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					   Chapters 2 and 3:

Financial Statements and
  Transaction Analysis

                Course Overview
   Financial Accounting
    –   External users
    –   Emphasis on decision making of users
    –   Subject to regulation
    –   Publicly available
   Managerial Accounting
    – Internal users (within the company)
    – Emphasis on use to plan activities, make pricing
      decisions, and measure performance
    – Proprietary information

               Chapter 2
 Financial statements report the
  company activity during the year and
  the financial condition of the company at
  the end of the year.
 The required financial statements are:
   – Income Statement
   – Statement of Stockholders’ Equity
     (Statement of Owner’s Equity)
   – Statement of Cash Flows
   – Balance Sheet

          The Balance Sheet
 The balance sheet reports the financial
  position at a point in time (end of the
  quarter or year).
 The balance sheet is divided into three
  major categories:
   – Assets
   – Liabilities
   – Stockholders’ equity (Owner’s equity)

          The Balance Sheet
 The balance sheet is represented by the
  fundamental accounting equation:
  Assets = Liabilities + Equity
     A =      L        +     E
 The effects of all described business
  transactions may be represented in this

           The Balance Sheet (B/S)
 Assets - represent future benefit to the
  company, and are classified in order of liquidity
  (current assets; property and equipment; long-
  term investments; intangibles)
 Liabilities - represent obligations of the
  company, and are classified according to
  payment date (current liabilities, long-term
 Equity - represents the residual claims of the
    – Corporations: common stock and retained earnings
    – Proprietorships: owner’s capital account
       B/S Assets: Current Assets
   Current assets include
    – Cash: checking and savings accounts;
      petty cash.
    – Short-term investments: investments in
      stocks and bonds of other companies.
    – Accounts receivable: amounts owed to a
      company from its customers.
    – Inventory: products on hand designated
      for sale to customers.
    – Prepaid expenses: amounts paid for
      future expenses.
              B/S Assets:
         Property and Equipment
   Property and equipment are assets that are
    used in the production of goods and
    services. These productive assets are long-
    term in nature, and include the following:
     – Land: property upon which the productive
       facilities are located.
     – Building: the physical structure of the
       company’s operations.
     – Machinery and Equipment: include
       operating machinery, vehicles, computers,
       copy machines, etc.
B/S Assets: Long-term Investments
   Long-term investments are assets acquired by
    the company to provide long-term benefits to the
    company. Long-term investments include:
     – Long-term notes receivable owed to the
       company (from customers or others).
     – Investments in stock of other companies: held
       for expectation of dividends and/or stock price
     – Investment in bonds of other companies: held
       for expectation of dividends and/or stock price
     – Other assets, like land, held for the long term,
       but not part of operations.
       B/S Assets: Intangible Assets
   Intangible assets are long-lived assets that have
    no physical substance. Examples include:
     – Patents: legal claim to produce and sell a
     – Copyrights: legal claims to books, art, music
       and other created works.
     – Goodwill: recognized when one company
       buys another company, and the purchase
       price is greater than the fair value of the
       identifiable net assets.

B/S Liabilities: Current Liabilities
   Current liabilities are obligations expected to
    be paid (or services expected to be
    performed) within the next year or operating
    cycle. The elimination of the current liabilities
    requires the use of current assets (most
    commonly cash). Examples include:
     – Accounts payable
     – Wages payable
     – Interest payable
     – Short-term notes payable
     – Current maturities of long-term debt
     – Deferred (unearned) revenues

B/S Liabilities: Long-term Liabilities
   Long-term liabilities are obligations expected to
    require payments beyond the current year.
    Examples of long-term liabilities include:
     – Notes payable: amounts owed to banks and
       other creditors beyond the current year.
     – Mortgage payable: amounts owed to
       mortgage company beyond the current year.
     – Bonds payable: amounts owed to investors
       holding bond investments issued by the
       company, where payments of principal and
       interest are beyond the current year.

           B/S Owner’s Equity
 Owner’s equity is generated when owner (or
  owners for partnership) contribute cash and
  other assets into the company.
 Owner’s equity or, capital account, is affected
  by the income earned by the proprietorship,
  and by the withdrawals of the owner.
 Owner’s equity equation:
  Beginning owner’s equity
  Plus: net income
  Less: withdrawals
 =Ending owner’s equity
       OEBegin + NI - Draws = OEEnd
        B/S Stockholders’ Equity:
           Contributed Capital
   Contributed capital is generated when owners
    (shareholders) of the company contribute
    cash and other assets into the company.
    Components of contributed capital include
     – Common stock: shares of stock issued to
       owners to to reflect ownership.
     – Additional paid in capital: excess amounts
       contributed by shareholders for various

        B/S Stockholders’ Equity:
           Retained Earnings
   Retained earnings represent the excess
    earnings retained in the company after
    dividends have been paid to shareholders.
    This represents the equity generated by
    the company for the shareholders.

         The Statement
  of Stockholders’ Equity (SSE)
The following formula represents the
basic SSE:
     Beginning stockholders’ equity
     Plus: Issuance of stock
     Plus: Net income
     Less: Dividends
   =Ending stockholders’ equity
SEBegin + Issue + NI - Div = SEEnd
            The Statement
         of Retained Earnings
The statement of retained earnings is a
subset of the SSE, and calculates the
changes in the retained earnings component.
     Beginning retained earnings
     Plus: Net income
     Less: Dividends
   =Ending retained earnings
   REBegin + NI - Div = REEnd

    The Income Statement (I/S)
 The income statement shows the
  components of net income in detail.
 Revenues represent the inflow of assets
  (or decrease in liabilities) due to a
  company’s operating activities.
 Expenses represent the outflow of assets
  (or increases in liabilities) due to a
  company’s operating activities.
 The general formula for the I/S is:
  Revenues - Expenses = Net Income

The Income Statement Format
Operating revenues
 Fees earned
 Other revenues
Less: Operating expenses
 Cost of goods sold
 Wage expense
 Rent expense
 Selling expense
 Depreciation expense
 Other expenses
Net Income
     The Statement of Cash Flows
 Cash flows from operating activities:
  – Collections from sales, rent, interest, etc.
  – Cash paid to suppliers and employees, and for
    rent, selling activities, interest, and taxes etc.
 Cash flow from investing activities:
  – Proceeds from sale of investment securities,
    land, buildings, equipment, etc.
  – Purchase of investment securities, land,
    buildings, equipment, etc.
 Cash flow from financing activities:
  – Proceeds from issuance of notes, debt, sale of
    equity, etc.
  – Payments on notes, debt, dividends, etc.
        Relationships Among the
         Financial Statements
 Beginning                                 Ending
Balance Sheet                           Balance Sheet
    Assets          Statement of             Assets
    (Cash)          Cash Flows              (Cash)

       =                                       =
   Liabilities                              Liabilities
       +                                       +
    Equity           Statement of            Equity
                 Stockholders’ Equity
                   (Owner’s Equity)                       21
                  Chapter 3

 The first step in the accounting process is
  transaction analysis.
 This process examines relevant, objectively
  measurable economic events through their
  effect on the accounting equation:
          Assets = Liabilities + Equity

       Spreadsheet Analysis
 Using a spreadsheet template, analyze
  the transactions on the next slide. (Full-
  size spreadsheet at the back of your
 Note that effects may be on both sides of
  the equation, in the same direction, or
  effects may be on one side of the
  equation with offsetting directions.

Anna Corporation began on Dec. 1, 2008, and had
  the following activity during its first month:
1. Investors contributed $30,000 to start up the
2. The company purchased land for a future
  building site for $20,000.
3. The company borrowed $9,000 from the bank.
4. The company completed a consulting contract,
  and billed the customer $8,000 (provided
  services on account).
5. The company paid $5,500 for salaries to
6. The company distributed $500 of cash dividends
  to its investors.
               Spreadsheet Template

     Cash + A/R + Land =   N/Pay + C.Stock + Ret. Earn.
1.                     =
2.                     =
3.                     =
4.                     =
5.                     =
6.   ____ ____    ____ =   _____      _____    _____

       Financial Statements

Income Statement
   Revenues    $8,000
   Expenses      5,500
   Net Income  $2,500

Statement of Stockholders’ Equity
                CS          RE
Beginning     $      0     $     0
Issue CS        30,000
Net Income                   2,500
Less: Dividends               500
Ending         $30,000     $2,000
   Financial Statements
      Balance Sheet
 Cash           $13,000
  A/R             8,000
  Land           20,000
    Total       $41,000

Liabilities and S.E.
  N/P              $ 9,000
  CS                 30,000
  RE (ending)         2,000
  Total            $41,000
      Double Entry System
 Note that the transaction analysis was
  relatively simple with a few transactions
  and a few accounts. However, with
  thousands of transactions and hundreds
  of accounts, the spreadsheet program is
  not sufficient.
 Therefore accountants use a “double
  entry” system based on debits and

     Double Entry Accounting

 Debit (dr) - means an entry to the left
  hand side of an account.
 Credit (cr) - means an entry to the right
  hand side of an account.
 Note that a debit or credit, per se, does
  not indicate increase or decrease.
 To decide the effect of a debit or credit,
  the type of account must be considered.

        Effect of Debits and Credits
 Based on the accounting equation, we
  can increase or decrease various
  accounts depending on their classification:
          Assets = Liabilities + Equity
Increase    DR =       CR         CR
Decrease CR =           DR         DR

   Note that we use debits and credits
    instead of plusses and minuses.

The following rules can be derived from
the basic formula:
   Assets have normal debit balances and are
    increased with a debit.
   Liabilities and equities have normal credit
    balances and are increased with a credit.
   Revenues (a part of equity) have normal credit
    balances and are increased with a credit.
   Expenses (which decrease equity) have normal
    debit balances and are increased with a debit.
   Dividends (which decrease equity) have a
    normal debit balance and are increased with a
    The Format of a Journal Entry
To initially record transactions, we use a journal
entry to represent the debits and credits.
For example, in Item 1:
                          Debit Credit
Cash                     30,000
     Common Stock                  30,000

Note that the debit is to the left and the credit is
to the right. First we list the account (left hand
entry on top), then the amount.

   Now back to Anna Corp., and
 prepare the other journal entries:
2: Purchased land for $20,000 cash.

3: Borrowed $9,000 cash from bank.

Now back to Anna Corp. and prepare
     the other journal entries:
4: Consulting services (on account) $8,000.

5: Paid $5,500 cash for expenses.

   Now back to Anna Corp., and
 prepare the other journal entries:

6: Paid $500 cash dividend to investors.

Note that dividends is a contra equity and
 reduces retained earnings.

        The Accounting Cycle
Components of the accounting cycle include:
  A. Preparation of General Journal Entries
     -Post to the General Ledger
     -Unadjusted Trial Balance
  B. Preparation of Adjusting Journal Entries
     -Post to the General Ledger
     -Adjusted Trial Balance
  C. Financial Statements
  D. Closing Journal Entries (or closing process)
     -Final Trial Balance
A. General Journal Entries (GJEs)
   The first step in the accounting process.
   Prepared for daily activity.
   Usually journalized in special journals for
    efficiency, but we will record in “General Journal”
   Identified through a document flow:
     – cash receipt, record a cash sale
     – charge receipt, record a credit sale
     – bank note, record a notes payable
     – employee time card, record wages
   The transactions on Slide 23 are general journal
    The General Ledger (G/L)
 The G/L serves as a place to “total”
  amounts by account titles.
 After GJEs and AJEs are recorded, they
  are posted (by account) to the G/L.
 We will use “T” accounts to represent G/L
  accounts where needed.
 Note that most G/L printouts have detailed
  information on left side of ledger, and 2
  columns (or DR and CR notation) on the
  right side of the printout. Our T-account
  represents the right side.

             Posting to G/L
Now post transactions (for cash) to “T” account:

            Unadjusted Trial Balance
   Trial balances are prepared throughout the
    accounting cycle.
   The list resembles the Chart of Accounts
    (usually organized with account codes).
   The Unadjusted Trial Balance represents G/L
    totals (by account) at a particular point in time.
   For the GJEs, the Unadjusted Trial Balance
    would consist of a list of all of the ending debit
    or credit balances taken from the various
    account totals (illustrated on the next slide).
   The Unadjusted Trial Balance is a preliminary
    total, and is a starting point for the Adjusting
    Journal Entries (discussed later in this
    chapter).                                         40
 Unadjusted Trial Balance - Anna Corp.
(after posting and totaling G/L accounts)
                       Debit     Credit
Cash                   13,000
Accounts Receivable     8,000
Land                   20,000
Notes Payable                     9,000
Contributed Capital              30,000
Retained Earnings                     0
Dividends                 500
Revenues                          8,000
Expenses                5,500
Totals                 47,000    47,000
    B. Adjusting Journal Entries (AJEs)
    Prepared at the end of the accounting period
     to align revenues and expenses (matching).
    Usually NO document flow to trigger recording.
    Based on the accrual system of accounting
     which records revenues as earned and
     expenses as incurred (rather than based on
     cash flows).
    Types of AJEs
     1. Accrual of expenses
     2. Accrual of revenues
     3. Prepaid expenses
     4. Unearned revenues
1. Accrual of Expenses
 Probably the most common type of AJE.
  Ex: accrue wages of $100at the end of the
      Wages Expense        100
             Wages Payable       100
 Other examples of expense/payable include
  interest, rent, taxes.

2. Accrual of Revenues
 For revenues that have not yet been
  recorded at the end of the period.
 Ex: accrue interest revenue of $50:
     Interest Receivable        50
          Interest Revenue           50
 Another example of receivable/revenue
  accruals relates to rent revenue, where
  the rental payment has not yet been
    3.Prepaid Expenses
 This category of AJE relates to the concept of
  asset capitalization and the matching
 Asset capitalization occurs when a cost (with
  future economic benefit) is incurred. An asset
  is recognized at that time.
 As the asset is “used up” in the generation of
  revenue, the related cost is recognized as an
  expense (matching).
 Some expenses are deferred for a short period
  of time (Supplies Expense), and some
  expenses are deferred for many years
  (Depreciation Expense).
3.Prepaid Expenses
   Example: Purchase 1 year, $1,200 insurance
    General JE at time of purchase:
        Prepaid Insurance      1,200
             Cash                         1,200
    AJE at end of the first month (for the portion
    that has been used):
        Insurance Expense        100
             Prepaid Insurance              100

4.Unearned Revenues
Cash is received from customer before
goods/services are delivered (before
revenue can be recognized).
Ex: Received a 3-year subscription of
$360 in advance.
General JE at time cash received:
   Cash                            360
        Unearned Revenues                360
AJE at end of the first quarter (for 3 mos.):
   Unearned Revenues                  30
        Subscription Revenues              30
           Adjusted Trial Balance
 The Adjusted Trial Balance reflects totals
  after the AJEs are posted to the general
 The balance sheet accounts reflect the end-
  of-year balances, and the income statement
  accounts reflect the proper revenues and
  expense to be recognized for the year.
 This list of accounts and amounts is used to
  prepare the balance sheet and income

 D. Closing Journal Entries (CJEs)
 Prepared after the financial statements
  have been completed.
 Close temporary accounts to retained
  earnings, so that the balances in those
  accounts at the start of the next accounting
  period will be zero.
 Temporary accounts include revenues,
  expenses and dividends.
 The final trial balance after closing will
  display only permanent, balance sheet
 D. Closing Journal Entries (CJEs)
Back to Anna Corp. Trial Balance. To close
 Revenues and Expenses and Dividends:

Close Net Income to RE:
Service Revenue      8,000
    Salary Expense           5,500
    Retained Earnings        2,500
Close Dividends to RE:
Retained Earnings      500
    Dividends                  500


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