA
PE
OA
OA
15
Ex. 2-14 - continued

• Indicate CA, PE, OA, CL, LTL, SE
• ___ Taxes Payable
• ___ Inventory
• ___ Wages Payable
• ___ Accounts Payable
• ___ Marketable Securities
• ___ Land
• ___ Goodwill
• ___ Interest Payable

CL
CA
CL
CL
CA/OA
PE
OA
CL
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Balance Sheet - Transactions

• The balance sheet is affected by every
  transaction that an entity encounters.
• Each transaction has counter balancing
  entries that keep total assets equal to
  total liabilities and owners equity,
  i.e., the balance sheet equation and
  the balance sheet must always
  be balanced.

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Balance Sheet - Transactions

• A balance sheet could be prepared after every
  transaction, but this practice would be awkward
  and unnecessary.
• Therefore, balance sheets are usually prepared
  monthly or on some other periodic schedule.

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Balance Sheet - Transactions

• Transactions are recorded in accounts, which are
  summary records of the changes in particular
  assets, liabilities, or owners equity.
• The account balance is the total of all entries
  to the account.
• For each transaction, the accountant determines
• Which specific accounts are affected
• Whether the account balances are increased or
  decreased
• The amount of the change in each account

19
Analyzing the impact of transactions on the
companys Balance Sheet Smile Inc.

• 1/5/06 Gil invests 60,000 to begin his comic
  book store business (Smile Inc), and Smile Inc.
  issues common stock.
• 1/7/06 Smile Inc. purchases a small store, paying
  50,000 in cash.
• 1/10/06 Smile Inc. acquires furniture for 4,000
  on account (payable/due within 14 days).
• 1/11/06 Smile Inc. purchases a computer system,
  costing 2,000 on account (payable/due within 30
  days).
• 1/15/06 Smile Inc. applies and receives a loan in
  the amount of 10,000 from Best Bank.
• 1/20/06 Smile Inc. purchases comic books
  (Inventory) for 8,000 (1,000 cash and the rest
  on account due within 30 days).
• 1/22/06 Gil buys some furniture for his apartment
  for 1,500 using his credit card.
• 1/24/06 Smile Inc. returns some inventory (which
  was purchased for 500) for full credit.
• 1/24/06 Smile Inc. pays for the furniture bought
  in transaction 3.
• Required 1. Record the transactions using the
  Balance Sheet Equation
• 2. Prepare a Balance Sheet for 1/31/2006

Point in Time
20
Smile Inc.

• Stockholders
  Assets Liabilities Equity
  
• (1)
• (2)
• (3)
• (4)
• (5)
• (6)
• (7)
• (8)
• (9) ______ ______ ______ ______ _______
  ________ ________
• Tot

Furniture Computers
Accounts Payable
Loan (note Payable)
Common Stock
Cash
Inventory
Store
60,000
60,000
-50,000
50,000
4,000
4,000
2,000
2,000
10,000
10,000
-1,000
8,000
7,000
No Transaction
-500
-500
-4,000
-4,000
15,000 7,500 6,000 50,000
8,500 10,000 60,000
Point in Time 1/31/2006
21
Smile Inc.
Point in Time

• Balance Sheet
• Jan / 31 / 2006
• Assets Liabilities
• Cash 15,000 A / P 8,500
• Inventory 7,500 Loan (N/P) 10,000
• PPE-Furniture 6,000 18,500
• PPE-Store 50,000 SE 60,000
• 78,500 78,500

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The Statement of Stockholders Equity

• Equity represents the claims of the owners
  against the assets of a company.
• Equity is the excess of assets over liabilities
  of a company (Net Assets)

23
The Statement of Owners Equity

• Beginning owners equity (OEBegin)
• Plus Investments by owners (I)
• Plus Net income (NI)
• Less Withdrawals by owners (W)
• Ending owners equity (OEEnd)
• OEBegin I NI - W OEEnd

Period of Time
24
The Statement of Stockholders Equity

• Beginning stockholders equity (SEBegin)
• Plus Issue of stock (I)
• Plus Net income (NI)
• Less Dividends paid to stockholders (Div)
• Ending stockholders equity (SEEnd)
• SEBegin I NI - Div SEEnd

Period of Time
25
The Statement of Retained Earnings

• Beginning retained earnings balance (REBegin)
• Plus Net income (NI)
• Less Dividends (Div)
• Ending retained earnings balance (REEnd)
• REBegin NI - Div REEnd
• Note that the Statement of Retained Earnings is a
  subset of the Statement of Stockholders Equity.

Period of Time
26
Ex. 2-17 (20X1, 20X2, and 20X3)

• Use the following formulas to solve for the
  missing items
• A L SE
• SEBegin Issue NI - D SEEnd

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Ex. 2-17 (20X1, in 000s)

• (a) SE, 1/1/X1
• A L SE
• 100 60 SE
• 40 SE
• (b) SE, 12/31/X1
• SEBegin Issue NI - D SEEnd
• 40 18 20 - 20
  SEEnd
• 58
  SEEnd

28
Ex. 2-17 (20X2, in 000s)

• (c) Liabilities, 1/1/X2
• A L SE
• 120 L 58
• 62 L
• (d) SE, 1/1/X2 SE,12/31/X1
• 58
• (e) SE, 12/31/X2 SE, 1/1/X3 75,000

29
Ex. 2-17 (20X3, in 000s)

• (f) Assets, 1/1/X3
• A L SE
• A 72 75
• 147 72 75
• (g) Income or (loss)
• 57 75 17 (1)

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The Statement of Stockholders Equity
Statement of Retained Earnings

Beginning balance of SE
Start of Period

Beginning balance of Contributed Capital
Beginning balance of Retained Earnings
PERIOD

Net Income
- Dividends
Issue of Stock

Ending balance of Retained Earnings
Ending balance of Contributed Capital
End of Period
Ending balance of SE
31
Todays class objectives
Financial Statements
Point in Time
Period of Time
Statement of Stockholders Equity
Balance Sheet
Statement of Cash Flows
Income Statement
Contributed Capital
Retained Earnings
Operating
Revenues
Assets
Expenses
Investing
Liabilities
Stock
Statement of Retained Earnings
Gains
Financing
Net Income
Equity
Losses
Dividends
Transaction Analysis
32
The Income Statement

• Revenues (Rev.)
• inflow of assets or settlement of liabilities
• from delivery of goods or services
• related to a companys central operations.
• Expenses (Exp.)
• outflow or consumption of assets or incurrence of
  liabilities
• from delivery of goods or services
• related to a companys central operations.

Period of Time
33
The Income Statement

• Gains
• inflow of net assets
• from activities that are peripheral operations.
• Losses
• outflow of net assets
• from activities that are peripheral operations.
• Note that some items that fall into this category
  still have the title revenue or expense.
  Examples include interest revenue and interest
  expense.

34
The Income StatementRevenues - Expenses Net
Income

• Revenue examples
• Sales
• Fees earned
• Other revenues and gains
• Expense examples
• Cost of goods sold
• Wage expense
• Rent expense
• Selling expense
• Depreciation expense
• Other expenses and losses

35
The Statement of Cash Flows

• Cash flows from operating activities
• Usually cash flows related to income statement
  items (e.g., cash inflows from sales, cash
  outflows from interest payments).
• Cash flow from investing activities
• Usually cash flows related to non-current assets
  (e.g., cash outflow from purchase of equipment).
• Cash flow from financing activities
• Usually cash flows related to equity items or
  non-current liabilities (e.g., sale of stock,
  issuance of bonds).

Period of Time
36
Relationships Among theFinancial Statements
Ending Balance Sheet
Beginning Balance Sheet
Statement of Cash Flows
Assets (Cash)
Assets (Cash)
Income Statement


Liabilities
Liabilities


Statement of O.E. or Statement of
R.E. or Statement of S.E.
Equity
Equity
37
The Statement of Stockholders Equity

Beginning balance of SE
Start of Period
Beginning balance of Contributed Capital
Beginning balance of Retained Earnings
PERIOD

Revenues
Net Income
- Expenses
- Dividends
Issue of Stock

Ending balance of Retained Earnings
Ending balance of Contributed Capital
End of Period
Ending balance of SE
38

• Solution
• Issue of stocks?
• A 50 50 0
• Net Income?
• Net Income Rev. - Exp
• B NI 150 100 50
• REbeg?
• REbeg NI Div REend
• C 50 30 110
• C 90

39

• Solution
• Asset beginning?
• A L SE
• A L (Cont. Capital RE)
• D 95 (50 90) 235
• Liabilities ending?
• 250 E (50 110)
• E 90

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Transaction Analysis

• The foundation of financial accounting.
• Based on the balance sheet/accounting equation
• Assets Liabilities Equity
• Every economic transaction affects at least two
  items in the accounting equation.
• Illustration Ex. 2-44.

41
Ex. 2-44 Worksheet

• Cash Parts A/R A/P
  C/S RE
• 9/3
• 9/9
• 9/12
• 9/18
• 9/20
• 9/26
• 9/29 _____ _____ _____ _____
  _____ _____

15,000
15,000
5,000
5,000
(2,500)
(2,500) exp.
2,200
2,200 rev.
(1,150)
(1,150) exp.
850
(850)
(1,000)
(1,000)

Tot. 12,350 3,850 1,350 4,000
15,000 (1,450)
Point in Time
42
Ex. 2-44 Financial Statements
Period of Time

• Income Statement - Month of September
• Revenues ________
• Expenses ________
• Net Income (loss) ________
• Statement of Retained Earnings - September
• RE (beginning) ________
• Net Income (loss) ________
• Dividends ________
• RE (ending) ________

2,200
(3,650)
(1,450)
-0-
(1,450)
-0-
(1,450)
43
Ex. 2-44 Financial Statements
Point in Time

• Balance Sheet - at September 30
• Assets
• Cash ________
• Parts ________
• A/R ________
• Total ________
• Liab. and S.E.
• A/P ________
• CS ________
• RE (ending) ________
• Total ________

12,350
3,850
1,350
17,550
4,000
15,000
(1,450)
17,550
44
Ex. 2-44 Financial Statements
Period of Time

• Statement of Cash Flows - for September
• Cash flow from operating activities
• Cash collected from customers ________
• Cash paid to suppliers ________
• Cash paid for rent ________
• Cash flow from financing activities
• Cash from issue of stock ________
• Net increase in cash ________

850
(1,000)
(2,500)
Total (2,650)
15,000
12,350
45
Ex. 2-45 Worksheet

• Nov. Cash A/R Supp N/P U.Rev
  C/S RE
• Bal. 7,500 2,000 2,200 300
  3,000 4,000
• 2
• 7
• 11
• 17
• 30 _____ _____ _____ _____
  _____ _____ _____

100
100 rev.
150
150 rev.
(200)
(200) exp.
(200)
200 rev.
(500)
(500) exp.
Tot. 7,400 150 1,500 2,200 100
3,000 3,750

Point in Time
46
Ex. 2-45 Financial Statements
Period of Time

• Income Statement - Month of November, 2001
• Revenues ________
• Expenses ________
• Net Income (loss) ________
• Statement of Retained Earnings - November
• RE (beginning) ________
• Net Income (loss) ________
• Dividends ________
• RE (ending) ________

450
(700)
(250)
4,000
(250)
-0-
3,750
47
Ex. 2-45 Financial Statements
Point in Time

• Balance Sheet - at November 30, 2001
• Assets
• Cash ________
• A/R ________
• Supplies ________
• Total ________
• Liab. and S.E.
• N/P ________
• Unearned Fees ________
• C/S ________
• RE (ending) ________
• Total ________

7,400
150
1,500
9,050
2,200
100
3,000
3,750
9,050
48
Ex. 2-45 Financial Statements
Period of Time

• Statement of Cash Flows - for November, 2001
• Cash flow from operating activities
• Cash collected from customers ________
• Cash paid to employees ________
• Cash paid for supplies ________
• Net decrease in cash ________
• Beginning cash balance ________
• Ending cash balance ________

100
(200)
--
(100)
7,500
7,400
49
Accrual Basis and Cash Basis

• The most common ways of measuring income are the
  accrual basis and the cash basis.
• Accrual basis - recognizes the impact of
  transactions for the time periods when revenues
  and expenses occur even if no cash changes hands
• Cash basis - recognizes the impact of
  transactions only when cash is received or
  disbursed

50
Accrual Basis and Cash Basis

• Under the accrual basis
• Revenues are recorded when earned.
• For example, a sale on account is recorded as
  revenue when the transaction takes place even
  though the seller receives no cash at that
  moment.
• Expenses are recorded when incurred.
• For example, a purchase on account is recorded as
  an expense when the transaction takes place even
  though the buyer disburses no cash at that moment.

51
Accrual Basis and Cash Basis

• Under the cash basis
• Revenues are recorded when a sale is made for
  cash at the time when the cash changes hands.
• Expenses are recorded when a purchase is made for
  cash at the time when the cash changes hands.

52
Accrual Basis and Cash Basis

• The accrual basis is the current standard for the
  measurement of income.
• Presents a more complete summary of what happened
  during the year
• Recognizes revenues when they are earned and
  expenses when they are incurred
• Matches costs to revenues

53
Accrual Basis

• Revenue Recognition has two parts. Both must
  occur for revenues to be recognized
• Earned Delivery has occurred or services have
  been rendered.
• Realization Cash collection is reasonably
  assured.
• Matching is the recording of expenses in the
  same time period as the related revenues are
  recognized. There are two types of expenses
• Product costs, which are naturally linked with
  revenues (e.g., cost of goods sold).
• Period costs, which are expenses that are
  incurred over a particular time period.

54
Ex. 2-38 Adjustments to Financial statements
Tax Payable 500
RE (Tax Expense) -500
Wages Payable 2,400
RE (Wages Exp.) -2,400
Interest Receivable 75
RE (Interest Rev.) 75
Rental Payable 240
RE (Rental Exp.) -240
Unearned Rev. -600
RE (Rent Revenue) 600
RE (Rent Revenue) 300
Rent Receivable 300
No Entry
RE (Insurance Exp.) 320
Prepaid Insurance 320
55
2-32 Cash Flow Calculation

• Assets Liabilities Stockholders
  Equity
• Credit Sales
• Collections
• Salaries Expenses
• Payments to Employees _______
  ________
• ARbeg Revenues Collections ARend
• Payablesbeg Expenses Payments
  Payablesend

Accounts Receivable
Wages Payable
Cash
Retained Earnings
Beg. Bal.
Beg. Bal.



Net Income (RevenuesIS)
-


- Net Income (ExpensesIS)
-
-
End. Bal.
End. Bal.
56
2-32 Cash Flow Calculation

• ARbeg Revenues Collections ARend
• 3 11 - X 2
• X 12
• Payablesbeg Expenses Payments Payablesend
• 2 6 - Y 3
• Y 5

57
Template CompanyIncome StatementFor the Period
Ended December 31, 20XX

• Revenues
• Service revenues
• Sales revenues
• Total revenues
• Cost of revenues/goods sold -
• Gross profit
• Operating expenses
• Sales and marketing -
• General and administrative -
• Total operating expenses -
• Income from operations
• Other income, gains and losses /-
• Income from operations before income taxes
• Provision for income tax (tax expense) -
• Net income

58
Template CompanyBalance Sheet December 31, 20XX

• ASSETS
• Current Assets
• Cash
• Accounts Receivable (net)
• Inventory
• Short Term Investments
• Prepaid Expenses
• Total Current Assets
• Long Term Investments
• Property, Plant and Equipment
• Land, Buildings, Improvements
• Equipment, Furniture, Vehicle
• (Less Accumulated Depreciation)
• Total PPE (net)

• LIABILITIES
• Current LiabilitiesAccounts PayableWages
  Payable
• Notes Payable
• Unearned Revenues
• Total Current Liabilities
• Long-Term LiabilitiesLong-Term LoansLong-Term
  Notes
• Mortgage
• Total Long-Term Liabilities
• TOTAL LIABILITIES
• EQUITY
• Contributed Capital
• Preferred/Common stock
• Additional Paid in Capital
• Retained Earnings
• TOTAL EQUITY
• LIABILITIES AND EQUITY