Financial Accounting – Self Study

Session 1 – Chapter 1 – Introducing Financial Accounting

What is the role of accounting in the economy, capital markets and business?
- Provide accountability from Firms to Providers of capital

What happens if accounting information is not reliable?

- Low confidence (investors)
- Under-capitalization resulting in low employment, low growth and low GDP

How is the accounting system made more reliable?

- Standards (discretion but not too much so that managers don’t mislead investors), enforcement by auditors,
regulations on auditors to ensure their reliability

LO1
IDENTIFY THE USERS OF ACCOUNTING INFORMATION AND DISCUSS COSTS AND BENEFITS OF DISCLOSURE

Who are users? – Financial Accounting (outside of the company) investors, creditors, suppliers, Managerial Accounting
(within the company) – Management, marketing, strategy

What is disclosure? Provide financial information to external users

What the benefits of disclosure? Lower financing and borrowing rates, lower operating costs through better supplier
prices
What are the costs? Cost of hiring accountants, allowing competitors to see information, political costs.

LO2 DESCRIBE A COMPANY’S BUSINESS ACTIVITIES AND EXPLAIN HOW THESE ACTIVITIES ARE REPRESENTED BY THE
ACCOUNTING EQUATION.

Business activities:
What does a company actually do?
Where to open new stores? What products to bring to the market? How to determine if a product is a success?
 Those questions define the activities of a company!

plan activities, finance those activities, invest resources into those activities, and then engages in operating activities
(production, promotion and selling of products).

Investing activities are acquiring and disposing of resources (assets) – There are short-term assets and long term assets

Financing activities is to fund investments (Debt financing by creditors and Equity Financing by owners)

ACCOUNTING EQUATION

INVESTING = CREDITOR FINANCING + OWNER FINANCING

ASSETS = LIABILITIES + EQUITY

Operating Activities – production, promotion, and selling of products and services

Input markets – Inventory, salaries, materials logistics (Generate operating expenses)

Output markets – Customers (generate operating revenues and some expenses = Marketing and distribution)

INCOME = REVENUE - EXPENSES

LO3 – INTRODUCE THE 4 KEY FINANCIAL STATEMENTS: BALANCE SHEET, INCOME STATEMENT, STATEMENT OF SH
EQUITY AND STATEMENT OF CASH FLOWS

Balance sheet: reports a company’s financial position at a point in time. It summarizes the result of the company’s
investing and financing activities by listing the amounts of assets, liabilities and equity.

Income statement: reports the results of a company’s operating activities over a period of time. It details amounts for
revenues and expenses and que difference between these two amounts is net income.
STATEMENTS LINKAGE
Cash flows – link the beginning and end cash of balance sheet
Income statement – link the beginning and end retained earnings in the statement of stockholders equity
Statement of stockholders equity – links the beginning and end equity in the balance sheet

Reports beyond financial statements: MD&A Management Discussion and Analysis

Independent Auditor Report
Financial statement footnotes
Proxy statements and other SEC filings

LO4 – DESCRIBE THE INSTITUTIONS THAT REGULATE FINANCIAL ACCOUNTING AND THEIR ROLE IN ESTABLISHING
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

SEC – Securities and Exchange Commission (Fed Gov, acct for public companies, regulates the issuance and trading of
securities in the US, encourage private standard body, adhere GAAP, companies with more than 10k assets and more
than 500 owners must report)

AICPA – American Institute of Certified Public Accountants ( Committee on Acc procedures – 1939 to 1959, 51 Acct
Research Bulletins ARBs, problem-by-problem fail – Accounting principles board – 1959 to 1973, 31 Acct Principle
Board Opinions APBO, wheat committee rec adopted in 1973 that created FASB)

FASB – Financial Accounting Standards Board – Stablish and improve financial acc and reporting.

GAAP – Generally Accepted Accounting Principles

SOX – Sarbanes-Oxley Act of 2001 – developed due to concerns over quality of corp financial report, goal increase
confidence, SOX stablished PCAOB and monitor quality of GAAP

IASB – International Acct Standards Board

LO5 – COMPUTE TWO KEY RATIONS: RETURN ON EQUITY AND DEBT TO EQUITY RATIO

Return on Equity – Profitability – Ability to earn and return for its stockholders

ROE = Net Income / Average Stockholders equity (the higher the number the better)

Debt-to-Equity Ratio – Credit risk analysis, Solvency – the ability of a company to remain in business, and avoid
bankruptcy

Debt-to-equity ratio = Total Liabilities / Total Stockholders Equity (the lower the number the better)

LO6 – CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Benefits > Costs – Reported accounting information must be cost effective. Benefit must exceed costs
Relevance - To be relevant, accounting information must make a difference in decision making.
Materiality – Whether or not a particular amount is large enough to affect decision. Some items are not reported
because they are considered not material (omission would not influence decision).
Predictive Value – accounting information should help predict future outcomes (not as a forecast necessarily)
Confirmatory value - Provide feedback about previous evaluations.
Understandability and Decision Usefulness – Information presented so that a knowledgeable reader can understand it.
There must be a line between reporting too much or too little.
Relevance – It has to make a difference in a decision. It might be able to use information to make predictions in the
future or providing feedback.
Timeliness - It must be available before it loses its capacity to influence decision.
Predictive value – increase accuracy of a forecast
Feedback Value – enable users to confirm or correct prior expectations.
Reliability - Accurate and free of misstatement or bias.
Representational faithfulness – must reflect the events its meant to measure
Verifiability – a third party should be able to examine the events and transactions and reach same conclusions
Neutrality – should not induce a particular behavior (decision)
Comparability - Financial statements from different companies should be presented in a way that allows it to make
comparisons across companies relating to their financial condition and performance – Firms on the same industry
should use similar reporting techniques.
Consistency – Statements should exhibit conformity from previous reports so that its easy to evaluate performance
overtime.

Four Underlying Assumptions of Financial Statements

Separate Economic Entity – Firms are considered separate from stockholders’ activities and from other companies
Going Concern – Assumption of continuity (no bankruptcy)
Accounting period – Reporting period on each fiscal year (such as quarterly, monthly reports and annual)
Measuring Unit – Monetary measure must be in the country in which the firm’s reports are issued

CHAPTER ONE BOOK QUESTIONS

Multiple choice
1. Which of the following is a potential cost of the public disclosure of accounting information?
Correct answer D (all the above) – Loss of competitive advantage for reporting their information, potential
increase of taxes for reporting excessive profits, raising or failing to meet investors expectations.
2. Banks that lend money to corporations are considered:
Correct answer A - Creditors
3. Which of the following financial statement reports the financial condition of a company at a point in time?
Correct answer A – Balance sheet
4. Which of the following is not one of the four basic financial reports?
Correct answer D – Notes to the financial statements
5. Which of the following expressions is a correct statement of the accounting equation?
Correct answer B Assets – (Liabilities + Equity)=0

QUESTIONS
Q1-1 What are the three major business activities of a company that are motivated and shaped by planning activities?
Investing, financing and operating activities.

Q1-2 The accounting equation (Assets = Liabilities + Equity) is a fundamental business concept. Explain what this
equation reveals about a company’s sources and uses of funds and the claims on company resources.
The equation reveals: Investing equal financing (assets: investing / Liabilities/Equity: financing). Show all the
assets that a company owns and how it has been financed.

Q1-3 Companies prepare four primary financial statements. What are those financial statements and what information
is typically conveyed in each.
Balance sheet: company’s investments and sources of financing
Income statement: results of operations
Statement of stockholders Equity: details changes in owner financing
Statement of cash flows: sources and uses of cash

Q1-4 Does a balance sheet report on a period of time or at a point in time? Also, explain the information conveyed in
that report. Does an income statement report on a period of time or at a point in time? Also, explain the information
conveyed in that report.
Balance sheet reports at a point in time. It reports company’s investments and sources of financing.
Income statement reports on a period of time. It reports results of operations (revenues and expenses)
Q1-5 Warren Buffet does not invest in companies that he can’t understand the financial statements. Would you agree?
Name several items reported in financial statements that corporate finance officers would find particularly relevant in
considering whether to invest in a firm.
I would agree. Investors should know if their investment will be worth it. The financial statements reveals many
information of the company, such as their continuance, their ability to pay its debts, their income from
operations, and so on.

Q1-6 Does a statement of cash flows report on a period of time or at a point in time? Also, explain the information and
activities conveyed in that report.
Cash flows report on a period of time. It shows money in and out from operating, investing and financing
activities.

Q1-7 Explain what is meant by the articulation of financial statement.

Articulation is the Financial Statements Linkage, which is a central feature of the accounting system (the linkage
of the four primary statements). Three of the keys linkage are: cash flows linking beginning and ending cash on
balance sheet, Income statement linking beginning and end retained earnings on stockholders equity, and
stockholders equity linking beginning and ending equity in balance sheet.

Q1-8 Return cannot be evaluated without considering risk; the greater the risk of any decision, the greater the expected
return. Investments are riskier when the expectancy of return is low or uncertain. However when there is the return its is
large, as a compensation for the risk taken.

Q1-9 Disclosure f information often lowers financing and operating costs. For example, when a company applies for a
loan, the bank uses the company’s financial statements to help determine appropriate interest rate. Companies would
choose to disclose extra information when the information is beneficial to the company.

Q1-10 Investors: would be interested on the company’s profitability.

Creditors: would be interested on the company’s ability to pay
Government agencies: would be interested on company’s profitability and income
Suppliers: would be interested on company’s ability to pay and cash flows.

Q1-11 Confidential information are those information that are not available for public. It might be about the employers
and customers. When dealing with confidential information, there are personal benefits for managers and thus, ethical
issues arise when they are benefitted through disclosing it.

Q1-12 ROE is the return on equity. Its computed like: ROE = Net Income / (Average Equity)
It shows the ability to earn and return money to its stockholders.

Q1-13 More disclosure might bring negative inputs to the company. Disclosing more information will show competitors
the company’s profits and other information, as well as it might increase rates if the accounting of the company isn’t
that healthy as well as increase taxation if the profits are too high. There are effects for disclosure, some positive and
other negative.

Q1-14 GAAP are accounting standards and accepted practices that guide the preparation of financial statements.

Q1-15 IFRS is an international standard for financial reporting. However, its not mandatory and many countries change
it as they please. It is good having international standards, however, if its not mandatory it might not actually help the
analysis of accounting between countries.

Q1-16 Auditors provide an opinion as to whether the statements present fairly and in all material respects a company’s
financial condition and the results of operations. Audit opinion is not guarantee, they only provide reasonable
assurance that the statements are free of material misstatements.
Q1-17 The objective of financial reporting is to provide information that is useful to present and potential equity
investors, as well as lenders and other creditors, in making decisions about providing resources to the entity.

Q1-18 – Comparability, Verifiability, timeliness and understandability.

MINI EXERCISES

M1-19 Assets: 2283.2 Equity: 961.4

Assets= Liabilities + Equity

2283.2= x + 961.4
2283.2-961.4=x
X= 1321.8

The amount of liabilities is $1321.8 million. WhiteWave foods receive more financing from non-owners. The owners
provide 42.1% of the financing resources.

M1-20 Assets: 90055 Liabilities: 56615

90055 = 56615 + x
90055-56615 = x
X = 33440

The amount of equity is $33440 million. Coke receives more financing from non-owners. The percentage of financing
provided by its owners is 37.13%.

M1-21
a. $27656 (73.8% non owner)
b. $16140.3 (69.7% non owner)
c. $9405 (68% non owner)
Howlett-Packard is more non-owner financed.

M1-22 Apple Assets (Sep27 2014) 231,839

Apple Liabilities (Sep27 2014) 231,839

Accounting equation holds. Shareholders finances 48.1% of Apple Assets.

M1-23

M1-24
a. Cash asset (BS)
b. Expenses (IS)
c. Non-cash assets (IS)
d. Contributed capital (SE)
e. Cash outflow for land (SCF)
f. Retained earnings (IS)
g. Cash inflow for stock issued (SCF)
h. Cash outflow for dividends (SCF)
i. Net Income (IS)

M1-25 If I do not report these future earnings the company will miss the Wall Street estimates. Investors might face a
drop in the face value of the stock price.

M1-26 Internal controls are:_______

EXERCISES

E1-27
a. 8162 (68.9% creditor fin)
b. 23148 (77.6% creditor fin) <<<< Higher creditor financed
c. 52326 (50.5% creditor fin)
E1-28
Investors and analysts – Buy or sell stock? > Sales and costs (income statement)
Creditors – Lend or not? > Cash in and out (Statement of cash flows)
Suppliers and customers – Purchase/sell goods or not? > Assets and Liabilities (balance sheet)

E1-29
a. 92358= 34102+equity
Equity = 58256

b. Beginning 7070 = liabilities + 1888

7070 = 5182 + 1888
During (+280) = (+34)
7350 = 5216 + 2134

c. Beginning Assets = 32940

74898 = 32940 + 41958
+6343 = +151
End 81241 = 33091 + 48150

E1-30
2013 income – 2410

a. 15542
b. 86.6%

E1-32
Revenue 17420 Cost of good sold 7219 Net income 2410

Company Name
Income Statement
For year Ended

Revenues ……………………………………………………………………….. 17420

- Cost of goods sold ……………………………………………………….. 7219
=Gross profit………………………………………………………………….. 15010
-Other expenses including income taxes ………………………. 12600
=Net Income (or loss)……………………………………………………. 2410

E1-32
a. 2410/((2536+2390)/2) 97.8%
b. 11340/2536 4.47

E1-33
a. 8720/((43363+39330)/2) 21.1%
b. 125155/43363 2.89

E1-34
a. What role does financial accounting play in the allocation of society’s financial resources?
 b. What are three aspects of the accounting environment that can create ethical pressure on management

E1-35

a. Refers to whether or not a particular amount is large enough to affect a decision >>> 4 Materiality
b. The activities of a business are considered to be independent and distinct from those of its owners or from
other companies >>> 10 Economic entity
c. Whenever possible, information in concurrent periods should be presented without changes to policies and
procedures >>> 8 Consistency
d. Accounting information should be accurate and free of misstatement or bias >>> 9 Reliability
e. Information is useful if it has the ability to influence decision >>> 1 Relevance
f. Consensus among measures assure that information is free of error >>> 2 Verifiability
g. Accounting information should reflect the underlying economic events that it purports to measure > 6
Representational faithfulness
h. The financial reports are presented in one consistent monetary unit >>> 5 Measuring unit
i. A business is expected to have continuity in that it is expected to continue to operate indefinitely >> 3 going
concern
j. The life of a business can be divided into discrete accounting periods such as a year or a quarter >>> 7
accounting period

PROBLEMS
P1-36
a.
Year Assets Liabilities Equity Net Income
2011 138354 70353 68001 11927
2012 132244 68209 64035 10904
2013 139263 70554 68709 11402

b. ROE 2012 10904/((138354+132244)/2) 8.05%

ROE 2013 11402/((132244+139263)/2) 8.40%

P&G return on investment is below the median, with 8.05% return on investment in 2013 and 8.40% return on
investment in 2013. Which means that P&G ability to earn return to its stockholders is lower than the average.

c. 2012 68209/64035 1.06

2013 70554/68709 1.03

P&G debt-to-equity ratio is below the median, which means that it has a higher ability to pay its debts

P1-37

a.
General Mills
Income Statement
For Year Ended May 25, 2014
Sales revenues 17909.60
Cost of goods sold 11539.80
Gross profit 6369.80
Other expenses 4508.50
Net Income (loss) 1861.3
 General Mills
Balance Sheet
May 25, 2014
Cash…………………………………………………………….867.30 Total Liabilities……………………………………………..16140.30
Noncash assets……………………………………………22278.40 Stockholders equity………………………………………7005.40
Total Assets………………………………………………..23145.70 Total Liabilities and stockholders equity………..23145.70

General Mills
Statement of Cash Flows
For Year Ended May 25, 2014
Cash flow from operations 2541.00
Cash flow from investing (561.80)
Cash flow from financing (1824.10)
Effect of exchange rates on cash (29.20)
Net increase (decrease) in cash (125.9)
Cash, beginning of year 741.40
Cash, end of year 615.50

b. the portion of the financing contributed by the owners is 43.4%

P1-38
a.
Abercrombie & Fitch
Income Statement
For Year Ended February 14, 2014
Sales revenues 4116.90
Cost of goods sold 1541.50
Gross profit 2575.40
Other expenses 2520.80
Net Income (loss) 54.6

Abercrombie & Fitch

Balance Sheet
February 14, 2014
Cash…………………………………………………………….600.10 Total Liabilities……………………………………………..1121.50
Noncash assets……………………………………………2250.90 Stockholders equity………………………………………1729.50
Total Assets………………………………………………..2851.00 Total Liabilities and stockholders equity………..2851.00

Abercrombie & Fitch

Statement of Cash Flows
For Year Ended February 14, 2014
Cash flow from operations 175.50
Cash flow from investing (173.90)
Cash flow from financing (40.80)
Effect of exchange rates on cash (4.2)
Net increase (decrease) in cash (43.40)
Cash, beginning of year 643.50
Cash, end of year 600.10

b. Owner 60.7% Creditor 39.3%

P1-39
Tillys Inc Tillys Inc
Balance Sheet Balance Sheet
February 1, 2014 February 1, 2013
Cash…………………….25412 Total Liabilities………..91484 Cash…………………….17314 Total Liabilities………..88085
Noncash assets….206995 Stockholders equity…140923 Noncash assets….188067 Stockholders equity…117296
Total Assets……….232407 Tot Liab and SH Eq…..232407 Total Assets……….205381 Tot Liab and SH Eq…..205381

Tillys Inc Tillys Inc

Income Statement Income Statement
For Year Ended February 1, 2014 For Year Ended February 1, 2013
Sales revenues 495837 Sales revenues 467291
Cost of goods sold 343542 Cost of goods sold 317096
Gross profit 152295 Gross profit 150195
Other expenses 134158 Other expenses 126302
Net Income (loss) 18137 Net Income (loss) 23893

Tillys Inc Tillys Inc

Statement of Cash Flows
For Year Ended February 1, 2014
Cash flow from operations 43794
Cash flow from investing (37530)
Cash flow from financing 1834
Effect of exchange rates on cash
Net increase (decrease) in cash 8098
Cash, beginning of year 17314
Cash, end of year 25412
Statement of Cash Flows
For Year Ended February 1, 2013
Cash flow from operations 41730
Cash flow from investing (72326)
Cash flow from financing 22819
Effect of exchange rates on cash
Net increase (decrease) in cash (7777)
Cash, beginning of year 25091
Cash, end of year 17314

Session 1 – Chapter 2 – Constructing Financial Statements

LO1 – DESCRIBE AND CONSTRUCT THE BALANCE SHEET AND UNDERSTAND HOW IT CAN BE USED FOR ANALYSIS

Balance sheet reports on a company’s financial condition (divided in 3 parts: assets, liabilities and equity)

Assets – resources that are expected to provide future benefits – Must be owned and controlled by the company.

Why do companies acquire assets? – Return to shareholders, generate revenue (directly from sales or indirectly)

Categories of Assets (assets are presented in order of liquidity – how fast it can be converted to cash)

- Current: converted into cash or used within the next year (or operating cycle) Listed in order of liquidity (short-
term assets)
o Common current assets: cash, marketable securities, accounts receivable, inventory, prepaid expenses

- Non-Current assets: not expected to be converted into cash within one year or next operating cycle (also called
long-term assets)
o Common non-current assets: long-term financial investments (don’t intent to sell), property, plant,
equipment, intangible and other assets.

Measuring Assets
Assets intended to be used (such as inventory, property, plant, equipment) are reported at historical cost – original
acquisition price. (Reliable – because it can be determined accurately but undervalued – some assets gain value over
time ex. property)

Some assets are reported at current fair value (ex. Marketable securities). Fair value increases the relevance of the
information (how useful the information is to those who use the statements).

Internally created intangible assets are not reported on the balance sheet (a logo, an image – Mickey mouse, walgreens
logo)

Liabilities and Equity – Represent sources of capital to the company (used to finance acquisition of assets)
Liabilities – borrowed / Equity – invested by shareholders (directly by buying shares or indirectly by reinvesting
retained earnings)

Reporting Liabilities:
Amounts are reported when:
1) A future sacrifice is probable
2) Amount is known or estimated
3) event has occurred

When 1-2 are met but not 3 (when the event/service has not occurred the obligation is called executory contract and
no liability is reported

Categories of Liabilities
- Current: due within a year
o Common current liabilities: accounts payable, accrued liabilities, short-term borrowings, deferred
(unearned) revenue, current maturities of long-term debt

- Non-Current: not due within one year

o Common non-current liabilities: long-term debt, other long-terms liabilities

Reporting Stockholders’ Equity

Contributed capital: common stock, additional paid-in capital (amount in addition to par value of the common stock),
treasury stock (reacquired stocks)
Earned Capital: retained earnings, accumulated other comprehensive income or loss

MID CHAPTER REVIEW

Accounts receivable – CURRENT ASSETS

Short-term notes payable- CURRENT LIABILITIES
Land – NONCURRENT ASSETS
Retained Earnings - EQUITY
Intangible assets – NONCURRENT ASSETS
Common stock - EQUITY
Repairs expense – NOT REPORTED
Equipment – NONCURRENT ASSETS
Treasury stock - EQUITY
Investments (noncurrent) – NONCURRENT ASSETS
Rent expense – NOT REPORTED
Cash – CURRENT ASSETS
Buildings – NONCURRENT ASSETS
Accounts payable – CURRENT LIABILITIES
Prepaid rent – CURRENT ASSETS
Borrowings (due in 25 years) – NONCURRENT LIABILITES
Marketable securities – CURRENT ASSETS
Inventories – CURRENT ASSETS
Additional paid-in capital - EQUITY
Unearned revenue – CURRENT LIABILITIES

LO2 -USE THE FSET TO ANALYZE TRANSACTIONS

FSET TEMPLATE

Balance Sheet Income Statement

Transaction Cash Non-Cash Liabilities Contrib. Earned Revenues Expenses Net
Asset + Asset = + Capital + Capital - = Income

The Account
What’s an account? Is a mechanism for accumulating the effects of an organization’s transactions and events.
A record of increases and decreases for each asset, liability, equity, revenue or expense.

Before recording a transaction, we first analyze the effect on the accounting equation by asking:
- What accounts are affected by the transaction?
- What is the direction and magnitude of each effect? (must affect at least 2 accounts)

Double-entry accounting system – dual effects in accounts.

Chart of accounts – listing of the titles of all accounts for a company.

Account must affect at least two accounts to maintain equality (increase, decrease, dollar amount)

LO3 – DESCRIBE AND CONSTRUCT THE INCOME STATEMENT AND DISCUSS HOW IT CAM BE USED TO EVALUATE
MANAGEMENT PERFORMANCE.

Income statement: Reports the results of operations as net income/loss for a period of time
Revenues – cost of goods sold = gross profit – expenses = net income
Revenues: increase in net asset / Expenses: decrease in net assets (cost of products and services sold, operating costs,
non-operating costs)

Nonoperating revenues and expenses: relates to the company’s financing and investing activities (interest
revenue/expense), recurring items (persist in the future), non-recurring (not relevant in future)

LO4 EXPLAING REVENUE RECOGNITION, ACCRUAL ACCOUNTING, AND THEIR EFFECTS ON RETAINED EARNINGS

Accrual accounting is required by US GAAP and IFRS and states that:

Revenues – increases in net assets that are earned by delivering goods and services to customer
Expenses – Decreases in net assets from operating revenue and supporting operations.

- Revenue is earned when delivered to the customer (even if paid later) > Revenue Recognition

- Cost of good sold expenses are matched against the revenue they helped to earn (you only recognize costs of
the value you have sold – even when not yet paid) > Expense Recognition

Accrual Accounting – the practice of recognizing revenues when earned through the company’s operations and
recognizing expenses as the assets used and obligations incurred in carrying out those operations >> Even if there has
been no cash payment yet<<<

LO5 Illustrate equity transactions and the statement of stockhorlders’ equity.

When recording a dividend payment we decrease cash and decrease retained earnings.

LO6 – Use journal entries and T-accounts to analyze and record transactions

T- Account

Account Title
Debits (Dr.) Credits (Cr.)
Always the left side Always the right side

Debit and credit system

Asset Accounts = Liability Accounts + Equity Accounts

Debit Increase Credit Decrease Debit Decrease Credit Increase Debit Decrease Credit Increase
Assets: Normal Debit Balance Liabilities/SH Equity: Normal Credit Balance

Increase in Asset is a Debit – Increase In liabilities/SHE is Credit

Compound entries – more than one credit/debit entry

Assets =Liabil +Common St -Dividen +Revenu -Expens

Dr. Normal Cr. Normal Cr. Normal Dr. Normal Cr. Normal Dr. Normal

The Journal Entry

Journal entry records each transaction by summarizing the debits and credits

Wages expense (+Expense (E), -StockH Eq (SE)………………………………… 1200

Cash (-Asset(A))………………………………………………………………….. 1200

Equipment (+A)……………………………………………………………………………….. 9500

Cash (-A)……………………………………………………………………………… 9500

Cash (A) Equipment (A) Wages Expense (E)

Debits (Dr.) Credits (Cr.) Debits (Dr.) Credits (Cr.) Debits (Dr.) Credits (Cr.)
1200 9500 1200
9500

LO7 Compute net working capital, the current ration, and the quick ratio, and explain how they reflect liquidity.

Analyzing Financial Statements

Net Working Capital: Net Working Capital = Current Assets – Current Liabilities

Cash operating cycle – the time between paying for goods and employee services and the receipt of cash from sales for
cash or credit.

Purchase Inventory > Sales of inventory (Accounts Receivable) > Returned to Cash (payment of AR) > Use Cash to
purchase more inventory

Current Ratio Current Ration = Current Assets / Current Liabilities

Company prefer a current ration greater than 1 but less than 2 – the ratio helps us discern whether the company is
likely to have difficulty meeting short-term obligations.

Current ratio has additional value. Net working capital depends on the size of the company, but the Current ratio cam
be useful when comparing companies.

Quick ratio: Quick ration= (cash + short-term securities + accounts receivable) / Current liabilities

Quick ratio excludes inventories. Only assets that are cash, or near cash are considered – it’s a more stringent test of
liquidity.

SUMMARY

LO1 – Describe and construct the balance sheet and understand how it can be used for analysis
 Assets, which reflect investment activities, are reported (in order of liquidity) as current and noncurrent assets
 Assets reported at historical cost (which few exceptions)
 Not all assets are reported (intellectual capital as an example)
 Asset reported must be owned/operated by the company, and carry future economic benefits
 Liabilities and Equity are sources of company financing: ordered by maturity date

LO2 – Use the financial statement effects template to analyze transactions

 FSET capture effects of balance sheet, income st, st. of SH equity and st of cash flows
 Income St effects are separated into revenues, expenses and net income.

LO3 – Describe and construct the income statement and discuss how it can be used to evaluate management
performance
 Income st. present revenues, expenses, and net income during an accounting period
 Net income (or loss) is the increase (or decrease) in net assets that results from business activities
 Net income is determined based on the use of accrual accounting

LO4 – Explain revenue recognition, accrual accounting, and their effects on retained earnings
 Revenues are recognized only when good/services are delivered
 Expenses should be recognized when assets are used (or liabilities incurred)

LO5 – Illustrate equity transactions and the statement of stockholders’ equity

 St. SH Eq. reports changes in equity accounts during the accounting period
 Transactions between company and owners (dividends) are not reported in the income statement

LO6 – Use journal entries and T-accounts to analyze and record transactions
 Transactions are recorded using journal entries
 Journal entries are posted to a general ledger, T-accounts
 Debts and credits record the transactions

LO7 – Comput net working capital, the current ratio, and the quick ratio, and explain how they reflect liquidity
 Net working capital: ability to pay its short-term debts (difference between current assets and current
liabilities)
 Current ratio (CR): measure of liquidity, the degree of coverage of current liabilities by current assets
 Quick ratio (QR): does not use inventory

Multiple Choice
1. Which of the following conditions must exist for an item to be recorded as an Asset?
Correct answer: D Item Must expect to yield future benefits
2. Company assets that are excluded from the company financial statements:
 Correct answer: A are presumably reflected in the company’s stock price
3. If an asset declines in price, which of the following must be true?
Correct answer: C either a liability or equity also declines, or other asset increases in value
4. Which of the following is true about accrual accounting
Correct answer: Accrual accounting is required by GAAP.
5. Which of the following options accurately identifies the effects a cash sale of an iPhone has on apple’s
accounts?
Correct answer: D Cash increases, sales revenues increases, cost of good sold increases and inventory
decreases.

Questions
Q2-1 The balance sheet consists of assets, liabilities, and equity. Define each category and provide two examples of
accounts reported within each category
 Asset: owned and operated by the company and expected to provide future benefit (Cash, Equipment, Land,
Accounts receivable)
 Liabilities: probable future sacrifice resulted from a past or current event (Accounts payable, Unearned
revenue,
 Equity: capital provided by company’s owners (including stock, retained earnings, and additional paid-in
capital) (retained earnings, common stock)

Q2-2 Two important concepts that guide income statement reporting are the revenue recognition principle and the
expense recognition principle. Define and explain each of these two guiding principles.
 Revenue and expense must be recognized when the good/service/liability occurred (even if no cash transaction
occurred yet)

Q2-3 GAAP is based on the concept of accrual accounting. Define and describe accrual accounting.
 Recognizing revenue when earned (service/good provided) and expense when incurred

Q2-4 What is the statement of stockholders’ equity? What information is conveyed in that statement?
 Statement that reports changes in equity over a period of time.
 Stock that has been issued, net income, dividends

Q2-5 What are two essential characteristics of an asset?

 Owned/operated by company and with future benefits

Q2-6 What does the concept of liquidity refers to? Explain

 Ability of a company to pay its current obligations

Q2-7 What does the term current denote when referring to assets?
 Current assets are the ones that can be converted into cash in less than 1 year

Q2-8 Assets are recorded at historical costs even though current market values might, arguably, be more relevant to
financial statement readers. Describe the reasoning behind historical cost usage.
 Historical cost can be verifiable (by looking at the purchase price)

Q2-9 Identify three intangible assets that are likely to be excluded from the balance sheet because they cannot be
reliably measured.
 Company’s logo, trade marks, icons, figures (coca-cola logo, mickey mouse, etc)

Q2-10 How does the quick ratio differ from the current ration?
 Quick ratio excludes inventory (it’s a more accurate way to analyze liquidity)

Q2-11 What three conditions must be satisfied to require reporting of a liability on the balance sheet?
  Future sacrifice is probable > amount of obligation is known (or estimated) > transaction/event that caused
obligation has occurred.

Q2-12 Define net working capital. Explain how increasing the amount of trade credit can reduce the net working capital
for a company.
 Difference between current assets and current liabilities (working capital)
 Net working capital required to conduct business depends on the company’s operating cycle, so if the trade
credit increase, the delay payment increase, and the current liabilities increase while the current assets stay the
same > so the net working capital will reduce.

Q2-13 On December 31, 2015 Miller Company had 700000 in total assets and owed 220000 to creditors. If this
corporation’s common stock totaled 300000, what amount of retained earnings is reported on its December 31, 2015,
balance sheet?
 180000

MINI EXERCISES

M2-14
a.

Kinney Corporation
Balance Sheet
December 31, 2015
Cash…………………….8000 Accounts pay………..11000
Acct Receivable….23000
Supplies Invent…..9000 Common Stock…110000
Equipment………….138000 Retained earn…….57000
Total Assets……….178000 Tot Liab and SH Eq…..178000

b. Retained earnings December 31, 2014 30000

Add. Net Income 39000
Less Dividends (12000)
Retained earnings December 31, 2015 57000

M2-15
Assets Liabilities Equity
A 200000 85000 115000
B 60000 32000 28000
C 93000 41000 52000

M2-17
a. Equity: 124000
b. Liabilities: 453000
c. Assets: 785000

M2-18
a. No effect
b. Decrease
c. Decrease
d. No effect
e. Increase
f. Increase
g. Increase
E3-35

E3-39, P3-41, P3-51, P3-52, P3-53, P3-54, E4-21, E4-23, E4-29, E4-44, P4-52, P4-53

Chapter 3 – Adjusting accounts for Financial Statements

LO1 – Identify the major steps in the accounting cycle

Accounting cycle – a sequence of activities to accumulate and report financial statements.

STEPS: ANALYSE > RECORD > ADJUST > REPORT > CLOSE

Fiscal year – annual (one year) accounting period

Calendar year – firms that end fiscal year on December 31

LO2 Review the process of journalizing and posting transactions

Analyzing and recording transactions – Review accounting procedures

Chart of accounts – lists the titles and numbers of all accounts found in a company’s general ledger (grouped in the 5
major sections: assets, liabilities, equity, revenues and income, expenses)

General Journal (book of original entry) – tabular record where business activities are captured in debits and credits
and recorded in chronological order before they are posted to the general ledger.

Posting – reporting entries from journal to the general ledger

LO3 – Describe the adjusting process and illustrate adjusting entries

Preparing the Unadjusted Trial Balance

The set of T-accounts balances is called an Unadjusted Trial Balance (because shows the balance before adjusting
entries) > the purpose is to make sure the general ledger’s debits and credits are in balance.

NATURAL BEAUTY SUPPLY

Unadjusted Trial Balance
December 31, 2015
Debit Credit
Cash 6825
Accounts Receivable 2250
Inventory 7300
Prepaid Insurance 1680
Security Deposit 2000
Fixtures & Equipment 18000
Accounts payable 4400
Unearned Revenue 1500
Notes Payable 11000
Common Stock 20000
Retained earnings 20
Sales revenue 13000
Cost of goods sold 8000
Wages expense 1625
Rent expense 1500
Advertising expense 700
Total 49900 49900
Types of Adjustments

Deferred (unearned) revenues – allocate earned portion of unearned revenues to revenue to reflect revenues earned in
the period

Deferred (prepaid) expenses – Allocate used or expired assets to expense to reflect expenses incurred in the period

Accrued Revenues – Record revenues to reflect revenues earned in the period that are not yet received in cash or
recorded

Accrued Expenses – Record expenses to reflect expenses incurred in the period that are not yet paid in cash or recorded

Adjusting entries – journal entries made to reflect adjustments

Deferrals – the first two types of adjustments (allocating assets to expense and allocating unearned revenues to
revenue

Accruals – The last two types of adjustments (accruing expenses and revenues) – accrual deals with an amount not
previously recorded in any account

Type 1: Deferred Revenue – Allocating unearned revenue to revenue

Companies often receive fees for services/goods before performing/delivering them. The transaction is recorded as
debit to cash and credit to unearned revenue. As the service/goods are performed/delivered, revenue is earned. At the
end of the period an adjusting entry records the revenue that was earned and the liability that was reduced

Type 2: Prepaid Expenses – Allocating Assets to Expenses

At the endo of the period the estimated portion of the outlay that has expired in that period or benefited the company
is transferred to an expense account (pre-paid rent, pre-paid insurance, depreciation)

Straight-line depreciation – assuming that the entire asset cost is depreciated

The reduction in depreciation is not recorded in the asset account, but into a contra asset account called “Accumulated
Depreciation”

The introduction of a the contra asset account requires an extra column in the FSET

Cash asset + Non Cassh Asset – Contra Assets = Liabilities + Cont. Capital + Earned Capital

Debit to depreciation expense…………………………………000

Credit to accumulated depreciation ……………………………000

Type 3: Accrued revenues – end of period adjusting entries are made to reflect any revenues or income earned, but not
yet billed or received. Such accumulated revenue is often called accrued revenue, or accrued income

Debit to the not yet billed receivable…………………………………000.

Credit to the type of income in earned capital……………………………000

Type 4: Accrued Expenses (wages, interest, utilities, taxes)

Debit to the accrued expense …………………………………………….000

Credit to the account in liabilities…………………………………………..000
Example: Wages expense……………………………………………123
Wages payable (liability)…………………………..123

(usually the expense account recorded in liabilities will be “something payable”)

SUMMARY OF ADJUSTMENTS
Effect if not adjusted
Ac. Adjustment Example Adj. Entry Balance Sheet Income Statement
Deferrals
Unearned revenue Delivery on advance Dr. Liability Liab. Overstated Revenue Understated
Cr. Revenue Equity Understated

Prepaid Expenses Expiration of pre-paid Dr. Expense Asset Overstated Expense understated
Cr. Asset (contra As.) Equity overstated

Accruals
Accrued revenues Earned not received Dr. Asset Asset Under Revenue Under
Cr. Revenue Equity Under

Accrued Expenses Incurred unpaid Dr. Expense Liability under Expense under
Cr. Liability Equity over

LO4 - Prepare Financial statements from adjusted accounts

Adjusted Trial Balance – after all adjustments company prepares it.

The content for the financial statements are taken from the adjusted trial balance

Preparing Statements
Adjusted Trial Balance then:
1 – Income Statement
2 – Statement of Equity
3 – Balance Sheet
4 – Cash flows

LO5 – Closing Temporary Accounts

Temporary accounts: Revenues/Expenses

Permanent Accounts: Assets, Liabilities, Equity, Contributed Capital, Retaine Earnings

Closing process – the Retained Earnings account can be used to close the temporary revenue and expenses accounts

1. Close revenue accounts – debit each revenue account for an amount equal to its balance, and credit retained
earnings for the total revenues
2. Close expense accounts – credit each expense account for an amount equal to its balance, and debit Retained
Earnings for the total expenses.

Journal entry:

Revenues………………………………………000
Retained earnings………………………………….000
Retained earnings…………………………………….000
Expense 1………………………………………………..000
Expense 2………………………………………………..000
Expense 3………………………………………………. 000

Post closing trial balance – prepared after closing entries are recorded and temporary accounts are re-set to zero.
Only balance sheet accounts appear on the post-closing because the income statement accounts have the balance of
zero.

LO6 – Analyze changes in balance sheet account

Using information on Levels and Flows

SUMMARY

LO1 – Identify the major steps in the accounting cycle

Analyze Record Adjust Report Close

LO2 – Review the process of journalizing ang posting transactions

 Initially recorded in a journal, chronological order, journal shows total effect of each transaction
 Posting is the transfer from journal to general ledger of accounts

LO3 – Describe the adjusting process and illustrate adjusting entries

 Adjusting entries achieve the proper recognition of revenues and expenses

Adjusting prepaid (deferred) expenses ______________________ Increase Expense / Decrease Asset

Adjusting unearned (deferred) revenues _____________________ Decrease liability / Increase revenue
Accruing expense ________________________________________ Increase expense / Increase liability
Accruing revenues _______________________________________ Increase asset / Increase revenue

LO4 – Prepare financial statements from adjusted accounts

 An income statement, st. of sh equity, balance sheet, and cash flows prepared from an adjusted trial balance
and other information

LO5 – Describe the process of closing temporary accounts

 Closing the books means (yielding balance zero) revenues and expenses (temporary accounts). Those balances
are transferred to Retained Earnings

LO6 – Analyze changes in balance sheet accounts

 The combination of balance sheet levels and income statement flows allows a financial statement reader to
infer the effects of transactions and adjustments that are not disclosed directly

Chapter 4 Reporting and Analyzing Cash Flows

Statement of cash flows – tells us how a company generated cash (cash inflows) and how it used cash (cash outflow)

What do we mean by cash?

The cash flows explain changes in cash and cash equivalents (such as easily convertible to cash, close enough to
maturity (3 months or less), treasury bills, money market funds. (cash and cash equivalents are summed together

Framework of the S. of Cash Flows

Divided in 3 categories: operating, investing and financing activities.
Cash from operating activities:
 CASH INFLOW: Receipts from customers from sales or services, cash of interest and dividends, cash not relating
to investing or financing activities (rentals, lawsuits, refunds)
 CASH OUTFLOW: payment to employees or suppliers, purchase of inventory, interest to creditors, taxes to
government, other payments nor related to financing and investing, such as charity and lawsuits)

Cash from investing activities:

 CASH INFLOWS: cash from sales of property, plant, equipment (PPE) assets and intangible assets, sales of
investments in government securities and securities of other companies, repayment of loans by borroers
 CASH OUTFLOWS: purchase of property plant and equipment assets and intangible assets, payments to
purchase government securities, lend money to borrowers.

Cash from Financing activities:

 CASH INFLOWS: receipts from issuances of common stock and preferred stock and from sales of treasury stock,
receipts from issuances of bonds payable, mortgage notes payable and other notes payable.
 CASH OUTFLOWS: payment to acquire treasury stock, payment of dividends, settle outstanding bonds payable,
mortgage notes payable, and other notes payable.

Usefulness of Classification
Cash provided from:
Operations: the best seen by investors, because cash flow from operations can be continuous.
Investing: cash increase from investments are results from selling property, plant, and so on. Those activities are not
continuous, meaning that next month there wont be such increase in investing cash flows.
Financing: if an increase in finance is from borrowed funds, that means that the company have way more liabilities as
their cash flows increased.

Mid-chapter review
1. Out – Investment – purchase of warehouse
2. Out – Operating – interest on loan
3. Out – Operating – wages
4. In – Financing – issuance of stock
5. Out – Operating – taxes
6. In – Operating – legal case
7. In – Investment – Sale of security
8. In – Investment – Sale of equipment
9. Out – Financing – dividends
10. In – Operating – Interest on bond

Preparing Cash Flows – Operating Activities

To prepare cash flows we can use the values on the cash T-account (if a company is small with not many transactions)
When a company has too many transactions we can prepare the cash flows with data from balance sheet and income
statement.

Converting revenues and expenses to cash flows from operating

Sales Revenues to Cash Received from Customers

Cash Flow = Net Income (Sales revenue) – Change in Accounts Receivable + Change in unearned revenue

Cost of goods sold to cash paid for merchandise purchased

Cash Flow = Net Income (COGS expense) – Change in inventory + Change in accounts payable

Convert wages expense to cash paid to employees

Cash flow = Net income (Wage expense) + change in wages payable
Rent and advertising expense to cash
No adjustments necessary

Other adjustments
Insurance expense, interest income, interest expense and income tax. Only adjusting entries, so no cash flow.

GENERAL RULE
The difference between a revenue or an expense reported in the income statement and a related cash receipt or
expenditure reported in the statement of cash flows will be reflected in the balance sheet as a change in one or more
balance sheet accounts.

Net income +- Adjustments = Cash from operations

Net income + Depreciation expense – Change in operating assets + change in operating liabilities = cash from
operations

Operating assets: receibables, inventories, prepaid expenses and similar assets

Operating Liabilities: accounts and wages payable, accrued expenses, unearned revenues, taxes payable, interest
payable and similar.