A100

[pistolpete463]

<p>Can anyone post the word document that you have to read in that class?</p>

<p>I'd like to get a head start on reading it over break in my free time (thats what my life has come to)</p>

<p>Thanks
Peter</p>

[I_mOnABoat]

<p>This is what we had to read in Fall 2010.</p>

<h1>Preface</h1>

<p>Accounting is an exciting and dynamic subject. This statement may surprise some of you who might be expecting it to be dull and repetitive. All of accounting is based on a clever system which uses simple math to organize and report all business transactions. The basics of the accounting system we use today were invented over five hundred years ago, and it works as perfectly today as it did then. In all that time and with all the changes that have occurred during those years, the basic accounting system still is able to handle perfectly every transaction of every business.
Accounting is constantly changing, but its nucleus stays the same. New rules are continually implemented, but these changes are minor compared to the basics. The core of accounting is fixed—debits must always equal credits and the accounting equation must always be in balance. The beauty of accounting lies in understanding these rules and in using them to record the variety of transactions that every company has.
Knowledge of accounting is power. Accounting is called the “language of business” because it is a method of reporting the status of a company that can be understood by anyone who understands accounting. The better you understand accounting, the more capable you are of interpreting this information to make informed and insightful decisions.
A100 is an overview of four basic areas of accounting from the corporate viewpoint: financial accounting, auditing, managerial accounting, and tax. This short course looks at these areas from on overview approach—you will learn the details in more advanced classes. The material presented in this course will benefit you whether you plan to major in accounting or some other area of business or never take another business class. My hope is that you will enjoy this material as much as I do.

Chapter 1 – Introduction to Financial Accounting</p>

<p>Learning Objectives:
After studying Chapter 1, you should be able to
· Discuss the different classifications of financial transactions
· Define an equity investor and a debt investor and understand the difference
· Discuss the role of the Securities and Exchange Commission
· Name the Big Four accounting firms and define the term “independent auditor”
· Define corporate governance
· Discuss GAAP and IFRS and the concept of rules-based versus principles-based
· Discuss the roles of the board of directors and the audit committee
· Discuss the basics of Sarbanes-Oxley
· Discuss how legal liability and corporate ethics work to help strengthen corporate governance
· Define the words in bold in this chapter</p>

<p>“Accounting” is the recording of business transactions and the preparation of reports summarizing these transactions. These reports are called “financial statements”, and they are available to be read by anyone who might be interested, either inside or outside the company. Because the information in the financial statements is often the basis for decisions by analysts outside the company, it is important that the statements be prepared impartially, objectively, and in accordance with established standards. The term “financial accounting” refers specifically to the records and related reports that are available to be read by people outside of the company.
We will take an overview approach to financial accounting in this course. Accounting is based on debits and credits, but we will not have time to cover these in this course. You will learn about debits and credits and the basics of an accounting system when you take the first Principles of Accounting course. Instead, the approach used in this course is an overview called “impact on the financial statements”. It is a top-down approach of looking at financial accounting and how various transactions impact the financial statements.
Classifications of Business Operations:
Every business transaction can be classified into one of three types: financing activity, investing activity, or operating activity. “Financing activities” are those transactions that raise funds for the company to operate. “Investing activities” are the transactions in which the company is investing in assets that it will keep in the business to use in its operations. “Operating activities” are all of the other transactions that a business engages in which cannot specifically be classified as financing or investing. Examples of operating transactions are the payment of rent, salaries, and insurance expenses.
Financing Activities:<br>
Imagine a company which is just going into business. The first thing it needs to do is raise money to begin operations. There are two basic ways a company can raise money to help finance its operations: (1) equity and (2) debt. The term “equity” refers to ownership. When a company sells equity, it is selling ownership in the company. The usual way this is done is for the company to form a corporation and sell shares of stock. Purchasers of the stock are called “equity investors” (or “stockholders” or “shareholders”). When equity investors buy stock in the company, they are buying ownership of the company. The typical reason that an investor would want to do this is because they believe in the concept of the company and believe the corporation will be profitable and either pay dividends or the value of the stock will rise or both.
Buying stock in the company entitles the holders to two rights, the first of which is to vote for the “directors” of the company. All the directors together form the corporation’s “board of directors”. The job of the directors is to represent the stockholders’ interest to management and protect the stockholders’ investment. Many stockholders are not located near the corporation or do not have the time or expertise to do this for themselves.
The second right the stockholder has is to receive dividends from the company when dividends are paid. The company is usually not required to pay dividends but will often do so if it has sufficient cash which it is not expecting to need for its operations.
Notice that, as owners, equity investors have no guarantee that they will receive their investment back. There are two ways an equity investor can make money on his or her investment: (1) by receiving dividends from the company or (2) by selling their stock at some time in the future when the stock price has increased. Typically neither of these is guaranteed. While the stockholder is in a position to benefit if the company does well, he or she also bears the risk of either no return on their investment or the loss of part or all their investment if the company does not perform as hoped.
The other way a company can raise funds is by using “debt”. This refers to borrowing money from investors or banks. The company will have to sign a contract agreeing to repay the borrowed money plus interest. Those who loan the company money are called “creditors” of the business. One important way in which creditors are different from stockholders is that creditors have the legal right to receive back the money loaned, called the “principal”, as well as interest payments on this money for the period of time the loan is outstanding. “Interest” is the amount that the creditor is charging the borrower (also called “debtor”) for using the money.
The specific requirements of the loan are spelled out in an agreement called a “loan contract”. These contracts specify a “maturity date” (the date by which the loan is to be repaid), interest that will accrue, and “collateral”. The term “collateral” refers to the assets that are pledged by the borrower to the creditor if the borrower is not able to repay the loan. The requirements (or “terms”) specified in loan contracts may vary. For example, creditors may require that interest payments are made periodically or maybe no interest will be due until the principal is due. Also creditors may not require certain borrowers to put up collateral, while those same creditors may require extensive collateral from other borrowers.
Notice that equity investors differ in substance from debt investors. Equity investors become owners of the business, but debt investors do not. Equity investors may benefit if the company is successful, but they may also be hurt if the company is not. Debtors do not have this type of participation in the results of the company’s operations. They have the right to receive the principal and interest back, but nothing more.
Both equity and debt investors are interested in the financial statements issued by the company. They want to see the success of the company over the last year. Has management made good decisions on how to use their money? Does it look like the company will continue to be successful in the future? Is their investment in this company still a good investment? If the financial statements show that management has not been successful during the past period, stockholders may try to vote in new management. If creditors see that management has not been successful, they will become worried about the risk of “default”, which is the term for the company being unable to repay its loans. Loan agreements will often call for harsher terms if the company’s financial statements fall below specified levels. Examples of this type of change in terms might be provisions in the loan agreements for higher interest rates or requirements of additional collateral if the financial statements do not show the creditor’s minimum acceptable level of success.
Investing Activities:<br>
Companies will often need to purchase land, buildings, and equipment to help them operate the business. These are called “fixed assets”. Transactions that are classified as investing activities are purchases made of property that is (1) likely to last a number of years and (2) expected to be used in the operations of the business rather than sold as part of the company’s general operations. Generally, the assets included in the category are relatively expensive and expected to last for more than two years.
The term “investing activities” typically only applies to purchases and not rentals. For example, if a company rented the building where it conducted its operations and was required to pay a few months’ rent in advance, this is considered an operating activity and not an investing activity.
Also, the category of investing activities generally does not include any items that were purchased for resale. For example, if a consulting firm purchases a building for its offices, this purchase is an investing activity. However, if a real estate firm purchases a building which it bought with the intention to resell at a profit and if the real estate firm is in this line of business, this purchase is not considered an investing activity. Instead, it is an operating activity, which is covered next.
Operating Activities:<br>
In general, everything that cannot specifically be classified as a financing activity or an investing activity is classified as an operating activity. This includes any transactions that are related to running the business and marketing the company’s product. There is a wide variety of transactions included in this category, such as salaries and wages, rent, utilities, insurance, and purchases of goods to be resold.
The Business Cycle:
The business cycle is universal and applies to all businesses. First, a company needs start-up money, which may be obtained from owners (“stockholders”) or by borrowing (“creditors”). The company uses these funds to invest in fixed assets which it will use to operate. The goal of management should be to use these funds and investments to run the operations of the business to the best of its ability.
As the company earns additional cash from its operations, it is required first to pay any amounts to creditors that are due. If there is still cash left after the debts currently due are paid, management faces a decision as to how to use the remaining cash. The basic choices are (1) to invest in more fixed assets or other types of investments, or (2) elect to pay dividends to the owners of the business, or (3) hold on to the extra cash for use in the future.
The Setting of Financial Accounting:
A Little History… In the 1930’s, shortly after the market crash in 1929, the government realized that stockholders needed assurance that the information corporations were reporting in their financial statements was the truth. This had become more important than ever because the country had grown and new technology meant that many investors were no longer located near their investments. In response to this requirement the “Securities and Exchange Commission”, or the “SEC”, was established. The basic purpose of the SEC is to maintain fair and truthful capital markets. The SEC’s coverage only extends to “publicly-held corporations”. A corporation is “publicly-held” if its stock is traded on an exchange, such as the New York Stock Exchange or NASDAQ.
The SEC requires corporations to file a “Form 10K” annually (audited financial report) and a “Form 10Q” quarterly (unaudited financial reports covering the most current quarter). These are SEC forms that help analysts analyze and compare various companies. These forms are available on-line for all publicly-held companies at the SEC’s Electronic Data Gathering, Analysis, and Retrieval site ([Index</a> No Browsing](<a href=“http://www.sec.gov/edgar]Index”>SEC.gov | Filings & Forms)).<br>
In addition, the SEC requires that all publicly-held companies prepare annually a financial statement, called an “annual report”, which must be audited by an outside, independent auditor. These annual reports are mailed to stockholders and are available on the company’s website. The annual reports are required to include the four standard financial statements: (1) balance sheet, (2) income statement, (3) statement of stockholders’ equity (or statement of retained earnings), and (4) statement of cash flows. (We will begin covering these statements in the next chapter.) In addition, the annual report typically includes a letter from the president of the company discussing management’s performance to date and what the company hopes to accomplish in the future. Another component of every annual report is the footnotes. “Footnotes” give additional information supporting the data in the financial statements. The cover sheet of the financial statements is required to be a letter from the company’s independent auditors which states the auditor’s opinion as to whether or not the auditors have found the financial statements to have been prepared in accordance with the required accounting standards.
Both the Form 10K and the financial statements included in the company’s annual report are required to be audited by an “independent auditor”. An independent auditor, also called an “external auditor”, is an accounting firm that specializes in “public accounting”. Public accounting means the company is in business to provide accounting services to other companies. The external auditors performing the audit must be independent of the company they are auditing. Auditors are considered independent if they (1) do not work for the company they are auditing and (2) do not own a substantial investment in this company.
In performing the audit, the auditors examine the financial statements that management has prepared and issue an opinion that becomes the cover sheet to the financial statements. This opinion is available to all who access the financial statements, including the stockholders, creditors, and any other interested parties. This outside opinion lends credibility to the financial statements issued by the company. The audited financial statements for all publicly-held corporations are available on the SEC web site. (See [Index</a> No Browsing](<a href=“http://www.sec.gov/edgar]Index”>SEC.gov | Filings & Forms))
There are many public accounting firms in the United States and around the world. The most widely known of all the accounting firms are called the “Big Four”. These firms are the largest of all the public accounting firms. They are international and are responsible for much of the public accounting work done in the world. You need to know the names of the Big Four accounting firms, which are:
Deloitte
Ernst & Young
KPMG
PricewaterhouseCoopers</p>

<p>For many years the requirements of the SEC seemed to be a sufficient control on publicly-held companies. However, significant financial disasters have occurred just in the past decade, and many of these have had fraudulent financial data at the core of the problem. Enron and WorldCom are two of these, and their collapse has shown how important it is for the financial statements to be credible. Even with the requirements of the SEC, these companies and several others found a way to get around the rules and issue fraudulent statements for a period of years before they were discovered. Most investors have little to go on other than company’s published financial statements, and billions of investment dollars are at stake. Literally, the economy of the world is at least in part dependent on reliable, truthful financial statements being published by corporations.
Corporate Governance: This term “corporate governance” refers to the mechanisms which encourage managers in a business to report the truth in their financial statements. There are three different ways that strong corporate governance is encouraged. One of these is the reputation of the managers and of the business. A strong reputation as a person or a business with high ethical standards is widely recognized as important, and generally neither managers nor auditors want to risk damaging theirs.
The second way strong corporate governance is encouraged is by the threat of legal liability. In recent years legal liability for managers who did not run the company as they should have has been shown to be a definite possibility and one that could have long-lasting implications.
The third mechanism is referred to simply as “ethics”, meaning that running the business and reporting the results of operations in a clear, truthful manner is the right thing to do. Most successful companies have found that doing the right thing is also the most profitable way to run a company. The most important factor in keeping a company ethical is for management to set high standards which they themselves follow.
Generally Accepted Accounting Principles (GAAP): When firms based in the United States prepare their financial statements, they are required to use the set of rules called “Generally Accepted Accounting Principles”, or “GAAP”. These are the accounting standards that have been formally in use in the United States since the formation of the SEC in the early 1930’s. GAAP gives direction on how to account for both common and uncommon transactions of companies. Some examples of guidance that GAAP gives for common transactions are (1) how quickly purchases are to be expensed, (2) when should assets on the balance sheet be recorded at their cost and when should they be recorded at their fair value, and (3) when revenue can be considered “earned”.
From time to time companies will also enter into more unusual transactions and need to know how to account for those. GAAP covers these as well. An example of a more unusual transaction is how to appropriately account for a purchase of a piece of equipment by using an old piece of equipment as a trade-in which, along with cash and other assets, is used to purchase the new equipment.
The goal of GAAP has always been to establish rules so that outside readers of financial statements can trust that statements from different companies will be relatively comparable. Because GAAP tries to give specific directions for how to account for all types of transactions, it is called a “rules-based” system. GAAP is a huge body of work. It has grown as the variety of transactions in which companies engage has increased. In the summer of 2009, a GAAP “codification” project was completed, the purpose of this is to make GAAP easier to navigate.
The SEC requires that publicly-held companies based in the United States prepare financial statements using GAAP. Readers of these financial statements know that the statements and the underlying transactions were prepared using the same rules as were used by other companies because external auditors are required to verify this and report on it in their annual audit report accompanying the financial statements.
GAAP is the responsibility of an organization called the “Financial Accounting Standards Board” (“FASB”). When the Board makes a change to the standards, it does so only after receiving input from anyone who might be interested, which includes the SEC, Congress, the While House, other government agencies, public hearings, and letters from individuals. Even though the use of GAAP in the United States is mandated by the federal government through the SEC, the FASB (which is responsible for creating GAAP) is a private institution.
International Financial Reporting Standards (IFRS): Companies based in most other countries use a different set of standards, called the ”International Financial Reporting Standards” (“IFRS”). These are the responsibility of an organization called the “International Accounting Standards Board” (“IASB”). These international standards are relatively new but are gaining momentum in countries around the world. IFRS is now used in more than 100 countries.
One of the main differences between IFRS and GAAP is that IFRS gives substantially less guidance and relies on interpretation to be handled on an individual basis by the preparers of the statements and their external auditors. Because of this, IFRS is considered a “principles-based” standard. U.S. GAAP also contains the underlying principles, but while IFRS stops there, GAAP goes on to prescribe the exact way the principles should be applied.
In prior years foreign companies who were based in countries using IFRS but whose stock was traded on American exchanges could file financial statements with the SEC using IFRS only if they also filed a statement of reconciliation to U.S. GAAP. The SEC required this in an attempt to maintain the comparability of financial statements of all companies traded on U.S. public exchanges. However, the companies complained that the preparation of this reconciliation was expensive and time-consuming. In late 2007, the SEC dropped the requirement for these companies (based in countries using IFRS but whose stock was also traded on a U.S. exchange) to file a reconciliation to GAAP. Now, the SEC is being pressured by some U.S.-based companies who want approval to use IFRS to file their financial statements. Their argument is that the flexibility of IFRS may give foreign firms an advantage.
The FASB and IASB have been working hard to develop standards to merge GAAP and IFRS while keeping the best of both. In 2002 the two organizations publicly declared their commitment to this in the “Norwalk Agreement”. The SEC has also made this a priority and made that declaration in its 2005 “Roadmap”. The most likely result in the future is that there will be a convergence of the two methods, probably under the name of IFRS, and this one new set of standards will be used worldwide.
It may come as a surprise to you that accounting standards could differ to this extent, but GAAP and IFRS are quite different. Besides the basic difference between being “rules-based” versus “principles-based”, there are theoretical differences in the underlying principles as well. Since we only have time to skim over the top of accounting in this introductory course, we will not encounter any of the real differences between these two sets of standards. However, in your next accounting course you will start covering concepts that require different treatment depending on the standard in use.<br>
Types of Reporting Entities: “Reporting entities” are those organizations that prepare financial statements. One type of reporting entity is a profit-seeking business (also called “company” or “firm”). Many of these businesses are large and could be subdivided into smaller segments or subsidiaries.
There are other reporting entities whose purpose might not be to make a profit. Examples of these are governmental entities, such as cities, states, and school districts. Also included in this category are charitable organizations and foundations. In this course we will only cover accounting as it is applied to profit-seeking corporations.
Profit-seeking entities can be categorized in many ways, and one common classification is by type of business: (1) service, (2) retail, and (3) manufacturing. Service businesses are those businesses whose main source of revenue is their knowledge and ability, rather than a product. Examples of service businesses are medical practices, law offices, and accounting firms. Some large service companies are Federal Express, Verizon Wireless, and Google. These companies sell their service, knowledge, and ability.
Retail firms are companies that buy inventory from manufacturers or wholesalers and resell it to consumers at a higher price. We are all familiar with a wide variety of retail firms, which include stores such as K-Mart, Radio Shack, Macy’s, and Kroger’s.
Manufacturing companies are those businesses which purchase inventory, process it in some way, and sell the new product. The product a manufacturing firm sells is different from the raw material it purchased. Examples of manufacturing companies are Coca-Cola, IBM, and Ford Motor Company.
We will talk more about these types of businesses throughout the course. When analyzing financial statements, it is important to have a good understanding of the industry in which the company operates. It is helpful to compare the company you are analyzing to other companies in the industry. Also, helpful is a good understanding of the types of issues that are important to companies in that industry.
Capital Markets:
The “capital markets” are the networks that exist for raising money. Many types of markets, including public markets (called “exchanges”), exist to facilitate the transfer of debt and equity investments. The largest of these public exchanges is the New York Stock Exchange (NYSE), but there are many others throughout the world.
The public exchanges allow for bidding on debt and equity securities, and the prices vary based on investors’ expectations about the future performance of the issuing company. One of the important tools investors use in determining these expectations is the financial statements of the issuing company.
Individuals as well as businesses and other entities may hold both debt and equity securities. Corporations will often invest in the stock of other corporations. This buying and selling of stock is facilitated by public markets, but it is also possible to buy and sell a company’s stock even if that company’s stock is not traded on a public exchange. Debt issuances in the forms of bonds allow any investor the chance to purchase an interest in the debt of a company. Businesses also have the option of obtaining debt financing by borrowing from a bank.
Overseers of Management:
There are two groups which are in a position to oversee management. These are the board of directors and the audit committee.
Board of Directors: Members of the “board of directors” are elected by the stockholders to represent their interest in overseeing management. The board of directors meets with management periodically to determine company policies, decide if dividends should be paid, and review the performance of the company’s officers as well as determine their compensation. The board has the ability to fire top management as well as hire replacements.
Audit Committee: The “audit committee” is a subcommittee of the board of directors. This committee’s main responsibility is to select the audit firm that will perform the annual audit and to make sure that the audit was performed in a professional manner. A strong audit committee helps strengthen corporate governance. However, the independent audit firms are well aware that their fee is paid by management, and in many situations, management preference may help determine which firm will get the job the following year. Because of this, it is important for the audit committee to remain as independent as possible and to keep the best interest of the stockholders firmly in mind. If company management or the audit committee has considerable disagreements with its audit firm, these differences must be reported to the SEC in a “Form 8K”.
Sarbanes-Oxley:
“The Sarbanes-Oxley Act” is an act that was passed in 2002 in response to several corporate scandals which resulted in billions of dollars in losses to stockholders and debt holders. The losses were incurred in large part because of deception by top corporate management as well as external auditors who overlooked obvious problems. As a result, inaccurate financial statements were published and were relied upon by innocent investors. The purpose of this Act was to ensure that frauds of this type could not happen again, and it did this by trying to boost corporate governance and restoring lost faith in the financial accounting system. This Act established (1) more controls on management, (2) more responsibility on the Audit Committee and the Board of Directors, and (3) stricter requirements for the external auditors. The Act placed more emphasis on the quality of the company’s “internal controls”. The internal controls of a company are the procedures and policies in place which have the purpose of protecting the company’s assets and helping to ensure the financial statements are correct.
Legal Liability:
Management, the board of directors, and external auditors all have a legal as well as a moral responsibility to act in the best interest of the stockholders. The stockholders are the owners of the business and, because in many instances they are not near the company and do not have sufficient expertise, they are reliant upon others to protect their interest. Also, they are reliant upon the external auditors to do a thorough audit and to report the truth in their cover letter regarding their findings.
If any of these groups do not follow through on their required responsibilities to the stockholders, they can be sued. Sarbanes-Oxley has made management and external auditors more responsible for the information contained in the financial statements. This has made it easier to bring legal action against management and external auditors, and as a result, in the United States litigation has steadily increased each year. This potential for litigation plays an important role in keeping corporate governance strong.
Ethics:
Because of recent corporate scandals that found management and independent auditors to be dishonest and because of a general distrust that has developed among stockholders, management, and auditors, many companies have recently instituted new policies to emphasize the importance of ethical behavior in their company. Business schools have added ethics to their curriculum. The American Institute of Certified Public Accountants (AICPA) and many other professional organizations have professional codes of ethics by which their members must abide. All of these are to encourage employees to do the right thing. The truth, however, is that strong ethical behavior in a business is one of the best assets a corporation can have. And it all starts with the “tone at the top”, which is the term for the ethical tone set by top management.
Research has proven that an emphasis on ethics is good for business. Both investors and creditors prefer to deal with a company that has a good reputation. Some of the qualities that help a company maintain a good reputation are high quality in their products and service, ethical behavior both inside and outside the company, and clear, accurate financial statements. Another benefit is that ethical companies are involved in less litigation.
In the same way that ethical behavior is good for companies, it is also good for audit firms. Companies prefer to work with external auditors who have a good reputation and who are involved in less litigation. Ethical firms of all types are more likely to be sought after by stockholders, creditors, employees, and customers.</p>

[I_mOnABoat]

<p>Chapter 2 - Financial Statements</p>

<p>Learning Objectives:
After studying Chapter 2, you should </p>

[I_mOnABoat]

<p>Springfield Repair Services Corporation<br>
Balance Sheet<br>
31-Dec-09 </p>

<p>ASSETS<br>
Current assets:<br>
Cash $240<br>
Accounts receivable $85
Prepaid insurance $90
Total current assets $415
Property, plant, and equipment:<br>
Building $22,000<br>
Less: Accumulated depreciation ($4,600) $17,400
Equipment $10,000<br>
Less: Accumulated depreciation ($2,200) $7,800<br>
Land $4,200 $4,200<br>
Total property, plant, and equipment $29,400</p>

<p>TOTAL ASSETS $29,815</p>

<p>LIABILITIES & STOCKHOLDERS’ EQUITY<br>
LIABILITIES:<br>
Current liabilities:<br>
Accounts payable $200<br>
Wages payable $140<br>
Utilities payable $80<br>
Unearned revenue $125<br>
Total current liabilities $545<br>
Long-term liabilities:<br>
Long-term notes payable $12,000<br>
Interest payable $480<br>
Total long-term liabilities $12,480
TOTAL LIABILITIES $13,025</p>

<p>STOCKHOLDERS’ EQUITY:<br>
Common stock $10,000
Retained earnings $6,790<br>
TOTAL STOCKHOLDERS’ EQUITY $16,790</p>

<p>TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY $29,815</p>

<p></p>

<p>Springfield Repair Services Corporation<br>
Statement of Cash Flows<br>
For the Year Ending December 31, 2009 </p>

<p>Beginning balance, January 1, 2009 $1,900 </p>

<p>Operating activities:<br>
Plus revenue collected $42,000<br>
Minus payments for insurance ($1,250)<br>
Minus payments for wages and salaries ($21,860)<br>
Minus payments for utilities ($1,240)<br>
Minus payments for property taxes ($860)<br>
Minus payments for equipment rentals ($4,000)<br>
Net cash flows from operating activities $12,790 </p>

<p>Financing activities:<br>
Plus long-term borrowing $12,000<br>
Minus payment of dividends ($22,250)<br>
Net cash flows from financing activities ($10,250)</p>

<p>Investing activities:<br>
Minus purchase of land ($4,200)</p>

<p>Ending cash balance, December 31, 2009 $240 </p>

<p>Chapter 3 - Common Transactions and Their Impact on the Financial Statements</p>

<p>Learning Objectives:
After studying Chapter 3, you should</p>

[I_mOnABoat]

<p>Chapter 4 – End-of-the-Period Adjustments</p>

<p>Learning Objectives:
After studying Chapter 4, you should
· Understand the purpose of end-of-period adjustments
· Know how to adjust the supplies account at the end of the period
· Understand prepaid amounts and how they are adjusted at the end of the period
· Understand the concept of depreciation and how it applies to buildings and equipment
· Understand the impact of depreciation on the Balance Sheet and the Income Statement
· Understand the concepts of principal and interest on a loan
· Understand how to accrue interest and the impact on the Balance Sheet and Income Statement</p>

<p>To ensure the financial statements are accurate, it is usually necessary to make some adjustments to the accounts before preparing the statements. Adjustments are prepared after all of the transactions for the period have been recorded. To determine which accounts need an adjustment, go through each Balance Sheet account to see if the ending balance is correct. If the ending balance is wrong, an adjustment needs to be made. Below are some accounts that typically need end-of-the-period adjustments.
Supplies:
When supplies are held by a business, a count must be taken or estimation made of the supplies still on hand at the end of the period. The asset account, called simply “supplies”, must be adjusted to reflect the dollar amount of supplies remaining. The other side of this entry goes to the Income Statement account, “supplies expense” to reflect the amount of supplies used during the period. The amount of the adjustment is the amount needed to bring the asset account to its correct balance.<br>
For example, assume a company started the period with no supplies and purchased $800 worth during the period. At the time of purchase, cash was decreased by $800 and the asset account “supplies” was increased by $800. At the time of purchase, the transaction was an exchange of one asset for another.
Some of these supplies were used during the period and, at the end of the period when an inventory is taken, the count shows that only $240 worth is still on hand. An adjustment must be made in the amount of $560 to reduce the amount shown on the Balance Sheet from $800 to the actual balance of $240.
The adjustment reduces the account balance of supplies on the Balance Sheet, but the Income Statement must also reflect that the company had supplies expense for the period of $560. So, the other side of the adjusting entry goes to the Income Statement account, “supplies expense”. This entry, reducing the asset account by $560 and increasing the expense account by $560, correctly shows the expense during this period on the Income Statement and also correctly shows the balance of supplies still on hand as $240 on the Balance Sheet.
Prepaid Amounts:
Some types of expenditures are typically required to be paid in advance. Examples of these “prepaid expenses” are rent and insurance. When you make the payment for rent or insurance, it is all an asset. You give up the asset cash and receive the asset of having prepaid an upcoming expense. Prepaid expenses are typically assets which are used up as time goes by, such as rent and insurance.<br>
Assume you purchase business insurance for the next six months at a cost of $600. On the date you buy the insurance, you have a $600 asset. At the end of the first month, however, you have used up one-sixth of this asset, or $100 of it. At this time you only have five months of coverage left as a prepaid asset, so you need to reduce the balance in your asset account by $100 to correctly reflect the $500 of prepaid insurance that is remaining at the end of the month.
In addition, you need to show $100 as insurance expense during this month. This was an expense that was incurred in order to generate the revenue of this period. The adjustment at the end of the period is to decrease the prepaid insurance asset account by $100 and to increase insurance expense to $100. Doing this correctly states both the Balance Sheet and the Income Statement.
Fixed Assets:
The category “fixed assets” includes assets that were purchased to be used in the business (not intended for resale) and are expected to last at least for several years. This category includes equipment, buildings, and land the business uses in its operations. When these assets are first purchased, the transaction is an exchange of cash for a fixed asset. For example, if a piece of manufacturing equipment was purchased for $20,000 in cash, the cash account would be reduced by $20,000 and the equipment account would be increased by $20,000.
At the time the company purchases the fixed asset, it is worth the purchase price. However, as time goes by, the asset declines in value. This happens as a result of wear and tear on the asset as well as obsolescence. When a building or a piece of equipment is purchased, management must estimate the asset’s (1) expected useful life and (2) the value of the asset at the end of its useful life. This value is called its “salvage value”.
Assume that management estimates that the piece of equipment mentioned above which was purchased for $20,000 will have an expected useful life of 10 years and no salvage value at the end of that life. Assume also that the purchase was made on January 1, 2009. If we are preparing financial statements for the year 2009, as of December 31, 2009 we no longer have a new asset worth $20,000. Instead, we have an asset that has had a year of use and is now worth some amount less than the amount we paid for it. We need a way to show that the asset has declined in value. Also, because we would have used this asset to generate revenue during the year 2009, we need to show that a portion of the asset’s cost was an expense of this period.
Accountants developed “depreciation” as a way to account both for the decline in fixed assets as well as to show that part of the decline is due to use in this period. Depreciation is not intended to be reflective of the value of fixed assets. Instead it is a way to methodically allocate the cost of using the asset to the Income Statement as an expense over the life of the asset. When the asset is first purchased, it is worth the amount paid for it. At the end of the asset’s life, it is usually worth little or nothing. Accountants needed a method to allocate the purchase price to the Income Statement as the asset was being used up, and depreciation was developed for that purpose.
There are several different types of depreciation methods from which management may choose, but the only method we cover in this course is called “straight-line depreciation”. Under the straight-line method of depreciation, we subtract the salvage value from the purchase price (which leaves us with an amount called the “amount to be depreciated”) and divide this remainder evenly over the period of time we expect to be using the asset. For this asset which has an expected life of ten years, no salvage value, and which was purchased on January 1, 2009, we can say that by December 31, 2009, one-tenth of the asset has been used. This would mean that we should take depreciation for 2009 of $2,000, which is the depreciable amount of $20,000 x 1/10.
This $2,000 would be shown as an expense called “depreciation expense” on the Income Statement. This correctly allocates this amount as an expense against the revenue earned during this year. The other side of this entry is to show the decrease in the carrying value of the asset. This is done by adding a line below the equipment account on the Balance Sheet called “accumulated depreciation-equipment”. The accumulated depreciation account is always a negative and is subtracted from the fixed asset account above it. It is called a “contra-asset” account because it is “opposed to” or against the asset account. It is usually reflected on the Balance Sheet as follows:
Equipment $20,000
Accumulated depreciation-equipment ( 2,000)
Net equipment $18,000</p>

<p>Below the line for accumulated depreciation, is another new line titled “net equipment”. When you see the word “net”, it usually means that something has been subtracted out. In this case, the “net carrying value” of the equipment is $18,000. That means that $18,000 is the amount shown as the net asset for this equipment on the books of the company at the end of 2009.
Companies are required to show all this information for fixed assets on their financial statements. They must show the original purchase price of the fixed assets minus the accumulated depreciation that has been deducted over the years and the net amount of equipment. Notice that this is over and above what is reported on the Balance Sheet for prepaid expenses. For prepaid expenses the only amount shown in the Balance sheet is the amount that is still prepaid at the end of the period. The additional information is required for fixed assets because they are normally large investments the company has made, and this information gives the reader of the financial statements a little more insight into the company than if just the net amount of $18,000 was presented. With this presentation, the reader can estimate how old the company’s equipment is and when it might need to be replaced, as well as get an idea of how much the company has invested in fixed assets.
Because the expected life and the salvage value are just estimates by management, these are often incorrect and sometimes the estimates are off by a substantial amount. You should know that there are systems in place to make corrections to these estimates as the need arises, but those adjustments are beyond the scope of this course.
Take the same example and assume now that the $20,000 piece of equipment was purchased by the company on July 1, 2009 instead of January 1, 2009. Assume also that management still estimates the equipment will last 10 years and will have no salvage value at the end of its useful life. The depreciation for a full year would still be $2,000, but the company only owned the asset for one-half of 2009. The depreciation adjustment for 2009 would only be one-half of a full year’s depreciation, or $1,000. Depreciation expense for 2009 would be $1,000 and accumulated depreciation on the end-of-the-year Balance Sheet would be $1,000, so the net carrying value at December 31, 2009 for this piece of equipment would be $19,000.
Let’s take this last example (assuming the equipment was purchased on July 1, 2009) one step further and look at the impact on the financial statements at the end of the next year, 2010. For the financial statements for the period ending December 31, 2010, the company would make the depreciation adjustment for 2010 which was a full year of use. For the year 2010 the adjustment would be for $2,000, which is the depreciable amount of $20,000 divided by its expected life of 10 years.
At the beginning of 2010, the Income Statement amounts for 2009 would have fallen away so that the beginning Income Statement amounts for 2010 would be zero. The Balance Sheet amounts, however, would have rolled over from the end of 2009 to become the beginning balances for 2010. So, the accumulated depreciation account on the Balance Sheet would start at ($1,000) and the depreciation expense account on the Income Statement would start at $0. When the adjustment for 2010 is made, accumulated depreciation is increased by $2,000 and depreciation expense on the Income Statement is increased to $2,000. Accumulated depreciation at the end of 2010 will be $3,000 and the presentation would look like the following on the Balance Sheet:</p>

<pre><code>Equipment $20,000
Accumulated depreciation-equipment ( 3,000)
Net equipment $17,000
</code></pre>

<p>This process of recording the depreciation expense every year and steadily increasing accumulated depreciation will continue until the asset is either “fully depreciated”, meaning that accumulated depreciation equals the depreciable amount of the asset, or until the asset is sold. The entries involved in the sale of assets are beyond the scope of this course. Notice that the amount on the Income Statement will never by higher than $2,000 per year.
Both buildings and equipment are subject to depreciation. These assets are first recorded on the Balance Sheet at their purchase price, and depreciation deductions (based on the depreciable amount) are taken over the expected useful life of the assets to steadily reduce their net carrying value. Notice however that land is never depreciated. It is the only fixed asset on which depreciation is not taken. It is always assumed that the value of land does not decline.
Interest Expense:
When funds are borrowed, the repayment includes two components: principal and interest. The principal is the amount borrowed. Interest is the amount the borrower pays to the lender for the privilege of using the money. Interest is an expense to the individual or company borrowing the money, and it is revenue to the individual or company which made the loan. Interest is usually set as a percentage of the amount borrowed, and the amount of interest owed increases as time goes by and the loan is still outstanding.
The loan agreement will state when the principal and interest payments are due, and the loan repayment may be structured in any manner that is agreed upon by the two parties. Some common examples of the structuring of loan repayments are (1) partial payments of both principal and interest are due every month, or (2) interest payments are due quarterly and the principal repayment is due at the end of the loan period or (3) all of the interest and all of the principal may be due at the end of the loan period.
When a company borrows money, the interest that will be due on that borrowing is an expense that accrues (or builds up) as time passes. On the day the company borrows money, it don’t owe any interest. After one month has gone by, it still owes the principal amount plus now one month’s interest. The company owes this amount even if it is not yet due. The amount that is owed is the amount that must be shown as a liability on the Balance Sheet.
On your accounting records, you record the liability of the principal at the time the money was borrowed. The entry for this transaction is to increase cash and increase the account “note payable”, both Balance Sheet accounts. So, at the time of borrowing, the impact of the transaction is to increase assets and increase liabilities. Notice that the principal amount borrowed does not have any impact on the Balance Sheet.
As time passes, you also have to record the fact that now you owe interest as well. Interest owed on money borrowed is an expense to the company. As interest is accrued, it is reported as an expense that goes on the Income Statement and an additional liability on the Balance Sheet.
For example, assume your company borrows $10,000 on January 1, 2009, and that you will need to repay this on January 1, 2010, along with $1,200 in interest. The entry on January 1, 2009 is to increase cash by $10,000 and increase the liability account, “notes payable” by $10,000. This liability is classified as a short-term liability because it is due in exactly one year. At the time of borrowing, there is no interest to record because no time has passed.
Let’s assume that your company is preparing quarterly financial statements at March 31, 2009. Because the interest is $1,200 per year, by dividing this amount by 12, we know that the amount of interest per month is $100. When we prepare the financial statements at March 31st, three months have gone by. At this time, we now not only owe $10,000 in principal but now we also owe $300 in interest.
To correctly state the financial statements, we need to make an adjustment to reflect the fact that we incurred interest expense during the period and also that we now owe more than just the principal. This adjusting entry records $300 as interest expense (Income Statement account) for the quarter and $300 as interest payable (a current liability account on the Balance Sheet). Notice that this entry causes both the Income Statement and the Balance Sheet to be correctly stated. The $300 in interest expense was an expense of the period and needs to be matched on the Income Statement against the revenue that it was used to earn. Under accrual accounting this is true even though the interest was not paid. The Balance Sheet is correctly stated because it now shows the additional liability of interest that we now owe along with the principal.
So, at this point we have two liability accounts on the Balance Sheet associated with the loan. The principal amount of the loan is shown in the account, “note payable”. The interest owed on this loan as of the date of the Balance Sheet is shown in the account, “interest payable”.
Let’s change this example and take it one step further. Assume that your company borrowed $10,000 on January 1, 2009 and the principal will not be due until January 1, 2012. The interest is still $100 per month and it is due with the principal on January 1, 2012. Assume you are preparing annual financial statements for your company at December 31, 2009. You will have already recorded the transaction of borrowing the money, which occurred on January 1, 2009 and would have increased the cash account by $10,000 and increased the notes payable account by $10,000.
At December 31, 2009, you will need to record interest expense for the entire year. The transaction will be to increase interest payable by $1,200 ($100 x 12 months) and to increase interest expense by the same amount. This records the amount of expense that was incurred (even though it was not paid) during the period and shows the increased liability of the company as a result of having held the loan throughout 2009. Both of these liabilities would be classified as long-term because they are not due until after one year from the date of the Balance Sheet.
At December 31, 2010, you will need to make an adjustment for interest expense for that year. It will be the same adjustment that was made at the end of 2009—increase interest payable by $1,200 ($100 x the 12 months of 2010) and increase interest expense by the same amount. Because the 2009 Income Statement amounts would have been closed out at the end of 2009, the beginning balances on all the Income Statement accounts at the beginning of 2010 would all be zeroes. The amount showed for interest expense for 2010 would be only the expense incurred during that year, $1,200. The Balance Sheet amounts at the end of 2009 would have rolled over to become the beginning balances at January 1, 2010. Because of this, the adjustment that was made at the end of 2009 of $1,200 will still be on the Balance Sheet at the end of 2010. When you make the adjustment for interest expense for the year 2010, the interest payable account will now show a balance of $2,400, which is $1,200 from 2009 and $1,200 from 2010.
Notice that the financial statements now correctly reflect reality. The Balance Sheet shows that the company has a principal liability of $10,000 (carried over from when the original transaction was recorded on January 1, 2009), plus it shows another liability for interest of $2,400 ($1,200 for 2009 and $1,200 for 2010). This is correct because the company has held the borrowed money for two years, so it owes two years of interest. If the company was to repay the loan and the interest owed at December 31, 2010, it would owe a total of $12,400, just as the Balance Sheet reflects.
The annual Income Statement is correctly stated as well. It shows interest expense of $1,200, which is the amount of interest incurred during 2010.
Taking that to the next year, the same adjustment would be made—interest expense would be $1,200 again and the interest payable account would be increased by $1,200. This would bring the interest payable account up to $3,600 on December 31, 2011.
The loan plus interest is due on January 1, 2012, so one of the company’s first transactions at the beginning of 2012 would be to pay back the loan plus interest. This will be a total of $13,600; $10,000 return of principal plus $3,600 in interest. The entry to record this transaction will be to reduce cash by $13,600, reduce the note payable account by $10,000 (which leaves it at zero), and to reduce the interest payable account by $3,600 (which leaves it at zero). The entry to record the repayment only impacts Balance Sheet accounts, reducing assets and liabilities. The Income Statement was correctly adjusted as time went by and the interest expense was incurred.</p>

<p>Chapter 5 - Adding a Few Complications</p>

<p>Learning Objectives:
After studying Chapter 5, you should
· Understand the concept of cost of goods sold and gross profit
· Know the two entries required when a company sells an item of inventory
· Understand how a gain or loss on sale of an investment is shown on the Income Statement
· Know the entry required when a company has a gain or loss on sale of an investment
· Understand the concept of unearned revenue</p>

<p>The Income Statement that we covered earlier was in its most basic form:
Revenue
-Expenses
Net income (loss)</p>

<p>This is the format for Income Statements used by companies in the service industry. Companies that sell their knowledge and abilities are considered in the service industry. Some examples of these companies are consulting firms of all types, doctors’ offices, lawyers, accountants, etc.
Companies that sell a product typically will present a slightly different Income Statement. For these companies it is helpful to offer the reader a little more information. Companies that sell a product include retailers, wholesalers, and manufacturing firms.
Cost of Goods Sold:
The format for an Income Statement for a company that sells a product is:
Sales
-Cost of goods sold
Gross profit
-Operating expenses
Net income (loss)</p>

<p>There are several things that you should notice about this Statement. One is that the top line is now called “sales” rather than “revenue” or “fee income”. Both of these terms mean the same thing but the word “sales” is generally applied to companies selling a product, while “revenue” or “fee income” is generally applied to companies that sell their knowledge and abilities. Another term that also means the same thing and is a combination of the terms is “sales revenue”.
The next line, “cost of goods sold”, is the cost to the company to purchase or manufacture the products that were sold during the period. So, the top line of this Income Statement is the total the company received for selling the products it is in business to sell, and the second line is the amount the company had paid for, or had invested in, the products it sold.
The third line is the difference between sales and cost of goods sold and is called “gross profit”. This is how much is left over after the cost of the products sold has been subtracted out. This is just a subtotal in the middle of the Income Statement, but it is an important figure. A company’s gross profit from all of its sales must be sufficient to cover all of its other expenses with hopefully some left over for net income for the owners. The gross profit line is of interest to management as well as to analysts and others outside the company who are trying to make a determination about the health of the company.
The terms “inventory” and “cost of goods sold” only refer to the products the company is in business to sell. The “inventory” account is an asset account and the “cost of goods sold” account is an expense account. When inventory is purchased by a company, the asset account inventory is increased and either cash is decreased or a liability account “accounts payable” is set up to record the fact that this amount is now owed. The account “accounts payable” is only used to record purchases of inventory made on account. When inventory is purchased and payment is made at a later date, it is said that the inventory is purchased “on account”.
For example, assume a company purchases $4,000 of inventory and agrees to pay for this purchase no later than the 10th of the following month. The entry would be to increase the inventory account (an asset account) and to increase the accounts payable account (a liability account). Notice that this transaction only impacted the Balance Sheet. What the company owns (its assets) increased and what the company owes (its liabilities) also increased.
If these are the only transactions during the month, then at the end of the month the inventory account has a balance of $4,000 and the accounts payable account has a balance of $4,000. When the company pays the balance due, it will reduce the asset cash by $4,000 and also reduce the liability accounts payable by $4,000. This transaction of paying its debt will also only impact the Balance Sheet—both liabilities (accounts payable) and assets (cash) will decrease.
Another point to notice about the recording of this transaction is that, once it is recorded, the two parts of the transaction are split. The inventory is an asset on the Balance Sheet and may be sold before or after the payment is due to the company’s supplier. Also, the liability may be paid at any time without impacting the fact that the inventory is an asset on the Balance Sheet.
When the inventory is sold, two balancing entries must be made. The first entry is to record the sale, and the second entry is to record the fact that inventory has now been sold. For example, assume that one-fourth of the inventory purchased above was sold for $2,800. First, the sale is recorded. If the sale was paid in cash, the Income Statement account “sales” is increased and the asset account cash is increased, both by the sales price of $2,800. If, the sale was made but the cash has not yet been received, the Income Statement account sales would still be increased by $2,800 but on the Balance Sheet, instead of increasing cash, the account “accounts receivable” would be increased. The “accounts receivable” account is only used for sales made “on account”, meaning that the sale was made but the cash has not yet been collected.
This treatment of recording the revenue on the Income Statement before the cash is collected is another example of accrual accounting. When the cash is later received, we will reduce the asset account accounts receivable by $2,800 and increase cash by $2,800. The Income Statement is correctly impacted when the sale is made, not when the cash is collected.
The other balancing entry that must be made is to show that we no longer have $4,000 of inventory, but that we were required to use up $1,000 of that inventory in order to make the $2,800 sale. To show this, the Income Statement account “cost of goods sold” is increased by $1,000 and the asset account “inventory” is decreased by $1,000. “Cost of goods sold” is the name of the account on the Income Statement to record the cost of inventory that has been sold. This treatment of making a second entry to transfer the cost of the inventory sold to the Income Statement at the time of sale correctly matches the revenue earned from the sale with the cost of the inventory that was sold. Also, it leaves the Balance Sheet correctly stated in that the inventory which was sold has been removed and a balance of $3,000 of inventory remains.
If we were to determine our gross profit at this time, it would be as follows:
Sales $2,800
-Cost of goods sold -1,000
Gross profit $1,800</p>

<p>This means that this sale gave us $1,800 in gross profit to go towards covering our other expenses of operating the business and hopefully leaving us some for net income.
Gains and Losses on Sales of Investments:
The purpose of the Income Statement is to show clearly to readers outside the company the amount of income the company earned during the period. Typically the majority of the revenue will be the result of the company doing what it is in business to do. If there was a gain or loss on an investment which the company made that was not related to the operations of the business, this gain or loss needs to be shown on the Income Statement but it needs to be set out separately. This Income Statement would have two additional lines and look like this:

Sales revenue
-Cost of goods sold
Gross profit
-All other operating expenses
Net income (loss) from operations
+/-Gain or loss on sales of investments
Net income (loss)</p>

<p>An investment is an asset that the company purchased which is not being used in the operations of the business. For example, if the company purchased land that it is not using in the business and then sells the land for a gain or loss, the amount of this gain or loss is a part of net income and should be recorded on the Income Statement. However, it needs to be made clear to the reader of the financial statement that this gain or loss is not expected to be a recurring part of net income and was not generated by the normal operations of the company.
When an investment is sold, there is only one balancing entry. Assume your company purchased land for $8,000 in cash and then decided to sell the land when it received an offer of $11,000. When the land was first purchased, it was an exchange of one asset for another. The asset account land was increased by $8,000 and the asset account cash was decreased by $8,000.
Now that you are going to sell the land, you will need to reduce the land account by $8,000 because you are selling all of the land. Be careful and do not reduce the land account by the amount of cash received. If you did that in this case, you would leave your balance in the “land” account at a negative $3,000! That obviously is not correct. Your goal is to make the Balance Sheet as correctly stated as possible. Since you sold all of the land that you owned, you want the land account to have a zero balance. Your entry to the land account is to reduce it by $8,000.
A second part of the entry is to record the actual amount of cash received. In this case, you will increase the asset account cash by $11,000. Because you have reduced one asset account by $8,000 and increased another asset account by $11,000, your entry is out of balance by $3,000. This $3,000 goes in an Income Statement account called “gain on sale of investment”. Then when you prepare the Income Statement, it will be shown on the next to last line of the statement, showing the reader that this transaction did occur, but also making it clear that the net income for the period received a $3,000 boost that was not from the regular operations of the business but rather a good investment the company made.
Assume again that your company owned the piece of land that it had purchased for $8,000, but now decides to sell one-half of the land for $3,500. Be very careful not to reduce the asset account land by $3,500. That is the amount of cash received, but because we sold one-half of the land and because we want the Balance Sheet to be as correct as possible, we need to reduce the asset account land by one-half of the amount originally paid for the land, or $4,000. This will leave a $4,000 balance in the land account which is correct because we still own the other half of the land.
We still need to record the actual amount of cash received of $3,500 into the cash account. After we have reduced the asset account land by $4,000 and increased the asset account cash by $3,500, we have $500 left to account for to complete this entry. This amount of $500 goes to an Income Statement account called “loss on the sale of investment”. It will be shown on the next to last line of the Income Statement, coming right after the line “net income from operations”. Again, this is to let the reader know that the $500 was a loss that was incurred by the company, but it was not from the results of operations.
Unearned Revenue:
Many times payments are made by a customer before the service or product is received. One example of this is tuition. You pay tuition ahead of the time you receive the service. Another example is magazines subscriptions. When you subscribe to a magazine, you are usually required to pay at least one year ahead of time, and the magazine will encourage you to subscribe for a longer period of time for a reduced amount, but to receive that reduced rate, the payment is due now.
When a company receives cash ahead of providing the service or product, this amount cannot be shown as revenue. The goal of accrual accounting is to show the revenue that has been earned during the period. When a company receives advance payments, just that fact that cash was received is not enough to allow it to be considered earned. The proper recording of this transaction is to increase cash by the amount of cash that was actually received, and the other side of this entry is to increase a liability account called “unearned revenue”.
It may seem odd that this is classified as a liability, but it does accurately show the transaction. If the sale is not completed, the customer will be entitled to receive the cash back. Assume you have a house-sitting business and take care of people’s houses while they are away on vacation. You ask that your customers pay one-third of the total before leaving and the remainder when they return. If you were to receive $50 from one of your customers who then is unfortunately in an accident before leaving and cancels the trip, you would owe the $50 back to the customer.
Assume now that the customer is not in an accident and does go on the trip. You take care of her house and charge her a total of $150, $50 of which you have already received and $100 that is still owed to you. One entry that you will need to make is to reduce the liability account unearned revenue by $50 (because now you have earned that amount) and increase the Income Statement account revenue by $50. This entry shows that the $50 received early has now been earned. Also, you now have an additional $100 of revenue which should also be recorded on the Income Statement. The entry to record this is to increase revenue on the Income Statement by $100 and to increase the Balance Sheet account accounts receivable by $100.
If this was your only transaction for this company, you would show cash of $50, accounts receivable of $100, and revenue of $150. When you receive the balance you are due from this customer, you will reduce “accounts receivable” by $100 and increase “cash”. Notice the Income Statement is only impacted when the revenue is actually earned. Receiving the cash either early or late impacts only the Balance Sheet.
Unearned revenue can be confusing, but it is important to understand because it is relatively common in practice. Remember that the only way unearned revenue can exist is if the company receives payment (actually receives the cash) ahead of earning the revenue. It can be thought of as the opposite of accounts receivable. A company has an account receivable if it earned the revenue but has not yet received the cash. A company has unearned revenue if it received the cash but has not yet earned the revenue.</p>

[I_mOnABoat]

<p>Chapter 6 - Analyzing Accounts</p>

<p>Learning Objectives:
After studying Chapter 6, you should
· Understand how accounts receivable is used and what makes it go up and what makes it go down.
· Understand the inventory and cost of goods sold accounts. Know what causes the inventory account to increase and decrease.
· Understand prepaid accounts and what causes them to increase and decrease.
· Understand long-term assets and how these accounts are impacted by sales and purchases.
· Understand the accounts payable account and how it relates to inventory. Know what causes increases and decreases in both of these accounts.
· Understand the notes payable account and the interest payable account and how they are increased and decreased.
· Understand some of the other common payable accounts and how they are impacted by transactions of the business.
· Understand the common stock account and what increases it.
· Know how to prepare a Statement of Retained Earnings and understand how it fits into the accounting cycle. Know the possible causes of increases and decreases in the retained earnings account.</p>

<p>To understand financial accounting, it is important to think about how the accounts are impacted by transactions. For example, when the “cash” account increases, it is because cash has been received. When it decreases, it is because cash has been paid out.
Accounts Receivable:<br>
When the account “accounts receivable” increases, it is because a sale has been made for which the cash has not yet been collected. The entry is to increase the Income Statement account revenue (or “fee income” or “sales”) and to increase the Balance Sheet account accounts receivable. At the time of the sale, the Income Statement and the Balance Sheet are both impacted, and the impact on both is an increase.
When accounts receivable decreases, it is because all or part of the amount owed to the company has been collected. When cash is collected, accounts receivable is reduced and cash is increased. When the cash is collected, the transaction is just an exchange of one asset, the receivable, for another asset, cash, and only the Balance Sheet is impacted.
Inventory:<br>
When the asset account “inventory” increases, it is because inventory has been purchased. Recall that the term “inventory” is only used when referring to the product the company is in business to sell. Typically inventory will be purchased “on account”, which means that it is usually not paid for at the time of receipt but is paid later when an invoice is submitted by the selling company. Companies are often allowed to purchase on account because they may purchase many products from the same suppliers and could receive shipments as often as daily. A purchase of inventory on account is recorded by increasing the asset account inventory and increasing the liability account accounts payable. The company has increased what it owns, but it has also increased what it owes. This transaction increases the totals at the bottom of the Balance Sheet because both total assets and total liabilities have increased.
If the inventory had been purchased with cash, the transaction would have been an exchange of one asset for another, and the entry would be to increase inventory and to decrease cash. Because these are both asset accounts and the increase is one is offset by the decrease in the other, the Balance Sheet totals would not have changed.
When the inventory account decreases, it is usually because inventory has been sold. When inventory is sold, the inventory account on the Balance Sheet is decreased by the cost of the inventory sold, and the Income Statement expense account cost of goods sold is increased by the same amount. The account called “cost of goods sold” is the expense account associated with the sale of inventory. This account shows the cost the company had in the inventory that was sold during the period.
Recall that it is the selling of inventory that requires two separate, balancing entries. One entry is made at the cost the company has in the inventory that was sold. This entry reduces the asset account inventory and increases the Income Statement account cost of goods sold. The purpose of this entry is (1) to show that the company no longer has as much of the asset inventory on hand and (2) to deduct on the Income Statement the expense of the cost the company had in the inventory that was sold.
The other entry is to record the sale, and this entry is made at the sales price. A revenue account on the Income Statement is increased and an asset account on the Balance Sheet (either cash or accounts receivable) is increased. The purpose of this entry is (1) to show on the Income Statement the revenue that was earned as a result of the sale, and (2) to show that assets have increased by the sales price.
Prepaid Accounts:<br>
Most businesses will have some future expenses that must be prepaid. Examples of typical prepaid items are rent and insurance. Both of these usually require payments to be made in advance, and both are for products that are used up as time goes by.
When prepaid accounts increase, it is because more has been purchased. At the time of purchase, it is an exchange of cash for the prepaid item. Total assets do not change because cash is decreased by the exact by which the prepaid asset is increased.
Prepaid assets are typically used up as time goes by. This is the case with both prepaid insurance and prepaid rent. As time goes by, the portion of the prepayment that was associated with the time that passed is no longer an asset. That portion of the prepayment is an expense of the period that passed and should be taken out of the asset account and shown as an expense on the Income Statement.
Assume on October 1, 2009, your company pays $1,200 for insurance for one year. At the time of purchase, your company has exchanged one asset for another. The entry at this time is to reduce the cash account by $1,200 and to increase the prepaid insurance account by $1,200.
When your company prepares financial statements at December 31, 2009, three months of this insurance has expired. To correctly state the financial statements, it is necessary to reduce the asset account so that the Balance Sheet shows only nine months of prepaid insurance remaining and to record the portion of insurance that has expired as an expense of this period on the Income Statement. To do this, the entry is to reduce the asset account prepaid insurance by $300 (leaving a balance of $900) and to increase insurance expense by $300. The amount of $300 was determined by dividing the amount paid for one year of $1,200 by twelve months to get $100 a month as the charge for insurance. At the end of December, three months of insurance have been used, which is $100 times 3 months, or $300.
Long-term Assets:<br>
Examples of these assets are the category called “fixed assets”, which typically include land, buildings, and equipment. When the cost shown on the Balance Sheet for these assets (the amount directly to the right of the account title) increases from one period to the next, we know more of these assets have been purchased during the period. When the amount directly to the right of these account titles decreases from one period to the next, we know that some of these assets have been sold during the period.
Recall that depreciation deductions decrease the “net amount” of these accounts, and the term “net amount” refers to the original cost of the asset minus accumulated depreciation. The term “directly to the right” refers to the original cost or the amount recorded for the asset at the time it was purchased. The “write down” (reduction of the net amount shown on the Balance Sheet) of long-term assets differs from prepaid accounts in that, as the amount remaining on the Balance Sheet is reduced, the deductions do not reduce the amount directly to the right of the account title. Instead these deductions, called “depreciation deductions” are subtracted out below the original cost using a contra-account called “accumulated depreciation”. The net amount shown on the Balance Sheet is the original cost minus the accumulated depreciation.
Recall also that when a long-term asset is sold, the account balance is reduced by the original purchase price of the asset, not the amount of cash received. The entry for the sale of an asset such as an investment in land is to reduce the land account by the amount that had originally been paid for that segment of land, increase the cash account by the amount of cash actually received, and to record the difference as either a “gain” or “loss” on the next to last line of the Income Statement. Be sure to notice the difference between this treatment for sales of investments and the treatment of two balancing entries for the sales of a company’s inventory. The reason for this treatment for the sale of investments on the Income Statement is to separate this transaction from the revenue and expenses that were incurred by the business in its general operations.
Accounts Payable:<br>
The liability account “accounts payable” increases when inventory is purchased on account. This term means that the cost of the inventory purchased by a company was not paid at the time of purchase. When inventory is purchased on account, both the asset inventory and the liability accounts payable are increased. Notice that this purchase on account increases the totals on the Balance Sheet, and there is no impact on the Income Statement. Once this entry has been made, the two components of this transaction have been accounted for and separated in the company’s records, and the accounts payable may be paid off before or after the related inventory is sold.
When the payable is paid, both the asset cash and the liability accounts payable are reduced. This transaction of paying a liability decreases the totals of the Balance Sheet, and again there is no impact on the Income Statement.
If, at the end of the period the balance in the accounts payable account has increased over what it was at the end of the prior period, there have been more purchases of inventory on account during the period than there have been payments. If the balance has decreased from the end of one period to the next, there have been more payments on accounts payable than there were purchases of inventory on account.
Be careful of the phrase “on account”. It can refer to a sale in which the cash has not yet been collected, or it can refer to a purchase that has not yet been paid. Pay special attention to the context in which this term is used to make sure you are handling the transaction correctly.
Notes Payable and Interest Payable:<br>
The notes payable account is a liability that increases as funds are borrowed. If your company takes out a loan in the amount of $10,000, the entry would be to increase the asset cash and increase the liability notes payable. This entry increases both assets and liabilities on the Balance Sheet, and there is no impact on the Income Statement.
Interest will accrue on the note as time goes by. At the date the money was borrowed, there was no interest due. The longer the loan is “outstanding” (the money is held by the borrower), the more interest will accrue. Assume in the above example that a note payable in the amount of $10,000 was borrowed on July 1, 2009 and a total of $12,000 must be paid back on July 1, 2011. At that time the loan will have been outstanding for a total of two years, and the repayment of $12,000 will be for $10,000 in principal and $2,000 in interest. Any amount repaid over and above the amount borrowed can be assumed to be interest.
When the principal portion is repaid, there is again no impact on the Income Statement. Both the asset cash and the liability note payable are reduced. While the principal portion of the loan only impacts the Balance Sheet, the interest incurred on the loan impacts the Income Statement. Any interest that is due is an expense to the company. In this example, the interest that must be paid as a result of holding the money for two years is $2,000.
However, because this interest will have been building up over two years (from July 1, 2009 to July 1, 2011), it is necessary to use accrual accounting to allocate it to the Income Statement in the correct periods as it is incurred. Since the interest expense is $2,000 for two years, it is $1,000 per year, or $500 per six month period. When your company prepares its financial statements as of December 31, 2009, it will need to accrue this amount as the interest that is an expense associated with 2009.
The entry to accrue the interest is to increase the interest expense account on the Income Statement by $500. This reflects the amount of interest that accrued during 2009 and appropriately charges this amount against the revenue earned in that period. The other side of this entry is to increase the liability interest payable by $500 to show the balance due as of December 31, 2009. This entry correctly states the Balance Sheet because as of December 31, 2009, the company now owes not only the $10,000 borrowed but also the $500 of interest expense.<br>
So, when the liability account interest payable increases, it is because more interest has accrued and is now owed than has been paid. If it decreases, it is because more interest has been paid than has accrued during the period. The entry when interest is paid is to decrease the asset account cash and to decrease the liability account interest payable.
Other Payable Accounts:
There are many other possible payable accounts that a company can have on its Balance Sheet. One common such account is “salaries and wages payable”. This account results from employees having worked and the company owing them their pay checks at the end of the period. This is common because the end of the period might be in the middle of the week and the pay date not until Friday. The entry is at the end of the period is to increase the account salaries expense and to increase the liability account salaries payable.
When the salaries are paid, the asset account cash is reduced and the liability account salaries payable is reduced. Notice that when payment of this liability is made later, it only impacts the Balance Sheet. The entry that impacts the Income Statement is correctly placed in the period in which the work occurred.
Another common liability account is utilities payable. Utilities are usually paid after they have been used, but the expense needs to be recorded in the period in which the utilities were used. Often the invoice will be received at the end of the month and will be due within 15 days. Increasing the expense account utilities expense and increasing the liability account utilities payable correctly states the Income Statement and Balance Sheet at the end of the period. It shows the expense that was incurred during the period and also shows that there is an additional liability now because the utilities payment will be owed within a few days into the next period. As was true for salaries payable, the liability account utilities payable and the asset account cash will both be decreased when a payment is made.
Any account that is labeled a “payable” is always a liability. Recall that a liability always means that a debt is owed that has not yet been paid. Because of this, all payable accounts are increased by additional debt and decreased when they are paid.
Common Stock:<br>
The first transaction of a corporation is usually to issue stock to the owners in exchange for an asset, typically cash. This transaction increases the cash account and increases the stockholders’ equity account called common stock. In practice, there are other types of stock besides common stock. For example, preferred stock is a different class of stock, and there can be several classes of preferred stock issuances. We will only cover common stock in this class.
In practice, there are often other transactions with a corporation’s common stock after the initial issuance. For example, the company could issue additional stock at a later point in time or it could buy back some of its stock that is outstanding. For simplicity in this course, we will presume there are no changes in the common stock account once there has been an initial issuance.
Retained Earnings:<br>
Retained earnings is increased when the company earns net income (or decreased when the company incurs a net loss). It is also decreased when the company pays dividends to its stockholders. Remember the name of the account “retained earnings” means earning of the company that have been retained, or not yet been paid out in dividends. When dividends are paid, the amount of earnings that have been retained declines. Paying dividends is a way of rewarding the company’s investors with an immediate return.
When the company first begins business, its retained earnings balance is zero. At the end of the first period, the net income (or net loss) from the Income Statement is closed into retained earnings on the Statement of Retained Earnings. This gives the retained earnings account its first balance. Any dividends paid are deducted out and the remainder is the retained earnings balance at the end of the period. Recall that the meaning of “retained earnings” is the amount of income minus any losses the company has earned during its lifetime in business and minus any dividends it has paid out also during its lifetime in business. That is the reason for the title “retained” (which means “held”) “earnings” (which means “net income”).
The balance at the bottom of the Statement of Retained Earnings is brought forward to the end-of-the-period Balance Sheet to bring it into balance. Once this is done, all revenue minus all expenses and all dividends paid have been brought over to the stockholders’ equity section of the Balance Sheet. It is because all of these figures have been netted together and “stored” on the Balance Sheet that it is not necessary to keep beginning balances on the Income Statement.
To analyze retained earnings, compare the ending balance of this period with the ending balance of the prior period. If the balance at the end of the current period in the account retained earnings is greater than the balance in this account in the prior period, then you know that the company earned a net income during the period and that, if dividends were paid out, the amount paid was less than the amount of net income. However, if the balance at the end of this period is lower than the prior period, the company may have incurred a net loss during the period or it may have paid out more in dividends that it earned in net income or both of these might have occurred during the period.</p>

[I_mOnABoat]

<p>Chapter 7 - Some Examples of Account Analysis</p>

<p>Learning Objectives:
After studying Chapter 7 you should
· Know how to calculate a missing amount in the accounts receivable equation.
· Know how to calculate a missing amount in inventory equation.
· Know how to calculate a missing amount in the prepaid expenses equation.
· Know how to calculate a missing amount in the accounts payable equation.
· Understand the relationship between inventory and accounts payable and be able to calculate a missing amount in one account using information from the other account.
· Know how to calculate a missing amount in both notes payable and interest payable equations.
· Know how to calculate a missing amount in the other payables.
· Understand the concept of unearned revenue and how balances in this account impact accounts receivable and revenue.</p>

<p>Recall that Balance Sheet accounts carry over from one period to the next. An ending balance for one period in a Balance Sheet account becomes the beginning balance for the next period. (Remember that this is true for Balance Sheet accounts, but is not true for Income Statement accounts. It is also not true of entries on the Statement of Cash Flows.) Because all the statements are related and because the Balance Sheet account balances roll over from one period to the next, we can use the information given in the statements to analyze the account and obtain more information about the transactions during the period.
Accounts Receivable:<br>
Assume you know the ending balance of accounts receivable in the prior year was $24,000 and the ending balance in the current year was $30,000. Given this information, you know that the balance at the beginning of the period was $24,000 and there were transactions during the period that made the account go up as well as transactions that made it go down, and the ending balance was $30,000. Assume you also know that sales on account during the period were $90,000. You know that these sales would have made the account go up. You know that the account would have been decreased by cash collections. If you were trying to answer the question, “How much cash was collected?” you could set up the following equation:
$24,000 + $90,000 - X = $30,000
Then, just solving for X shows that cash collected must have been $84,000. This must be correct because it is solving for the amount by which accounts receivable was reduced during the period, and cash collected on account reduces the balance in accounts receivable.
This way of analyzing this type of problem will give you the correct answer whether or not all sales of the company were made on account. Because we are adding in all sales (which could have included some sales which were paid immediately in cash), we will get all the cash collected. We have to use the accounts receivable beginning and ending balances because the change in this account is a necessary part of the computation.
Alternatively, if we had been given the amount of cash collected, then we could have determined the total revenues by solving for the amount that had increased the accounts receivable. However, because accounts receivable is closely related to unearned revenue, when analyzing accounts receivable, always look to see if there is also any unearned revenue. These computations for analyzing unearned revenue are explained in detail in the discussion at the end of this chapter.
Assuming there are no unearned revenues, the equation to analyze accounts receivable is:
Beginning accounts receivable + sales – cash collected = ending accounts receivable
Inventory:<br>
This asset account is increased when the company purchases additional inventory and decreased as the inventory is sold. If we know the beginning balance in inventory is $12,000 and the ending balance is $11,000, then we only need to know either the amount of inventory purchased or the amount of inventory sold in order to determine the missing figure. In this case, assume that $48,000 of inventory was sold during the period. This means that the account was reduced by $48,000. Then we can determine how much inventory was purchased (or added in) by the following formula:
$12,000 + X - $48,000 = $11,000
Solving for X shows that $47,000 worth of inventory must have been purchased during the period.
The equation to use to analyze the inventory account is:
Beginning inventory + inventory purchases – cost of goods sold = ending inventory
If any of these amounts are missing, you can solve for it if you know the other three amounts.
Prepaid Amounts:<br>
This category includes items such as prepaid rent, prepaid insurance, or prepaid professional fees. This type of asset is increased as additional payments are made. It is decreased as time goes by and the prepaid amount is used up. As it expires, it is taken away from the asset account and shown as an expense of the period. So, prepaid accounts are analyzed in the same way. They are increased as more payments are made and decreased as the prepaid amount expires.
For example, assume you started the month with $4,000 in prepaid rent listed as an asset on your balance sheet. You ended the month with $6,000. Assume also that during the month you paid $4,000 more for prepaid rent. You can use this information to answer the question, “How much is your rent expense per month?”
$4,000 + $4,000 - X = $6,000
Solving this, X equals $2,000, which is the amount of rent expense per month. If any one of the amounts are missing in this equation, you can solve for it as long as you know the other three amounts.
The equation to use to analyze prepaid amounts is:
Beginning prepaid amount + additional payments – expense = ending prepaid amount
Accounts Payable:<br>
This liability is increased as additional inventory is purchased “on account”, and it is decreased as payments are made to the suppliers. If we know that the beginning balance in accounts payable was $6,000 and the ending balance was $18,000 and we also know that inventory purchased during the period was $92,000, we can use this to determine how much was paid to inventory suppliers during the period. Set up the calculation as follows:
$6,000 + $92,000 - X = $18,000
Solving this for X, we see that $80,000 must have been paid to inventory suppliers during the period.
As was true with “Accounts receivable”, this analysis of the “Accounts payable” account is the same whether or not all of the purchases a company makes of inventory are purchases “on account” or not. Because we are adding in all of the purchases on account, we will be solving for the total amounts paid to suppliers.
Use the following equation to analyze accounts payable and determine any missing amount:
Beginning accounts payable + inventory purchases – amount paid = ending accounts payable
Relationship between Inventory and Accounts Payable:<br>
Both the inventory account and the accounts payable account are increased when inventory is purchased on account. Because we can assume for purposes of this analysis that all inventory is purchased on account, then we can say that if we know the increase in the inventory account during the period, we can assume that amount is also the increase in the accounts payable account. Look carefully at the following two equations:

Inventory:
Beg. balance + inventory purchased –cost of goods sold = ending balance</p>

<pre><code>Accounts payable:
Beg. balance + inventory purchased – payments on account = ending balance
</code></pre>

<p>Because both of these accounts are increased by inventory purchases, if we are given the amount of inventory sold, we can use the amount of inventory purchases to determine the payments on account. To make this determination, first analyze the Inventory account to arrive at the amount of inventory purchased. Plug this figure for inventory purchased into the accounts payable analysis and determine the payments made on account during the period.
For example, assume you have the following beginning and ending balances for inventory and accounts payable:
Inventory Accounts Payable
Beginning $26,000 $ 8,000
Ending 23,000 10,000</p>

<p>Now assume that you know cost of goods sold was $46,000, and the question is how much in payments on account was made to suppliers during the period? To approach this problem, your only choice is to use the information given. Since you are given cost of goods sold, you have to analyze inventory first because that is the only place it appears on the Balance Sheet. The formula is:
$26,000 + X - $46,000 = $23,000
Solving this gives the amount of inventory purchased of $43,000. Now that you have the amount of inventory purchased during the period, you can use it to analyze accounts payable and determine the payments made on account:
$8,000 + $43,000 - X = $10,000
Solving this gives the amount paid to suppliers of $41,000 which is the answer to the problem.
Or, the computation could go the other way. If you are given the payments on account and asked to compute the amount of inventory sold, you can first analyze the accounts payable account to arrive at the amount of inventory purchased. Use that amount to analyze the inventory account and determine the amount of inventory sold.
For example assume the same information given above, except that you are given that $50,000 was paid to suppliers and asked to compute the cost of goods sold. Because you have to use what you are given, first analyze accounts payable and use the resulting inventory purchased amount to analyze inventory to arrive at cost of goods sold.
$8,000 + X - $50,000 = $10,000
Since this shows that total purchases during the period were $52,000, you can use this figure to determine cost of goods sold through the inventory equation:
$26,000 + $52,000 - X = $23,000
Solving this shows that cost of goods sold for the period must have been $55,000.
Notes Payable and Interest Payable:<br>
Notes payable are increased when additional funds are borrowed, while interest payable is increased as time goes by and interest expense is incurred. Both of these accounts are decreased when payments are made. Following is the equation for the notes payable account:
Beginning notes payable + addt’l. funds borrowed – payments made = ending notes payable
The equation for interest payable is as follows:
Beginning interest payable + interest accrued – payments made = ending interest payable
Just as was true in the other accounts, if you know any three of these figures, you can determine the missing figure.
Other Payables:<br>
Examples of other types of payable accounts are “Salaries payable” and “Utilities payable”. These are increased as expenses are incurred. As salaries and wages are earned, the amount owed becomes an expense to the company (shown on the income statement) and also a liability. When the employees are paid, both the liability account and the cash account are reduced.
Utilities expense is typically recorded when the invoice is received and at the same time, the liability account is increased to show the amount owed. When payment is made to the utility company, both the liability account and the cash account are reduced.
The formula for analyzing any payable is:
Beginning balance + expenses incurred – amounts paid = ending balance
Unearned Revenue:<br>
Unearned revenue exists if the company has received cash in advance of having earned it. When the cash comes in, the cash account is increased along with the unearned revenue liability account. Notice that these are both Balance Sheet accounts. As the revenue is earned, the liability account is reduced and revenue (on the Income Statement) is increased. In accordance with accrual accounting, the Income Statement is not impacted until the revenue is actually earned.
Think of unearned revenue as the opposite of accounts receivable. When the company has accounts receivable, it means that the company has earned revenue, but has not yet received the cash. When the company has unearned revenue, it means that the company has received the cash, but has not yet earned the revenue. Because these two accounts are so closely related, if you are analyzing a company’s accounts receivable, always look to see if there is also a balance in unearned revenue. If there is, that will change your answer.
If you have a beginning balance in the unearned revenue account, it means that your company had received cash in the prior period which had not yet been recorded as revenue as of the start of this period. (Unearned revenue is only recorded when the cash comes in, so you know that a beginning balance in this account means you received the cash in a prior period.) If you have an ending balance, it means that your company had received cash by the end of this period that had not yet been earned and so, had not yet been recorded in revenue.
If you are trying to determine the amount of revenue the company earned during the period and you are doing it by looking at the amount of cash received, first analyze accounts receivable to find the impact of this account on revenue. After you have analyzed accounts receivable, always look to see if there is a beginning or ending balance in unearned revenue. If there is a beginning balance in unearned revenue, add it to the amount you determined as revenue by analyzing accounts receivable. If there is an ending balance, subtract this out.
You add in the beginning balance because this cash was received in a prior period and was not yet recorded as revenue. Remember you are trying to determine the revenue by looking at the amount of cash received. You can safely assume that this amount was recorded as revenue in this period.
You subtract out the ending balance because this is cash received this year that was not included in revenue. You know it was not included in revenue because it is still in the account unearned revenue. Since you are finding revenue by using as a base the amount of cash you received, you need to subtract out this cash that was received but not yet recorded in revenue.
Look at the following example. Assume you have the following balances on the balance sheet:
Accounts Receivable Unearned Revenue
Beginning $20,000 $1,000
Ending 18,000 1,500</p>

<p>Now assume that you are given that there was a total of $124,000 of cash collected during the period, and the question asks you to find the amount of total revenue. First analyze accounts receivable, remembering that cash received reduces the balance in accounts receivable:
$20,000 + X -$124,000 = $18,000
Solving this shows that the accounts receivable account had total increases during the period of $122,000. These increases would be the amount of total revenue if there was no unearned revenue. However, looking in the liability section of the Balance Sheet, you see that there was both a beginning and ending balance of unearned revenue. The beginning balance of $1,000 needs to be added in. You add it in because when you analyze the accounts receivable account, you are basing your computation of revenue on the amount of cash received during the period. This $1,000 that was the beginning balance of unearned revenue would not be included in this because it was cash that was received in a prior period. So, in addition, this beginning balance of unearned revenue should be included in revenue.
The ending balance of $1,500 should be subtracted out of revenue. This is because, if this cash came in this year, you have included it in your computation of revenue. However, even though it is cash received during the year, it is not revenue this year because it still is unearned at the end of the period. To adjust for this, it must be subtracted out. The final computation is as follows:
$122,000 + $1,000 - $1,500 = X
Solving for X gives an answer of $121,500, and this is the answer to the problem.
There is the possibility that the $1,000 that was unearned at the beginning of the period is still unearned at the end of the period. This method of adding in the beginning balance (assuming all the unearned revenue at the beginning of the period was earned during the period) and subtracting out the ending balance (assuming all the ending unearned revenue was received during the period) will accurately account for this and give you the correct answer.
There is another way to look at this which some students find easier. Once you have analyzed the accounts receivable account and determined the amount of $122,000, instead of analyzing separately the beginning and ending balances in unearned revenue, look at the difference between the beginning and ending balance. In this case, the account balance in unearned revenue increased from the beginning of the period to the end of the period by $500. This means that an additional $500 was not included in revenue, because it is still classified as a liability. Since $500 less was included in revenue, this net amount needs to be deducted from the revenue computed of $122,000, and the final answer is $121,500.
Let’s change the example slightly. If the question had been the opposite and you had been given the amount of revenue and needed to compute the amount of cash collected, you would still first analyze accounts receivable and then look to the account unearned revenue. Use the same balance sheet figures and now assume that the total revenue was $84,000. First analyze accounts receivable:
$20,000 + $84,000 - X = $18,000
Solving this shows that cash collected during the year equals X which equals $86,000. If there was no unearned revenue, this would be the amount of cash collected. However, you know there was both a beginning and ending balance in unearned revenue, and these must be taken into account.
The beginning balance of $1,000 represents cash that was collected in a prior period but, as of the start of this period, had not yet been recorded in revenue. Assuming that this amount has been recorded in revenue this year, we must subtract it out because the cash had been collected in a prior year, not this year. The ending balance of $1,500 must be added in because this amount does represent cash collected this year that has not yet been reflected in revenue. Since we are trying to determine the amount of cash collected and we are doing it based on the amount of revenue recorded, we must add this $1,500. This brings the answer to $86,500 was collected in cash this year.
Notice again that it does not matter whether the $1,000 that is the beginning balance of unearned revenue is part of the $1,500 balance at the end of the year or not. All that matters is that the beginning balance and the ending balance are both given the correct treatment.
Another way is to look at the difference. From the beginning of the period to the end of the period, the balance in the unearned revenue account increased by $500. This represents additional cash received that was not recorded in revenue, so this $500 should be added to the $86,000 determined from the accounts receivable analysis, to give a final answer of $86,500.
Either of these methods will work every time if you use the correct logic. It is best not to just memorize rules because the logic changes depending on the situation. The best way to understand these concepts is to work problems until the logic makes sense to you, and you can find many problems by going through old exams which are posted on Oncourse.</p>

<p>Chapter 8 – Analyzing Financial Statements</p>

<p>Learning Objectives:
After studying Chapter 8 you should
· Understand analyzing financial statements across time.
· Understand analyzing financial statements with industry averages.
· Know how to prepare common-size financial statements.
· Understand the debt to equity ratio and know how to calculate.
· Understand the return on equity ratio and know how to calculate.
· Understand the current ratio and know how to calculate.
· Understand the asset turnover ratio and know how to calculate.
· Understand the basic earnings per share and know how to calculate.</p>

<p>The information a company publishes in its financial statements is its representation of its status to the world. The “world” includes professional financial analysts, stockholders, debtors, and suppliers of the company as well as competitors of the company and many others who have various reasons to be interested in the condition of the company. Many of these readers of financial statements have little or no other means of understanding the financial condition about the company. Because of this and because there is a large volume of information contained in the financial statements, analysts of all kinds have developed a few standard approaches to analyzing the data to help them focus on the important points.
Analysis Across Time:
It is important to look at the current year’s financial statements and make some comparisons with the company’s statements of prior years. This helps the reader to answer questions such as:
· Is the company buying increasing amounts of assets?
· Is the debt or equity of the company increasing?
· How has net income changed?
· How has the gross profit of the company changed?
· How much of the company’s earnings has it maintained and how much as it paid out as dividends?
Answers to questions such as these as well as many others help the reader understand the intentions and the effectiveness of management. Analyses across time give the reader a feeling for the trend in which the company is moving.
Analysis Within the Industry:
It is helpful for outside readers of financial statements as well as the management of a company to look at the financial statements of other businesses in the same industry. These competitor companies face many of the same obstacles and their financial data can provide valuable information as to how they operate and how successful their choices have been. Some things which can be discovered about the competitor companies from looking at their financial statements are:
· Are major assets purchased or leased?
· Are the majority of their assets financed with debt or with equity?
· How high is their gross profit?
· Do they pay dividends?
· Are they continually investing in more fixed assets?
Common-Size Financial Statement:
Common-size financial statements have percentages included that are helpful to the reader in making comparisons, both over time and with other companies in the same industry. Typically both the Balance Sheet and the Income Statement are made common size.
The Balance Sheet usually will have total assets set at 100%. Then, all other accounts on the Balance Sheet have their percentage of the whole listed next to the dollar amount. These percentages let the reader know at a glance, for example, what percentage cash is of total assets. To make this calculation, the balance of cash is divided by the total assets. Another percentage that is often of particular interest is the percentage of current assets to total assets. This is determined by dividing the amount of current assets by total assets. The percentages of all individual asset accounts should add to 100%, which is the percentage of total assets.
Because the total dollar amount on the other side of the Balance Sheet, liabilities plus stockholders’ equity, is the same as the dollar amount of total assets, this is also set at 100%. Of special interest on this side of the Balance Sheet is what percentage total liabilities are to total liabilities plus stockholders’ equity. To determine this, divide total liabilities by total liabilities plus stockholders’ equity.
The Income Statement is usually made common size by setting total revenue at 100%. Each expense has a percentage next to it which shows its percentage of total revenue. For example, the cost of goods sold percentage is an important one for analysts. This is determined by dividing cost of goods sold by total revenue. Another percentage of interest particularly for service businesses (where the majority of expenses is usually in salaries) is the percentage of salaries and wages expense compared to total revenue. This is determined by dividing the amount of salaries and wages expense for the period by the revenue for the period.
The net income percentage is also important to readers of financial statements. This is computed in the same way–the net income of the company divided by the total revenue. This percentage gives the percent of each dollar of revenue that remains as profit after all the expenses of a company have been paid.
The common-size financial statements make the statements more comparable. When comparing financial statements of a company to that same company’s statements of prior years, common-size percentages make it easier to see where the company is expanding or contracting and if it is becoming more or less efficient. For example, if you see a company almost doubled its revenues and increased its gross profit by $12,000, it is easier to make comparisons between the two years if you have percentages that standardize these figures.
In addition, it is easier to make comparisons between other companies in the same industry if you have common-size percentages for all the companies you are comparing. The percentages standardize the figures and reduce the impact of the relative sizes of the companies. For example, you could easily compare the cost of goods sold percentage, various expense percentages, and the net income percentages of companies of all different sizes to see their relative efficiencies.
A copy of financial statements with common-size percentages for the Paintball Company (one of the problems assigned for you to work through in this course) is shown at the end of this chapter.
Debt-to-Equity Ratio:
The debt-to-equity ratio is a measure of a company’s liabilities compared to its equity. This is a measure of how the company has financed its assets. Every company has a choice as to whether to finance its assets by borrowing money or by using its equity. The computation of the debt-to-equity ratio is:
Average total liabilities
Average stockholders’ equity</p>

<p>The result of this formula is the percentage that a company uses debt in comparison to its equity. The finance term for the extent a company uses debt is “leverage” and this ratio is considered a “leverage ratio”. Some companies use considerably more debt than they do equity. This is often the case for companies that have requirements for expensive fixed assets. Other companies, for example consulting firms, may use almost no debt because their business requires few expensive assets.
Notice that the first word in both the numerator and the denominator is “average”. Typically average figures are used on Balance Sheet amounts because end-of-the-year figures may not reflect the typical balances during the year. To compute this ratio, you need to get an estimate of the average total liabilities as well as the average stockholders’ equity during the period. Most analysts do not have access to the details to compute this exactly, so there is a commonly-used shortcut. To get a rough estimate of the “average”, take the beginning of the year balance plus the end of the year balance and divide by 2. Written out, the formula becomes:
(Beginning total liabilities + ending total liabilities)/2
(Beginning stockholders’ equity + ending stockholders equity)/2</p>

<p>Notice that the numerator includes all liabilities, whether short- or long-term. Notice also that the denominator includes all stockholders’ equity, which would mean both retained earnings and common stock.
Debt-to-equity ratios vary by industry and the policy of the management of each company. A company that uses a high percentage of debt compared to its equity would have a high debt-to-equity ratio. Companies that require a large amount of expensive fixed assets, such as manufacturing firms, tend to fall into this category and have ratios of 2.0 or higher. A ratio of 2.0 means the company has twice as much debt on its balance sheet as equity. A large amount of debt increases the risk of the company since the company must be able to have sufficient cash to pay the loans back along with interest when these come due.
Businesses with low needs for expensive fixed assets, such as consulting firms, tend to have lower debt-to-equity ratios, often around .5, which means that the company has twice as much equity as debt.
Return on Equity:
The return on equity (ROE) ratio is a measure of how efficiently the company is using its equity. This is important to owners and analysts alike. This is calculated by the following formula:
Net income
Average stockholders’ equity</p>

<p>The word “return” is often used to refer to net income, and remembering this will help you to remember this formula. This is a “profitability ratio” which means it is a ratio analysts use to measure the relative profitability of a company. Profitability ratios always compare net income to some number on the Balance Sheet. Doing this allows analysts to compare companies of different sizes.
The net income figure in the numerator refers to the net income taken from the bottom of the Income Statement. The denominator is the average of all stockholders’ equity over the period. The above formula could be restated to read:
Net income
(Beginning stockholders’ equity + ending stockholders’ equity)/2</p>

<p>This calculation for the denominator makes it a rough estimate of the average stockholders’ equity during the period. Recall that the Income Statement figures are for one period only, so the numerator is the total net income for only the current period.
ROE is useful when comparing financial statements of various companies. It gives the percent of net income to the total amount of equity invested in the company and is a way to measure how efficiently the company is using the stockholders’ investment. ROE’s vary from one industry to another and industries requiring large investments of fixed assets typically will have lower ROE’s.

Current Ratio:
The current ratio is a commonly-used estimate of the company’s ability to pay its debts. Whether or not a company can pay its debts in the coming year is important information for readers of the financial statements, because insufficient cash is the number one reason companies fail. This is called a “solvency” ratio, meaning it is a rough measure of the company’s ability to remain solvent during the coming year.
The formula for the current ratio is as follows:
Current assets
Current liabilities</p>

<p>There are several things you should pay careful attention to regarding this formula. First, only the current assets are used in the numerator and only the current liabilities are used in the denominator. Recall the definition of current assets is cash plus any assets expected to be converted into cash within one year. The definition of current liabilities is any debts that are expected to become due within one year. So, if a company had a current ratio of 1, its current assets are exactly the same amount as its current liabilities. A current ratio of greater than 1 means that there looks to be somewhat of a cushion. A current ratio of less than 1 means that there may be more debts coming due during the next year than there will be cash to cover these. Analysts typically want to see a current ratio comfortably above 1.0, but too high of a ratio may mean that the company is not doing a good job of investing its assets.
The other point you should be aware of is that, even though these accounts are both Balance Sheet accounts, you do not take an average of beginning and end of the year figures for this ratio. Instead, it uses only year-end amounts. The reason for this is that this ratio is forward looking. Its purpose is to get a rough estimate of whether or not the company will have the ability to pay its debts from where it is at the end of the year.
Inventory Turnover Ratio:
The inventory turnover ratio is a measure of how fast the company moves its inventory through the company. This is a test on the inventory as a whole, because individual items of inventory would move through the company at different rates. This ratio is one of a class called an “asset turnover ratio”. The inventory turnover ratio is computed as follows:
Cost of goods sold
Average inventory</p>

<p>The numerator is cost of goods sold taken from the Income Statement, and the denominator is the average inventory taken from the beginning and ending Balance Sheets. This formula can be restated to the following:
Cost of goods sold
(Beginning inventory + ending inventory)/2</p>

<p>In general, a high inventory turnover ratio means that the company is doing a good job of selecting inventory for resale and the company has a relatively small amount of inventory that it is having trouble moving. Since there is a high cost associated with holding inventory (it has to be stored, insured, kept dry, and the longer it is held the greater the possibility of it becoming obsolete or spoiling), analysts usually like to see high inventory turns.
The general rule is that a company which has a gross profit of 20% to 30% should try to achieve an inventory turnover ratio of 5 to 7 times per year. If a company has a lower gross profit percentage, it should try for a higher turnover ratio, and a company with a higher gross profit percentage in general does not need to have as high a turnover ratio. These are estimates or “rules of thumb” and the gross profit percentage as well as the inventory turnover rate is governed to a large degree by the industry in which the company operates.
Earnings Per Share:
“Earnings per share” (EPS) is one of the most important figures on the financial statements. It is one of a miscellaneous category of ratios upon which analysts place a lot of reliance. The formula for earnings per share is as follows:
Net income
Average number of shares outstanding</p>

<p>The net income figure used in the numerator is from the bottom line of the Income Statement. The denominator is an average of the number of shares outstanding. The formula could be changed to the following:
Net income
(Beginning number of shares outstanding + ending number of shares outstanding)/2</p>

<p>This formula determines what is called the “primary earnings per share”. There is also “fully-diluted earnings per share” which is beyond the scope of this class and which you will cover in detail in more advanced classes.
“Earnings per share” is important to analysts because it is a return on each share of stock outstanding. In addition, it is easy to compare companies in different industries and of different sizes by using this one ratio.
EPS is the one ratio that is required to be on the face of the financial statements, and it goes on the Income Statement directly below net income. It is usually seen as the most important of all ratios because it is often an important component in determining the value of a share of stock.
</p>

<h1>Paintball Company</h1>

<pre><code>Common-size Financial Statements

End of Month 3
</code></pre>

<p>Our Company’s Balance Sheet at the End of Month 3 Our Company’s Month 3 Income Statement<br>
ASSETS<br>
Current Assets: Sales Revenue - Services $ 5,200 88.1%<br>
Cash $ 12,300 52.1% Sales Revenue - Mdse. 700 11.9%<br>
Accounts Receivable 3,000 12.7% Total Revenues $ 5,900 100.0%<br>
Inventory 700 3.0% Cost of Goods Sold 300 5.1%<br>
Prepaid Rent 800 3.4% Gross Profit $ 5,600 94.9%<br>
Prepaid Insurance 600 2.5% Salary Expense $ 800 13.6%<br>
Total Current Assets $ 17,400 73.7% Rent Expense $ 400 6.8%<br>
Fixed Assets: Insurance Expense $ 600 10.2%<br>
Equipment $ 2,400 10.2% Depreciation Expense $ 100 1.7%<br>
Accumulated Depreciation - Eqpt (200) -0.8% Net Income $ 3,700 62.7%<br>
Land 4,000 16.9%<br>
Total Fixed Assets $ 6,200 26.3% Our Company’s Month 3 Statement of Retained Earnings </p>

<pre><code>Total Assets $ 23,600 100.0% Beginning Retained Earnings $ 10,400
Net Income 3,700
</code></pre>

<p>LIABILITIES Dividends (1,000)<br>
Current Liabilities: Ending Retained Earnings $ 13,100<br>
Accounts Payable $ 500 2.1%<br>
Total Liabilities $ 500 2.1% </p>

<p>STOCKHOLDERS’ EQUITY<br>
Common Stock $ 10,000 42.4%<br>
Retained Earnings 13,100 55.5%<br>
Total Stockholders’ Equity $ 23,100 97.9% </p>

<pre><code>Total Liabilities & Stkhldrs’ Equity $ 23,600 100.0%
</code></pre>

[pistolpete463]

<p>thanks so much!</p>