Week 2Creating Financial Statements From Transactions

The Fundamental Accounting Equation

Assets = Liabilities + Stockholders’ Equity

I.O.U.= +

I.O.U.

Economic Events Relevant events have economic significance

to a company and include any occurrence that affects its financial condition.

The dollar values assigned these events must be determined in an objective manner.

Two Methods To Record Transactions Traditional (Hard!) way used by

accountants/bookkeepers Debits Credits T-accounts

Our methods Spreadsheet based on accounting equations

Increases and decreases

Journal Entries

The Journal Entry Box1. What accounts are affected?

2. What is the directionof the effect?

AssetsLiabilities andStockholders’ Equity

Increase

Decrease

3. What is the dollar value of the transaction?

Asset Accounts

$Debit(left)

Liab/Stock Eq. Accounts

$Credit(right)

Asset Accounts Liab/Stock Eq. Accounts

$Credit(right)

$Debit(left)

=

Recording Transactions Accounting equation (A = L + OE) Debits = credits Journal entries T-accounts

The Balance Sheet Depicts net worth at a point in time Assets

Resources with future value Liabilities

Obligations to non-owners A source of the resources

Owners’ Equity The difference between assets and liabilities Another source of the resources Two forms

Contributed Capital (Common Stock) Earned Capital (Retained Earnings)

Assets Something owned Has future value (otherwise expense in current period) Current versus long-term Examples include: cash, accounts receivable, notes receivable,

marketable securities, prepaid expense, property plant and equipment, intangibles

Appears on balance sheet Permanent account Normal balance is a debit

Liabilities Something owed Current versus long-term Examples include: accounts payable, notes

payable, other payables, unearned revenue Appears on balance sheet Permanent account Normal balance is a credit

I.O.U.

Equity Difference between assets and liabilities Net worth (book value) Stock (Paid-in-capital) Retained Earnings (accumulated net earnings less dividends

distributed) Income statement and dividends are closed to retained

earnings Appears on balance sheet and separate statement Permanent account Normal balance is a credit

The Income Statement A measure of entity performance for a period of

time. Based on accrual accounting Ties to the Balance Sheet through retained earnings Major components

Revenues and gains Expenses and losses

Closed to R/E and starts new period with a clean sheet

Revenue Usually results in an increase to assets Results from the sale of merchandise,

performance of service, rental of property, or lending of money

Appears on income statement Temporary account closed to R/E Normal balance is a credit

Gains Similar to revenues Results when an assets is sold for more than

book value (cost – accumulated depreciation) Temporary account appears on income

statement and closed to R/E Normal balance is a credit

Expenses Asset used or service consumed If it had future value then it is ‘capitalized’ as an asset Expected or actual cash outflows Examples include: salaries, interest expense, COGS,

utilities, rent, supplies, and taxes Appears on income statement Temporary account closed to R/E Normal balance is a debit

Losses Opposite of gains Similar to expenses Results when an assets is sold for less than

book value (cost – accumulated depreciation) Temporary account appears on income

statement and closed to R/E Normal balance is a debit

Dividends Distribution to shareholders (return of capital) NOT AN EXPENSE! Does not appear on the income statement,

instead a temporary account closed straight to R/E

Normal balance is a debit

Transaction Analysis

Credit Sales Transaction

Expense Payment Transaction

Accrued Expense Transaction

Deferred Revenue Transaction

Asset Write-Down (Impairment) Transaction

Sample Transactions1.Purchase inventory for cash (4 @ $25 each)2. Purchase inventory on account (2 @ $25 each)3. Sell inventory for cash (3 @ $50 each)4. Sell inventory on account (3 @ $50 each)5. Pay for inventory purchased on account6. Receive remaining receivables7. Pay in cash other expenses of $80

Arcadia Company Review Problem1. Smith contributed $250,000 in cash2. The firm purchased a shop for $150,0003. The firm borrowed $120,000

1. Interest only of 6% paid semi-annually4. $150,000 of inventory purchased with $120,000 cash and

$30,000 credit5. $80,000 (cost) of the inventory was sold for $160,000 in

cash6. The shop is depreciated over 20 years on a straight-line

basis7. Smith withdrew $20,000 of his capital contribution

Recognizing Gains and Losses Often investments and non-current assets are

sold for more or less than the amounts at which they are carried on the balance sheet

In such cases a gain or loss must be recognized Example: Purchase a truck 1/1/01 for $10,000,

5 year life, sell 7/1/04 for $7,000

Periodic Adjustments Accruals

Accruals refer to amounts in asset and liability accounts that build up over time

Adjustments to record accruals are made at the end of an accounting period

The term accrue means to build up gradually Examples include accrued wages and accrued interest

Cost expirations Expirations refer to the write down of an already established

account over time One example is depreciation

Problem 2.2 Received $50,000 in cash from investors as an equity

investment. Borrowed $40,000 from a bank. Purchased two parcels of land, each costing $15,000, for a

total of $30,000 cash. Paid $10,000 cash to rent office equipment for the year. Provided real estate appraisal services valued at $25,000,

receiving $20,000 in cash and an account receivable for an additional $5,000.

Paid miscellaneous expenses totaling $11,000 in cash. Sold one parcel of land, costing $15,000, for $22,000 cash. Paid a $5,000 cash dividend to shareholders.

Some Useful Ratios Profitability

Why not just consider net income?

Return on Assets (ROA) Considers how will you did with what you

invested. Both income statement and balance sheet.

ROA Tells us what is available for all investors

(both debt and equity). Return of equity (ROE) similar for just

shareholders. Can be decomposed into two components in

order to shed more light on performance.

ROA ROA = Return on sales (ROS) x Asset Turnover (AT)

Return on Equity Only considers return to shareholders Therefore no need to add back interest

expense Also only divide by shareholders’ equity

rather than total assets

ROE Like ROA, ROE can also be decomposed Sometimes called the Dupont Model ROE = ROS x AT x Leverage

Evaluating Risk Debt to equity Interest coverage

What Number Do You Want? Accounting is a political process, not an exact

science.

There is a great deal of discretion available to managers.

Earnings Management Reasons to manage earnings

ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS

Earnings Management - Why Compensation contracts

Debt contracts

Political considerations

Question?Why might a company’s stockholders want its

managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary?

Debt Contracts Firms that are near violation of their debt

contracts have incentives to manage earnings upward.

Question?The following excerpt was taken from a recent

financial statement of Cummins Engine Company:Loan agreements contain covenants which impose

restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings.

Why would a creditor such as a bank impose such restrictions when making a loan?

Political Reasons Firms may wish to portray a certain image to

the public, government, or regulatory body.

Common Earnings Management Smoothing earnings Managing earnings upward Taking a bath Off balance sheet financing

Problem 2.11 See handout