Financial Accounting
1
Introduction to Financial Accounting
Day 1
2
Module 1
Accounting Concepts
3
Learning Objectives
After this session, you should be able to:
•
•
•
•
•
Describe the components of the balance sheet.
Analyze the effect of transactions on the balance
sheet equation.
Compare the features of sole proprietorships,
partnerships, and corporations.
Describe the function of an audit.
Explain the regulation of financial reporting.
4
Introduction to Financial Accounting
•
•
•
•
Accounting as a process to provide information for decision makers
Financial accounting: to serve external decision makers
Management accounting: to serve internal decision makers
The Annual Report
Balance Sheet Equation
•
•
•
•
•
Assets = Liabilities + Equity
Asset side represents economic resources of a corporation
Liabilities represent economic obligations (to creditors) and how a company uses debt to
finance its assets
Owners’ equity shows investment by owners and residual economic ownership of company’s
resources
Basic transactions affecting Balance Sheet
Types of Ownership
•
•
•
Proprietorship
Partnership
Corporation
Function of an Audit
•
•
•
CPAs and the Auditor’s Opinion
Generally Accepted Accounting Principles (GAAP)
International Financial Reporting Standards (IFRS)
5
The Process of Accounting
• Accounting is the process of identifying, recording,
summarizing, and reporting economic information
for decision makers.
• Accountants present this information in reports
called financial statements.
Business
Event
Accountant’s
Analysis and
Recording
Financial
Statements
Users
6
Financial Accounting
Financial accounting serves external decision
makers:
•
•
•
•
Stockholders
Lenders and other Creditors
Suppliers and Customers
Government Agencies and Regulators
7
Management Accounting
Management accounting serves internal decision
makers:
•
•
•
•
•
Top executives (CEO, CFO, COO)
Board of Directors
Department Heads
Administrators
Other managers within the organization
8
The Annual Report
The annual report
is prepared by
management and
informs investors
about the
company’s past
performance,
current financial
state and future
prospects.
9
The Annual Report
• A letter from corporate
management.
• Management discussion and
analysis (MD&A).
• Footnotes explaining many
elements of the financial
statements in more detail.
• The report of the independent
auditors.
• A statement of management’s
responsibility for preparation of
the financial statements.
• Other corporate information.
10
The Annual Report
A company’s financial statements can also be
found in filings with the government regulator
The three major financial statements are the:
• Balance Sheet
• Income Statement
• Statement of Cash Flows
In addition, a company will file quarterly reports.
11
The Annual Report
The balance
sheet focuses
on the financial
position of a
company at the
end of a
reporting
period.
12
The Annual Report
The income
statement
and cash
flow
statement
focus on the
company’s
performance
over time.
13
The Balance Sheet
• The balance sheet (also called the statement of
financial position) shows the financial status of a
company at a particular instant in time.
• The left side lists the resources of the firm.
• The right side lists the claims against those resources.
Assets = Liabilities + Owners’ Equity
14
The Balance Sheet
• Assets are economic resources that the company
expects to help generate future cash inflows or reduce
or prevent future cash outflows.
• Examples: Cash, inventories, equipment
• Liabilities are economic obligations of the organization
to outsiders (creditors).
• Example: Bank debt in the form of a note payable
• Owners’ Equity shows the owners’ investments in the
company and any accumulated profits; should exactly
equal the difference between assets and liabilities.
15
The Balance Sheet
Open account – the practice of making most
purchases on a credit basis instead of cash basis.
Use of open accounts result in:
• Accounts receivable: assets that arise from the sale of
goods or services on an open account.
• Accounts payable: liabilities that result from a purchase
of goods or services on an open account.
16
Balance Sheet Transactions
Every transaction of a company or entity affects
the balance sheet equation.
• An entity is an organization that stands apart from
other organizations and individuals as a separate
economic unit.
• A transaction is any event that affects the financial
position of an entity and that can reliably recorded in
money terms.
17
Balance Sheet Transactions
• An account is a summary record of the changes in a
particular asset, liability, or owners’ equity item.
• The double-entry accounting system records each
transaction in at least two accounts.
• A compound entry affects more than two balance sheet
accounts.
18
Balance Sheet Transactions
Capital of $400,000 from Upstart founder Smith
Assets
=
Cash
(1)
+ $400,000
Liabilities
+
Owners’ Equity
Paid-in Capital
=
+$400,000
(Owners’ Investment)
19
Balance Sheet Transactions
Loan of $100,000 from Private Placement
Assets
=
Cash
Liabilities
Note payable
(1)
+ $400,000
=
(2)
+ $100,000
=
+ $100,000
$500,000
=
$100,000
Bal.
$500,000
+
Owners’ Equity
Paid-in Capital
+$400,000
$400,000
$500,000
20
Balance Sheet Transactions
Acquire Equipment for Cash, $15,000
Assets
Cash
Bal.
=
Equipment
$500,000
+
Note payable
=
(3)
-15,000
+15,000
=
Bal.
485,000
15,000
=
$500,000
Liabilities
Owners’ Equity
Paid-in Capital
$100,000
$400,000
100,000
$400,000
$500,000
21
Preparing the Balance Sheet
Upstart Company
Balance Sheet January 3, 2017
Assets
Cash
Equipment
Total Assets
Liabilities and Owners’ Equity
$485,000
15,000
$500,000
Liabilities (note payable) $100,000
Paid-in Capital
Total Liabilities
and Owners’ Equity
$400,000
$500,000
22
Types of Ownership
• Sole proprietorship – a business with a single owner.
• Partnership – an organization that joins two or more
individuals who act as co-owners.
• Corporation – a business organization created under
under national or state laws.
23
Advantages/Disadvantages of the Corporate Form
Advantages
• Limited liability
• Easy transfer of ownership
• Ability to raise capital
from hundreds or
thousands of potential
stockholders
• Continuity of existence
• Prestige
Disadvantages
• Tax laws ?
• Regulatory Burden
24
Accounting Differences Among Legal Forms
Proprietorships and partnerships:
•
•
Owners’ equities are labeled capital.
Owners’ equities are recorded in the capital account.
Corporations:
•
Owners’ equities are labeled stockholders’ equity or
shareholders’ equity.
•
Owners’ equity is recorded in two parts:
• Common stock at par value.
• Paid-in capital in excess of par value.
25
The Meaning of Par Value
• Par value (or stated value) – the dollar amount printed on
the stock certificate.
• Paid-in capital in excess of par value (or additional paid-in
capital) – the difference between the total amount the
company receives for the stock and the par value.
• Common stock is recorded at the par value.
• Common shareholders are owners who have a “residual”
ownership in the corporation through the purchase of
common stock.
26
Stockholders / Board of Directors
• Shareholders elect a board of directors to look out
for their interests.
• Members of a board often include CEOs and
presidents of other corporations; university
presidents and professors; attorneys; and
community representatives .
• The chairman of the board may also be the top
manager, the chief executive officer (CEO).
• Minimum number of outside/independent
directors.
27
Stockholders / Board of Directors
•
•
The board’s duty is to ensure that managers act in
the interest of shareholders.
When boards do their duty in monitoring
management, the corporate form of organization is
effective.
Stockholders
Board of Directors
Managers
28
Certified Public Accountants and Auditor’s Opinion
•
•
•
Third party assurance about the credibility of
financial statements is provided by audit
professionals called Certified Public Accountants
(CPAs).
CPAs are public accountants who offer services
including auditing, preparing income taxes, and
consulting on a fee basis.
In most countries there are National Boards that
charter Public Accountants.
29
Global Standard Setting Bodies
The International Accounting Board (IASB):
•
•
Is responsible for developing high quality,
understandable and enforceable global accounting
standards; International Accounting Standards (IAS).
Standards agreed to in 2002 have been adopted by
the European Union and over a hundred countries
worldwide.
30
Global Standard Setting Bodies
The International Federation of Accountants (IFAC):
•
•
IFAC is the global organization for the accountancy
profession dedicated to serving the public interest by
strengthening the profession and contributing to the
development of strong international economies.
IFAC is comprised of over 175 members and
associates in more than 130 countries and jurisdictions,
representing almost 3 million accountants in public
practice, education, government service, industry, and
commerce.
31
Exercises
Emirates Group reported total assets of $17 billion and total liabilities of
$14 billion at the end of 20X0.
1. Construct the balance sheet equation for Emirates at the end of 20X0
and include the correct amount for owners’ equity.
2. Suppose that during January 20X1 Emirates borrowed $2 million from
First Gulf Bank . How would this affect Emirates’ assets, liabilities, and
owners’ equity?
32
Exercises
Review Table of Contents of Starbucks 10-K
1. For Starbucks identify the amount of cash (including cash equivalents,
if any) shown on the most recent balance sheet.
2. What were the total assets shown on the most recent balance sheet,
and the total liabilities plus stockholders’ equity? How do these two
amounts compare?
3. Identify (a) total liabilities, and (b) total stockholders’ equity. (Assume
that all items on the right side of the balance sheet that are not explicitly
listed as stockholders’ equity are liabilities.)
Compare the size of the liabilities to stockholders’ equity, and comment
on the comparison. Write the company’s accounting equation, as of the
most recent balance sheet date, by filling in the dollar amounts.
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34
35
Module 2
Measuring Income
36
Learning Objectives
After this session, you should be able to:
•
•
•
•
•
Explain how accountants measure income.
Determine when a company should record revenue
from a sale.
Use the concept of matching to record the expenses
for a period.
Demonstrate how an income statement is related to
a balance sheet.
Account for cash dividends and prepare a statement
of retained earnings.
37
The Income Statement
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Meaning of income
Operating cycle
Accounting time period
Revenues
Expenses
Revenue Recognition and the Matching Concept
•
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Revenue recognition: earned versus realized
Expired Assets
Relationship between balance sheet and income statement
•
•
Expanded Balance Sheet Equation
Cash dividends
Statement of Retained Earnings
•
•
Definition
Calculation
Earnings per Share
•
•
Definition
Calculation
38
Measuring Income
• Income is a measure of the increase in the “wealth”
of an entity over a period of time.
• Accountants have agreed on a common set of rules
for measuring income and wealth.
• Income is generated primarily through the operating
cycle of a company.
39
Operating Cycle
Starts with
Cash
$100,000
Buys Merchandise
Merchandise
Accounts
Sells Merchandise
Inventory
Receivable
$100,000
$160,000
Collects Cash
40
The Accounting Time Period
• Companies measure their performance over
discrete time periods.
• The calendar year is the most common time period
for measuring income or profits.
• About 40% of large companies use a fiscal year that
differs from a calendar year.
41
The Accounting Time Period
• The fiscal year-end date is often the low point in
annual activity when inventories can be counted
more easily.
• Companies also prepare financial statements for
interim periods.
• Interim periods may be for a month or a quarter (3month period).
42
Revenues and Expenses
• Revenues and expenses are the key inflows and
outflows of assets that occur during a business’s
operating cycle.
• Revenues are the amount of assets received in
exchange for the delivery of goods or services to
customers.
• Expenses are measures of the assets that a company
gives up or consumes in order to deliver goods or
services to a customer.
43
Revenues and Expenses
• Income is the excess of revenues over expenses.
• Profits or earnings are common synonyms for
income.
• Retained earnings are the total cumulative equity
generated by income.
44
Revenues and Expenses
Sales on open account for the entire month of January
amount to $160,000. The cost of the inventory sold is
$100,000.
Assets
Accounts Receivable
= Liabilities + Owners’ Equity
Merchandise Inventory
Sales +160,000
Cost of
inventory
sold
-100,000
Retained Earnings
=
+160,000
(sales revenues)
=
-100,000
(cost of goods
sold expenses)
45
Revenues and Expenses
• Accounts receivable are the amounts owed by
customers as a result of delivering goods or services
on account in the ordinary course of business.
• Cost of goods sold (COGS) expense for retailers and
wholesalers is the original acquisition cost of the
inventory that a company sells to customers during
the reporting period. For manufacturers, it also
includes directly attributable production costs.
46
Accrual Basis and Cash Basis
• The accrual basis recognizes the impact of
transactions in the financial statements for the time
periods when revenues and expenses occur.
• Accountants record revenue as a company earns it,
and they record expenses as the company incurs
them.
• More on this in subsequent modules.
47
Accrual Basis and Cash Basis
• The cash basis recognizes the impact of transactions
in the financial statements only when a company
receives or pays cash.
• The accrual basis is the best basis for measuring
economic performance.
48
Recognition of Revenues
Revenues are recognized:
•
When they are earned.
• A company earns revenues when it delivers goods or services
to customers.
•
And when they are realized.
• A company realizes revenues when it receives cash or claims
to cash in exchange for goods or services.
49
Matching Principle
There are two kinds of expenses in every accounting
period:
•
•
Product costs are those linked with the revenues earned
that period (cost of goods sold to customers).
Period costs are those linked with the time period itself
(e.g., rent, salaries, insurance, etc.).
Matching occurs when the expenses incurred in a period
are matched to the revenues generated in the same
period.
50
Applying Matching
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•
•
•
•
Assets that help generate revenues across multiple
periods also wear out (equipment, furniture, buildings).
The “wearing out” of these tangible assets is accounted
for as depreciation.
Depreciation is the systematic allocation of the
acquisition cost of long-lived assets to the periods that
benefit from the use of the assets.
Land is not subject to depreciation because it does not
deteriorate over time.
Depreciation will be examined in detail in a subsequent
module but let’s take a look at an example.
51
Applying Matching
The following transaction records depreciation expense.
Assets
Equipment
Recognize depreciation expense
-100
= Liabilities + Owners’ Equity
=
=
Retained Earnings
-100
(increase depreciation
expense)
52
Applying Matching
We can account for the purchases and uses of goods
and services in two basic steps:
• The acquisition of the assets.
• The use or expiration of the assets as expenses.
Acquisition of assets affects the balance sheet.
• The subsequent use or expiration of the assets are
expenses affecting both balance sheet and income
statement.
• Expense accounts are deductions from stockholders’
equity.
53
Recognition of Expired Assets
Acquisition
ASSETS
(Inventory,
Prepaid Rent, Equipment)
Unexpired Costs
Expiration
Instantaneously
or Eventually
Become
EXPENSES
(Cost of Goods Sold,
Rent, Depreciation,
Other Expenses)
Expired Costs
54
Expanded Balance Sheet Equation
(1) Assets
=
Liabilities + Stockholders’ Equity
(2) Assets
=
Liabilities + Paid-in Capital + Retained Earnings
(3) Assets
=
Liabilities + Paid-in Capital + Revenues - Expenses
55
Expanded Balance Sheet Equation
• The income statement collects all the changes in
owners’ equity for the accounting period and
combines them in one place.
• Revenue and expense accounts are nothing more
than subdivisions of stockholders’ equity –
temporary stockholders’ equity accounts.
56
The Income Statement
• An income statement is a report of all revenues and
expenses pertaining to a specific time period.
• Net income = revenues minus all expenses.
• A net loss occurs if expenses exceed revenues.
57
Income Statement and Balance Sheet
• A balance sheet shows the financial position of the
company at a discrete point in time.
• An income statement explains the changes that take
place between those points in time.
58
Income Statement and Balance Sheet
Balance Sheet
December 31
20X1
Balance Sheet
January 31
20X2
Income
Statement
For January
Balance Sheet
February 28
20X2
Income
Statement
For February
Balance Sheet
March 31
20X2
Income
Statement
For March
Time
Time
Income Statement for Quarter Ended March 31, 20X2
59
Cash Dividends
• Are distributions of some of the company’s assets
(cash) to stockholders.
• Reduce Cash and Retained Earnings.
• Are not expenses—they are transactions with
stockholders.
60
Cash Dividends
Cash dividends of $50,000 are disbursed to stockholders
Assets
Declaration and
payment of cash
dividends
= Liabilities + Owners’ Equity
Cash
=
-50,000
=
Retained Earnings
-50,000
(dividends)
61
Cash Dividends
A cash dividend involves three important dates:
•
•
•
•
Declaration date—the date on which the board of
directors declares the dividend.
Ex-dividend date—first day on which a stock trades
without entitling the buyer to receive the dividend
(differs from Record date due to lag in settlement of
shares).
Record date—stockholders owning the stock on this
date receive the dividend.
Payment date—the date on which the corporation
pays the dividend.
62
Retained Earnings and Cash
In order to pay a cash dividend, a corporation
needs:
•
•
Cash
Retained Earnings
Cash and Retained Earnings are two entirely
separate accounts, sharing no necessary
relationship.
•
Retained earnings reflects profits that have not been
distributed to the owners of the company.
63
Statement of Retained Earnings
The annual statement of retained earnings consists
of the:
Beginning balance
+ Addition of net income
- Deduction of dividends
= Ending balance
A net loss (negative net income) is subtracted from
the beginning balance of retained earnings.
Negative retained earnings is called an accumulated
deficit.
64
Statement of Retained Earnings
Retained earnings, January 31, 20X2
Add: Net income for month of February
Total
Less: Dividends declared
Retained earnings, February 28, 20X2
•
•
$ 57,900
63,900
$121,800
50,000
$ 71,800
Some companies add the statement of retained
earnings to the bottom of the income statement.
The next slide shows a combined statement of
income and retained earnings.
65
Statement of Retained Earnings
Sales
Deduct expenses:
Cost of goods sold
$110,000
Rent
2,000
Depreciation
100
Net income
Retained earnings, January 31, 20X2
Total
Less: Dividends declared
Retained earnings, February 28, 20X2
$176,000
112,100
$ 63,900
57,900
$121,800
50,000
$ 71,800
66
Statement of Retained Earnings
Note how the combined statement of income and
retained earnings is anchored to the balance sheet
equation.
Assets
=
Liabilities +
Paid-in Capital
+
Retained earnings
[Beginning balance + Revenues - Expenses - Dividends]
[57,900
+ 176,000 - 112,100 - $50,000]
Ending Retained Earnings Balance = $71,800
67
Earnings Per Share (EPS)
Net Income
EPS =
Average number of shares outstanding
•
•
EPS tells investors how much of a period’s net
income “belongs to” each share of common stock.
Investors should consider a company’s future EPS
before deciding whether to buy the company’s
common shares.
68
Exercises
Financial Statement Research: Starbucks Annual Report
1. What was the amount of sales (or total revenues) and the
net income for the most recent year?
2. What was the total amount of cash dividends for the most
recent year?
3. What was the ending balance in retained earnings in the
most recent year? What were the two most significant items
during the year that affected the retained earnings balance?
69
Exercises
A clothing manufacturer had the following transactions during
June 20X1:
a. Collections of accounts receivable, $75,000.
b. Payment of accounts payable, $45,000.
c. Acquisition of inventory, $18,000, on open account.
d. Sale of merchandise, $30,000 on open account and $23,000
for cash. The sold merchandise cost the manufacturer$28,000.
e. Depreciation on equipment of $1,000 in June.
f. Declared and paid cash dividends of $15,000. Use the balance
sheet equation format to enter these transactions into the
books of the manufacturer. Suppose that that the manufacturer
has a cash balance of $15,000 at the beginning of June. What
was the cash balance on June 30?
15,000 + 75,000 -45,000 + 23,000 – 15,000 = 38,000
70
71
Module 3
Recording
Transactions
72
Learning Objectives
After this session, you should be able to:
•
•
•
•
•
Explain the double entry accounting system.
Analyze and journalize transactions.
Post journal entries to the ledgers.
Prepare and use a trial balance.
Explain the accounting adjustments required at the
end of the fiscal period.
73
Double–entry system
•
•
•
•
Ledger accounts
T-accounts
Debit-left
Credit-right
Recording Process
•
•
•
•
•
General journal
Journal entries
Ledger
Revenue and Expense transactions
Prepaid Expenses and Depreciation
Trial Balance
•
•
•
Ledger accounts
Closing the accounts
Errors
74
The Double-Entry Accounting System
•
•
In the double-entry system, every transaction affects
at least two accounts
After each transaction, the balance sheet equation
must always remain in balance
Assets = Liabilities + Owners’ Equity
•
This balance sheet format is too cumbersome for
recording each and every transaction
75
Ledger Accounts
• The elements of transactions are organized into
accounts that group similar items together
• In a double-entry system, a ledger contains the
records for a group of related accounts
• A general ledger is the collection of accounts that
accumulate the amounts reported in the financial
statements
76
Ledger Accounts
•
A T-account is a simplified version of accounts used
in practice.
Cash
Left side
(Increases in cash)
•
•
Right side
(Decreases in cash)
The vertical line in the T divides the account into left
and right sides for recording increases and
decreases.
The account title is on the horizontal line.
77
Ledger Accounts
The T-accounts for the first three Upstart transactions are as
follows:
Assets
=
Liabilities + Stockholders’ Equity
Cash
Increases
(1)
400,000
(2)
100,000
Decreases
(3)
150,000
Merchandise Inventory
Increases
(3)
150,000
Decreases
Note Payable
Decreases
Increases
(2)
100,000
Paid-in Capital
Decreases
Increases
(1)
400,000
78
Ledger Accounts
• Each transaction affects at least two accounts.
• The process of creating a new T-account in preparation for
recording a transaction is called opening the account.
• An account balance is the difference between the total leftside and right-side amounts at any particular time.
Cash
10,000
6,000
Balance 4,000
79
Ledger Accounts
Asset accounts have left-side balances:
•
•
Entries on the left side increase asset account
balances.
Entries on the right side decrease them.
Liabilities and owners’ equity accounts have
right-side balances:
•
•
Entries on the right side increase their balances.
Entries on the left side decrease them.
80
Debits and Credits
Accountants use the terms:
•
•
•
Debit (abbreviated Dr.) to denote an entry on the
left side of any account.
Credit (abbreviated Cr.) to denote an entry on the
right side of any account.
Some accountants use the word “charge” instead of
debit.
Cash
Dr.
Cr.
81
The Recording Process
The sequence of five steps in recording and
reporting transactions is as follows:
Transactions
Documentation
Journal
Ledger
Trial
Balance
Financial
Statements
Source documents are the original records of any
transaction.
82
The Recording Process
• The general journal is a formal chronological listing
of each transaction and how it affects the balances
in the accounts.
• Transactions are entered into the ledger accounts.
• The trial balance is a simple listing of the accounts in
the general ledger together with their balances.
• Preparation of financial statements occurs at least
once a quarter for publicly traded companies.
83
Chart of Accounts
• A chart of accounts is a
numbered or coded list of
all account titles.
• Account numbers are used
as references in the Post
Ref. column of the journal.
_______________________________________________________________
Account
Account
Account
Account
Number
Title
Number
Title
100
Cash
202
Note payable
120
Accounts receivable
203
Accounts payable
130
Merchandise inventory 300
Paid-in capital
140
Prepaid rent
400
Retained earnings
170
Equipment
500
Sales revenues
170A
Accumulated
600
Cost of goods sold
(Contra
depreciation,
601
Rent expense
Account) equipment
602
Depreciation expense
_______________________________________________________________
84
Journalizing Transactions
• Journalizing is the process of entering transactions
into the general journal.
• A journal entry is an analysis of all the effects of a
single transaction on the various accounts, usually
accompanied by an explanation.
• A compound entry means that a single transaction
affects more than two accounts.
85
Journalizing Transactions
The following conventions
are used for recording in
the general journal:
• The title of the account or
accounts to be debited are
placed at the left margin.
• The title of the account or
accounts to be credited are
indented in a consistent way.
Entry
Date No.
20X1
12/31
12/31
20X2
1/2
1
2
3
Accounts and Explanation
Post.
Ref.
Cash
100
Paid-in capital
300
Capital stock issued to Smith
Debit
Credit
400,000
400,000
Cash
100
100,000
Note Payable
202
Borrowed at 9% interest on a one year note
100,000
Merchandise Inventory
Cash
Acquired inventory for cash
150,000
130
100
150,000
86
Journalizing Transactions
The following conventions
are used for recording in
the general journal:
• The journal entry is followed
by the narrative explanation
of the transaction.
• The Post. Ref. column
contains an identifying
number that is assigned to
each account and is used for
cross-referencing to the
ledger accounts.
Entry
Post.
Date No. Accounts and Explanation Ref.
Debit
20X1
12/31
400,000
12/31
20X2
1/2
1
2
3
Cash
100
Paid-in capital
300
Capital stock issued to Smith
Credit
400,000
Cash
100
100,000
Note Payable
202
Borrowed at 9% interest on a one year note
100,000
Merchandise Inventory
130
Cash
100
Acquired inventory for cash
150,000
150,000
87
Journalizing Transactions
The following conventions
are used for recording in
the general journal:
• The debit and credit
columns are for recording
the dollar amounts that are
debited or credited for each
account.
Entry
Post.
Date No. Accounts and Explanation Ref.
Debit
20X1
12/31
400,000
12/31
20X2
1/2
1
2
3
Cash
100
Paid-in capital
300
Capital stock issued to Smith
Credit
400,000
Cash
100
100,000
Note Payable
202
Borrowed at 9% interest on a one year note
100,000
Merchandise Inventory
130
Cash
100
Acquired inventory for cash
150,000
150,000
88
Posting Transactions to the Ledger
Posting is the transferring of amounts from the
journal to the appropriate accounts in the ledger.
The following example shows:
•
•
How the debit to merchandise inventory and the
credit to cash are posted.
Columns for dates, explanations, journal references,
and amounts in the ledger.
89
Posting Transactions to the Ledger
Date
20X1
12/31
12/31
20X2
1/2
Entry
Post.
No. Accounts and Explanation Ref.
1
2
3
Cash
100
Paid-in capital
300
Capital stock issued to Smith
Debit
400,000
400,00
Cash
100
100,000
Note Payable
202
Borrowed at 9% interest on a one year note
100,000
Merchandise Inventory
130
Cash
100
Acquired inventory for cash
150,000
150,000
CASH
Date
Explanation
20X1
12/31
12/31
Date
20X2
1/2
Credit
Journ.
Ref.
1
2
Explanation
Debit
Date
Expanation
20X2
400,000 1/2
100,000
MERCHANDISE INVENTORY
Journ.
Ref.
Debit
Date
Expanation
3
Account No. 100
Journ.
Ref.
Credit
3
150,000
Account No. 130
Journ.
Ref.
Credit
150,000
90
Posting Transactions to the Ledger
• Cross-referencing is the process of using numbering,
dating, and/or some other form of identification to
relate each ledger posting to the appropriate journal
entry.
• A single transaction from the journal might be
posted to several different ledger accounts.
• Cross-referencing allows users to find all the
components of the transactions in the ledger no
matter where they start.
91
Revenue and Expense Transactions
Ignoring dividends, T-accounts can be grouped as follows:
Assets
+
Debit
Credit
=
Liabilities
Debit
+
Credit
+
Paid-in Capital
Debit
+
Credit
+ Retained
Earnings
+
Debit
Expenses
+
Debit
Credit
Revenues
+
Credit
92
Revenue and Expense Transactions
• Revenue and expense information is accumulated
separately to prepare a more meaningful income
statement.
• Expense and revenue accounts eventually become
part of Retained Earnings.
• We can think of:
• Revenue accounts increase retained earnings.
• Expense accounts decrease retained earnings.
93
Revenue and Expense Transactions
Transaction: Sales on credit, $160,000.
Analysis : The asset account Accounts Receivable increases.
The stockholders’ equity account Sales Revenues increases.
Journal Entry: Accounts receivable……….160,000
Sales revenues…………...160,000
Posting:
Accounts Receivable
160,000
Sales Revenues
160,000
94
Revenue and Expense Transactions
Transaction: Cost of merchandise sold, $100,000.
Analysis : The asset Merchandise Inventory decreases
Stockholders’ equity decreases because an expense account,
Cost of Goods Sold (a negative stockholders’ account).
increases
Journal Entry: Cost of Goods Sold………………..100,000
Merchandise Inventory…………100,000
Posting:
Merchandise Inventory
100,000
Cost of Goods Sold
100,000
95
Prepaid Expenses
Transaction: Paid rent for 3 months in advance, $6,000.
Analysis: The asset Cash decreases.
The asset Prepaid Rent increases.
Journal Entry: Prepaid rent………………..6,000
Cash……………………6,000
Posting:
Cash
Prepaid Rent
6,000
6,000
96
Prepaid Expenses
Transaction: Recognized expiration of rental services, $2,000.
Analysis : The asset Prepaid Rent decreases.
The negative stockholders’ equity account Rent Expense.
increases
Journal Entry: Rent expense………………..2,000
Prepaid Rent…………………. 2,000
Posting:
Prepaid Rent
6,000
2,000
Rent Expense
2,000
97
Depreciation Transactions and Contra Accounts
Transaction: Recognized depreciation, $100.
Analysis : The asset reduction account Accumulated Depreciation,
Equipment increases.
The negative stockholders’ equity account Depreciation Expense
increases.
Journal Entry: Depreciation expense………………………………100
Accumulated depreciation, equipment………100
Posting:
Accumulated Depreciation,
Equipment
100
Depreciation Expense
100
98
Depreciation Transactions and Contra Accounts
Asset:
Equipment
Contra Account: Accumulated depreciation, equipment
Net asset:
Book value
$14,000
100
$13,900
The book value or carrying value is the balance
of an account minus the value of any contra
accounts.
99
Preparing the Trial Balance
A trial balance is a list of all the accounts with
their balances.
The trial balance has two main objectives:
•
•
Proving whether the total debits equal the total
credits in the ledger.
Summarizing the balances in the ledger accounts in
preparation to construct the financial statements.
100
Preparing the Trial Balance
Cash
Accounts receivable
Merchandise Inventory
Prepaid Rent
Store equipment
Accumulated depreciation,
store equipment
Note payable
Accounts payable
Paid-in capital
Retained earnings
Sales revenues
Cost of goods sold
Rent expense
Depreciation expense
Total
Debits
$ 336,700
160,300
59,200
4,000
14,000
Credits
$
100,000
2,000
100
$ 676,300
100
100,000
16,200
400,000*
0
160,000
$ 676,300
*Retained earnings in the trial balance does not yet reflect the income for the period.
101
Preparing the Trial Balance
The trial balance is prepared with the accounts in
the following order:
•
•
•
Asset accounts
Liability accounts
Stockholders’ equity accounts
• Revenue accounts
• Expense accounts
The trial balance is the foundation for preparing
the balance sheet and the income statement.
102
Deriving Financial Statements from the Trial Balance
Cash
Accounts receivable
Merchandise Inventory
Prepaid Rent
Store equipment
Accumulated depreciation,
store equipment
Note payable
Accounts payable
Paid-in capital
Retained earnings
Sales revenues
Cost of goods sold
Rent expense
Depreciation expense
Total
Debits
$ 336,700
160,300
59,200
4,000
14,000
Credits
$
100,000
2,000
100
$ 676,300
100
100,000
16,200
400,000
0
160,000
Balance
Sheet
Income
Statement
$ 676,300
103
Closing the Accounts
Closing the accounts has two purposes:
•
•
It transfers the balances of the “temporary”
stockholders’ equity accounts (revenues and
expenses) to the “permanent” stockholders’ equity
account (retained earnings) .
It makes the revenues and expense accounts have a
zero balance, which readies them for the next
period’s transactions.
104
Closing the Accounts
Cost of Goods Sold
Bal. 100,000
There are three closing entries:
C1: Close all revenue accounts.
C2 100,000
C2: Close all expense accounts.
0
C3: Close the Income Summary account.
Rent Expense
Bal.
2,000
C2
Sales
Income Summary
2,000
0
C2
102,100
C3
57,900
C1
160,000
C1
160,000
Bal. 160,000
0
0
Depreciation Expense
Bal.
100
0
C2
Retained Income
100
Bal
C3
0
57,900
New bal. 57,900
105
Closing the Accounts
C1. Transaction: Clerical procedure of transferring the ending balances of revenue
accounts to the Income Summary account.
Analysis : The stockholders' equity account Sales decreases to zero.
The stockholders’ equity account Income Summary increases.
Journal Entry: Sales………………………160,000
Income Summary……………..160,000
C2. Transaction: Clerical procedure of transferring the ending balances of expense
accounts to the Income Summary account.
Analysis : The negative stockholders’ equity (expense) accounts Cost of Goods
Sold, Rent Expense, etc. decrease to zero.
The stockholders’ equity account Income Summary decreases.
Journal Entry: Income Summary……………102,100
Cost of goods sold…………………100,000
Rent expense………………………….2,000
Depreciation expense…………………..100
106
Closing the Accounts
C3. Transaction: Clerical procedure of transferring the ending balance of Income
Summary account to the Retained Earnings account.
Analysis : The stockholders' equity account Income Summary decreases to
zero.
The stockholders’ equity account Retained Earnings increases.
Journal Entry: Income summary…………57,900
Retained earnings…………57,900
107
Effects of Errors
If an error is detected after posting to the ledger
accounts, a correcting entry must be made.
The following is an example of a correcting entry:
CORRECT ENTRY
ERRONEOUS ENTRY
CORRECTING ENTRY
12/27 Repair Expense
Cash
500
12/27 Equipment
Cash
500
12/31 Repair Expense
Equipment
500
500
500
500
The correcting entry cancels or offsets the erroneous
debit to Equipment.
108
Some Errors are Temporary Errors—Others Persist
Until Corrected
• Some errors in one period are automatically
corrected in the next period.
• Such errors misstate net income in both periods.
• By the end of the second period the errors
counterbalance or cancel each other out.
• They affect the balance sheet of only the first
period—not the second.
• Some errors will keep subsequent balance sheets in
error until correcting entries are made.
109
Exercises
For each of the following accounts, indicate whether it normally possesses a debit or a
credit balance :
1. Sales
2. Supplies Expense
3. Accounts Receivable
4. Accounts Payable
5. Supplies Inventory
6. Retained Earnings
7. Dividends Payable
8. Depreciation Expense
9. Paid-in Capital
10. Subscription Revenue
11. Equipment
12. Accumulated Depreciation
13. Cost of Goods Sold
14. Prepaid Rent
110
Exercises
True or False?
1. Repayments of bank loans should be charged to Notes
Payable and credited to Cash.
2. Cash payments of accounts payable should be recorded by a
debit to Cash and a credit to Accounts Payable.
3. Inventory purchases on account should be credited to
Accounts Payable and debited to an expense account.
4. All credit entries are recorded on the right side of accounts
and represent decreases in the account balances.
5. Cash collections of accounts receivable should be debited to
Cash and credited to Accounts Receivable.
6. Credit purchases of equipment should be debited to
Equipment and charged to Accounts Payable.
111
Retailer Transactions Excel Exercise
112
113
Financial Accounting Professional Certificate
Day 2
114
Module 4
Accrual Accounting
and Financial
Statement Formats
115
Learning Objectives
After this session, you should be able to:
•
•
•
•
•
•
Explain the role of adjustments in accrual
accounting.
Explain the difference between explicit and implicit
transactions.
Describe the components of a Classified Balance
Sheet.
Prepare a Classified Balance Sheet.
Describe the components of a Single- and Multiplestep Income Statement .
Prepare a Multiple-step Income Statements.
116
Adjustments to accounts
•
•
•
Explicit transactions
Implicit transactions
Accruals
Implicit transactions
•
•
•
•
Expiration of unexpired costs
Earning of revenues received in advance
Accrual of unrecorded expenses
Accrual of unrecorded revenues
Classified Balance Sheet
•
•
•
•
Assets
Liabilities
Equity
Format
Income Statement
•
•
Single-step
Multi-step
117
Adjustments to the Accounts
Explicit transactions are:
•
•
Observable events that trigger nearly all day-to-day
routine entries.
Supported by source documents.
Implicit transactions:
•
•
•
Do not generate source documents or any visible
evidence that the event actually occurred.
Are recorded in end-of-period entries called
adjustments.
Adjusting entries are prepared after the trial balance
and before financial statements.
118
Adjustments to the Accounts
• Adjustments help assign the financial effects of
implicit transactions to the appropriate time
periods.
• Accrue means to accumulate a receivable (asset) or
payable (liability) during a given period even though
no explicit transaction occurs.
119
Adjustments to the Accounts
Adjustments arise from four basic types of
implicit transactions:
•
•
•
•
Expiration of unexpired costs.
Earning of revenues received in advance.
Accrual of unrecorded expenses.
Accrual of unrecorded revenues.
120
Expiration of Unexpired Costs
•
•
An explicit transaction in the past creates an asset,
and subsequent implicit transactions serve to adjust
the value of the asset.
Suppose a company purchases $10,000 of Office
Supplies Inventory on March 1, 2018. The journal
entry to record this explicit transaction is:
Office Supplies Inventory
Cash
$10,000
$10,000
121
Expiration of Unexpired Costs
•
The company uses $1,500 of the Office Supplies
Inventory during the month. The following adjusting
entry is required to increase Office Supplies Expense
(debit) and reduce Office Supplies Inventory (credit):
Office Supplies Expense
Office Supplies Inventory
•
$1,500
$1,500
Failure to make this adjusting entry will overstate
assets and understate expenses.
122
Expiration of Unexpired Costs
Buyer
Assets
(Prepaid
Expense)
Appear in the
Balance Sheet
Adjustments
Expenses
Incurred
Appear in the
Income Statement
123
Earning of Revenues Received in Advance
Unearned revenue (revenue received in advance
or deferred revenue):
•
•
Represents payments from customers who pay in
advance for goods or services that the company
promises to deliver at a future date.
Requires recording both the receipt of cash and the
liability for future services.
124
Earning of Revenues Received in Advance
A company receives rent for three months in
advance, $6,000.
The journal entries below represent:
•
•
An explicit transaction that recognizes the receipt of
unearned revenue.
A transaction showing the adjustment for one month’s
rent earned.
Cash
6,000
Unearned rent revenue
Unearned rent revenue
2,000
Rent revenue
6,000
2,000
125
Earning of Revenues Received in Advance
•
•
•
The revenue is recognized (earned) only when the
owner makes the adjusting entries in the second
transaction.
The liability, Unearned Rent Revenue, is decreased
(debited), the stockholders’ equity account Rent
Revenue is increased (credited).
Failure to record the adjusting entry overstates
liabilities and understates revenues.
126
Earning of Revenues Received in Advance
Seller
Liabilities
(Unearned
Revenue)
Appear in the
Balance Sheet
Adjustments
Revenues
Earned
Appear in the
Income Statement
127
Accrual of Unrecorded Expenses
• Some liabilities (and expenses) grow moment to
moment with the passage of time. Examples include:
• Wages
• Interest
• Income taxes
• Adjustments are made to bring each accrued expense
(and corresponding liability) account up to date at the
end of the period before preparation of the financial
statements.
• Adjustments are necessary to accurately match the
expense to the period.
128
Accounting for Accrual of Wages
•
•
•
Assume a company owes $30,000 for employee
services rendered during the last 3 days of the
month of January, but will not pay the employees
for these services until Friday, February 2.
Assume the company also wants to properly record
the expenses for the month of January.
The following transaction shows the entry to accrue
wages for Monday, January 29, through Wednesday,
January 31:
129
Accounting for Accrual of Wages
•
The transaction recognizes both an expense and a
liability.
Wages expense
Accrued wages payable
•
30,000
30,000
Failure to record the adjustment understates both
expenses and liabilities.
130
Accrual of Interest
• Interest is the “rent” paid for the use of money.
• Interest accumulates (accrues) as time passes,
regardless of when a company actually pays cash for
interest.
• Assume a company borrows $100,000 on December
31, 2018, and the terms of the loan are:
• 9% annual interest.
• Repayment of the loan amount of $100,000 plus interest on
December 31, 2019.
131
Accrual of Interest
Calculation of interest for any part of a year is as
follows:
Principal x Interest rate x Fraction of a year = Interest
For the full year, the interest is:
$100,000 x .09 x 1 = $9,000
132
Accrual of Interest
As of January 31, the amount of interest owed is
1/12 x .09 x $100,000 = $750
The adjusting journal entry is:
Interest expense
Accrued interest payable
750
750
Failure to record the adjustment understates
both liabilities and expenses.
133
Accrual of Unrecorded Revenues
•
•
The accrual of unrecorded revenues is the mirror
image of the accrual of unrecorded expenses.
An adjustment is required to recognize revenues
earned but not received in cash.
134
Accrual of Unrecorded Revenues
• Assume a law firm renders $10,000 of services
during January, but does not bill for these services
until March 31.
• The following adjustment is made for unrecorded
revenues for the month of January:
Accrued (Unbilled) Fees Receivable
Fee Revenue
10,000
10,000
• Failure to make this adjustment understates both
assets and revenues.
135
Unearned Revenue and Revenue Recognition
Conservatism means selecting methods of
measurement that yield:
•
•
•
Lower net income
Lower assets
Lower stockholders’ equity
It is unethical to knowingly overstate or
understate revenue and net income.
136
The Adjusting Process in Perspective
The complete accounting cycle now becomes:
Transactions
Documentation
Journal
Ledger
Unadjusted
Trial Balance
Journalize and
Post Adjustments
Adjusted
Trial Balance
Financial
Statements
137
The Adjusting Process in Perspective
• Each adjusting entry affects at least:
• One income statement account.
• One balance sheet account.
• The Cash account is not adjusted.
• The end-of-period adjustment process is reserved
for implicit transactions, which anchor the accrual
basis of accounting.
138
The Adjusting Process in Perspective
Advance Cash
Payments for
Future
Services to be
Received
Advance Cash
Collections for
Future
Services to be
Rendered
Create
Create
Noncash
Assets in the
Balance Sheet
Liabilities in the
Balance Sheet
Transformed
by
Transformed
By Adjustments
into
Expenses in
the Income
Statement
Revenues in
the Income
Statement
Expiration
of
Unexpired
Costs
Earnings of
Revenues
Received
in Advance
139
The Adjusting Process in Perspective
Passing of Time
and the
Continuous Use
of Services
Recorded by
Adjustments
as Increases
in
Expenses in the
Income
Statement
and
Liabilities in the
Balance Sheet
Decreased by
Later Cash
Payments
Accrual of
Unrecorded
Expenses
140
The Adjusting Process in Perspective
Passing of Time
and the
Continuous
Rendering of
Services
Recorded by
Adjustments Revenues in the
as Increases
Income
in
Statement
and
Noncash Assets
In the Balance
Sheet
Decreased by
Later Cash
Collections
Accrual of
Unrecorded
Revenues
141
Classified Balance Sheet
• A classified balance sheet further groups asset,
liability, and owners’ equity accounts into
subcategories.
• Assets are classified into two groups:
• Current assets
• Noncurrent (or long-term) assets
• Liabilities are classified into:
• Current liabilities
• Noncurrent (or long-term) liabilities
142
Classified Balance Sheet
• Current assets are cash and other assets that a
company expects to convert to cash, sell, or
consume during the next 12 months (or within the
normal operating cycle if longer).
• Current assets are listed in the order in which they
are likely to be converted to cash during the coming
year.
143
Classified Balance Sheet
• Current liabilities are those that come due within
the next year (or within the operating cycle if
longer).
• Current liabilities are listed in the order in which
they will decrease cash during the coming year.
• Working capital is the excess of current assets over
current liabilities.
• The following slide shows the classified balance
sheet for Upstart Company:
144
Classified Balance Sheet
Upstart
Balance Sheet
January 31, 20X2
Assets
Current assets:
Cash
$ 71,700
Accounts receivable
160,300
Note receivable
40,000
Accrued interest receivable
400
Merchandise inventory
250,200
Prepaid rent
10,000
Total current assets
$532,600
Long-term assets:
Store equipment $114,900
Accumulated
depreciation
1,000 113,900
Total
$646,500
Liabilities and Owners’ Equity
Current liabilities:
Accounts payable
$117,100
Unearned rent revenue
2,500
Accrued wages payable
3,750
Accrued interest payable
750
Accrued income taxes payable 11,200
Note payable
100,000
Total current liabilities
$235,300
Stockholders’ Equity:
Paid-in capital
$400,000
Retained earnings
11,200 411,200
Total
$646,500
145
Statement of Financial Position Format (IFRS)
146
Statement of Financial Position Format (IFRS)
147
Classified Balance Sheet
Upstart
Balance Sheet
January 31, 20X2
Assets
Current assets:
Cash
$ 71,700
Accounts receivable
160,300
Note receivable
40,000
Accrued interest receivable
400
Merchandise inventory
250,200
Prepaid rent
10,000
Total current assets
$532,600
Long-term assets:
Store equipment $114,900
Accumulated
depreciation
1,000 113,900
Total
$646,500
Liabilities and Owners’ Equity
Current liabilities:
Accounts payable
$117,100
Unearned rent revenue
2,500
Accrued wages payable
3,750
Accrued interest payable
750
Accrued income taxes payable 11,200
Note payable
100,000
Total current liabilities
$235,300
Stockholders’ Equity:
Paid-in capital
$400,000
Retained earnings
11,200 411,200
Total
$646,500
148
Formats of Balance Sheets
• A balance sheet may be presented in the:
• Report format
• Account format
• The report format presents the accounts vertically.
• The account format puts the assets at the left and
liabilities and owners’ equity at the right.
• Either format is acceptable.
149
Income Statement Formats
• Two commonly used formats for income statements
are the:
• Single-step income statement
• Multiple-step income statement
• The next slide presents a single-step income
statement for Upstart Company:
• It groups all types of revenue together.
• It lists and deducts all expenses without drawing any
intermediate subtotals.
150
Single Step Income Statement
Upstart
Income Statement
For the Month Ended January 31, 20X2
Sales
Rent revenue
Interest revenue
Total sales and other revenues
Expenses:
Cost of goods sold
$100,000
Wages
31,750
Depreciation
1,000
Rent
5,000
Interest
750
Income taxes
11,200
Total Expenses
Net income
$160,000
500
400
$160,900
149,700
$ 11,200
151
Multiple Step Income Statements
Most multiple-step income statements disclose:
• Gross profit (gross margin)
• The excess of sales revenue over the cost of the inventory that was
sold.
• Operating expenses
• A group of recurring expenses that pertain to the firm’s routine,
ongoing operations (wages, rent, depreciation, telephone, heat,
advertising, etc.).
• Operating income
• The remainder of gross profit after the deduction of operating
expenses.
152
Multiple Step Income Statements
Non-operating revenues and expenses
• Revenues and expenses not directly related to the mainstream of a
firm’s operation (e.g., profit from the sale of a piece of
equipment).
Other (non-operating) revenue and expenses
• Revenues and expenses that are not part of the ordinary
operations of selling goods or services; i.e., interest revenue and
interest expense.
Income taxes appear in both income statement formats.
The next slide presents a multiple-step income statement
for Upstart Company:
153
Multiple Step Income Statement
Upstart
Income Statement
For the Month Ended January 31, 20X2
Sales
$160,000
Cost of goods sold
100,000
Gross profit
60,000
Operating expenses:
Wages
$ 31,750
Depreciation
1,000
Rent
5,000 37,750
Operating income
$ 22,250
Other revenues and expenses:
Rent revenue
$
500
Interest revenue
400
Total other revenue
$
900
Deduct: Interest expense
750
150
Income before income taxes
$ 22,400
Income taxes (at 50%)
11,200
Net income
$ 11,200
154
Exercises
True or False?
1. Retained Earnings should be accounted for as a noncurrent
liability.
2. Deferred Revenue will appear on the income statement.
3. Machinery used in the business should be recorded as a
noncurrent asset.
4. A company that employs cash-basis accounting cannot have
a Prepaid Expense account on the balance sheet.
5. From a single balance sheet, you can find stockholders’
equity for a period of time but not for a specific day.
6. It is not possible to determine changes in the financial
condition of a business from a single balance sheet.
155
Exercises
True or False?
1. Retained Earnings should be accounted for as a noncurrent
liability. F
2. Deferred Revenue will appear on the income statement. F
3. Machinery used in the business should be recorded as a
noncurrent asset. T
4. A company that employs cash-basis accounting cannot have
a Prepaid Expense account on the balance sheet. T
5. From a single balance sheet, you can find stockholders’
equity for a period of time but not for a specific day. F
6. It is not possible to determine changes in the financial
condition of a business from a single balance sheet. T
156
Module 5
Accounting for
Revenues
157
Learning Objectives
After this session, you should be able to:
•
•
•
•
Determine proper period in which to record
revenues.
Discuss revenue measurement issues.
Estimate bad debts using allowance method.
Assess accounts receivable.
158
Revenue recognition
•
•
Earned: goods or services must be delivered
Realized: assurance of payment being converted to cash
Revenue measurement
•
•
•
•
•
Cash and credit sales
Sales returns and allowances
Trade discounts
Cash discounts
Bank card charges
Credit sales and accounts receivable
•
•
•
•
•
Uncollectible accounts
Bad debts expense
Specific write-off method
Allowance method
Recoveries
Assessing level of accounts receivable
•
•
Accounts receivable turnover
Days to collect
159
Recognition of Sales Revenue
Revenue recognition requires a two-pronged
test:
•
•
Goods or services must be delivered to the
customers (the revenue must be earned).
Cash or an asset virtually assured of being converted
into cash must be received (the revenue must be
realized).
Most companies recognize revenue at the point
of sale.
160
Measurement of Sales Revenue
A $100 cash sale is recorded as:
Cash
Sales Revenue
100
100
A $100 credit sale is recorded as:
Accounts receivable
Sales revenue
100
100
161
Merchandise Returns and Allowances
•
•
•
•
•
Gross sales are the initial revenues or asset inflows
based on the initial sales price.
Gross sales are decreased by the amount of the
returns and allowances to calculate the net sales.
A sales return occurs when a customer returns
previously purchased merchandise.
A sales allowance is a reduction of the original
selling price.
A contra account (Sales Returns and Allowances)
combines both returns and allowances in a single
account.
162
Merchandise Returns and Allowances
Suppose a retailer has $900,000 of gross sales on
credit and $80,000 of sales returns and
allowances.
The journal entries are:
Accounts receivable
Sales
Sales returns and allowances
Accounts receivable
900,000
900,000
80,000
80,000
163
Merchandise Returns and Allowances
The income statement would show:
Gross sales
Deduct: Sales returns and allowances
Net sales
$900,000
80,000
$820,000
164
Cash and Trade Discounts
•
•
•
Trade discounts offer one or more reductions to the
gross selling price for a particular class of customers.
The gross sales revenue recognized from a trade
discount sale is the price received after deducting
the discount.
Companies set trade discount terms to be
competitive in industries where such discounts are
common or to encourage certain customer behavior.
165
Cash and Trade Discounts
Cash discounts are rewards for prompt payment:
Credit Terms
Meaning
n/30
The full billed price (net price) is due on the thirtieth day
after the invoice date.
1/5, n/30
A 1% discount can be taken for payment within 5 days
of the invoice date: otherwise the full billed price is due
in 30 days.
15 E.O.M.
The full price is due within 15 days after the end-of the
month of sale (an invoice dated December 20 is due
January 15).
166
Recording Charge Card Transactions
There are three major reasons that retailers
accept credit cards:
•
•
•
To attract credit customers who would otherwise
shop elsewhere.
To get cash immediately instead of waiting for
customers to pay in due course.
To avoid the cost of tracking, billing and collecting
customers’ accounts.
Card companies’ service charges are typically
from 1% to 4% of gross sales.
167
Recording Charge Card Transactions
Suppose VISA charges a company a straight 3% of
sales for its credit card services.
Credit sales of $10,000 will result in cash of only
$9,700 [$10,000 – (0.03 x $10,000)]
The journal entry is:
Cash
Cash discounts for bank cards
Sales
9,700
300
10,000
168
Accounting for Net Sales Revenue
A detailed income statement might contain
multiple elements as follows:
Gross sales
Deduct:
Sales returns and allowances
Cash discounts on sales
Net sales
$ 1000
$ 270
20
290
$ 710
Reports to shareholders typically omit details
and show only net revenues.
169
Cash
•
•
Many companies combine cash and cash equivalents
on their balance sheets.
Cash equivalents are highly liquid short-term
investments that can easily and quickly be converted
into cash. Examples include:
• Time deposits
• Commercial paper
• 90-day Government bills
•
Cash includes paper money and coins; money
orders; and checks.
170
Credit Sales and Accounts Receivable
•
Most sales are on credit, which create Accounts
Receivable.
•
Credit sales create a new set of problems for
measuring revenue and managing the company’s
assets.
•
Credit sales generate potential uncollectible
accounts.
171
Uncollectible Accounts
Granting credit entails both costs and benefits:
•
•
•
The main benefit is the boost in sales and profit that
a company generates when it extends credit.
The most significant cost is uncollectible accounts or
bad debts—receivables that some credit customers
are either unable or unwilling to pay.
The cost of granting credit that arises from
uncollectible accounts is called bad debts expense.
172
Measurement of Uncollectible Accounts
Uncollectible accounts require special accounting
procedures.
There are two basic ways to record uncollectible
accounts:
•
•
The specific write-off method
The allowance method
173
Specific Write-Off Method
•
•
•
The specific write-off method assumes that all sales
are fully collectible until proved otherwise.
When a company identifies a specific customer
account as uncollectible, it reduces the Accounts
Receivable.
The journal entry for the write-off of a specific
Account Receivable of $40,000 is:
Bad debts expense
Accounts receivable
40,000
40,000
174
Specific Write-Off Method
•
The specific write-off method fails to apply the
matching principle of accrual accounting.
•
Matching requires recognition of the bad debts
expense at the same time as the related revenue.
175
Allowance Method
The allowance method has two basic elements:
•
•
An estimate of the amounts that will ultimately be
uncollectible.
A contra account, which contains the estimated
uncollectible amount that is deducted from the total
Accounts Receivable.
176
Allowance Method
• The contra account is called allowance for
uncollectible accounts.
• The contra account recognizes bad debts in general
during the proper period before uncollectible
accounts from specific individuals are identified in
the following period.
177
Allowance Method
Suppose Best Buy:
•
•
•
•
Knows from experience that it will not collect about
2% of sales.
Has sales in 20X1 of $100,000.
Estimates that 2% x $100,000 or $2,000 of the 20X1
sales will be uncollectible.
Does not know on December 31, 20X1, which
customers will fail to pay their accounts.
Best Buy can still acknowledge the $2,000 worth
of bad debts in 20X1.
178
Allowance Method
The journal entries are:
20X1 Sales:
Accounts receivable
Sales
100,000
20X1 Allowances:
Bad debts expense
Allowance for uncollectible accounts
100,000
2,000
2,000
179
Allowance Method
The journal entry for the write-off of two
customer accounts in 20X2 is:
20X2 Write-offs:
Allowance for uncollectible accounts
Accounts receivable, Jones
Accounts receivable, Montero
2,000
1,400
600
180
Applying the Allowance Method Using a % of Sales
• Expressing the amount of bad debts as a percentage
of total sales is known as the percentage of sales
method.
• This approach directly calculates the bad debts
expense that appears on the income statement.
• The previous example illustrates this approach.
181
Applying the Allowance Method Using a % of
Accounts Receivable
• The percentage of accounts receivable method
estimates uncollectible accounts based on the
historical relationship between uncollectables to
year-end gross accounts receivable—not sales.
• Additions to the allowance account are calculated to
achieve a target ending balance.
182
Applying the Allowance Method Using a
Percentage of Accounts Receivable
Consider the historical experience in the following table:
20X1
20X2
20X3
20X4
20X5
20X6
Six-year total
Accounts
Receivable
At End
Of Year
$100,000
80,000
90,000
110000
120,000
112,000
$612,000
Average (divide by 6)
$102,000
Bad Debts Deemed
Uncollectible and
Written Off
$ 3,500
2,450
2,550
4,100
5,600
2,200
$20,400
$ 3,400
Average percentage not collected = $3,400 / $102,000 = 3.33%
183
Applying the Allowance Method Using a
Percentage of Accounts Receivable
Assume the accounts receivable balance is
$115,000 at the end of 20X7.
The average percentage of accounts receivable
not collected is applied to the 20X7 ending
balance ($115,000 x 3.33%).
The adjusting journal entry is:
Bad debts expense
Allowance for bad debts
3,829
3,829
184
Applying the Allowance Method Using the Aging of
Accounts Receivable
• The aging of accounts receivable method directly
incorporates the customers’ payment histories.
• As more time elapses after the sale, collection
becomes less likely.
• The $115,000 balance in Accounts Receivable on
December 31, 20X7, might be aged as shown on the
next slide.
185
Applying the Allowance Method Using the Aging of
Accounts Receivable
Name
Total
Oxwall Tools
$
20,000
1-30 Days
$
10,000
10,000
Estee
20,000
15,000
Sarasota Pipe
22,000
5,000
12,000
$
39,000
$ 115,000
27,000
$
72,000
8,000
$
0.10%
$
10,000
3,000
Historical bad debt percentages
Bad debt allowance to be provided
$
4,000
Other accounts (each detailed)
Total
61-90 Days
20,000
Chicago Castings
Ceilcote
31-60 Days
3,772 = $
More Than
90 Days
72 + $
25,000
$
2,000
$
1%
250 + $
15,000
1,000
2,000
$
5%
750 + $
3,000
90%
2,700
The journal entry to record the Bad Debts Expense is:
Bad debts expense
Allowance for bad debts
3,772
3,772
186
Bad Debt Recoveries
When bad debt recoveries occur, the write-off is reversed
and the collection is handled as a normal receipt on account.
The following October journal entries reverse the February
write-off of an individual account receivable:
Feb. 20X2
Oct. 20X2
Allowance for uncollectible accounts
Accounts receivable
600
Accounts receivable
Allowance for uncollectible accounts
600
Cash
Accounts receivable
600
600
600
600
187
Assessing the Level of Accounts Receivable
One measure of the ability to control receivables is the
accounts receivable turnover:
Accounts Receivable Turnover =
Credit Sales
Average Accounts Receivable
Higher turnovers indicate that a company collects its
receivables quickly.
Lower turnovers indicate slower collection.
188
Assessing the Level of Accounts Receivable
Suppose credit sales for Best Buy in 20X8 were
$1 million and beginning and ending accounts
receivable were $115,000 and $112,000,
respectively.
Accounts receivable turnover =
$1,000,000
= 8.81
0.5x($115,000 + $112,000)
189
Assessing the Level of Accounts Receivable
The days to collect accounts receivable, or
average collection period, is calculated by
dividing 365 by the accounts receivable turnover.
Days to collect A/R = 365 / Accounts receivable turnover
= 365 days / 8.81
= 41.4 days
There is significant variability in accounts
receivable turnover levels among industries.
190
Management’s Responsibility
Management bears the primary responsibility for
a company’s financial statements and for the
success of internal controls.
The audit committee oversees the:
•
•
•
Internal accounting controls
Financial statements
Financial affairs of the corporation
191
Exercises
Uncollectable Accounts:
During 20X1, a department store had credit sales of $900,000. The store
manager expects that 2% of the credit sales will never be collected,
although no accounts are written off until 10 assorted steps have been
taken to attain collection. The 10 steps require a minimum of 14 months.
Assume that during 20X2, specific customers are identified who are never
expected to pay $16,000 that they owe from the sales of 20X1. All 10
collection steps have been completed.
1. Show the impact on the balance sheet equation of the preceding
transactions in 20X1 and 20X2 under (a) the specific write-off method, and
(b) the allowance method. Which method do you prefer? Why?
2. Prepare journal entries for both methods. Omit explanations.
192
Module 6
Cash Flows
193
Learning Objectives
After studying this module, you should be able to:
• Explain the concept of the statement of cash flows.
• Distinguish among Cash flow from Operations,
Financing and Investing.
• Classify accounting items as operating, investing or
financing cash flows.
• Compute a statement of cash flows using the direct
and indirect method.
194
Purpose of the statement of cash flows
• Report cash receipts and cash payments
• Classify the cash flows as operating, investing, and financing activities
• Detail the changes in the cash account
Types of cash flow
• Operating Activities
• Financing Activities
• Investing Activities
• Cash Inflow versus Outflows
Preparing the Statement of Cash Flows
• Direct Method
• Indirect Method
• Examples
195
Overview
The purpose of the statement of cash flows is to:
• Report cash receipts and cash payments of an entity
over a period of time.
• Classify the cash flows as operating, investing, and
financing activities.
• Detail the changes in the cash account on the
balance sheet.
196
Overview
Balance Sheet
December 31,
20X0
Balance Sheet
December 31,
20X1
Statement of Income
Statement of Cash Flows
197
Purpose of the Cash Flow Statement
A statement of cash flows:
• Shows the relationship of net income to changes in cash
balances.
• Helps to predict future cash flows.
• Evaluates how management generates and uses cash.
• Determines a company’s ability to pay interest, dividends,
and debts when they are due.
• Identifies specific increases and decreases in a firm’s
productive assets.
198
Purpose of the Cash Flow Statement
• The term “cash” also refers to cash equivalents.
• Cash equivalents are highly liquid short-term
investments that a company can easily and
quickly convert into cash:
• Money market funds
• Treasury bills
199
Typical Activities Affecting Cash
Managers affect cash by three types of decisions:
• Operating decisions
• Financing decisions
• Investing decisions
Operating decisions are concerned with the major
day-to-day activities that generate revenues and
expenses.
200
Typical Activities Affecting Cash
Operating activities are transactions that affect the
purchase, processing, and selling of a company’s
products and services:
• Making sales.
• Collecting accounts receivable.
• Purchasing inventory.
• Paying accounts payable.
The first major section of the statement of cash
flows is labeled cash flows from operating
activities.
201
Typical Activities Affecting Cash
• Investing decisions include the choices to acquire
or dispose of long-term productive assets or
long-term investments.
• Investing activities are transactions that acquire
or dispose of assets that are expected to provide
services for more than one year.
• Purchasing or disposing of equipment
• The investing section on the statement is labeled
cash flows from investing activities.
202
Typical Activities Affecting Cash
Financing decisions are concerned with how to
obtain or repay cash.
Financing activities are a company’s transactions
that obtain resources from debt and equity
transactions:
• Issuance of additional stock.
• Borrowing money from the bank.
• Repaying previous loans.
The financing section on the statement is labeled
cash flows from financing activities.
203
Typical Activities Affecting Cash
Cash Inflows
Cash Outflows
Operating Activities:
Collections from customers
Cash payments to suppliers
Interest and dividends collected
Cash payments to employees
Other operating receipts
Interest and taxes paid
Other operating cash payments
Investing Activities:
Sale of property, plant, and equipment Purchase of property, plant, and equipment
Sale of securities that are not
Purchase of securities that are not
cash equivalents
cash equivalents
Receipt of loan repayments
Making loans
Financing:
Borrowing cash from creditors
Repayment of amounts borrowed
Issuing equity securities
Repurchase of equity shares (including the
Issuing debt securities
purchase of treasury stock)
Payment of dividends
204
Preparing the Statement of Cash Flows
The following two slides for Upstart Company
show the:
• Changes in the balance sheet equation (transactions)
during the first month of operations.
• Income statement for the first month of operations and
the January 31 balance sheet.
Notice that the cash balance increased from $0 to
$351,000 during the month.
205
Preparing the Statement of Cash Flows
Assets
Description of Transactions
(1) Initial investment
(2) Loan from private
placement
(3) Acquire equipment for
cash
(4) Acquire inventory for cash
(5) Acquire inventory on credit
(6) Acquire inventory for cash
plus credit
(7) Sales of equipment
(8) Return of inventory
acquired on January 5
(9) Payments to creditors
(10a) Sales on open account
(10b) Cost of merchandise
inventory sold
(11) Collect accounts
receivable
(12) Pay rent in advance
(13) Recognize expiration of
rental services
(14) Depreciation
Balance January 31, 20X2
Cash
Accounts
+ Receivable
Merchandise
+
Inventory +
=
Prepaid
Rent
+
Store
Equipment =
Liabilities
Note
Payable
+400,000
=
+100,000
= +100,000
-15,000
-120,000
-10,000
+1,000
=
-1,000 =
+20,000
-800
=
=
=
-800
-4,000
+160,000
-100,000
+5,000
-6,000
-5,000
+6,000
+155,000
+59,200
583,100
Paid-in
Capital
+4,000
+
Retained
Earnings
+160,000
=
-2,000
351,000
+
+10,000
+30,000
-4,000
Stockholders' Equity
+400,000
+15,000 =
=
=
+120,000
+10,000
+
Accounts
+ Payable
-100,000
=
=
=
-100 =
+13,900 =
100,000
+25,200
+400,000
-2,000
-100
+57,900
583,100
206
Preparing the Statement of Cash Flows
Upstart Company
Income Statement
For the Month Ended January 31, 20X2
Sales (revenues)
Deduct expenses:
Cost of goods sold
Rent
Depreciation
Total expenses
Net income
$160,000
$100,000
2,000
100
102,100
$ 57,900
Balance Sheet, January 31, 20X2
Assets
Cash
Accounts receivable
Merchandise inventory
Prepaid rent
Store equipment
$351,000
155,000
59,200
4,000
13,900
Total assets
$583,100
Liabilities and Stockholders’ Equity
Liabilities
Note payable
$100,000
Accounts payable
25,200
Total liabilities
$125,200
Stockholders’ equity
Paid-in capital
$400,000
Retained earnings
57,900
Total stockholders’ equity
457,900
Total liabilities and
stockholders’ equity
$583,100
207
Cash Flows from Financing Activities
Two general rules apply for identifying financing
activities:
• Increases in cash (cash inflows) stem from increases in
long-term liabilities or paid-in capital.
• Decreases in cash (cash outflows) stem from decreases in
long-term liabilities or paid-in capital.
Upstart had two such transactions in January:
• Transaction 1: Initial investment, $400,000.
• Transaction 2: Loan from private placement, $100,000.
208
Cash Flows from Investing Activities
Two general rules apply for identifying investing
activities:
• Increases in cash (cash inflows) from decreases in longlived assets, loans, and investments.
• Decreases in cash (cash outflows) stem from increases in
long-lived assets, loans, and investments.
There were two such transactions relating to
equipment in January:
• Transaction 3: Acquire equipment for cash, $15,000.
• Transaction 7: Sale of equipment for cash, $1,000.
209
Noncash Investing and Financing Activities
Sometimes financing and investing activities do not
affect cash.
Example: If Upstart acquires $8,000 of equipment
by issuing common stock:
• The purchase of equipment is an investing activity.
• The issuance of common stock is a financing activity.
Companies must report such items in a schedule of
noncash investing and financing activities (IFRS).
210
Cash Flow from Operating Activities
Two approaches may be used:
Direct method:
• Subtracts operating cash
disbursements from
operating cash collections.
• Is encouraged by IFRS for
operating cash flows.
Indirect method:
• Adjusts accrual-based net
income from the income
statement to reflect only
cash receipts and
disbursements.
• Is used by most U.S.
companies.
211
The Direct Method
Examining the cash column of Upstart balance sheet
equation, transactions 1, 2, 3, and 7 are financing and
investing activities.
The remaining transactions must be operating activities:
Upstart Company
Cash Flows from Operating Activities—Direct Method
For the Month of January 20X2
Cash payments for inventory (transactions 4 and 6)
Cash payments to creditors for accounts payable (transaction 9)
Cash collections on accounts receivable (transaction 11)
Cash payments for rent (transaction 12)
Net cash used by operating activities
$(130,000)
(4,000)
5,000
(6,000)
$(135,000)
212
The Indirect Method
• When the cash flow from a sale or outflow from
an expense occurs in one accounting period and
the revenue or expense occurs in another, net
income differs from cash flows from operations.
• The indirect method highlights these differences
by starting with net income, and adjusts it to
cash flows from operating activities.
• Example: Depreciation is added back to net
income because it is a non-cash expense.
213
The Indirect Method
Net income:
• Adjust for revenues and expenses not requiring cash:
• Add back depreciation.
• Other adjustments.
• Adjust for changes in noncash assets and liabilities
relating to operating activities:
• Add decreases in assets.
• Deduct increases in assets.
• Add increases in liabilities.
• Deduct decreases in liabilities.
214
The Indirect Method
Upstart Company
Cash Flows from operating Activities—Indirect Method
For the Month of January 20X2
Net income
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation
Net increase in accounts receivable
Net increase in inventory
Net increase in accounts payable
Net increase in prepaid rent
Net cash provided by operating activities
$ 57,900
100
(155,000)
(59,200)
25,200
(4,000)
$(135,000)
215
Example of Statement of Cash Flows
Upstart Company
Statement of Cash Flows
For the Month of January 20X2
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation
Net increase in accounts receivable
Net increase in inventory
Net increase in accounts payable
Net increase in prepaid rent
Net cash provided by operating activities
$ 57,900
100
(155,000)
(59,200)
25,200
(4,000)
$(135,000)
Cash flows from investing activities:
Purchase of equipment
Proceeds from sale of equipment
Net cash provided by investing activities
$ (15,000)
1,000
Cash flows from financing activities:
Proceeds from initial investment
Proceeds from private placement
Net cash provided by financing activities
$ 400,000
100,000
Net increase in cash
Cash, January 2, 20X2
Cash, January 31, 20X2
(14,000)
500,000
351,000
0
$351,000
216
Balance Sheet Equation and Cash Flows
The balance sheet equation can be written as:
Assets
= Liabilities + Stockholders' equity
Cash + Noncash assets = Liabilities + Stockholders' equity
Cash
= Liabilities + Stockholders' equity – Noncash assets
So:
D Cash = D Liabilities + D Stockholders’ Equity - D Non-Cash Assets
217
Balance Sheet and Cash Flows
Upstart Company
Balance Sheet, January 31, 20X2
Assets
Cash
Accounts receivable
Merchandise inventory
Prepaid rent
Equipment
$351,000
155,000
59,200
4,000
13,900
Total assets
$583,100
Liabilities and Stockholders’ Equity
Liabilities
Note payable
$100,000
Accounts payable
25,200
Total liabilities
$125,200
Stockholders’ equity
Paid-in capital
$400,000
Retained earnings
57,900
Total stockholders’ equity
457,900
Total liabilities and
stockholders’ equity
$583,100
$351,000 = $125,200 + $457,900 - $232,100
218
The Importance of Cash Flow
• The income statement matches revenues and
expenses using accrual concepts and provides a
measure of economic performance.
• The statement of cash flows explains changes in
the cash account rather than owners’ equity.
• Free cash flow:
• Is a measure of cash management performance.
• Refers to cash flows from operations less capital
expenditures (and sometimes less dividends).
219
Exercises
Cash Received from Customers:
Upstart had sales of $900,000 during 20X1, 80% of them on
credit and 20% for cash. During the year, accounts
receivable increased from $60,000 to $90,000, an increase
of $30,000. What amount of cash was received from
customers during 20X1?
220
Exercises
Cash Received from Customers: Solution
Sales
Less increase in accounts receivable
Cash received from customers
$900,000
(30,000)
$870,000
Or
Cash sales (.2 × $900,000)
Collections of receivables
[(.8 × $900,000) + $60,000 – $90,000]
Cash received from customers
$180,000
690,000
$870,000
221
Exercises
Cash Paid to Suppliers:
Cost of Goods Sold for Upstart during 20X1 was $600,000.
Beginning inventory was $100,000, and ending inventory
was $150,000. Beginning trade accounts payable were
$24,000, and ending trade accounts payable were $42,000.
What amount of cash did Upstart pay to suppliers?
222
Exercises
Cash Paid to Suppliers: Solution
Cost of goods sold
Add increase in inventory ($150,000 – $100,000)
Deduct increase in accounts
payable ($42,000 – $24,000)
Cash paid to suppliers
$600,000
50,000
(18,000)
$632,000
223
Exercises
Cash Paid to Employees:
Upstart reported Wage and Salary Expense of $220,000 on
its 20X1 income statement. It reported cash paid to
employees of $185,000 on its statement of cash flows. The
beginning balance of Accrued Wages and Salaries Payable
was $18,000. What was the ending balance in Accrued
Wages and Salaries Payable?
224
Exercises
Cash Paid to Employees: Solution
Wage and salary expense
Cash paid to employees
Increase in accrued wages and salaries payable
Beginning balance, accrued wages and
salaries payable
Increase in accrued wages and salaries payable
Ending balance, accrued wages and
salaries payable
$220,000
185,000
$ 35,000
$ 18,000
35,000
$ 53,000
225