Financial Statements Limitations

Document Sample
Financial Statements Limitations Powered By Docstoc

This chapter reviews the conceptual framework relevant to the balance sheet (the objective of external fin
chapter discusses the accounting model and illustrates its application in the accounting system for a busin
and liabilities between the business and other individuals and organizations, and (2) certain events that do
entity (such as recording adjustments to reflect the use of equipment in operations).

Application of the accounting model (Assets = Liabilities + Stockholders’ Equity) is illustrated for Papa Joh
entries, and (3) the accounts (T-account format). Each transaction causes at least two different accounts
double-entry system because each transaction has a dual effect. The process used in transaction analysis
liability, or stockholders’ equity account and (2) determining that the accounting equation remains in balan

The transaction analysis model (built on the accounting model) and the mechanics of the debit-credit conc

Transaction Analysis Model

Assets (A)                     =                      Liabilities (L)                =

Increase Decrease                                     Decrease          Increase
Debit    Credit                                       Debit             Credit
T-Account Format

Assets (A)                                            Liabilities (L)

Beg. Bal.                                                               Beg. Bal.

Increase Decrease                                     Decrease          Increase
Debit     Credit                                      Debit             Credit
End. Bal.                                                               End. Bal


     LO1 Define the objective of financial reporting, the elements of the balance sheet, and the rel
     LO2 Identify what constitutes a business transaction and recognize common balance sheet a
     LO3 Apply transaction analysis to simple business transactions in terms of the accounting m
     LO4 Determine the impact of business transactions on the balance sheet using two basic too
     LO5 Prepare a simple classified balance sheet and analyze the company using the financial le
     LO6 Identify investing and financing transactions and demonstrate how they are reported on

      1. An understanding of a company’s financial statements requires knowledge of business activi
      2. Financial statement analysis will allow the decision maker to arrive at decisions about a comp
      3. Analysis of investing and financing activities of a business should be explored.
      4. The concepts presented in Exhibit 2-1 are the framework of objectives, terms, concepts and

      A. Primary objective of financial reporting
         1.    To provide useful economic information about a business to help external parties (invest
            a.   These decision makers are expected to have a reasonable understanding of accounti
            b.   Decision makers need to be able to use financial information to help them predict futu

      B.    Elements of the Balance Sheet
           1.    Balance sheet elements present the basic accounting equation (A = L + SE).
              a.   Assets: economic resources with probable future benefits owned by the entity as a re
                  1.      Listed on the balance sheet in the order of liquidity.
                  2.      Current assets are assets that will be used or turned into cash within one year.
                  3.      Historical cost principle: requires assets to be recorded at historical cost that, on t
              b.   Liabilities: are probable debts or obligations of the entity that result from past transac
                  1.      Listed on balance sheet in the order of maturity dates.
                  2.      Current liabilities are obligations that will be paid in cash or other current assets o
              c.     Stockholders equity (Owners Equity): the owners’ residual interest in net assets (a
              Two categories:
                      a.      Contributed capital
                      i.      Results from owners’ providing assets to the company in exchange for stock (e
                      ii.    The investments of the owners.

                     b.    Retained earnings
                     i.     The cumulative earnings that are not distributed to the owners and are reinves
                     ii.   Increased by net income and reduced by declared dividends.

      C.   The Related Key Accounting Assumptions and Principles
            1. Underlying assumptions of accounting help the decision maker to understand what accou
           2.    Recall assumptions noted earlier in the text. There are four basic accounting assumption
              a.   Separate-entity assumption – “business” transactions are separate from “owner” tra
              b.   Unit-of-measure assumption – accounting information will be measured and reporte
              c.    Continuity (going-concern) assumption – a business is expected to continue opera
              d.   Time period assumption
           3.    There are four basic accounting principles. The first directly relates to the balance sheet
              a.   Historical Cost Principle: The historical cost principle states that the cash (or cash-
              b.   Revenue Recognition Principle
              c.    Matching Principle
                    d.    Full Disclosure Principle

             A. Nature of business transactions
                   1.    Transactions are certain recorded economic “events” which impact an entity.
                      a.    External events: exchanges of assets, goods, or services by one party for assets, ser
                      Examples: sales, borrowing, owner investments.
                      b.    Internal events: certain events that are not exchanges between the business and othe
                      Example: Adjustments to record usage of assets (depreciation).
                      c.     Some events are not reflected in the financial statements.
                      Example: The signing of a contract.

       B.   Accounts
       1.   Account: a standardized format that organizations use to accumulate the dollar effects of transactio
       2.   Chart of accounts: a listing of the account titles and their unique numbers that a company uses to r
                    a.   Each company has its own chart of accounts.
                    b.   Balance sheet accounts are listed first.
                        1.     Assets are listed first, in the order of their liquidity.
                        2.     Liabilities are listed next, in order of maturity.
                        3.     Stockholders’ equity lists contributed capital and retained earnings.
                        4.     Revenues
                        5.     Expenses
                    c.     In formal record keeping, unique numbers are used for each account listed in the Cha

             C.   Common Balance Sheet accounts:
                  1.    Assets:
                     a.    Cash
                     b.    Receivables are always assets.
                     c.    Prepaid Expenses is an asset because it represents amounts paid to others for future
                     d.    Buildings
                     e.    Land
                  2.    Liabilities:
                     a.    Accounts with “payable” in the title are always liabilities.
                     b.    Accounts with “unearned” in the title are liabilities. They are amounts paid in the past
                  3.    Stockholders’ Equity
                     a.    Common Stock, Preferred Stock
                     b.    Retained Earnings

               A. Historical record keeping provides information to managers
                   1.   In order to evaluate the effects of past decisions and
                   2.   To plan for the future.
      3.   Important for managers to understand how past transactions affect financial statement it

B.  Principles of Transaction Analysis
   1.    Involves studying a transaction to determine its economic effect on the entity in terms of
   2.    Principles of transaction analysis:
      a.    Dual effect: each transaction affects at least two accounts.
           1.   Identification of the appropriate accounts and the direction of the effects (increase
           2.   The fact that every transaction has at least two effects on the basic accounting eq
           3.   Whether the transaction is external (involves an exchange) or internal (involves an
      b.    Accounting equation: must remain in balance after each transaction. After each tran
C. Analyze Papa John’s transactions: In this chapter, several transactions are analyzed using

        ·   Journal entries and T-accounts: the two tools to aid in reflecting the results of trans
        ·   Analyze → Journalize → Post

A. Analyze: The Direction of Transaction Effects
   1.  It is important to understand which accounts increase and decrease because of a transa
   2.  By referencing the accounting equation, increases are on the left for assets (which are o
B. Journalize
  1. Debit means the left side of an account; Credit means the right side of an account.
  2. By referencing the accounting equation, debits increase asset accounts and credits increas
   3.  The normal balance of an account is on the increase side; therefore, asset accounts no
   4.  Total debits must equal total credits in a transaction. This is necessary to keep the accou

C.    Post: Analytical Tool: The T-account.
      1.    Posting is the act of transferring journal entry amounts to the appropriate accounts in the
      2.    Journal entries show all of the accounts affected by a transaction, but do not provide acc
      3.    Account balances are found in the ledger (a group of accounts). The ledger is referred to
      4.    A T-account is a simplified version of a ledger account.
         a.    This tool allows for summarization of journal entry effects on an account. The balance
         b.    Important for managers to understand how past transactions affect financial statemen

D.    Transaction Analysis Illustrated
      1.    Use transaction analysis as well as the journal entry and T-account tools to process typic
      2.    There are beginning balances in many balance sheet accounts since the ending balance
      3.    It is essential to understand:
         a.     The accounting model
         b.      The transaction analysis process
         c.      Recording the dual effects of each transaction
         d.      The dual-balancing system

A. How is the balance sheet prepared?
    1.   Account balances for asset, liability, and stockholders’ equity accounts are used to prepa
            2.   If comparative balance sheets are prepared, the most recent amounts are usually presen
            3.   The balance sheet presents the accounting equation: A = L + SE
            4.   Account balances will change during the accounting period, but the accounting equation

       B.    Financial Leverage Ratio measures the relationship of assets to equity. The higher the porti

                                                 Average Total Assets
Financial Leverage Ratio 
                                          Average Stockholders' Equity
       A. Investing Activities:
             1.   Purchases/ sales of non-current assets.
             2.   Lending cash to others
             3.   Receiving principal payments on loans made to others

       B.    Financing Activities:
              1. Borrowing and repaying debt.
              2. Issuing and repurchasing stock.
              3. Paying dividends.

       C.   Only report transactions where cash is involved.


After each learning objective, the students can be given a hands-on exercise to reinforce the topic. It is su

  1.   Bookkeeping does not equal accounting. Rather, bookkeeping is an important part (a subset) of a
      a.   Bookkeeping is the routine, clerical function of recording and posting journal entries. A basic
      b.   Accounting involves the design of accounting systems, analysis of complex transactions, inte
  2.   The results of the accounting processes do not reflect "exact" information.
      a.   Many estimates are used that influence account balances.
      b.   Generally, the amounts on financial statements do not represent current market values. They
      c.   It is important to gain an understanding of what financial statements reflect and fail to presen
  3.   Accounting is neither inflexible nor is it a “cut and dried” subject. Instead, it is a dynamic and crea
     LO1 Define the objective of financial reporting, the elements of the balance sheet, and the rel
   1.     Point out that most decision makers are neither ignorant nor superhuman. They often are ave
   2.     Distinguish between “going concern” and liquidation valuations.
   3.     Point out that some companies present amounts on the balance sheet in dollars, thousands o

     LO2 Identify what constitutes a business transaction and recognize common balance sheet a
    1.    Note that the chart of accounts often differs widely by industry.
    2.    Distinguish between historical costs recorded in the accounts and current fair market value.

     LO3 Apply transaction analysis to simple business transactions in terms of the accounting m
   1.     Owners are “external” to a company because of the separate-entity concept. There should be
   2.     After discussing the effects of a transaction on the accounting equation, the instructor may wis
     1.    Individuals invest $50,000 to start the business. They receive Capital Stock from the compan
     2.    The company borrows $75,000 and signs a note agreeing to pay back the money.
     3.    Purchased $15,000 worth of supplies on credit.
     4.    Land is purchased for $25,000 cash.
   Required: Show how each transaction affects the accounting equation.

Assets                                              =                Liabilities
                                                                     Notes       Accts

Cash        Supplies          Land                                   Payable      Payable
75,000                                                               75,000
            15,000                                                                15,000
-25,000                       25,000
100,000     15,000            25,000               =                 75,000       15,000
                                           140,000 =                                90,000
                                           140,000 =

        LO4 Determine the impact of business transactions on the balance sheet using two basic too

Increase Increase

Debit       Credit
Legend for Alice:
A        Assets
L        Liabilities
I        Income        or
C        Capital       or
E        Expenses
   This is a way to help your students learn the debit/credit rules with the help of an acronym. Assets an
   2.      T-accounts are great visual learning devices. Encourage students to use them throughout the
   3.      It is quite important that students identify accounts (as A, L, or SE) when doing transaction an
   4.      Briefly mention how subsidiary ledgers support the details of general ledger accounts such as
   5.      After discussing journal entries and posting to the ledger, the instructor may wish to continue t

1-Jan     Cash                                             50,000
            Capital Stock                                                       50,000

10-Jan      Cash                                           75,000
              Notes Payable                                                     75,000

15-Jan      Supplies         15,000
              Accounts Payable                                                  15,000

17-Jan      Land                                           25,000
              Cash                                                              25,000

Cash                                                       Supplies
   50,000               25,000                                        15,000


Notes Payable                                              Accounts Payable
                        75,000                                                      15,000

                                                                                             Posting to an account in
                                                                                             transactions affecting a
   Note that in a single account the debits do not usually equal the credits.

       LO5 prepare a simple classified Balance Sheet and analyze the company using the financial l
  1.     The instructor may wish to continue the previous example and prepare a simple balance sheet fro

                                 Sample Company
                                  Balance Sheet

         Assets                                      Liabilities
Cash     $100,000               Accounts Payable                       $15,000
Supplies 15,000                 Notes Payable                          75,000
Land     25,000                 Total Liabilities                      $90,000
Assets   $140,000                               Stockholders’ Equity
                                Capital Stock                          $50,000
          Total Liabilities +
          Equity                                                       $140,000

     LO6 Identify investing and financing transactions and demonstrate how they are reported on
  1.         This chapter presents an excellent experience with several cash transactions that affect the
  2.   The instructor may wish to continue the previous example and identify which transactions would a
     The issuance of stock and the note payable both represent inflows of cash from financing activities.
     The purchase of land for cash represents an outflow of cash from investing activities.
     The purchase of supplies on account does not affect the statement of cash flows because no cash i
objective of external financial reporting, definitions of balance sheet elements, and the cost principle). The
nting system for a business. For accounting purposes, transactions are defined as (1) exchanges of assets
2) certain events that do not occur between the business and other parties but exert a direct effect on the

illustrated for Papa John’s International. The application involves (1) transaction analysis, (2) journal
two different accounts to be affected in terms of the accounting model. The model often is referred to as a
d in transaction analysis involves (1) identifying the accounts affected and classifying each as an asset,
uation remains in balance.

 of the debit-credit concepts in T-account format can be summarized as follows:

           Stockholders’ Equity (SE)

           Decrease    Increase
           Debit       Credit

           Stockholders’ Equity (SE)

                       Beg. Bal

           Decrease    Increase
           Debit       Credit
                       End. Bal.

nce sheet, and the related key accounting assumptions and principles.
mmon balance sheet account titles used in business.
s of the accounting model: Assets = Liabilities + Stockholders’ Equity.
et using two basic tools, journal entries and T-accounts.
y using the financial leverage ratio.
 they are reported on the statement of cash flows.
edge of business activities and their effects on account balances.
decisions about a company. This evaluation can be used to compare one company to other companies.

s, terms, concepts and principles used in financial accounting and reporting.


external parties (investors and creditors) make sound financial decisions.
derstanding of accounting concepts and procedures.
o help them predict future cash flows related to investing and financing.

A = L + SE).
ned by the entity as a result of past transactions.

 ash within one year.
historical cost that, on the date of the transaction, is cash paid plus the current dollar value of all noncash considerat
result from past transactions, which will be paid with assets or services.

r other current assets or satisfied by providing cash, goods, or services within one year.
 nterest in net assets (assets minus liabilities).

in exchange for stock (evidence of ownership).

owners and are reinvested in the business.

understand what accounting information reports as well as the inherent limitations.
 accounting assumptions, the first three relate directly to the balance sheet
parate from “owner” transactions.
e measured and reported in the national monetary unit of that company.
 ected to continue operations in the foreseeable future without forced liquidation.

es to the balance sheet:
 that the cash (or cash-equivalent cost) should be used to initially record financial statement elements. This historica

ct an entity.
ne party for assets, services, or a promise to pay (liability) by one or more other parties.

 n the business and other parties but nevertheless have a direct and measurable effect on the entity.

 llar effects of transactions on each financial statement item.
hat a company uses to record the transactions of its business operations.

account listed in the Chart of Accounts.

 paid to others for future benefits.

mounts paid in the past to the company by others expecting future goods or services from the company.

ct financial statement items (accounts) and how future events may impact those accounts.

 n the entity in terms of the basic accounting equation (A = L + SE).

  of the effects (increase or decrease) is key.
the basic accounting equation is the essence of the double-entry system of record keeping.
) or internal (involves an adjustment), the duality of effects results.
 saction. After each transaction, the accounting equation must be tested for equality.
ons are analyzed using the principles of the transaction analysis approach.

cting the results of transaction analysis.

 se because of a transaction.
 for assets (which are on the left side of the accounting equation) and increase are on the right for liabilities and stock

e of an account.
unts and credits increase liability and stockholders’ equity accounts.
fore, asset accounts normally have debit balances, and liability and stockholders’ equity accounts usually have credi
ssary to keep the accounting equation in balance at all times.

propriate accounts in the ledger.
, but do not provide account balances.
The ledger is referred to as the “final” book of entry.

n account. The balance of the account can be determined with T-accounts.
ffect financial statement items (accounts) and how future events may impact those accounts.

nt tools to process typical transactions.
nce the ending balances carry over to the new period.


ounts are used to prepare a balance sheet.
ounts are usually presented first (in the left column) with the older amounts to the right.

he accounting equation must still remain in balance.

ity. The higher the portion of assets financed with stockholders’ equity, the lower the ratio. The higher the ratio, the


nforce the topic. It is suggested that the students be provided with the solutions immediately to reinforce the concep

tant part (a subset) of accounting.
ournal entries. A basic knowledge of accounting is necessary to perform these bookkeeping tasks.
mplex transactions, interpretation of financial data, financial reporting, auditing, taxation, and management consulting

ent market values. They typically present historical cost amounts.
 eflect and fail to present. The user needs to understand financial statement limitations.
t is a dynamic and creative area of study. It requires dedicated involvement for the users of financial statements as w
nce sheet, and the related key accounting assumptions and principles.
 an. They often are average investors (or creditors); however, they are expected to have the tools to evaluate what g

 in dollars, thousands of dollars, etc. The student should be sure to reference the balance sheet heading for this info

mmon balance sheet account titles used in business.

ent fair market value.

 s of the accounting model: Assets = Liabilities + Stockholders’ Equity.
ncept. There should be no commingling of assets or liabilities of owners and companies.
n, the instructor may wish to use the following in class exercise:
Stock from the company in exchange.
k the money.

          +           Equity


          +           50,000
          +           50,000

et using two basic tools, journal entries and T-accounts.
 an acronym. Assets and expenses work the same while liabilities, revenues and capital share the same rules.
se them throughout the course.
en doing transaction analysis and preparing journal entries. It typically makes the analysis process clearer and the jo
edger accounts such as accounts receivable, accounts payable, and equipment.
  may wish to continue the previous exercise. The students should journalize the transactions and post them to T-acc



           Capital Stock

  Posting to an account in the ledger puts all of the
  transactions affecting a specific account in one place.

 y using the financial leverage ratio.
simple balance sheet from the T-account balances. The name of the company is Sample Company and the date of t
 they are reported on the statement of cash flows.
sactions that affect the statement of cash flows. There are references to cash flows throughout the text. Comprehen
ch transactions would affect the statement of cash flows and which would be investing or financing transactions. Wh

om financing activities.

ows because no cash is received and no cash is paid out.
ost principle). The
xchanges of assets
rect effect on the

s, (2) journal
 is referred to as a
ch as an asset,
 her companies.


 ue of all noncash consideration given in exchange.

ment elements. This historical cost amount is measured on the initial transaction date and does not typically reflect m
 n the entity.

m the company.

e right for liabilities and stockholders’ equity (which are on the right side of the equation. Decrease work in the oppos

accounts usually have credit balances.
o. The higher the ratio, the more debt financing. Debt financing is riskier.


ately to reinforce the concepts. After covering the material and going over the in-class exercises, the students should

ping tasks.
 and management consulting. A high degree of knowledge, professional judgment, and experience are needed to pe

 of financial statements as well as those who prepare the statements. Problem solving and communication skills are

 the tools to evaluate what goes on in the business world.

e sheet heading for this information.
share the same rules.

s process clearer and the journal entry preparation easier for them at this stage of learning.

tions and post them to T-accounts.

e Company and the date of the balance sheet is 12/31/06.
ughout the text. Comprehensive coverage of the statement of cash flows is in Chapter 13.
r financing transactions. Why would the purchase of supplies on account not affect the statement of cash flows?
d does not typically reflect market value changes.
Decrease work in the opposite manner.
xercises, the students should be encouraged to attempt the Demonstration Case at the end of the chapter before tryi

experience are needed to perform these accounting functions.

and communication skills are extremely important in accounting.
statement of cash flows?
end of the chapter before trying the homework problems.
E2-15 Analyzing the Effects of Transactions Using T-Accounts, Preparing a Balance Sheet, and Ev
Officer LO4, 5

Chu Delivery Company, Inc., was organized in 2010. The following transactions occurred during ye

a. Received $40,000 cash from organizers in exchange for stock in the new company.
b. Purchased land for $12,000, signing a one-year note (ignore interest).
c. Bought two used delivery trucks for operating purposes at the start of the year at a cost of $10
rest (ignore interest).
d. Sold one-fourth of the land for $3,000 to Pablo Moving, which signed a six-month note.
e. Paid $1,000 cash to a truck repair shop for a new motor for one of the trucks. (Hint: Increase th
productive life of the truck has been improved.)
f. Stockholder Jingbi Chu paid $27,600 cash for a vacant lot (land) for her personal use.


1. Set up appropriate T-accounts with beginning balances of Zero for Cash, Short-Term Note Rece
Notes Payable, and Contributed Capital. Using the T-accounts, record the effects of these transact

2. Prepare a classified balance sheet for Chu Delivery Company at December 31, 2010.
3. At the end of the next two years, Chu Delivery Company reported the following amounts on its b

                 31-Dec-11 31-Dec-12
Assets              $90,000  $120,000
Liabilities          40,000    60,000

Equity               50,000      60,000
Compute the company's financial
leverage ratio for 2011 and 2012.

4. At the beginning of year 2013, Chu Delivery Company applied to your bank for a $100,000 loan to
to review the information and make a recommendation on lending the funds based solely on the re
would you make to the bank’s vice president about lending the money to Chu Delivery Company?

Req. 1

                       Cash                                          Short-Term Note Receivable
Beg.                      0                                   Beg.               0
                  Equipment                  Notes Payable
Beg.                   0

              Contributed Capital
                                    0 Beg.

Req. 2



Stockholders’ Equity

Total Liabilities & Stockholders’ Equity

Req. 3

Financial              =                 Average Total Assets
Leverage                              Average Stockholders’ Equity

Financial              =                 Average Total Assets
Leverage                              Average Stockholders’ Equity

Req. 4
 Balance Sheet, and Evaluating the Financial Leverage Ratio over Time as a Bank Loan

ons occurred during year 2010:

w company.

he year at a cost of $10,000 each; paid $4,000 cash and signed a note due in three years for the

six-month note.
ucks. (Hint: Increase the account you used to record the purchase of the trucks since the

personal use.

 Short-Term Note Receivable, Land, Equipment, Short-Term Notes Payable, Long-Term
ffects of these transactions by Chu Delivery Company.

er 31, 2010.
owing amounts on its balance sheets:

nk for a $100,000 loan to expand the business. The vice president of the bank asked you
s based solely on the results of the financial leverage ratio. What recommendation
hu Delivery Company?

Term Note Receivable                                     Land
                                        Beg.              0
 Short-Term               Long-Term
Notes Payable            Notes Payable
                0 Beg.                   0 Beg.

Description: Financial Statements Limitations document sample