11 Chapters 2 and 3: Financial Statements and Transaction Analysis.

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Chapters 2 and 3:Chapters 2 and 3:

Financial Statements andFinancial Statements andTransaction AnalysisTransaction Analysis

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Course OverviewCourse OverviewFinancial Accounting

– External users– Emphasis on decision making of users– Subject to regulation – Publicly available

Managerial Accounting– Internal users (within the company)– Emphasis on use to plan activities, make pricing

decisions, and measure performance– Proprietary information

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Chapter 2 Financial statements report the

company activity during the year and the financial condition of the company at the end of the year.

The required financial statements are:– Income Statement– Statement of Stockholders’ Equity (Statement of Owner’s Equity)– Statement of Cash Flows – Balance Sheet

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The Balance SheetThe balance sheet reports the financial

position at a point in time (end of the quarter or year).

The balance sheet is divided into three major categories:– Assets– Liabilities– Stockholders’ equity (Owner’s equity)

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The Balance SheetThe balance sheet is represented by the

fundamental accounting equation:

Assets = Liabilities + Equity

A = L + E The effects of all described business

transactions may be represented in this formula.

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The Balance Sheet (B/S)Assets - represent future benefit to the

company, and are classified in order of liquidity (current assets; property and equipment; long-term investments; intangibles)

Liabilities - represent obligations of the company, and are classified according to payment date (current liabilities, long-term liabilities)

Equity - represents the residual claims of the owners– Corporations: common stock and retained earnings– Proprietorships: owner’s capital account

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B/S Assets: Current AssetsCurrent assets include

– Cash: checking and savings accounts; petty cash.

– Short-term investments: investments in stocks and bonds of other companies.

– Accounts receivable: amounts owed to a company from its customers.

– Inventory: products on hand designated for sale to customers.

– Prepaid expenses: amounts paid for future expenses.

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B/S Assets:Property and Equipment

Property and equipment are assets that are used in the production of goods and services. These productive assets are long-term in nature, and include the following:– Land: property upon which the productive

facilities are located.– Building: the physical structure of the

company’s operations.– Machinery and Equipment: include

operating machinery, vehicles, computers, copy machines, etc.

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B/S Assets: Long-term Investments Long-term investments are assets acquired by

the company to provide long-term benefits to the company. Long-term investments include:– Long-term notes receivable owed to the

company (from customers or others).– Investments in stock of other companies: held

for expectation of dividends and/or stock price increase.

– Investment in bonds of other companies: held for expectation of dividends and/or stock price increase.

– Other assets, like land, held for the long term, but not part of operations.

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B/S Assets: Intangible Assets Intangible assets are long-lived assets that have

no physical substance. Examples include:– Patents: legal claim to produce and sell a

product. – Copyrights: legal claims to books, art, music

and other created works.– Goodwill: recognized when one company

buys another company, and the purchase price is greater than the fair value of the identifiable net assets.

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B/S Liabilities: Current Liabilities Current liabilities are obligations expected to

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

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B/S Liabilities: Long-term Liabilities

Long-term liabilities are obligations expected to require payments beyond the current year. Examples of long-term liabilities include:– Notes payable: amounts owed to banks and

other creditors beyond the current year.– Mortgage payable: amounts owed to

mortgage company beyond the current year.– Bonds payable: amounts owed to investors

holding bond investments issued by the company, where payments of principal and interest are beyond the current year.

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B/S Owner’s Equity Owner’s equity is generated when owner (or owners for

partnership) contribute cash and other assets into the company.

Owner’s equity or, capital account, is affected by the income earned by the proprietorship, and by the withdrawals of the owner.

Owner’s equity equation: Beginning owner’s equity Plus: net income Less: withdrawals =Ending owner’s equity

OEBegin + NI - Draws = OEEnd

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B/S Stockholders’ Equity: Contributed Capital

Contributed capital is generated when owners (shareholders) of the company contribute cash and other assets into the company. Components of contributed capital include– Common stock: shares of stock issued to

owners to to reflect ownership.– Additional paid in capital: excess amounts

contributed by shareholders for various activities.

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B/S Stockholders’ Equity:Retained Earnings

Retained earnings represent the excess earnings retained in the company after dividends have been paid to shareholders. This represents the equity generated by the company for the shareholders.

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The Statement of Stockholders’ Equity (SSE)

The following formula represents the basic SSE:

Beginning stockholders’ equity

Plus: Issuance of stock

Plus: Net income

Less: Dividends

=Ending stockholders’ equity

SEBegin + Issue + NI - Div = SEEnd

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The Statement of Retained Earnings

The statement of retained earnings is a subset of the SSE, and calculates the changes in the retained earnings component.

Beginning retained earnings

Plus: Net income

Less: Dividends

=Ending retained earnings

REBegin + NI - Div = REEnd

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The Income Statement (I/S)The income statement shows the

components of net income in detail.Revenues represent the inflow of assets

(or decrease in liabilities) due to a company’s operating activities.

Expenses represent the outflow of assets (or increases in liabilities) due to a company’s operating activities.

The general formula for the I/S is:Revenues - Expenses = Net Income

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The Income Statement FormatOperating revenues

Sales Fees earnedOther revenues

Less: Operating expensesCost of goods soldWage expenseRent expenseSelling expenseDepreciation expenseOther expenses

Net Income

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The Statement of Cash Flows Cash flows from operating activities:

– Collections from sales, rent, interest, etc.– Cash paid to suppliers and employees, and for

rent, selling activities, interest, and taxes etc. Cash flow from investing activities:

– Proceeds from sale of investment securities, land, buildings, equipment, etc.

– Purchase of investment securities, land, buildings, equipment, etc.

Cash flow from financing activities:– Proceeds from issuance of notes, debt, sale of

equity, etc.– Payments on notes, debt, dividends, etc.

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Relationships Among the Financial Statements

Statement ofCash Flows

IncomeStatement

Statement ofStockholders’ Equity

(Owner’s Equity)

EndingBalance Sheet

Assets (Cash)

=

Liabilities

+

Equity

BeginningBalance Sheet

Assets(Cash)

=

Liabilities

+

Equity

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Chapter 3 Chapter 3

The first step in the accounting process is transaction analysis.

This process examines relevant, objectively measurable economic events through their effect on the accounting equation:

Assets = Liabilities + Equity

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Spreadsheet AnalysisSpreadsheet Analysis

Using a spreadsheet template, analyze the transactions on the next slide. (Full-size spreadsheet at the back of your handouts.)

Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions.

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TransactionsTransactionsAnna Corporation began on Dec. 1, 2008, and had

the following activity during its first month:1. Investors contributed $30,000 to start up the

company.2. The company purchased land for a future

building site for $20,000.3. The company borrowed $9,000 from the bank.4. The company completed a consulting contract,

and billed the customer $8,000 (provided services on account).

5. The company paid $5,500 for salaries to employees.

6. The company distributed $500 of cash dividends to its investors.

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Spreadsheet TemplateSpreadsheet Template

Cash + A/R + Land = N/Pay + C.Stock + Ret. Earn.

1. =

2. =

3. =

4. =

5. =

6. ____ ____ ____ = _____ _____ _____

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Financial StatementsFinancial Statements

Income Statement

Revenues $8,000

Expenses 5,500

Net Income$2,500

Statement of Stockholders’ Equity CS RE

Beginning $ 0 $ 0Issue CS 30,000 Net Income 2,500Less: Dividends 500Ending $30,000 $2,000

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Financial StatementsFinancial Statements Balance SheetAssets Cash $13,000

A/R 8,000Land 20,000

Total $41,000

Liabilities and S.E.N/P $ 9,000CS 30,000RE (ending) 2,000Total $41,000

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Double Entry SystemDouble Entry System

Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.

Therefore accountants use a “double entry” system based on debits and credits.

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Double Entry AccountingDouble Entry Accounting

Debit (dr) - means an entry to the left hand side of an account.

Credit (cr) - means an entry to the right hand side of an account.

Note that a debit or credit, per se, does not indicate increase or decrease.

To decide the effect of a debit or credit, the type of account must be considered.

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Effect of Debits and CreditsEffect of Debits and CreditsBased on the accounting equation, we

can increase or decrease various accounts depending on their classification:

Assets = Liabilities + Equity

Increase DR = CR CR

Decrease CR = DR DR

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

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The following rules can be derived from The following rules can be derived from the basic formula:the basic formula:Assets have normal debit balances and are

increased with a debit.Liabilities and equities have normal credit

balances and are increased with a credit.Revenues (a part of equity) have normal credit

balances and are increased with a credit.Expenses (which decrease equity) have normal

debit balances and are increased with a debit. Dividends (which decrease equity) have a

normal debit balance and are increased with a debit.

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The Format of a Journal EntryThe Format of a Journal Entry To initially record transactions, we use a journal

entry to represent the debits and credits. For example, in Item 1:

Debit CreditCash 30,000

Common Stock 30,000

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

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

2: Purchased land for $20,000 cash.

3: Borrowed $9,000 cash from bank.

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

4: Consulting services (on account) $8,000.

5: Paid $5,500 cash for expenses.

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

6: Paid $500 cash dividend to investors.

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

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The Accounting CycleThe Accounting Cycle

Components of the accounting cycle include:A. Preparation of General Journal Entries -Post to the General Ledger -Unadjusted Trial BalanceB. Preparation of Adjusting Journal Entries -Post to the General Ledger

-Adjusted Trial BalanceC. Financial Statements D. Closing Journal Entries (or closing process) -Final Trial Balance

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A. General Journal Entries (GJEs)A. General Journal Entries (GJEs) The first step in the accounting process. Prepared for daily activity. Usually journalized in special journals for

efficiency, but we will record in “General Journal” format.

Identified through a document flow:– cash receipt, record a cash sale– charge receipt, record a credit sale– bank note, record a notes payable– employee time card, record wages

The transactions on Slide 23 are general journal entries.

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The General Ledger (G/L)The General Ledger (G/L)The G/L serves as a place to “total”

amounts by account titles.After GJEs and AJEs are recorded, they

are posted (by account) to the G/L.We will use “T” accounts to represent G/L

accounts where needed.Note that most G/L printouts have detailed

information on left side of ledger, and 2 columns (or DR and CR notation) on the right side of the printout. Our T-account represents the right side.

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

Cash

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Unadjusted Trial BalanceUnadjusted Trial BalanceTrial balances are prepared throughout the

accounting cycle. The list resembles the Chart of Accounts

(usually organized with account codes).The Unadjusted Trial Balance represents G/L

totals (by account) at a particular point in time. For the GJEs, the Unadjusted Trial Balance

would consist of a list of all of the ending debit or credit balances taken from the various account totals (illustrated on the next slide).

The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter).

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Unadjusted Trial Balance - Anna Corp.Unadjusted Trial Balance - Anna Corp.(after posting and totaling G/L accounts)(after posting and totaling G/L accounts)

Debit CreditCash 13,000Accounts Receivable 8,000

Land 20,000 Notes Payable 9,000

Contributed Capital 30,000 Retained Earnings 0

Dividends 500Revenues 8,000Expenses 5,500

Totals 47,000 47,000

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B. Adjusting Journal Entries (AJEs)B. Adjusting Journal Entries (AJEs) Prepared at the end of the accounting period

to align revenues and expenses (matching). Usually NO document flow to trigger recording. Based on the accrual system of accounting

which records revenues as earned and expenses as incurred (rather than based on cash flows).

Types of AJEs1. Accrual of expenses2. Accrual of revenues3. Prepaid expenses 4. Unearned revenues

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1. Accrual of Expenses1. Accrual of Expenses Probably the most common type of AJE.

Ex: accrue wages of $100at the end of the period:

Wages Expense 100

Wages Payable 100 Other examples of expense/payable include

interest, rent, taxes.

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2. Accrual of Revenues2. Accrual of Revenues

For revenues that have not yet been recorded at the end of the period.

Ex: accrue interest revenue of $50:

Interest Receivable 50

Interest Revenue 50Another example of receivable/revenue

accruals relates to rent revenue, where the rental payment has not yet been received.

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3.Prepaid Expenses 3.Prepaid Expenses This category of AJE relates to the concept of

asset capitalization and the matching principle.

Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset is recognized at that time.

As the asset is “used up” in the generation of revenue, the related cost is recognized as an expense (matching).

Some expenses are deferred for a short period of time (Supplies Expense), and some expenses are deferred for many years (Depreciation Expense).

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3.Prepaid Expenses 3.Prepaid Expenses Example: Purchase 1 year, $1,200 insurance

policy.

General JE at time of purchase:

Prepaid Insurance 1,200

Cash 1,200

AJE at end of the first month (for the portion that has been used):

Insurance Expense 100

Prepaid Insurance 100

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4.Unearned Revenues 4.Unearned Revenues Cash is received from customer before

goods/services are delivered (before revenue can be recognized).

Ex: Received a 3-year subscription of $360 in advance.

General JE at time cash received:Cash 360

Unearned Revenues 360 AJE at end of the first quarter (for 3 mos.):

Unearned Revenues 30Subscription Revenues 30

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Adjusted Trial BalanceAdjusted Trial BalanceThe Adjusted Trial Balance reflects totals

after the AJEs are posted to the general ledger.

The balance sheet accounts reflect the end-of-year balances, and the income statement accounts reflect the proper revenues and expense to be recognized for the year.

This list of accounts and amounts is used to prepare the balance sheet and income statement.

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D. Closing Journal Entries (CJEs)D. Closing Journal Entries (CJEs)Prepared after the financial statements

have been completed.Close temporary accounts to retained

earnings, so that the balances in those accounts at the start of the next accounting period will be zero.

Temporary accounts include revenues, expenses and dividends.

The final trial balance after closing will display only permanent, balance sheet accounts.

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D. Closing Journal Entries (CJEs)D. Closing Journal Entries (CJEs)Back to Anna Corp. Trial Balance. To close

Revenues and Expenses and Dividends:

Close Net Income to RE:Service Revenue 8,000

Salary Expense 5,500Retained Earnings 2,500

Close Dividends to RE:Retained Earnings 500

Dividends 500