Accounting and Financial Analysis Lecture Notes Lectures 1 10 PDF

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Accounting and Financial Analysis - Lecture notes, lectures 1

- 10
Accounting and Financial Analysis (Copenhagen Business School)
Distributing prohibited | Downloaded by Nush Ahmd (nuzhahalymohamed@gmail.com)

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Accounting and Financial analysis:
Chapter 1
Financial accounting + financial statement analysis
Accrual accounting – dobbeltentry book keeping - always two things going on -

Looking at assets and cash separately.
If I buy a car for my company, paying, it affects my cash negatively and my assets
positively
If I loan the money, I increase the liability via credit.
A list of ratios will be provided at the exam - but understand how to use them.
Excell kursus!
Accounting equation : A = L + SE
Principal agent theory - audtited financial statements
Management - owner - auditor
1. Explain what a business is about:
Business - Consists of activities necessary to provide goods and services to members

of the society.
Some of these businesses focus on providing goods, some produce or manufacture, some distribute
either as a wholesalers (under armour who sells to retailers) or the retailers such as Intersport. Others
provide services, like British Airways, Disneyland etc.
2 . Distinguish among forms of organization:
A convenient way to categorize the different types of organization is to distinguish between those who
exists to earn money and those who exist for other purposes.
Business entity: An organization operating to generate a profit
Non-business entities: Exists to serve segments of society. Governments entities or private

organizations like hospitals, universities etc. These do not have an identifiable owner.
Different type of accounting - fund accounting.
US entities recognize the social aspects and have established programs to meet these responsibilities -
donating to charities etc.
Sole proprietorship: A form of organization with a single owner

Partnership: a business owned by two or more individuals:
Corporation: A form of entity organized under the laws of a particular state: ownership evidenced by
shares of stock.

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Bond: A certificate that represents a corporations promise to repay a certain amount of money and
interest in the future. If you buy a bond, you are lending the company money.
Advantages with a corporation:

• Can raise large amounts of money in a relatively brief period of time
• Ownership in a corporation is transferred easily - You simply sell all your shares.
• Stockholders have limited liability: Only liable for the share it has payed.
Sole proprietorship - Owning a coffee shop —> gets a partner (maybe because of investing needs)
partnership —> gets listed on the stock exchange raising capital - starbucks.
3. Describe the various types of business activities:
Financing activities: Borrowing or sale of stock
Liability: An obligation of business. When a company borrows money at the bank, the liability is
called a note payable - when a company sells bonds, the obligation is called bonds payable. When the
supplier gives a company 30 days to pay the amount owned the obligation is noted as accounts
payable.
Capital stock: The dollar amount of stock sold to the public.

Stockholders do not lend money to the company like people buying bonds -
stockholders provide permanent financing - no due date to when the stockholder
needs to be repaid - so to get money they will have to sell their stock.
People buying bonds are called creditors - repayment of amount loaned + interest.
Investing activities: Investing in growth, purchase and sale of assets - an asset is a future
economic benefit to a business. Cash, buildings, land or intangible assets like a patent.
Operating activities: Sale of products/services + costs incurred to operate the

business.
Revenue: an inflow of assets resulting from the sale of goods and services.
Expenses: An outflow of assets resulting from the sale of goods and services.
(salaries, suppliers payed, utility companies payed the government payed taxes)
4. Define accounting and identify the primary users of accounting information and their needs.
Accounting is a process of identifying, measuring and communicating economic information to

various users as seen below.
The users of the information naturally depends on which information the statements provide - however,
the users can generally be divided into two different categories:

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Internal: Management, to facilitate planning and control.

external: stockholders, creditors etc. needs information that differs from internal users - however, as
they lack day-to-day information, they have to rely on the information provided by the company’s
management in financial statements through financial accounting.
Besides the above, government agencies have information needs specified by law, like
the IRS.
5 step framework to make a financial decision
1. Formulate the question

2. Gather information from the financial statements and other sources
3. Analyze the information gathered
4. Make the decision
5. Monitor your decision
5. Explain the purpose of each of the financial statements and the relationship among them
and prepare a set of simple statements.
Accountants use financial statements to communicate important information to those who need it to
make decisions.
The accounting equation
Assets = liabilities + Owners equity
Left = valuable economic resources that will provide future benefit to the company
Right = Indicates who provided or has claim to the assets
Owners equity: The owners claims on the assets of an entity

Stockholders equity: The owners’ equity in a corporation.
Arises when 1. a company issues stock to an investor or 2. owners of a share of a corporation have
claims on the assets of a business when it is profitable. Retained earnings represent this claim of the
company’s assets that result from its earnings that have not been paid out in dividends(payments to
stockholders). Earnings retained by the company “reinvested".
Balance sheet: (or statement of financial position) is the financial statement that
summarizes the assets, liabilities and owners’ equity of a company. It is a snapshot of the business at a
certain date. Can be prepared any day of the year but usually last day of month, quarter, year or season
(skiresort)
At any time assets MUST equal liabilities and owners equitys
Example.
Assets (cash, accounts receivable, land) = Liabilities (accounts payable, notes payable) +
Owners equity (capital stock, retained earnings)

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Questions after a balance sheet:

Is the revenue distribution hold up ?
Are expenses representative for the future? Will new expenses like marketing or
income taxes appear?
When can we expect to receive the accounts receivable? Is there a chance we won’t collect all?
When do we need to pay accounts payable?
What is the interest rate on the note payable? When is interest paid? When is the note
itself due?
The Income Statement: Summarizes the revenues and expenses of a company for a period of time.
It is a flow statement, thus it summarizes the flow of revenues and expenses for the
year.
Net income (profit, earnings) = Excess of revenue over expenses.
The Statement of Retained earnings: The statement that summarizes the income earned and
dividends paid over the life of a business.
Net income - dividends = retained earnings.
The Statement of Cash Flows:

The financial statement that summarizes a company’s cash receipts and cash payments during the
period from operating, investing and financing activities
Relationship among the financial statements:
6. Identify and explain the primary assumptions made in preparing

financial statements:
Besides the record-keeping aspect of accounting “bookkeeping” most of the accountant job requires a
great deal of judgement in communicating relevant information in financial statements these have been
developed and combined into a conceptual framework for accounting
Economic entity concept: Requires that an identifiable, specific entity be the subject
of a set of financial statements
Does not intermingle the personal assets and liabilities of the employees or any of the other
stockholders - personal affairs are kept away from business. So when looking at the balance sheet we
need assurance that it shows the financial position of the entity only and does not intermingle any
personal assets or liabilities.
Asset valuation/ Cost principle: Assets are recorded at the costs to acquire them
Original cost or historical cost until the company disposes them.
Thus more objective than market value -
This will be examined in later chapters - where some assets are valued on subsequent balance sheets

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like a company’s shares in other companies.
Going concern: The assumption that an entity is not in the process of liquidation and that it will
continue indefinitely. This also justifies the use of historical cost as valuation.
Monetary unit - The yardstick used to measure amounts in financial statements, the dollar in the US.
Assumes monetary unit is relatively stable; no adjustment for inflation made in
financial statements
Time Period assumption: An artificial segment on the calendar used as the basis for preparing
financial statements.
Accountants assume that it is possible to prepare an income statement that accurately reflects net
income or earnings for a specific time period. Would be more accurate to measure the earnings of a
company at the end of its life but users of statements demand information on a regular basis.
7. Identify the various groups involved in setting accounting

standards and the role of auditors in determining wether the
standards are followed.
Generally accepted accounting principles (GAAP)
The various methods, rules, practices and other procedures that have evolved over time in response to
the need to regulate the preparation of financial statements (changes in business environment).
Who determines the rules?

A joint effort among:
Securities and Exchange comission (SEC)) -

Federal agency with ultimate authority to determine the rules for preparing statements
Financial accounting standards board (FASB) - the group in the private sector with
authority to set accounting standards.
American Institute of Certified Public Accountants (AICPA) - Professional

organization of Certified Public Accountants (CPA)
Public Company Accounting Oversight Board (PCAOB) Five-member body

created by an act of Congress in 2002 to set auditing standards
International Accounting Standards Board (IASB) Develop worldwide accounting

standards
Auditing: The process of examining the financial statements and the underlying records of a company
to render an opinion as to wether the statements are fairly presented.
Financial statements are prepared by a company’s accountant and are the responsibility of the
company’s management. Then an external auditor performs various tests to verify the statements,
providing an opinion not a state of fact.
8. Explain the critical role that ethics plays in providing useful

financial information:

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• Investors and other users must have confidence in a company, its accountants, and
its outside auditors that the information presented in financial statements is
relevant, complete, neutral, and free from error
• Moral and social ethical behavior must be considered while decision making within the company -
you need to stay alert for potential pressures on you or others to make choices that are not in
the best interest of the company.
The information needs to be:
Relevant - Useful in the decision making process.

Faithful - complete, neutral (free from bias( and free from error.
Here is an ethical decision model to assists in decision making for the cases and
assignments.
Chapter 2
Financial Statements and the annual report.
1. Describe the objectives of financial reporting: To provide useful

information to those making financial decisions.
Balance sheet - Shows what obligations will be due in the near future and what assets
will be available to satisfy them
Income statements -The income statement shows the revenues and expenses for a
period of time
Statement of cash flow - where cash comes from and how its been used (Financing,
Investing, Operating)
Notes (accounting policies) essential details about the company’s accounting policies and other key
factors that affect its financial condition and performance.
Objectives:
• Provide information for decision making
• Reflect prospective cash receipts to investors and creditors - If I buy stock, how much cash will
i receive in dividends/sale of stock. Banker: If i loan money how much will i receive? interest
+ loan repaid.
• Reflect prospective cash flows to an enterprise -
• Reflects resources and claims to resources.
2. Describe the qualitative characteristics of accounting information:
Understandability: Comprehensive to those willing to spend.

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Relevance: The capacity of information to make a difference in a decision.
Faithful representation: Complete, neutral (unbiased) and free from error.
Comparability and consistency: Allows for comparisons between or among companies despite
different methods of accounting. Consistency means that the financial statements can be compared
within a single company from one accounting period to another.
Materiality: Deals with the size of an error in accounting information - will the error be important
enough to affect the judgement on someone relying on the data. A 5$ pen doesn’t have an affect, a
50.000 computer might - depending on the threshold for determining materiality in the respective
company.
Conservatism: The practice of using the least optimistic estimate when two estimates of amounts are
about equally likely - For example, inventory held for resale is reported on the balance sheet at the
lower of cost or market value- this requires a comparison of the inventory with the market price, or
current cost to replace that inventory - in this case the lowest cost will go on the balance sheet.
3. Explain the purpose of a classified balance sheet.
A classified balance sheet separates both assets and liabilities into

current and non current. Current assets will be realized in cash, sold or
consumed during the operating cycle or within a year if the cycle is
shorter than a year. Current liabilities will be satisfied within the same
period.
Non current assets:
Long term or non current liabilities will not be paid within the operating
cycle, including bonds or notes payable (long term loan/debt)
Operating cycle: The period of time between the purchase of inventory and the collection of
any receivable from the sale of the inventory.
If a bike shop buys a bike for inventory, and a customer purchases the bike and pays up front after 20
days, the operating cycle is 20 days. If the shop gives the customer 50 days to pay, the operating cycle
is 50 days and they have accounts receivable until then.
Stockholders equity: Owners claims on the assets of a business that arise from
two sources: contributed capital and earned capital.
Contributed capital: Capital stock (owners investment) + Paid-in capital in excess of

par value
Earned capital: retained earnings - net income minus dividends paid.

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4. Use a classified balance sheet to analyze a company’s financial

position:
A company’s ability to pay its debts as they come due can be judged by computing the amount of
working capital and the current ratio.
Working capital: Current assets minus currents liabilities. Negative working capital
may indicate inability to pay creditors in time
Liquidity: The ability of a company to pay its debts.
Current ratio: Current assets divided by current liabilities.
Some companies can operate at a lower ratio than other though - for instance air lines, as they do not
have large amounts in inventories or accounts receivable.
5. Explain the difference between single-step and a multiple-step

income statement and prepare each type of income statement.
Single-step income statement: expenses are added together and subtracted from all revenues in a
single step. Primary advantage is its simplicity.
Multiple-step income statement: Shows classifications of revenues and expenses as well as

important sub-totals.
Three important subtotals:
Gross profit: Sales - Cost of goods sold. Where cost of goods sold is the cost of the
units of inventory sold during a year. Its relevant to associate cost of goods sold with
revenue as the latter represents the selling price.
Income from operations: Subtracting total operating expenses from the gross profit.
Operating expenses are further divided between selling expenses and general and
administrative expenses.
Two depreciation expenses are included in operating expenses - depreciation of
store furniture and fixtures, is a selling expense because they are located where the
sale takes place.
The buildings are offices for administrative staff, thus depreciation of the buildings
is classified as a general and administrative expense.
Income before taxes: interest revenue and interest expense are subtracted and the amount is
subtracted from the income from operations.
6. Use a multiple-step income statement to analyze a company’s

operations.
A company’s profit margin, computed by dividing net income by sales, is a good indicator of its
profitability.

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Profit income = net income / sales
A profit margin of 11% means that for every dollar of sales, Dixon has 0.11 $ of in net
income.
Two key factors when evaluating any financial statement ratio:
How does this year’s ratio differ from ratios of prior years?
How does the ratio compare with industry norms?
7. Identify the components of the statement of retained earnings and

prepare the statement.
6. Reports net income and any dividends declared within the period
7. Important link between income statement and balance sheet
8. Explains the changes in the components of owner’s equity during the period.
8. Identify the components of the statement of cash flows and prepare

the statement.
Summarizes a company’s financing, Investing and operating activies during the period, and all three
can result in a net inflow or a net outflow in cash .
9. Read and use the financial statements and other elements in the
annual report of a publicly held company.
Chapter 3
1. Explain the differences between external and internal events:
External events involves interaction between a company and its

environment, while internal events occur entirely within the company.
All events are categorized as transactions - events that are recognized in a

financial statement. To be recognized an event must be measured, but
some things like a new chief executive or the price of a supply good are

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harder to measure.
2. Explain the role of source documents in an accounting system
A piece of paper that is used as evidence to record a transaction - come in

many shapes, invoice, cash register tapes, time cards etc.
3. Analyze the effects of transactions on the accounting equation and

understand how these transactions affect the balance sheet.
Some transaction affect just the balance sheet, others affect both balance
sheet and income statement - however, the accounting equation must
stay balanced.
Thus we have to analyze the effect on the balance sheet for every single
transaction:
Assets = liabilities + stockholders equity.
In the example from the book (from page 106) the transactions are
registered in the following way, continuously maintaining the balance of
the equation:
Assets = Liabilities
Notes Capi.
Cash AR Equip Build Land AP
payable Stock
Total assets: 325,000 Total liabilities + SE: 3
These numbers are entered into the balance sheet on each side.
Income statement include revenues (membership and court fees in this

ex) and expenses (salaries & wages + utilities) - Dividends are not
included in the income statement as they are distribution of net income of
the period, thus not a determinant of net income as are expenses.

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The central idea behind the accounting equation: Even though

individual transactions may change the amount and composition of the
assets and liabilities, the equation must always balance for each
transaction and the balance sheet must always balance after each
transaction.
The cost principle:
The cost principle requires that we record an asset at the cost to acquire it
and continue to show this amount on all balance sheets until we dispose
the asset.
So except a few exceptions, an asset is not carried at the market value but
at its original cost.
4. Define the concept of a general ledger and understand the use of

the T account as a method for analyzing transactions.
Account: A record used to accumulate amounts for each individual asset,

liability, revenue, expense and component of stockholders’ equity.
Example: There was used 9 accounts in the Glenburry example from

above: cash, accounts receivable etc..
Chart of accounts: A numerical list of all accounts used by a company.
General ledger: Contains all the accounts and is the basis for preparation
of the statements.
The T account: A format used to analyze transactions - showing amounts

coming into, and leaving the account.
Assets : left side is increase (debit), right side is decrease (credit)- and the
opposite is the case for liabilities and stockholder equity.
5. Explain the rules of debit and credit
Debit: Entry on the left side of an account.

Increase asset accounts and expenses

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Credit: Entry on the right side of an account.

Increase liabilities + SE and increase revenue accounts.
They only represent location - not increases or decreases
Because assets and liabilities are opposites, if an asset is increased with a

debit, a liability is increased with a credit.
Assets Liabilities SE
Debit + /// Credit - Debit - /// Credit + Deb
Revenue:
Retained earnings is increased with a credit
Revenue is an increase in retained earnings
Revenue is increased with a credit
Because of this - it is decreased with a debit.
Expenses:
Retained earnings is decreased with a debit

Expense is a decrese in retained earnings
Expense is increased with a debit
Because of this it is decreased with a credit.
Dividends:
Reduces cash but also reduces owners claim on the asset of a
business. Separate Dividends account:
1. retained earnings is decreased with a debit

2. Dividends are a decrease in retained earnings
3. Dividends are increased with a debit.
4. Because dividends are increased with a debit, they are decreased with a
credit.
Debits and credits equal for every transaction. For example, the 100,000
debit to the cash account equals the 100,000 credit to the capital stock

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account.
6. Explain the purposes of a journal and the posting process
A journal is a chronicle record of a company’s transactions. Transactions

are periodically posted from the journal to ledger accounts.
A journal entry contains a date with columns for the amounts debited and
credited.
Example:
Jan. xx
Building cash debit 100.000 capital stock credit 100.000
To record the issuance of 10,000 shares of stock for cash.
7. Explain the purpose of a trial balance.
A trial balance is a list of each account and its balance used to prove the
equality of debits and credits. It is normally prepared at the end of the
accounting period and is the basis (a device not a statement itself) for
preparation of financial statements.
In practic we have all the normal balanced Debits and credits for each
account on either side - adding up to a balance of total debits and credits
at the end.
Chapter 4
Income measurement and accrual

accounting:
Explain the significance of recognition and
measurement in preparation and use of financial
statements:
Recognition is the process of recording items in the financial statements as an

asset, a liability, a revenue, an expense or the like. Additionally, to be able to

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recognize an event, the statement preparer must measure the event’s financial
effects on the company.
The measurement requires that two choices to be made.

1. Which attribute to be measured
What characteristic of the property should be used to measure abd thus recognize
it as an asset on the balance sheet - in the example of property, the cost of the
asset at the time it is acquired is the logical choice.
How do we report the property on a balance sheet a year from now ?
Historical cost - the amount originally paid.

or
Current value - The amount of cash or its equivalent that could be received by
selling an asset currently, I.E. selling price, reduced by any commissions or other
fees involved in making the sale.
2. A scale of measurement, or unit of measure, must be

chosen.
The US dollar for instance.
Explain the differences between cash and accrual

accounting
Cash accounting: Revenues are recognized when cash is received and expenses
are recognized when cash is paid.
Accrual accounting: Revenues are recognized when earned and
expenses are recognized when incurred.
Example: our firm is hired to pain a house. In case of accrual accounting, we

recognize the revenue when the house is painted — in cash accounting, when the
cash is received.
Thus there is two journal entries:

First accounts receivable is debited and service revenue is credited.
Then, when cash is received, we debit cash and credit accounts receivable.
Describe the revenue recognition principle and

explain its application in various situations
Revenue recognition principle involves two factors:

Revenues are recognized in the income statement when they are both realized
and earned. Revenues are realized when goods or services are exchanged for
cash or claims to cash usually at the time of sale, usually when delivered to the
customer.
However, for long-term contracts, franchises, commodities and installment sales it
might be necessary to modify the meaning of the revenue recognition principle.
When revenues are earned continuously over time, the earning process takes
place with the passage of time and not at a certain time. Interest or rent - we get
back to this.

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Describe the matching principle and the various

methods for recognizing expenses
The association of revenue of a period with all the costs necessary

to generate that revenue.
Overtime a cost is incurred, an asset is acquired. An asset ceases
being an asset and becomes an expense when the economic
benefits from having incurred the cost have expired.
Classic bathing principle example: cost of goods sold expense and

sales revenue. A cost is incurred and an asset is recorded when the
inventory is purchased. The asset, inventory becomes and expense
when it is sold. Another clear example is commissions, as this is
directly linked to the sale as well.
An indirect form of matching is used to recognize the benefits

associated with long-term assets such as buildings and equipment.
It is usually not possible to link these to a specific sale - instead they
are matched with the periods during which they will provide
benefits.
For example an office building may be useful to a company for 30 years.

Depreciation is the process of allocating the cost of a tangible long-term asset to
its useful life. Depreciation expense is the account used for recognition.
Expenses come about in two ways:

From the use of an asset (product sold)
Or recognition of a liability.
Identify the four major types of adjusting entries

and prepare them for a variety of situations
Adjusting entries are made at the end of an accounting period.

Internatl transactions - do not affect cash account
Adjustment of either asset or liability with corresponding change in
revenue or expense.
Deferred expense (Cash paid before expense is

incurred)
Assets that are acquired before its usage.
Examples: Prepaid rent, prepaid insurance, office supplies, property
and equipment.
The journal entry at the purchase of an insurance will be:

Because $200 of benefits expires every month, the adjusting entry after a month is as
follows:
1 - reduction in the asset prepaid insurance. 2. Expense associated with using the

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benefit for a month:
The deferred expense adjustment of depreciation is similar to the

one made for insurance expense.
Nordstrom buys store fixtures for $5000. The journal entry is:
Assets:
Store fixtures 5000
Cash (5000)
To depreciate we must make two estimates; 1 the useful life of the

asset(5 years), the estimated salvage value (how much they will
be able to sell it for) - ($500)
Depreciable cost is 5000-500.

We then use the straight line method, assignment of equal
amount of depreciation to each period, so we divide 4500 with 60
months (5 years) = $75 pr month.
Now the asset account is reduced an expense recognized every

month.
Normally firms use a contra account, an account with a balance

that is opposite that of a related account, to reduce the total
amount of long-term tangible assets by the amount of depreciation.
For example, Accumulated depreciation is used to record the
decrease in a long-term asset for depreciation; thus it carries a
credit balance.
An increase in accumulated depreciation is recorded with a credit

because we’re decreasing assets.
Journal entry:
Income statement:
expenses + net income = (75)
Balance sheet:
Assets: Accumulated depreciation (75) = Stockholders equity (75)
why extra account and not directly? because we need the original
cost.
Deferred revenue (Cash received before revenue is

earned)

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Examples: Airline tickets, subscriptions collected in advance, gift

cards.
Receipts are initially collected as liabilities (unearned or

refundable receipts) and recorded as revenues in the future when
earned.
Opposite example from before, here the insurance

company receives insurance payment in advance.
The insurance company has a liability as it has taken cash from Nordstrom but has
yet to perform the service to earn the revenue.
It is the same case with gift cards. They are a liability until they have been used.
When used, sales revenue increases with a credit and deferred revenue decreases
debit.
Accrued liability (Expense incurred before cash is

paid)
Examples: payroll, interest and taxes.
Record expense and corresponding liability in a period incurred, pay

for it in a future period.
No cash flow on recording, only when paid.
Example: salary payment
Note: we assume they work 7 days a week, thus daily cost is 1/14 =
$20.000.
Another typical example is interest. In many cases, the interest on a

short-term loan is repaid with the amount of the loan, called the
principal.
Example: 9%, 90 day, $20.000 loan on march 1, and pay on may

30.
Cash: Debit 20.000

Notes payable credit 20.000
The basic formula for calculating interest: I = P x R x T

dollar amount of interest = principal amount of loan x annual rate of
interest as a % x time in years.
2000 x 0.09 x 3/12 = $450 - this is the amount that must be

recognized as an expense on march 30 is one third of 450 (one
month out of three)
For one month: 2000 x 0.09 x 1/12 = $150.

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The adjusting entry for march is:

Expenses: interest expense 150 - net income (150)
Liabilities: interest payable 150 + Stockholders equity (150)
On may 30:
Interest payable = 300
Interest expense = 150
Notes payable = 20.000
cash = (20.450)
The reduction in interest payable eliminates the liability recorded at

the end of march and april. The recognition of $150 is for the
expense cost for the month of may. The reduction in cash represents
the $20.000 of principal and the total interest of $450 for three
months.
Accrued asset (Revenue earned before cash is received)

Examples: accounts receivable, interest receivable.
Record revenue (and corresponding receivable) in a period earned;

receive payment in future period.
Revenue earned before receipt of cash. Rent and interest are earned
with the passage of time and require adjustment if cash has not yet
been received.
Rent out of warehouse. the tenant pay $2500 pr month, within first
10 days every month.
Journal entry
Rent revenue $2500 - expenses = net income 2500
Assets: rent receivable 250 = liabilities + stockholders equity
When the tenants pay:

assets: cash 2500
Rents receivable (2500)
Explain the steps in the accounting cycle and

significance of each step
Explain why and how closing entries are made at

the end of an accounting period
Balance sheet accounts are called real accounts because

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they are permanent in nature. Real accounts are

never closed and the balance in each of them is carried
over from one period to the next.
Revenue, expense, and dividends accounts are temporary

or nominal accounts. The balance in the income
statement accounts and the dividends account are closed
and not carried forward from one accounting period to
the next.
Closing entries are made at the end of an

accounting period and have two purposes:
• To return the balance of revenues an expenses and
dividends accounts to zero to begin the next period.
• Transfer the net income or loss and dividends to retained
earnings.
An account with a debit balance is closed by crediting the

account for the amount of the balance.
An account with a credit balance is closed by debiting the
account for the amount of the balance.
We use a temporary holding account called Income

Summary to facilitate the closing process:
1. A single entry is made to close all of the revenue

accounts. The total amount debited to the revenue
accounts is credited to Income summary.
2. Similarly, a single entry is made to close all of the
expense accounts, and the offsetting debit is made to
Income Summary.
3. After the revenue and expense accounts are closed,
income Summary has a credit balance if revenues exceed
expenses. The credit balance in Income Summary is
closed by debiting the account and crediting Retained
Earnings for the same amount. The net result of the
process is that all of the revenues less expenses (i.e. net
income) have been transferred to Retained Earnings.
4. The Dividends account is closed directly to retained
earnings. Because dividends are not an expense, the
dividends account is not closed first to the Income

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Summary account. A credit is made to close the Dividends

account with an offsetting debit to Retained Earnings.
Chapter 5
Inventories and cost of goods sold
Accounting for sales of merchandise and inventory.

Inventory costing methods - assigning cost to the products sold.
How a company keeps track of inventory
Relationship between sales on the income statement and inventory on the
balance sheet can be assess how well a company is managing its inventory.
One of the biggest challenges as a retailer is controlling the cost of

its inventory while at the same time ensuring the quality of the
merchandise. Also, to minimize stock, as cost if carrying inventory,
including storage and insurance, can be high.
Identifying the forms of inventory held by different

types of businesses and the types of costs incurred:
Two types of inventory

Finished inventory, held by retailers and wholesalers
Material inventory, held by manufacturers.
Thrre types of inventory costs

Inventory costs borne by manufacturers: direct materials, direct labor and
manufacturing overhead.
Three distinct forms of inventory for a manufacturer: raw

materials, work in process, and finished goods.
Companies selling inventory can be divided into two groups:

Retailers and wholesalers, purchase inventory in finished form and
hold it for resale (like gap)
Manufacturers transform raw materials into a finished product prior
to sale. (Ford motor company)
Recording inventory - an example:

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Explain how wholesalers and retailers account for sales of

merchandise:
Vocabulary:
Gross profit: Net sales less cost of goods sold

Net sales: Sales revenue less sales returns and allowances for discounts
Sales revenue: A representation if the inflow of assets.
Sales returns and allowances: contra-account used to record refunds to customers and
reduction of their accounts.
Sales discounts: an contra revenue account used to record discounts given to
customers for early payment of their accounts.
costs of goods available for sale: Beginning inventory + costs of goods purchased.
Example - recording sales of merchandise.
The cost of inventory that has been sold = COGS, this is an expense on the income
statement.
The cost of the inventory on hand = inventory, this is an asset on the balance sheet.
Inventory systems: Perpetual and Periodic
Perpetual: A system in which the inventory account is increased at

the time of each purchase and decreased at the time of sale. Thus
at any point during the period, the Inventory account is up to date.
However, this can be costly to maintain with a lot of transactions..
Income statement: expenses (70) = Net income = (70)

Balance sheet assets = (70) = SE (70)
Periodic: A system in which the inventory account is updated only

at the end of the period.
Buys Nike sneaks for $4000

Income statement : expenses 4000 = Net income (4000)
Balance sheet: Liabilities A/P 4000 + SE (4000)
Refunds $850

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Income statement; Expenses (850) Net Income 850

BS - Liabilities (850) + SE 850
Recording purchase discounts:

A purchase on march 13 1/10 n/30. entry is as follows:
Income statement: expenses 500 = Net income (500)

BS - Liabilities A/P 500 + SE (500)
If they dont pay within discount period, simply journalize payment $5000 cash
and reduction in A/P. IF they pay within:
Income statement - expenses: Purchase discount (5) = net income 5
BS- Assets: Cash 495 = Li. = A/P (500) stockholders equity = 5.
Here purchase discount is a contra-account.
Inventory costing methods
These numbers will be used in explaining all methods:
Specific investigation methods
An inventory costing method that relies on matching unit costs with

the actual units sold, as seen below.
Here we subtract cost of goods sold from cost of goods available for sale.
One problem with this method is that it allows management to manipulate

income. They would do this by boosting net income by selling units with
the lowest possible unit cost to keep cost of goods sold down and net
income up.
Weighted Average Cost Method:
An inventory costing method that assigns the same unit cost to all units
available for sale during the period:

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Total cost of units, not just the beginning inventory or purchases, /

number of units to find price. Then calculate the ending inventory
with the price, and inventory sold with the price.
First in first out method (FIFO)
An inventory costing method that assigns the most recent costs to ending inventory. In
many businesses, such as a grocery store, this cost-flow assumption is a fairly
accurate reflection of the physical flow of products.
We sell our beginning inventory first, then the next bought, and lastly 5 units of the
most recent purchased units at a value of $18, to complete the 40 units sold. Had it
been 30 units, we would have taken the first 10 and the 20 of the second units.
Last in first out method (LIFO)
An inventory method that assigns the most recent costs to cost of

goods sold. Reverse of FIFO.
<— the 10 left units from below.
Note! there may be cases, such as the illustration with LIFO, where it is easier to
determine ending inventory and then deduct it from cost of goods available for sale to
find cost of goods sold. While own others it may be quicker to determine cost of
goods sold first and then plug in ending inventory.
Income effects of the four methods:
Selecting an inventory method:
The choice of an inventory method will impact cost of goods sold and
thus net income. A company should choose the method that results in the
most accurate measure of net income for the period.

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Chapter 6
Cash and Internal Control
Cash Management
- Bank reconciliation
Internal control.
Identify and describe various forms of cash reported on a balance

sheet:
Regardless of the form it takes, cash reported on the balance sheet must be readily
available to pay debts. Cash equivalents are those investments readily convertible to a
known amount of cash and has original maturity to the investor of three months or
less.
On the balance sheet
Cash Management
Companies use a variety of devices to control cash. Amount them are bank reconciliations and petty
cash funds.
Vocabulary:
Bank statement: A detailed list, provided by the bank, of all activity for a particular
account during the month.
Outstanding check: A check written by a company but not yet presented to the bank
for payment.
Deposit in transit: A deposit recorded on the books but not yet reflected on the bank
statement.
Bank reconciliation:
A form used by accountants to reconcile or resolve any differences between the
balance shown on the bank statement for a particular account with the balance shown
in the accounting records.
Two records of cash: bank statement and cash account in general ledger:
1. Any deposits recorded on the books but not yet on the bank statement are deposits

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in transit. Prepare a list of deposits in transit.

2. Arrange the canceled checks in numerical order and trace each of them to the
books. Any checks recorded on the books but not yet listed on the bank statement
are outstanding. Prepare a list of outstanding checks.
3. List all items, other than deposits, shown as additions on the bank statement, such
as interest paid by the bank and amount collected by the bank form one of the
company’s customers. When the bank pays interest or collects an amount owed to a
company, the bank increases, or credits, its liability to the company on its books. For
that reason these items are called credit memoranda. Prepare a list of credit
memoranda.
4. List all amounts,, other than cancelled checks shown as subtractions on the bank statement, such as
any NFS checks and service charges. When a company deposits money in the bank, a liability
is credited on the books of the bank. Therefore when the bank reduces the amount of its liability for
these various items, it debits the liability on its own books - debit memoranda.
5. Identify errors made by the bank or by the company in recording cash transactions.
An example:
Adjusted balances for both bank and book must balance !
Petty cash fund:

Money kept on hand for making minor disbursements in coin and currency rather than
writing checks.
Setting up a petty cash fund:

1. A check is written for a lump-sump amount, such as $100 or $500. The check is cashed, and the coin
and currency are entrusted to a petty cash fund.
2. A journal entry is made to record the establishment of a fund.
3. Upon presentation of the necessary documentation, employees receive minor disbursements from
the fund. In essence, cash is traded from the fund in exchange for a receipt.
4. Periodically, the fund is replenished by writing and cashing a check in the amount necessary to bring
the fund back ton its original balance.
5. At the time the fund is replenished, an adjustment is made to record its
replenishment and to recognize the various expenses incurred.
See example on page 306
Internal control
An internal control system includes policies and procedures to ensure the safeguarding of an entity’s
assets, reliability of its accounting records, and the accomplishment of overall company objective.
The first element in the fraud triangle is motive/financial

pressure. This usually results from either critical need or greed on

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the part of the person who commits the fraud (the perpetrator).
Sometimes it is a matter of just never having enough (because
some persons who commit fraud are already rich by most people’s
standards). Other times the perpetrator of the fraud might have a
legitimate financial need, such as a medical emergency, but he or
she uses illegitimate means to meet that need.
The second element in the fraud triangle is opportunity. The

opportunity to commit fraud usually arises through weak internal
controls. It might be a break-down in a key element of controls, such
as improper segregation of duties and/or improper access to assets.
Or it might result from a weak control environment, such as a
domineering CEO, a weak or conflicted board of directors, or lax
ethical practices, allowing top management to override whatever
controls the company has placed in operation for other transactions.
The third element in the triangle is rationalization. The perpetrator

engages in distorted thinking, such as: “I deserve this;” “Nobody
treats me fairly;” “No one will ever know;” “Just this once, I won’t let
it happen again;” or “Everyone else is doing it.” Sometimes
rationalization of small fraudulent acts that go undetected can lead
to other more serious or a series of similar acts later. That’s why
having good internal control is important.
Internal control procedures
Internal control procedures can be either administrative or accounting in nature.
Administrative controls: procedures concerned with efficient operation of the

business and adherence to managerial policies.
Accounting controls: Procedures concerned with safeguarding the assets or the

reliability of the financial statements.
Proper authorization: Management grants specific departments the authority to

perform various activities. Along with authority comes responsibility. Personal
department have authority to hire fx.
Cashier is authorized to sell a book - ringing up the transaction (general) - but if the
store manager is required before a book may be returned (specific)
Segregation of duties: A good system of control requires that the physical custody of assets
be separated from the accounting for those assets, to avoid fraud or theft. This is not attainable for some

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smaller businesses though.
Independent verification: Work of one department should act as a check on the work
of another.
Safeguarding of Assets and records: Cash registers, safes, and lockboxes are
important safeguards for cash. Secured storage with limited access is essential for
safeguarding inventory. Protection of accounting records are equally important.
Independent review and appraisal: Periodic review of the accounting system and the people
operating it. Internal audit staff is primarily in charge of this. They focus on the efficiency of the
company while external auditors is wether the financial statements are prepared fairly.
Design and use of business document: The crucial link between economic transaction and the
accounting records of those events. Another word for business document i source document - that is for
example a time card as recognition for an employee’s wage.
Business documents also include:
Purchase requisition form, purchase order, invoice, receiving report, invoice approval
form and check with remittance advice, see more on page 317.
Limitations on a company’s effective system of internal control:
• - Costs should not exceed benefit

• – Size of the business
• – No system of internal control can prevent collusion by
two or more employees
• – The lack of support from upper management may
weaken an otherwise strong commitment to a system of
internal control
• – The element of human error can never be eliminated
in any operation, regardless of how big or small
Chapter 7
Receivables and investments
Key learning objectives:

• Accounting for accounts receivable, including bad debts.
• Accounting for notes receivable
• Accounting for investments (stocks and bonds)

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Accounts receivable
Accounts receivable vs notes receivable:

Notes receivable arises from a written promise by someone to pay a
specific amount of money in the future with interest.
An account receivable arises from granting a customer an open line
of credit and does not normally include interest.
Accounts receivable are stated on the balance sheet at net realizable, which takes into account an
estimate of the uncollectible amount. Two methods are possible in estimating bad debts:
There are two methods to account for bad debt allowances:
Direct write off method: The recognition of bad debts expense at the point an
account is written off as uncollectible.
In the income statement, after the accounting department is noticed that the money
won’t be received they enter bad debt expense $500.
In the balance sheet, the accounts receivable entry is credited from assets - and
income is taken from stockholders equity. Now the account is written off directly.
Deficiencies:
Robert will overstate the value of the asset at December 31, 2014 as he ignores the possibility that not
all accounts receivable will be collected.
He is also violating the matching principle as he is ignoring the possibility of bad debts on sales made
during 2014. All costs must be associated with making sales in a period be matched with the sales of
that period. So the problem is timing.
Allowance method:
A method of estimating bad debts on the basis of either net credit sales of the period or the accounts
receivable at the end of the period.
Assume that Roberts’ total sales during 2014 amount to $600,000

and that at the end of the year, the outstanding accounts receivable
total $250,000. Also, assume that Roberts estimates that 1% of the
sales of the period, or $6,000, will prove to be uncollectible.
Percentage of Net Credit Sales Approach:

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Bad debts percentage of credit sales.

This occasion the average is 2 % - then we take 2 % of this year (2014)
net credit sales, 2.340 and make the following entry:
Bad debts expense 46800

Allowance for doubtful accounts 46800
Income statement: expense - bad debt expense 46800 = net income

(46800)
balance sheet: Assets : allowance for doubtful accounts (46800) = SE
(46800)
A percentage of receivables approach.
% net credit sales versus % of accounts receivable
Note the one major difference between these two approaches:
9. - Under the % of the net credit sales approach, the

balance in the allowance account is ignored and the bad debts
expense is simply a percentage of the sales of the period.
10. - Under the % of accounts receivable approach,
however, the balance in the allowance account must be
considered
Aging schedule to estimate bad debt:
Aging schedule: categorizes the various accounts according to their

length of time outstanding -
The totals on the aging schedule are used as the basis for
estimating bad debts, as shown below.
As we can see from the table, the older an account is the less likely it is to
be collected.
Accounting for notes receivable

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More formal than accounts receivable

• Written promise to pay a sum at the maturity date
– Plus interest
Also called promissory notes.
• Maker: party that borrowed and owes money (debtor, borrower)
• Payee: party to whom money is owed (lender)

Notes payable: a liability resulting from the signing of a
promissory note.
Key terms:
• Principal—the cash received, or the fair value of the products or

services received, by the maker when a promissory note is
issued
• Maturity date—the due date of promissory note
• Term—the length of time a note is outstanding
• Maturity value—the amount to be paid by the maker on the
maturity date
• Interest—the difference between the principal amount and the
maturity value
• Interest rates are always expressed as an annual percent, unless
stated otherwiseOften interest is computed based on days –
Denominator would be days/360
If person buys a computer and is short on cash an therefor gives the seller a 90
day 12% promissory note. The total amount of interest due on the maturity date
is determined as:
$15.000 x 0.12 x 90/360 = $450
The entry to record receipt of the note is as follows:
Income statement: Revenues - sales revenue 15.000 = net income

15.000
Balance sheet : Assets - N/R 15.000 = SE 15.000.
He makes the purchase 13 december. to calculate the interest earned in 2014:
as there is 18 days left: $15.000 x 0.12 x 18/360 = $90.
Interest receivable 90
Interest revenue 90

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Income statement: revenues - interest rev. 90 = net income 90

Balance: Assets - interest receivable: 90 = SE 90.
On march the shop receives the principal amount and interest from
the customer.
Cash 15.450
Notes receivable: (15.000)
Interest revenue: (360)
Interest receivable: (90)
Income Statement: Revenues: 360 = Net income 360

BS: Assets Cash 15.450, Notes receivable (15.000) interest
receivable (90) SE 360.
Accounting for investments
• Certificate of deposit (CD): highly liquid financial instrument

• Equity securities (stock): issued by corporations as a form of
ownership in the business
• Debt securities (bonds): issued by corporations and governmental
bodies as a form of borrowing
Companies invest idle cash in a variety of financial instrument, including CD’s,
debt securities (bonds) and equity securities (stock). Interest revenue is earned on
the first two and dividend income is earned on equity securities that pay
dividends.
Investment 100.000
Cash (100.000)
Assets interest receivable.

interest revenue ,, same as interest.
Chapter 8
Operating assets: Property, plant, equipment and intangible assets.
Current and non current assets on balance sheets
• Assets are resources a company owns. They consist of both

current and noncurrent resources.
• Current assets are ones the company expects to convert to cash
or use in the business within one year of the balance sheet
date.

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• Concurrent assets are ones the company will hold for at least one year.
Operating assets are generally presented in two categories 1. property, plant and equipment PPE and
2. intangible assets. They are presented at their acquisition cost (or historical cost) that includes all
normal and necessary costs to acquire an asset and prepare it for its intended use - like purchase price,
taxes paid at time of purchase (fx sales tax), transportation charges, installations costs etc.
- Additionally Operating assets are essential to a firm’s long-term future as they are
used to produce the goods and services that the company sells to its customers.
Acquisition price for assets bought together for a lump-sum
Group purchase: Several assets purchased with a lump-sum amount. The most common example
is in regards to the purchase of a building and the land under it. As buildings depreciate and lands
doesn’t the acquisition cost is measured separately - on the basis of the proportion of the fair market
value.
Example: January 1 company purchased a building and the land for $100.000. The
accountant established the value as:
Land $30.000
building $90.000
total $120.000
The purchase price should be allocated as follows:

To land: $100.000 x $30.000/$120.000 = $25.000
To building: $100.000 x $90.000/$120.000 = $75.000
Now we can make the journal entry on assets: Cash ($100.000) land $25.000 + building $75.000
Land improvements: Costs that are related to land but that have a limited life time. Example, paving a
parking lot or landscaping costs. Limited life, should be depreciated over their useful lives.
Capitalization of interest
Generally the interest on borrowed money should be treated as an expense for the
period, and not as part of the acquisition costs. Purchase of an asset is regarded as
investment, and this is separate from the financing of the asset.
If a company constructs an asset over time and borrows money to finance the construction the interest
incurred during the construction period is not treated as interest expense. Instead the interest must be
included as part of the acquisition cost of the asset. Interest on constructed assets is added to
the assets account.

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Depreciation
Systematic allocation of cost of an asset over its life

– Charged to Income Statement
– Cumulative amount charged is called
Accumulated depreciation supports the matching principle.
All the depreciation methods are based on the asset’s original acquisition cost. Additionally all
methods require two estimations- 1. the assets life 2. its salvage value.
Depreciable amount = Asset cost - salvage value

Management selects the method it believes best measures an
asset’s contribution to revenue over its useful life:
Example for calculation purposes:
Straight line:
Depreciation cost = (Acquisition Cost - Residual Value) / Life.
Book value : The original value of an asset minus the amount of

depreciation accumulated:
Partial year: If for instance a truck is bought on april 1, 2014 and you are asked to calculate
depreciation for 2014 and 2015:
Depreciation 2014: 2.400 * 9/12 = $1.800

Depreciation 2015: 2.400
Total $4.200.
Units of production method:
Depreciation is determined as a function of the number of units the asset produces.
Depreciation pr unit: acquisition cost - residual value / total number of units in assets
life.
Annual depreciation = depreciation per unit x units produced in the current year, thus
expenses vary based on number of units produced.

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Accelerated depreciation method:
In the cases where most cost should be allocated to the early years of an asset’s use and less to the later
years. The term accelerated depreciation method refers to several depreciation methods but one form is
double-declining-balance method.
Through this method, depreciation is recorded at twice the rate as straight-line method but the balance
is reduced each period.Thus first we need to find the straight line rate, lets say for 5 years. 100 % / 5
years = 20 %.
We double the percentage = 40%, This percentage is used in all years to the asset’s book value at the
beginning of each year. As depreciation is recorded, value declines. Thus, a constant rate is applied to a
declining amount. This constant rate is applied to the full cost or initial book value, not to cost
minus residual as the other methods. However, a machine cannot be depreciated beneath its value.
The amount for 2014 = Depreciation = beginning book value x 40 % —> 20.000 x 40% = 8000.
2015 = (20.000 - 8.000) x 40 % = 4.800.
Capital versus Revenue Expenditures
Capital expenditures: A cost that improves an asset and is added to the

asset account.
Revenue expenditure: A cost that maintains an asset in its normal
operating condition and is treated as an expense on the income statement.
The materiality of an expenditure must also be considered - most

companies establish a policy of treating an expenditure that is smaller
than a specified amount as a revenue expenditure (an expense on the
income statement).
An item is treated as a capital expenditure affects the amount of depreciation that should be recorded
over th asset’s remaining life. Example:
Disposal of Property, Plant and Equipment
Occurs when an asset is sold, traded or discarded. At this time, a company must
update depreciation to the date of sale and must calculate a gain or loss on the
disposal. A gain occurs when the selling price of the asset exceeds its book value. A
loss occurs when its lower.

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An asset is eliminated by either debiting accumulated depreciation or by crediting the

asset account.
Intangible assets
Intangible asset are long-lived and have no physical properties, but provide rights or privileges.
They are recorded at their acquisition costs.
Most common intangible assets:

– Patent: right to use, manufacture, or sell a product
– Copyright: right to reproduce or sell a published work
– Trademark: symbol or name that allows a product or service to be
identified
- Goodwill: excess purchase price to acquire a business over the
value of net assets acquired.
Research and development is NOT an intangible cost.
Acquisition costs of intangible assets include cost to acquire it and to prepare it for its intended use (i.e,
legal fees, registration fees, etc)
Example of Nike:
Amortization of Intangibles
Amortization involves allocating the acquisition cost of an intangible

asset to the periods benefited by the use of the asset. Most firms
use the straight line method of amortization.
• Intangibles with finite life must be amortized

– Recorded over the legal life or the useful life, whichever is shorter
– Mostly recorded using the straight-line method
• Intangibles with indefinite life are not amortized
Example:
Nike makes a patent worth $10.000, they believe it will last for 5 years. So recording $10.000/5 years
= $2.000
Accounting entry:
Patent Amortization expense debit 2000

Accumulated amortization - patent- credit 2000

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Income statement: expenses 2000 - net income (2000)

Assets: Accumulated amortization patent (2000) = Se (2000)
The Accumulated amortization account has increased. It is shown as a decrease in the equation because
it is a contra account and causes total assets to decrease.
Impairments:
A loss should be recorded when the value of the asset has declined. Xerox and Polaroid are trademarks
that has declined in value over time. Instead of recording the decline when the asset is sold, it is
recorded in the time period where the value decreased.
“loss on patent (8.000)” could be the entry for an expense.
An intangible asset should be checked each year for impairments.
Chapter 9
Current liabilities
• Obligation that will be satisfied within one year or within current operating cycle
• Normally recorded at face value and are important because they are indications of
a company’s liquidity
• Examples:
• Accounts payable
• Notes payable
• Current maturities of long-term debt
Accounts payable:
11. Amounts owed for inventory, goods, or services acquired in
the normal course of business
12. Usually do not require the payment of interest
13. Terms may be given to encourage early payment
14. Example: 2/10, n/30, which means that a 2% discount is
available if payment occurs within the first ten days
15. if payment is not made within ten days, the full amount must
be paid within 30 days
Notes payable:
• Amounts owed that are represented by a formal contract
• Formal agreement is signed by the parties to the transaction
• Arise from dealing with a supplier or acquiring a cash loan from a bank or creditor
• The accounting depends on whether the interest is paid on the note’s due date or
is deducted before the borrower receives the loan proceeds

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The accounting for notes payable depends on whether the interest is paid on the note’s due date or is
deducted before the borrower receives the loan proceeds.
Recording interest on notes payable:
Deducting a note
Recording current maturities on long-term assets

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Other accrued liabilities: include any amount incurred that has not yet been paid.
The amount of the salary payable would be classified as a current liability and could appear in a
category such as Other Accrued Expenses.

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IFRS and Current Liabilities:
• International accounting standards require companies to present

classified balance sheets with liabilities classified as either
current or long term
• U.S. standards do not require a classified balance sheet
Current liabilities on the statement of cash flows
Most current liabilities are reflected in the Operating activities of the statement of cash flows. If a
current liability increased during the period, the amount of the change should appear as a
positive amount - vice versa if decreased. Some may be reflected in the financing section, if not
directly linked to operation.
Contingent liabilities
A contigent liability is an existing item whose outcome is unknown because it is dependent on some
future event.
Contingent liabilities should be accrued and presented on the balance sheet if it is probable and if the
amount can be reasonably estimated.
Estimated liability: A contingent liability that is accrued and reflected on the balance sheet.
• Existing condition for which the outcome is not known but

depends on some future event
• Recorded if the liability is probable and the amount can be
reasonably estimated
• Accrued and reflected on the balance sheet if it is probable and if
the amount can be reasonably estimated
• Examples:

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• Premiums or coupons
• Lawsuits and legal claims
• Warranties and guarantees
Example: recording a liability for warranties:
IFRS

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Time value of money - Compounding of interest
A immediate amount should be preferred over an amount in the future because of the interest factor.
The amount can be invested, and the resulting accumulation will be larger than the amount received in
the future. Compound interest means that the interest is calculated on the principle plus
previous amounts of the accumulated interest.
Simple interest is calculated on the principle amount:

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Compound interest:
Future value of a single amount:

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Present value of a single amount
Future value of an annuity:
Annuity: A series of payments of equal amounts, with all payments occurring at equal time intervals.
Future value of an annuity: The amount accumulated in the future when a series of payments is
invested abd accrues interest.

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Present value of an annuity:
The amount at a present time that is equivalent ti a series of payments and interest in
the future:

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Solving for an interest rate:

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Chapter 10
Long-term liabilities.
Key learning objectvies for the chapter: Accounts for bonds payable, accounts for
leases
Current liabilities vs long-term liabilities

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Bonds payable:
A bond is a security or financial instrument that allows firms to

borrow large sums of money and repay the loan over a long period
of time.
Face value or par value: the principal amount of the bond as
stated on the bond certificate.
Face value or par value: the principal amount of the bond as stated on
the bond certificate
3 factors affecting the price of a bond:
1. Face rate of interest: also called stated rate, nominal rate, contract
rate, coupon rate
- The rate of interest on the bond certificate. The amount paid in
each period. Fx. $10.000 with 8% annual face rate of interest -
$800 ($10.000 x 8% x 1 year) will be paid at the end of each annual
period.

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2. Market rate of interest: also called effective rate, bond yield
• The rate that investors could obtain by investing in other bonds.

3. Bond issue price: the present value of the annuity of interest
payments plus the present value of the principal.
Premium or discount on bonds:
Calculating bond issuance at a discount:

Discount firm wants to issue bonds for 10.000. The face or coupon rate has been set at
8%. The bond pays interest annually, and the principal amount is due in four years.
Market rate is 10 %.
1. An annual interest payment of $800 ($10.000 x 8%) per four years.

2. Repayment of the principal amount of $10.000 at the end of the fourth year.
Using the tables from chapter 9: page 455.

$800 - 3.16987 (factor from table 9-4 for 4 periods, 10%) 2.536
$10.000 x 0.68301 (table 9.2 - 4 periods- 10%): 6.830.
issue price : $9.366

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Bond amortization:
The process of transferring an amount from the discount or premium account to

interest expense every time period.
Interest expense is higher than cash interest, because you get less money than the amount you have
to pay.
Discount amortized is the difference between total interest and cash interest.
We add this to the carrying value.
Effective interest method : this method results ion constant effective interest rate.
Carrying value: The face value of a bond plus the amount if unamortized premium or minus the
amount of unamortized discount.

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Column 1 indicates that cash interest to be paid is $800 ($10.000 x 8%).

Column 2: the annual interest expense at the effective rate of interest. Interest
expense is calculated by multiplying the carrying value as of the beginning of the
period by market rate of interest. In 2014, the interest expense is $937 ($9,366x10%).
This amount changes each year as the carrying value changes as discount is
amortized.
Column 3: The amount of discount amortized - the difference between the cash
interest in col 1 and the interest expense in col 2.
This amount also changes each year.
Column 4: Previous year’s carrying value + discount amortized in col. 3.
When bonds are issued at a discount, the carrying value starts at an amount less than face value and
increases each period until it reaches the face value amount. This is opposite for bonds issued with a
premium.
Recording the journal entries:

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Calculating a premium:

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Bond prices:
Redemption of bonds:
Redemption of bonds represents repayment of the principal. Redemption refers to retirement of bonds
by repayment of the principal. When bonds are retired on their due date, the accounting entry is not
difficult. Refer again to Discount firm from examples 10-1 and 10-3. If discount firm retires the bonds
on the due date of Dec. 31 2017 it must repay the principal of $10.000 and cash is reduced by $10.000.
No gain or loss is incurred because the carrying value of the bond at that point is $10.000.
A firm might want to retire the bonds before this date, however.

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Gain or loss on redemption: The difference between the carrying value and the
redemption price at the time bonds are redeemed.
• Retirement of bonds by repayment of the principal

16. If redeemed at maturity, no gain or loss occurs– If retired
before maturity, a gain or loss occurs
17. The gain or loss on bond redemption is shown on the

income statement
Liability for leases:
Contractual arrangement between two parties - Allows the lessee

the right to use an asset in exchange for making payments to its
owner, the lessor.
Capital lease criteria:

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• Lessee will record the present value of lease payments on its

books
18. Depreciated in accordance to the entity’s usual depreciation
policy
• Lease payments made will be set off against lease interest

expense, and remaining balance used to reduce the
outstanding lease payment
Calculating the amount to capitalize for a lease

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Lease amortization

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Accounting and Financial Analysis - Lecture notes, lectures 1

Accounting and Financial Analysis (Copenhagen Business School)

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Accounting and Financial analysis:

Accrual accounting – dobbeltentry book keeping - always two things going on -

If I loan the money, I increase the liability via credit.

1. Explain what a business is about:

Business - Consists of activities necessary to provide goods and services to members

2 . Distinguish among forms of organization:

Business entity: An organization operating to generate a profit

Non-business entities: Exists to serve segments of society. Governments entities or private

Sole proprietorship: A form of organization with a single owner

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Advantages with a corporation:

3. Describe the various types of business activities:

Financing activities: Borrowing or sale of stock

Capital stock: The dollar amount of stock sold to the public.

Operating activities: Sale of products/services + costs incurred to operate the

Accounting is a process of identifying, measuring and communicating economic information to

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Internal: Management, to facilitate planning and control.

5 step framework to make a financial decision

1. Formulate the question

The accounting equation

Assets = liabilities + Owners equity

Owners equity: The owners claims on the assets of an entity

At any time assets MUST equal liabilities and owners equitys

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Questions after a balance sheet:

Net income (profit, earnings) = Excess of revenue over expenses.

Net income - dividends = retained earnings.

The Statement of Cash Flows:

Relationship among the financial statements:

6. Identify and explain the primary assumptions made in preparing

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like a company’s shares in other companies.

7. Identify the various groups involved in setting accounting

Who determines the rules?

Securities and Exchange comission (SEC)) -

American Institute of Certified Public Accountants (AICPA) - Professional

Public Company Accounting Oversight Board (PCAOB) Five-member body

International Accounting Standards Board (IASB) Develop worldwide accounting

8. Explain the critical role that ethics plays in providing useful

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Relevant - Useful in the decision making process.

Financial Statements and the annual report.

1. Describe the objectives of financial reporting: To provide useful

2. Describe the qualitative characteristics of accounting information:

Understandability: Comprehensive to those willing to spend.

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Relevance: The capacity of information to make a difference in a decision.

Faithful representation: Complete, neutral (unbiased) and free from error.

3. Explain the purpose of a classified balance sheet.

A classified balance sheet separates both assets and liabilities into

Non current assets:

Contributed capital: Capital stock (owners investment) + Paid-in capital in excess of

Earned capital: retained earnings - net income minus dividends paid.

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4. Use a classified balance sheet to analyze a company’s financial

Liquidity: The ability of a company to pay its debts.

Current ratio: Current assets divided by current liabilities.

5. Explain the difference between single-step and a multiple-step