chapter 2: financial statements and the accounting process
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Chapter 2: Financial Statements and the Accounting Process
Financial AccountingGAAP (Generally
Accepted Accounting Principles)
The Accounting Information System
Financial Statements
Parties involved in Standard Setting
Conceptual framework
Qualitative Characteristics or Fundamental
Concepts
Recognition and Measurement
Concepts
Assumptions
Principles
Constraints
Objectives
Financial AccountingGAAP (Generally
Accepted Accounting Principles)
The Accounting Information System
Financial Statements
Transaction Analysis
Financial StatementsParties
involved in Standard Setting
Conceptual framework
Qualitative Characteristics or Fundamental
Concepts
Recognition and Measurement
Concepts
Assumptions
Principles
Constraints
Objectives
Today’s class objectives
Transaction Analysis
Financial Statements
Statement of Stockholders’ Equity
Balance Sheet
Statement of Cash Flows
Income Statement
Assets
Liabilities
Equity
Statement of Retained
Earnings
Contributed Capital
Retained Earnings
Stock
Net Income
Dividends
Point in Time Period of Time
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
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).
The B/S: Assets Current assets (CA)
Cash Short-term marketable securities Accounts receivable Inventory Prepaid expenses
Property, plant, and equipment (PP&E) Long-term investments Intangible assets
Patents Goodwill
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.
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
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.
The B/S: Equity for Single Owner (Proprietorship)
Owner’s equity account consists of: contributions by owner withdrawals by owner earnings of the proprietorship
Ex: John Smith, Capital $150,000
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
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
Ex. 2-14Indicate: 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
Ex. 2-14 - continuedIndicate: 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
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.
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.
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
Analyzing the impact of transactions on the company’s Balance Sheet – Smile Inc.
1. 1/5/06 Gil invests $60,000 to begin his comic book store business (“Smile Inc”), and Smile Inc. issues common stock.
2. 1/7/06 Smile Inc. purchases a small store, paying $50,000 in cash.3. 1/10/06 Smile Inc. acquires furniture for $4,000 on account (payable/due within
14 days).4. 1/11/06 Smile Inc. purchases a computer system, costing $2,000 on account
(payable/due within 30 days).5. 1/15/06 Smile Inc. applies and receives a loan in the amount of $10,000 from
Best Bank.6. 1/20/06 Smile Inc. purchases comic books (Inventory) for $8,000 ($1,000 cash
and the rest on account due within 30 days).7. 1/22/06 Gil buys some furniture for his apartment for $1,500 using his credit
card.8. 1/24/06 Smile Inc. returns some inventory (which was purchased for $500) for
full credit.9. 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
Smile Inc.
Stockholders’ Assets = Liabilities + Equity
=
(1) =
(2) =
(3) =
(4) =
(5) =
(6) =
(7) =
(8) =
(9) ______ ______ ______ ______ = _______ ________ ________
Tot
Cash Inventory
Furniture & Computers Store
Accounts
Payable
Loan (note Payable)
Common Stock
+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
Smile Inc.Balance Sheet
Jan / 31 / 2006
Assets: Liabilities:
Cash 15,000 A / P 8,500
Inventory 7,500 Loan (N/P) 10,000
PP&E-Furniture 6,000 18,500
PP&E-Store 50,000 SE 60,000
78,500 78,500
Point in Time
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”)
The Statement of Owner’s Equity
Beginning owner’s equity (OEBegin) Plus: Investments by owners (I) Plus: Net income (NI) Less: Withdrawals by owners (W) Ending owner’s equity (OEEnd)
OEBegin + I + NI - W = OEEnd
Period of Time
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
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
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
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
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
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)
The Statement of Stockholders’ Equity
Start of Period
Beginning balance of SE
Statement of Retained Earnings
Beginning balance of Contributed Capital
Beginning balance of Retained Earnings
End of Period
PERIOD
Ending balance of SE
Ending balance of Retained Earnings
Ending balance of Contributed Capital
+ Net Income
- Dividends
+ Issue of Stock
Today’s class objectives
Transaction Analysis
Financial Statements
Statement of Stockholders’ Equity
Balance Sheet
Statement of Cash Flows
Income Statement
Assets
Liabilities
Equity
Statement of Retained
Earnings
Contributed Capital
Retained Earnings
Stock
Net Income
Dividends
Operating
Losses
Gains
Revenues
Expenses Investing
Financing
Point in Time Period of Time
The Income Statement Revenues (Rev.)
inflow of assets or settlement of liabilities from delivery of goods or services related to a company’s central operations.
Expenses (Exp.) outflow or consumption of assets or
incurrence of liabilities from delivery of goods or services related to a company’s central operations.
Period of Time
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.
The Income Statement:Revenues - 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
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
Relationships Among theFinancial Statements
Statement ofCash Flows
IncomeStatement
Statement of O.E.or
Statement of R.E.or
Statement of S.E.
EndingBalance Sheet
Assets (Cash)
=
Liabilities
+
Equity
BeginningBalance Sheet
Assets (Cash)
=
Liabilities
+
Equity
The Statement of Stockholders’ Equity
Start of Period
Beginning balance of SE
Beginning balance of Contributed Capital
Beginning balance of Retained Earnings
End of Period
PERIOD
Ending balance of SE
Ending balance of Retained Earnings
Ending balance of Contributed Capital
+ Net Income
- Dividends
+ Issue of Stock
+ Revenues
- Expenses
Solution:Issue of stocks?A = 50 – 50 = 0
Net Income?Net Income = Rev. - ExpB = NI = 150 – 100 = 50
REbeg?
REbeg + NI – Div = REend C + 50 – 30 = 110C = 90
Revenues $150
Expenses 100
Dividend 30
Issue of stocks A
Net Income B
RE – Beg C
RE – End 110
Cont. Capital – Beg 50
Cont. Capital – End 50
Total Assets – Beg D
Total Assets – End 250
Total Liabilities – Beg 95
Total Liabilities – End E
Solution:
Asset – beginning?
A = L + SE
A = L + (Cont. Capital + RE)
D = 95 + (50 + 90) = 235
Liabilities – ending?
250 = E + (50 + 110)
E = 90
Revenues $150
Expenses 100
Dividend 30
Issue of stocks A=0
Net Income B=50
RE – Beg C=90
RE – End 110
Cont. Capital – Beg 50
Cont. Capital – End 50
Total Assets – Beg D
Total Assets – End 250
Total Liabilities – Beg 95
Total Liabilities – End E
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.
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 _____ _____ _____ = _____ _____ _____
Tot. 12,350 + 3,850 + 1,350 = 4,000 + 15,000 + (1,450)
15,000 15,0005,000 5,000
(2,500) (2,500) exp.
2,200 2,200 rev.
(1,150) (1,150) exp.850 (850)
(1,000) (1,000)
Point in Time
Ex. 2-44 Financial StatementsIncome 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)
Period of Time
Ex. 2-44 Financial StatementsBalance 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
4,00015,000(1,450)
17,550
Point in Time
Ex. 2-44 Financial Statements
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)
15,000
12,350
Period of Time
Total (2,650)
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 _____ _____ _____ = _____ _____ _____ _____
Tot. 7,400 + 150 + 1,500 = 2,200 + 100 + 3,000 + 3,750
100 100 rev.
150 150 rev.
(200) (200) exp.
(200) 200 rev.(500) (500) exp.
Point in Time
Ex. 2-45 Financial StatementsIncome 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
Period of Time
Ex. 2-45 Financial StatementsBalance 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
1,5009,050
2,200100
3,7509,050
3,000
Point in Time
Ex. 2-45 Financial Statements
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)
7,5007,400
Period of Time
Accrual Basis and Cash BasisThe 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
Accrual Basis and Cash BasisUnder 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.
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.
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
Accrual BasisRevenue 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.
Ex. 2-38 Adjustments to Financial statements
Assets = Liabilities + Stockholders’ equity
a. =
b. =
c. =
d. =
e. =
f. =
g. =
h. =
Tax Payable +500
Wages Payable +2,400
Rental Payable +240
Unearned Rev. -600
Interest Receivable +75
RE (Tax Expense) -500
RE (Wages Exp.) -2,400
RE (Interest Rev.) +75
RE (Rental Exp.) -240
RE (Rent Revenue) +300
RE (Insurance Exp.) +320
RE (Rent Revenue) +600
Rent Receivable +300
No Entry
Prepaid Insurance +320
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
CashAccounts Receivable
Wages Payable Retained Earnings
+
Beg. Bal. Beg. Bal.
+ Net Income (Revenues–IS)
- +
+ - Net Income (Expenses–IS)
- -End. Bal.End. Bal.
2-32 – Cash Flow CalculationARbeg + Revenues – Collections = ARend
3 + 11 - X = 2
X = 12
Payablesbeg + Expenses – Payments = Payablesend
2 + 6 - Y = 3
Y = 5
Template CompanyIncome Statement
For the Period Ended December 31, 20XX
RevenuesService 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) - $Net income =$
Template CompanyBalance Sheet
December 31, 20XX
ASSETS
Current AssetsCashAccounts Receivable (net)InventoryShort Term InvestmentsPrepaid Expenses
Total Current Assets
Long Term Investments
Property, Plant and EquipmentLand, Buildings, ImprovementsEquipment, Furniture, Vehicle(Less Accumulated Depreciation)
Total PPE (net)
TOTAL ASSETS
LIABILITIES Current Liabilities
Accounts PayableWages PayableNotes PayableUnearned Revenues
Total Current LiabilitiesLong-Term Liabilities
Long-Term LoansLong-Term NotesMortgage
Total Long-Term LiabilitiesTOTAL LIABILITIES
EQUITYContributed Capital
Preferred/Common stockAdditional Paid in Capital
Retained Earnings TOTAL EQUITYLIABILITIES AND EQUITY