Accounting Clinic I

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Clinic 1-1

Introduction
Accounting clinic I contains the following: A brief review of the four financial statements Examples of how each financial statement is prepared A summary of the principles of measurement in financial statement

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Clinic 1-3

The Financial Statements

1. Balance Sheet 2. Income Statement 3. Cash Flow Statement 4. Statement of Shareholders Equity
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The Balance Sheet: Dell Inc.

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Clinic 1-5

The balance sheet reports the assets of the firm at a point in time and the claims against those resources. The claims are broken up into liabilities and shareholders equity.

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Clinic 1-6

The Form of the Balance Sheet

Assets = Liabilities + Shareholders Equity or Shareholders Equity = Assets Liabilities Assets are economic resources that produce future earnings. Liabilities are obligations to transfer assets or provide services to parties other than the owners. Equity is the owners' residual interest in the assets of an entity that remains after deducting the liabilities.
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Example - Balance Sheet Preparation

Presented below are selected accounts of Biking Corporation at December 31, 2008:
Patent Interest payable Bonds payable Common stock, $5 par value Preferred stock, $10 par value Prepaid insurance Accounts payable Trading securities Land Accounts receivable Rent payable Retained earnings $150,000 30,000 450,000 400,000 150,000 89,000 283,000 117,000 520,000 143,000 45,000 ? Income taxes payable Notes payable (short-term) Equipment Discount on bonds payable Refundable federal and state income taxes Accumulated depreciation equipment Inventory Cash Accumulated depreciation building Long-term loan from bank Building $93,000 264,000 950,000 25,000 97,630 232,000 242,000 360,000 450,000 640,000 1,200,000

Required: Prepare a classified balance sheet.

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Solution
Current assets Cash Trading securities Accounts receivable Inventory Prepaid insurance Total current assets Property, plant and equipment Land Buildings Less acc. depreciation Equipment Less acc. depreciation Total Property, plant and equipment Intangible assets Patent $ 360,000 117,000 143,000 242,000 89,000 951,000 Current liabilities Accounts payable Notes payable Interest payable Income taxes payable Rent payable Total current liabilities Long-term liabilities Long term loan from bank Bonds payable Less discount on bonds payable Total long term liabilities Total liabilities Stockholders equity Capital stock Preferred stock, $10 par; Common stock, $5 par Retained earnings Total stockholders equity Total liabilities and stockholders equity $ 283,000 264,000 30,000 93,000 45,000 715,000

520,000 1,200,000 (450,000) 950,000 (232,000) 750,000 718,000 1,988,000

640,000 450,000 (25,000) 425,000 1,065,000 1,780,000

150,000

150,000 400,000

550,000 759,000

Total assets

3,089,000

3,089,000

Retained earnings are calculated as a plug number.

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Clinic 1-9

The balance sheet reports assets and the claims on those assets at a point in time. The other three financial statements summarize the effects of transactions and economic events occurring between two balance sheets dates. The income statement reports revenues less expenses (earnings) that increase owners' equity between two balance sheet dates.
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The Income Statement: Dell Inc.

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Clinic 1-11

The Form of the Income Statement

Net Revenue Cost of Goods Sold = Gross Margin Gross Margin Operating Expenses = Operating Income before Tax (EBIT)

Operating Income before Tax Interest Expense = Income before Taxes

Income before Taxes Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income Preferred Dividends = Net Income Available to Common
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Example - Income Statement Preparation

below are selected ledger accounts of Grant Corporation at December 31, 2008:
Merchandise Inventory Office salaries Sales Purchases Insurance expense Sales commission Sales returns Purchase discounts 409,000 282,000 5,000,000 2,548,000 26,000 76,000 42,000 31,000 Accounting and legal services Shipment-in Advertising Depreciation of office Depreciation of sales equipment Sales salaries Extraordinary loss (before tax) Interest expense 24,000 81,000 108,000 62,000 58,000 257,000 96,000 176,000

A physical inventory indicates that the ending inventory is $547,000. Assume a tax rate of 35%. Required:
Prepare a condensed income statement

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Solution
Net Sales (1) Cost of goods sold (2) Gross profit Selling expense (3) Administrative expense (4) Income from operations Other expense Income before taxes Income taxes (35%) Income before extraordinary item Extraordinary loss, net of $33,600 taxes Net income 4,958,000 2,460,000 2,498,000 499,000 394,000 893,000 1,605,000 176,000 1,429,000 500,150 928,850 62,400 866,450

(1) 5,000,000-42,000
(2) 409,000+(2,548,000+81,000-31,000)-547,000 (3) 257,000+76,000+108,000+58,000 (4) 282,000+26,000+24,000+62,000

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Clinic 1-14

The Statement of Cash Flows : Dell Inc.

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The statement of cash flows explains the change in cash during the period in terms of cash provided by or used for operating, investing and financing activities.

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Clinic 1-16

The Form of the Cash Flow Statement

Change in Cash = Cash from Operations + Cash from Investing

+ Cash from Financing

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Clinic 1-17

The Form of the Cash Flow Statement

The primary purpose of a statement of cash flows is to provide relevant information about the cash inflows and outflows of an enterprise during a period. The statement has three main sections: Cash Flows from Investing Activities - Investing activities involve acquiring and disposing of debt or equity investments, property, plant and equipment and other productive assets used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory).

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The Form of the Cash Flow Statement

Cash Flows from financing Activities - Financing activities involve obtaining resources from owners and providing them with a return on their investment; borrowing money and repaying amounts borrowed, and obtaining and paying for other resources obtained from creditors on long-term credit. Cash Flows from operating Activities - Operating activities involve all transactions and other events that are not defined as investing or financing. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.
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Direct Method Cash Flow Statement

A few firms report cash flow from operations using the direct method (see Chapter 10). Here is an example form Northrop Grumman Corp.:

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Clinic 1-20

Example Preparation of a cash flow statement

Presented below are the balance sheets of Scientific Instruments, Ltd. for December 31, 2005 and 2004
Scientific Instruments, Ltd. Balance Sheet December 31, 2005 and 2004 2005 Cash Accounts receivables Inventories Loan to company B Land Equipment Acc. Depreciation 70 170 200 1,500 500 500 (190) 2,750 Accounts Payable Bonds Payable Deferred tax liability Common Stock Retained Earnings
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2004 110 300 240 550 (200) 1,000 200 300 250 250

120 1,000 380 1,220 30 2,750

1,000
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Additional Information:
Equipment with original cost of $50 was sold for $35 Dividend declared and paid in cash was $300 Stocks and Bonds were issued for cash Net income reported was $80.

Required: Prepare a statement of cash flow for 2005 Note: Cash from operating activities involves adjusting net income for all the non-cash items in net income.
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Solution
Scientific Instruments, Ltd. Statement of Cash Flow For the year ended December 31, 2005 Cash flows from operating activities Net Income Adjustments to reconcile net income to net cash provided by operating activities: Gain on sale of equipment Depreciation Increase in deferred tax liability Decrease in accounts receivables Decrease in inventories Decrease in accounts payable Net cash provided by operating activities 80

(10) 15 80 130 40 (80)

175 255

Cash flows from investing activities Loan to B Purchase of Land Sale of Equipment Net cash used by investing activities Cash flows from financing activities Issuance of common stock Issuance of bonds payable Payment of cash dividend Net cash provided by financing activities Net decrease in cash Cash, December 31, 2004 Cash, December 31, 2005

(1,500) (500) 35 (1,965)

970 1,000 (300) 1,670 (40) 110 70

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Clinic 1-23

The Statement of Stockholders Equity: Dell Inc.

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Shareholders Equity
Has two primary components:
contributed capital which represents stockholders investment common stock (par value) and additional paid in capital, and retained earnings which equals cumulative net income minus cumulative dividends since the formation of the company. (Dividends are distributions of assets to stockholders.)

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Clinic 1-25

Comprehensive Income
Comprehensive income in net income (from the income statement) plus other comprehensive income To avoid earnings fluctuations some of the unrealized gains/losses are reported in other comprehensive income and not included in net income.

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Clinic 1-26

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The Stocks and Flows Equation

Ending equity = Beginning equity + Total (comprehensive) income Net payout to shareholders

Comprehensive income = Net income + Other comprehensive income

Net payout to shareholders = Dividends + Share repurchases -Share issues

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Clinic 1-28

The Articulation of the Financial Statements

Cash Flow Statement
Cash from operations Cash from investing

Beginning Balance Sheet

Cash + Other Assets

Cash from financing Net change in cash

Ending Balance Sheet

Cash + Other Assets

Statement of Shareholders Equity

Total Assets
Investment and disinvestment

Total Assets
by owners Net income and other earnings Net change in owners equity

- Liabilities Owners equity

- Liabilities Owners equity

Income Statement
Revenues Expenses Net income

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Principles of Measurement
Two types of measurement are used in financial statements Fair value accounting Assets and liabilities are reported at their fair value and gains and losses from revaluing them are reported in the income statement or as part of other comprehensive income in the equity statement. Fair value is either market value or an estimate of value.
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Historical cost accounting Assets and liabilities are reported at their historical cost (the dollar amount paid when they were acquired or incurred). In subsequent periods, those costs are amortized to the income statement as the assets are deemed to have been used up in operations or as liabilities accrue costs. GAAP accounting uses both types of measurement.
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Mark-to Market Accounting

Under U.S. GAAP, the following assets and liabilities are approximately at market value:
Cash and Cash Equivalents Short-term investments Accounts payable Equity Investments considered trading securities or available for sale. See Accounting Clinic III.

The following assets and liabilities are measured with estimates of that are usually close to market value:
Net Accounts Receivables (net of estimate of likely bad debt.) Accrued and Estimated Liabilities Note that debt (short-term and long-term) is at historical cost but that is typically close to fair value)
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Historical Cost Accounting

The following assets and liabilities are at historical cost on the balance sheet:
Long-term Tangible Assets (depreciated) Recorded Intangible Assets (amortized) Goodwill (not amortized)

These assets can be written down if their value is deemed to have been impaired, but are never written up (in the U.S.).

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Mixed Accounting Measurement

The following assets are sometimes measured at historical cost and sometimes at fair values:
Inventories: Lower of cost or market rule applies Debt investments
Trading Available-for-sale Held to maturity

Equity investments
Trading Available-for-sale

See Accounting Clinic III

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Clinic 1-34

Historical Cost Accounting in The Income Statement

Revenue recognition principle - value added is recognized when:
The earnings process is substantially accomplished Receipt of cash is reasonably certain

Matching principle Expenses are recognized in the income statement by their association with revenues for which they are incurred. The earnings number reflects net value added from revenues, that is, net of matched expenses.

Go to Accounting Clinic II for more on matching

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Cost of Goods Sold: An Application of Matching

Cost of goods sold is an accrual concept, calculated in the following way: Inventory, beginning XXX + Purchases XXX Goods available for sale XXX - Inventory, ending (XXX) Cost of Goods Sold XXX

The beginning balance of inventory and purchases of goods during the year sum up to the total goods that the firm could have sold during the year. The ending balance of inventory (usually available from physical count) is subtracted to get the cost of the goods actually sold.
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In the income statement preparation example total purchases were 2,598,000 (after adding shipment and subtracting discounts). The beginning of inventory was 409,000 and the ending of inventory was 547,000. Therefore total cost of goods sold was: 409,000+2,598,000-547,000=2,460,000

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Clinic 1-37

The cash outflow equivalent to the cost of goods sold is payment to suppliers. Accrual accounting performs two main adjustments to this amount to arrive at the cost of goods sold: Accounts Payable adjustment payment might not reflect
the entire expenditure on inventories. Some inventories were purchased on account.

Inventory adjustment inventory is a pure accrual concept

and is recognized in order to match the expense (COGS) with revenue (the amount we received for the goods sold).

More about the matching concept in Accounting Clinic II.

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Clinic 1-38

R&D accounts: An Example of Poor Matching

Peabody Co. produces operating income of $30,000 from operations each year. The company invested $20,000 in an R&D project in December 31, 2004. The investment will produce an incremental income of $7,000 in each of the following 5 years. Calculate operating income for the years 20042009
1. if the firm expenses R&D immediately (as GAAP requires) 2. if the firm capitalizes R&D and amortize it using straight line method.

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(1) R&D is expensed immediately 2004 $30,000 2005 $30,000 2006 $30,000 2007 $30,000 2008 $30,000 2009 $30,000

Operating income before R&D Incremental income from R&D R&D expense Operating income

__0 30,000 (20,000) 10,000

7,000 37,000 __0 37,000

7,000 37,000 __0 37,000

7,000 37,000 __0 37,000

7,000 37,000 __0 37,000

7,000 37,000 __0 37,000

(2) R&D is capitalized using straight line The total R&D expenditure is 20,000. It is amortized 20,000/5=4,000 per year for 5 years. 2004 $30,000 2005 $30,000 2006 $30,000 2007 $30,000 2008 $30,000 2009 $30,000

Operating income before R&D Incremental income from R&D R&D expense Operating income
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______ 30,000 __0 30,000

7,000 37,000 (4,000) 33,000

7,000 37,000 (4,000) 33,000

7,000 37,000 (4,000) 33,000

7,000 37,000 (4,000) 33,000

7,000 37,000 (4,000) 33,000

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Fully expensing R&D in the year in which it was incurred results in poor matching in operating income.

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How Financial Reporting Issues Arise

Efficiencies of Generally Accepted Accounting Principles (GAAP)

Examples: Assets omitted from the balance sheet: R&D and brand assets Off-balance-sheet obligations not recognized (FIN 46 helps to rectify) Losses on conversions into common stock and options settled with common stock are not recognized (SFAS 150 attempts to rectify)
Poor Application of Accounting Principles Examples: Excessive restructuring charges (SFAS 146 helps here) Biased estimates of bad debts, sales returns, warranties Aggressive revenue recognition Conservative revenue recognition: Creation of a cookie jar with unearned revenue Creative accounting that yields form over substance: using bright lines in GAAP to obscure; structural engineering

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How Should You Deal with the Accounting Issues?

Understand GAAP and its limitations Appreciate the relevance-reliability tradeoff Recognize unresolved issues in GAAP Recognize where choices can be made Be alert to poor application of GAAP How sensitive are earnings to estimates? How would you characterize the revenue recognition aggressive or conservative? Does the application of GAAP faithfully represent the business?

These issues will come to the fore as we proceed through the book
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Who Sets the Rules (in the U.S.)?

U.S. Congress Securities and Exchange Commission (SEC) www.sec.gov

Financial Accounting Standards Board (FASB) www.fasb.org From the past: Accounting Principles Board (APB) General Acceptance In the future: How will the International Accounting Standards Board (IASB) influence accounting principles? The SEC Roadmap (Box 2.5)
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