ACCOUNTING FOR INTERNATIONAL AND
PUBLIC AFFAIRS – U6200 – PART – I
Spring Term 2023
IAB Building Room 403
NOTE: After the Add/Drop Period Ends on January 27,
Our Classroom will Change to Room 107 in
Jerome Greene Hall
435 West 116th Street
(Amsterdam & 116th Street)
Wednesdays – 6:10 P.M. to 900 P.M.
January 18 through April 26, 2023
DR. NORMAN J. BARTCZAK
Norman J. Bartczak
FSI
56 Craftsland Road
Chestnut Hill, MA 02467
617 232 0970 Office
617 642 4160 Mobile
617 734 9960 Facsimile
E-Mail: njb7@columbia.edu
1
General Course Information:
The purpose of this course is to enable you to become an informed user of financial information. To be
properly informed you need to understand financial statements and the language of accounting and financial reporting. We will focus on the three major financial statements: the balance sheet, the income
statement and the statement of cash flows. We will examine the underlying concepts that go into the
preparation of these financial statements as well as specific accounting rules that apply when preparing
financial statements. As we gain an understanding of the financial information, we will look at approaches
to analyze the financial strength and operations of an entity. We will use actual financial statements to
understand how financial information is presented.
Achieving Success in U6200:
Financial statements are the language used to convey information about an enterprise’s performance and
financial position as well as to evaluate the trend of an enterprise’s performance and provide information to
make projections about future performance. This course is designed to provide you with a solid understanding of financial statements and provide you with tools to analyze this information. An overriding theme
during the course will be how management’s assumptions and estimates impact the information presented.
Students taking this course will face several challenges. You will need to learn the language of accounting and financial statements which includes learning how to describe transactions using “T-account shorthand” and learning the terminology of accounting. This will be addressed throughout the course, but particularly in the first few sessions.
Accounting concepts are not learned by reading the material. To master the concepts, you need to apply
them. In addition to the assigned cases, the required problems will provide you the opportunity to apply
what you have learned. Although the cases may be discussed with others, individual preparation is also
required. Your ability to prepare the cases and problems will be a strong indicator of how well you understand the material.
Textbook:
There is no required textbook. We will use Class Notes prepared by myself and other members of the
Columbia Business School faculty for the introductory accounting course in the Columbia MBA program.
In-Class Assignments:
Page(s) in this document
1. January 18 – Class Session #1 – Sunshine Lite Stick, Inc.
7
2. January 25 – Class Session #2 – Sunshine Lite Stick, Inc. (continued)
9
3. February 1 – Class Session #3 – Overlook Inn
11
4. February 8 – Class Session #4 – Green Acres Lumber Company
13
5. February 15 – Class Session #5 – Toddler Town, Inc.
15
6. February 22 – Class Session #6 – Toddler Town, Inc. (continued) & Review
17
7. March 1 – Mid-Term Exam
Assignments to be Completed and Turned In before Class On:
To be distributed separately
1. February 1 – Written Assignment #1 – Glo-Stick, Inc. – I
Distributed 1/25
2. February 8 – Written Assignment #2 – Glo-Stick, Inc. – II
Distributed 2/1
3. February 15 – Written Assignment #3 – Revenue Recognition
Distributed 2/8
4. February 22 – Written Assignment #4 – Doubtful Accounts & Deferred Taxes
Distributed 2/15
List of Case Studies:
1. Sunshine Lite Stick, Inc. (4 pages)
2. Overlook Inn (13 pages)
3. Green Acres Lumber Company (14 pages)
4. Toddler Town, Inc. (20 pages)
2
Page(s) in this document
19 – 22
23 – 35
37 – 50
51 – 70
List of Case Solutions:
Page(s) in this document
1. Sunshine Lite Stick, Inc. (5 pages)
71 – 75
2. Sunshine Lite Stick, Inc. using Alternative Accounting Decisions (4 pages)
77 – 80
3. Steps to Prepare Financial Statements using Sunshine Lite Stick (6 pages)
81 – 86
4. Overlook Inn (8 pages)
87 – 94
5. Steps to Prepare Financial Statements using Overlook Inn (8 pages)
95 – 102
6. Green Acres Lumber Company (12 pages)
103 – 114
7. Steps to Prepare Financial Statements using Green Acres Lumber (14 pages)
115 – 128
8. Toddler Town, Inc. (12 pages)
129 – 140
9. Steps to Prepare Financial Statements using Toddler Town, Inc. (9 pages)
141 – 149
List of Class Notes:
Page(s) in this document
1. CN 01 Double-Entry Bookkeeping & T-Accounts (8 pages)
151 – 158
2. CN 02 Introduction to Financial Statements (14 pages)
159 – 172
3. CN 03 Common Stock, Retained Earnings, Dividends (4 pages)
173 – 176
4. CN 04 Capitalizing vs. Expensing, Depreciation & Amortization (6 pages)
177 – 182
5. CN 05 Inventory and Cost of Goods Sold (“COGS”) – Abridged (4 pages)
183 – 186
6. CN 06 Statement of Cash Flows – Introduction (6 pages)
187 – 192
7. CN 07 Statement of Cash Flows – FSI (10 pages)
193 – 202
8. CN 08 Revenue Recognition – Conventional Criteria (4 pages)
203 – 206
9. CN 09 Accounting Estimates – Allowance Accounts (10 pages)
207 – 216
10. CN 10 Deferred Income Taxes – FSI (12 pages)
217 – 228
NOTE WELL: The Class Notes are REQUIRED READINGS.
Supplemental Notes:
The following Supplemental Note has proven useful for reviewing financial statements; however, it is 47
pages so I have put it the course website where you can view and/or download it your discretion:
1. “The Merrill Lynch Guide to Understanding Financial Reports”, 47 pages
CourseWorks and Other Course Materials:
The following additional information will be available on CourseWorks:
• In-class overheads, articles, and/or readings
• Optional written assignments and solutions (solutions will be posted after cases are submitted).
• Exams and exam solutions
Method of Instruction:
Case studies and case analysis will be the primary method of instruction. However, as appropriate, particular concepts and/or certain financial analytic mechanics will be explained directly by the instructor.
Class Participation and Attendance:
Please come to class prepared to answer my questions and to ask your own. Classroom etiquette is also
required: no constant cell phone checking or non-academic laptop usage.
Note Well: Despite the assignments and exams quantitatively accounting for 100% of the course
grade, preparation of the cases and class participation can have a significant impact on the final
course grade. All students are expected to prepare the materials prior to class and to be prepared
to discuss the issues in class. Both "cold calls" and "volunteers" are used to stimulate class debate. A cold call list of randomly selected students will be E-mailed to those students on-call for
the upcoming class. Students who are prepared and who demonstrate insight through their class
participation can improve on their exam grades. Conversely, students who are unprepared may
see a reduction from their overall exam grades.
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Attendance to all class sessions is expected. An attendance sheet for each class will be completed by the TA/Reader to confirm student attendance. Students who are going to be absent, late, or
need to leave early from class are expected to E-mail me at njb7@columbia.edu before class to
inform me of their situation. Failure to do so is not only disrespectful but may also lead to an unsatisfactory participation notation if the student happens to be on the call list that day. Also, more
than two absences will require my permission. More than two absences without my permission
will subject a student to the possibility of not being allowed to sit for the final exam.
You are NOT ALLOWED to attend other sections of U6200 that I teach without receiving my permission. In certain circumstances and for good reason, if you are unable to attend the U6200 section in which you are enrolled, I will grant permission to attend an alternate section. In order to do
so, the protocol to follow is: (1) send an E-mail to njb7@columbia.edu requesting a section switch
with the reason for the request; (2) receiving an E-mail from me granting permission for the
switch. DO NOT simply send me an E-mail TELLING me you will be attending a different section.
Such an E-mail is not a request and I will not allow you to attend the alternate section since you
have not asked for and received my permission. The limit on permitted section switches is two.
Assignments:
There will be 8 assignments (four in Part I and four in Part II) to be handed in and the best 7 will contribute to your overall grade. While I recommend that you work in groups to discuss the problems, you must
write up (or type up) the assignments on your own. It is not acceptable to copy another student’s work
and turn it in. Doing so will result in a grade of 0 for all parties involved. The assignments must be submitted in class on the due date noted in the syllabus. No late assignments are accepted. Solutions will be
posted on Canvas after class on the due date.
The assignments are graded based on effort; you receive credit as long as an honest attempt is made to
complete each problem. Specifically,
All problems answered correctly
All problems properly attempted with some errors
Missing problems, low effort, substantial errors
Late or no submission
6 points
3 – 5 points
1 – 2 points
0 points
Exams:
Both the midterm and the final will be open note (open book) exams. The final will be comprehensive but
the second part of the course will be emphasized.
Teaching Assistants:
The Teaching Assistants hold weekly recitations as well as office hours throughout the semester. The two
Teaching Assistants associated with my two sections of U6200 are:
1. Rocio Redondo rr3409@columbia.edu
2. Xinhui Han xinhui.han@columbia.edu
A Primary TA will be assigned to each section; however, we act as a team so you should feel free to contact any of the TAs/Readers if you are unable to contact the Primary TA for your section.
Readers:
The Readers grade the written assignments and hold office hours throughout the semester. The two
Readers associated with my two sections of U6200 are:
1. Nanda Hutabalian ndh2116@columbia.edu
2. Jiaxuan Huang jh4388@columbia.edu
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A Primary Reader will be assigned to each section; however, we act as a team so you should feel free to
contact any of the Readers/TAs if you are unable to contact the Primary Reader for your section.
Recitations:
TA-led recitations will be held weekly during the term. Attendance is not required, but is recommended
for those desiring to enhance their understanding of the class material and to review the solutions for the
Assigned Cases. Sessions are scheduled for Fridays (see below for specific TA Recitation times). You
are allowed to attend any of the two Recitations no matter in which section you are enrolled.
Course Code
Teaching Assistant
Class Day
Class Begin Time
Class End Time
Classroom
SIPAU6200_R01
TBA
Friday
TBA
1 hour 50 minutes
TBA
SIPAU6200_R02
TBA
Friday
TBA
1 hour 50 minutes
TBA
Academic Integrity:
http://sipa.columbia.edu/resources_services/student_affairs/academic_policies/deans_discipline_policy.html
The School of International & Public Affairs does not tolerate cheating and/or plagiarism in any form.
Those students who violate the Code of Academic & Professional Conduct will be subject to the Dean’s
Disciplinary Procedures (see link above).
Violations of the Code of Academic & Professional Conduct should be reported to the Associate Dean for
Student Affairs.
First Class Session:
NOTE WELL: The first class session is on Wednesday, January 18, in IAB 404.
Please refer to page 7 of this document, Class Session #1 In-Class Assignment. Please read through the
four page case study and the three Class Notes referred to on page 7. Be prepared to work with me in
addressing the Assignment questions. There is no written assignment.
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Instructor Information & Background:
Norman J. Bartczak
Lecturer in Discipline
Phone: (617) 232-0970
Mobile: (617) 642-4160
Fax:
(617) 734-9960
E-mail: njb7@columbia.edu
Office:
804A IAB, 420 West 118th Street.
Office Hours:
Norman Bartczak is a full-time faculty member as a
Lecturer in Discipline with Columbia University’s School
of International and Public Affairs (SIPA) where he has
been teaching since 2011. In addition, he has taught
(since 1993) in the MBA and EMBA programs at the Columbia University Graduate School of Business. In 2000,
he began teaching as a Senior Lecturer in Law at the
Columbia University Law School where he continues to
instruct. Prior to teaching at Columbia, for ten years
Professor Bartczak was a full-time faculty member at
the Harvard University Graduate School of Business
Administration in Boston. He is the author or co-author
of over 200 case studies and has written articles for
both practitioner-oriented publications, Harvard Business Review, and academic journals, The Journal of
Accounting Research.
Wednesdays – 11:15 A.M. – 1:00 P.M. and
4:15 P.M. – 6:00 P.M.
Professor Bartczak has received The Margaret Chandler Memorial Award for Commitment to Teaching Excellence from Columbia Business School’s Executive
Thursdays – 1:00 P.M. – 3:00 P.M.
MBA Program. The award honors the high standards
Also, after class and by prearranged apset by the late Professor Margaret K. Chandler. Dr.
pointment. It is usually a good idea to confirm
Bartczak has also received the Dean’s Award for
a specific time with me since other students
Teaching Excellence at Columbia Business School.
may also be trying to see me at the same
During each of the four school years, from 2018
time.
through 2021, out of nearly 200 courses taught in each
semester, students rated Professor Bartczak’s course
and his teaching in the “Top Five” at Columbia’s School of International and Public Affairs. For courses
taught in 2020-2021, Dr. Bartczak was the recipient of SIPA’s Outstanding Teaching Award for teaching
Accounting for International and Public Affairs.
For over 25 years (through 2007), Professor Bartczak taught a five-day, twice a year, Financial Analysis
for Credit and Equity Analysts seminar in Northwestern University’s Executive Education Program. Since
2008, he has been teaching in Yale University’s School of Management Executive Education Programs
as well as a biannual program in accounting and finance at the University of Navarra in Spain.
In the private sector, Dr. Bartczak is the founder (in 1985) of Financial Statement Investigation, Inc., a
Boston-based company specializing in designing, developing and delivering executive education seminars throughout the United States and overseas. Additionally. he is a registered investment advisor and a
founding partner (in 2002) of West End Advisors (WEA), a New York-based registered investment advisory firm. Professor Bartczak has also served as an expert witness in judicial proceedings involving misrepresentations in financial statements and valuation issues.
Dr. Bartczak passed the CPA exam in Seattle and he received a Ph.D. in Business Administration from
the University of Washington. He is a member of the American Institute of Certified Public Accountants,
the American Accounting Association, the CFA Institute, the New York Society of Security Analysts, and
the American Bar Association.
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Class Session #1 – In-Class Assignment
Case Study:
Topic:
1. “Sunshine Lite-Stick, Inc.” on pages 19 – 22 of this document
Preparing Financial Statements
Class Notes: 1. CN 01: “Double-Entry Bookkeeping & T-Accounts” on pages 151 – 158 of this
document
2. CN 02: “Introduction to Financial Statements” on pages 159 – 172 of this
document
3. CN 03: “Common Stock, Retained Earnings, Dividends” on pages 173 – 176
of this document
Handouts: 1. Sunshine Lite-Stick, Inc. – The Accounting Equation
Case Solution: 1. “Sunshine Lite-Stick, Inc. Solution” on pages 71 – 75 of this document
2. “Sunshine Lite-Stick, Inc. Solution using Alternative Accounting Decisions” on pages 77 – 80 of this document
Steps: 1. “Steps to Prepare Financial Statements using Sunshine” on pages 81 – 86
is document
Assignment: 1. As best you can from the case study, with the help of the Class Notes,
prepare an income statement and a balance sheet for Sunshine Lite-Stick,
Inc. We will prepare cash flow statements for Class Sessions #3 & #4. If you
get stuck or if you want to check your answer, a solution is provided with this
document on pages 71 – 75.
2. The Supplemental Note, “The Merrill Lynch Guide to Understanding Financial Reports” is an extremely useful Reference Note for everyone. In
particular, if you have never taken an accounting course it will add tremendously to your understanding of the materials. I have used “The Merrill Lynch
Guide to Understanding Financial Reports” in all of my courses for many
years. According to many students it is an invaluable reference guide for understanding not only financial statements but also accounting and financial
terms.
1
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Class Session #2 – In-Class Assignment
Case Study: 1. “Sunshine Lite-Stick, Inc.” on pages 19 – 22 of this document
New
Class Notes: 1. CN 04: “Capitalizing vs. Expensing, Depreciation and Amortization –
Abridged ” on pages 177 – 182 of this document
2. CN 05: Inventory and Cost of Goods Sold (“COGS”) – Abridged on pages 183 –
186 this document
3. CN 06: “Statement of Cash Flows – Introduction” on pages 187 – 192 of this
document
4. CN 07: Statement of Cash Flows – FSI” on pages 193 – 202 of this document
Supplemental
Note:
1. “The Merrill Lynch Guide to Understanding Financial Reports” posted in
CourseWorks in Reference Materials folder
Class Notes: 1. CN 01: “Double-Entry Bookkeeping & T-Accounts” on pages 151 – 158 of this
document
2. CN 02: “Introduction to Financial Statements” on pages 159 – 172 of this
document
3. CN 03: “Common Stock, Retained Earnings, Dividends” on pages 173 – 176 of
this document
Case Solution: 1. “Sunshine Lite-Stick, Inc. Solution” on pages 71 – 75 of this document
2. “Sunshine Lite-Stick, Inc. Solution using Alternative Accounting Decisions” on pages 77 – 80 of this document
Steps: 1. “Steps to Prepare Financial Statements using Sunshine” on pages 81 – 86
of this document
Assignment: 1. As best you can from the case study, with the help of the Class Notes,
prepare a cash flow statement for Sunshine Lite-Stick, Inc. using both the direct method format for operating cash flows and the indirect method format.
If you get stuck or if you want to check your answer, a solution is provided
with this document on pages 71 – 75.
2.
The Supplemental Note, “The Merrill Lynch Guide to Understanding Financial Reports” is an extremely useful Reference Note for everyone. In
particular, if you have never taken an accounting course it will add tremendously to your understanding of the materials. I have used “The Merrill Lynch
Guide to Understanding Financial Reports” in all of my courses for many
years. According to many students it is an invaluable reference guide for understanding not only financial statements but also accounting and financial
terms.
1
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Class Session #3 – In-Class Assignment
Case Study: “Overlook Inn”, 13 pages, on pages 23 – 35 of this document)
New Topics: 1.
2.
3.
4.
5.
6.
Allowance for Doubtful Accounts
Advance Payments
Accrued Expenses
Prepaid Expenses
Long-Term Debt
Income Tax Expenses for "Book" Financial Reporting Purposes
References: 1. CN 08: “Revenue Recognition – Conventional Criteria”, on pages 203 – 206 of
this document
2. CN 09: “Accounting Estimates – Allowance Accounts, Earnings Management”, on pages 207 – 216 of this document
Solution: 1. “Overlook Inn – Suggested Solution” on pages 87 to 94 of this document
2. “Steps to Prepare Financial Statements using Overlook Inn” on pages 95
to 102 of this document
Assignment: 1. Answer the questions on page 5 of the case study.
1
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Class Session #4 – In-Class Assignment
Case Study: Green Acres Lumber Company, 14 pages, on pages 37 – 50 of this document)
New Topics: 1. Write-off of Bad Debts
2. Recovery of Bad Debts
3. Deferred Income Taxes
References: 1. CN 10: “Deferred Income Taxes – FSI”, on pages 217 to 228 of this
document
Solution: 1. “Green Acres Lumber Company – Suggested Solution” on pages 103 to
114 of this document
2. “Steps to Prepare Financial Statements using Green Acres Lumber” on
pages 115 to 128 of this document
Assignment: 1. Answer the questions on pages 5 and 6 of the case study.
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Class Session #5 – In-Class Assignment
Case Study: “Toddler Town, Inc.” 20 pages on pages 51 – 70 of this document
Topics: Comprehensive Preparation of Financial Statements
Previous
Reference: 1. CN 10: “Deferred Income Taxes – FSI” on pages 217 to 228 of this
document
Solution: 1. “Toddler Town, Inc – Solution” on pages 129 to 140 of this document
2. “Steps to Prepare Financial Statements using Toddler Town, Inc.” on
pages 141 to 149 of this document
Assignment: 1. Answer the questions on pages 7 through 11 of the case study.
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Class Session #6 – In-Class Assignment
Case Study:
“Toddler Town, Inc.” (continued) and Review for Mid-Term
Assignment: 1. Finish “Toddler Town, Inc.” and Review previous materials
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FSI
Financial Statement Investigation
05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
In 2019, Mary Davis, a chemical engineer, applied for and received a patent for one of her inventions, a
Sunshine Lite-Stick. A Sunshine Lite-Stick is a small, fragile glass vial where one chemical is inserted
into a plastic, translucent cylinder that then is filled with a second chemical and sealed. Bending the
cylinder causes the glass vial inside to break, allowing the two chemicals to mix. When combined, the
two chemicals gave off a bright glow. While similar products to the Sunshine Lite-Stick exist, Mary was
able to obtain a patent for her invention because it used different chemicals which created a brighter
illumination that lasted twice as long as existing light sticks. An independent patent valuation firm, Carter
& Associates, appraised the value of the patent at $200,000.
On January 1, 2020, Mary, together with three “angel investors”, established Sunshine Lite-Stick, Inc.
(see Exhibit 1 on page 4 for the Company’s Vision and Mission Statement prepared by Mary Davis).
1,000,000 shares of Sunshine Lite-Stick common stock were issued at $1 per share (Transaction a.). Mary
Davis purchased 550,000 shares for $550,000 and the other investors acquired the remaining 450,000
shares for $450,000. By owning 55 percent of the shares of the Company, Mary is able to maintain voting
control of the entire Company. Also on January 1, 2020, Sunshine Lite-Stick purchased the patent from
Mary Davis for $200,000 (Transaction b). During the period January 1, 2020, through December 31,
2020, Sunshine Lite-Stick, Inc., engaged in the following transactions:
1. On January 1, the Company borrowed $100,000 from Central National Bank repayable on
January 1, 2021 (a one year, short-term bank loan).
2. On January 1, the Company spent $300,000 for the machinery that would be used to produce the
first commercial models of the Sunshine Lite-Stick.
3. Throughout the year, the Company purchased $300,000 worth of plastics and chemicals from
various suppliers for use in the production of Sunshine Lite-Sticks. On December 31, 2020, the
Company still owed one of the suppliers $25,000 (included in the $300,000 of purchases) which
was due to be paid on January 30, 2021.
4. Throughout the year, the Company spent a total of $15,000 on television and trade journal
advertising to introduce and market Sunshine Lite-Sticks.
5. During the twelve months ended December 31, 2020, the company expended $500,000 on direct
manufacturing labor, and on manufacturing-related overhead (utilities, supervisory labor; does
not include the cost of machinery usage, see No. 11 on pages 2 and 3). All of the direct labor and
overhead costs associated with the year ended December 31, 2020 had been paid.
6. An additional $150,000 was paid for corporate salaries and other corporate expenses. Corporate
salaries and expenses are not associated with the direct manufacturing (direct labor costs) of
Sunshine Lite-Sticks. They include the salaries of the president, vice-president, corporate office
supplies, etc.
Norman J. Bartczak, Columbia University, prepared this case as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2017 Norman J. Bartczak.
1
05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
7. During the twelve months from January 1 through December 31, 2020, the Company sold
$1,000,000 of Sunshine Lite-Sticks. On December 31, 2020, the largest single purchaser, an auto
parts distributor still owed Sunshine Lite-Stick, Inc., $100,000 (included as part of the $1,000,000
of Sunshine Lite-Sticks sold). All other customers' accounts were paid in full by year-end.
8. On December 31, 2020, the Sunshine Lite-Stick made a rent payment of $10,000 to pay for the
Company’s rent for the month of January, 2021.
9. The annual interest rate on the $100,000 bank loan (see transaction 1 on the previous page) is 10
percent. At the end of the day on December 31, 2020, the Company owed the bank $10,000 in
interest payable on January 1, 2021.
In preparing her state of the corporation report, Mary Davis notes with some anxiety that the Company's
bank balance has fallen from $1,000,000 at the beginning of the year to only $550,000 on December 31,
2020. It bothers her because she believes that the Company is really doing quite well, and she fails to
understand why the bank account does not appear to reflect this condition. In surveying the cash outflows
incurred by Sunshine Lite-Stick, Inc., over the entire year, she notes the following:
Summary of Cash Deposits and Withdrawals, January 1, 2020 – December 31, 2020
Transaction
#
Cash Deposits:
a.
Issuance of Common Stock
1.
Loan from Bank
7.
Sales of Sunshine Lite-Sticks
Total
b.
2.
3.
4.
5.
6.
8.
$1,000,000
100,000
900,000
$2,000,000
Cash Withdrawals:
Purchase of Patent
Purchase of Machinery
Purchase of Plastics and Chemicals
Payment for Advertising
Payment for Direct Labor and Overhead
Payment for Corporate Salaries
Payment for January 2021 Rent
Total
200,000
300,000
275,000
15,000
500,000
150,000
10,000
$1,450,000
Ending Cash Balance, December 31, 2020
$
$
550,000
In addition to documenting all of the Company’s cash flows (see above), Mary is confused as to how to
treat the following items:
10. A physical inventory on December 31, 2020 shows the following:
Raw Materials (Plastics and Chemicals):
Work in Process (Partially Finished Sunshine Lite-Sticks):
Finished Goods (Completed Sunshine Lite-Sticks not yet Sold):
Total
$100,000
0
0
$100,000
How should the Company treat the $200,000 reduction in the $300,000 of plastics and chemicals
that were purchased in 2020?
11. How much of the machinery used to manufacture the Sunshine Lite-Sticks has been used up
(depreciated) over the twelve months ended December 31, 2020? The manufacturer of the
machinery provided the following estimates for the machinery’s “useful life”:
2
Sunshine Lite-Stick, Inc.
Light Usage
Average Usage
Heavy Usage
05-31-2017
Revised 09-04-2022
15 years
12 years
10 years
On the one hand, after considering the manufacturer’s estimates, Mary’s “best guess” with
respect to the use of the machinery during 2020 is average usage. On the other hand, she knew if
demand for Lite-Sticks were to substantially increase in 2021 and beyond, the machinery would
require heavy usage and vice versa, if demand were to substantially decrease in 2021 and beyond,
the machinery would require light usage. Mary is comfortable with using straight-line
depreciation to spread the cost of the machinery over 12 years, but she is concerned if her sales
forecasts for 2021 and beyond proved to be significantly incorrect?
12. Although the patent that the Company has acquired has a legal life of 20 years, Mary expects
competitors to develop equivalent products in about five years, using different chemical formulas
from Sunshine’s patented method. What makes the most economic sense? Using straight-line
amortization, spread the cost of the patent over its protected legal life of 20 years or over its
expected useful life of five years?
13. In December 2020, the Company received a firm order from the committee organizing the 2021
IAAF World Championships to be held in London in 2021. The committee has placed a firm
order with the Company for 60,000 Sunshine Lite-Sticks at a price of $3.00 each. It is their
intention to give a Sunshine Lite-Stick to each person at the evening opening ceremony of the
2021 IAAF World Championships and to have athletes and fans “light” their Sunshine LiteSticks, symbolic of the opening of the games. Mary wonders how the Company should show the
order in its 2020 financial statements, if at all?
Mary Davis is an inventor, not a businessperson, and she is perplexed about how to report the events of
the year to the angel investors as well as herself. She has a feeling that things are going well, but she isn’t
sure how to convey this message to her fellow investors. As a result, she has hired a local accounting firm
to assist her in preparing a set of financial statements to assess how the Company has performed in 2020.
Separately, the accounting firm will also produce Sunshine Lite-Stick’s tax return for 2020. However, the
accounting firm made it clear to Mary that a Company’s tax return and its financial statements for
investors are not the same. The tax return is prepared using the tax accounting rules of the U.S. Treasury
Department. The financial statements for investors are prepared using accounting standards developed by
the Financial Accounting Standards Board (FASB) known as generally accepted accounting principles
(GAAP). The corporate tax rate on profits before income taxes for Sunshine Lite-Stick, Inc. is 20%
05-31-2017
Revised 09-04-2022
Exhibit 1 – Sunshine Lite-Sticks, Inc. Vision and Mission Statement
4
Sunshine Lite-Stick, Inc.
FSI
Financial Statement Investigation
01-23-2013
Revised 09-05-2022
Overlook Inn
On the morning of September 1, 2018, John and Sandra Darby invested $109,200 of their life
savings to purchase all of the equity ownership shares of Overlook Inn (also, “Overlook” or the
“Inn”). Earlier that same morning, the Darbys had legally incorporated Overlook Inn as the entity
they would use to fulfill their dream of owning a business of their own. Throughout the month of
September, Overlook Inn undertook a series of transactions that would lead to its establishment as
a quaint “bed and breakfast” inn near Waterville, New Hampshire. Waterville had always been a
popular summer and autumn vacation area. In addition, the popularity of alpine skiing made the
area a busy winter resort as well.
In early September, the Inn received a mortgage loan of $294,000 from Waterville Savings
Bank. The $294,000 from the loan plus the $109,200 from the Darbys allowed the Inn to purchase
land, valued at $66,000, and a building, valued at $258,000, from which it could commence operations. The building was a converted nineteenth-century farmhouse that appeared to be ideal for a
bed and breakfast. In addition to the $324,000 used to pay for the land and building, throughout
the rest of September the Inn paid $73,800 for furnishings and equipment used to transform the
building to a functioning guesthouse. Finally, just before opening for customers, the Inn purchased initial food and supplies for $2,400 in cash.
By the end of September, the Inn was ready to receive its first guests. Overlook offered nine
guest rooms on the second and third floors, including two luxury suites, which featured fireplaces
and private balconies with spectacular views. The main floor had two sitting rooms, one with a
large fireplace, a dining room, kitchen, and a parlor that was used as an office. The price of a
room included breakfast, which was served “family style” each morning in the dining room. The
Inn did not serve lunch or dinner, and breakfast was available only to overnight guests. The “bed
and breakfast” format was popular among visitors from eastern metropolitan areas such as Boston
and New York, and the Darbys were extremely pleased with the high occupancy rates for the Inn
throughout the remainder of 2018 and well into 2019.
The Darbys had no formal business training or experience. However, Mr. Darby was an experienced carpenter and was able to handle most of the repairs and maintenance for the Inn by himself. The Darbys worked full time operating Overlook. In addition, they hired a part-time employee to handle cleaning and miscellaneous chores around the Inn. Overall, the Darby’s were
very satisfied with the running of the Inn for the 12 months ended August 31, 2019. Nevertheless,
they were very unsure regarding the financial performance of Overlook. Was the Inn a good investment from which they could live a comfortable and enjoyable life over the next number of
years? Due to their inability to answer this question, the Darbys decided to visit their accountant
to discuss the long-term viability of operating Overlook.
Norman J. Bartczak, Columbia University, prepared this case as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2013 Norman J. Bartczak.
1
Overlook Inn
01-23-2013
Revised 09-05-2022
Bill Martin, a local C.P.A., had been retained by the Darbys to prepare their tax return for fiscal year1 2019. Still, he was surprised to see the Darbys enter his office on Friday, September 1,
2019. John and Sandra explained their dilemma with respect to the enjoyment they received from
operating Overlook but not being sure of its financial sustainability. They told Martin that they
planned to close the Inn for three weeks the following April, when business is slow, and take a
trip to Florida. Unfortunately, as of now they weren’t sure if they could afford the vacation.
“It sounds as if you could use a set of financial statements,” Martin said. “You know, a profit
and loss statement, a balance sheet, and a statement of cash flows. They will tell you how well
your business did last year and where you stand at year end.” John Darby interjected: “But isn’t a
profit and loss statement just the same as our tax statement?”
“Not exactly,” replied Martin. “The objectives of the tax return and profit and loss statement
are somewhat different. I think it will be easier to explain after I prepare your statements. I’ll
stop by the Inn tomorrow to get the information I need.”
The only records that the Darbys kept for Overlook Inn were a checkbook register (see next
page), which included detailed explanations of all checks drawn, and a file of all invoices received. Sandra Darby explained to Bill Martin that she was sure that the Inn earned a profit in
fiscal 2019 because the cash balance in the checking account was $63,000. Martin gathered the
information he needed and returned to his office to prepare the financial statements.
Upon returning to his office, the first thing Martin did was to record (“bookkeep”) all of the
transactions that the Darbys had entered into with respect to the Overlook Inn since they started it
on September 1, 2018. He decided to assume a balance sheet with zero balances as of the morning
of September 1, 2018 (see below) so he could record all of the transactions involving Overlook
Inn, including its acquisition on September 1, 2018 and its operations through August 31, 2019.
Statement of Financial Position (Balance Sheet) as of September 1, 2018
ASSETS
Cash
Food and Supplies Inventory
Total Current Assets
Land
Building
Furnishings and Equipment
TOTAL ASSETS
$
$
$
$
0
0
0
0
0
0
0
LIABILITIES AND OWNERS’ EQUITY
Accounts Payable
Total Current Liabilities
$
$
0
0
Mortgage Payable
Total Liabilities
$
$
0
0
Owners’ Capital
TOTAL LIABILITIES AND
OWNERS’ EQUITY
$
0
$
0
Martin noted that in starting the Inn, the Darbys had: (1) put $109,200 in cash into Overlook
for 100% of the equity ownership of the Inn; and, (2) Overlook had received a $294,000 mortgage
loan. The Inn had used the cash to: (3) purchase land for $66,000; (4) a building for $258,000; (5)
furnishings and equipment for $73,800; and, (6) initial food and supplies for $2,400. These transactions left Overlook Inn with $3,000 in cash to begin running the business.
1A
fiscal year is any 12-month period, without specific regard to the calendar year, at the end of which a company determines its
financial condition. A company's fiscal year will always reflect the date of the calendar year in which it ends. For example: The
financial operations Wal-Mart are carried out in a fiscal year that begins on February1 and ends on January 31. Therefore WalMart’s fiscal year for 2017 would begin on February 1, 2016 and end on January 31, 2017. The key thing to remember is that a
fiscal year doesn't necessarily correspond with the calendar year.
2
01-23-2013
Revised 09-05-2022
Overlook Inn
Next, Martin prepared a summary of cash deposits and withdrawals for the Inn from September 1, 2018 through August 31, 2019, based on the Overlook Inn checkbook (see below).
Check Book Summary of Cash Deposits and Withdrawals, September 1, 2018-August 31, 2019
Transaction
#
Cash Deposits:
1.
Owners’ Capital
2.
Mortgage Funds
a.
Advance Deposits
a.
Payments Collected from Customers (for services provided during fiscal 2019)
Total
3.
4.
5.
6.
c.
c.
d.
e.
f.
f.
f.
f.
g.
$109,200
294,000
11,700
241,030
$655,930
Cash Withdrawals:
Land
Building
Furnishings and Equipment
Food and Supplies (purchased for cash on September 1, 2018)
Mortgage Interest Payment
Mortgage Principal Payment
Insurance
Food and Supplies (initially purchased on account but paid in fiscal 2019)
Wages
Utilities
Advertising
Owners’ Salaries
Firewood
Total
$ 66,000
258,000
73,800
2,400
29,340
900
2,100
24,300
25,200
4,950
3,600
100,000
2,340
$592,930
Ending Cash Balance, August 31, 2019
$ 63,000
Once he had completed recording (“bookkeeping”) all of these transactions, Martin began to
piece together the information he needed to prepare a balance sheet at August 31, 2019, as well as
an income statement and cash flow statement for the 12 months ended August 31, 2019.
a. When they began operating the Inn, the Darbys instituted a policy of requiring a $150 deposit for advance reservations. By August 31, 2019, Overlook Inn had collected cash advance deposits totaling $11,700 for reservations in September and October, 2019. Also,
by August 31, 2019. Overlook Inn had collected totaling $241,030 for bed and breakfast
services provided to customers during fiscal 2019.
b. Overlook Inn did not accept credit cards or other forms of credit. However, on a few occasions, some guests did not have enough cash to settle their bills and the Darbys allowed
these customers to send the Inn the remaining balance once they returned home. At August 31, 2019, Overlook Inn had $2,000 in accounts receivable outstanding from guests.
During early September 2019, the Inn received cash payments of $1,500 for the accounts
receivable. When the Darbys phoned the guest who owed the Inn the remaining $500, they
were told that he had moved. Martin decided to make an allowance for doubtful accounts
for the $500 because the Darbys told Martin they thought the guest might return next year
and pay the $500 at that time.
c. Martin determined that, out of the $30,240 paid toward the Overlook Inn mortgage,
$29,340 was interest and the remaining $900 was paid to reduce the principal balance.
d. The $2,100 paid for insurance provided fire and casualty coverage for the 14-month period from September 1, 2018 through October 31, 2019.
3
Overlook Inn
01-23-2013
Revised 09-05-2022
e. During fiscal 2019, Overlook Inn purchased $29,550 of food and supplies on credit. This
was in addition to the $2,400 of initial food and supplies purchased for cash in September,
2018. At year end, Overlook Inn still owed a total of $5,250 to various suppliers. In addition, the Darbys estimated that year-end inventories of food and supplies for the Inn totaled $1,650.
f. Employee wages of $25,200, utilities of $4,950, and advertising expenses of $3,600 had
been paid in full by year end. Overlook Inn paid the Darbys a total of $100,000 as their
salaries for the 12-month period. Martin considered the Darbys’ salaries as reasonable
payment for their work at the Inn and included them as part of the operating expenses for
Overlook Inn.
g. From September 1, 2018 through August 31, 2019, Overlook Inn paid $2,340 for firewood. Mr. Darby estimated that the firewood remaining in the woodpile at August 31,
2019 had cost $1,500.
h. Martin determined that straight-line depreciation of the building, furnishings, and equipment totaled $22,620 during the 12-month period ending August 31. Martin felt that depreciation of $22,620 would be a fair reflection of the amount of the building, furnishings,
and equipment that had been “used up” during the 12-month operating period. He used a
25-year useful life for the building ($258,000/25 = $10,320 depreciation expense per year)
and a 6-year useful life for the furnishings and equipment ($73,800/6 = $12,300 depreciation expense per year).
i. Martin had just about completed the financial statements for the Overlook Inn when he received a phone call from Mrs. Darby. She explained that she had just received a property
tax2 statement from the Town of Waterville. According to the statement, Overlook Inn
owed property taxes totaling $3,120 for the 13-month period ending September 30, 2019.
2
Property taxes are not income taxes. Normally, property taxes are levied by local and/or state governments as an
annual percentage of the estimated value of real tangible property (including land and buildings). Income taxes are
levied by local and/or state and/or federal government entities on the taxable earnings of individuals and/or business
enterprises.
4
01-23-2013
Revised 09-05-2022
Overlook Inn
Questions:
1. Using the attached T-Accounts, as best you can record (“bookkeep”) the transactions for the
Overlook Inn from the period September 1, 2018 through August 31, 2019.
2. After you have completed the T-Accounts, prepare an Income Statement from the Income
Statement T-Account for the 12-month period from September 1, 2018 through August 31,
2019. To determine Overlook’s financial reporting income tax expense, apply a 20% tax rate
to the income before income taxes number you calculated. Enter the income tax expense as a
“left-hand” side entry in the Income Statement T-Account and as taxes payable, a “righthand” side entry on the liability side of Overlook’s balance sheet. To determine Overlook’s
net income, subtract the income tax expense from the income before income taxes. The income statement will be given to the Darbys to explain Overlook Inn’s financial performance
during the 12-month period.
3. Using the balances from your T-Accounts, prepare a Balance Sheet as of August 31, 2019.
“Close out” Overlook’s Income Statement T-Account (by “zeroing out” the net income, i.e.
putting a left-hand side entry for the amount of net income in the income statement) for the
12-month period to Overlook’s balance sheet (a right-hand side entry by increasing Overlook’s equity account, i.e. its retained earnings account by the amount of net income for the
period, i.e. from $0 to $0 + Overlook’s Net Income) at August 31, 2019.
4. From the cash T-Account, prepare a statement of cash flows using the direct method for the
Overlook Inn for the 12-month period from September 1, 2018 through August 31, 2019.
NOTE: Since the initial balance sheet has zero balances, the beginning cash for the cash flow
statement is also zero, The ending cash balance is $63,000. The cash flow statement explains
how the “cash flowed” from $0 to $63,000 from operating, investing and financing activities.
5. After you have prepared a cash flow statement using the direct method, prepare a cash flow
statement for Overlook Inn using the indirect method. NOTE: You only need to show the section that shows Cash Flow from Operations using the indirect method. The sections for Cash
from Investing and Financing sections will be exactly the same as with the direct method. Do
not waste your time copying these sections in the indirect method.
6. Did the Overlook Inn have a “good” year or a “bad” year from September 1, 2018 through
August 31, 2019? Briefly explain your answer.
5
Overlook Inn
01-23-2013
Revised 09-05-2022
OVERLOOK INN
1.
Using the following T-Accounts, or, on your own separate sheets of paper, record (“bookkeep”) the transactions
for the Overlook Inn from the period September 1, 2018 through August 31, 2019. NOTE: You will need to supply “titles”. The number of T-Accounts supplied is “suggestive” as to how many you will need.
Balance Sheet T-Accounts
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01-23-2013
Revised 09-05-2022
Overlook Inn
OVERLOOK INN
Balance Sheet T-Accounts
(continued)
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7
Overlook Inn
01-23-2013
Revised 09-05-2022
OVERLOOK INN
Balance Sheet T-Accounts
(continued)
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8
01-23-2013
Revised 09-05-2022
Overlook Inn
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
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Revenues, Gains, Other Income
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9
Overlook Inn
10
01-23-2013
Revised 09-05-2022
01-23-2013
Revised 09-05-2022
Overlook Inn
11
Overlook Inn
12
01-23-2013
Revised 09-05-2022
01-23-2013
Revised 09-05-2022
Overlook Inn
13
THIS PAGE INTENTIONALLY LEFT BLANK
FSI
Financial Statement Investigation
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
On January 1, 2018, Arnold Ziffer completed the legal papers to establish his new company,
the Green Acres Lumber Company (“Green Acres” or the “Company”) in Green Acres, North
Carolina. Located next to the railroad station at Green Acres, Mr. Ziffer converted an abandoned
drive-in theater at the site into a lumberyard. Green Acres was a suburban community located just
outside of Charlotte, North Carolina. The entire area was one of the fastest growing metropolitan
sections of the United States. Residential as well as commercial construction was booming and
Mr. Ziffer expected Green Acres Lumber to grow correspondingly.
The Company sold both finished and unfinished lumber to building contractors as well as “doit-yourself” individuals for their construction projects. Unfinished lumber was either sold as is or
was cut to the specifications of the customer, with a minimal charge for the cutting. Finished
lumber usually consisted of adding some type of coating (e.g. weathercoating) to the lumber and,
if necessary, also cutting the lumber to the customer’s specifications. For the most part, the labor
and materials associated with this process were minimal as were the customer’s cost. In addition,
Green Acres only carried unfinished lumber in its inventory, with the finishing process being
completed as ordered by customers.
Arnold Ziffer had no formal business training or experience. However, he had been a contractor for a number of years prior to establishing Green Acres. Mr. Ziffer, a widower, worked
full time operating the lumberyard and handled all the cutting and finishing of the lumber. In
addition, two of his children (ages 18 and 19) worked for him part-time after school and on weekends. They helped to fill customer orders, load lumber, and, in general, clean-up around the lumberyard. Overall, Mr. Ziffer was pleased with the success of his business in 2018 and felt that he
had learned a great deal about running the lumberyard during his first year.
Unfortunately, Mr. Ziffer did not feel as comfortable in his understanding of the Company’s
financial accomplishments. As a result, at the end of the business day on December 31, 2018, he
went to see his friend and accountant, Will Hudson. Mr. Hudson, a local C.P.A., had been retained by Mr. Ziffer to prepare Green Acres’ tax return for 2018. Mr. Ziffer wondered if the tax
return would provide a good explanation as to how the Company had performed financially for
2018 as well as provide an indication of how the Company was likely to perform in the future.
At 6:00 P.M. on December 31, 2018, Mr. Ziffer and Mr. Hudson met in Mr. Hudson’s office to
discuss Green Acres’ tax return along with the Company’s overall financial performance for 2018.
Mr. Hudson explained that in addition to preparing and filing the Company’s tax return to comply
with U.S. tax law, he would prepare a set of financial statements using U.S. generally accepted
accounting principles (GAAP) to understand how Green Acres is functioning as a business.
Norman J. Bartczak, Columbia University, prepared this case as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2013 Norman J. Bartczak.
1
Green Acres Lumber Company
01-23-2013
Revised 09-06-2022
Together with living off of his salary from Green Acres, Mr. Ziffer hoped to grow the Company as a successful investment that he could leave to his children.
Mr. Hudson said to Mr. Ziffer, “I think the financial statements, a profit and loss statement, a
balance sheet, and a cash flow statement, will tell you how well your business did last year and
where you stand at year end.”
Mr. Ziffer interjected: “But isn’t a profit and loss statement just the same as a tax statement?”
“Not exactly,” replied Mr. Hudson. “The objectives of the tax return and profit and loss
statement are somewhat different. I think it will be easier to explain after I prepare your statements. I’ll stop by the yard on Monday to get the information I need.”
The only records that the Mr. Ziffer kept for his business were a checkbook register (see below) which included detailed explanations of all checks drawn, and a file of all invoices received.
Check Book Summary of Cash Deposits and Withdrawals, January 1, 2018-December 31, 2018
Transaction
#
1.
2.
3.
a.
4.
5.
6.
7.
b.
b.
b.
c.
d.
e.
e.
e.
f.
h.
Deposits:
Owners’ Capital
Funds from Mortgage Payable
Funds from Notes Payable to Bank
Receipts collected from customers
Total
$203,200
100,000
50,000
261,400
$614,600
Withdrawals:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Initial Purchase of Unfinished Lumber Inventory
Mortgage Interest Payment
Mortgage Principal Payment
Interest Paid on Notes Payable to Bank
Insurance
Amount of Additional Purchase of Unfinished Lumber Paid for in Fiscal 2018
Salary
Hourly Wages
Utilities
Finishing Materials
Payment of Property Taxes
Total
$ 56,000
178,000
43,000
11,400
10,000
10,000
3,500
7,000
199,600
50,000
22,400
5,700
13,200
2,800
$612,600
Ending Cash Balance, December 31, 2018
$
2,000
Arnold Ziffer explained to Will Hudson that he wasn’t sure if the lumberyard earned a profit
in 2018 because on December 31, 2018 there was only $2,000 in cash left in the checking account
for Green Acres.
On January 1, 2018, Green Acres:
1. Sold all of its owners’ capital (equity) to Mr. Ziffer for $203,200, which is Mr. Ziffer’s lie
savings;
2. Received $100,000 from a mortgage loan from Green Acres National Bank (GANB) (no
relation to Green Acres Lumber Company). The Company’s fixed assets would be
pledged as collateral for the mortgage loan;
2
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
3. Received $50,000 from an unsecured one year note (short-term loan) from GANB, renewable at the bank’s discretion;
4. Paid $56,000 for the purchase of land;
5. Paid $178,000 for the purchase of a building;
6. Paid $43,000 for the purchase of furnishings and equipment; and,
7. Paid $11,400 to purchase the Company’s initial unfinished lumber inventory.
As Mr. Hudson gathered the information he needed to prepare financial statements for Green
Acres, he told Mr. Ziffer not to worry. Mr. Hudson assured Mr. Ziffer that the financial statements
would give him a much clearer picture of Green Acres’ operating and financial condition in 2018.
Upon returning to his office, the first thing Mr. Hudson did was to record (“bookkeep”) all of
the transactions that Mr. Ziffer had entered into with respect to Green Acres Lumber Company
since he began operating the company on January 1, 2018. Mr. Hudson decided to assume a balance sheet with zero balances as of the morning of January 1, 2018 so he could record all of the
transactions that Mr. Ziffer had entered into in both setting up the business during January, 2018
and in running the business through December 31, 2018. Mr. Hudson noted that Mr. Ziffer had
invested $203,200 of his own money and had borrowed the remaining amount to finance the business. Mr. Hudson began recording Green Acre’s transactions from the cash deposits and withdrawals based on Mr. Ziffer’s checkbook (see previous page). Once he had completed recording
the transactions, Mr. Hudson began to piece together the information he needed to prepare financial statements for 2018 from the following additional information.
a. Ordinarily, Mr. Ziffer did not offer credit to his customers. He had decided that by making the business “cash and carry”, he could offer better prices to his customers compared
to his competitors. This strategy had proven to be very successful and contractors often
told Mr. Ziffer that they came to Green Acres because the Company had the “lowest prices in town”. On occasion, however, for “good customers” who placed large orders, Mr.
Ziffer did extend credit for up to 90 days. When Arnold Ziffer gave Will Hudson the
check register he told him that the Company had sold two large orders, one for $9,600 in
September, 2018 and one for $30,400 in December, 2018, which had not been paid as of
December 31, 2018.
On the one hand, Mr. Ziffer expressed concern about his ability to collect on the $9,600
order shipped in September. The amount was already outstanding for over 90 days and the
contractor who had purchased the material had just filed for personal bankruptcy. On the
other hand, he did not want to “write-off” the $9,600 unless and until he was sure he
would receive nothing from the bankruptcy proceedings.
Mr. Ziffer had received a call on December 31, 2018 from the customer who purchased
the $30,400 worth of materials on credit in December, 2018 and the customer informed
Mr. Ziffer that the "check was in the mail." Mr. Ziffer had sold on credit to this customer
on numerous occasions and the customer had always paid within 90 days of his purchases.
The cash received from sales to customers and deposited in the Green Acres’ checking account through December 31, 2018 totaled $261,400.
3
Green Acres Lumber Company
01-23-2013
Revised 09-06-2022
b. Mr. Hudson determined that, out of the $20,000 paid toward the Company’s mortgage
payable, $10,000 was interest and the remaining $10,000 was principal. In addition, he
had paid $3,500 in interest during the year on the $50,000 revolving notes payable to the
bank. Both the mortgage payments and the interest payments on the notes all related only
to 2018. In December, the bank had agreed to renew the revolving notes for another year.
As a result, the balance in the notes payable account at December 31, 2018 was still
$50,000.
c. The $7,000 paid for insurance provided fire and casualty coverage for the period from
January 1, 2018 through February 28, 2019.
d. Green Acres purchased $243,000 of unfinished lumber on account throughout fiscal 2018.
At year end, the Company still owed a total of $43,400 to various suppliers of lumber. In
addition, he had conducted a physical inventory of the lumber still on hand at the lumberyard on December 31, 2018 and determined that it had cost $112,600. This is the amount
that Mr. Hudson put on the December 31, 2018 balance sheet.
e. During fiscal 2018, Green Acres paid $50,000 in salary to Mr. Ziffer and $22,400 in hourly wages to his children working part-time) and $5,700 for utilities. There were no outstanding wages payable or utilities bills for fiscal 2018.
f. During 2018, Green Acres purchased $13,200 of finishing materials for cash. At year end,
Mr. Ziffer estimated that the Company still had $10,700 of the finishing materials on
hand.
g. Mr. Hudson determined that straight-line depreciation of the building, furnishings, and
equipment totaled $17,500 during the 12-month period ending December 31, 2018. Mr.
Hudson felt that depreciation of $17,500 would be a fair reflection of the amount of the
building, furnishings, and equipment that had been “used up” during the 12-month operating period. He used a 20-year useful life for the building ($178,000/20 = $8,900 depreciation expense per year) and a 5-year useful life for the furnishings and equipment
($43,000/5 = $8,600 depreciation expense per year).
h. On December 31, 2018, the Company made a payment of $2,800 to the Town of Green
Acres for property taxes for the Company for the 14-month period ending February 28,
2019.
4
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
Questions:
1. Using either the T-accounts provided in Exhibit 2 or whatever method you prefer, record
(“bookkeep”) the transactions for the Green Acres Lumber Company from the period January
1, 2018 through December 31, 2018.
2. Based on you answer to Question 1, prepare an income statement for the 12-month period
from January 1, 2018 through December 31, 2018 and a statement of financial position (i.e.
balance sheet) as of December 31, 2018. Assume a tax rate of 20%.
Next, prepare a statement of cash flows (using both the direct and the indirect methods) for
the Green Acres Lumber Company for the 12-month period from January 1, 2018 through
December 31, 2018. NOTE: Since the initial balance sheet has zero balances, the beginning
cash for the cash flow statement is also zero. The ending cash balance is $2,000 (the difference between cash receipts and disbursements from the checkbook register). You need to explain how the “cash flowed” from $0 to $2,000 from operating, investing and financing activities.
The income statement, balance sheet and cash flow statements you prepare will be given to
Mr. Ziffer to explain the Green Acres Lumber Company’s financial performance during the
12-month period.
3. Using whatever criteria you feel appropriate, did the Green Acres Lumber Company have a
“good” year or a “bad” year from January 1, 2018 through December 31, 2018? Briefly explain your criteria and reasoning.
5
Green Acres Lumber Company
01-23-2013
Revised 09-06-2022
4. Answer this question after you have completed answering Questions 1 and 2.
Assume that for tax purposes, the U.S. Internal Revenue Service allows the Company to use a
10-year useful life for the building ($178,000/10 = $17,800 depreciation expense per year)
and a 2.5-year useful life for the furnishings and equipment ($43,000/2.5 = $17,200 depreciation expense per year). As a result, Green Acres will be allowed to deduct $35,000 for depreciation for tax purposes in fiscal 2018 (instead of the $17,500 used for financial reporting purposes).
a. For tax purposes, what would the Green Acres Lumber Company’s income before income
taxes (before deducting its income tax expense) be for the 12-month period ended December 31, 2018?
b. Using the income before income taxes from the income statement you prepared in Question 2 and a tax rate of 20%, what income tax expense did you show for Green Acres for
financial reporting purposes?
c. Using the income before income taxes for tax purposes from your answer in a. above and
assuming a tax rate of 20%, how much will Green Acres actually have to pay in taxes to
the U.S. Internal Revenue Service for the 12-month period ended December 31, 2018?
d. Where would the difference show up on Green Acres' financial statements and what is the
difference called?
e. Adjust the financial statements you originally prepared to reflect the difference in accounting for financial reporting purposes and for tax purposes.
6
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
GREEN ACRES LUMBER COMPANY
Using the following T-accounts, record (“bookkeep”) the transactions for the Green Acres Lumber Company from
the period January 1, 2018 through December 31, 2018. NOTE: You will need to supply “titles”. The number of Taccounts is “suggestive” as to how many you will need.
Balance Sheet T-Accounts
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7
Green Acres Lumber Company
01-23-2013
Revised 09-06-2022
GREEN ACRES LUMBER COMPANY
Balance Sheet T-Accounts
(continued)
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8
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
GREEN ACRES LUMBER COMPANY
Balance Sheet T-Accounts
(continued)
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9
Green Acres Lumber Company
01-23-2013
Revised 09-06-2022
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
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Revenues, Gains, Other Income
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10
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
11
Green Acres Lumber Company
12
01-23-2013
Revised 09-06-2022
01-23-2013
Revised 09-06-2022
Green Acres Lumber Company
13
Green Acres Lumber Company
14
01-23-2013
Revised 09-06-2022
FSI
Financial Statement Investigation
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
On January 31, 2019, Daniela Porter, age 47, and Arthur Porter, age 48, signed the final legal
documents so they could begin operation on February 1, 2019 of their new business venture, a preschool “edutainment”1 store, Toddler Town, Inc. (“Toddler Town” or “TTI”), located in an upscale
shopping area in Greenwich, Connecticut. To provide initial financing for the business on January
31, 2019, Daniela and Arthur invested $350 thousand of their life savings for all of the common
stock of Toddler Town, Inc. In addition, on January 31, 2019, Daniela and Arthur’s parents lent
TTI a total of $200 thousand to help Daniela and Arthur get the business off the ground.
Also on January 31, 2019, Daniela and Arthur’s uncle, Don Williams purchased and paid for
$100 thousand (at TTI’s regular selling price) of pre-school games and toys from Toddler Town
for a group of daycare centers he was acquiring in the Greenwich area. Although the games and
toys for Uncle Don’s daycare centers were not yet available and would not be shipped until March
2019, when Uncle Don’s acquisition of the centers would be completed, he wanted to give Toddler
Town a “jump start” by placing an advance order as soon as possible.
Additionally, on January 31, 2019, Toddler Town took delivery from various vendors of $40
thousand worth of furniture and equipment, and $200 thousand of an initial games and toys inventory so TTI could begin operations as soon as possible. All of the furniture and equipment were
paid for as of January 31, 2019. The games and toys inventory was purchased on account and
would be paid for at the end of February 2019. (These initial transactions are reflected in the Balance Sheet as of January 31, 2019 on page four of this case study).
Daniela and Arthur had always aspired to own their own business and had been saving do to
so throughout their marriage. However, as the new millennium came and went, the Porters began
to accept the likelihood that their dream would not happen. Arthur had spent his entire career
working in sales for Craindoodle, Inc., a company which operates a chain of education-oriented
toy stores with outlets in Connecticut, New York, and New Jersey. Since 2010, Daniela had
worked as a special needs teacher for children at a high school in Stamford, Connecticut.
At the beginning of 2018, Arthur was a district sales manager for Craindoodle. Unfortunately, due to a variety of competitive factors and questionable strategic moves, Craindoodle and all
of its subsidiaries filed for Chapter 11 bankruptcy in January 2018. Although Craindoodle
emerged from bankruptcy fairly quickly in April 2018, Arthur Porter felt his career at Craindoodle
1An
“edutainment” store is a term used to describe pre-school children’s stores that are considered innovative, providing baby
boomer parents with a better selection than competitors of games and toys designed to expand children’s minds. To be successful, the stores maintain a good product selection, hold numerous events in the stores to educate and entertain children, and hire
employees trained as "kid-sultants" who advise parents on the best games and toys for their child's age and educational development.
Norman J. Bartczak, Columbia University, prepared this case as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2017 Norman J. Bartczak.
1
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
was on shaky grounds, at best. He decided to accept the company’s severance package and left
Craindoodle in the summer of 2018. Arthur and Daniela began looking for business ventures
through the latter half of 2018 and when the TTI opportunity presented itself in early 2019, they
jumped at the chance.
Throughout 2019 and early 2020, the Porters worked full time operating Toddler Town, Inc.
In addition, they hired a number of employees both full-time (two) for selling and administrative
work and part-time (5) for selling, cleaning and miscellaneous jobs around the store. Unfortunately, none of the employees, including the Porters, was knowledgeable with respect to formal record-keeping techniques for a business. As a result, TTI’s financial records were kept in its checkbook register (see next page), which included explanations of all checks drawn, and a file of all
invoices and receipts, and a list of sales made on account from various sources. Neither Daniela
nor Arthur were concerned about their finances throughout the year because there always seemed
to be plenty of cash on hand in the bank. However, as the end of the year approached, they realized that they would have to file their tax return for the business. In addition, they began to wonder if they were really doing as well as their cash balance suggested.
At a family gathering, during the December holidays, Arthur Porter’s father, Alexander Porter, asked his son how TTI was getting along. Alexander Porter is a retired CPA and one of the
parent lenders to TTI. He was surprised to learn that his son was not very clear as to how the
business was performing. Arthur kept emphasizing that the Company seemed to have plenty of
cash. When his father asked him if he had prepared a set of financial statements for the Company,
Arthur told him that he didn’t have to file TTI’s tax return until April 15, 2020 for the business
year ended January 31, 2020. Arthur’s father replied that he wasn’t asking about the tax return
financial statements. He wanted to know how TTI was doing using accrual accounting concepts
under generally accepted accounting principles (GAAP). At this point Arthur looked perplexed.
“What’s the difference?”, he said. Alexander Porter smiled at his son and said, “I guess you need
my help.”
Arthur’s father explained that there is a difference between the two types of statements because they are prepared for different reasons and, in many cases, using accounting choices that are
also different. The tax statements are prepared to satisfy the government’s tax policies. The
GAAP or “book” statements are prepared to explain the underlying economics of the business. As
a result, there can be a big difference between tax return financial statements and financial statements prepared using GAAP. Arthur’s father agreed to come back at the end of January to assist
in the preparation of both sets of financial statements.
Alexander Porter returned to Greenwich, Connecticut during the week of January 30th to begin
sorting through the various financial information for Toddler Town, Inc. By Tuesday, January 31,
he was ready to draft TTI’s tax return as well as a set of “book” financial statements prepared
according to GAAP for the fiscal year ended January 31, 2020. The only items that remained to
be incorporated were from the January 31 transactions as well as the final count on the physical
inventory. Alexander Porter got back to Daniela and Arthur on Saturday morning with tax financial statements for the fiscal year ended January 31, 2020 (see the Tax Return on the next page).
He expected the GAAP financial statements to be ready later that day.
2
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
Summary of Cash Deposits and Withdrawals, February 1, 2019 – January 31, 2020
(all dollar amounts in thousands)
Transaction: Deposits:
a.
Funds from Mortgage Loan from Knickerbocker National Bank
d.
Funds from Notes Payable from Pilgrim National Bank
q.
Cash Receipts Collected from Credit Card in Fiscal 2020
r.
Cash Advance Payments Received for Backordered Games and Toys
Total
Checks Drawn:
Purchase of Structure and Build-Out for TTI Store
Purchase of Furnishings, Fixtures and Equipment
Payment of Accounts Payable for Games & Toys Inventory
Purchased and Received on January 31, 2019
Wages (excluding salaries of Daniela and Arthur Porter)
Advertising (including Grand Opening Expense)
Insurance Payments Made in Fiscal 2020
Utilities Paid for in Fiscal 2020
Mortgage Principal Payment
Mortgage Interest Payment
Note Payable Principal Payment
Note Payable Interest Payment
Games and Toys Purchased and Paid for in Fiscal 2020
Estimated Income Tax Payment Made in Fiscal 2020
Total
b.
c.
e.
g.
h.
j.
k.
l.
l.
m.
m.
o.
v.
Decrease in Cash
Cash at Beginning of Period
Cash at End of Period
$
600
100
2,600
30
$3,330
800
50
200
240
54
24
18
40
48
100
10
2,000
26
$3,610
$ (280)
610
$ 330
Tax Return for the Twelve Months February 1, 2019 through January 31, 2020
(all dollar amounts in thousands)
Revenues:
Cash Received from Uncle Don on January 31, 20192
Cash Receipts Collected from Sales in Fiscal 2020
Cash Collected from Advance Payments
Total
Expenses:
Wages (excluding salaries of Daniela and Arthur Porter) 240
Advertising (including Grand Opening Expense)
54
Insurance Payments Made in Fiscal 2020
24
Utilities Paid for in Fiscal 2020
18
Interest Expense on Mortgage Loan
48
Interest Expense on Note Payable
10
Games and Toys Purchased and Paid for in Fiscal 2020
2,000
Write-Off of Account Receivable
6
Depreciation Expense–Building
80
Depreciation Expense-Furnishings, Fixtures & Equipment
30
Total Expenses
100
2,600
30
$2,730
$2,510
Pretax Taxable Income
Taxes Payable to the IRS (assume a 20% tax rate)
Tax Net Income
$
$
$
220
44
176
Actual Taxes Payable for the 12 Months Ended January 31, 2020
Apply and Reduce Prepaid Income Taxes Against Taxes Payable
Remaining Taxes Payable after Applying Prepaid Tax Payment
$
44
26
18
$
2If
Toddler Town had been in operation on January 31, 2019, the $100,000 received from Uncle Don on January 31, 2019 would
have been treated as revenue for tax purposes on January 31, 2019. However, since Toddler Town did not begin operations until
February 1, 2019, the $100,000 is treated as revenue for tax purposes for the tax year ended January 31, 2020.
3
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
In beginning his preparation of the accrual accounting based financial statements for Toddler
Town, Inc. for its fiscal year (12 months) ended January 31, 2020, the first thing Alexander Porter
did was to “bookkeep” all of the transactions that the Porters had entered into with respect to
Toddler Town, Inc. since (and including) February 1, 2019. He used the following balance sheet
on January 31, 2019 as his starting point for the assets, liabilities, and equity of the Company as of
February 1, 2019. Note that the ending balance sheet on January 31, 2019 is the beginning balance sheet for February 1, 2019.
TODDLER TOWN, INC.
Statement of Financial Position (Balance Sheet) as of January 31, 2019
(all dollar amounts in thousands)
Assets:
Cash
Games and Toys Inventory
Current Assets
$610
200
810
Furnishings and Fixtures
40
Total Assets
$850
Liabilities and Equity:
Accounts Payable
Unearned Revenue
Loan from Parents
Current Liabilities
Shareholders’ Equity:
Common Stock
Total Liabilities & Equity
200
100
200
500
350
$850
Alexander then began recording TTI’s transactions from the cash deposits and withdrawals
record (see Exhibit 1) for the Company from February 1, 2019 through January 31, 2020. He went
through each of the cash transactions and then made accrual accounting adjustments from the
following information (all dollar amounts in thousands):
a. On February 1, 2019, TTI received a $600 mortgage loan from Knickerbocker National
Bank as part of the cash needed to purchase the store structure from which Toddler Town,
Inc. will operate.
b. Subsequently, on February 1, 2019, TTI paid $800 to purchase the structure and pay for
the build-out of the store from which TTI operates.
c. Another $50 in cash was spent to purchase furniture and equipment on February 1, 2019.
The $50 was in addition to the $40 that had been spent on furniture and equipment on January 31, 2019.
d. Also, on February 1, 2019, Toddler Town received a loan in the form of a note payable for
$100 from Pilgrim National Bank for working capital purposes. The principal on the note
was due on February 1, 2020; however, the loan was renewable, at the bank’s discretion,
as long as the interest was paid and the business was complying with the requirements of
the loan agreement.
e. On February 28, 2019, Toddler Town paid the $200 in accounts payable for its initial
games and toys inventory which had been purchased and received on January 31, 2019.
f. In March 2019, Uncle Don completed the acquisition of a number of daycare centers. Also, in March 2019, Toddler Town shipped the $100 of games and toys Uncle Don had ordered and paid for on January 31, 2019.
4
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
g. TTI paid both its full-time (two people) and part-time (five people) employees on the last
day of the month of the month worked, e.g. employees were paid on February 28, 2019 for
working during the month of February, 2019. Wages (excluding the salaries of the Porters)
of $20 per month totaling $240 for the year had been paid as of January 31, 2020. The
next wage payment of $20 for the month of February, 2020 was due on February 28, 2020.
h. TTI paid $54 for advertising during its fiscal year ending January 31, 2020.
i. The Porters decided that their annual salaries would be $140 each, for a 12 month total of
$280 as their salaries through January 31, 2020. Alexander Porter believed that this represented a “fair” salary to the Porters for the work they performed at the Company from
February 1, 2019 through January 31, 2020. However, since Arthur Porter was still receiving severance payments from Craindoodle, the Porters decided that they did not need to
receive their salaries in cash until sometime in the next 12 months (ending on January 31,
2021). Their $280 in salaries was recorded as deferred compensation for the 12 months
ended January 31, 2020.
j. On February 1, 2019, the Company made a premium payment of $24 for fire and casualty
insurance coverage for the twelve months ended January 31, 2020.
k. TTI’s utility bill of $18 for utility usage over the twelve months ended January 31, 2020
was paid in full as of January 31, 2020.
l. For the year ended January 31, 2020, TTI made mortgage payments totaling $88 consisting of $40 in principal payments and $48 in interest payments.
m. Also on February 1, 2019 (as was mentioned under item d.), TTI received a new $100 loan
from Pilgrim National Bank. At the end of the day on January 31, 2020, TTI paid both the
principal of $100 and the accrued interest of $10 that were due on the next day, February
1, 2020.
n. The terms of the loan from their parents were very flexible. In order to provide their parents with a 12% return on the loan, the loan would accrue (accumulate) interest at an annual rate of 12% throughout the period it remained outstanding. On January 31, 2020, TTI
owed Daniela and Arthur’s parents $24 in interest as well as the $200 in principal. Their
parents agreed that they would wait one more year before being paid the interest and principal that was owed to them at January 31, 2020.
o. Games and toys were purchased on account for $2,300 during fiscal 2020. TTI paid
$2,000 of the accounts payable to its games and toys suppliers and, as a result, still owed
suppliers $300 for games and toys that it had purchased and received during the fiscal year
ended January 31, 2020. Normal supplier terms called for the purchases of games and toys
on account to be paid within 60 days. TTI had been complying with these credit terms. It
did not owe suppliers for any other items on January 31, 2020.
p. Near midnight on January 31, 2020, the Porters finished the physical count of TTI’s
games and toys inventory and determined that the Company had $400 worth of games and
toys left in inventory as of January 31, 2020.
5
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
q. In-store sales of Toddler Town’s products were for cash or credit, with the vast majority
(over 90%) sold on credit. Normally, credit was provided by means of the Company accepting a third-party credit card such as VISA, MasterCard, or American Express. However, the Company had quickly developed a relationship with a number of daycare centers in
the Greenwich area. Typical sales made to these institutions involved a 10% cash down
payment (before the institutions received the games and toys) and the remainder on account, payable to Toddler Town within 45 days of having been provided the games and
toys.
Through January 31, 2020, the Company received $2,600 in cash from customers through
collections from credit card companies for sales made on account, cash payments from
daycare center accounts, and direct cash sales.
r. During January 2020, the Company received $30 in down payments for games and toys
that had been backordered for daycare centers and were expected to be delivered to the centers in February and March 2020.
s. On January 31, 2020, the credit card companies still owed Toddler Town $246 for sales of
games and toys made to Toddler Town customers using VISA, MasterCard, or American
Express credit cards through January 31, 2020. The Company expected to collect all of the
$246 owed from the credit card companies by the end of February, 2020.
t. In addition, daycare centers still owed Toddler Town $100 on January 31, 2020 for games
and toys they purchased through January 31, 2020. All of the daycare center accounts were
current except for one center which still owed $10 (included in the $100 still owed to Toddler Town) for games and toys it purchased from Toddler Town at the beginning of June
2019. Unfortunately, the center had closed at the end of August 2019 and filed for bankruptcy.
In December 2019, the bankruptcy court informed Toddler Town that it could expect to
receive “somewhere between 0 cents and 40 cents on the dollar” for the $10 that it was
owed. The court also noted that Toddler Town would not receive any more than $4 (0.40
times $10) of the $10 it was owed by the bankrupt center. As a result, for the year ended
January 31, 2020, Alexander Porter decided to make an allowance for $4 of the $10 it was
owed and to immediately “write-off” the remaining $6.
u. Alexander Porter determined that for financial reporting (“book”) purposes to TTI,
straight-line depreciation over a 20 year useful life of the Company’s store structure was
appropriate. He felt that the furnishings, fixtures and equipment should be depreciated on
a straight-line basis over a useful life of five years. As a result, for fiscal 2020, Alexander
recorded depreciation of $40 for the building and $18 for the furnishings, fixtures and
equipment.
Finally, Alexander noted that the IRS tax code allowed the store structure and the furnishings, fixtures and equipment to be depreciated on an accelerated depreciation rate.
v. On January 15, 2020, TTI made an estimated income tax payment of $26 for the 12 month
tax period ended on January 31, 2020.
6
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
Once he had completed bookkeeping all of the transactions, Alexander Porter began to piece
together the information he needed to prepare an income statement for the 12 months ended January 31, 2020, as well as a balance sheet at January 31, 2020 and a cash flow statement for the 12
months ended January 31, 2020.
Questions:
1. Using the attached T-accounts (or any other method you prefer) and accrual accounting, as
best you can record (“bookkeep”) the transactions for Toddler Town’s from the period February 1, 2019 through January 31, 2020 (record all dollar amounts in thousands).
2. Based on you answer to Question 1, for financial reporting purposes (not tax purposes) prepare, “in good form” (i.e. proper headings for the reports, distinguish such items as current assets and current liabilities; in the income statement, operating earnings = earnings before interest and taxes):
a. A statement of financial position (i.e. balance sheet) as of January 31, 2020; and,
b. An income statement for the 12-month period from February 1, 2019 through January 31,
2020. Assume an income tax rate of 20% is appropriate for Toddler Town.
c. A statement of cash flows using the Direct Method for Toddler Town for the 12-month period from February 1, 2019 through January 31, 2020; and,
d. A statement of cash flows using the Indirect Method for Toddler Town for the 12-month
period from February 1, 2019 through January 31, 2020.
As long as you show the investing and financing sections of the cash flow statement using
the Direct Method approach, you do not need to show them again for the Indirect Method
approach since they will be the same. For the Indirect Method cash flow statement, you do
need to show the operating activities section.
7
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
3. Overall do you think Toddler Town, Inc. had a “good” year or a “bad” year from February 1,
2019 through January 31, 2020? What criteria did you use to gauge Toddler Town’s performance?
8
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
4. How has Toddler Town performed on a cash flow basis for the year ended January 31, 2020?
Should the Porters be concerned about the Company’s cash position at January 31, 2020 with
respect to operating their business during the upcoming year? Why or why not?
9
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
5. The bank had two requirements for its $100 thousand bank loan: (1) the company have earnings before interest and taxes of at least 2.25 times the company’s interest expense; and, (2)
interest-bearing debt divided by shareholders’ equity (“leverage”) on January 31, 2020 would
be no greater than 2 times. If you were the banker at Pilgrim Bank, would you renew the
$100 thousand bank loan to Toddler Town? Under the same terms? Why or why not?
10
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
6. When you compare your income statement to the tax income statement provided in of the
case, which three items had the most significant impact on deferred income taxes for Toddler
Town? Please state if the items initiated a deferred tax liability or a deferred tax asset.
11
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
1. Using the following T-accounts, record the transactions for Toddler Town from the period
February 1, 2019 through January 31, 2020. NOTE: You will need to supply “titles”. The
number of T-accounts supplied is “suggestive” as to how many you will need. Depending
upon how you record the transactions, you may need more or less T-accounts than supplied
(dollar amounts are specified in thousands).
Cash
--------------------------+
|
Bal. 02/01/19|
=
|
$610
|
|
|
|
|
|
|
|
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12
--------------------------|
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|
--------------------------|
|
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|
|
Games & Toys Inventory
--------------------------+
|
Bal. 02/01/19|
=
|
$200
|
|
|
|
|
|
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
Furniture & Fixtures, Gross
--------------------------- --------------------------+
|
|
Bal. 02/01/19|
|
=
|
|
$ 40
|
|
|
|
|
|
|
|
--------------------------- --------------------------|
|
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|
|
--------------------------- --------------------------|
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|
--------------------------- --------------------------|
|
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|
13
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
Accounts Payable
Unearned Revenue
--------------------------- --------------------------|
+
|
+
|Bal. 02/01/19
|Bal. 02/01/19
|=
|=
|
$200
|
$100
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loan from Parents
--------------------------- --------------------------|
+
|
|Bal. 02/01/19
|
|=
|
|
$200
|
|
|
|
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|
|
|
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|
|
|
|
|
--------------------------- --------------------------|
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14
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
--------------------------- --------------------------|
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|
--------------------------- --------------------------|
|
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|
|
|
|
|
Owners’ Capital
--------------------------- --------------------------|
+
|
|Bal. 02/01/19
|
|=
|
|
$350
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
15
Toddler Town, Inc.
03-09-2017
Revised 09-07-2022
------------------------------------------------------|
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16
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
17
Toddler Town, Inc.
18
03-09-2017
Revised 09-07-2022
03-09-2017
Revised 09-07-2022
Toddler Town, Inc.
19
Toddler Town, Inc.
20
03-09-2017
Revised 09-07-2022
FSI
Financial Statement Investigation
S05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
Suggested Solution
The following T-accounts “bookkeep” the transactions for Sunshine Lite-Stick, Inc. from the period
January 1, 2020 through December 31, 2020. The bookkeeping was done using a “Normal” approach
to the accounting judgments/estimates.
Balance Sheet T-Accounts
Asset T-Accounts:
Cash
--------------------------+
|
Bal @ 1/01/20|
$
0 |
a. 1,000,000 |
|$ 200,000 b.
1.
100,000 |
|
300,000 2.
|
275,000 3.
|
15,000 4
|
500,000 5.
|
150,000 6.
7,
900,000 |
|
10,000 8.
--------------------------2,000,000 | 1,450,000
--------------------------Bal $550,000 |
.
Prepaid Rent
-------------------------+
|
Bal @ 1/01/20|
$
0 |
8.
10,000 |
-------------------------Bal $ 10,000 |
Accounts Receivable
--------------------------+
|
Bal @ 1/01/20|
$
0 |
7.
100,000 |
|
|
--------------------------Bal $100,000 |
Plastics & Chemicals
--------------------------+
|
Bal @ 1/01/20|
$
0 |
3.
300,000 |
|
|
$200,000 10.
--------------------------Bal $100,000 |
Building & Machinery, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
2. 300,000 |
--------------------------Bal $300,000 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
$ 25,000 11.
--------------------------|Bal $ 25,000
Patent, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
b.
200,000 |
--------------------------Bal $200,000 |
Accumulated Amortization
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
40,000 12.
--------------------------|Bal $ 40,000
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
25,000 3.
--------------------------|$
25.000 Bal
Interest Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
10,000 9.
--------------------------|$
10,000 Bal
Taxes Payable
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
12,000 13.
--------------------------|Bal $ 12,000
Note Payable (aka Bank Loan)
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
100,000 1.
--------------------------|$ 100,000 Bal
Equity T-Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 1/01/20
|$
0
| 1,000,000 a.
--------------------------|$1,000,000 Bal
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
48,000 14.
--------------------------|$
48,000 Bal
Norman J. Bartczak, Columbia University, prepared this suggested solution as a basis for class discussion of the Sunshine LiteStick, Inc. case study. It is not intended to illustrate either effective of ineffective handling of an administrative situation. Copyright © 2017 Norman J. Bartczak.
1
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-offs
|
Revenues, Gains, Other Income
|
+
| $ 900,000 cash collected
7.
|
100,000 receivable auto parts distributor
7.
4. Expensing of advertising
$
15,000 |
5. Direct labor, overhead
500,000 |
6. Corporate salaries
150,000 |
9. Expensing of interest
10,000 |
10. Cost of goods sold
200,000 |
11. Depreciation of machinery
25,000 |
12. Amortization of patent
40,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 940,000 | $1,000,000
------------------------------------------------------------------------------------------------13. Calculate Income tax expense
|
= $1,000,000 - $940,000 =
|
= $60,000 * 20% =
12,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 952,000 | $1,000,000
------------------------------------------------------------------------------------------------14. Close out difference to
retained earnings
48,000 |
------------------------------------------------------------------------------------------------Balance
$1,000,000 | $1,000,000
-------------------------------------------------------------------------------------------------
From the “raw materials of the T-accounts, the formal (“pretty”) income statement and balance
sheet can be prepared. The formal (“pretty”) income statement looks like:
Sunshine Lite-Stick, Inc.
Income Statement (aka Statement of Operations) for the Year Ended December 31, 2020
Normal
Sales
Cost of Goods Sold (COGS):
Direct Labor, Overhead
Materials
Depreciation of Machinery
Gross Profit
$1,000,000
500,000
200,000
25,000
275,000
Corporate Salaries
Advertising
Amortization of Patent
150,000
15,000
40,000
Earnings before Interest & Taxes (EBIT)
70,000 (often referred to as Operating Profit)
Interest
10,000
Profit before Income Taxes
60,000
Income Tax Expense at 20% Tax Rate
12,000 (also called Provision for Income Taxes)
Net Income
2
$
48,000
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
Using the balance sheet T-accounts:
Cash
--------------------------+
|
Bal @ 1/01/20|
$
0 |
a. 1,000,000 |
|$ 200,000 b.
1.
100,000 |
|
300,000 2.
|
275,000 3.
|
15,000 4
|
500,000 5.
|
150,000 6.
7,
900,000 |
|
10,000 8.
--------------------------2,000,000 | 1,450,000
--------------------------Bal $550,000 |
.
Prepaid Rent
-------------------------+
|
Bal @ 1/01/20|
$
0 |
8.
10,000 |
-------------------------Bal $ 10,000 |
Accounts Receivable
--------------------------+
|
Bal @ 1/01/20|
$
0 |
7.
100,000 |
|
|
--------------------------Bal $100,000 |
Plastics & Chemicals
--------------------------+
|
Bal @ 1/01/20|
$
0 |
3.
300,000 |
|
|
$200,000 10.
--------------------------Bal $100,000 |
Building & Machinery, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
2. 300,000 |
--------------------------Bal $300,000 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
$ 25,000 11.
--------------------------|Bal $ 25,000
Patent, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
b.
200,000 |
--------------------------Bal $200,000 |
Accumulated Amortization
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
40,000 12.
--------------------------|Bal $ 40,000
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
25,000 3.
--------------------------|$
25.000 Bal
Interest Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
10,000 9.
--------------------------|$
10,000 Bal
Taxes Payable
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
12,000 13.
--------------------------|Bal $ 12,000
Note Payable (aka Bank Loan)
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
100,000 1.
--------------------------|$ 100,000 Bal
Equity T-Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 1/01/20
|$
0
| 1,000,000 a.
--------------------------|$1,000,000 Bal
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
48,000 14.
--------------------------|$
48,000 Bal
The formal (“pretty”) balance sheet looks like:
Sunshine Lite-Stick, Inc.
Balance Sheet (aka Statement of Financial Condition) at Ended December 31, 2020
Assets:
Cash
Accounts Receivable
Plastics & Chemicals
Prepaid Rent
Current Assets
Machinery, Gross
Accumulated Depreciation
Machinery, Net
Patent, Gross
Accumulated Amortization
Patent, Net
Total Assets
$
550,000
100,000
100,000
10,000
760,000
300,000
(25,000)
275,000
200,000
(40,000)
160,000
$1,195,000
Liabilities and Shareholders’ Equity:
Accounts Payable
$
25,000
Interest Payable
10,000
Taxes Payable
12,000
Note Payable
100,000
Current Liabilities
147,000
Long-Term Liabilities
0
Total Liabilities
147,000
Shareholders’ Equity:
Common Stock
1,000,000
Retained Earnings
48,000
Total Shareholders’ Equity
$1,048,000
Total Liabilities & Shareholders’ Equity $1,195,000
3
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
The cash flow statement comes in two formats, Direct Method and Indirect Method and is separated into three sections: operating, investing and financing. The ONLY T-account you need to
prepare the Direct Method Cash Flow Statement is the Cash T-account (see next page).
Cash
--------------------------+
|
Bal @ 1/01/20|
$
0 |
a. 1,000,000 |
|$ 200,000 b.
1.
100,000 |
|
300,000 2.
|
275,000 3.
|
15,000 4
|
500,000 5.
|
150,000 6.
7.
900,000 |
|
10,000 8.
--------------------------2,000,000 | 1,450,000
--------------------------Bal $550,000 |
.
A straightforward way to determine if a cash flow is an operating cash flow is to ask: 1. Does the
item affect cash? and, 2. Will the item appear on the income statement as either a revenue or an
expense (either now or in the future)? If the answer is yes to both questions, the cash flow is an
operating cash flow. If the answer is no, the next questions are: 1. Is the cash flow an incoming
cash flow? If the answer is yes, it is a financing cash flow. 2. Is the cash flow an outgoing cash
flow? If the answer is yes, it is an investing cash flow.
From the Cash T-account (see above), prepare the Direct Method Cash Flow Statement:
Sunshine Lite-Stick, Inc.
Direct Method Statement of Cash Flows for the Year Ended December 31, 2020
Cash Flow From (Used In) Operating Activities:
Cash Received for Sales
Cash Paid for Plastics & Chemicals
Cash Paid for Advertising
Cash Paid for Direct Labor & Overhead
Cash Paid for Corporate Salaries
Cash Paid for January 2021 Rent
Cash Flow From (Used In) Operating Activities
900,000
(275,000)
(15,000)
(500,000)
(150,000)
(10,000)
$ (50,000)
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing Activities
$ (200,000)
(300,000)
$ (500,000)
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash Received from Bank Loan
Cash From Financing Activities
$1,000,000
100,000
$1,100,000
Cash Flow From (Used In) Operating Activities
Cash (Used In) Investing Activities
Cash From Financing Activities
Increase in Cash
Cash Balance, Beginning of Period
Cash Balance, End of Period
4
$
$
(50,000)
(500,000)
1,100,000
550,000
0
$ 550,000
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
The alternative format for the Cash Flow Statement is the Indirect Method which only affects the
format for the operating cash flow section, with no change in the investing and financing sections.
See the Class Notes on Cash Flow Statements for how the following Indirect Method is prepared:
Sunshine Lite-Stick, Inc.
Indirect Method Statement of Cash Flows for the Year Ended December 31, 2020
Cash Flow From (Used In) Operating Activities:
Net Income
Adjustments to reconcile net income to cash
generated by operating activities:
+ Depreciation
+ Amortization
Changes in Operating Assets and Liabilities:
(Increase) Decrease in Accounts Receivable
(Increase) Decrease in Plastics & Chemicals
(Increase) Decrease in Prepaid Rent
Increase (Decrease) in Accounts Payable
Increase (Decrease) in Interest Payable
Increase (Decrease) in Taxes Payable
Cash Flow From (Used In) Operating Activities
(100,000)
(100,000)
(10,000)
25,000
10,000
12,000
$ (50,000)
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing Activities
$ (200,000)
(300,000)
$ (500,000)
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash Received from Bank Loan
Cash From Financing Activities
$1,000,000
100,000
$1,100,000
Cash Flow From (Used In) Operating Activities
Cash (Used In) Investing Activities
Cash From Financing Activities
Increase in Cash
Cash Balance, Beginning of Period
Cash Balance, End of Period
$
48,000
25,000
40,000
$
(50,000)
(500,000)
1,100,000
550,000
0
$ 550,000
NOTE: For the Indirect Method, changes in Inventories (in this case, Plastics & Chemicals) and Accounts Payables are linked, such that the NET CHANGE in the two accounts
is what affects cash flow. We recorded the $300,000 purchase of Plastics & Chemicals
as follows:
Cash
--------------------------+
|
|$ 275,000 3.
|
Plastics & Chemicals
--------------------------+
|
3.
300,000 |
|
Accounts Payable
--------------------------|
+
|$
25,000 3.
|
Obviously, the cash outflow is $275,000 not $300,000.
In the Indirect Cash Flow Statement we see the following changes:
(Increase) Decrease in Plastics & Chemicals
Increase (Decrease) in Accounts Payable
The Net Change between Plastics & Chemicals and Accounts Payable
(100,000)
25,000
(75,000)
When combined with the $200,000 Plastics & Chemicals expense on the income statement,
the cash outflow is the correct $275,000.
5
THIS PAGE INTENTIONALLY LEFT BLANK
FSI
Financial Statement Investigation
S05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
(financial statements prepared using alternative accounting decisions)
The following financial statements have been prepared using the “Normal” T-Accounts from above, as well as using
four alternative assumptions regarding the accounting judgments/estimates for Sunshine Lite-Stick, Inc. The Tax
financial statements ARE NOT entirely reflective of current tax accounting in the United States but are shown on a
“what if” basis, i.e. what if tax accounting/law in the United States allowed you to make the judgments/estimates as
reflected. Likewise, the “Normal”, “Liberal”, and “Go to Jail Liberal” financial statements are reflective of “what if”
assumptions regarding the accounting judgments/estimates (refer to the footnotes at the bottom of this page for the
accounting judgments/estimates that were made in preparing each set of financial statements).
Sunshine Lite-Stick, Inc.
INCOME STATEMENTS:
Conservative
Tax
Sales
COGS:
Direct Labor, Overhead
Materials
Depreciation of Machinery
Gross Profit
Corporate Salaries
Advertising6
Amortization of Patent
January 2021 Rent Payment
EBIT
Interest
Profit before Income Taxes
Income Tax Expense
Net Income
$
“Normal”
900,0001 $1,000,0002 $1,000,000
Liberal
$1,000,000
"Go to Jail"
Liberal
$1,180,0003
500,000
275,000
50,0004
75,000
500,000
200,000
30,0005
270,000
500,000
200,000
25,000
275,000
500,000
200,000
20,000
280,000
500,000
200,000
20,000
460,000
150,000
15,000
13,3337
10,00010
150,000
15,000
40,0008
0
150,000
15,000
40,000
0
150,000
15.000
10,0009
0
150,000
15,000
10,000
0
65,000
70,000
105,000
285,000
10,000
10,000
10,000
10,000
55,000
60,000
95,000
275,000
11,000
12,000
19,000
55,000
(113,333)
011
(113,333)
0
$(113,333) $
44,000
$
48,000
$
76,000
$
220,000
1
Assumes the company is on a "modified cash basis" for income tax purposes..
Assumes the $100,000 account receivable will be 100% collectible.
3
Assumes the IAAF order cannot be cancelled & will be 100% collectible. However, even with these assumptions, it would never be GAAP or
IFRS acceptable.
4
Assumes accelerated ("double declining balance") depreciation for income tax purposes.
5
Assumes straight-line depreciation for financial reporting purposes; conservative use 10 years; normal uses 12 years and liberal uses 15 years.
6
Assumes advertising is treated as expense even though it may create future value. Assumes the future value cannot be measured with any degree
of accuracy.
7
Under the current U.S. tax code, intangibles like patents have to be amortized over a fixed 15 year period. This is a case where tax accounting
can be less conservative than book accounting.
8
Assumes the patent has value over its estimated 5 year economic life.
9
Assumes the patent has value over its 20 year legal life.
10
The prepaid rent is recognized as an expense for tax purposes because the company has already paid the cash.
11
The interest expense cannot be deducted for tax purposes until it is paid.
2
Norman J. Bartczak, Columbia University, prepared this suggested solution as a basis for class discussion of the Sunshine LiteStick, Inc. case study. It is not intended to illustrate either effective of ineffective handling of an administrative situation.
Copyright © 2017 Norman J. Bartczak.
1
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
BALANCE SHEETS:
Conservative
Tax
Assets:
Cash
Accounts Receivable
Materials
Prepaid Rent
Current Assets
$
550,000
0
0
0
550,000
$
550,000
100,000
100,000
10,000
760,000
“Normal”
$
550,000
100,000
100,000
10,000
760,000
Liberal
$
"Go to Jail”
Liberal
550,000
100,000
100,000
10,000
760,000
$
550,000
280,000
100,000
10,000
940,000
Machinery, Gross
Accumulated Depreciation
Machinery, Net
300,000
(50,000)
250,000
300,000
(30,000)
270,000
300,000
(25,000)
275,000
300,000
(20,000)
280,000
300,000
(20,000)
280,000
Patent, Gross
Accumulated Amortization
Patent, Net
200,000
(13,333)
186,667
200,000
(40,000)
160.000
200,000
(40,000)
160.000
200,000
(10,000)
190,000
200,000
(10,000)
190,000
Total Assets
Liabilities:
Accounts Payable
Interest Payable
Taxes Payable
Note Payable
Total Liabilities
$
986,667
$1,190,000
$1,195,000
$1,230,000
$1,410,000
$
0
0
0
100,000
100,000
$
$
$
$
Shareholders’ Equity:
Common Stock
Retained Earnings
25,000
10,000
11,000
100,000
146,000
25,000
10,000
12,000
100,000
147,000
25,000
10,000
19,000
100,000
154,000
25,000
10,000
55,000
100,000
190,000
1,000,000
(113,333)
1,000,000
44,000
1,000,000
48,000
1,000,000
76,000
1,000,000
220,000
Total Shareholders’ Equity
886,667
1,044,000
1,048,000
1,076,000
1,220,000
Total Liabilities &
Shareholders’ Equity
986,667
$1,190,000
$1,195,000
$1,230,000
$1,410,000
2
$
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
DIRECT METHOD
CASH FLOW STATEMENTS:
Conservative
Tax
Cash
Cash
Cash
Cash
Cash
Cash
Cash
Flow From (Used In) Operations:
Sales
Paid for Plastics & Chemicals
Paid for Advertising
Paid for Labor and Overhead
Paid for Corporate Salaries
Paid for January 2021 Rent
Cash Flow (Used In) Operations
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash from Bank Loan
Cash from Financing
Cash Flow (Used In) Operations
Cash (Used In) Investing
Cash from Financing
Increase in Cash
$
$
Liberal
"Go to Jail"
Liberal
900,000 $ 900,000 $ 900,000 $ 900,000 $ 900,000
(275,000)
(275,000)
(275,000)
(275,000)
(275,000)
(15,000)
(15,000)
(15,000)
(15,000)
(15,000)
(500,000)
(500,000)
(500,000)
(500,000)
(500,000)
(150,000)
(150,000)
(150,000)
(150,000)
(150,000)
(10,000)
(10,000)
(10,000)
(10,000)
((10,000)
(50,000) $
(50,000) $
(50,000) $
(50,000) $
(50,000)
$ (200,000) $ (200,000) $ (200,000) $ (200,000) $ (200,000)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
$ (500,000) $ (500,000) $ (500,000) $ (500,000) $ (500,000)
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,100,000
$1,100,000
$1,100,000
$1,100,000
$1,100,000
$
(50,000) $ (50,000) $ (50,000) $ (50,000) $ (50,000)
(500,000)
(500,000)
(500,000)
(500,000)
(500,000)
1,100,000
1,100,000
1,100,000
1,100,000
1,100,000
$ 550,000 $ 550,000 $ 550,000 $ 550,000 $ 550,000
Cash Balance, Beginning of Period
Cash Balance, End of Period
“Normal”
0
$
550,000
0
$
550,000
0
$
550,000
0
$
550,000
0
$
550,000
3
Sunshine Lite-Stick, Inc. – Suggested Solution
S05-31-2017
Revised 09-04-2022
Sunshine Lite-Stick, Inc.
INDIRECT METHOD
CASH FLOW STATEMENTS:
Conservative
Tax
Cash Flow From (Used In) Operations:
Net Income
$ (113,333)
Adjustments to reconcile net income
to cash generated by operations:
+ Depreciation
50,000
+ Amortization
13,333
Changes in Operating Assets and Liabilities:
(Increase) Decrease in Accounts Receivable
0
(Increase) Decrease in Plastics & Chemicals
0
(Increase) Decrease in Prepaid Rent
0
Increase (Decrease) in Accounts Payable
0
Increase (Decrease) in Interest Payable
0
Increase (Decrease) in Taxes Payable
0
Cash Flow From (Used In) Operations
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash from Bank Loan
Cash from Financing
Cash Flow (Used In) Operations
Cash (Used In) Investing
Cash from Financing
Increase in Cash
$
4
$
44,000
$
Liberal
48,000
$
"Go to Jail"
Liberal
76,000
$
220,000
30,000
40,000
25,000
40,000
20,000
10,000
20,000
10,000
(100,000)
(100,000)
(10,000)
25,000
10,000
11,000
(100,000)
(100,000)
(10,000)
25,000
10,000
12,000
(100,000)
(100,000)
(10,000)
25,000
10,000
19,000
(280,000)
(100,000)
(10,000)
25,000
10,000
55,000
(50,000) $
(50,000) $
(50,000) $
(50,000)
$ (200,000)
(300,000)
$ (200,000) $ (200,000) $ (200,000) $ (200,000)
(300,000)
(300,000)
(300,000)
(300,000)
$ (500,000)
$ (500,000) $ (500,000) $ (500,000) $ (500,000)
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,000,000
100,000
$1,100,000
$1,100,000
$1,100,000
$1,100,000
$1,100,000
$
$
(50,000)
(500,000)
1,100,000
$ 550,000
Cash Balance, Beginning of Period
Cash Balance, End of Period
(50,000)
$
“Normal”
(50,000) $ (50,000) $ (50,000) $ (50,000)
(500,000)
(500,000)
(500,000)
(500,000)
1,100,000
1,100,000
1,100,000
1,100,000
$ 550,000 $ 550,000 $ 550,000 $ 550,000
0
$
550,000
0
$
550,000
0
$
550,000
0
$
550,000
0
$
550,000
Financial Statement Investigation
FSI
ST05-31-2017
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements
(Using the Sunshine Lite-Stick, Inc. Case Study)
1. Record all of the company’s transactions in T-accounts. For any transaction affecting
Cash, be sure to put an O (for Operating) or an I (for Investing) or an F (for Financing)
next to the entry in the Cash T-account to make it easier for yourself when you are preparing the Direct Method Cash Flow Statement.
2. Once you have recorded all of the transactions, go to the Income Statement T-account
and add up the entries on the left hand side and the entries on the right hand side; write
the totals down on each side (see below):
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-offs
|
Revenues, Gains, Other Income
|
+
| $ 900,000 cash collected
7.
|
100,000 receivable auto parts distributor
7.
4. Expensing of advertising
$
15,000 |
5. Direct labor, overhead
500,000 |
6. Corporate salaries
150,000 |
9. Expensing of interest
10,000 |
10. Cost of goods sold
200,000 |
11. Depreciation of machinery
25,000 |
12. Amortization of patent
40,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 940,000 | $1,000,000
-------------------------------------------------------------------------------------------------
3. When the right hand side total is greater than the left hand side total, calculate the difference. Multiply the difference times the tax rate (say, 20%) and write the answer down in the
left hand side of the Income Statement T-account as the company’s tax expense (see below):
------------------------------------------------------------------------------------------------Subtotals
$ 940,000 | $1,000,000
------------------------------------------------------------------------------------------------13. Calculate Income tax expense
|
= $1,000,000 - $940,000 =
|
= $60,000 * 20% =
12,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 952,000 | $1,000,000
-------------------------------------------------------------------------------------------------
On the balance sheet, to record the Tax Expense from the Income Statement T-account
record the Taxes Payable liability as follows:
Balance Sheet T-account:
Taxes Payable
--------------------------|
+
|Bal @ 01/01/20
| $
0
|
12,000 13.
--------------------------| $ 12,000 Bal
Norman J. Bartczak, Columbia University, prepared this note as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2017 Norman J. Bartczak.
1
Steps to Follow to Prepare Financial Statements – Using Sunshine Lite-Stick, Inc.
ST05-31-2017
Revised 09-04-2022
4. After you have recorded the tax expense and the taxes payable, go back to the Income
Statement T-account and add the Tax Expense to the total expenses you calculated earlier
on the left hand side. Put this new total down on the left hand side. Bring the right hand
side total down to compare with the left hand side total you just calculated (see below):
Calculate the difference between the right hand side total and the left hand side total. This
difference is Net Income. Put the difference on the left hand side of the Income Statement
T-account and the right hand side on an equity account called Retained Earnings in the
Balance Sheet T-accounts. The Income Statement T-account has now been “closed out”
(the left hand side total equals the right hand side total) to the Balance Sheet (see below):
Income Statement T-account:
------------------------------------------------------------------------------------------------Subtotals
$ 952,000 | $1,000,000
------------------------------------------------------------------------------------------------14. Close out difference to
retained earnings
48,000 |
------------------------------------------------------------------------------------------------Balance
$1,000,000 | $1,000,000
-------------------------------------------------------------------------------------------------
Balance Sheet T-account:
Retained Earnings
--------------------------|
+
| $ 48,000
14.
--------------------------| $ 48,000 Bal @ 12/31/20
5. You are now ready to prepare an Income Statement for the shareholders from the Income
Statement T-account. Take the entries from the Income Statement T-account (see below)
and put them into an Income Statement for the shareholders (see below):
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-offs
|
Revenues, Gains, Other Income
|
+
| $ 900,000 cash collected
7.
|
100,000 receivable auto parts distributor
7.
4. Expensing of advertising
$
15,000 |
5. Direct labor, overhead
500,000 |
6. Corporate salaries
150,000 |
9. Expensing of interest
10,000 |
10. Cost of goods sold
200,000 |
11. Depreciation of machinery
25,000 |
12. Amortization of patent
40,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 940,000 | $1,000,000
------------------------------------------------------------------------------------------------13. Calculate Income tax expense
|
= $1,000,000 - $940,000 =
|
= $60,000 * 20% =
12,000 |
------------------------------------------------------------------------------------------------Subtotals
$ 952,000 | $1,000,000
------------------------------------------------------------------------------------------------14. Close out difference to
retained earnings
48,000 |
------------------------------------------------------------------------------------------------Balance
$1,000,000 | $1,000,000
-------------------------------------------------------------------------------------------------
6. The Income Statement for the shareholders is reproduced on the next page. You need to
make one adjustment to prepare this Income Statement. You need to take out the interest
expense from the total expenses and put it separately as a financing expense to be sub2
ST05-31-2017
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Sunshine Lite-Stick, Inc.
tracted from Earnings before Interest. In this case, you need to take out $10,000 of Interest
Expense from total expenses before income taxes of $940,000 which leaves $930,000.
The $930,000 equals the company’s total operating expenses. In this case, to get to Earnings before Interest, take the Total Revenues of $1,000,000 less the Total Operating Expenses of $930,000 to get to Earnings before Interest & Taxes of $70,000. Next, subtract
the Interest Expense of $10,000 from the Earnings before Interest & Taxes $70,000 to get
to Profit before Income Taxes of $60,000. Finally, subtract the calculated Income Tax of
$12,000 from Profit before Income Taxes to determine Net Income (see below):
Sunshine Lite-Stick, Inc.
Income Statement (aka Statement of Operations) for the Year Ended December 31, 2020
Normal
Sales
Cost of Goods Sold (COGS):
Direct Labor, Overhead
Materials
Depreciation of Machinery
Gross Profit
$1,000,000
500,000
200,000
25,000
275,000
Corporate Salaries
Advertising
Amortization of Patent
150,000
15,000
40,000
Earnings before Interest & Taxes (EBIT)
70,000 (often referred to as Operating Profit)
Interest
10,000
Profit before Income Taxes
60,000
Income Tax Expense at 20% Tax Rate
12,000 (also called Provision for Income Taxes)
Net Income
$
48,000
7. You are now ready to prepare the Balance Sheet from the remaining T-accounts that have
balances in them. For some of the T-accounts, for example Cash, you will need to add
and total the left hand side entries as well as add and total the right hand side entries to
arrive at a positive balance on the left hand side (since cash is an asset). Likewise, you
may need to do the same thing, calculate a balance, for other T-accounts that have more
than one entry in the T-account (see below).
Asset T-Accounts:
Cash
--------------------------+
|
Bal @ 1/01/20|
$
0 |
a. 1,000,000 |
|$ 200,000 b.
1.
100,000 |
|
300,000 2.
|
275,000 3.
|
15,000 4
|
500,000 5.
|
150,000 6.
7,
900,000 |
|
10,000 8.
--------------------------2,000,000 | 1,450,000
--------------------------Bal $550,000 |
.
Accounts Receivable
--------------------------+
|
Bal @ 1/01/20|
$
0 |
7.
100,000 |
|
|
--------------------------Bal $100,000 |
Plastics & Chemicals
--------------------------+
|
Bal @ 1/01/20|
$
0 |
3.
300,000 |
|
|
$200,000 10.
--------------------------Bal $100,000 |
Building & Machinery, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
300,000 |
--------------------------Bal $300,000 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
25,000 11.
--------------------------|Bal $ 25,000
3
Steps to Follow to Prepare Financial Statements – Using Sunshine Lite-Stick, Inc.
ST05-31-2017
Revised 09-04-2022
Asset T-Accounts (continued):
Prepaid Rent
-------------------------+
|
Bal @ 1/01/20|
$
0 |
8.
10,000 |
-------------------------Bal $ 10,000 |
Patent, Gross
--------------------------+
|
Bal @ 1/01/20|
$
0 |
b.
200,000 |
--------------------------Bal $200,000 |
Accumulated Amortization
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
40,000 12.
--------------------------|Bal $ 40,000
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
25,000 3.
--------------------------|$
25.000 Bal
Interest Payable
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
10,000 9.
--------------------------|$
10,000 Bal
Taxes Payable
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
12,000 13.
--------------------------|Bal $ 12,000
Note Payable (aka Bank Loan)
--------------------------|
+
|Bal @ 1/01/20
|$
0
|
100,000 1.
--------------------------|$ 100,000 Bal
Equity Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 1/01/20
|$
0
| 1,000,000 a.
--------------------------|$1,000,000 Bal
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 1/01/20
|
$
0
|
48,000 14.
--------------------------|Bal $ 48,000
8. Prepare the Balance Sheet for Shareholders (see below) from the Balance Sheet T-accounts:
Sunshine Lite-Stick, Inc.
Balance Sheet (aka Statement of Financial Condition) at Ended December 31, 2020
Assets:
Cash
Accounts Receivable
Plastics & Chemicals
Prepaid Rent
Current Assets
$
Machinery, Gross
Accumulated Depreciation
Machinery, Net
300,000
(25,000)
Patent, Gross
Accumulated Amortization
Patent, Net
200,000
(40,000)
Total Assets
4
550,000
100,000
100,000
10,000
760,000
Liabilities and Shareholders’ Equity:
Accounts Payable
Interest Payable
Taxes Payable
Note Payable
Current Liabilities
Long-Term Liabilities
Total Liabilities
$
25,000
10,000
12,000
100,000
147,000
0
147,000
275,000
160,000
$1,195,000
Shareholders’ Equity:
Common Stock
Retained Earnings
Total Shareholders’ Equity
1,000,000
48,000
$1,048,000
Total Liabilities & Shareholders’ Equity $1,195,000
Steps to Follow to Prepare Financial Statements – Using Sunshine Lite-Stick, Inc.
ST05-31-2017
Revised 09-04-2022
9. You are now ready to prepare the Direct Method Cash Flow Statement. The ONLY Taccount you need to prepare the Direct Method Cash Flow Statement is the Cash Taccount (see below).
F
F
O
Cash
--------------------------+
|
Bal @ 1/01/20|
$
0 |
a. 1,000,000 |
|$ 200,000 b.
1.
100,000 |
|
300,000 2.
|
275,000 3.
|
15,000 4.
|
500,000 5.
|
150,000 6.
7.
900,000 |
|
10,000 8.
--------------------------2,000,000 | 1,450,000
--------------------------Bal $550,000 |
.
I
I
O
O
O
O
O
.
10. From the Cash T-account (see above), prepare the Direct Method Cash Flow Statement:
Sunshine Lite-Stick, Inc.
Direct Method Statement of Cash Flows for the Year Ended December 31, 2020
Cash Flow From (Used In) Operating Activities:
Cash Received for Sales
Cash Paid for Plastics & Chemicals
Cash Paid for Advertising
Cash Paid for Direct Labor & Overhead
Cash Paid for Corporate Salaries
Cash Paid for January 2021 Rent
Cash Flow From (Used In) Operating Activities
$
900,000
(275,000)
(15,000)
(500,000)
(150,000)
(10,000)
$ (50,000)
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing Activities
$ (200,000)
(300,000)
$ (500,000)
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash Received from Bank Loan
Cash From Financing Activities
$1,000,000
100,000
$1,100,000
Cash Flow From (Used In) Operating Activities
Cash (Used In) Investing Activities
Cash From Financing Activities
Increase in Cash
Cash Balance, Beginning of Period
Cash Balance, End of Period
$
(50,000)
(500,000)
1,100,000
550,000
0
$ 550,000
5
Steps to Follow to Prepare Financial Statements – Using Sunshine Lite-Stick, Inc.
ST05-31-2017
Revised 09-04-2022
11. You are now ready to prepare the Cash Flow Statement using the Indirect Method. You
only need to show the calculation of Cash Flow from Operating Activities using the Indirect Method format. The format for Investing and Financing Cash Flows is exactly the
same using the Direct and Indirect Methods. The Cash Provided from Operating Activities
using the Indirect Method should look as follows:
Sunshine Lite-Stick, Inc.
Indirect Method Statement of Cash Flows for the Year Ended December 31, 2020
Cash Flow From (Used In) Operating Activities:
Net Income
Adjustments to reconcile net income to cash
generated by operating activities:
+ Depreciation
+ Amortization
Changes in Operating Assets and Liabilities:
(Increase) Decrease in Accounts Receivable
(Increase) Decrease in Plastics & Chemicals
(Increase) Decrease in Prepaid Rent
Increase (Decrease) in Accounts Payable
Increase (Decrease) in Interest Payable
Increase (Decrease) in Taxes Payable
Cash Flow From (Used In) Operating Activities
$
48,000
25,000
40,000
(100,000)
(100,000)
(10,000)
25,000
10,000
12,000
$ (50,000)
Cash (Used In) Investing Activities:
Cash Paid for Patent
Cash Paid for Machinery
Cash (Used In) Investing Activities
$ (200,000)
(300,000)
$ (500,000)
Cash From Financing Activities:
Cash from Issuance of Common Stock
Cash Received from Bank Loan
Cash From Financing Activities
$1,000,000
100,000
$1,100,000
Cash Flow From (Used In) Operating Activities
Cash (Used In) Investing Activities
Cash From Financing Activities
Increase in Cash
Cash Balance, Beginning of Period
Cash Balance, End of Period
$
(50,000)
(500,000)
1,100,000
550,000
0
$ 550,000
NOTE: For the Indirect Method, changes in Inventories (in this case, Plastics & Chemicals) and Accounts Payables are linked, such that the NET CHANGE in the two accounts
is what affects cash flow. We recorded the $300,000 purchase of Plastics & Chemicals
as follows:
Cash
--------------------------+
|
|$ 275,000 3.
|
Plastics & Chemicals
--------------------------+
|
3.
300,000 |
|
Accounts Payable
--------------------------|
+
|$
25,000 3.
|
Obviously, the cash outflow is $275,000 not $300,000.
In the Indirect Cash Flow Statement we see the following changes:
(Increase) Decrease in Plastics & Chemicals
Increase (Decrease) in Accounts Payable
The Net Change between Plastics & Chemicals and Accounts Payable
(100,000)
25,000
(75,000)
When combined with the $200,000 Plastics & Chemicals expense on the income statement,
the cash outflow is the correct $275,000.
6
FSI
Financial Statement Investigation
S01-23-2013
Revised 09-04-2022
Overlook Inn
Suggested Solution
Questions:
1. Using the attached T-accounts, as best you can “bookkeep” the transactions for the Overlook
Inn from the period September 1, 2018 through August 31, 2019.
See pages 3 through 5.
2. After you have completed the T-accounts, prepare an Income Statement from the Income
Statement T-account for the 12-month period from September 1, 2018 through August 31,
2019. To determine Overlook’s financial reporting income tax expense, apply a 20% tax rate
to the income before income taxes number you calculated. Enter the income tax expense as a
“left-hand” side entry in the Income Statement T-Account and as taxes payable, a “righthand” side entry on the liability side of Overlook’s balance sheet. To determine Overlook’s
net income, subtract the income tax expense from the income before income taxes. The income statement will be given to the Darbys to explain Overlook Inn’s financial performance
during the 12-month period. Did the Overlook Inn have a “good” year or a “bad” year from
September 1, 2018 through August 31, 2019? Briefly explain your answer.
See Exhibit TN-1 on page 6. A variety of answers were acceptable
for this question. Did they have a “good” year? Well, Overlook
Inn paid the Darbys $100,000 after which they still had net income of $16,800 against an initial equity investment of
$109,200. This translates into a ($16,800/$109,200) = 15.4% after-tax rate of return on equity. I was looking for answers that
tried to consider how the Darbys might have fared if they had
invested the $109,200 in alternative investments compared to
their investment in Overlook Inn. In addition, the Darbys probably earned some “non-quantitative” returns (the pleasure of owning their own business, etc.).
1. Using the balances from your T-Accounts, prepare a Balance Sheet as of August 31, 2019.
“Close out” Overlook’s Income Statement T-Account (by “zeroing out” the net income, i.e.
putting a left-hand side entry for the amount of net income in the income statement) for the
12-month period to Overlook’s balance sheet (a right-hand side entry by increasing Overlook’s equity account, i.e. its retained earnings account by the amount of net income for the
period, i.e. from $0 to $0 + Overlook’s Net Income) at August 31, 2019.
See Exhibit TN-2 on page 6.
Norman J. Bartczak, Columbia University, prepared this suggested solution as a basis for class discussion of the Overlook Inn
case study. It is not intended to illustrate either effective of ineffective handling of an administrative situation. Copyright © 2013
Norman J. Bartczak.
1
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
3. From the cash T-account, prepare a statement of cash flows using the direct method for the
Overlook Inn for the 12-month period from September 1, 2018 through August 31, 2019.
NOTE: Since the initial balance sheet has zero balances, the beginning cash for the cash flow
statement is also zero, The ending cash balance is $63,000. The cash flow statement explains
how the “cash flowed” from $0 to $63,000 from operating, investing and financing activities.
See Exhibit TN-3 on page 7.
4. After you have prepared a cash flow statement using the direct method, prepare a cash flow
statement for Overlook Inn using the indirect method. NOTE: You only need to show the section that shows Cash Flow from Operations using the indirect method. The sections for Cash
from Investing and Financing sections will be exactly the same as with the direct method. Do
not waste your time copying these sections in the indirect method.
See Exhibit TN-4 on page 8.
2
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
2. Using the attached T-Accounts, as best you can record (“bookkeep”) the transactions for
the Overlook Inn from the period September 1, 2018 through August 31, 2019. NOTE:
You will need to supply “titles”. The number of T-accounts supplied is “suggestive” as
to how many you will need. Depending upon how you bookkeep the transactions, you
may need more or less T-accounts than supplied.
Balance Sheet T-Accounts
Asset T-Accounts:
F
F
O
O
Cash
--------------------------+
|
Bal @ 9/01/18|
$
0 |
1.
109,200 |
2.
294,000 |
a.
11,700 |
a.
241,030 |
|$ 66,000
3.
| 258,000
4.
| 73,800
5.
|
2,400
6.
| 29,340
c.
|
900
c.
|
2,100
d.
| 24,300
e.
| 25,200
f.
|
4,950
f.
|
3,600
f.
| 100,000
f.
|
2,340
g.
--------------------------Bal @ 8/31/19|
$ 63,000 |
Accounts Receivable, Gross
Allowance for Doubtful Accounts
--------------------------- ------------------------------+
|
|
+
Bal @ 9/01/18|
|Bal @ 9/01/18
$
0 |
|
$
0
b.
2,000 |
|
500 b.
--------------------------- ------------------------------Bal @ 8/31/19|
|Bal @ 8/31/19
$ 2,000 |
|
$
500
I
I
I
O
O
Food & Supplies Inventory
Firewood Inventory
F
----------------------------------------------------O
+
|
+
|
O
Bal.@ 9/01/18|
Bal @ 9/01/18|
O
$
0 |
$
0 |
O
6.
2,400 |
|
O
e.
29,550 |
g. $ 2,340 |
O
|
30,300 e.
|
$
840 g.
O
----------------------------------------------------Bal @ 8/31/19|
Bal @ 8/31/19|
$ 1,650 |
$ 1,500 |
Prepaid Insurance
--------------------------+
|
Bal @ 9/01/18|
$
0 |
d.
2,100 |
1,800
d.
--------------------------Bal @ 8/31/19|
$
300 |
Land
--------------------------+
|
Bal @ 9/01/18|
$
0 |
3.
66,000 |
--------------------------Bal @ 8/31/19|
$ 66,000 |
Building
--------------------------+
|
Bal @ 9/01/18|
$
0 |
4.
258,000 |
--------------------------Bal @ 8/31/19|
$258,000 |
Furnishings and Equipment
--------------------------+
|
Bal @ 9/01/18|
$
0 |
5.
73,800 |
--------------------------Bal @ 8/31/19|
$ 73,800 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
10,320 h.
--------------------------|Bal @ 8/31/19
|
$ 10,320
Accumulated Depreciation
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
12,300 h.
--------------------------|Bal @ 8/31/19
|
$ 12,300
3
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
OVERLOOK INN
Balance Sheet T-Accounts
(continued)
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
e.
24,300 |
29,550 e.
--------------------------|Bal @ 8/31/19
|
$ 5,250
Advance Deposits
Accrued Property Taxes Payable
--------------------------- ------------------------------|
+
|
+
|Bal @ 9/01/18
|Bal @ 9/01/18
|
$
0
|
$
0
|
11,700 a.
|
2,880 i.
--------------------------- ------------------------------|Bal @ 8/31/19
|Bal @ 8/31/19
|
$ 11,700
|
$ 2,880
Income Taxes Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
4,200 j.
-------------------------|Bal @ 8/31/19
|
$ 4,200
Mortgage Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
294,000 2.
c.
900 |
--------------------------|Bal @ 8/31/19
|
$293,100
Equity T-Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
109,200 1.
--------------------------|Bal @ 8/31/19
|
$109,200
4
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
16,800 k.
--------------------------|Bal @ 8/31/19
|
$ 16,800
S01-23-2013
Revised 09-04-2022
Overlook Inn – Suggested Solution
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
|
+
|
241,030 a. Revenue = Cash received for services
|
performed from 9/01/18 thru 8/31/19
|
2,000 b. Revenue = On account
Bad debt expense
b.
500 |
Interest expense on
|
mortgage payable
c.
29,340 |
Insurance expense for the
|
12 months ended 8/31/19
d.
1,800 |
Wages
f.
25,200 |
Utilities
f.
4,950 |
Advertising
f.
3,600 |
Owners’ Salaries
f.
100,000 |
Cost of Food & Supplies
|
consists of the $24,300 paid
|
in cash + $2,400 (which is cash
|
paid for the initial Food &
|
Supplies at the 9/01/18 acqui|
sition date) + $5,250 which
|
how much the Accounts Payable
|
account went up in 2019) |
$1,650 which is the amount in
|
the ending Food & Supplies
|
at 8/31/19
e.
30,300 |
Firewood
g.
840 |
Depreciation – Building
h.
10,320 |
Depreciation – Furnishings
h.
12,300
Property tax expense
i.
2,880 |
-------------------------------------------------------------------------------------------Subtotals
$222,030 |
$243,030
-------------------------------------------------------------------------------------------Income before income taxes
|
= $243,030 - $222,030
|
= $ 21,000 * 0.20
= income tax expense
j.
4,200 |
-------------------------------------------------------------------------------------------Subtotals
$226,230 |
$243,030
-------------------------------------------------------------------------------------------Close out difference, $12,600,
|
i.e. net income to
|
retained earnings
k. $ 16,800 |
-------------------------------------------------------------------------------------------Balance
$243,030 |
$243,030
--------------------------------------------------------------------------------------------
5
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit TN-1
OVERLOOK INN
Income Statement for the Twelve Months Ended August 31, 2019
Revenues:
Cash
On Account
Revenues, Total
Operating Expenses:
Bad Debt Expense
Food and Supplies
Wages
Depreciation Expense
Utilities
Advertising
Owners’ Salaries
Property Tax Expense
Insurance Expense
Firewood
Total Operating Expenses
$241,030
2,000
243,030
500
30,300
25,200
22,620
4,950
3,600
100,000
2,880
1,800
840
192,690
Earnings before Interest and Taxes
50,340
Interest Expense
29,340
Income before Income Taxes
21,000
Income Tax Expense
4,200
Net Income
$ 16,800
Exhibit TN-2
OVERLOOK INN
Balance Sheet at August 31, 2019
ASSETS
Cash
Accounts Receivable, Gross
Allowance for Doubtful Accounts
Accounts Receivable, Net
Food and Supplies Inventory
Firewood Inventory
Prepaid Insurance
Current Assets
08/31/19
$ 63,000
2,000
(500)
1,500
1,650
1,500
300
67,950
Land
66,000
Building, Gross
258,000
Less: Accumulated Depreciation (10,320)
Building, Net
247,680
Furnishings &d Equipment, Gross 73,800
Less; Accumulated Depreciation (12,300)
Furnishings & Equipment, Net
61,500
TOTAL ASSETS
$443,130
6
LIABILITIES & SHAREHOLDERS’ EQUITY
Accounts Payable
Accrued Property Taxes Payable
Advance Deposits
Income Taxes Payable
Current Liabilities
Mortgage Payable
Total Liabilities
Shareholders’ Equity:
Common Stock
Retained Earnings
Total Shareholders’ Equity
08/31/19
$ 5,250
2,880
11,700
4,200
24,030
293,100
317,130
109,200
16,800
126,000
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY $443,130
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit TN-3
OVERLOOK INN
Statement of Cash Flows for the Twelve Months Ended August 31, 2019
Direct Method
Cash Provided from Operating Activities:
Advance Deposits (collected from customers in fiscal 2019)
Payments Collected from Customers (for services provided during fiscal 2019)
Cash Disbursements:
Food and Supplies
Wages
Utilities
Advertising
Owners’ Salaries
Insurance Expense
Firewood
Interest Expense
Cash Provided from Operating Activities
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
Cash Provided from Financing Activities:
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
Increase in Cash from Inception through August 31, 2019:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$ 11,700
241,030
252,730
(26,700)
(25,200)
(4,950)
(3,600)
(100,000)
(2,100)
(2,340)
(29,340)
$ 58,500
$(66,000)
(258,000)
(73,800)
$(397,800)
$294,000
(900)
109,200
$402,300
$ 58,500
(397,800)
402,300
$ 63,000
Cash at Inception (the $3,000 at 9/01/18 is after inception, i.e. after
the capital to purchase the land, buildings, etc. was raised and the
transaction to acquire the Inn by the Darbys was culminated)
$
0
Cash at the End of the Period (at August 31, 2019)
$ 63,000
7
Overlook Inn – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit TN-4
OVERLOOK INN
Statement of Cash Flows for the Twelve Months Ended August 31, 2019
Indirect Method
Cash Provided from Operating Activities:
Net Income
Add back (Subtract from) Operating Items Not Affecting Cash Flow:
Depreciation
(Increase) in Accounts Receivable, Gross
(Increase) in Food and Supplies Inventory (remember, at inception, this was 0)
(Increase) in Firewood Inventory
(Increase) in Prepaid Insurance
Increase in Allowance for Doubtful Accounts
Increase in Accounts Payable
Increase in Accrued Property Taxes Payable
Increase in Advance Deposits (this is added to Net Income because it was not
included in the Income Statement but the cash was received)
Increase in Income Taxes Payable
Cash Provided from Operating Activities
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
Cash Provided from Financing Activities:
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
Increase in Cash from Inception through August 31, 2019:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$ 16,800
22,620
(2,000)
(1,650)
(1,500)
(300)
500
5,250
2,880
11,700
4,200
58,500
$(66,000)
(258,000)
(73,800)
$(397,800)
$294,000
(900)
109,200
$402,300
$ 58,500
(397,800)
402,300
$ 63,000
Cash at Inception (the $3,000 at 9/01/18 is after inception, i.e. after
the capital to purchase the land, buildings, etc. was raised and the
transaction to acquire the Inn by the Darbys was culminated)
$
Cash at the End of the Period (at August 31, 2019)
$ 63,000
8
0
FSI
Financial Statement Investigation
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements
(Using the Overlook Inn Case Study)
1. Record all of the company’s transactions in T-accounts. For any transaction affecting
Cash, be sure to put an O (for Operating) or an I (for Investing) or an F (for Financing)
next to the entry in the Cash T-account to make it easier for yourself when you are preparing the Direct Method Cash Flow Statement.
2. Once you have recorded all of the transactions, go to the Income Statement T-account
and add up the entries on the left hand side and the entries on the right hand side; write
the totals down on each side (see below):
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
------------------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
|
+
|
241,030 a. Revenue = Cash received for services
|
performed from 9/01/18 thru 8/31/19
|
2,000 b. Revenue = On account
Bad debt expense
b.
500 |
Interest expense - mortgage
c.
29,340 |
Insurance expense for the
|
12 months ended 8/31/19
d.
1,800 |
Wages
f.
25,200 |
Utilities
f.
4,950 |
Advertising
f.
3,600 |
Owners’ Salaries
f.
100,000 |
Cost of Food & Supplies
|
consists of the $24,300 paid
|
in cash + $2,400 (which is cash
|
paid for the initial Food &
|
Supplies at the 9/01/18 acqui|
sition date) + $5,250 which
|
how much the Accounts Payable
|
account went up in 2019) |
$1,650 which is the amount in
|
the ending Food & Supplies
|
at 8/31/19
e.
30,300 |
Firewood
g.
840 |
Depreciation – Building
h.
10,320 |
Depreciation – Furnishings
h.
12,300 |
Property tax expense
i.
2,880 |
-------------------------------------------------------------------------------------------Subtotals
$222,030 |
$243,030
--------------------------------------------------------------------------------------------
3. When the right hand side total is greater than the left hand side total, calculate the difference. Multiply the difference times the tax rate (say, 20%) and write the answer down in the
left hand side of the Income Statement T-account as the company’s tax expense (see below):
Subtotals
$222,030 |
$243,030
-------------------------------------------------------------------------------------------Income before income taxes
|
= $243,030 - $222,030
|
= $ 21,000 * 0.20
= income tax expense
j.
4,200 |
--------------------------------------------------------------------------------------------
Norman J. Bartczak, Columbia University, prepared this note as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2013 Norman J. Bartczak.
1
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
ST01-23-2013
Revised 09-04-2022
On the balance sheet, to record the Tax Expense from the Income Statement T-account
record the Taxes Payable liability as follows:
Balance Sheet T-account:
Taxes Payable
--------------------------|
+
|Bal @ 9/01/18
| $
0
|
4,200 j.
--------------------------| $ 4,200 Bal
4. After you have recorded the tax expense and the taxes payable, go back to the Income
Statement T-account and add the Tax Expense to the total expenses you calculated earlier
on the left hand side. Put this new total down on the left hand side. Bring the right hand
side total down to compare with the left hand side total you just calculated (see below):
Subtotals
$222,030 | $243,030
-----------------------------------------------------------------------------------------Tax Expense
4,200 |
-----------------------------------------------------------------------------------------Subtotals
$226,230 | $243,030
------------------------------------------------------------------------------------------
5. Calculate the difference between the right hand side total and the left hand side total. This
difference is the Net Income for the company. Put the difference on the left hand side of
the Income Statement T-account and the right hand side on an equity account called Retained Earnings in the Balance Sheet T-accounts. The Income Statement T-account has
now been “closed out” (the left hand side total equals the right hand side total) to the Balance Sheet (see below):
Income Statement T-account:
Subtotals
$226,230 | $243,030
-----------------------------------------------------------------------------------------Net Income =
|
k. $243,030 - $226,230 =
16,800 |
(“closed out” to Retained
|
Earnings on the Balance Sheet)
|
-----------------------------------------------------------------------------------------Balance
$243,030 | $243,030
------------------------------------------------------------------------------------------
Balance Sheet T-account:
Retained Earnings
--------------------------|
+
|Bal @ 9/01/18
| $
0
|
| $ 16,800
k.
--------------------------| $ 16,800 Bal
6. You are now ready to prepare an Income Statement for the shareholders from the Income
Statement T-account. Take the entries from the Income Statement T-account (next page)
and put them into an Income Statement for the shareholders (see on page 4):
2
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
Income Statement T-Accounts to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
|
+
|
241,030 a. Revenue = Cash received for services
|
performed from 9/01/18 thru 8/31/19
|
2,000 b. Revenue = On account
Bad debt expense
b.
500 |
Interest expense on
|
mortgage payable
c.
29,340 |
Insurance expense for the
|
12 months ended 8/31/19
d.
1,800 |
Wages
f.
25,200 |
Utilities
f.
4,950 |
Advertising
f.
3,600 |
Owners’ Salaries
f.
100,000 |
Cost of Food & Supplies
|
consists of the $24,300 paid
|
in cash + $2,400 (which is cash
|
paid for the initial Food &
|
Supplies at the 9/01/18 acqui|
sition date) + $5,250 which
|
how much the Accounts Payable
|
account went up in 2019) |
$1,650 which is the amount in
|
the ending Food & Supplies
|
at 8/31/19
e.
30,300 |
Firewood
g.
840 |
Depreciation – Building
h.
10,320 |
Depreciation – Furnishings
h.
12,300 |
Property tax expense
i.
2,880 |
-------------------------------------------------------------------------------------------Subtotals
$222,030 |
$243,030
-------------------------------------------------------------------------------------------Income before income taxes
|
= $243,030 - $222,030
|
= $ 21,000 * 0.20
= income tax expense
j.
4,200 |
-------------------------------------------------------------------------------------------Subtotals
$226,230 |
$243,030
-------------------------------------------------------------------------------------------Close out difference, $16,800,
|
i.e. net income to
|
retained earnings
k. $ 16,800 |
-------------------------------------------------------------------------------------------Balance
$243,030 |
$243,030
--------------------------------------------------------------------------------------------
7. The Income Statement for the shareholders is reproduced on the next page. You need to
make one adjustment to prepare this Income Statement. You need to take out the interest
expense from the total expenses and put it separately as a financing expense to be subtracted from Earnings before Interest and Taxes. In this case, the total expenses before
Tax Expense equaled $222,030 (see the T-account on the previous page). This includes
the $29,340 interest expense (see the T-account on the previous page). You need to subtract $29,340 from $222,030 which equals $192,690. The $192,690 equals the company’s
total operating expenses. In this case, to get to Earnings before Interest and Taxes, take
the Total Revenues of $243,030 less the Total Operating Expenses of $192,690 to get to
Earnings before Interest and Taxes of $50,340. Next, subtract the Total Interest Expense
of $29,340 from the Earnings before Interest and Taxes of $50,340 to get to Earnings before Taxes of $21,000. Next, subtract the Tax Expense of $4,200 from the Earnings before Taxes of $21,000 and, voila!, you get to Net Income of $16,800 and you have completed the Income Statement for the shareholders (see below):
3
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
ST01-23-2013
Revised 09-04-2022
Income Statement for the Twelve Months Ended August 31, 2019
Revenues, Cash
Revenues, on Account
Revenues, Total
$241,030
2,000
243,030
Operating Expenses:
Owners’ Salaries
Employee Wages
Bad Debt Allowance or Expense
$100,000
25,200
500
Depreciation Expense
22,620
Cost of Food and Supplies
30,300
Utilities
4,950
Insurance Expense
1,800
Advertising Expense
3,600
Firewood
Property Tax Expense
840
2,880
Total Operating Expenses
192,690
Earnings before Interest and Taxes (Operating Earnings)
50,340
Interest Expense, Total
29,340
Earnings before Income Taxes
21,000
Tax Expense
Net Income
4,200
$ 16,800
8. You are now ready to prepare the Balance Sheet from the remaining T-accounts that have
balances in them. For some of the T-accounts, for example Cash, you will need to add
and total the left hand side entries as well as add and total the right hand side entries to
arrive at a positive balance on the left hand side (since cash is an asset). Likewise, you
may need to do the same thing, calculate a balance, for other T-accounts that have more
than one entry in the T-account (see the next page).
4
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
Balance Sheet T-Accounts
Asset T-Accounts:
F
F
O
O
Cash
--------------------------+
|
Bal @ 9/01/18|
$
0 |
1.
109,200 |
2.
294,000 |
a.
11,700 |
a.
241,030 |
|$ 66,000
3.
| 258,000
4.
| 73,800
5.
|
2,400
6.
| 29,340
c.
|
900
c.
|
2,100
d.
| 24,300
e.
| 25,200
f.
|
4,950
f.
|
3,600
f.
| 100,000
f.
|
2,340
g.
--------------------------Bal @ 8/31/19|
$ 63,000 |
Accounts Receivable, Gross
Allowance for Doubtful Accounts
--------------------------- ------------------------------+
|
|
+
Bal @ 9/01/18|
|Bal @ 9/01/18
$
0 |
|
$
0
b.
2,000 |
|
500 b.
--------------------------- ------------------------------Bal @ 8/31/19|
|Bal @ 8/31/19
$ 2,000 |
|
$
500
I
I
I
O
O
Food & Supplies Inventory
Firewood Inventory
F
----------------------------------------------------O
+
|
+
|
O
Bal.@ 9/01/18|
Bal @ 9/01/18|
O
$
0 |
$
0 |
O
6.
2,400 |
|
O
e.
29,550 |
g. $ 2,340 |
O
|
30,300 e.
|
$
840 g.
O
----------------------------------------------------Bal @ 8/31/19|
Bal @ 8/31/19|
$ 1,650 |
$ 1,500 |
Prepaid Insurance
--------------------------+
|
Bal @ 9/01/18|
$
0 |
d.
2,100 |
1,800
d.
--------------------------Bal @ 8/31/19|
$
300 |
Land
--------------------------+
|
Bal @ 9/01/18|
$
0 |
3.
66,000 |
--------------------------Bal @ 8/31/19|
$ 66,000 |
Building
--------------------------+
|
Bal @ 9/01/18|
$
0 |
4.
258,000 |
--------------------------Bal @ 8/31/19|
$258,000 |
Furnishings and Equipment
--------------------------+
|
Bal @ 9/01/18|
$
0 |
5.
73,800 |
--------------------------Bal @ 8/31/19|
$ 73,800 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
10,320 h.
--------------------------|Bal @ 8/31/19
|
$ 10,320
Accumulated Depreciation
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
12,300 h.
--------------------------|Bal @ 8/31/19
|
$ 12,300
5
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
ST01-23-2013
Revised 09-04-2022
Balance Sheet T-Accounts
(continued)
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
e.
24,300 |
29,550 e.
--------------------------|Bal @ 8/31/19
|
$ 5,250
Advance Deposits
Accrued Property Taxes Payable
--------------------------- ------------------------------|
+
|
+
|Bal @ 9/01/18
|Bal @ 9/01/18
|
$
0
|
$
0
|
11,700 a.
|
2,880 i.
--------------------------- ------------------------------|Bal @ 8/31/19
|Bal @ 8/31/19
|
$ 11,700
|
$ 2,880
Income Taxes Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
4,200 j.
-------------------------|Bal @ 8/31/19
|
$ 4,200
Mortgage Payable
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
294,000 2.
c.
900 |
--------------------------|Bal @ 8/31/19
|
$293,100
Equity T-Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
109,200 1.
--------------------------|Bal @ 8/31/19
|
$109,200
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 9/01/18
|
$
0
|
16,800 k.
--------------------------|Bal @ 8/31/19
|
$ 16,800
9. Prepare the Balance Sheet for Shareholders (see below) from the Balance Sheet T-accounts:
Balance Sheet at August 31, 2019
ASSETS
Cash
Accounts Receivable, Gross
Allowance for Doubtful Accounts
Accounts Receivable, Net
Food and Supplies Inventory
Firewood Inventory
Prepaid Insurance
Current Assets
08/31/19
$ 63,000
2,000
(500)
1,500
1,650
1,500
300
67,950
Land
66,000
Building, Gross
258,000
Less; Accumulated Depreciation (10,320)
Building, Net
247,680
Furnishings & Equipment, Gross 73,800
Less: Accumulated Depreciation (12,300)
Furnishings & Equipment, Net
61,500
TOTAL ASSETS
$443,130
LIABILITIES & SHAREHOLDERS’ EQUITY
Accounts Payable
Accrued Property Taxes Payable
Advance Deposits
Income Taxes Payable
Current Liabilities
Mortgage Payable
Total Liabilities
Shareholders’ Equity:
Common Stock
Retained Earnings
Total Shareholders’ Equity
TOTAL LIABILITIES AND
SHAREHOLDERS’ EQUITY
08/31/19
$ 5,250
2,880
11,700
4,200
24,030
293,100
317,130
109,200
16,800
126,000
$443,130
10. You are now ready to prepare the Direct Method Cash Flow Statement. The ONLY Taccount you need to prepare the Direct Method Cash Flow Statement is the Cash Taccount (see the next page).
6
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
ST01-23-2013
Revised 09-04-2022
F
F
O
O
Cash
--------------------------+
|
Bal @ 9/01/18|
$
0 |
1.
109,200 |
2.
294,000 |
a.
11,700 |
a.
241,030 |
|$ 66,000
3.
| 258,000
4.
| 73,800
5.
|
2,400
6.
| 29,340
c.
|
900
c.
|
2,100
d.
| 24,300
e.
| 25,200
f.
|
4,950
f.
|
3,600
f.
| 100,000
f.
|
2,340
g.
--------------------------Bal @ 8/31/19|
$ 63,000 |
I
I
I
O
O
F
O
O
O
O
O
O
O
11. From the Cash T-account (see above), prepare the Direct Method Cash Flow Statement:
Statement of Cash Flows for the Twelve Months Ended August 31, 2019
Direct Method
Cash Provided from Operating Activities:
Advance Deposits (collected from customers in fiscal 2019)
Payments Collected from Customers (for services provided during fiscal 2019)
$ 11,700
241,030
252,730
Cash Disbursements:
Food and Supplies
Wages
Utilities
Advertising
Owners’ Salaries
Insurance Expense
(26,700)
(25,200)
(4,950)
(3,600)
(100,000)
(2,100)
Firewood
Interest Expense
Cash Provided from Operating Activities
(2,340)
(29,340)
$ 58,500
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
Cash Provided from Financing Activities:
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
Increase in Cash from Inception through August 31, 2019:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$(66,000)
(258,000)
(73,800)
$(397,800)
$294,000
(900)
109,200
$402,300
$ 58,500
(397,800)
402,300
$ 63,000
Cash at Inception (the $3,000 at 9/01/18 is after inception, i.e. after
the capital to purchase the land, buildings, etc. was raised and the
transaction to acquire the Inn by the Darbys was culminated)
$
0
Cash at the End of the Period (at August 31, 2019)
$ 63,000
7
Steps to Follow to Prepare Financial Statements – Using Overlook Inn
ST01-23-2013
Revised 09-04-2022
12. You are now ready to prepare the Cash Flow Statement using the Indirect Method. You
do not need to reproduce the Cash Used in Investing Activities nor the Cash Provided
from Financing Activities. These portions of the Cash Flow Statement do not change
when you use the Indirect Method. You only need to show the calculation of Cash Flow
from Operating Activities using the Indirect Method format. The Cash Provided from
Operating Activities using the Indirect Method should look as follows:
Statement of Cash Flows for the Twelve Months Ended August 31, 2019
Indirect Method
Cash Provided from Operating Activities:
Net Income
Add back (Subtract from) Operating Items Not Affecting Cash Flow:
Depreciation
(Increase) in Accounts Receivable, Gross
(Increase) in Food and Supplies Inventory (remember, at inception, this was 0)
(Increase) in Firewood Inventory
(Increase) in Prepaid Insurance
Increase in Allowance for Doubtful Accounts
Increase in Accounts Payable
Increase in Accrued Property Taxes Payable
Increase in Advance Deposits (this is added to Net Income because it was not
included in the Income Statement but the cash was received)
Increase in Income Taxes Payable
Cash Provided from Operating Activities
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
Cash Provided from Financing Activities:
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
Increase in Cash from Inception through August 31, 2019:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$ 16,800
22,620
(2,000)
(1,650)
(1,500)
(300)
500
5,250
2,880
11,700
4,200
58,500
$(66,000)
(258,000)
(73,800)
$(397,800)
$294,000
(900)
109,200
$402,300
$ 58,500
(397,800)
402,300
$ 63,000
Cash at Inception (the $3,000 at 9/01/18 is after inception, i.e. after
the capital to purchase the land, buildings, etc. was raised and the
transaction to acquire the Inn by the Darbys was culminated)
$
Cash at the End of the Period (at August 31, 2019)
$ 63,000
8
0
FSI
Financial Statement Investigation
S01-23-2013
Revised 09-04-2022
Green Acres Lumber Company
Suggested Solution
1. Using either the T-accounts provided or whatever method you prefer (blank paper provided),
record (“bookkeep”) the transactions for the Green Acres Lumber Company from the period
January 1, 2018 through December 31, 2018.
See the attached o pages 3 and 4.
2. Based on you answer to Question 1, prepare an income statement for the 12-month period
from January 1, 2018 through December 31, 2018 and a statement of financial position (i.e.
balance sheet) as of December 31, 2018. Assume a tax rate of 20%. Initially, do not consider
the difference between the depreciation expense ($17,500) for financial reporting purposes
and the depreciation expense ($35,000) for tax purposes.
Next, prepare a statement of cash flows (using both the direct and the indirect methods) for
the Green Acres Lumber Company for the 12-month period from January 1, 2018 through
December 31, 2018. NOTE: Since the initial balance sheet has zero balances, the beginning
cash for the cash flow statement is also zero. The ending cash balance is $2,000 (the difference between cash receipts and disbursements). You need to explain how the “cash flowed”
from $0 to $2,000 from operating, investing and financing activities.
The income statement, balance sheet and cash flow statements you prepare will be given to
Mr. Ziffer to explain the Green Acres Lumber Company’s financial performance during the
12-month period.
3. Using whatever criteria you feel appropriate, did the Green Acres Lumber Company have a
“good” year or a “bad” year from January 1, 2018 through December 31, 2018? Briefly explain your criteria and reasoning.
See the attached Exhibits 1, 2, 3 and 4.
A variety of answers were acceptable for the question, “Did Green Acres have a ‘good’
or ‘bad’ year? Mr. Ziffer paid himself $50,000 and his children $22,400 after which
Green Acres still had a profit after tax of $24,000 against an initial equity investment of
$203,200. This translates into a ($24,000/$203,200) = 11.8% after-tax rate of return on
equity. I was looking for answers that tried to consider how Mr. Ziffer might have fared
if he had invested the $203,200 in alternative investments compared to his investment in
Green Acres. In addition, Mr. Ziffer probably earned some “non-quantitative” returns
(the pleasure of owning his own business, having his children working for him??? etc.).
Norman J. Bartczak, Columbia University, prepared this suggested solution as a basis for class discussion of the Green Acres
Lumber Company case study. It is not intended to illustrate either effective of ineffective handling of an administrative situation.
Copyright © 2013 Norman J. Bartczak.
1
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
4. Answer this question after you have completed answering Questions 1 and 2.
Assume that for tax purposes, the U.S. Internal Revenue Service allows the Company to use a
10-year useful life for the building ($178,000/10 = $17,800 depreciation expense per year)
and a 2.5-year useful life for the furnishings and equipment ($43,000/2.5 = $17,200 depreciation expense per year). As a result, Green Acres will be allowed to deduct $35,000 for depreciation for tax purposes in fiscal 2018 (instead of the $17,500 used for financial reporting purposes).
a. For tax purposes, what would the Green Acres Lumber Company’s income before income
taxes (before deducting its income tax expense) be for the 12-month period ended December 31, 2018?
Since the only difference is depreciation, for tax purposes, income before income taxes (before deducting its income tax expense) for the 12-month period ended December 31, 2018 would be:
Income before Income Taxes for Financial Reporting
Add back Depreciation for Financial Reporting
Deduct Depreciation for Tax Purposes
Income before Income Taxes for Tax Purposes
$ 30,000
$ 17,500
$(35,000)
$ 12,500
b. Using the income before income taxes from the income statement you prepared in Question 2 and a tax rate of 20%, what income tax expense did you show for Green Acres for
financial reporting purposes?
Income before Income Taxes for Financial Reporting
Tax Rate
Tax Expense for Financial Reporting Purposes
$ 30,000
0.20
$ 6,000
c. Using the income before income taxes for tax purposes from your answer in a. above and
assuming a tax rate of 20%, how much will Green Acres actually have to pay in taxes to
the U.S. Internal Revenue Service for the 12-month period ended December 31, 2018?
Income before Income Taxes for Tax Purposes
Tax Rate
Taxes Payable for Tax Purposes
$ 12,500
0.20
$ 2,500
d. Where would the difference show up on Green Acres' financial statements and what is the
difference called?
The difference of $6,000 - $2,500 = $3,500 would be reported in the balance sheet as a Deferred Tax Liability
e. Adjust the financial statements you originally prepared to reflect the difference in accounting for financial reporting and for tax purposes.
See attached Exhibits 5, 6, 7 and 8.
2
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
GREEN ACRES LUMBER COMPANY
Using the following T-accounts, “bookkeep” the transactions for the Green Acres Lumber Company from the period
January 1, 2018 through December 31, 2018. Alternatively, you may use whichever method you prefer to "bookkeep
the transactions by utilizing the blank sheets after the T-accounts.
Balance Sheet T-Accounts
Asset T-Accounts:
F
F
F
O
Cash
--------------------------+
|
Bal @ 1/01/18|
$
0 |
1.
203,200 |
2.
100,000 |
3.
50,000 |
| $ 56,000
4.
| 178,000
5.
|
43,000
6.
|
11,400
7.
a. $261,400 |
|
10,000
b.
|
10,000
b.
|
3,500
b.
|
7,000
c.
| 199,600
d.
|
72,400
e.
|
5,700
e.
|
13,200
f.
|
2,800
h.
--------------------------Bal $ 2,000 |
Accounts Receivable, Gross
Allowance for Doubtful Accounts
----------------------------------------------------+
|
|
+
Bal @ 1/01/18|
|Bal @ 1/01/18
$
0 |
| $
0
a.
9,600 |
|
9,600
a.
a.
30,400 |
|
----------------------------------------------------I
Bal $ 40,000 |
| $ 9,600 Bal
I
I
Unfinished Lumber Inventory
Finishing Materials Inventory
O
----------------------------------------------------+
|
+
|
F
Bal @ 1/01/18|
Bal @ 1/01/18|
O
$
0 |
$
0 |
O
7.
11,400 |
f.
13,200 |
O
d.
243,000 |
| $ 2,500
f.
O
| $141,800
d.
|
O
--------------------------|
O
Bal $112,600 |
--------------------------O
Given
Bal $ 10,700 |
O
Given
Prepaid Insurance
--------------------------+
|
Bal @ 1/01/18|
$
0 |
c.
7,000 | $ 6,000
c.
|
--------------------------Bal $ 1,000 |
Prepaid Property Taxes
--------------------------+
|
Bal @ 1/01/18|
$
0 |
h.
2,800 | $ 2,400
h.
|
--------------------------Bal $
400 |
Building
--------------------------+
|
Bal @ 1/01/18|
$
0 |
5.
178,000 |
|
--------------------------Bal $178,000 |
Furnishings and Equipment
--------------------------+
|
Bal @ 1/01/18|
$
0 |
6.
43,000 |
|
--------------------------Bal $ 43,000 |
Accumulated Depreciation
--------------------------|
+
|Bal @ 1/01/18
|
$
0
|
8,900 g.
--------------------------|Bal $ 8,900
|
Accumulated Depreciation
--------------------------|
+
|Bal @ 1/01/18
|
$
0
|
8,600 g.
--------------------------|Bal $ 8,600
|
Land
--------------------------+
|
Bal @ 1/01/18|
$
0 |
4.
56,000 |
|
--------------------------Bal $ 56,000 |
3
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
GREEN ACRES LUMBER COMPANY
Balance Sheet T-Accounts
(continued)
Liabilities T-Accounts:
Accounts Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
| $243,000
d.
d.
199,600 |
--------------------------| $ 43,400 Bal
Given
Notes Payable, Bank
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
50,000
3.
|
--------------------------| $ 50,000 Bal
Taxes Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
6,000
i.
|
--------------------------| $ 6,000 Bal
Mortgage Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
| 100,000
b. $ 10,000 |
--------------------------| $ 90,000 Bal
Equity T-Accounts:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 1/01/18
| $
0
| 203,200
1.
|
--------------------------| $203,200 Bal
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
| $ 24,000
j.
--------------------------| $ 24,000 Bal
GREEN ACRES LUMBER COMPANY
Income Statement T-Account to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
|
+
| $261,400 Cash Collected
a.
|
9,600 Sold on Account in September
a.
|
30,400 Sold on Account in December
a.
a. Bad Debt Allowance or Expense $ 9,600 |
b. Interest Expense Mortgage
10,000 |
b. Interest Expense Notes
3,500 |
c.
Insurance Expense
6,000 |
d. Cost - Unfinished Lumber Sold 141,800 |
e.
Wages
72,400 |
e.
Utilities
5,700 |
f. Cost – Finishing Material Sold
2,500 |
g.
Depreciation - Building
8,900 |
g.
Depreciation – Furnishings
8,600 |
h.
Property Tax Expense
2,400 |
------------------------------------------------------------------------------------------------Subtotals
$271,400 | $301,400
------------------------------------------------------------------------------------------------i. Calculate Tax Expense =
|
$301,400 - $271,400 =
|
$ 30,000 * 20% tax rate =
6,000 |
------------------------------------------------------------------------------------------------Subtotals
$277,400 | $301,400
------------------------------------------------------------------------------------------------j. Net Income =
|
$301,400 - $277,400 =
24,000 |
(“closed out” to Retained
|
Earnings on the Balance Sheet)
|
------------------------------------------------------------------------------------------------Balance
$301,400 | $301,400
-------------------------------------------------------------------------------------------------
4
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 1
GREEN ACRES LUMBER COMPANY
Income Statement for the Twelve Months Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Revenues, Gross
$301,400
Operating Expenses:
Cost of Unfinished Lumber
$141,800
Cost of Finishing Materials
2,500
Bad Debt Allowance or Expense
9,600
Depreciation Expense
17,500
Wages
72,400
Utilities
5,700
Insurance Expense
6,000
Property Tax Expense
2,400
Total Operating Expenses
257,900
Earnings before Interest and Taxes
43,500
Interest Expense, Total
13,500
Income before Income Taxes
30,000
Tax Expense
Net Income
6,000
$ 24,000
5
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 2
GREEN ACRES LUMBER COMPANY
Balance Sheet at December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Assets:
Cash
$
Accounts Receivable, Gross
40,000
Less: Allowance for Doubtful Accounts
(9,600)
Accounts Receivable, Net
30,400
Unfinished Lumber Inventory
112,600
Finishing Materials Inventory
10,700
Prepaid Insurance
1,000
Prepaid Property Taxes
400
Total Current Assets
157,100
Land
56,000
Building, Gross
Less: Accumulated Depreciation
Building, Net
Furnishings and Equipment, Gross
Less: Accumulated Depreciation
Furnishings and Equipment, Net
Total Assets
Liabilities and Shareholders’ Equity:
Accounts Payable
Notes Payable, Bank
Taxes Payable
Total Current Liabilities
Mortgage Payable
Total Liabilities
Common Stock
Retained Earnings
Total Owners' Equity
Total Liabilities and Shareholders’ Equity
6
2,000
178,000
(8.800)
169,200
43,000
(8,600)
34,400
$416,600
$ 43,400
50,000
6,000
99,400
90,000
189,400
203,200
24,000
227,200
$416,600
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 3
GREEN ACRES LUMBER COMPANY
Statement of Cash Flows for the Twelve Months Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Direct Method
Cash Provided from Operating Activities:
Cash Receipts:
Collected from Customers
$261,400
Cash Disbursements:
Unfinished Lumber ($ 11,400 + $199,600)
(211,000)
Finishing Materials
(13,200)
Wages
(72,400)
Utilities
(5,700)
Insurance
(7,000)
Property Taxes
(2,800)
Interest, Total
(13,500)
Cash Provided from Operating Activities
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
$(56,000)
Purchase of Building
(178,000)
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
$ 50,000
Increase in Mortgage Payable
100,000
(Decrease) in Mortgage Payable
(10,000)
Cash from Issuance of Common Stock
203,200
Cash Provided from Financing Activities
$343,200
Cash at Inception
$
0
Cash at the End of the Period (at December 31, 2018)
$
2,000
7
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 4
GREEN ACRES LUMBER COMPANY
Statement of Cash Flows the Twelve Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Indirect Method
Cash Provided from Operating Activities:
Net Income
$ 24,000
Add back (Subtract from) Operating Items
Not Affecting Cash Flow:
Depreciation
(Increase) in Accounts Receivable, Gross
17,500
(40,000)
Increase in Allowance for Doubtful Accounts
(Increase) in Unfinished Lumber Inventory
(Increase) in Finishing Materials Inventory
9,600
(112,600)
(10,700)
(Increase) in Prepaid Insurance
(1,000)
(Increase) in Prepaid Property Taxes
(400)
Increase in Accounts Payable
43,400
Increase in Taxes Payable
Cash Provided from Operating Activities
6,000
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
$(56,000)
Purchase of Building
(178,000)
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
$ 50,000
Increase in Mortgage Payable
100,000
(Decrease) in Mortgage Payable
(10,000)
Cash from Issuance of Common Stock
203,200
Cash Provided from Financing Activities
$343,200
Cash at Inception
$
0
Cash at the End of the Period (at December 31, 2018)
$
2,000
8
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 5
GREEN ACRES LUMBER COMPANY
Income Statement for the Twelve Months Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Revenues, Gross
$301,400
Operating Expenses:
Cost of Unfinished Lumber
$141,800
Cost of Finishing Materials
2,500
Bad Debt Allowance or Expense
9,600
Depreciation Expense
17,500
Wages
72,400
Utilities
5,700
Insurance Expense
6,000
Property Tax Expense
2,400
Total Operating Expenses
257,900
Earnings before Interest and Taxes
43,500
Interest Expense, Total
13,500
Income before Income Taxes
30,000
Tax Expense
Net Income
6,000
$ 24,000
9
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 6
GREEN ACRES LUMBER COMPANY
Balance Sheet at December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Assets:
Cash
$
Accounts Receivable, Gross
40,000
Less: Allowance for Doubtful Accounts
(9,600)
Accounts Receivable, Net
30,400
Unfinished Lumber Inventory
112,600
Finishing Materials Inventory
10,700
Prepaid Insurance
1,000
Prepaid Property Taxes
400
Total Current Assets
157,100
Land
56,000
Building, Gross
Less: Accumulated Depreciation
Building, Net
Furnishings and Equipment, Gross
Less: Accumulated Depreciation
Furnishings and Equipment, Net
Total Assets
Liabilities and Shareholders’ Equity:
Accounts Payable
Notes Payable, Bank
Taxes Payable
Total Current Liabilities
Deferred Income Tax Liability
Mortgage Payable
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
10
2,000
178,000
(8.800)
169,200
43,000
(8,600)
34,400
$416,600
$ 43,400
50,000
2,500
95,900
3,500
90,000
189,400
203,200
24,000
227,200
$416,600
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 7
GREEN ACRES LUMBER COMPANY
Statement of Cash Flows for the Twelve Months Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Direct Method
Cash Provided from Operating Activities:
Cash Receipts:
Collected from Customers
$261,400
Cash Disbursements:
Unfinished Lumber ($ 11,400 + $199,600)
(211,000)
Finishing Materials
(13,200)
Wages
(72,400)
Utilities
(5,700)
Insurance
(7,000)
Property Taxes
(2,800)
Interest, Total
(13,500)
Cash Provided from Operating Activities
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
$(56,000)
Purchase of Building
(178,000)
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
$ 50,000
Increase in Mortgage Payable
100,000
(Decrease) in Mortgage Payable
(10,000)
Cash from Issuance of Common Stock
203,200
Cash Provided from Financing Activities
$343,200
Cash at Inception
$
0
Cash at the End of the Period (at December 31, 2018)
$
2,000
11
Green Acres Lumber Company – Suggested Solution
S01-23-2013
Revised 09-04-2022
Exhibit 8
GREEN ACRES LUMBER COMPANY
Statement of Cash Flows the Twelve Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Indirect Method
Cash Provided from Operating Activities:
Net Income
$ 24,000
Add back (Subtract from) Operating Items
Not Affecting Cash Flow:
Depreciation
17,500
Increase in Deferred Income Tax Liability
3,500
(Increase) in Accounts Receivable, Gross
(40,000)
Increase in Allowance for Doubtful Accounts
(Increase) in Unfinished Lumber Inventory
9,600
(112,600)
(Increase) in Finishing Materials Inventory
(10,700)
(Increase) in Prepaid Insurance
(1,000)
(Increase) in Prepaid Property Taxes
(400)
Increase in Accounts Payable
43,400
Increase in Taxes Payable
Cash Provided from Operating Activities
2,500
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
$(56,000)
Purchase of Building
(178,000)
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
$ 50,000
Increase in Mortgage Payable
100,000
(Decrease) in Mortgage Payable
(10,000)
Cash from Issuance of Common Stock
203,200
Cash Provided from Financing Activities
$343,200
Cash at Inception
$
0
Cash at the End of the Period (at December 31, 2018)
$
2,000
12
FSI
Financial Statement Investigation
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements
(Using Green Acres Lumber Company’s Case Study)
(before accounting for difference between financial reporting and tax depreciation)
1. Record all of the company’s transactions in T-accounts. For any transaction affecting
Cash, be sure to put an O (for Operating) or an I (for Investing) or an F (for Financing)
next to the entry in the Cash T-account to make it easier for yourself when you are preparing the Direct Method Cash Flow Statement.
2. Once you have recorded all of the transactions, go to the Income Statement T-account
and add up the entries on the left hand side and the entries on the right hand side; write
the totals down on each side (see below):
Income Statement T-Account to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
-
|
+
| $261,400 Cash Collected
a.
|
9,600 Sold on Account in September
a.
|
30,400 Sold on Account in December
a.
a.
Bad Debt Allowance or Expense $ 9,600 |
b.
Interest Expense Mortgage
10,000 |
b.
Interest Expense Notes
3,500 |
c.
Insurance Expense
6,000 |
d.
Cost - Unfinished Lumber Sold 141,800 |
e.
Wages
72,400 |
e.
Utilities
5,700 |
f. Cost – Finishing Material Sold
2,500 |
g.
Depreciation – Building
8,900 |
g.
Depreciation – Furnishings
8,600 |
h.
Property Tax Expense
2,400 |
-----------------------------------------------------------------------------------------Subtotals
$271,400 | $301,400
------------------------------------------------------------------------------------------
3. When the right hand side total is greater than the left hand side total, calculate the difference. Multiply the difference times the tax rate (say, 20%) and write the answer down in
the left hand side of the Income Statement T-account as the company’s tax expense (see
below):
Subtotals
$271,400 | $301,400
-----------------------------------------------------------------------------------------i. Calculate Tax Expense =
|
$301,400 - $271,400 =
|
$ 30,000 * 20% tax rate =
6,000 |
------------------------------------------------------------------------------------------
Norman J. Bartczak, Columbia University, prepared this note as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2013 Norman J. Bartczak.
1
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
4. On the balance sheet, you need to record the Tax Expense from the Income Statement Taccount. In this case, the Taxes Payable liability is recorded as:
Balance Sheet T-account:
Taxes Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
6,000
i.
|
--------------------------| $ 6,000 Bal
5. Calculate the difference between the right hand side total and the left hand side total. This
difference is the Net Income for the company. Put the difference on the left hand side of
the Income Statement T-account and the right hand side on an equity account called Retained Earnings in the Balance Sheet T-accounts. The Income Statement T-account has
now been “closed out” (the left hand side total equals the right hand side total) to the Balance Sheet (see below):
Income Statement T-account:
Subtotals
$277,400 | $301,400
-----------------------------------------------------------------------------------------j. Net Income =
|
$301,400 - $277,400 =
24,000 |
(“closed out” to Retained
|
Earnings on the Balance Sheet)
|
-----------------------------------------------------------------------------------------Balance
$301,400 | $301,400
------------------------------------------------------------------------------------------
Balance Sheet T-account:
Retained Earnings
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
| $ 24,000
j.
--------------------------| $ 24,000 Bal
6. You are now ready to prepare an Income Statement for the shareholders from the Income
Statement T-account. Take the entries from the Income Statement T-account (see below)
and put them into an Income Statement for the shareholders (see next page):
2
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
Income Statement T-Account to be "Closed Out" to
Retained Earnings on the Balance Sheet
-----------------------------------------------------------------------------------------Expenses, Losses, Write-Offs
|
Revenues, Gains, Other Income
|
+
| $261,400 Cash Collected
a.
|
9,600 Sold on Account in September
a.
|
30,400 Sold on Account in December
a.
a. Bad Debt Allowance or Expense $ 9,600 |
b. Interest Expense Mortgage
10,000 |
b. Interest Expense Notes
3,500 |
c.
Insurance Expense
6,000 |
d. Cost - Unfinished Lumber Sold 141,800 |
e.
Wages
72,400 |
e.
Utilities
5,700 |
f. Cost – Finishing Material Sold
2,500 |
g.
Depreciation – Building
8,900 |
g.
Depreciation – Furnishings
8,600 |
h.
Property Tax Expense
2,400 |
------------------------------------------------------------------------------------------------Subtotals
$271,400 | $301,400
------------------------------------------------------------------------------------------------i. Calculate Tax Expense =
|
$301,400 - $271,400 =
|
$ 30,000 * 20% tax rate =
6,000 |
------------------------------------------------------------------------------------------------Subtotals
$277,400 | $301,400
------------------------------------------------------------------------------------------------j. Net Income =
|
$301,400 - $277,400 =
24,000 |
(“closed out” to Retained
|
Earnings on the Balance Sheet)
|
------------------------------------------------------------------------------------------------Balance
$301,400 | $301,400
-------------------------------------------------------------------------------------------------
7. The Income Statement for the shareholders is reproduced on the next page. You need to
make one adjustment to prepare this Income Statement. You need to take out the interest
expense from the total expenses and put it separately as a financing expense to be subtracted from Earnings before Interest and Taxes. In this case, the total expenses before
Tax Expense equaled $271,400 (see the T-account on the previous page). This includes
the $10,000 + $3,500 = $13,500 interest expense (see the T-account on the previous
page). You need to subtract $13,500 from $271,400 which equals $257,900. The
$257,900 equals the company’s total operating expenses. In this case, to get to Earnings
before Interest and Taxes, take the Total Revenues of $301,400 less the Total Operating
Expenses of $257,900 to get to Earnings before Interest and Taxes of $43,500. Next, subtract the Total Interest Expense of $13,500 from the Earnings before Interest and Taxes
of $43,500 to get to Income before Taxes of $30,000. Next, subtract the Tax Expense of
$6,000 from the Income before Taxes of $30,000 and, voila!, you get to Net Income of
$24,000 and you have completed the Income Statement for the shareholders (see next
page):
3
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
Income Statement for the Twelve Months Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Revenues, Total
$301,400
Operating Expenses:
Cost of Unfinished Lumber
$141,800
Cost of Finishing Materials
2,500
Bad Debt Allowance or Expense
9,600
Depreciation Expense - Building
17,500
Wages
72,400
Utilities
5,700
Insurance Expense
6,000
Property Tax Expense
2,400
Total Operating Expenses
257,900
Earnings before Interest and Taxes (Operating Earnings)
43,500
Interest Expense, Total
13,500
Income before Income Taxes
30,000
Tax Expense
Net Income
6,000
$ 24,000
8. You are now ready to prepare the Balance Sheet from the remaining T-accounts that have
balances in them. For some of the T-accounts, for example Cash, you will need to add
and total the left hand side entries as well as add and total the right hand side entries to
arrive at a positive balance on the left hand side (since cash is an asset). Likewise, you
may need to do the same thing, calculate a balance, for other T-accounts that have more
than one entry in the T-account (see the next page).
4
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
Balance Sheet T-Accounts
ASSET ACCOUNTS:
F
F
F
O
Cash
--------------------------+
|
Bal @ 1/01/18|
$
0 |
1.
203,200 | $ 56,000
4.
2.
100,000 | 178,000
5.
3.
50,000 |
43,000
6.
|
11,400
7
a. $261,400 |
10,000
b.
|
10,000
b.
|
3,500
b.
|
7,000
c.
| 199,600
d.
|
72,400
e.
|
5,700
e.
|
13,200
f.
|
2,800
h.
--------------------------Bal $ 2,000 |
I
I
I
O
F
O
O
O
O
O
O
O
O
Accounts Receivable, Gross
--------------------------+
|
Bal @ 1/01/18|
$
0 |
a.
9,600 |
a.
30,400 |
--------------------------Bal $ 40,000 |
Unfinished Lumber Inventory
--------------------------+
|
Bal @ 1/01/18|
$
0 |
7.
11,400 |
d.
243,000 |
| $141,800 d.
--------------------------Bal $112,600 |
Land
--------------------------+
|
Bal @ 1/01/18|
$
0 |
4.
56,000 |
--------------------------Bal $ 56,000 |
Prepaid Insurance
--------------------------+
|
Bal @ 1/01/18|
$
0 |
c.
7,000 | $ 6,000
c.
--------------------------Bal $ 1,000 |
Building
--------------------------+
|
Bal @ 1/01/18|
$
0 |
5.
178,000 |
--------------------------Bal $178,000 |
Accum. Depr. Building
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
8,900
g.
-----------------------------| $ 8,900 Bal
Allowance for Doubtful Accounts
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
9,600
a.
--------------------------| $ 9,600 Bal
Finishing Materials Inventory
--------------------------+
|
Bal @ 1/01/18|
$
0 |
f.
13,000 | $ 2,500
f.
--------------------------Bal $ 10,700 |
Prepaid Property Taxes
--------------------------+
|
Bal @ 1/01/18|
$
0
h.
2,800 | $2,400
h.
--------------------------Bal $
400 |
Furnishings & Equipment
--------------------------+
|
Bal @ 1/01/18|
$
0 |
6.
43,000 |
--------------------------Bal $ 43,000 |
Accum. Depr. Furnishings
-------------------------|
+
|Bal @ 1/01/18
| $
0
|
8,600 g.
-------------------------| $ 8,600 Bal
LIABILITIES ACCOUNTS:
Accounts Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
d.
199,600 | $243,000 d.
--------------------------| $ 43,400 Bal
Notes Payable, Bank
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
50,000
3.
--------------------------| $ 50,000 Bal
Taxes Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
6,000
i.
--------------------------| $ 12,000 Bal
Mortgage Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
| 100,000
2.
b. $ 10,000 |
--------------------------| $ 90,000 Bal
EQUITY ACCOUNTS:
Equity – Contributed Capital
Common Stock
--------------------------|
+
|Bal @ 1/01/18
| $
0
| 203,200
1.
|
--------------------------| $203,200 Bal
Equity – Earned Capital
Retained Earnings
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
| $ 24,000
j.
--------------------------| $ 24,000 Bal
5
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
9. Prepare the Balance Sheet for Shareholders (see below) from the Balance Sheet Taccounts:
Balance Sheet at December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Assets:
Cash
$
Accounts Receivable, Total
40,000
Less: Allowance for Doubtful Accounts
(9,600)
Accounts Receivable, Net
2,000
30,400
Unfinished Lumber Inventory
112,600
Finishing Materials Inventory
10,700
Prepaid Insurance
1,000
Prepaid Property Taxes
400
Total Current Assets
157,100
Land
56,000
Building, Gross
Less: Accumulated Depreciation
Building, Net
Furnishings and Equipment, Gross
Less: Accumulated Depreciation
Furnishings and Equipment, Net
Total Assets
178,000
(8,900)
169,100
43,000
(8,600)
34,400
$416,600
Liabilities and Shareholders’ Equity:
Accounts Payable
Notes Payable, Bank
Taxes Payable
Total Current Liabilities
Mortgage Payable
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
6
$ 43,400
50,000
6,000
99,400
90,000
189,400
203,200
24,000
227,200
$416,600
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
10. You are now ready to prepare the Direct Method Cash Flow Statement. The ONLY Taccount you need to prepare the Direct Method Cash Flow Statement is the Cash T-account.
F
F
F
O
Cash
--------------------------+
|
Bal @ 1/01/18|
$
0 |
1.
203,200 | $ 56,000
4.
2.
100,000 | 178,000
5.
3.
50,000 |
43,000
6.
|
11,400
7.
a. $261,400 |
|
10,000
b.
|
10,000
b.
|
3,500
b.
|
7,000
c.
| 199,600
d.
|
72,400
e.
|
5,700
e.
|
13,200
f.
|
2,800
h.
--------------------------Bal $ 2,000 |
I
I
I
O
F
O
O
O
O
O
O
O
O
11. From the Cash T-account (see above), prepare the Direct Method Cash Flow Statement:
Direct Method Statement of Cash Flows for the Twelve Months Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Cash Provided from Operating Activities:
Cash Inflows:
Collected from Customers
$261,400
Cash Outflows:
Unfinished Lumber ($ 11,400 + $199,600)
Finishing Materials
Wages
Utilities
Insurance
Property Taxes
Interest, Total
Cash Provided from Operating Activities
(211,000)
(13,200)
(72,400)
(5,700)
(7,000)
(2,800)
(13,500)
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
$(56,000)
(178,000)
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
$ 50,000
100,000
(10,000)
203,200
$343,200
Summary:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$(64,200)
$(277,000)
$343,200
Increase in Cash for the 12 Months Ended December 31, 2018
Cash at Beginning of the Period
Cash at the End of the Period (at December 31, 2018)
$
$
$
2,000
0
2,000
7
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
12. You are now ready to prepare the Cash Flow Statement using the Indirect Method. You
do not need to reproduce the Cash Used in Investing Activities nor the Cash Provided
from Financing Activities. These portions of the Cash Flow Statement do not change
when you use the Indirect Method. You only need to show the calculation of Cash Flow
from Operating Activities using the Indirect Method format. To prepare the Cash Flow
Statement using the Indirect Method, follow the steps I provided on page 12 of the casebook. The Cash Provided from Operating Activities using the Indirect Method should
look as follows:
Indirect Method Statement of Cash Flows the Twelve Ended December 31, 2018
(before accounting for difference between financial reporting and tax depreciation)
Cash Provided from Operating Activities:
Net Income
$ 24,000
Add back (Subtract from) Operating Items
Not Affecting Cash Flow:
Depreciation
(Increase) in Accounts Receivable, Total
Increase in Allowance for Doubtful Accounts
(Increase) in Unfinished Lumber Inventory
(Increase) in Finishing Materials Inventory
(Increase) in Prepaid Insurance
(Increase) in Prepaid Property Taxes
Increase in Accounts Payable
Increase in Taxes Payable
Cash Provided from Operating Activities
8
17,500
(40,000)
9,600
(112,600)
(10,700)
(1,000)
(400)
43,400
6,000
$(64,200)
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
Steps to Follow to Prepare Financial Statements
(Using Green Acres Lumber Company’s Case Study)
(after accounting for difference between financial reporting and tax depreciation)
NOTE: Everything will be recorded exactly the same except the treatment of income taxes. When
there is a timing difference between accounting for an item between “book” accounting and tax
accounting, in this case depreciation expense, you need to separate the amount of taxes currently
payable from the amount of taxes deferred (due to the book-tax accounting difference).
1. To determine the amount of income taxes the company actually has to pay, refer to the company’s tax return (in the Green Acres case, a separate tax return was not provided; if it had been
provided it would look as follows). Note that in the Green Acres case, the only book-tax difference is deprecation, $17,500 for book purposes and an accelerated amount, $35,000 for tax purposes. This creates lower income before income taxes of $17,500 which lowers the amount of
taxes currently payable from $6,000 to $2,500. The difference of $3,500 is a timing difference
which will be paid in the future when the timing difference reverses.
Tax Return Income Statement for the Twelve Months Ended December 31, 2018
Revenues, Total
$301,400
Operating Expenses:
Cost of Unfinished Lumber
$141,800
Cost of Finishing Materials
2,500
Bad Debt Allowance or Expense
9,600
Depreciation Expense (NOTE: This is the only
difference between book and tax accounting
in the Green Acres Lumber Company case study
35,000
Wages
72,400
Utilities
5,700
Insurance Expense
6,000
Property Tax Expense
2,400
Total Operating Expenses
275,400
Earnings before Interest and Taxes (Operating Earnings)
26,000
Interest Expense, Total
13,500
Income before Income Taxes
12,500
Tax Expense (equals current Taxes Payable, i.e. the
amount of taxes the company will actually pay in the
current year
Net Income for Tax Purposes
2,500
$ 10,000
9
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
On the book balance sheet, you need to make two entries to record the Tax Expense from
the book Income Statement T-account. The first is to record the liability for the actual
taxes that the company will pay for the current period. In this case, the Taxes Payable liability is recorded as:
Balance Sheet T-account:
Taxes Payable
--------------------------|
+
|Bal @ 1/01/18
| $
0
|
2,500
i.
|
--------------------------| $ 2,500 Bal
The second entry on the balance sheet is to record the difference between the book tax
expense (from the book Income Statement T-account), in this case, $6,000, and the
amount of current Taxes Payable that you just recorded in the Balance Sheet Taxes Payable T-account, in this case, $2,500. The difference is the net effect on the company’s Deferred Income Taxes, in this case, since the book Tax Expense of $6,000 is greater than
the current Taxes Payable of $2,500, the net difference is an increase in the company’s
Deferred Income Tax Liability, i.e. $6,000 - $2,500 = $3,500. It would be recorded as follows:
Balance Sheet T-account:
Deferred Income Tax Liability
----------------------------|
+
|Bal @ 1/01/18
| $
0
|
3,500
i.
|
----------------------------| $ 3,500 Bal
On November 20, 2015, the FASB issued Accounting Standards Update 2015-17, Balance Sheet Classification of Deferred Taxes. To simplify presentation, the new guidance
requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet.
2. After you have recorded the tax expense and the taxes payable and either the change in the
deferred tax liability or the change in the deferred tax asset, go back to the book Income
Statement T-account and add the Tax Expense to the total expenses you calculated earlier
on the left hand side. Put this new total down on the left hand side. Bring the right hand
side total down to compare with the left hand side total you just calculated (see below):
Subtotals
$271,400 | $301,400
-----------------------------------------------------------------------------------------Tax Expense
6,000 |
-----------------------------------------------------------------------------------------Subtotals
$277,400 | $301,400
------------------------------------------------------------------------------------------
10
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
3. Even though only $2,500 of the Tax Expense is currently payable, the full $6,000 of Tax
Expense is recorded on the book Income Statement since the remaining $3,500 of Tax
Expense will have to be paid in the future. Therefore, the Income Statement taking into
consideration the book-tax timing difference will be exactly the same:
Income Statement for the Twelve Months Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Revenues, Total
$301,400
Operating Expenses:
Cost of Unfinished Lumber
$141,800
Cost of Finishing Materials
2,500
Bad Debt Allowance or Expense
9,600
Depreciation Expense
17,500
Wages
72,400
Utilities
5,700
Insurance Expense
6,000
Property Tax Expense
2,400
Total Operating Expenses
257,900
Earnings before Interest and Taxes (Operating Earnings)
43,500
Interest Expense, Total
13,500
Income before Income Taxes
30,000
Tax Expense
Net Income
6,000
$ 24,000
4. The only difference on the Balance Sheet arising from a book-tax timing difference is the
introduction of a deferred income tax account. In the Green Acres case, the deferred income tax account is a $3,500 Deferred Income Tax Liability. Instead of showing Taxes
Payable of $6,000 (when there was no book-tax timing difference), the $6,000 is shown
as a $2,500 Taxes Payable (Current) and a $3,500 Deferred Income Tax Liability (LongTerm Payable in the future). The Balance Sheet with a book-tax timing difference for
Green Acres looks like (where the only difference is Taxes Payable and Deferred Income
Tax Liability):
11
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
Balance Sheet at December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Assets:
Cash
$
Accounts Receivable, Total
40,000
Less: Allowance for Doubtful Accounts
(9,600)
Accounts Receivable, Net
2,000
30,400
Unfinished Lumber Inventory
112,600
Finishing Materials Inventory
10,700
Prepaid Insurance
1,000
Prepaid Property Taxes
400
Total Current Assets
157,100
Land
56,000
Building, Gross
Less: Accumulated Depreciation
Building, Net
Furnishings and Equipment, Gross
Less: Accumulated Depreciation
Furnishings and Equipment, Net
Total Assets
178,000
(8,900)
169,100
43,000
(8,600)
34,400
$416,600
Liabilities and Shareholders’ Equity:
Accounts Payable
Notes Payable, Bank
Taxes Payable
Total Current Liabilities
Deferred Income Tax Liability
Mortgage Payable
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
12
$ 43,400
50,000
2,500
95,900
3,500
90,000
189,400
203,200
24,000
227,200
$416,600
ST01-23-2013
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
5. When the Taxes due for Income Tax purposes are actually paid, there will be an effect on
cash flows. In the Green Acres case, the $3,500 Deferred Income Taxes means that Green
Acres will currently paying $3,500 less in taxes when it pays its current taxes than it
would be with no book-tax timing difference (when it would pay $6,000). However, until
it pays its current Tax Expense of $2,500 there is no effect on its cash flow statement.
Direct Method Statement of Cash Flows for the Twelve Months Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Cash Provided from Operating Activities:
Cash Inflows:
Collected from Customers
$261,400
Cash Outflows:
Unfinished Lumber ($ 11,400 + $199,600)
Finishing Materials
Wages
Utilities
Insurance
Property Taxes
Interest, Total
Cash Provided from Operating Activities
(211,000)
(13,200)
(72,400)
(5,700)
(7,000)
(2,800)
(13,500)
$(64,200)
Cash Used in Investing Activities:
Purchase of Land
Purchase of Building
Purchase of Furnishings and Equipment
Cash Used in Investing Activities
$(56,000)
(178,000)
(43,000)
$(277,000)
Cash Provided from Financing Activities:
Increase in Notes Payable
Increase in Mortgage Payable
(Decrease) in Mortgage Payable
Cash from Issuance of Common Stock
Cash Provided from Financing Activities
$ 50,000
100,000
(10,000)
203,200
$343,200
Summary:
Cash Provided from Operating Activities
Cash Used in Investing Activities
Cash Provided from Financing Activities
$(64,200)
$(277,000)
$343,200
Increase in Cash for the 12 Months Ended December 31, 2018
Cash at Beginning of the Period
Cash at the End of the Period (at December 31, 2018)
$
$
$
2,000
0
2,000
6. Finally, the same logic for cash flows holds true for the Indirect Method of preparing
Cash Flow from Operating Activities as the Direct Method. In the Green Acres case, the
$3,500 increase in the Deferred Income Tax Liability is a non-cash charge on the Income
Statement so it is added back to Net Income on the Indirect Method Cash Flow Statement.
13
Steps to Follow to Prepare Financial Statements – Using Green Acres Lumber Company
ST01-23-2013
Revised 09-04-2022
Indirect Method Statement of Cash Flows the Twelve Ended December 31, 2018
(after accounting for difference between financial reporting and tax depreciation)
Cash Provided from Operating Activities:
Net Income
$ 24,000
Add back (Subtract from) Operating Items
Not Affecting Cash Flow:
Depreciation
Deferred Income Taxes
(Increase) in Accounts Receivable, Total
Increase in Allowance for Doubtful Accounts
(Increase) in Unfinished Lumber Inventory
(Increase) in Finishing Materials Inventory
(Increase) in Prepaid Insurance
(Increase) in Prepaid Property Taxes
Increase in Accounts Payable
Increase in Taxes Payable
Cash Provided from Operating Activities
1
17,500
3,5001
(40,000)
9,600
(112,600)
(10,700)
(1,000)
(400)
43,400
2,500
$(64,200)
In this case, because it was an increase in a deferred tax liability, it is added back to the net income number (because it was deducted in the income statement to get to net income). If it had been an increase in a deferred tax
asset, it would have been subtracted in the indirect cash flow statement because the tax expense in the income statement would be less than the actual amount of taxes that the company has to pay.
14
FSI
Financial Statement Investigation
S03-12-2015
Revised 09-04-2022
Toddler Town, Inc.
Suggested Solution
Questions:
1. Using the attached T-accounts (or any other method you prefer) and accrual accounting,
as best you can record (“bookkeep”) the transactions for Toddler Town’s from the period
February 1, 2019 through January 31, 2020 (record all dollar amounts in thousands).
Cash
----------------------------------+
|
Bal @ 02/01/19 |
|
= $ 610
|
F a.
600
|
|
800
b. I
|
50
c. I
F d.
100
|
|
200
e. O
|
|
240
g. O
|
54
h. O
|
24
j. O
|
18
k. O
|
40
l. F
|
48
l. O
|
100
m. F
|
10
m. O
| 2,000
o. O
O q.
2,600
|
O r.
30
|
|
26
v. O
----------------------------------Subtotals 3,940
| 3,610
----------------------------------Bal @ 01/31/20 |
|
= $ 330
|
Accounts Receivable
----------------------------------+
|
s.
246
|
t.
100
|
|
6
t.
----------------------------------Bal @ 01/31/20 |
=
|
$ 340
|
Allowance for Doubtful Accounts
----------------------------------|
+
|$
4
t.
|
----------------------------------| Bal @ 01/31/20
|=
|$
4
Prepaid Insurance
----------------------------------+
|
j.
24
|
|$
24
j.
----------------------------------Bal @ 01/31/20 |
|
= $
0 |
Norman J. Bartczak, Columbia University, prepared this case as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2015 Norman J. Bartczak.
1
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
Games and Toys Inventory
----------------------------------+
|
Bal @ 02/01/19 |
=
|
$ 200
|
o.
2,300
|
| 2,100
p.
----------------------------------Bal @ 01/31/20 |
=
|
$ 400
|
Prepaid Income Taxes
----------------------------------+
|
v. $
26
|
|$
26
y.
|
----------------------------------Bal @ 01/31/20 |
=
|
$
0 |
Deferred Income Tax Asset
----------------------------------+
|
w. $
8
|
|
|
----------------------------------Bal @ 01/31/20 |
=
|
$
8
|
Furnishings, Fixtures & Equipment
----------------------------------+
|
Bal @ 02/01/19 |
=
|
$
40
|
c.
50
|
----------------------------------Bal @ 01/31/20 |
=
|
$
90
|
Accumulated Depreciation
----------------------------------|
+
|$
18
u.
|
----------------------------------|Bal @ 01/31/20
|=
|$
18
Building
----------------------------------+
|
b. $ 800
|
|
----------------------------------Bal @ 01/31/20 |
=
|
$ 800
|
Accumulated Depreciation
----------------------------------|
+
|$
40
u.
|
----------------------------------|Bal @ 01/31/20
|=
|$
40
2
S03-08-2020
Revised 09-04-2022
Toddler Town, Inc. – Suggested Solution
Accounts Payable
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 200
e.
200
|
| 2,300
o.
o. 2,000
|
----------------------------------|Bal @ 01/31/20
|=
|$ 300
Unearned Revenue
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 100
f.
100
|
|
30
r.
----------------------------------|Bal @ 01/31/20
|=
|$
30
Bank Loan
----------------------------------|
+
|$ 100
d.
m.
100
|
----------------------------------|Bal @ 01/31/20
|=
|$
0
Loan from Parents
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 200
----------------------------------|Bal @ 01/31/20
|=
|$
200
Deferred Compensation
----------------------------------|
+
|$ 280
i.
|
----------------------------------|Bal @ 01/31/20
|=
|$ 280
Accrued Interest Payable
----------------------------------|
+
|$
24
n.
|
----------------------------------|Bal @ 01/31/20
|=
|$
24
Taxes Payable
----------------------------------|
+
|$
44
w.
y.
26
|
----------------------------------|Bal @ 01/31/20
|=
|$
18
Mortgage Loan
----------------------------------|
+
|$ 600
a.
l. $
40
|
----------------------------------|Bal @ 01/31/20
|=
|$ 560
Common Stock
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 350
----------------------------------|Bal @ 01/31/20
|=
|$ 350
Retained Earnings
----------------------------------|
+
|
144
x.
|
|
----------------------------------|Bal @ 01/31/20
|=
|$ 144
3
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
Income Statement – T-Account
----------------------------------------------------------------------------|
+
Expenses
|
Revenues
|
| $ 100
Uncle Don
f.
| 2,600
Cash collected
q.
|
246
Credit sales still owed s.
|
100
Day care still owed
t.
g. Wage expense
240
|
h. Advertising expense
54
|
i. Owner salaries
280
|
j. Insurance expense
24
|
k. Utilities expense
18
|
l. Mortgage interest
48
|
m. Bank loan interest
10
|
n. Parents interest
24
|
p. Cost of toys sold
2,100
|
t. Writeoff of receivable
6
|
t. Bad debt expense
4
|
u. Depreciation expense—
|
building
40
|
u. Depreciation expense|
furnishings, fixtures
|
& equipment
18
|
-----------------------------------------------------------------------------Subtotal $2,866
|$3,046
Subtotal
-----------------------------------------------------------------------------Difference = $180
|
-----------------------------------------------------------------------------w. Income tax expense
|
= $180 * 0.20
36
|
-----------------------------------------------------------------------------Subtotal $2,902
|$3,046
Subtotal
-----------------------------------------------------------------------------x. Difference equals
|
Net income which is
|
closed out to
|
retained earnings
144
|
-----------------------------------------------------------------------------Total $3,046
|$3,046
Total
------------------------------------------------------------------------------
4
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
2. Based on you answer to Question 1, for financial reporting purposes (not tax purposes) prepare,
“in good form” (i.e. proper headings for the reports, distinguish such items as current assets and
current liabilities; in the income statement, operating earnings = earnings before interest and
taxes):
a. A statement of financial position (i.e. balance sheet) as of January 31, 2020; and,
b. An income statement for the 12-month period from February 1, 2019 through January 31,
2020. Assume an income tax rate of 20% is appropriate for Toddler Town.
c. A statement of cash flows using the Direct Method for Toddler Town for the 12-month period from February 1, 2019 through January 31, 2020; and,
d. A statement of cash flows using the Indirect Method for Toddler Town for the 12-month
period from February 1, 2019 through January 31, 2020.
As long as you show the investing and financing sections of the cash flow statement using
the Direct Method approach, you do not need to show them again for the Indirect Method
approach since they will be the same. For the Indirect Method cash flow statement, you do
need to show the operating activities section.
See Exhibits TN-1, TN-2, TN-3, and TN-4.
Exhibit TN-1
TODDLER TOWN, INC.
Income Statement for the Twelve Months Ended, January 31, 2020
Revenues:
Cash collected for Uncle Don’s January 2019 order
shipped and paid for in March 2019
Cash collected for sales
Credit card sales still owed
Daycare center sales still owed
Total Revenues
Expenses:
Wage expense (excluding salaries)
Advertising expense
Salaries
Insurance expense
Utilities expense
Cost of games and toys
Write-off of accounts receivable
Bad debt expense
Depreciation expense
Total Operating Expenses
$
100
2,600
246
100
$3,046
$
240
54
280
24
18
2,100
6
4
58
2,784
Earnings before Interest and Income Taxes
262
Interest Expense
82
Earnings before Income Taxes
180
Income Tax Expense @ 20% Tax Rate
Net Income
36
$
144
5
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
Exhibit TN-2
TODDLER TOWN, INC.
Statement of Financial Position (Balance Sheet) as of January 31, 2020
Assets:
Cash
Accounts receivable, gross
340
Less: Allowance for doubtful accounts (4)
Accounts receivable, net
Games and toys inventory
Current assets
Deferred income tax asset
Building, gross
800
Less: accumulated depreciation
(40)
Building, net
Furnishings, fixtures and
equipment, gross
90
Less: accumulated depreciation
(18)
Furnishings, fixtures & equipment, net
Total Assets
6
$
330
336
400
1,066
8
Liabilities and Equity:
Accounts payable
$ 300
Unearned revenue
30
Deferred compensation
280
Accrued interest payable
24
Taxes payable
18
Loan from parents
200
Current liabilities after parents’ loan 852
Mortgage loan
560
Total liabilities
1,412
760
72
$1,906
Equity:
Common Stock
Retained earnings
Total equity
Total Liabilities & Equity
350
144
494
$1,906
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
Exhibit TN-3
TODDLER TOWN, INC.
Direct Method Cash Flow Statement for the 12 months Ended, January 31, 2020
Cash from Operating Activities:
Collection of cash sales and sales made on account
Collection of down payments
Total cash received from operating activities
2,600
30
2,630
Cash Expenses:
Payment for fiscal 2019 games & toys accounts payable $ 200
Wage payments
240
Advertising payments
54
Insurance payments
24
Utilities payments
18
Interest payment
48
Interest payment
10
Payment for fiscal 2020 games & toys accounts payable 2,000
Estimated income tax payment
26
Total cash payments for operating activities
Cash Provided by Operations
2,620
$
10
Cash Used in Investing Activities:
Building purchase
Furnishings, fixtures and equipment
$ (800)
(50)
Cash Used for Investments
$ (850)
Cash Provided by Financing Activities:
Mortgage loan
Mortgage loan repayment
Loan from bank
Bank loan repayment
Cash Provided by Financing
Summary of Cash Flows:
Cash Provided by Operations
Cash Used for Investments
Cash Provided by Financing
$
600
(40)
100
(100)
$
560
$
10
(850)
560
Decrease in Cash
$ (280)
Cash, Beginning of the Period
$
610
Cash, End of the Period
$
330
7
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
Exhibit TN-4
TODDLER TOWN, INC.
Indirect Method Cash Flow Statement for the 12 months Ended, January 31, 2020
Cash from Operating Activities:
Net Income
Add or Subtract Income Statement Items Not Affecting Cash Flow:
+ Depreciation
- Increase in deferred tax asset
- Increase in accounts receivable
- Increase in games & toys inventory
+ Increase in allowance for doubtful accounts
+ Increase in accounts payable
- Decrease in unearned revenue
+ Increase in deferred compensation
+ Increase in taxes payable
+ Increase in accrued interest payable
Cash Provided by Operations
$144
58
(8)
(340)
(200)
4
100
(70)
280
18
24
$
10
Cash Used in Investing Activities:
Building purchase
Furnishings, fixtures and equipment
$ (800)
(50)
Cash Used for Investments
$ (850)
Cash Provided by Financing Activities:
Mortgage loan
Mortgage loan repayment
Loan from bank
Bank loan repayment
Cash Provided by Financing
Summary of Cash Flows:
Cash Provided by Operations
Cash Used for Investments
Cash Provided by Financing
$
600
(40)
100
(100)
$
560
$
10
(850)
560
Decrease in Cash
$ (280)
Cash, Beginning of the Period
$
610
Cash, End of the Period
$
330
8
S03-08-2020
Revised 09-04-2022
Toddler Town, Inc. – Suggested Solution
3. Overall do you think Toddler Town, Inc. had a “good” year or a “bad” year from February 1,
2019 through January 31, 2020? What criteria did you use to gauge Toddler Town’s performance?
Most people answered this question positively (assuming they arrived at close to the
right answers on the financial statements). Various responses were as follows:
a. TTI showed a positive net income of $144 for the year ended January 31, 2020.
When this is related to its initial equity investment of $350, the return on equity
for the year is $144/$350 = 41.1% which is very good for a company that has
been in business for a while, let alone its first year of operation.
b. TTI also showed a positive operating cash flow of $10 despite significant increases in accounts receivable and inventories (offset, in part, by increases in accounts
payable and deferred compensation). This is also a pretty good result for a company in its first year of operation. On the other hand, many people pointed out
that TTI’s overall cash flow declined by $280 which should cause some concern.
c. TTI also had an ending cash balance of $330 (more on this in question 4).
d. Although the Porters did postpone the payment of their $280 in salaries for the
year, it could be argued that once they are paid that, in addition to making a
profit with TTI, the Porters were also compensated fairly well for their first year
in business.
e. Finally, the Porters were also able to realize their life-long dream of owning their
own business
9
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
4. How has Toddler Town performed on a cash flow basis for the year ended January 31, 2020?
Should the Porters be concerned about the Company’s cash position at January 31, 2020 with
respect to operating their business during the upcoming year? Why or why not?
Most people felt that TTI had down at least “OK” on a cash flow basis since the company did generate $10 of cash flow from operations and its cash balance on January 31,
2020 is $330. However, most people did not feel that the company should feel comfortable about TTI’s cash position entering 2020. The following arguments are representative of the reasons:
a. Although it is very unlikely, if the bank decides not to renew the $100 working
capital loan on February 1, 2020 (which is unlikely since TTI did meet the two
bank requirements), the company could find itself going right back to the parents of the Porters to get an additional loan for its working capital needs. That
would likely cause the parents to wonder if their children were financially capable of running the business.
b. TTI also needs $280 to pay the Porters their deferred compensation for fiscal
2020 as well as $280 to pay the Porters their salaries for fiscal 2021.
c. Also on TTI’s cash payment horizon, is the $224 of interest and principal on the
loan from the parents.
Fortunately for the company, the terms of the parents’ loan are far more flexible
than any loan TTI can expect to receive from a typical financial institution. On
the one hand, the flexibility of the terms is offset by the higher, 12%, interest
rate. However, the flexibility of not having to pay off any of the loan until January 31, 2021 is likely to be worth the extra interest. In some respect the loan
from the parents can be viewed as “quasi-equity” where the parents have a
greater risk of getting nothing (or, at least, less than the bank) if TTI gets into financial difficulty but they get a good return, 12%, if the company prospers.
10
S03-08-2020
Revised 09-04-2022
Toddler Town, Inc. – Suggested Solution
5. The bank had two requirements for its $100 thousand bank loan: (1) the company have earnings before interest and taxes of at least 2.25 times the company’s interest expense; and, (2)
interest-bearing debt divided by shareholders’ equity (“leverage”) on January 31, 2020 would
be no greater than 2 times. If you were the banker at Pilgrim Bank, would you renew the
$100 thousand bank loan to Toddler Town? Under the same terms? Why or why not?
The answers to this question were mixed with some unwilling to renew the loan under
any conditions; some willing to renew the loan only changing the terms; and, some willing to renew the loan under the same terms.
The requirements:
(1) EBIT/Interest Expense >= 2.25 EBIT = $262 Interest Expense = $82
$262/$82 = 3.20 so coverage requirement is met
(2) Interest-Bearing Debt/Equity <= 2 = ($200 + $560)/($350 + $144) =
$760/$494 = 1.54 so leverage requirement is also met; many people forgot to add the
retained earnings increase of $144 in calculating total equity
a. Many of those who did not want to renew the loan calculated the requirements
incorrectly and simply cited the fact that since TTI had not met one or both of
the requirements.
b. Some who were unwilling to renew the loan because of TTI’s failure to meet one
or both of the requirements said they would consider renewing the loan with
some changed terms. Namely, with an increase in the interest rate and/or collateral, such as the inventories and/or accounts receivable (since the loan is a working capital loan).
c. Some were willing to renew the loan without any change in the terms simply because TTI had “just missed” the requirements and/or a significant portion of the
interest-bearing debt is attributable to the mortgage for the building. They
pointed out that TTI had: (1) paid the $100 principal and $10 interest payments
on bank loan one day early on January 31, 2020; (2) had paid the $40 principal
and $88 interest on the mortgage loan; and (3) had made a good profit and good
operating cash flow in its first year of operations.
However, some also pointed out that they would include a restriction in the loan
agreement that the funds from the loan could only be used for working capital
purposes and not to repay other loans (such as the loan to the parents).
11
Toddler Town, Inc. – Suggested Solution
S03-08-2020
Revised 09-04-2022
6. When you compare your income statement to the tax income statement provided in of the
case, which three items had the most significant impact on deferred income taxes for Toddler
Town? Please state if the items initiated a deferred tax liability or a deferred tax asset.
Comparing the book income statement with the tax income statement yielded the following threes significant differences (with one tie):
Expense
Revenue
Revenue
Expense
Book
Salaries
(280)
Credit card sales still owed
246
Daycare center sales still owed 100
Cost of games and toys
(2,100)
–
–
-
Tax
0
0
0
(2,000)
Book – Tax
Difference
(280)
246
100
(100)
Effect on
DTL or DTA
Incr DTA (56.0)
Incr DTL
49.2
Incr DTL
20.0
Incr DTA (20.0)
I was very lenient in grading this question because many people said that depreciation
was the most significant difference yet, as you can see from the detailed breakdown below, depreciation was the fifth most significant difference.
Although I did not expect a breakdown like the comparison that follows, a complete
comparison between book and tax looks like:
Book
Tax
Book – Tax
Difference
Revenues:
Cash collected from sales in fiscal 2020 $2,600
Revenue from sale to Uncle Don
100
Credit card sales still owed
246
Daycare center sales still owed
100
Cash collected from advance payments
0
Total Revenues
$3,046
$2,600
100
0
0
30
$2,730
$
Expenses:
Wages
Advertising
Salaries
Insurance
Utilities
Interest expense on mortgage loan
Interest expense on note payable
Interest expense on parents’ loan
Cost of games and toys
Write-off of accounts receivable
Bad debt expense
Depreciation expense- building
Depreciation expense-furnishings, etc.
Total Expenses
$ (240)
(54)
0
(24)
(18)
(48)
(10)
0
(2,000)
(6)
0
(80)
(30)
$2,510
$
$ (240)
(54)
(280)
(24)
(18)
(48)
(10)
(24)
(2,100)
(6)
(4)
(40)
(18)
$2,866
Earnings before income taxes
Income tax expense @ 20% tax rate
Net income
12
$
180
220
36
44
144
$
176
$
0
0
246
100
(30)
316
0
0
(280)
0
0
0
0
(24)
(100)
0
(4)
40
12
$ (356)
(40)
Effect on
DTL or DTA
No effect
No effect
Incr DTL
Incr DTL
Incr DTA
Incr DTL
49.2
20.0
(6.0)
63.2
No effect
No effect
Incr DTA (56.0)
No effect
No effect
No effect
No effect
Incr DTA
(4.8)
Incr DTA (20.0)
No effect
Incr DTA
(0.8)
Incr DTL
8.0
Incr DTL
2.4
Incr DTA (71.2)
Incr DTA
(8.0)
Incr DTA
(8.0)
FSI
Financial Statement Investigation
ST01-14-2020
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements
(Using Toddler Town Inc.’s Case Study)
1. Record all of the company’s transactions in T-accounts. For any transaction affecting
Cash, be sure to put an O (for Operating) or an I (for Investing) or an F (for Financing)
next to the entry in the Cash T-account to make it easier for yourself when you are preparing the Direct Method Cash Flow Statement.
2. Once you have recorded all of the transactions, go to the Income Statement T-account
and add up the entries on the left hand side and the entries on the right hand side; write
the totals down on each side (see below):
Income Statement – T-Account
----------------------------------------------------------------------------|
+
Expenses
|
Revenues
|
| $ 100
Uncle Don
f.
| 2,600
Cash collected
q.
|
246
Credit sales still owed s.
|
100
Day care still owed
t.
g. Wage expense
240
|
h. Advertising expense
54
|
i. Owner salaries
280
|
j. Insurance expense
24
|
k. Utilities expense
18
|
l. Mortgage interest
48
|
m. Bank loan interest
10
|
n. Parents interest
24
|
p. Cost of toys sold
2,100
|
t. Writeoff of receivable
6
|
t. Bad debt expense
4
|
u. Depreciation expense—
|
building
40
|
u. Depreciation expense|
furnishings, fixtures
|
& equipment
18
|
-----------------------------------------------------------------------------Subtotal $2,866
|$3,046
Subtotal
------------------------------------------------------------------------------
3. When the right hand side total is greater than the left hand side total, calculate the difference. Multiply the difference times the tax rate (say, 20%) and write the answer down in
the left hand side of the Income Statement T-account as the company’s tax expense (see below):
Norman J. Bartczak, Columbia University, prepared this note as a basis for class discussion. It is not intended to illustrate either
effective of ineffective handling of an administrative situation. Copyright © 2020 Norman J. Bartczak.
1
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
ST01-14-2020
Revised 09-04-2022
-----------------------------------------------------------------------------Subtotal $2,866
|$3,046
Subtotal
-----------------------------------------------------------------------------Difference = $180
|
-----------------------------------------------------------------------------w. Calculate income tax expense
|
= $180 * 0.20
36
|
-----------------------------------------------------------------------------Subtotal $2,902
|$3,046
Subtotal
4. On the balance sheet, you need to record the $44 Taxes Payable from the company’s Income Tax Return on page 3 of the case study. In this case, the Taxes Payable liability is
recorded as:
Balance Sheet T-account:
Taxes Payable
--------------------------|
+
|Bal @ 1/31/20
| $
0
|
44
w.
--------------------------| $
44 Bal
Since the Taxes Payable (for tax purposes) are greater than the Tax Expense (for book
purposes) on the income statement, you need to record a Deferred Tax Asset:
Deferred Tax Asset
--------------------------+
|
Bal @ 1/31/20|
$
0 |
w.
8 |
--------------------------Bal $
8 |
5. After you have recorded the tax expense and the taxes payable, go back to the Income
Statement T-account and add the Tax Expense to the total expenses you calculated earlier
on the left hand side. Put this new total down on the left hand side. Bring the right hand
side total down to compare with the left hand side total you just calculated (see below):
Calculate the difference between the right hand side total and the left hand side total. This
difference is Net Income. Put the difference on the left hand side of the Income Statement
T-account and the right hand side on an equity account called Retained Earnings in the
Balance Sheet T-accounts. The Income Statement T-account has now been “closed out”
(the left hand side total equals the right hand side total) to the Balance Sheet (see below):
-----------------------------------------------------------------------------Subtotal $2,902
|$3,046
Subtotal
-----------------------------------------------------------------------------x. Close out difference to
|
retained earnings
144
|
-----------------------------------------------------------------------------Subtotal $3,046
|$3,046
==============================================================================
2
ST01-14-2020
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
Balance Sheet T-account:
Retained Earnings
--------------------------|
+
| $144
x.
--------------------------| $144 Bal @ 01/31/20
6. You are now ready to prepare an Income Statement for the shareholders from the Income
Statement T-account. Take the entries from the Income Statement T-account (see below)
and put them into an Income Statement for the shareholders (see next page):
Income Statement – T-Account
----------------------------------------------------------------------------|
+
Expenses
|
Revenues
|
| $ 100
Uncle Don
f.
| 2,600
Cash collected
q.
|
246
Credit sales still owed s.
|
100
Day care still owed
t.
g. Wage expense
240
|
h. Advertising expense
54
|
i. Owner salaries
280
|
j. Insurance expense
24
|
k. Utilities expense
18
|
l. Mortgage interest
48
|
m. Bank loan interest
10
|
n. Parents interest
24
|
p. Cost of toys sold
2,100
|
t. Writeoff of receivable
6
|
t. Bad debt expense
4
|
u. Depreciation expense—
|
building
40
|
u. Depreciation expense|
furnishings, fixtures
|
& equipment
18
|
-----------------------------------------------------------------------------Subtotal $2,866
|$3,046
Subtotal
-----------------------------------------------------------------------------Difference = $180
|
-----------------------------------------------------------------------------w. Income tax expense
|
= $180 * 0.20
36
|
-----------------------------------------------------------------------------Subtotal $2,902
|$3,046
Subtotal
-----------------------------------------------------------------------------x. Difference equals
|
Net income which is
|
closed out to
|
retained earnings
144
|
-----------------------------------------------------------------------------Total $3,046
|$3,046
Total
------------------------------------------------------------------------------
3
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
ST01-14-2020
Revised 09-04-2022
TODDLER TOWN, INC.
Income Statement for the Twelve Months Ended, January 31, 2020
Revenues:
Cash collected for Uncle Don’s January 2019 order
shipped and paid for in March 2019
Cash collected for sales
Credit card sales still owed
Daycare center sales still owed
Total Revenues
$
100
2,600
246
100
$3,046
Expenses:
Wage expense (excluding salaries)
$ 240
Advertising expense
54
Salaries
280
Insurance expense
24
Utilities expense
18
Cost of games and toys
2,100
Write-off of accounts receivable
6
Bad debt expense
4
Depreciation expense-building
40
Depreciation expense-furnishings, fixtures & equipment 18
Total Operating Expenses
2,784
Earnings before Interest and Income Taxes
262
Interest Expense
82
Earnings before Income Taxes
180
Income Tax Expense @ 20% Tax Rate
Net Income
36
$
144
7. You are now ready to prepare the Balance Sheet from the remaining T-accounts that have
balances in them. For some of the T-accounts, for example Cash, you will need to add
and total the left hand side entries as well as add and total the right hand side entries to
arrive at a positive balance on the left hand side (since cash is an asset). Likewise, you
may need to do the same thing, calculate a balance, for other T-accounts that have more
than one entry in the T-account (see the next page).
4
ST01-14-2020
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
Balance Sheet T-Accounts
ASSET ACCOUNTS:
Cash
----------------------------------+
|
Bal @ 02/01/19 |
|
= $ 610
|
F a.
600
|
|
800
b. I
|
50
c. I
F d.
100
|
|
200
e. O
|
|
240
g. O
|
54
h. O
|
24
j. O
|
18
k. O
|
40
l. F
|
48
l. O
|
100
m. F
|
10
m. O
| 2,000
o. O
O q.
2,600
|
O r.
30
|
|
26
v. O
----------------------------------Subtotals 3,940 | 3,610
----------------------------------Bal @ 01/31/20 |
|
= $ 330
|
Accounts Receivable
----------------------------------+
|
s.
246
|
t.
100
|
|
6
t.
----------------------------------Bal @ 01/31/20 |
=
|
$ 340
|
Games and Toys Inventory
----------------------------------+
|
Bal @ 02/01/19 |
=
|
$ 200
|
o.
2,300
|
|$2,100
p.
----------------------------------Bal @ 01/31/20 |
=
|
$ 400
|
Prepaid Income Taxes
----------------------------------+
|
v. $
26
|
|$
26
y.
|
----------------------------------Bal @ 01/31/20 |
=
|
$
0 |
Deferred Income Tax Asset
----------------------------------+
|
w. $
8
|
|
|
----------------------------------Bal @ 01/31/20 |
=
|
$
8
|
Furnishings, Fixtures & Equipment
----------------------------------+
|
Bal @ 02/01/19 |
=
|
$
40
|
c.
50
|
----------------------------------Bal @ 01/31/20 |
=
|
$
90
|
Accumulated Depreciation
----------------------------------|
+
|$
18
u.
|
----------------------------------|Bal @ 01/31/20
|=
|$
18
Building
----------------------------------+
|
b. $ 800
|
|
----------------------------------Bal @ 01/31/20 |
=
|
$ 800
|
Accumulated Depreciation
----------------------------------|
+
|$
40
u.
|
----------------------------------|Bal @ 01/31/20
|=
|$
40
Allowance for Doubtful Accounts
----------------------------------|
+
|$
4
t.
----------------------------------| Bal @ 01/31/20
| =
|$
4
Prepaid Insurance
----------------------------------+
|
j. $
24
|
|$
24
j.
----------------------------------Bal @ 01/31/20 |
=
|
$
0
|
5
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
LIABILITY ACCOUNTS:
Accounts Payable
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 200
e.
200
|
| 2,300
o.
o. 2,000
|
----------------------------------|Bal @ 01/31/20
|=
|$ 300
Unearned Revenue
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 100
f.
100
|
|
30
r.
----------------------------------|Bal @ 01/31/20
|=
|$
30
Bank Loan
----------------------------------|
+
|$ 100
d.
m.
100
|
----------------------------------|Bal @ 01/31/20
|=
|$
0
Loan from Parents
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 200
----------------------------------|Bal @ 01/31/20
|=
|$
200
Deferred Compensation
----------------------------------|
+
|$ 280
i.
|
----------------------------------|Bal @ 01/31/20
|=
|$ 280
Accrued Interest Payable
----------------------------------|
+
|$
24
n.
|
----------------------------------|Bal @ 01/31/20
|=
|$
24
Taxes Payable
----------------------------------|
+
|$
44
w.
y.
26
|
----------------------------------|Bal @ 01/31/20
|=
|$
18
Mortgage Loan
----------------------------------|
+
|$ 600
a.
l. $
40
|
----------------------------------|Bal @ 01/31/20
|=
|$ 560
EQUITY ACCOUNTS;
Common Stock
----------------------------------|
+
|Bal @ 02/01/19
|=
|$ 350
----------------------------------|Bal @ 01/31/20
|=
|$ 350
6
Retained Earnings
----------------------------------|
+
|
144
x.
|
|
----------------------------------|Bal @ 01/31/20
|=
|$ 144
ST01-14-2020
Revised 09-04-2022
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
ST01-14-2020
Revised 09-04-2022
8. Prepare the Balance Sheet for Shareholders (see below) from the Balance Sheet Taccounts:
TODDLER TOWN, INC.
Statement of Financial Position (Balance Sheet) as of January 31, 2020
Assets:
Cash
Accounts receivable, gross
340
Less: Allowance for doubtful accounts (4)
Accounts receivable, net
Games and toys inventory
Current assets
Deferred income tax asset
Building, gross
800
Less: accumulated depreciation
(40)
Building, net
Furnishings, fixtures and
equipment, gross
90
Less: accumulated depreciation
(18)
Furnishings, fixtures & equipment, net
Total Assets
$
330
336
400
1,066
8
Liabilities and Equity:
Accounts payable
$ 300
Unearned revenue
30
Deferred compensation
280
Accrued interest payable
24
Taxes payable
18
Loan from parents
200
Current liabilities after parents’ loan 852
Mortgage loan
560
Total liabilities
1,412
760
72
$1,906
Equity:
Common Stock
Retained earnings
Total equity
350
144
494
Total Liabilities & Equity
$1,906
9. You are now ready to prepare the Direct Method Cash Flow Statement. The ONLY Taccount you need to prepare the Direct Method Cash Flow Statement is the Cash Taccount.
Cash
----------------------------------+
|
Bal @ 02/01/19 |
|
= $ 610
|
F a.
600
|
|
800
b. I
|
50
c. I
F d.
100
|
|
200
e. O
|
|
240
g. O
|
54
h. O
|
24
j. O
|
18
k. O
|
40
l. F
|
48
l. O
|
100
m. F
|
10
m. O
| 2,000
o. O
O q.
2,600
|
O r.
30
|
|
26
v. O
----------------------------------Subtotals 3,940
| 3,610
----------------------------------Bal @ 01/31/20 |
|
= $ 330
|
7
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
ST01-14-2020
Revised 09-04-2022
10. From the Cash T-account (see above), prepare the Direct Method Cash Flow Statement:
TODDLER TOWN, INC.
Direct Method Cash Flow Statement for the 12 months Ended, January 31, 2020
Cash from Operating Activities:
Collection of cash sales and sales made on account
Collection of down payments
Total cash received from operating activities
2,600
30
2,630
Cash Expenses:
Payment for fiscal 2019 games & toys accounts payable $ 200
Wage payments
240
Advertising payments
54
Insurance payments
24
Utilities payments
18
Interest payment
48
Interest payment
10
Payment for fiscal 2020 games & toys accounts payable 2,000
Estimated income tax payment
26
Total cash payments for operating activities
Cash Provided by Operations
2,620
$
10
Cash Used in Investing Activities:
Building purchase
Furnishings, fixtures and equipment
$ (800)
(50)
Cash Used for Investments
$ (850)
Cash Provided by Financing Activities:
Mortgage loan
Mortgage loan repayment
Loan from bank
Bank loan repayment
Cash Provided by Financing
Summary of Cash Flows:
Cash Provided by Operations
Cash Used for Investments
Cash Provided by Financing
$
600
(40)
100
(100)
$
560
$
10
(850)
560
Decrease in Cash
$ (280)
Cash, Beginning of the Period
$
610
Cash, End of the Period
$
330
11. You are now ready to prepare the Cash Flow Statement using the Indirect Method. You
do not need to reproduce the Cash Used in Investing Activities nor the Cash Provided
from Financing Activities. These portions of the Cash Flow Statement do not change
when you use the Indirect Method. You only need to show the calculation of Cash Flow
from Operating Activities using the Indirect Method format. To prepare the Cash Flow
8
Steps to Follow to Prepare Financial Statements – Using Toddler Town Inc.
ST01-14-2020
Revised 09-04-2022
Statement using the Indirect Method, follow the steps I provided in the casebook. The
Cash Provided from Operating Activities using the Indirect Method should look as follows:
TODDLER TOWN, INC.
Indirect Method Cash Flow Statement for the 12 months Ended, January 31, 2020
Cash from Operating Activities:
Net Income
Add or Subtract Income Statement Items Not Affecting Cash Flow:
+ Depreciation
- Increase in deferred tax asset
- Increase in accounts receivable
- Increase in games & toys inventory
+ Increase in allowance for doubtful accounts
+ Increase in accounts payable
- Decrease in unearned revenue
+ Increase in deferred compensation
+ Increase in taxes payable
+ Increase in accrued interest payable
Cash Provided by Operations
$144
58
(8)
(340)
(200)
4
100
(70)
280
18
24
$
10
Cash Used in Investing Activities:
Building purchase
Furnishings, fixtures and equipment
$ (800)
(50)
Cash Used for Investments
$ (850)
Cash Provided by Financing Activities:
Mortgage loan
Mortgage loan repayment
Loan from bank
Bank loan repayment
Cash Provided by Financing
Summary of Cash Flows:
Cash Provided by Operations
Cash Used for Investments
Cash Provided by Financing
$
600
(40)
100
(100)
$
560
$
10
(850)
560
Decrease in Cash
$ (280)
Cash, Beginning of the Period
$
610
Cash, End of the Period
$
330
9
THIS PAGE INTENTIONALLY LEFT BLANK
FSI
Financial Statement Investigation
09-05-2018
Revised 01-14-2023
Class Notes 01: Double Entry Bookkeeping and T-Accounts
Under the patronage of the Duke of Urbino, the Italian friar and mathematician Luca Pacioli in
1494 published his Summa de Arithmetica, which included the first published description of
double-entry bookkeeping. Pacioli suggested that traders draw up their ledgers with debits on the
left side equal to credits on the right side (DEBEO SUMMA CREDO, see picture below), thus setting the standard for the calculation of assets and liabilities that's still in use today.1
LUCA PACIOLI (1445-1517)
Over time, the financial reporting basis of Pacioli’s approach has evolved into the following set of
primary financial statements anchored by what is often referred to as the “basic accounting equation”: ASSETS = LIABILITIES + OWNERS’ EQUITY.
While we will use the current version of Pacioli’s system to understand how today’s financial
statements are prepared, we will not use the words debit and/or credit. As the explanation above
states “debits on the left side equal to credits on the right side”, it is important to realize that, for
all intents and purposes, debit means “on the left” and credit means “on the right”. The overriding
principle of double-entry bookkeeping is that any transaction entries on the left-hand side must
his recent (2017) biography of Leonardo da Vinci, Walter Isaacson notes that the Medici bankers “were innovators in bookkeeping, including the use of debit-and-credit accounting that became one of the great spurs to progress during the Renaissance”.
1In
Norman J. Bartczak, Columbia University, prepared this class note as a basis for class discussion. Copyright © 2018
1|Page
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
09-05-2018
Revised 01-14-2023
be exactly offset by entries on the right-hand side. Every transaction has to balance. Thus the
concept of “debits equal credits” (debeo summa credo) where debits are left-hand side entries
and credits are right-hand side entries. Confusion often arises when more importance is ascribed
to the words debit and credit other than on the left and on the right.
For example, in a set of “T-accounts”2, using the basic accounting equation we see :
Assets
------------------+
|
Debit | Credit
|
=
Liabilities
------------------|
+
Debit | Credit
|
+
Equity
------------------|
+
Debit | Credit
|
It is easy to get confused, since a debit is an increase for an asset but it is a decrease for a liability
and/or an equity. The same is true with respect to a credit. It is a decrease for an asset but it is an
increase for a liability and/or an equity.
In addition, most conventional accounting textbooks record transactions in a somewhat undescriptive fashion by debiting (abbreviated Dr.) and crediting (abbreviated Cr.) the accounts involved in
the transaction. For example, when a company increases its cash account (an asset account) by
$100,000 from selling new common stock (an equity account), the conventional accounting textbook would record the transaction as:
Dr. Cash
Cr. Common Stock
$100,000
$100,000
We will approach things a little differently, but arrive at the same results as a conventional accounting textbook. Instead of using the terminology debit (left) and credit (right), we will refer to
making a left-hand side entry (an increase for assets, a decrease for liabilities and/or equity) and a
right-hand side entry (a decrease for assets, an increase for liabilities and/or equity). In addition,
we will only use T-accounts to record transactions in the following pictorial fashion:
Assets
------------------+
|
Increases|Decreases
|
=
Liabilities
------------------|
+
Decreases|Increases
|
+
Equity
------------------|
+
Decreases|Increases
|
The previous $100,000 transaction would be recorded as:
Assets
Cash
------------------+
|
$100,000 |
|
Equity
Common Stock
------------------|
+
|$100,000
|
Just as we did with the balance sheet accounts, separate T-accounts could be maintained to
record revenues and expenses so as to identify the types of transactions that cause an equity
account (retained earnings) to increase and decrease. However, creating separate T-accounts
There is a saying that “a picture is worth a thousand words” and T-accounts provide the best picture for observing the
effect a transaction has on a company’s financial statements. A T-account is nothing more than a “T” split into increases on the left and decreases on the right for asset accounts and decreases on the left and increases on the right for
liability and/or equity accounts.
2
2|Page
09-05-2018
Revised 01-14-2023
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
for revenues and expenses is cumbersome as well as unnecessary if we already know if the item
is a revenue or an expense. To simplify the preparation of an income statement, we will gather
all of the revenues and expenses into a single T-account, referred to as the Income Statement Taccount. Since the Income Statement T-account is simply a sub-account of equity (see chart on
page one), it takes on the same format as the equity T-account, i.e. increases are recorded on
the right and decreases on the left:
Income Statement T-account3
------------------------------------------|
+
Decreases in Equity | Increases in Equity
|
Expenses
|
Revenues
|
Revenues are increases in equity from operating the business and they are recorded on the
right hand side of the Income Statement T-account. Expenses are decreases in equity from operating the business (by the using up of assets in producing revenue or carrying out activities
that are part of a firm’s operations). Since increases in expenses are a “negative” to equity, they
are recorded on the left hand side of the Income Statement T-account. The excess of revenues
over expenses during a period results in net income which, at the end of the period, is “closed
out” to the balance sheet through an increase in the retained earnings account, a part of the equity account. Conversely, if revenues are less than expenses a net loss results and retained
earnings is reduced by the amount of the net loss.
While we have been discussing the terms, assets, liabilities, equity, revenues, and expenses, we
have not yet formally defined them. The next sections will do so as well as define a few more very
important terms needed to understand financial statements.
Balance Sheet & Balance Sheet Accounts
The balance sheet provides a picture of how much the company owns in the form of assets, how
much it owes in the form of liabilities, and how much is left over for the owners of the business. It
is a static statement in that it is always calculated at a single point in time.
Asset - something which has probable future economic benefits. An asset has three essential
characteristics: (a) it embodies a probable future benefit that involves a capacity to contribute to
future net cash inflows; (b) a particular entity can obtain the benefit and control others' access to it;
and, (c) the transaction giving rise to the entity's right to the benefit has already occurred. In “nonaccounting” terminology, an asset is something the company owns. It is a left-hand (debit) balance account, meaning that at the end of the period if there is a balance in the particular asset
account it will be on the left-hand (debit) side.
Liability - something which involves the probable future sacrifice of economic benefits (e.g. an
obligation to transfer assets or to provide services in the future). A liability has three essential
characteristics: (a) it involves the transfer of assets or services at a specified or determinable
date; (b) the entity has little or no discretion to avoid the transfer; and, (c) the event causing the
equity's obligation has already happened. In “non-accounting” terminology, a liability is somemore complete Income Statement T-account would include the terms “losses” and “other charges” on the Expenses side and
“gains” and “other income” on the Revenues side. However, since individual losses, other charges, gains, and other income are
almost always insignificant and non-predictable compared to normal operating expenses and revenues, they are absent from this
initial presentation of the Income Statement T-account. They will be incorporated, as appropriate, after we have completed the
introduction to the Income Statement T-account.
3A
3|Page
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
09-05-2018
Revised 01-14-2023
thing the company owes. It is a right-hand (credit) balance account, meaning that if there is a
balance in the particular liability account it will be on the right-hand (credit) side.
Equity - a claim to assets; a source of assets. Synonyms include “owners’ capital”, "owners' equity", "shareholders' equity", "shareowners' equity", and "stockholders' equity". The residual interest in the assets of an entity that remains after deducting its liabilities. Equity can be viewed as
consisting of two sources:
• Contributed capital – represents amounts provided by shareholders (purchase of the
company’s stock) or owners.
• Retained earnings (or “earned” capital) – represents the cumulative net income (revenue
less expenses) less dividends paid to the shareholders.
In “non-accounting” terminology, equity is “what’s left over” for owners after deducting what the
company owes from what the company owns. It is a right-hand (credit) balance account, meaning
that if there is a balance in the particular equity account it will be on the right-hand (credit) side.
Income Statement & Income Statement Accounts
The income statement provides a picture of how well (or how poorly) equity (the owners’ investment) has performed by operating the business during a specified period. For example, if
the income statement shows net income of $100,000 for the fiscal year4 (12 months) ended December 31, 2022, the equity of the company has increased by $100,000 due to the company’s
positive results for the period.
When a company earns revenues (increases in equity from operating the business), it normally causes an asset to increase (cash or accounts receivable). In turn, this causes equity (retained
earnings) to increase. When a company incurs an expense (decreases in equity from operating the business) it either results in a decrease in assets or an increase in liabilities. In turn, this
causes equity to decrease. Unlike the static balance sheet calculated at a single point in time, the
income statement is a flow statement accumulating revenues and expenses over a stated period.
Revenue - an increase in equity caused by the sale of goods or a service rendered.
Expense - a decrease in equity caused by the using up of assets in producing revenue or carrying
out other activities that are part of a firm’s operations. Should not be confused with cost, expenditure, or disbursement, which may occur before, when or after the related expense is recognized.
Use the word "cost" to refer to an item that still has benefits as an asset. Use the word "expense"
after the asset's benefits have been used up, i.e. an "expired cost".
Additional Accounts – Contra Accounts
Asset, liability, equity, revenue, and expense are by far and away the most used accounts in
preparing financial statements. However, there are a number of other accounts that need to be
described to fully understand financial statements.
A contra account offsets the balance in another, related account with which it is paired. If the
related account is an asset account, then a contra asset account is used to offset it with a right-
4
fiscal year is any 12-month period, without specific regard to the calendar year, at the end of which a company determines its
financial condition. A company's fiscal year will always reflect the date of the calendar year in which it ends. For example: The
financial operations Wal-Mart are carried out in a fiscal year that begins on February1 and ends on January 31. Therefore WalMart’s fiscal year for 2017 would begin on February 1, 2016 and end on January 31, 2017. The key thing to remember is that a
fiscal year doesn't necessarily correspond with the calendar year.
4|Page
09-05-2018
Revised 01-14-2023
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
hand side (credit) balance. If the related account is a liability or equity account, then a contra
liability or equity account is used to offset it with a left-hand side (debit) balance.
The Contra Asset Account
The most common contra account is the accumulated depreciation account, which offsets the
fixed asset account. The fixed asset account contains the original acquisition cost of a number
of fixed assets, while the contra account (accumulated depreciation) contains the sum total of all
the depreciation expense that has been charged against those assets over time. Taken together, the asset account and contra asset account reveal the net amount of fixed assets still remaining. A contra asset account is not classified as an asset, since it does not represent longterm value, nor is it classified as a liability, since it does not represent a future obligation.
The balances in contra accounts are reduced when the assets or liabilities with which they are
paired are disposed of. Thus, when a fixed asset is sold, the accumulated depreciation associated with it is reversed. Otherwise, the balances in the various contra asset accounts would
continue to increase over time.
Here are several examples of contra accounts, as they would be presented in the balance sheet:
Accounts receivable
Less: allowance for doubtful accounts
Net accounts receivable
$1,000,000
(50,000)
$ 950,000
Inventory
Less: Reserve for inventory obsolescence/write-downs
Net inventory
$2,500,000
(80,000)
$2,420,000
Plant and equipment, gross
Less: Accumulated depreciation
Plant and equipment, net
10,000,000
(8,500,000)
$ 1,500,000
The table below summarizes the methods of depreciation used to allocate the cost of productive
facilities:
Number of Companies
2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999
Straight-line
490 492 488 494 594 592 592 586 580 579 579 576 577
Declining-balance
9
10
10
10
13
16
14
16
22
22
22
22
27
Sum-of-the-years-digits
2
2
3
3
4
5
4
6
5
5
6
7
7
Accelerated method--not specified
9
13
17
21
24
27
30
32
41
44
49
53
53
Units-of-production
12
15
16
14
20
23
24
22
30
32
32
34
31
Group/composite
17
4
10
7
11
9
10
8
4 N/C N/C N/C N/C
Other
---------7
9
10
6
Number of Companies
1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
Straight-line
577 578 575 572 573 570 564 558 560 562 563 559
Declining-balance
25
26
28
27
27
26
26
28
38
40
44
44
Sum-of-the-years-digits
9
10
12
12
9
9
12
8
11
16
11
12
Accelerated method--not specified 43
50
48
49
49
56
62
70
69
69
70
76
Units-of-production
36
39
42
38
49
46
47
50
50
50
53
51
Other
9
10
12
11
11
9
5
7
8
8
9
12
Source: From Accounting Trends & Techniques, various editions, Copyright © 2012 by American Institute of Certified Public Accountants, Inc. –
2008-2011 based on 500 entities surveyed; 1987-2007 based on 600 entities surveyed.
5|Page
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
09-05-2018
Revised 01-14-2023
Examples of Contra Assets – Amazon.com
The asset side of Amazon.com’s 2021 Balance Sheet and excerpts from its 2021 Notes to Consolidated Financial Statements provide examples of contra assets and how they are reported:
AMAZON.COM, INC. – CONSOLIDATED BALANCE SHEETS (in millions)
December 31,
2020
2021
ASSETS
Current assets:
Cash and cash equivalents
Marketable securities
Inventories, net
Accounts receivable, net and other
Total current assets
Property and equipment, net
Operating leases
Goodwill
Other assets
Total assets
$
$
42,122
42,274
23,795
24,542
132,733
113,114
37,553
15,017
22,778
321,195
$
$
36,220
59,829
32,640
32,891
161,580
160,281
56,082
15,371
27,235
420,549
AMAZON.COM, INC. – NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – EXCERPTS
Accounts Receivable, Net and Other
Included in “Accounts receivable, net and other” on our consolidated balance sheets are amounts primarily related to
customers, vendors, and sellers. We estimate losses on receivables based on expected losses, including our historical experience of actual losses. Receivables are considered impaired and written-off when it is probable that all contractual payments due will not be collected in accordance with the terms of the agreement. The allowance for doubtful
accounts was $718 million, $1.1 billion, and $1.1 billion as of December 31, 2019, 2020, and 2021. Additions to the
allowance were $1.0 billion, $1.4 billion, and $1.0 billion, and deductions to the allowance were $793 million, $1.0
billion, and $1.1 billion in 2019, 2020, and 2021.
Inventories
Inventories, consisting of products available for sale, are primarily accounted for using the first-in, first-out method,
and are valued at the lower of cost and net realizable value. This valuation requires us to make judgments, based on
currently available information, about the likely method of disposition. The inventory valuation allowance, representing
a write-down of inventory, was $2.3 billion and $2.6 billion as of December 31, 2020 and 2021.
Property and Equipment, Net
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is recorded on a straight-line basis over the estimated useful lives of the assets (generally the lesser of 40
years or the remaining life of the underlying building, three years prior to January 1, 2020 and four years subsequent
to January 1, 2020 for our servers, five years for networking equipment, ten years for heavy equipment, and three to
ten years for other fulfillment equipment). Depreciation and amortization expense is classified within the corresponding operating expense categories on our consolidated statements of operations.
Note 3 — PROPERTY AND EQUIPMENT
Property and equipment, at cost, consisted of the following (in millions):
December 31,
2020
2021
Gross property and equipment:
Land and buildings
Equipment
Other assets
Construction in progress
Gross property and equipment
Total accumulated depreciation and amortization
Total property and equipment, net
$
$
57,324
97,224
3,772
15,228
173,548
60,434
113,114
$
$
Depreciation and amortization expense on property and equipment was $15.1 billion, $16.2 billion, and $22.9 billion
which includes amortization of property and equipment acquired under finance leases of $10.1 billion, $8.5 billion,
and $9.9 billion for 2019, 2020, and 2021.
6|Page
81,104
128,683
4,118
24,895
238,800
78,519
160,281
09-05-2018
Revised 01-14-2023
Class Notes 01: Double-Entry Bookkeeping and T-Accounts
The Contra Equity Account
Within equity, an example of a contra account is the treasury stock account; it is a deduction
from equity, because it represents the amount paid by a corporation to buy back its stock. The
accumulated deficit account (“negative retained earnings”) is another example of a contra equity
account. It occurs when a company’s accumulated net losses are greater than its accumulated
net incomes. Contra equity accounts are left-hand side (debit) balance accounts.
The Contra Revenue Account
Contra revenue is a deduction from gross revenue, which results in net revenue. Contra revenue transactions are recorded in one or more contra revenue accounts, which usually have a
left-hand side (debit) balance (as opposed to the right-hand side (credit) balance in the typical
revenue account). There are three commonly used contra revenue accounts, which are:
• Sales returns. Contains either an allowance for returned goods, or the actual amount of revenue deduction attributable to returned goods.
• Sales allowances. Contains either an allowance for reductions in the price of a product that
has minor defects, or the actual amount of the allowance attributable to specific sales.
• Sales discounts. Contains the amount of sales discount given to customers, which is usually
a discount given in exchange for early payments by customers.
Walmart Inc.’s 2021 financial statement notes provide an example of a contra revenue account:
Net Sales – The Company recognizes sales revenue, net of sales taxes and estimated sales returns, at the time it
sells merchandise or services to the customer. eCommerce sales include shipping revenue and are recorded upon
delivery to the customer. Estimated sales returns are calculated based on expected returns.
Additional Accounts – Right-Hand Side Income Statement Accounts – Gains, Other Income
Gains occur when a company sells or disposes of an asset at either a higher price than the asset’s cost or a higher price than the asset’s remaining book value on the company’s balance
sheet. For example, if a company uses excess cash to purchase marketable securities and subsequently sells the marketable securities at a higher price, the company will record a gain on its
income statement in the period in which it sells the securities. If a company, say an airline, sells
one of its airplanes that it is carrying on its balance sheet at a net book value after depreciation
and sells the airplane at a higher price than the net book value it will record a gain on its income
statement in the period in which it sells the airplane. Gains are increases in equity during a period. Like revenue, gains are right-hand side (credit) entries to a company’s income statement;
however, gains are not revenue. They involve transactions that do not involve the normal sale of
a company’s goods or services.
Other income occurs when a company receives cash or other benefits for non-operating transactions such as interest and/or dividend income from its investment in marketable securities or
income from seldom and/or non-recurring, non-operating sources. Like revenue and gains, other income is a right-hand side (credit) entry on a company’s income statement but it is not considered either a revenue or a gain.
Additional Accounts – Left-Hand Side Income Statement Accounts – Losses, Other Charges
Losses, write-offs and other charges are the converse of gains and other income. Even though
they are left-hand side (debit) entries on a company’s income statement, they are not considered or shown as a part of normal expenses.
Appendix A provides an Analysis of Accounts using T-accounts.
7|Page
09-05-2018
Revised 01-18-2022
Class Note 01: Double-Entry Bookkeeping and T-Accounts
Appendix A: Analysis of Accounts (What makes accounts go up and down)
Balance Sheet Accounts
Asset Account
Cash
--------------------Increases | Decreases
+
|
Cash rec’d| Cash
from all | payments
sources
|
|
Asset Account
Property, Plant
and Equipment
--------------------Increases | Decreases
+
|
Purchases | Sales &
of PP&E
| disposals
| of PP&E,
| impairment
| charges
Liability Account
Accounts Payable
--------------------Decreases | Increases
|
+
Payments | Purchases
|
|
|
|
|
|
Equity Account
Common Stock
--------------------Decreases | Increases
|
+
| Issuance
| of stock
|
|
|
|
|
Asset Account
Accounts Receivable
--------------------Increases | Decreases
+
|
Credit sales|Collections
Recoveries |
of amounts |Write-offs
written off |
Contra-Asset Account
Accumulated
Depreciation
--------------------Decreases | Increases
|
+
Sales &
|Depreciation
disposals |expense
of PP&E
|
|
|
Liability Account
Accrued Expenses
& Other Payables
--------------------Decreases | Increases
|
+
Payments |Recognition
|of expense
|from benefit
|received but
|not yet paid,
|e.g. heating,
|lighting, etc
Equity Account
Additional
Paid-In Capital
--------------------Decreases | Increases
|
+
| Issuance
| of stock
|
|
|
|
|
Contra-Asset Account
Allowance for
Doubtful Accounts
--------------------Decreases | Increases
|
+
Write-offs| Bad debt
| expense
|
|
Asset Account
Asset Account
Inventory
--------------------Increases | Decreases
+
|
Purchases | Cost of
| goods sold
| (COGS)
|
Prepaid Expenses
--------------------Increases | Decreases
+
|
Prepayment| “Using up”
of rent, | the
insurance,| prepayment
etc.
|
Asset Account
Asset Account
Intangible Assets
--------------------Increases | Decreases
+
|
Acquisi- |Amortization
tions of |expense,
patents, |impairment
licenses, |charges
goodwill |
Liability Account
Other Long-Term Assets
--------------------Increases | Decreases
+
|
Acquisi- | Sales of
tions of | investments,
invest| impairment
ments, etc| charges
|
Interest-Bearing Debt
--------------------Decreases | Increases
|
+
Repayment | Borrowing
of
| including
principal | selling
| bonds
|
|
|
Liability Account
Other Long-Term
Liabilities
--------------------Decreases | Increases
|
+
Payments |Recognition
|of expense
|but not yet
|paid, e.g.
|pensions
|
|
Contra-Equity Account
Equity Account
Treasury Stock
--------------------Increases | Decreases
+
|
Repurchase|Reissuance
of issued |of treasury
shares of |stock
stock
|
|
|
|
Retained Earnings
--------------------Decreases | Increases
|
+
Net loss | Net income
Dividends |
paid
|
|
|
|
|
Equity Account
Accumulated Other
Comprehensive Income
--------------------Decreases | Increases
|
+
Foreign
|Foreign
currency |currency
translation|translation
losses, un-|gains, unrealized
|realized
losses on |gains on
securities |securities
Income Statement Accounts
Income Statement – T-Account
------------------------------------------------------------------------------------------------------Decreases in Equity
|
Increases in Equity
from Operating the Business
|
from Operating the Business
|
Expenses5
|
Revenues6
|
+
| Sales of goods and/or services
Cost of sales and/or services |
All types of expenses |
------------------------------------------------------------------------------------------------------Subtotal = profit before income tax expense if revenues are greater than expenses; otherwise
| loss before income tax credit
------------------------------------------------------------------------------------------------------minus income tax expense |
------------------------------------------------------------------------------------------------------= Net income which gets closed out to retained |
earnings on the balance sheet at end of period |
=======================================================================================================
5Mainly
6Mainly
expenses but also includes Write-Offs, Losses on Sales of Assets, Other Losses.
revenues but also includes Gains on Sales of Assets, Other Income.
8|Page
FSI
Financial Statement Investigation
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
A company’s financial statements consist of: 1. The balance sheet (statement of financial position); 2. The
income statement (statement of operations); 3. The statement of cash flows; 4.The statement of shareholders' equity; 5.The statement of comprehensive income; and, 6. The notes to financial statements.
Balance Sheet
The balance sheet reflects the net resources the firm controls at a point in time. It is a detailed description
of the firm’s assets, liabilities and owners' equity. In straightforward terms, a balance sheet reflects what
a company owns, its assets, what it owes, its liabilities, and the book value of the shareholders’ investment (equity) in the company, i.e. its assets minus its liabilities. A balance sheet reflects the assets, liabilities, and shareholders’ equity of the company at a single point in time. In the United States, publiclytraded companies are required to prepare unaudited balance sheets at the end of each of the first three
quarters and an audited balance sheet at the end of its fiscal year (which incorporates the fourth quarter).
In general, a company’s balance sheet is usually broken into the following parts (see below):
Balance Sheet as at December 31, 2022
Assets
Current
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
Non-current
Property Plant and Equipment
Intangible Assets
Other Non-Current Assets
Total Assets
Liabilities
Current
Accounts Payable
Wages Payable
Taxes Payable
Other Current Liabilities
Total Current Liabilities
Non-current
Deferred Taxes
Long-term debt
Other Non-Current Liabilities
Total Liabilities
Owners' Equity
Common Stock (Contributed Capital)
Retained Earnings (Earned Capital)
Total Owners’ Equity
Total Liabilities & Owners’ Equity
1. Current Assets – assets that can be turned into cash or assets that will be “used up” within one fiscal year from the balance sheet date.
2. Non-Current Assets – assets that are expected to last longer than one fiscal year.
3. Total Assets – the summation of current assets and non-current assets.
4. Current Liabilities – liabilities that will be paid, settled or fulfilled within one fiscal year.
5. Non-Current Liabilities – liabilities that are expected to be paid (settled) in over one fiscal year.
6. Total Liabilities – the summation of current liabilities and non-current liabilities.
7. Shareholders’ Equity – the difference between Total Assets and Total Liabilities. Note that this
difference is not the market value of a company’s equity. The market value of the equity is dependent upon investor’s expectations about a company’s past and, most importantly, future performance.
Apple Inc.’s latest balance sheet, for its fiscal year ended September 24, 2022, is shown on the next page.
Note that on September 24, 2022, the market value of Apple’s shareholders’ equity was $2.6 trillion (emphasis added). The book value of Apple’s shareholders’ equity on September 24, 2022 was $50.7 billion.
As a result, on September 24, 2022, Apple’s shares were trading at a 51.3 MV/BV ratio, a reflection of Apple’s ability to earn more than its cost of capital and investors’ expectations that it will continue to do so.
Norman J. Bartczak, Columbia University, prepared this note for class discussion purposes. Copyright © 2018
1|Page
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
Apple Inc.
CONSOLIDATED BALANCE SHEETS
(In millions, except number of shares which are reflected in thousands and par value)
September 24,
2022
September 25,
2021
$
$
ASSETS:
Current assets:
Cash and cash equivalents
Marketable securities
Accounts receivable, net
Inventories
Vendor non-trade receivables
Other current assets
Total current assets
Non-current assets:
Marketable securities
Property, plant and equipment, net
Other non-current assets
Total non-current assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Current liabilities:
Accounts payable
Other current liabilities
Deferred revenue
Commercial paper
Term debt
Total current liabilities
Non-current liabilities:
Term debt
Other non-current liabilities
Total non-current liabilities
Total liabilities
Commitments and contingencies
Shareholders’ equity:
Common stock and additional paid-in capital, $0.00001 par value: 50,400,000 shares authorized; 15,943,425 and 16,426,786 shares issued and outstanding, respectively
Retained earnings/(Accumulated deficit)
Accumulated other comprehensive income/(loss)
Total shareholders’ equity
Total liabilities and shareholders’ equity
$
$
$
23,646
24,658
28,184
4,946
32,748
21,223
135,405
120,805
42,117
54,428
217,350
352,755
64,115
60,845
7,912
9,982
11,128
153,982
$
$
34,940
27,699
26,278
6,580
25,228
14,111
134,836
127,877
39,440
48,849
216,166
351,002
54,763
47,493
7,612
6,000
9,613
125,481
98,959
49,142
148,101
302,083
109,106
53,325
162,431
287,912
64,849
(3,068)
(11,109)
50,672
352,755
57,365
5,562
163
63,090
351,002
$
Income Statement
The income statement compares revenues/sales (increases in equity from a company selling its products/services) to the related expenses (decreases in equity associated with using up assets, e.g. paying
cash, or incurring liabilities) in order to sell its products/services. When sales/revenues exceed expenses
for the accounting period, e.g. a company’s fiscal year, net income results). Net income is simply the increase in a company’s shareholders’ equity from operating the business successfully.
Unlike the balance sheet which is static at a point in time, an income statement is a “flow” statement
which begins on the first day of a company’s new fiscal year and ends on the last day of its fiscal year.
During a typical 365 day year, a company begins recording sales and expenses on day one and continues
to do so for 365 days.
2|Page
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
A typical income statement looks like:
Income Statement for the period ended December 31, 2022
Revenue/Sales
Cost of Goods Sold or Cost of Sales
Gross Profit (calculated for manufacturing companies)
Selling Expenses
Administrative (general) expenses
Operating Profit
(also, Earnings before Interest & Taxes (EBIT))
-/+ Other Non-Operating Expenses/Income (most typical
Non-Operating Expense is Interest Expense)
=
Earnings before taxes (EBT)
Provision for income taxes
=
Net income
=
=
Apple’s latest income statement for the fiscal year ended September 24, 2022, is shown below. A company can decide its fiscal year end however it wants. Instead of using a standard calendar, Apple sets up its
own fiscal calendar and uses it to pay developers. Apple's fiscal calendar is based on the following rules:
1. Every month starts on a Sunday and ends on a Saturday; 2. The first quarter starts at the end of September; and, 3. Every quarter starts with a 5-week month, followed by two 4-week months. Apple states:
"The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September."
Apple Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except number of shares which are reflected in thousands and per share amounts)
Net sales:
Products
Services
Total net sales
Cost of sales:
Products
Services
Total cost of sales
Gross margin
Operating expenses:
Research and development
Selling, general and administrative
Total operating expenses
Operating income
Other income/(expense), net
Income before provision for income taxes
Provision for income taxes
Net income
Earnings per share:
Basic
Diluted
Shares used in computing earnings per share:
Basic
Diluted
September 24,
2022
Years ended
September 25,
2021
September 26,
2020
$
$
$
316,199
78,129
394,328
297,392
68,425
365,817
220,747
53,768
274,515
201,471
22,075
223,546
170,782
192,266
20,715
212,981
152,836
151,286
18,273
169,559
104,956
$
26,251
25,094
51,345
119,437
(334)
119,103
19,300
99,803
$
21,914
21,973
43,887
108,949
258
109,207
14,527
94,680
$
18,752
19,916
38,668
66,288
803
67,091
9,680
57,411
$
$
6.15
6.11
$
$
5.67
5.61
$
$
3.31
3.28
16,215,963
16,325,819
16,701,272
16,864,919
17,352,119
17,528,214
3|Page
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
Statement of Cash Flows
The statement of cash flows explains the net change in cash during the period. Apple’s latest statements
of cash flows as of September 24, 2022 are:
Apple Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
Cash, cash equivalents and restricted cash, beginning balances
Operating activities:
Net income
Adjustments to reconcile net income to cash generated by operating activities:
Depreciation and amortization
Share-based compensation expense
Deferred income tax expense/(benefit)
Other
Changes in operating assets and liabilities:
Accounts receivable, net
Inventories
Vendor non-trade receivables
Other current and non-current assets
Accounts payable
Deferred revenue
Other current and non-current liabilities
Cash generated by operating activities
Investing activities:
Purchases of marketable securities
Proceeds from maturities of marketable securities
Proceeds from sales of marketable securities
Payments for acquisition of property, plant and equipment
Payments made in connection with business acquisitions, net
Other
Cash used in investing activities
Financing activities:
Payments for taxes related to net share settlement of equity awards
Payments for dividends and dividend equivalents
Repurchases of common stock
Proceeds from issuance of term debt, net
Repayments of term debt
Proceeds from/(Repayments of) commercial paper, net
Other
Cash used in financing activities
Decrease in cash, cash equivalents and restricted cash
Cash, cash equivalents and restricted cash, ending balances
Supplemental cash flow disclosure:
Cash paid for income taxes, net
Cash paid for interest
September 24,
2022
$
35,929
Years ended
September 25,
2021
$
39,789
September 26,
2020
$
50,224
99,803
94,680
57,411
11,104
9,038
895
111
11,284
7,906
(4,774)
(147)
11,056
6,829
(215)
(97)
(1,823)
1,484
(7,520)
(6,499)
9,448
478
5,632
122,151
(10,125)
(2,642)
(3,903)
(8,042)
12,326
1,676
5,799
104,038
6,917
(127)
1,553
(9,588)
(4,062)
2,081
8,916
80,674
(76,923)
29,917
37,446
(10,708)
(306)
(1,780)
(22,354)
(109,558)
59,023
47,460
(11,085)
(33)
(352)
(14,545)
(114,938)
69,918
50,473
(7,309)
(1,524)
(909)
(4,289)
$
(6,223)
(14,841)
(89,402)
5,465
(9,543)
3,955
(160)
(110,749)
(10,952)
24,977
$
(6,556)
(14,467)
(85,971)
20,393
(8,750)
1,022
976
(93,353)
(3,860)
35,929
$
(3,634)
(14,081)
(72,358)
16,091
(12,629)
(963)
754
(86,820)
(10,435)
39,789
$
$
19,573
2,865
$
$
25,385
2,687
$
$
9,501
3,002
4|Page
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
(1) Three Sections of the Cash Flow Statement
The Statement of Cash Flows (SCF) is divided into three sections representing the 3 activities of the
firm: cash flow from operations, from investing and from financing:
Statement of Cash Flows for the period ended December 31, 2022
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Increase (Decrease) in cash and cash equivalents
Cash and cash equivalents – beginning of year
Cash and cash equivalents – end of year
(2) Why Cash Flow is Useful
• Net income on the income statement is measured using accrual basis accounting.
• Net income is not necessarily a good measure of cash generated from operations in the period and
additional information is required to assess the company’s liquidity and cash flow needs.
• Firms receive and disburse cash for items not directly related to operations and therefore not detailed on the income statement.
Statement of Shareholders’ Equity (sometimes referred to as Statement of Net Worth)
The statement of shareholders' equity summarizes the exchanges affecting the contributed capital and retained earnings (earned capital) equity accounts, and explains the change in the shareholders' equity balances shown at the start and end of the period. In its simplest form, the statement starts with net worth
(shareholders’ equity) at the beginning of the period, adds net income, subtracts dividends and ends up
with net worth (shareholders’ equity) at the end of the period, and looks like:
+
=
Net Worth at beginning of year
Net income for the period
Dividends declared
Nat Worth at end of year
Most companies have other items than net income and dividends that also affect shareholders’
equity like: (1) the issuance of shares during the year, e.g. by selling new shares in the market
and/or compensating employees with company shares; (2) the repurchase of shares during the
year; (3) “paper” transactions that affect shareholders’ equity, e.g. changes in the market value of
investments in marketable securities; foreign currency gains and losses; other nonoperating
changes that affect shareholders’ equity.
The 2022 Statements of Shareholders’ Equity for Apple, Inc. is presented below in condensed
form and on the next page as actually presented by Apple. Note how Apple’s net income each
year increases its retained earnings and its dividend each year reduces its retained earnings.
Shareholders’
+ Net Income
- Dividends
- Other Items
Shareholders’
+ Net Income
- Dividends
- Other Items
Shareholders’
+ Net Income
- Dividends
- Other Items
Shareholders’
Equity (Net Worth), September 29.2019
Affecting Shareholders’ Equity
Equity (Net Worth), September 26, 2020
Affecting Shareholders’ Equity
Equity (Net Worth), September 25, 2021
Affecting Shareholders’ Equity
Equity (Net Worth), September 24, 2022
$ 90,488
57,411
(14,087)
(68,413)
$ 65,399
94,680
(14,431)
(82,558)
$ 63,090
99,803
(14,793)
(97,428)
$ 50,672
5|Page
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
As can be observed from Apple’s actual statement of shareholders’ equity (see below), the statement has
become more complicated than Beginning Net Worth + Net Income – Dividends = Ending Net Worth.
Apple Inc.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In millions, except per share amounts)
Total shareholders’ equity, beginning balances
Common stock and additional paid-in capital:
Beginning balances
Common stock issued
Common stock withheld related to net share settlement of equity
awards
Share-based compensation
Ending balances
Retained earnings/(Accumulated deficit):
Beginning balances
Net income
Dividends and dividend equivalents declared
Common stock withheld related to net share settlement of equity
awards
Common stock repurchased
Cumulative effect of change in accounting principle
Ending balances
Accumulated other comprehensive income/(loss):
Beginning balances
Other comprehensive income/(loss)
Cumulative effect of change in accounting principle
Ending balances
Total shareholders’ equity, ending balances
Dividends and dividend equivalents declared per share or RSU
September 24,
2022
$
63,090
Years ended
September 25,
2021
$
65,339
September 26,
2020
$
90,488
57,365
1,175
50,779
1,105
45,174
880
(2,971)
9,280
64,849
(2,627)
8,108
57,365
(2,250)
6,975
50,779
5,562
99,803
(14,793)
14,966
94,680
(14,431)
45,898
57,411
(14,087)
(3,454)
(90,186)
—
(3,068)
(4,151)
(85,502)
—
5,562
(1,604)
(72,516)
(136)
14,966
$
163
(11,272)
—
(11,109)
50,672
$
(406)
569
—
163
63,090
$
(584)
42
136
(406)
65,339
$
0.90
$
0.85
$
0.795
Statement of Comprehensive Income
In 1997 the United States Financial Accounting Standards Board issued Statement on Financial Accounting Standards No. 130 entitled “Reporting Comprehensive Income”. This statement required all income
statement items to be reported either as a regular item in the income statement or a special item as other
comprehensive income. In general, this statement includes changes in shareholders’ equity arising from:
a. Net income
b. “Paper” (unrealized) gains and losses that effect a company’s equity account but are not included
in the income statement because they are unrealized.
The statement excludes changes in shareholders’ equity arising from:
a. The issuance of a company’s shares
b. The repurchase of a company’s shares
c. The payment of dividends
Apple’s latest statement of comprehensive income is as follows:
6|Page
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
Apple Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In millions)
September
24,
2022
$
99,803
Years ended
September
25,
2021
$
94,680
September
26,
2020
$
57,411
(1,511)
501
88
3,212
(1,074)
2,138
32
1,003
1,035
79
(1,264)
(1,185)
(12,104)
205
(694)
(273)
1,202
(63)
(11,899)
(11,272)
88,531
(967)
569
95,249
1,139
42
57,453
Net income
Other comprehensive income/(loss):
Change in foreign currency translation, net of tax
Change in unrealized gains/losses on derivative instruments, net of tax:
Change in fair value of derivative instruments
Adjustment for net (gains)/losses realized and included in net income
Total change in unrealized gains/losses on derivative instruments
Change in unrealized gains/losses on marketable debt securities, net of tax:
Change in fair value of marketable debt securities
Adjustment for net (gains)/losses realized and included in net income
Total change in unrealized gains/losses on marketable debt securities
Total other comprehensive income/(loss)
Total comprehensive income
$
$
$
Apple Inc.’s Notes to Consolidated Financial Statements – Condensed
The first note usually contains a summary of significant accounting policies. The other notes
elaborate on information presented in the financial statements.
Note 1 – Summary of Significant Accounting Policies
Basis of Presentation and Preparation
The consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries (collectively “Apple” or the “Company”). Intercompany accounts and transactions have been eliminated. The preparation of these consolidated financial statements and accompanying notes in conformity
with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain
prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation.
The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. An
additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters, which will occur in the first quarter of the Company’s fiscal year ending September 30, 2023. The Company’s fiscal years 2022, 2021 and 2020 spanned 52 weeks each. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s
fiscal years ended in September and the associated quarters, months and periods of those fiscal years.
Revenue Recognition
Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or
services is transferred to its customers. Control is generally transferred when the Company has a present
right to payment and title and the significant risks and rewards of ownership of products or services are
transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are deliv-
7|Page
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
ered. Payment for Products and Services net sales is collected within a short period following transfer of
control or commencement of delivery of services, as applicable.
For online sales to individuals, for some sales to education customers in the U.S., and for certain other
sales, the Company defers revenue until the customer receives the product because the Company retains a
portion of the risk of loss on these sales during transit. The Company recognizes revenue in accordance
with industry-specific software accounting guidance for the following types of sales transactions:
(i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware.
Deferred Revenue
As of September 24, 2022 and September 25, 2021, the Company had total deferred revenue of $12.4 billion and $11.9 billion, respectively. As of September 24, 2022, the Company expects 64% of total deferred revenue to be realized in less than a year, 27% within one-to-two years, 7% within two-to-three
years and 2% in greater than three years.
Disaggregated Revenue
Net sales disaggregated by significant products and services for 2022, 2021 and 2020 were as follows (in
millions):
IPhone
Mac
iPad
Wearables, Home and Accessories
Services
Total net sales
$
$
2022
205,489
40,177
29,292
41,241
78,129
394,328
$
$
2021
191,973
35,190
31,862
38,367
68,425
365,817
$
$
Software Development Costs
Research and development (“R&D”) costs are expensed as incurred. In most instances, the Company’s
products are released soon after technological feasibility has been established and as a result software development costs were expensed as incurred.
Advertising Costs
Advertising costs are expensed as incurred and included in selling, general and administrative expenses.
Income Taxes
Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable
income in effect for the years in which those tax assets and liabilities are expected to be realized or settled.
Allowance for Doubtful Accounts
The Company records its allowance for doubtful accounts based upon its assessment of various factors,
including historical experience, age of the accounts receivable balances, credit quality of the Company’s
customers, current economic conditions and other factors that may affect the customers’ ability to pay.
Inventories
Inventories are computed using the first-in, first-out method.
Property, Plant and Equipment
Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated
useful lives of the assets, which for buildings is the shorter of 40 years or the remaining life of the building; between one and five years for machinery and equipment, including manufacturing equipment; and
the shorter of the lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which
8|Page
2020
137,781
28,622
23,724
30,620
53,768
274,515
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
range from five to seven years. Depreciation and amortization expense on property, plant and equipment
was $8.7 billion, $9.5 billion and $9.7 billion during 2022, 2021 and 2020, respectively.
Property, Plant and Equipment, Net
The following tables show the Company’s consolidated financial statement details as of September 24,
2022 and September 25, 2021 (in millions):
Land and buildings
Machinery, equipment and internal-use software
Leasehold improvements
Gross property, plant and equipment
Accumulated depreciation and amortization
Total property, plant and equipment, net
2022
22,126
81,060
11,271
114,457
(72,340)
42,117
$
$
$
$
2021
20,041
78,659
11,023
109,723
(70,283)
39,440
Note 5 – Income Taxes
Provision for Income Taxes and Effective Tax Rate
The provision for income taxes for 2022, 2021 and 2020, consisted of the following (in millions):
2022
Federal:
Current
Deferred
Total
State:
Current
Deferred
Total
Foreign:
Current
Deferred
Total
Provision for income taxes
$
$
2021
7,890
(2,265)
5,625
$
2020
8,257
(7,176)
1,081
$
6,306
(3,619)
2,687
1,519
84
1,603
1,620
(338)
1,282
455
21
476
8,996
3,076
12,072
19,300
9,424
2,740
12,164
14,527
3,134
3,383
6,517
9,680
$
$
The foreign provision for income taxes is based on foreign pretax earnings of $71.3 billion, $68.7 billion
and $38.1 billion in 2022, 2021 and 2020, respectively.
A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate (21% in 2022, 2021 and 2020) to income before provision for income taxes for 2022,
2021 and 2020, is as follows (dollars in millions):
Computed expected tax
State taxes, net of federal effect
Impacts of the Act
Earnings of foreign subsidiaries
Foreign-derived intangible income deduction
Research and development credit, net
Excess tax benefits from equity awards
Other
Provision for income taxes
Effective tax rate
$
$
2022
25,012
1,518
542
(4,366)
(296)
(1,153)
(1,871)
(86)
19,300
16.2 %
$
$
2021
22,933
1,151
—
(4,715)
(1,372)
(1,033)
(2,137)
(300)
14,527
$
$
13.3 %
9|Page
2020
14,089
423
(582)
(2,534)
(169)
(728)
(930)
111
9,680
14.4 %
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
Deferred Tax Assets and Liabilities
As of September 24, 2022 and September 25, 2021, the significant components of the Company’s deferred tax assets and liabilities were (in millions):
2022
Deferred tax assets:
Amortization and depreciation
Accrued liabilities and other reserves
Lease liabilities
Deferred revenue
Unrealized losses
Tax credit carryforwards
Other
Total deferred tax assets
Less: Valuation allowance
Total deferred tax assets, net
Deferred tax liabilities:
Minimum tax on foreign earnings
Right-of-use assets
Unrealized gains
Other
Total deferred tax liabilities
Net deferred tax assets
$
$
2021
1,496
6,515
2,400
5,742
2,913
6,962
1,596
27,624
(7,530)
20,094
1,983
2,163
942
469
5,557
14,537
$
$
As of September 24, 2022, the Company had $4.4 billion in foreign tax credit carryforwards in Ireland
and $2.5 billion in California R&D credit carryforwards, both of which can be carried forward indefinitely. A valuation allowance has been recorded for the credit carryforwards and a portion of other temporary
differences.
Concepts Underlying Financial Statements
Below are some important assumptions/concepts in accounting:
• Monetary basis (money measurement) - Records show only facts that can be expressed in monetary terms.
• Entity - Accounts are kept for entities, as distinguished from persons associated with those entities.
• Going concern - Accounting assumes that a business will operate indefinitely.
• Historical cost - The focus is (was?) on the cost of assets, rather than on their market value.
• Realization - Revenues are recognized when goods are delivered or services are performed, in
amounts that are reasonably certain to be realized.
• Matching (emphasis added) - All costs associated with the revenues of a given period are matched (as
expenses) with those revenues.
• Uncertainty (emphasis added) - Although matching is always preferred, when the benefit to be derived
from the cost is determined to be so uncertain as to its measurability, the more conservative treatment
of expensing is followed, e.g. R & D costs for pharmaceutical companies are immediately expensed because of the uncertainty of the regulatory process in approving a drug for eventual sale to the public.
• Conservatism - Provision is made for all losses. Profits are not anticipated.
• Consistency - Same accounting methods are used from one period to the next.
• Materiality - Trivial matters are disregarded. All important matters are disclosed.
• Objectivity - Auditability of records
10 | P a g e
5,575
5,895
2,406
5,399
53
4,262
1,639
25,229
(4,903)
20,326
4,318
2,167
203
565
7,253
13,073
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
Accounting System Requirements
•
•
•
Understandability
Relevance (timeliness, predictive value, feedback value)
Reliability (verifiability, neutrality, representational faithfulness)
These qualities are enhanced if the information is comparable across companies and is based on principles
that are applied consistently over time.
Accounting Rulemakers
During the Great Depression, the U.S. Congress gave the Securities and Exchange Commission (SEC) the
ultimate responsibility for establishing accounting rules for companies that are owned by the general investing public. However, the SEC has delegated much of its rule-making power to the Financial Accounting Standard Board (FASB). As a result, in the U.S., accounting principles are influenced most by
the FASB. The FASB is an independently funded private organization operating under extensive due
process and broad participation to formulate accounting principles. The FASB has seven members. Rules
are passed by majority vote. The FASB’s web home page is http://www.fasb.org.
Other organizations that affect accounting rules in the U.S. are the American Institute of Certified Public
Accountants (AICPA) and the International Accounting Standard Committee/Board (IASC/IASB; IASC is
the predecessor of IASB). The AICPA establishes auditing standards and enforces a code of professional
ethics for its members. The IASB is an independent, privately-funded accounting standard setter based in
London with members from countries around the world. The IASB attempts to harmonize international
accounting principles. Its pronouncements, International Financial Reporting Standards (IFRS), have
helped reduce the diversity of accounting principles across countries. Over 100 countries have adopted
some form of IFRS.
In the U.S. the rules and principles under which external financial statements are constructed are known
as Generally Accepted Accounting Principles (GAAP). They are hardly complete or unique and are constantly changing. Although IFRS and U.S. GAAP have some differences with respect to specifics as well
as philosophy, principles versus rules, there continues to be a gradual harmonization of the standards
making their usage more and more comparable.
Financial Accounting Reports (annual, quarterly, 10-K, 10-Q, etc)
Annual report: issued every year by management to update shareholders and other interested parties on
the status of the company.
Annual reports typically have the following sections/items:
• Promotional material (pictures, “stories,” description of products, …)
• Management Discussion and Analysis (MD&A) is a letter from the firm’s management summarizing
activities of the current and past years and assessing the firm’s prospects for the future.
• Financial statements (balance sheet, income statement, statement of shareholders equity, statement of
cash flows)
• Notes to the financial statements
• Report of independent auditor
• Report of audit committee
• Report of management responsibilities
Quarterly report: similar to the annual report except that it is issued quarterly and has only condensed
information.
11 | P a g e
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
10-K: filed with the SEC annually. Contains the same financial information as the annual report, plus
many additional disclosures. The annual report on Form 10-K provides a comprehensive overview of the
company's business and financial condition and includes audited financial statements. Although similarly
named, the annual report on Form 10-K is distinct from the “annual report to shareholders,” which a
company must send to its shareholders when it holds an annual meeting to elect directors.
10-Q: filed with the SEC quarterly. Contains the same financial information as the quarterly report, plus
additional disclosures. (See Table on next page for more information)
Registration statement / prospectus: documents that must accompany a new issue of securities. They
contain historical, financial, and administrative information about the issuing corporation, including a list
of directors and officers, underwriters, financial reports, discussion of the intended use of funds, and other
information that potential investors may find relevant.
Proxy statement: provided to shareholders before they vote on corporate matters. It includes information
on directors’ compensation and details on resolutions.
8-K: filed with the SEC whenever an event that is deemed material (such as a change of auditor) occurs.
Form 10-K (from SEC website https://www.sec.gov/answers/form10k.htm)
The federal securities laws require public companies to disclose information on an ongoing basis. For example, domestic companies must submit annual reports on Form 10-K, quarterly reports on Form 10-Q,
and current reports on Form 8-K for a number of specified events and must comply with a variety of other
disclosure requirements. For publicly traded companies, copies of these reports may be obtained from:
• The Edgar Database: http://www.sec.gov/edgar.shtml
• The company’s web page or by contacting the company’s investor relations office.
To find a particular company's Form 10-K filings, use the Company Search for the SEC's EDGAR database. On the returned listing of filings for the company, enter “10-K” in the Filing Type box near the top
of the page to filter for only Forms 10-K that have been filed. To see a blank version of the Form (with
instructions), you can download this PDF version.
Following are the deadlines for companies to file Forms 10-K and 10-Q:
Category of Filer
(public float)
Periodic Reports Filing Deadlines
Form 10-K Deadline
Form 10-Q Deadline
Large Accelerated Filer
($700MM or more)
60 days
40 days
Accelerated Filer
($75MM or more and less than
$700MM)
75 days
40 days
Non-accelerated Filer
(less than $75MM)
90 days
45 days
12 | P a g e
09-05-2018
Revised 01-14-2023
Class Notes 02: Introduction to Financial Statements
Useful Acronyms
SEC – Securities & Exchange Commission
FASB – Financial Accounting Standard Board (US)
AICPA – American Institute of Certified Public Accountants
PCAOB – Public Company Accounting Oversight Board1
IFRS – International Financial Accounting Standards
IASB – International Accounting Standard Board
GAAP – Generally Accepted Accounting Principles (US)
MD&A – Management Discussion and Analysis
Auditors’ Opinion
The opinion normally contains three sections. The first section describes “Management’s Responsibility
for the Financial Statements and indicates that the responsibility for the financial statements rests with
management.
The second section affirms the Auditor’s Responsibility that the auditor has followed auditing standards and
practices generally accepted by the accounting profession unless otherwise noted and described. Exceptions to conducting the audit “in accordance with generally accepted auditing standards” are rare. There are
occasional references to the auditor’s having to rely on financial statements examined by other auditors,
particularly for subsidiaries or for data from prior periods.
The Opinion expressed by the auditor in the third section is the heart of the report. It may be unqualified
or qualified opinion. Most opinions are unqualified; that is, the auditor describes no exceptions or qualifications to his opinion that the statements “present fairly . . . the financial position . . . and the results of its
operations and its cash flows . . . in conformity with generally accepted accounting principles.” Qualifications to the opinion result primarily from material uncertainties regarding realization or valuation of assets,
outstanding litigation or tax liabilities, or accounting inconsistencies between periods caused by changes in
the application of accounting principles.
A qualification so material that the auditor cannot express an opinion as to the fairness of the financial
statements as a whole must result in either a disclaimer of opinion or an adverse opinion. Disclaimers of
opinions and adverse opinions rarely appear in published annual reports.
1
The Public Company Accounting Oversight Board (PCAOB) is a private-sector, nonprofit corporation created by
the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies and other issuers in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.
13 | P a g e
Class Notes 02: Introduction to Financial Statements
09-05-2018
Revised 01-14-2023
Example of Unqualified Auditor’s Report
The following is an example of a standard unqualified auditor's report on financial statements as it is currently used in most countries:
INDEPENDENT AUDITOR'S REPORT
Board of Directors, Stockholders, Owners, and/or Management of
XYZ Company, Inc.
123 Main St.
Anytown, Any Country
We have audited the accompanying financial statements of XYZ Company, Inc. (“state location”, e.g. a
New York corporation), which comprise the balance sheet as of December 31, 20XX, and the related
statements of income, retained earnings, and cash flows for the year then ended, and the related notes to
the financial statements.
Management's Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.
Auditor's Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with U.S. generally accepted auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated
financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in
the consolidated financial statements. The procedures selected depend on the auditors' judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether
due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to
the entity's preparation and fair presentation of the consolidated financial statements in order to design
audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit
also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for
our audit opinion.
Opinion
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company, Inc. as of December 31, 20XX, and the results of its operations and its
cash flows for the year then ended in accordance with U.S. generally accepted accounting principles.
AUDITOR'S SIGNATURE
Auditor's name and address
Date = Last day of any significant field work
This date should not be dated earlier than when the auditor has sufficient audit evidence to support the
opinion.
14 | P a g e
Financial Statement Investigation
FSI
04-16-2019
Revised 01-14-2023
Class Notes 03: Common Stock, Retained Earnings (Earned Capital) and Dividends
Common Stock – Capital Invested by Shareowners
Common Stock – Typically permits holders to vote on certain corporate matters, including
Board of Directors. Dividends at the discretion of the Board of Directors. Market value typically driven by earnings of the company.
Issuance of stock
Common stock normally has a par value1, which has certain legal implications in the event of
liquidation of the company. Often the par value is 1¢, 10¢ or $1. For common stock, par value
bears no relationship to the amount that the stock is originally issued for.
Example: Company issues 1,000,000 shares of $1 par value common stock for proceeds of $
27,500,000.
Asset Account
Cash
------------------+
|
27,500,000|
|
Equity Account
Common Stock
(1,000,000 @ $1)
------------------|
+
| 1,000,000
|
Equity Account
Additional Paid-In
Capital (APIC)
--------------------|
+
|26,500,000
|
Some companies do not break out common stock separately from Additional Paid-In Capital
(APIC) in their balance sheets. Sometimes called “Common stock and additional paid-incapital” or “Contributed capital.”
Retained Earnings – Earned Capital from Net Income
Retained Earnings – Retained earnings represent the accumulated changes in shareholders’ equity from operating the business. At the end of its fiscal year, a company’s net income is “closed
out” to the retained earnings account. As a result, retained earnings is the accumulated net incomes of a company since it has been in business less the accumulated amount of cash dividends
that it has paid to shareholders.
In 2022, Apple reported net income of $99,803 million and paid a dividend to its shareholders of
$14,841 million.
1
The par value of a stock has no relation to its market value and, as a concept, is somewhat archaic. The par value of
a share of stock is the value stated in the corporate charter below which shares of that class cannot be sold upon initial offering; the issuing company promises not to issue further shares below par value, so investors can be confident
that no one else will receive a more favorable issue price. Thus, par value is the nominal value of a security which is
determined by the issuing company to be its minimum price. This was far more important in unregulated equity
markets than in the regulated markets that exist today, where stock issuance prices must usually be published. Many
common stocks issued today do not have par values; those that do (usually only in jurisdictions where par values are
required by law) have extremely low par values (often the smallest unit of currency in circulation).
Norman J. Bartczak, Columbia University, prepared this note for class discussion purposes. Copyright © 2019.
1|Page
Class Notes 03: Common Stock, Retained Earnings, and Dividends
04-16-2019
Revised 01-14-2023
Apple Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except number of shares which are reflected in thousands and per share amounts)
Net sales:
Products
Services
Total net sales
Cost of sales:
Products
Services
Total cost of sales
Gross margin
Operating expenses:
Research and development
Selling, general and administrative
Total operating expenses
Operating income
Other income/(expense), net
Income before provision for income taxes
Provision for income taxes
Net income
September 24,
2022
Years ended
September 25,
2021
September 26,
2020
$
$
$
$
Payments for dividends and dividend equivalents
316,199
78,129
394,328
297,392
68,425
365,817
201,471
22,075
223,546
170,782
192,266
20,715
212,981
152,836
151,286
18,273
169,559
104,956
26,251
25,094
51,345
119,437
(334)
119,103
19,300
99,803
21,914
21,973
43,887
108,949
258
109,207
14,527
94,680
18,752
19,916
38,668
66,288
803
67,091
9,680
57,411
$
(14,841)
$
(14,467)
a. Net income of $99,803 is recorded on the left-hand side of the Income Statement TAccount to close-out the Income Statement for the year.
b. Net Income of $99,803 is recorded on the right-hand side of Retained Earnings because it
is an increase in Shareholders’ Equity from operating the business successfully (it is
“Earned Capital” as opposed to Contributed Capital).
c. Dividends of $14,841 reduce cash.
d. Dividends of $14,841 reduce Retained Earnings because they represent a return of capital
to the shareholders.
Cash
------------------+
|
|
|
|
|Dividend reduces
| $14,841 c.
Retained Earnings
------------------|
+
|Net Income
|increases
| $99,803 b.
Dividend reduces|
d. $14,841 |
220,747
53,768
274,515
Income Statement T-Account
--------------------------|
+
Net Income
|
closes out
|
a.
$99,803 |
(Accumulated Deficit) – Reduced Capital from Net Losses
Most often in the early stages of a company’s life, the business accumulates net losses such that
it has “negative” retained earnings. Rather than refer to the accumulated net losses as negative
retained earnings, it is called accumulated deficit.
2|Page
(14,081)
04-16-2019
Revised 01-14-2023
Class Notes 03: Common Stock, Retained Earnings and Dividends
For its fiscal year ended December 31, 2021, Airbnb, Inc. (ABNB) reported a net loss of
$674,339,000 and did not pay a dividend to its shareholders.
Consolidated Statements of Operations
(in thousands, except per share amounts)
Revenue
Costs and expenses:
Cost of revenue
Operations and support
Product development
Sales and marketing
General and administrative
Restructuring charges
Total costs and expenses
Income (loss) from operations
Interest income
Interest expense
Other income (expense), net
Loss before income taxes
Provision for (benefit from) income taxes
Net loss
$
Year Ended December 31,
2019
2020
4,805,239 $
3,378,199 $
2021
5,991,760
$
1,196,313
815,074
976,695
1,621,519
697,181
—
5,306,782
(501,543)
85,902
(9,968)
13,906
(411,703)
262,636
(674,339) $
1,155,833
847,057
1,425,048
1,186,332
835,324
112,849
5,562,443
429,317
12,734
(437,599)
(304,659)
(300,207)
51,827
(352,034)
876,042
877,901
2,752,872
1,175,325
1,134,851
151,355
6,968,346
(3,590,147)
27,117
(171,688)
(947,220)
(4,681,938)
(97,222)
(4,584,716) $
As of December 31, 2021, Airbnb’s accumulated deficit is $6,357,741,000 and its stockholders’
equity section on its balance sheet is shown as follows (in thousands):
Stockholders’ equity:
December 31, 2020 December 31, 2021
Common stock
Additional paid-in capital
Accumulated other comprehensive income (loss)
Accumulated deficit
Total stockholders’ equity
Total liabilities and stockholders’ equity
$
60
8,904,791
2,639
(6,005,707)
2,901,783
10,491,499 $
63
11,140,284
(6,893)
(6,357,741)
4,775,713
13,708,474
Its accounts were affected as follows (dollars in thousands):
Accumulated Deficit
------------------+
|
Airbnb’s net loss increases |
its accumulated deficit by
|
a.$674,339 |
|
since Airbnb has only shown |
net losses since it has been |
in business
Income Statement T-Account
--------------------------|
+
Expenses |
Revenues
Airbnb’s expenses exceeded its
revenues by | $674,339 a.
|
|this amount would be closed
out (a right-hand side T-account entry
because it is a net loss)
Double-entry bookkeeping requires that a company’s Assets = Liabilities + Stockholders’ Equity. Airbnb’s stockholders’ equity is negative which means that its liabilities are greater than its
assets. It does not mean that Airbnb is either insolvent or bankrupt. The market’s valuation of
Airbnb is not determined by the “book values” of its assets, liabilities, and stockholders’ equity.
The book values provide some historical insights into a company’s value but it is investors’ ex3|Page
Class Notes 03: Common Stock, Retained Earnings, and Dividends
04-16-2019
Revised 01-14-2023
pectations as to the company’s future prospects that drive a company’s share price. In the case of
Airbnb, as of February 25, 2022, the date ABNB filed its 10-K (annual report) with the SEC, the
market value of Airbnb’s stockholders’ equity was $101.773 billion, reflecting the optimistic
view that investors had regarding Airbnb’s future prospects.
Cash Dividends
As previously discussed, cash dividends result in the decrease of retained earnings. When the
dividend is declared by the Board, a liability is recognized. When paid, the liability is eliminated. Cash dividends reduce the amount of shareholders’ equity.
To record the declaration and payment of the dividend totaling $2,500,000:
Equity Account
Retained Earnings
------------------|
+
2,500,000|
|
Liability Account
Dividends Payable
------------------|
+
| 2,500,000
|
To record the payment of the dividend totaling $2,500,000:
Asset Account
Cash
------------------+
|
|2,500,000
|
Liability Account
Dividends Payable
------------------|
+
2,500,000|
|
4|Page
04-16-2019
Revised 01-14-2023
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
Agenda:
(1) Capitalize vs. Expense
(2) Costs to Capitalize – Tangible Assets
(3) Costs to Capitalize – Intangible Assets
(4) Depreciation Expense of Tangible Assets
(5) Amortization Expense of Intangible Assets
Accounting issues regarding capitalization versus expensing
Costs
Capitalize
= Asset
= Balance
Sheet
•
•
Expenses
= Income
Statement
Depreciate
or amortize
Is it appropriate to capitalize or expense a cost?
What method and period of depreciation or amortization is appropriate?
(1) Capitalize vs. Expense
Under the matching principle, accounting attempts to match revenues with the costs
associated with generating these revenues. When a cost incurred is expected to provide
future economic benefits, we capitalize (or defer) these costs – record them as assets and
then recognize the expense when the benefit occurs or the asset is used up.
(2) Costs to Capitalize – Tangible Assets
Tangible assets are assets that have a physical form and are expected to provide future
economic benefits. Tangible assets include both fixed assets, such as property, plant and
equipment, and current assets, such as inventory.
(3) Costs to Capitalize – Intangible Assets
Intangible assets are nonphysical assets that are expected to provide future economic
benefits. Examples are:
•
•
•
•
•
•
Patents (technology rights)
Licenses (marketing agreements)
Copyrights (original works rights)
Trademarks, logos, brand names
Goodwill
Research and development (R&D).
Columbia University prepared this note for class discussion purposes. Copyright © 2019
Page | 1
04-16-2019
Revised 01-14-2023
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
(4) Depreciation Expense of Tangible Assets
(a) Depreciation Methods
The purpose of depreciation is to allocate the cost of PP&E over the periods benefited and
match revenues with the costs to generate these revenues. Under GAAP, we use historical
cost and not current values to record PP&E. This means that depreciation is an allocation of
costs, not a valuation method.
Management estimates
To determine depreciation expense, management needs to decide the following:
•
•
•
Estimated life of the asset (period expected to provide benefits)
Estimated salvage value (amount that asset can be sold for at end of its useful life)
Method that best matches revenues with costs
Calculating depreciation (methods)
•
•
•
•
Straight-line (time) method: (Cost – salvage value) / Estimated life
Accelerated depreciation methods – declining balance, sum-of-the-years-digits
Units of production (Straight-line use method) – similar to straight-line method but
depreciation based on actual usage rather than the passage of time
Note: Land and projects-in-process are not depreciated. When projects are completed
and begin operating, depreciation commences.
Depreciation decreases property, plant and equipment (PP&E). However, financial reporting rules
require that companies maintain separate accounts for PP&E at cost and the amount of depreciation
taken against PP&E. In this way, users of financial statements can estimate what percentage of the
company’s PP&E has been used up and what percentage of the company’s PP&E remains to be used
up. The account for the accumulated depreciation taken is treated as a contra-asset to PP&E and is
appropriately called Accumulated Depreciation. So when a company records depreciation expense
for the period it records an expense and increases the contra-asset account, accumulated
depreciation:
Income Statement T-account
------------------------------------------|
+
Expenses
|
Revenues
|
Depreciation expense $$$ |
|
Contra-Asset Account
Accumulated Depreciation
----------------------|
+
|
|
|
$$$
|
Like all contra-asset accounts, accumulated depreciation is associated with the asset it is reducing,
PP&E, and is included as a deduction to the gross PP&E asset account. Unlike asset accounts, a
contra-asset has a right-hand side balance, not a left-hand side balance, and right-hand side entries
increase the balance in the contra-asset account. Although right-hand side entries to Accumulated
Depreciation increase the account balance, the right-hand side entries decrease total assets. Note that
a contra-asset “attaches” itself as a deduction to the asset to which it is associated. Thus when we
prepare a balance sheet, we include the balance in the gross PP&E account (which is at its original
cost) and then deduct the Accumulated Depreciation account, which results in PP&E, net.
Page | 2
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
04-16-2019
Revised 01-14-2023
Depreciation Methods – A Comparison
The table below summarizes the methods of depreciation used to allocate the cost of
productive facilities:
Straight-line
Declining-balance
Sum-of-the-years-digits
Accelerated method-not specified
Units-of-production
Group/composite
Other
Number of Companies
2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999
490 492 488 494 594 592 592 586 580 579 579 576 577
9
10
10
10
13
16
14
16
22
22
22
22
27
2
2
3
3
4
5
4
6
5
5
6
7
7
9
12
17
--
13
15
4
--
17
16
10
--
21
14
7
--
24
20
11
--
27
23
9
--
30
24
10
--
32
22
8
--
41
30
4
--
44
32
N/C
7
49
32
N/C
9
53
34
N/C
10
53
31
N/C
6
Number of Companies
1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
577 578 575 572 573 570 564 558 560 562 563 559
25
26
28
27
27
26
26
28
38
40
44
44
9
10
12
12
9
9
12
8
11
16
11
12
Straight-line
Declining-balance
Sum-of-the-years-digits
Accelerated method-not specified
43
50
48
49
49
56
62
70
69
69
70
76
Units-of-production
36
39
42
38
49
46
47
50
50
50
53
51
Group/composite
N/C N/C N/C N/C N/C N/C N/C N/C N/C N/C N/C N/C
Other
9
10
12
11
11
9
5
7
8
8
9
12
Source: From Accounting Trends & Techniques, various editions, Copyright © 2012 by American Institute of Certified Public Accountants, Inc. –
2008-2011 based on 500 entities surveyed; 1987-2007 based on 600 entities surveyed.
Depreciation Methods – Industry Comparison – Airlines
The table below describes the depreciation methods used by major airlines worldwide:
Airline
Aer Lingus
Air France
American Airlines
British Airways
Delta Airlines
Jet Blue Airways
Lufthansa Group
RyanAir Holdings
Southwest Airlines
United Airlines
PJSC Aeroflot
Air India
Avianca
Azul S.A.
Cathay Pacific
China Southern
Singapore Airlines
Depreciation Method
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Straight-Line
Useful Life of Planes
18 - 20 Years
20 - 25 Years
16 - 30 Years
18 - 25 Years
21 - 30 Years
25 Years
20 Years
23 Years
23 - 25 Years
25 - 30 Years
20 - 32 Years
25 Years
10 - 30 Years
12 Years
20 Years
15 - 20 Years
15 - 20 Years
Residual (Salvage) Value
10%
Reviewed Annually
5 - 10%
Reviewed Annually
5 - 10%
20%
5%
15%
2 - 20%
10 - 11%
Reviewed Annually
5%
Reviewed Annually
Reviewed Annually
10%
Reviewed Annually
5 - 10%
Notice that, although not required to do so, all of the carriers use the straight-line
depreciation method, by far the most common method (see Table on previous page) that
Page | 3
04-16-2019
Revised 01-14-2023
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
companies use for financial reporting to their shareholders. A separate Class Note on
Deferred Income Taxes discusses the depreciation methods that companies use for income
tax reporting1.
The calculation of straight-line depreciation is straightforward. Using Cathay Pacific from the
Table above, assume Cathay purchases an airplane for $100 million. At Cathay, the plane is
expected to have a useful of 20 years and a residual (salvage) value of 10%. The residual
(salvage) value is what Cathay expects the plane to be worth at the end of 20 years, in this case,
$10 million ($100 million * 10%). The residual value of $10 million is deducted from the $100
million cost of the plane to get $90 million as the amount the must be depreciated over the next
20 years. $90 million divided by 20 is $4.5 million of depreciation expense per year. At the end
of the first year of use, Cathay would record the following for depreciation:
Income Statement T-account
------------------------------------------|
+
Expenses
|
Revenues
|
Depreciation expense $4.5|
Contra-Asset Account
Accumulated Depreciation
----------------------|
+
|
|
|
$4.5
For year 20, Cathay would record the following for depreciation:
Income Statement T-account
------------------------------------------|
+
Expenses
|
Revenues
|
Depreciation expense $4.5|
|
|
Contra-Asset Account
Accumulated Depreciation
----------------------|
+
|
$85.5 Beg. Bal.
|
|
$4.5
|
|
$90.0 End. Bal.
At the end of year 20, Cathay’s accounts would show:
Asset Account
Airplane
----------------------+
|
|
$100|
|
Contra-Asset Account
Accumulated Depreciation
----------------------|
+
|
|
$90.0
|
Cathay’s balance sheet would show:
Airplane, gross
$100
Less: Accumulated Depreciation
(90)
Airplane, net
$ 10
946, “How to Depreciate Property”, Department of the Treasury, Internal Revenue Service, explains how to
determine depreciation of income tax purposes in the United States. “Worldwide Tax Guide” from PKF International Limited and
“Worldwide Corporate Tax Guide” from EY provide descriptions on how tax depreciation is determined in over 150 countries.
1Publication
Page | 4
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
04-16-2019
Revised 01-14-2023
(b) Financial Statement Presentation – Apple
With the exception of land, tangible assets are depreciated (used up) over an estimated useful life. As
mentioned, the most common method of depreciation is the straight-line method. For example, the
following footnote is from Apple’s 2022 10-K:
Depreciation on property, plant and equipment is recognized on a straight-line basis over
the estimated useful lives of the assets, which for buildings is the shorter of 40 years or
the remaining life of the building; between one and five years for machinery and
equipment, including manufacturing equipment; and the shorter of the lease term or
useful life for leasehold improvements. Depreciation and amortization expense on
property, plant and equipment was $8.7 billion, $9.5 billion and $9.7 billion during 2022,
2021 and 2020, respectively.
Property, Plant and Equipment, Net
Land and buildings
Machinery, equipment and internal-use software
Leasehold improvements
Gross property, plant and equipment
Accumulated depreciation and amortization
Total property, plant and equipment, net
$
$
2022
22,126
81,060
11,271
114,457
(72,340)
42,117
$
$
2021
20,041
78,659
11,023
109,723
(70,283)
39,440
(5) Amortization Expense of Intangible Assets
The accounting concept of amortization of intangible assets with finite lives is identical to
depreciation of tangible assets with finite lives, i.e. intangible assets with finite lives are
amortized over their useful lives. As with tangible assets, for financial reporting purposes to
shareholders, most intangible assets are amortized over their useful lives using the straightline method. In general, for income tax reporting, accounting for intangibles is governed by
Department of the Treasury, Internal Revenue Service, accounting bulletins2.
Indefinite-lived intangible assets, including goodwill, trademarks, brands, and broadcasting
licenses, are not amortized but are subject to annual impairment tests. If impairment is
deemed to have occurred, the intangible asset is written down to its fair value with a
corresponding charge to net income.
The following footnote on its intangible assets is from Apple Inc’s 2022 10-K:
Capitalized costs related to internal-use software are amortized on a straight-line basis
over the estimated useful lives of the assets, which range from five to seven years.
535, “Business Expenses”, Department of the Treasury, Internal Revenue Service, explains how to determine
amortization for income tax purposes in the United States. For example, Publication 535 states that “the following assets are
section 197 intangibles and must be amortized over 180 months: 1. Goodwill; 2. Going concern value; 3. Workforce in place;
4. Business books and records, operating systems, or any other information base, including lists or other information concerning
current or prospective customers; 5. A patent, copyright, formula, process, de-sign, pattern, know-how, format, or similar item.
6. A customer-based intangible; 7. A supplier-based intangible; 8. Any item similar to items 3 through 7; 9. A license, permit, or
other right granted by a governmental unit or agency (including issuances and renewals); 10. A covenant not to compete entered
into in connection with the acquisition of an interest in a trade or business; 11. Any franchise, trademark, or trade name; 12. A
contract for the use of, or a term interest in, any item in this list.
2Publication
Page | 5
04-16-2019
Revised 01-14-2023
Class Notes 04: Capitalizing vs. Expensing, Depreciation & Amortization – Abridged
The Company does not amortize goodwill and intangible assets with indefinite useful
lives, rather such assets are required to be tested for impairment at least annually or
sooner whenever events or changes in circumstances indicate that the assets may be
impaired. The Company performs its goodwill and intangible asset impairment tests in the
fourth quarter of each year. The Company did not recognize any impairment charges
related to goodwill or indefinite lived intangible assets during 2022, 2021 and 2020.
Similar to PP&E, Intangible Assets are stated at cost. When amortized, rather than reduce the
Intangible Asset account, the contra-asset account Accumulated Amortization is credited (however,
like Accumulated Depreciation, Accumulated Amortization in generally shown only in the footnotes
and not on the face of the balance sheet). This results in reducing total assets. This is analogous to
the use of the Accumulated Depreciation account for PP&E.
Amortization is recorded as follows:
Income Statement – T-account
----------------------------------------------|
+
Amortization Expense $$|
Contra Asset Account
Accumulated
Amortization
------------------|
+
| $$
Amortization of intangibles is normally not shown as a separate line item in the income statement.
Similar to depreciation, amortization is either included in COGS (cost of sales) or SG&A, depending
upon the nature of the intangible asset.
Page | 6
01-23-2019
Revised 01-14-2023
Class Notes 05: Inventory, Cost of Sales (COS), Cost of Goods Sold (“COGS”) – Abridged
Merchandising firms – the relationship between inventory and Cost of Sales
(a) Merchandising firms purchase products from suppliers. As a result, their inventory
equation looks as follows:
+
=
–
=
Inventory at beginning of year
Inventory purchases during the year
Cost of goods available for sale (“CGAS”)
Cost of sales (COS) (NOTE: Some merchandisers refer to their Cost of sales
(COS) as Cost of goods sold (COGS); however, COGS is much more associated
with manufacturing companies (see below and on next page)
Inventory at end of year
(b) The latest income statement for Walmart Inc., the world’s largest retailer, uses “Cost of
sales” as an expense in its income statement:
Walmart Inc.
Consolidated Statements of Income
(Amounts in millions, except per share data)
Revenues:
Net sales
Membership and other income
Total revenues
Costs and expenses:
Cost of sales
Operating, selling, general and administrative expenses
Operating income
Interest:
Debt
Finance lease
Interest income
Interest, net
Loss on extinguishment of debt
Other (gains) and losses
Income before income taxes
Provision for income taxes
Consolidated net income
Consolidated net income attributable to noncontrolling interest
Consolidated net income attributable to Walmart
Fiscal Years Ended January 31,
2022
2021
2020
$
$
567,762
4,992
572,754
$
555,233
3,918
559,151
$
519,926
4,038
523,964
429,000
117,812
25,942
420,315
116,288
22,548
394,605
108,791
20,568
1,674
320
(158)
1,836
2,410
3,000
18,696
4,756
13,940
(267)
13,673
1,976
339
(121)
2,194
—
(210)
20,564
6,858
13,706
(196)
13,510
2,262
337
(189)
2,410
—
(1,958)
20,116
4,915
15,201
(320)
14,881
$
$
(c) The latest balance sheet for Walmart Inc., shows “Inventories” and is determined as
described below:
Columbia University prepared this note for class discussion purposes. Copyright © 2019
Page | 1
Class Notes 05: Inventory, Cost of Sales (COS), Cost of Goods Sold (“COGS”) – Abridged
01-23-2019
Revised 01-14-2023
Walmart Inc.
Consolidated Balance Sheets
As of January 31,
2022
2021
(Amounts in millions)
ASSETS
Current assets:
Cash and cash equivalents
Receivables, net
Inventories
Prepaid expenses and other
Total current assets
Property and equipment, net
Operating lease right-of-use assets
Finance lease right-of-use assets, net
Goodwill
Other long-term assets
Total assets
$
$
LIABILITIES AND EQUITY
Current liabilities:
Short-term borrowings
Accounts payable
Accrued liabilities
Accrued income taxes
Long-term debt due within one year
Operating lease obligations due within one year
Finance lease obligations due within one year
Total current liabilities
Long-term debt
Long-term operating lease obligations
Long-term finance lease obligations
Deferred income taxes and other
Commitments and contingencies
Equity:
Common stock
Capital in excess of par value
Retained earnings
Accumulated other comprehensive loss
Total Walmart shareholders' equity
Noncontrolling interest
Total equity
Total liabilities and equity
$
$
Inventories
14,760
8,280
56,511
1,519
81,070
94,515
13,758
4,351
29,014
22,152
244,860
$
410
55,261
26,060
851
2,803
1,483
511
87,379
34,864
13,009
4,243
13,474
$
276
4,839
86,904
(8,766)
83,253
8,638
91,891
244,860
$
$
----------------------------------------------------------------------+
|
Beginning Inventory
44,949 |
|
Inventory Purchases
440,562 |The purchase number is not given by
|Walmart; it is estimated from Walmart’s
|balance sheet & income statement numbers
|
| 429,000 Cost of Sales to income statement
----------------------------------------------------------------------Ending Inventory
56,511 |
Cash
Income Statement – T-Account
------------------------------------------------+
|
|
+
|
Expenses
|
Revenues
|
|
| 429,000
Cost of Sales 429,000 |
Page | 2
17,741
6,516
44,949
20,861
90,067
92,201
13,642
4,005
28,983
23,598
252,496
224
49,141
37,966
242
3,115
1,466
491
92,645
41,194
12,909
3,847
14,370
282
3,646
88,763
(11,766)
80,925
6,606
87,531
252,496
01-23-2019
Revised 09-04-2022
Class Notes 05: Inventory, Cost of Sales (COS), Cost of Goods Sold (“COGS”) – Abridged
Manufacturing firms – the relationship between inventory and Cost of Goods Sold
(a) There are three types of inventory for manufacturing companies:
•
•
•
Raw materials inventory: the raw materials to be used in the manufacturing process.
Work-in-process inventory: the costs put into manufacturing of products that are not
complete at the period end.
Finished goods inventory: the costs of completed products that are ready for sale (but
not yet sold)
(b) each of the types of inventory, we have the following “inventory equation:”
Beginning Inventory + Cost Added – Cost Transferred Out = Ending Inventory
(c) Let’s first take a look of the “cost flow” during the production process.
Purchases
Raw
Material
Inventory
Production
Work-inProcess
Inventory
Completio
n
Finished
Goods
Inventory
Cost of Goods
Sold
Production
Direct Labor,
Machinery/Factory
Depreciation
Indirect Labor
Other Overhead
|
|
|
Beginning Inventory |
|
|
+ Cost Added
|+
|
|
|
|
|
- Cost Transferred Out ||
|
|
|
|
= Ending Inventory
|=
|
Inventory
Raw Materials
Inventory
|
Work-in-process
|
Inventory
|
Beginning inventory
|
Beginning inventory
|
|
Purchases of materials | + Raw materials,
|
direct labor,
|
overhead used
|
for production
|
|
Cost of materials
| - Costs of goods
used in production
|
manufactured (for
|
products completed
|
this period)
|
|
Ending inventory
| = Ending inventory
|
|
|
|
|
|
|
|+
|
|
|
|
|
||
|
|
|
|
|=
|
Finished Goods
Inventory
Beginning inventory
Cost of goods manufactured
Cost of goods sold (COGS)
Ending inventory
Page | 3
Class Notes 05: Inventory, Cost of Sales (COS), Cost of Goods Sold (“COGS”) – Abridged
01-23-2019
Revised 01-14-2023
(d) The latest balance sheet inventory footnote for Snap-on Inc., a manufacturer of tools and
equipment, displays the three levels of inventory:
Inventories by major classification as of 2021 and 2020 year end are as follows:
(Amounts in millions)
Finished goods
Work in progress
Raw materials
Total FIFO value
Excess of current cost over LIFO cost
Total inventories – net
2021
$
2020
686.5
64.3
140.2
891.0
(87.2)
803.8
$
$
643.4
61.6
125.5
830.5
(84.0)
746.5
$
Inventories accounted for using the FIFO method approximated 60% and 57% of total inventories
as of 2021 and 2020 year end, respectively. The company accounts for its non-U.S. inventory on
the FIFO method. As of 2021 year end, approximately 33% of the company’s U.S. inventory was
accounted for using the FIFO method and 67% was accounted for using the LIFO method.
(e) The latest income statement for Snap-on Inc. uses “Cost of goods sold” as an expense in its
income statement:
Snap-on Incorporated – Consolidated Statements of Earnings
(Amounts in millions, except per share data)
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating earnings before financial services
Financial services revenue
Financial services expenses
Operating earnings from financial services
Operating earnings
Interest expense
Other income (expense) – net
Earnings before income taxes and equity earnings
Income tax expense
Earnings before equity earnings
Equity earnings, net of tax
Net earnings
Net earnings attributable to noncontrolling interests
Net earnings attributable to Snap-on Incorporated
Page | 4
$
$
2021
4,252.0
(2,141.2)
2,110.8
(1,259.3)
851.5
349.7
(77.7)
272.0
1,123.5
(53.1)
16.5
1,086.9
(247.0)
839.9
1.5
841.4
(20.9)
820.5
$
$
2020
3,592.5
(1,844.0)
1,748.5
(1,116.6)
631.9
349.7
(101.1)
248.6
880.5
(54.0)
8.7
835.2
(189.1)
646.1
0.3
646.4
(19.4)
627.0
$
$
2019
3,730.0
(1,886.0)
1,844.0
(1,127.6)
716.4
337.7
(91.8)
245.9
962.3
(49.0)
8.8
922.1
(211.8)
710.3
0.9
711.2
(17.7)
693.5
01-23-2019
Revised 01-14-2023
Class Notes 06: Statement of Cash Flows (SCF) - Introduction
The balance sheet and income statement have been required statements for years, but the cash
flow statement has been formally required in the U.S. by the Financial Accounting Standards
Board only since 1988. In April 2001 the International Accounting Standards Board adopted
International Accounting Standard 7, Cash Flow Statements.
(1) Why Cash Flow is Useful
• Net income on the income statement is measured using accrual basis accounting.
• Net income is not necessarily a good measure of cash generated from operations in the
period and additional information is required to assess the company’s liquidity and cash
flow needs.
• Firms receive and disburse cash for items not directly related to operations and therefore
not detailed on the income statement.
(2) Three Sections of the Cash Flow Statement
The Statement of Cash Flows (SCF) is divided into three sections representing the 3 activities
of the firm: cash flow from operations, from investing and from financing.
Cash Flow from Operations - CFO
A straightforward way to determine if a cash flow is an operating cash flow is to ask:
1. Does the item affect cash? and, Will the item appear on the income statement as either a
revenue or an expense (either now or in the future)?
a. Items in this section of the cash flow statement have parallels on the income statement.
For example, “collections from customers” on the SCF is the cash item related to
“sales” on the income statement. Similarly, “payments to vendors” for goods and
services on the SCF is the cash item related to “expenses” on the income statement.
b. If the answer is yes to both questions, the cash flow is an operating cash flow. If the
answer is no, the next questions are:
2. Is the initial cash flow an outgoing cash flow? If the answer is yes, it is always an
investing cash flow even though, subsequently, it can be an incoming cash flow, e.g. an
airline’s purchase of an airplane is an investing cash flow. If the airline decides to sell the
airplane, the cash it receives is an incoming cash flow but it is still an investing cash flow.
3. Is the initial cash flow an incoming cash flow? If the answer is yes, it is always a
financing cash flow even though, subsequently, it can be an outgoing cash flow, e.g. a
bank loan is always a financing cash flow. When a company receives a bank loan it is an
incoming financing cash flow. When it pays back the bank loan, it is an outgoing
financing cash flow.
Columbia University prepared this note for class discussion purposes. Copyright © 2019
Page | 1
Class Notes 06: Statement of Cash Flows – Introduction
01-23-2019
Revised 01-14-2023
Cash Flow from Investing Activities - CFI
• Cash paid for the acquisition of plant and equipment (CAPEX), intangible assets (e.g.,
patents or copyrights) or the investment in other company’s shares or debt.
• Cash received from the sale of plant and equipment, intangible assets or the sale of shares
or debt held in other companies.
• These cash flow items relate to the investment decisions of management concerning longterm assets.
• Items in this section of the SCF have parallels to the long-term asset section of the balance
sheet. They explain why the balances in these accounts changed from the beginning of
the year to the end of the year.
Cash Flow from Financing Activities - CFF
• Cash received from issuing stock or borrowing money.
• Cash distributed to repay the principal of borrowed money and to pay dividends to the
shareholders of the company.
• Cash distributed to repurchase shares of the company (treasury stock).
• These cash flow items relate to the decisions of management on the financing needs of
the firm.
• Items in this section of the SCF have parallels to the long-term liabilities and stockholders’
equity sections of the balance sheet. They provide information as to why borrowings and
stockholders’ equity account balances increased or decreased during the year.
Classification of Certain Items
• Interest income/dividend income treated as Operating activity.
• Interest expense treated as Operating activity1.
What is included in cash
• Cash defined as cash in bank and cash equivalents.
• Equivalents have to be highly liquid, with original term < 90 days.
• Examples include certificates of deposit, short-term T-bills, short-term commercial paper.
1Paragraph
23 of the Statement of Financial Accounting Standards (SFAS) No. 95, Statement of Cash Flows, requires that "cash
outflows for operating activities are: .... Cash payments to lenders and other creditors for interest..." Three of the seven members
of the FASB at the time dissented to this requirement. They would have preferred that interest paid be reported as a financing
activity. See excerpts from SFAS No. 95 regarding dissenting opinions below.
Interest Paid and Received
88. The Exposure Draft required interest paid …to be classified as cash flows from operating activities.
89. Some respondents to the Exposure Draft favored classifying interest paid as a cash outflow for financing activities... Those
respondents generally said that interest paid, like dividends paid, is a direct consequence of a financing decision and thus should
be classified as a cash outflow for financing activities.
90. The Board considered those views and, as mentioned in paragraph 86, noted that a reasonable case can be made for
alternative classifications of certain items. However, the Board also noted that virtually all enterprises classify interest received
and paid as operating cash flows under Opinion 19. In particular, interest received and paid were commonly considered to be
operating cash flows of banks and other financial institutions. In addition, the Board perceived widespread support for the notion
that operating cash flows should, insofar as possible, include items whose effects are included in determining net income to
facilitate an understanding of the reasons for differences between net income and net cash flow from operating activities and net
income. The Board therefore was not convinced that changing the prevalent practice in classifying interest received and paid
would necessarily result in a more meaningful presentation of cash flows.
Income Taxes Paid
91. The Exposure Draft required all income taxes paid to be classified as operating cash outflows. A few respondents suggested
allocating income taxes paid to investing and financing transactions.
92. The Board decided that allocation of income taxes paid to operating, investing, and financing activities would be so complex
and arbitrary that the benefits, if any, would not justify the costs involved.
Page | 2
01-23-2019
Revised 01-14-2023
Class Notes 06: Statement of Cash Flows – Introduction
Treatment of non-cash transaction
• Significant (material) non-cash transactions not reflected in the SCF, but reported as a
note to the SCF.
• Examples:
• Purchase of equipment for notes payable (vendor financed purchases).
• Issuance of stock for assets (other than cash) or services.
(3) Purpose of the SCF sections
Cash is generally fungible, which means cash produced by the sale of an asset can be used to
reduce debt or to pay suppliers. These two uses would be disclosed in different sections of
the SCF. If a dollar from financing is the same as a dollar from operations, why is there a
difference in the presentation?
(1)
(2)
(3)
(4)
Impact of operations on firm liquidity.
How well cash from operations covers capital expenditures and dividends.
Level of capital expenditures needed to support current and future levels of activity.
How management is financing the firm’s capital needs.
(4) Printer’s Ink Example
Two types of Cash Flow Statements
• Direct – Cash from Operations presented as cash impact of operating transactions (cash
collections and cash disbursements related to operations)
• Indirect – Cash from Operations presented by adjusting Net Income for non-cash
revenues and expenses
• Investing and Financing sections of SCF the same under both types; only the Operating
section is different
Printers Ink begins operations in January 2022. An analysis of its cash transactions for the
quarter ending December 31, 2022 shows the following:
F
F
O
O
O
O
Cash
----------------------------------------------------------------------Increases
|
Decreases
1. Sale of stock or
| 150,000 Purchase of machinery
3.
Capital contribution
300,000 |
9,000 Salaries paid
4.
2. Bank borrowings
100,000 |
7,500 Rent payments
5.
12. Collections from sales
| 44,000 Purchase of inventory
6.
to customers
55,000 |
1,500 Misc. expenses paid
7.
13. Advance deposits
8,000 |
9,000 Advertising paid
8.
15. Interest received on
|
4,800 Insurance paid
9.
bond investment
1,900 |
2,700 Interest paid
10.
|
2,000 Sales commissions paid 11.
| 52,000 Purchase of Acme Paper
|
bonds as investment
14.
----------------------------------------------------------------------Total increases
464,900 | 282,500 Total decreases
----------------------------------------------------------------------= Operating Cash Flow; I = Investing Cash Flow; F = Financing Cash Flow
I
O
O
O
O
O
O
O
O
I
Page | 3
Class Notes 06: Statement of Cash Flows – Introduction
01-23-2019
Revised 01-14-2023
Printers Ink
Direct Statement of Cash Flows
For the 12 months ended December 31, 2022
Operating Activities:
Collections from customers (sales & advanced deposits)
Advance deposits
Interest received on bond investment
Cash payments:
Suppliers of inventory
Salaries
Rent
Sales commissions
Advertising
Insurance
Miscellaneous expenses
Interest on bank borrowings
Cash used in operations
Investing Activities:
Purchase of machinery (CAPEX)
Purchase of Acme Paper bonds
Cash used in investing
$ 55,000
8,000
1,900
(44,000)
(2,000)
(7,500)
(9,000)
(9,000)
(4,800)
(1,500)
(2,700)
$(15,600)
(150,000)
(52,000)
$(202,000)
Financing Activities:
Sale of stock (contributed capital)
Bank borrowings
Cash provided by financing
300,000
100,000
$400,000
Increase in cash
Balance, January 1, 2022
Balance, December 31, 2022
$182,400
0
$182,400
Indirect Statement of Cash Flows
Most companies present the indirect SCF rather than the direct SCF. The indirect SCF differs
from the direct SCF in the presentation of cash from operating activities only – the presentation
of investing and finance activities are the same under either presentation.
Under the direct method, CFO is presented based on an analysis of the cash account. The
indirect SCF starts with net income, and then has adjustments to net income to arrive at CFO.
For example, assume the following income statement for Printers Ink for the 12 months ended
December 31, 2022:
Sales
COGS
Gross profit
SG&A (same as cash expenses)
Depreciation expense
Interest income (same as cash income)
Interest expense (same as cash expense)
Net income
75,000
(21,000)
54,000
(33,800)
(7,500)
1,900
(2,700)
11,900
Page | 4
01-23-2019
Revised 01-14-2023
Class Notes 06: Statement of Cash Flows – Introduction
In addition, assume the following activity in accounts receivable, inventory and advance deposits
(Note: The analysis of Accounts Receivable assumes that all sales were on credit. If a portion of
the sales were cash sales, it would not change the amount of collections from customers).
Asset Account
Accounts Receivable
-------------------------------------------------Increases
|
Decreases
Beginning Balance
0|
a. Sales
75,000|
| 55,000 Collections
b.
-------------------------------------------------Ending Balance
20,000|
==================================================
Asset Account
Inventory
-------------------------------------------------Increases
|
Decreases
Beginning Balance
0|
c. Purchases
44,000|
| 21,000 COGS
d.
-------------------------------------------------Ending Balance
23,000|
==================================================
Liability Account
Advance Deposits
-------------------------------------------------Decreases
|
Increases
|
0 Beginning Balance
| 8,000 Collections
e.
-------------------------------------------------| 8,000 Ending Balance
==================================================
Page | 5
Class Notes 06: Statement of Cash Flows – Introduction
01-23-2019
Revised 01-14-2023
Printers Ink
Indirect Statement of Cash Flows
For the 12 months ended December 31, 2022
Operating Activities:
Net income
Adjustments to reconcile net income to cash used in operations:
Depreciation
Increase in accounts receivable
Increase in inventory
Increase in advance deposits
Cash used in operations
Investing Activities:
Purchase of machinery (CAPEX)
Purchase of bonds
Cash used in investing
$ 11,900
7,500
(20,000)
(23,000)
8,000
$(15,600)
(150,000)
(52,000)
$(202,000)
Financing Activities:
Sale of stock (contributed capital)
Bank borrowings
Cash provided by financing
300,000
100,000
$400,000
Increase in cash
Balance, January 1, 2022
Balance, December 31, 2022
$182,400
0
$182,400
Page | 6
FSI
Financial Statement Investigation
01-14-2016
Revised 01-14-2023
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Flow Formats
Effective for fiscal years ending after July 15, 1988, Statement of Financial Accounting Standards No. 95
requires enterprises to present a Statement of Cash Flows which classifies cash receipts and payments by
operating, investing, and financing activities. SFAS No. 95 superseded APB Opinion No. 19 which required a statement summarizing changes in financial position. SFAS No. 95 is codified at FASB Accounting Standards Codification (ASC) 230, Statement of Cash Flows.
ASC 230 defines those transactions and events that constitute operating cash receipts and payments. In
their deliberations to arrive at a Statement of Cash Flows Standard, two of the most controversial areas
involved the treatment of interest paid and received as operating cash flows, and the usage of either the
direct method or the indirect method for presenting operating cash flows. See Appendix B of this document for the contrasting views. ASC 230 (as did SFAS No. 95) recommends that the direct method be
used to report net cash flow from operating activities. Regardless of whether the direct or indirect method
is used, ASC 230 requires that a reconciliation of net income to net cash flow from operating activities be
presented and that interest and income tax payments be disclosed. Also, use of the direct or indirect method only has an impact on the format to arrive at cash flow from operating activities. The format for the
investing and financing sections of the Statement of Cash Flows is the same whether or not a company
uses the direct or indirect method to present cash flow from operating activities.
CVS Health Corporation (see page 2) is an example of a company using the direct method to report net
operating cash flows. Like most companies that use the direct method, CVS presents the reconciliation of
net income to net operating cash flows as a schedule at the bottom of the Statement of Cash Flows. Amazon.com, Inc. (see page 3) provides an example of a company using the indirect method to report net operating cash flows. Like most companies that use the indirect method, Amazon presents a reconciliation
of net income to net operating cash flows within the Statement of Cash Flows.
The table below shows the methods used to report cash flows from operating activities. As can be observed from the table, since the statement of cash flows became a required financial statement, the vast
majority of companies surveyed by the AICPA (99%) use the indirect method to present cash flows from
operating activities. Advocates of the indirect method state that it provides a useful link among the statement of cash flows, the income statement, and the balance sheet. They note further that the direct method
requires a supplemental disclosure to present a reconciliation of net income and net cash while the disclosure using the indirect method is incorporated in the Statement of Cash Flows.
METHOD OF REPORTING CASH FLOWS FROM OPERATING ACTIVITIES1
Indirect method
Direct method
Total Companies
Indirect method
Direct method
Total Companies
2011 2010 2009 2008
495 495 495 495
5
5
5
5
500 500 500 500
Number of Companies
2007 2006 2005 2004 2003 2002 2001 2000 1999
594 594 592 592 593 593 592 593 593
6
6
8
8
7
7
8
7
7
600 600 600 600 600 600 600 600 600
1998 1997 1996 1995
593 590 589 585
7
10
11
15
600 600 600 600
Number of Companies
1994 1993 1992 1991 1990 1989 1988 1987
586 585 585 585 585 583 526 N/A
14
15
15
15
15
17
16 N/A
600 600 600 600 600 600 542 N/A
1Adapted
from “Accounting Trends & Techniques”, Various Editions, AICPA, © 2012. 2008-2011 based on 500 entities surveyed; 1989-2007 based on 600 entities surveyed; 1988 based on 542 entities surveyed.
Norman J. Bartczak, Columbia University, prepared this note for classroom purposes. Copyright © 2016 Norman J. Bartczak.
1
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Formats
01-14-2016
Revised 01-14-2023
CVS HEALTH CORPORATION
Consolidated Statements of Cash Flows
In millions
Cash flows from operating activities:
Cash receipts from customers
Cash paid for inventory and prescriptions dispensed by retail network pharmacies
Insurance benefits paid
Cash paid to other suppliers and employees
Interest and investment income received
Interest paid
Income taxes paid
Net cash provided by operating activities
Cash flows from investing activities:
Proceeds from sales and maturities of investments
Purchases of investments
Purchases of property and equipment
Proceeds from sale-leaseback transactions
Acquisitions (net of cash acquired)
Proceeds from sale of subsidiary
Other
Net cash used in investing activities
Cash flows from financing activities:
Net repayments of short-term debt
Proceeds from issuance of long-term debt
Repayments of long-term debt
Derivative settlements
For the Years Ended December 31,
2021
2020
2019
$
Dividends paid
Proceeds from exercise of stock options
Payments for taxes related to net share settlement of equity awards
Other
Net cash used in financing activities
Net increase in cash, cash equivalents and restricted cash
Cash, cash equivalents and restricted cash at the beginning of the period
Cash, cash equivalents and restricted cash at the end of the period
Reconciliation of net income to net cash provided by operating activities:
Net income
Adjustments required to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Store impairments
Goodwill impairment
Stock-based compensation
(Gain) loss on sale of subsidiaries
Loss on early extinguishment of debt
Deferred income taxes
Other noncash items
Change in operating assets and liabilities, net of effects from acquisitions:
Accounts receivable, net
Inventories
Other assets
Accounts payable and pharmacy claims and discounts payable
Health care costs payable and other insurance liabilities
Other liabilities
Net cash provided by operating activiti
2
$
$
$
284,219
(165,783)
(63,598)
(31,652)
743
(2,469)
(3,195)
18,265
$
264,327
(158,636)
(55,124)
(29,763)
894
(2,904)
(2,929)
15,865
$
248,393
(149,655)
(52,242)
(28,932)
955
(2,954)
(2,717)
12,848
7,246
(9,963)
(2,520)
—
(146)
—
122
(5,261)
6,467
(9,639)
(2,437)
101
(866)
840
—
(5,534)
7,049
(7,534)
(2,457)
5
(444)
—
42
(3,339)
—
987
(10,254)
—
—
9,958
(15,631)
(7)
(720)
3,736
(8,336)
(25)
(2,625)
549
(168)
155
(11,356)
(2,624)
264
(88)
432
(7,696)
(2,603)
210
(112)
196
(7,654)
1,648
11,043
12,691
2,635
8,408
11,043
$
1,855
6,553
8,408
7,192
$
6,631
7,898
$
$
4,512
1,358
431
4,441
—
—
4,371
231
—
484
—
452
(428)
(390)
400
(269)
1,440
(570)
72
453
205
79
(654)
33
(2,703)
735
(3)
2,898
169
2,852
18,265
(1,510)
(973)
364
2,769
(231)
2,740
15,865
(2,158)
(1,075)
(614)
3,550
320
1,476
12,848
$
$
01-14-2016
Revised 01-14-2023
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Flow Formats
AMAZON.COM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
BEGINNING CASH, CASH EQUIVALENTS, & RESTRICTED CASH $
OPERATING ACTIVITIES:
Net income
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization of property and equipment and capitalized content costs, operating lease assets, and other
Stock-based compensation
Other operating expense (income), net
Other expense (income), net
Deferred income taxes
Changes in operating assets and liabilities:
Inventories
Accounts receivable, net and other
Accounts payable
Accrued expenses and other
Unearned revenue
Net cash provided by (used in) operating activities
INVESTING ACTIVITIES:
Purchases of property and equipment
Proceeds from property and equipment sales and incentives
Acquisitions, net of cash acquired, and other
Sales and maturities of marketable securities
Purchases of marketable securities
Net cash provided by (used in) investing activities
FINANCING ACTIVITIES:
Proceeds from short-term debt, and other
Repayments of short-term debt, and other
Proceeds from long-term debt
Repayments of long-term debt
Principal repayments of finance leases
Principal repayments of financing obligations
Net cash provided by (used in) financing activities
Foreign currency effect on cash, cash equivalents, and restricted cash
Net increase (decrease) in cash, cash equivalents, and restricted cash
ENDING CASH, CASH EQUIVALENTS, & RESTRICTED CASH
$
Year Ended December 31,
2019
2020
2021
32,173 $
36,410 $
42,377
11,588
21,331
33,364
21,789
6,864
164
(249)
796
25,251
9,208
(71)
(2,582)
(554)
34,296
12,757
137
(14,306)
(310)
(3,278)
(7,681)
8,193
(1,383)
1,711
38,514
(2,849)
(8,169)
17,480
5,754
1,265
66,064
(9,487)
(18,163)
3,602
2,123
2,314
46,327
(16,861)
4,172
(2,461)
22,681
(31,812)
(24,281)
(40,140)
5,096
(2,325)
50,237
(72,479)
(59,611)
(61,053)
5,657
(1,985)
59,384
(60,157)
(58,154)
1,402
(1,518)
871
(1,166)
(9,628)
(27)
(10,066)
70
4,237
36,410 $
6,796
(6,177)
10,525
(1,553)
(10,642)
(53)
(1,104)
618
5,967
42,377 $
7,956
(7,753)
19,003
(1,590)
(11,163)
(162)
6,291
(364)
(5,900)
36,477
3
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Formats
01-14-2016
Revised 01-14-2023
AMAZON.COM, INC.
CONSOLIDATED BALANCE SHEETS
(in millions)
December 31,
2020
2021
ASSETS
Current assets:
Cash and cash equivalents
Marketable securities
Inventories
Accounts receivable, net and other
Total current assets
Property and equipment, net
Operating leases
Goodwill
Other assets
Total assets
$
42,122
42,274
23,795
24,542
132,733
113,114
37,553
15,017
22,778
$
36,220
59,829
32,640
32,891
161,580
160,281
56,082
15,371
27,235
$ 321,195
$ 420,549
$
$
78,664
51,775
11,827
142,266
67,651
48,744
23,643
5
(1,837)
42,865
(180)
52,551
93,404
321,195 $
5
(1,837)
55,538
(1,376)
85,915
138,245
420,549
LIABILITIES AND STOCKHOLDERS’
EQUITY
Current liabilities:
Accounts payable
Accrued expenses and other
Unearned revenue
Total current liabilities
Long-term lease liabilities
Long-term debt
Other long-term liabilities
Stockholders’ equity:
Common stock authorized – 5,000; Issued – 527 & 532; Outstanding - 503 & 509
Treasury stock, at cost
Additional paid-in capital
Accumulated other comprehensive income (loss)
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
$
72,539
44,138
9,708
126,385
52,573
31,816
17,017
Perhaps the biggest criticism of the indirect method is its lack of “intuitive appeal” to users of financial
statements. For example, when learning how the statement of cash flows is prepared using the indirect
method, many individuals find it confusing that increases in accounts receivable are subtracted as an adjustment to net income and increases in accounts payable are added as an adjustment to net income. Since
an increase in account receivable is usually viewed as a “good thing” with respect to the income statement, i.e. an increase in accounts receivable reflects an increase in revenues (sales) which is usually
viewed as a good thing. However, because an increase in accounts receivable does not instantaneously
increase cash, it is not an immediate “good thing” from a cash flow standpoint. Since the indirect cash
flow statement starts with net income, and net income is positively affected by an increase in accounts
receivable through the increase in revenues, the increase in accounts receivable attributable to the increase
in revenues needs to be “backed out” of the net income number.
4
01-14-2016
Revised 01-14-2023
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Flow Formats
Below is a simple example of a direct and indirect statement of cash flows can be prepared using two
identical companies. The first company is the “all cash” company, meaning everything in its income
statement is in cash. The second company is the “all non-cash” company, meaning everything in its income statement in non-cash. Assume the following income statements:
Income Statements:
Revenues
Operating Expenses
Profit before Tax
Tax Expense (20%)
Net Income
All Cash
$1,000
(800)
200
(40)
$ 160
All Non-Cash
$1,000
(800)
200
(40)
$ 160
We don’t even need to formally prepare statements of cash flows for the two companies since, by definition, the “all cash” company’s cash flow from operating activities must be equal to net income of $160.
Likewise, by definition, the “all non-cash” company’s cash flow from operating activities must be $0.
Formally, we can prepare the direct method cash flow statements as follows:
Statement of Cash
Flows – Direct Method:
Revenues
Operating Expenses
Tax Expense
Cash Flow from Operating Activities
All Cash
$1,000
(800)
(40)
$ 160
All Non-Cash
$
0
0
0
$
0
Now let’s repeat the example, except this time we’ll prepare the Statement of Cash Flows using the indirect method. Assume the same income statements:
Income Statements:
Revenues
Operating Expenses
Profit before Tax
Tax Expense (20%)
Net Income
All Cash
$1,000
(800)
200
(40)
$ 160
All Non-Cash
$1,000
(800)
200
(40)
$ 160
Before we prepare the Statement of Cash Flows, we will record (“bookkeep”) the two income statements
using T-Accounts. For the “all cash” company, the income statement would be recorded as follows:
Balance Sheet:
Income Statement:
Cash
------------------------------+
|
|
a.
$1,000 |
| $ 800
b.
|
40
c.
------------------------------Balance $ 160 |
Income Statement T-Account
------------------------------|
+
Expenses
|
Revenues
| $1,000
a.
b.
$ 800 |
c.
40 |
------------------------------d.
160 |
-------------------------------
5
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Formats
01-14-2016
Revised 01-14-2023
Retained Earnings
------------------------------|
+
|
| $ 160
d.
------------------------------| $ 160 Balance
a.
b.
c.
d.
To record the $1,000 of revenues as an increase in cash.
To record the $800 of operating expenses as a decrease in cash.
To record the $40 of tax expense as a decrease in cash.
To “close out” the net income of $160 from the income statement to
the retained earnings account in the balance sheet.
For the “all non-cash” company, the income statement would be recorded as follows:
Balance Sheet:
Income Statement:
Cash
------------------------------+
|
|
------------------------------Balance $
0 |
Income Statement T-Account
------------------------------|
+
Expenses
|
Revenues
| $1,000
a.
b.
$ 800 |
c.
40 |
------------------------------d.
160 |
-------------------------------
Accounts Receivable
------------------------------+
|
a.
$1,000 |
------------------------------Balance $1,000 |
Accounts Payable
------------------------------|
+
| $ 800
b.
------------------------------| $ 800 Balance
Taxes Payable
------------------------------|
+
| $
40
c.
------------------------------| $
40 Balance
Retained Earnings
------------------------------|
+
| $ 160
d.
------------------------------| $ 160 Balance
a. To record the $1,000 of revenues as an increase in accounts receivable.
b. To record the $800 of operating expenses as an increase in accounts
payable.
c. To record the $40 of tax expense as an increase in taxes payable.
d. To “close out” the net income of $160 from the income statement to
the retained earnings account in the balance sheet.
6
01-14-2016
Revised 01-14-2023
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Flow Formats
We can now prepare the Statement of Cash Flows using the indirect method by adjusting the net income
number for any “non-cash” items in the income statement. Remember that, in this simple example, we
already know that cash flow from operating activities for the “all cash” company is $160 and cash from
operating activities for the “all non-cash” company is $0. Also, the cash flow from operating activities
must be the same under both the direct and indirect methods. The format for presenting cash flow from
operating activities does not and cannot have an effect on the cash flows.
Statement of Cash
Flows – Indirect Method:
Net Income
Less increase in accounts receivable
Plus increase in accounts payable
Plus increase in taxes payable
Cash Flow from Operating Activities
All Cash
$ 160
0 a.
0 b.
0 c.
$ 160
All Non-Cash
$ 160
(1,000) a.
800 b.
40 c.
$
0
a. For the “all cash” company there is no increase in accounts receivable so there is nothing to subtract. For the “all non-cash” company, all of its revenues are the result of an increase in accounts
receivable. Since the revenues are not cash, they are an increase in
accounts receivable, we have to adjust net income by taking away the
$1,000 increase in accounts receivable. The increase in accounts receivable has the “good” effect of increasing net income, but it has
the “bad” effect of not yet being a cash inflow.
b. For the “all cash” company there is no increase in accounts payable
so there is nothing to add. For the “all non-cash” company, all of
its operating expenses are the result of an increase in accounts
payable. Since the operating expenses are not cash, they are an increase in accounts payable, we have to adjust net income by adding
back the $800 increase in accounts payable. The increase in accounts
payable has the “bad” effect of decreasing net income, but it has
the “good” effect of not yet being a cash outflow.
c. For the “all cash” company there is no increase in taxes payable so
there is nothing to add. For the “all non-cash” company, all of its
tax expense is the result of an increase in taxes payable. Since the
tax expense is not cash, it is an increase in taxes payable, we have
to adjust net income by adding back the $40 increase in taxes payable. The increase in taxes payable has the “bad” effect of decreasing net income, but it has the “good” effect of not yet being a cash
outflow.
Appendix A provides a step by step approach for preparing a cash flow statement using the indirect method to report operating cash flows.
7
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Formats
01-14-2016
Revised 01-14-2023
Appendix A
Steps to Follow to Complete an Indirect Cash Flow Statement
1. Start with Net Income
2. Add or Subtract items from the Income Statement that did not affect Cash. The most
common items are:
a. Depreciation - always added back in the indirect cash flow statement
b. Amortization - always added back in the indirect cash flow statement
c. Deferred Income Taxes - added back if the income tax expense on the income
statement includes an increase in the deferred income tax liability; subtracted if
the income tax expense on the income statement includes an increase in a deferred
income tax asset. The portion of the income tax expense added back is the increase in the deferred income tax liability. The portion of the income tax expense
subtracted is the increase in the deferred income tax asset.
3. Add or Subtract changes in Operating Current Assets and Operating Current Liabilities (except for changes in Cash, because you are balancing to Cash, and changes in
short-term, interest-bearing debt, i.e. Bank Loans, Notes Payable, the Current Portion of
Long-Term Debt. Changes in the latter items are accounted for in the Financing section
of the Statement of Cash Flows). Here are the “rules” to follow:
a. Subtract any Increases in Operating Current Assets, e.g. if Accounts Receivable increase, it means that Sales includes the portion of the Increase in Accounts
Receivable which is not Cash. Since Sales have a positive effect on arriving at
Net Income you need to Deduct the Increase in Accounts Receivable to remove
the portion of Sales that is not Cash. Also, if Inventories increase, the Cost of
Goods Sold does not include the entire amount that the company spent in Cash for
goods it purchased during the period, therefore, you need to Subtract any Increases in Inventory in arriving at Cash Flow from Operations.
b. Add any Decreases in Operating Current Assets – the converse of the previous
paragraph.
c. Add any Increases in Operating Current Liabilities, e.g. if Accounts Payable
increase, it means the some of the expenses in the Income Statement have not yet
been paid for, therefore they have not yet used Cash. To arrive at cash flow you
need to add back any Increases in Current Liabilities.
d. Subtract any Decreases in Operating Current Liabilities – the converse logic
of the previous paragraph.
4. NOTE WELL: If a Current Asset or Current Liability does not affect an Operating
Item, e.g. Current Liabilities affecting financing transactions like Bank Loans repayable in one year; Current Liabilities affecting investing transactions like Depreciable
Equipment purchased on credit payable in less than one year. These items should not
be included in the Operating section using the Indirect Cash Flow format.
8
01-14-2016
Revised 01-14-2023
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Flow Formats
Appendix B
Conclusions of the Financial Accounting Standards Board Regarding
Interest Paid and Received as Operating Cash Flows and
the Direct and Indirect Methods for Reporting Operating Cash Flows2
Interest Paid and Received
88. The Exposure Draft required interest paid and interest and dividends received to be classified as
cash flows from operating activities. That classification is consistent with the view that, in general,
cash flows from operating activities should reflect the cash effects of transactions and other events
that enter into the determination of net income.
89. Some respondents to the Exposure Draft favored classifying interest paid as a cash outflow for
financing activities and interest and dividends received as cash inflows from investing activities.
Those respondents generally said that interest paid, like dividends paid, is a direct consequence of a
financing decision and thus should be classified as a cash outflow for financing activities. That is,
both interest and dividends are returns on the capital provided by creditors and investors, and both
should be classified with returns of those amounts because the distinction between returns of and returns on investment is largely irrelevant in the context of cash flows. Respondents made similar
comments for interest and dividends received.
90. The Board considered those views and, as mentioned in paragraph 86, noted that a reasonable
case can be made for alternative classifications of certain items. However, the Board also noted that
virtually all enterprises classify interest received and paid as operating cash flows under Opinion 19.
In particular, interest received and paid were commonly considered to be operating cash flows of
banks and other financial institutions. In addition, the Board perceived widespread support for the
notion that operating cash flows should, insofar as possible, include items whose effects are included
in determining net income to facilitate an understanding of the reasons for differences between net
income and net cash flow from operating activities and net income. The Board therefore was not
convinced that changing the prevalent practice in classifying interest received and paid would necessarily result in a more meaningful presentation of cash flows. This Statement does, however, require
that the amount of interest paid during a period (net of amounts capitalized) be disclosed, which will
permit users of financial statements who wish to consider interest paid as a financing cash outflow to
do so.
Conclusion on Reporting Net Cash Flow from Operating Activities – Direct and Indirect Methods
Because of the extensive attention in the comment letters on the Exposure Draft to the manner of reporting operating cash flows, the Board gave particular consideration to that issue in its deliberations
leading to the issuance of this Statement. As mentioned in paragraph 42, the FASB staff held a special meeting with representatives of interested groups of constituents to obtain more information
about the benefits and costs of the direct and indirect methods. Because most enterprises said that
they cannot now obtain amounts of gross operating cash receipts and payments directly from their
accounting systems, the Board considered means by which those amounts might be determined indirectly. Together with other efforts, the FASB staff commissioned an informal interview survey of a
limited number of enterprises concerning the potential costs they might incur in indirectly determining amounts of operating cash receipts and payments.
2Source:
Statement of Financial Accounting Standards No. 95, October 1987, pages 12, 13, 28, 29, 34 and 35.
9
Class Notes 07: Statement of Cash Flows – Direct & Indirect Operating Cash Formats
01-14-2016
Revised 01-14-2023
119. The Board believes that both the direct and the indirect methods provide potentially
important information. The more comprehensive and presumably more useful approach would
be to use the direct method in the statement of cash flows and to provide a reconciliation of net
income and net cash flow from operating activities in a separate schedule—thereby reaping the
benefits of both methods while maintaining the focus of the statement of cash flows on cash
receipts and payments. This Statement therefore encourages enterprises to follow that approach.
But most providers and users of financial statements have little or no experience and only limited
familiarity with the direct method, while both have extensive experience with the indirect
method. Not only are there questions about the ability of enterprises to determine gross amounts
of operating cash receipts and payments, as already discussed, but also little information is
available on which specific categories of operating cash receipts and payments would be most
meaningful.
This Statement was adopted by the affirmative votes of four members of the Financial Accounting
Standards Board. Messrs. Lauver, Leisenring, and Swieringa dissented.
Messrs. Lauver, Leisenring, and Swieringa dissent to this Statement's requirements to classify interest and dividends received and interest paid as cash flows from operating activities. They believe that
interest and dividends received are returns on investments in debt and equity securities that should be
classified as cash inflows from investing activities. They believe that interest paid is a cost of obtaining financial resources that should be classified as a cash outflow for financing activities.
Messrs. Lauver and Swieringa also dissent to this Statement's permitted use of the indirect method of
reporting net cash flow from operating activities. They believe that by permitting the continued use
of the indirect method, the Board has foregone the opportunity to make a significant contribution to
the quality of financial reporting and to enhanced user understanding of cash flows from operating
activities. Reporting information about cash received from customers, cash paid to suppliers and employees, income taxes paid, and other operating receipts and payments (the direct method) provides a
description of the operating activities of an entity during a period that is both more informative and
more consistent with the primary purpose of a statement of cash flows, which is described in paragraph 4 of this Statement as "to provide relevant information about the cash receipts and cash payments of an enterprise during a period."
Because the indirect method does not result in reporting separately major classes of gross operating
cash flows, Messrs. Lauver and Swieringa believe that method is inconsistent with the conclusion in
paragraph 11 that " generally, information about gross amounts of cash receipts and cash payments
during a period is more relevant than information about the net amounts of cash receipts and payments." Further, permitting use of the indirect method makes this Statement internally inconsistent
because major classes of gross cash flows from investing and financing activities are required to be
reported separately while major classes of gross operating cash flows are not. In addition, presenting
a reconciliation of net income and net cash flow from operating activities within the statement of
cash flows rather than in a separate schedule results in including the effects of certain noncash transactions and other events within the statement of cash flows. Messrs. Lauver and Swieringa believe
that is confusing and counter to the primary purpose of a statement of cash flows.
10
FSI
Financial Statement Investigation
01-23-2019
Revised 01-14-2023
Class Notes 08: Revenue Recognition
Revenue Recognition – Conventional Criteria
Prior to December 15, 2017, U.S. GAAP and IFRS revenue recognition require the satisfaction of both of
the following conditions:
1. Revenues are not recognized until earned. Revenues are considered to have been earned when
the entity has substantially accomplished what it must do to be entitled to the benefits represented
by the revenues.
2. The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.
Effective for 2018, the FASB and the IASB have created a single, unifying, five-step framework for determining when revenue should be recognized. The ASC Topic 606 five-step model is as follows:
1.
2.
3.
4.
5.
Identify the contract(s) with a customer.
Identify the performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations in the contract.
Recognize revenue when (or as) the entity satisfies a performance obligation.
All of the following conditions must be met for a firm to account for a contract with a customer under the
five-step model in ASC Topic 606:
•
•
•
•
•
All parties to the contract have approved the contract and are legally obligated to perform their obligations under the contract.
Each party’s rights regarding the goods and services being exchanged can be identified.
Payment terms can be identified, although consideration may include a variable component.
The contract has commercial substance. Commercial substance means the amount, timing, and/or uncertainty of the firm’s future cash flow stream has changed as a result of the contract.
Collection is probable.1 Assessment of collectibility “is based on whether the customer has the ability and intention to pay the consideration to which the entity will be entitled, as part of the determination of commercial substance.
The application of revenue recognition criteria has continuously changed over time. For example, in the
1990s, many companies recognized revenue upon mere shipment of goods. Unfortunately, this loose policy
for revenue recognition lead to abuses. In order to meet revenue and/or profit estimates, some companies
would often “hurry up” and ship goods and recognize revenue (and profits) at the end of fiscal quarters or
the fiscal year by shipping goods intended to be shipped at the beginning of the next fiscal quarter or next
fiscal year.
Today the policy for recognizing revenue upon shipment has evolved to the ASC Topic 606 five-step
model. The following is a typical revenue recognition footnote for a company that recognizes at least
some of its revenue upon shipment:
1“Probable”
under IFRS means “more likely than not,” resulting in a threshold of 50% probability. Under U.S. GAAP, “probable” means “likely to occur.” Although there is no bright-line probability level associated with the term “likely to occur” under
U.S. GAAP, it is generally interpreted to be a greater threshold than 50%, such as 75% or 80%.
Norman J. Bartczak, Columbia University, prepared this note for classroom purposes. Copyright © 2019 Norman J. Bartczak.
1
Class Notes 08: Revenue Recognition
01-23-2019
Revised 01-14-2023
Revenue Recognition
The Company recognizes revenues at the time of product shipment or delivery, depending upon when title
and risk of loss passes, to unaffiliated customers, and when all of the following have occurred: a firm sales
agreement is in place, pricing is fixed or determinable, and collection is reasonably assured. Revenue is
recognized as the net amount estimated to be received after deducting estimated amounts for product returns, discounts and allowances. The Company estimates future product returns, discounts and allowances
based upon historical return rates and its reasonable judgment.
All companies must include a description of their Revenue Recognition policy in the Notes to their Financial Statements. Apple provides the following description of its Revenue Recognition policy in the
Notes to its 2021 Financial Statements:
Revenue Recognition
Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company
recognizes revenue at the amount to which it expects to be entitled when control of the products or services
is transferred to its customers. Control is generally transferred when the Company has a present right to
payment and title and the significant risks and rewards of ownership of products or services are transferred
to its customers. For most of the Company’s Products net sales, control transfers when products are
shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services is collected within a short period following transfer of control or commencement of delivery of services, as applicable.
For online sales to individuals, for some sales to education customers in the U.S., and for certain other
sales, the Company defers revenue until the customer receives the product because the Company retains a
portion of the risk of loss on these sales during transit. The Company recognizes revenue in accordance
with industry-specific software accounting guidance for the following types of sales transactions:
(i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled
with hardware not essential to the functionality of the hardware.
Revenue Recognition – More Complicated, Industry Specific Issues
•
•
•
•
•
•
•
•
•
Magazine publisher who sells annual subscriptions.
Baseball team for sales of tickets (season and individual games).
Ticketmaster (sells tickets for shows and sporting events).
Software company that develops customized software, installs the software, provides training,
software updates and debugging under a contract.
Construction company building a major business complex.
Insurance company.
Insurance broker.
Companies that receive a one-time up front fee.
Retail company that sells gift cards.
1. Accounting for payments received prior to the recognition of revenue:
a. Recording the payment when it is received
Cash
----------------------+
|
$$$
|
Unearned Revenue
----------------------|
+
|
$$$
b. Recording when services are rendered or goods delivered
Unearned Revenue
----------------------|
+
|
$$$
|
2
Income Statement T-account
----------------------|
+
Expense | Revenue
|
$$$
01-23-2019
Revised 01-14-2023
Class Notes 08: Revenue Recognition
Revenue Recognition – Other issues
•
Sales returns – In certain industries sales returns are significant (businesses where right-of-return
is permitted)2. At the end of each reporting period, companies need to estimate how much of the
recorded sales are likely to be returned. Estimated sales returns result in reducing reported sales
revenue and gross profit.
•
Seller financing - When sales are made where payment is to be made over an extended period of
time, accounting rules require that a portion of the selling price be considered interest and the remainder to relate to the sale of the product. This means that a portion of the selling price will not
be recognized as revenue when the product is delivered. That portion will be considered interest
or financing income, and be recognized as the installment payments are received.
Expense Recognition – Matching Revenues with Expenses
A. Costs incurred prior to the sale
Under the matching principle, costs incurred prior to the sale should be capitalized. When the
revenue is recognized, the assets are deemed to expire and they are expensed. For example, the
manufacturer capitalizes all costs incurred to manufacture inventory. When the inventory is sold
and the revenue is recognized, the inventory account is reduced and COGS expense is recognized.
B. Costs to be incurred after the sale
When additional costs are expected to be incurred after the sale, the estimated future costs are
recognized as expenses when the revenue is recognized (again, the matching concept). The most
common costs relate to fulfilling product warranties.
Entry to record warranty expense (recorded in the same period as the sale of the product)
Estimated Warranty Liability
---------------------------|
+
|
|
|
$$$
Income Statement T-account
----------------------|
+
Expense | Revenue
Warranty |
$$$
|
This is considered in greater detail in the Class Notes on Accounting Estimates.
In General Motors Company’s (GM) 10-K Notes to Consolidated Financial Statements it states:
Product Warranty and Recall Campaigns The estimated costs related to product warranties are
accrued at the time products are sold and are charged to Automotive and other cost of sales.
These estimates are established using historical information on the nature, frequency and average cost of claims of each vehicle line or each model year of the vehicle line and assumptions
about future activity and events. Revisions are made when necessary and are based on changes in these factors.
11, 2021 – WASHINGTON — Consumers returned an estimated $428 billion in merchandise to retailers last year, approximately 10.6 percent of total U.S. retail sales in 2020. ... The survey found that for every $1 billion in sales, the average retailer
incurs $106 million in merchandise returns.
2Jan
3
Class Notes 08: Revenue Recognition
01-23-2019
Revised 01-14-2023
Included in GM’s Automotive and Other Cost of Sales on its 2021, 2020 and 2019 income statements are
the following Warranty Expense (in millions):
Years Ended December 31,
2021
2020
2019
Product warranty expense
Warranty expense
$
2,606
$
3,108
$
2,787
Included in GM’s Accrued and Other Liabilities on its 2021 and 2020 balance sheets are its Product Warranty Liabilities (in millions):
Note 12. Accrued and Other Liabilities
Accrued liabilities
Product warranty and related liabilities
4
December 31,
2021
December 31,
2020
3,769
3,048
01-23-2019
Revised 01-14-2023
Class Notes 09: Accounting Estimates – Allowance Accounts
Estimates are inherent in financial reporting. Without estimates, financial reporting would be
accurate but not relevant. In this session, we will look at some areas where accounting estimates
are common and significant in financial reporting. We will also consider how estimates impact
reported net income and how companies can use estimates to manage their earnings from period
to period.
Accounts Receivable and Uncollectible Accounts
Accounts receivable (trade receivables) represent amounts owed by customers who have either
purchased goods or received services on credit. Firms that sell on credit run the risk that customers
may be unable or unwilling to pay their accounts. Under accounting rules, accounts receivable are
reported in the balance sheet at what management expects to collect on the existing balances. In
the accounting records, the company will carry Accounts Receivable at the gross amount owed. A
separate account – Allowance for Doubtful Accounts [ADA; also referred to as: (a) Allowance for
Uncollectible Accounts; and, (b) Allowance for Bad Debts (less common)] – represents the portion
of the gross balance not expected to be collected. This account is a contra-asset account, meaning it is an asset account which carries a right-hand side balance rather than a left-hand side balance. As the ADA increases, assets decrease. Although a company may still be trying to collect a
receivable, it is required to report receivables at the amount they expect to collect. Note that a contra-asset “attaches” itself as a deduction to the asset to which it is associated.
For income statement purposes, accounting rules require that the amounts not expected to be collected in the future be recognized as an expense in the current period, not when the receivable is
“written off.” This provides a better matching of recognized revenues and the costs (uncollectible
receivables) associated with the revenues. This expense is referred to as Bad Debt Expense (also
Provision for Bad Debts or Provision for Uncollectible Accounts). It represents the portion of revenue recognized which management estimates will not be collected in the future. Bad debt expense is typically included in selling, general and administrative expense in the income statement.
An Example
In the first quarter of 2022, a company has sales of $1,500,000 and at the end of the quarter it has
accounts receivable of $200,000. Based upon an evaluation of the age of the remaining accounts
receivable, management estimates that $30,000 of the receivables will not be collected.
Income Statement – T-account
----------------------------------|
+
Expenses
|
Revenues
|
Bad debt expense 30,000 |
“Contra” Asset Account
Allowance for
Doubtful Accounts (ADA)
----------------------|
+
|
| 30,000
The balance sheet will report accounts receivable, net at $170,000, calculated as follows:
Columbia University prepared this note for class discussion purposes. Copyright © 2019
Page | 1
Class Notes 09: Accounting Estimates – Allowance Accounts
Accounts receivable (gross)
Allowance for doubtful accounts
Accounts receivable, net
01-23-2019
Revised 01-14-2023
200,000
(30,000)
170,000
On the balance sheet, normally only the net amount of receivables is disclosed. The balance of the
total receivables and the amount of the ADA is disclosed in the notes to the financial statements.
The amount of bad debt expense is typically not reported separately on the income statement or in
the notes (included as part of SG&A expense). However, publicly held companies are required to
report bad debt expense in a qualifying and valuation schedule in the 10-K annual report filed
with the SEC.
How Management Estimates the ADA
In estimating the amount of ADA (uncollectible receivables) that should be recognized, management considers the following factors:
(a) Company and industry experience as to the percentage (%) of sales that are eventually
written off.
(b) The age of the receivables.
(c) Information that is known about specific customers.
(d) The economic outlook and how it may impact the collection of receivables.
For many smaller companies and/or companies with a concentrated set of customers, the specific
receivables identification method is used (analogous to (c) above). The next three sections provide examples of actual companies which utilize one of the three methods, beginning with the
specific receivables identification method.
In general, for larger and/or publicly-traded companies with many customers, there are two approaches, the percentage (%) of sales method (analogous to (a) above) and the aging of accounts receivable method, also known as the percentage (%) of gross receivables method
(analogous to (b) above). Appendices A and B to this note provide examples of the percentage of
sales method and the percentage of gross receivables method, respectively. Appendix C provides
an example the Allowance for Credit Losses on Bank Loans (“ACLL”). It is similar to the ADA
calculation
The Specific Receivables Identification Method for Estimating ADA
The following is the footnote for Stericycle, Inc. (NasdaqGS:SRCL) regarding its specific receivables identification method for estimating its allowance for doubtful accounts at its fiscal
year ended December 31, 2021.
Accounts Receivable and Allowance for Doubtful Accounts: The Company reports accounts receivable at their net realizable value, which is management’s best estimate of the cash that will
ultimately be received. The Company maintains an allowance for doubtful accounts to reflect the
expected uncollectability of accounts receivable based on historical collection data and specific
risks identified among uncollected accounts, as well as management’s expectation of future economic conditions. If current or expected future economic trends, events, or changes in circumstances indicate that specific receivable balances may be impaired, further consideration is given
Page | 2
01-23-2019
Revised 01-14-2023
Class Notes 09: Accounting Estimates – Allowance Accounts
to the collectability of those balances and the allowance is adjusted accordingly. The adequacy of
allowances for uncollectible accounts is reviewed at least quarterly and adjusted as necessary
based on such reviews. Management’s judgment is required to assess the collectability of an account, based on detailed analysis of the aging of the receivables, the creditworthiness of the Company’s customers, historical collection trends, and current and future expected economic trends.
Allowance for doubtful accounts was $56.2 million and $67.9 million as of December 31, 2021
and 2020, respectively. During the year ended December 31, 2021, 2020 and 2019, bad debt expense was $21.7 million, $25.7 million and $24.9 million, respectively.
Write-offs of Receivables and Recoveries of Amounts Written Off
When a specific receivable is identified as uncollectible, the financial records should reflect the
fact that this specific asset no longer exists. Therefore, the receivable is written off.
Write-off of uncollectible receivables
1. Assume a company has a $6,000 accounts receivable that it has made a $6,000 allowance
for its potential uncollectibility (see T-account balances below). NOTE: The $6,000 accounts receivable was created when the company recognized $6,000 in revenue (a righthand side entry) in its income statement and the $6,000 allowance was created when the
company recognized $6,000 in bad debt expense (a left-hand side entry) in its income
statement.
Asset Account
Accounts Receivable
------------------+
|
Bal 6,000|
Contra Asset Account
Allowance for
Doubtful Accounts
------------------|
+
|6,000 Bal
Assume that despite its efforts to collect the delinquent $6,000 accounts receivable, the
company is unsuccessful in doing so. This may occur for a variety of reasons: the company that owes the $6,000 has gone out of business; the costs of continuing to try to collect
the accounts receivable are no longer worth the benefit of receiving the accounts receivable. As a result, the company decides to “write-off” the $6,000 accounts receivable. The
accounting entry would be:
Asset Account
Accounts Receivable
------------------+
|
Bal 6,000|
|6,000 write-off
Contra Asset Account
Allowance for
Doubtful Accounts
------------------|
+
|6,000 Bal
write-off 6,000|
Notes:
• Write-offs do not result in an expense, since the expense was already recorded (estimated) in the period that the revenue was recognized.
• The net book value of Accounts Receivable does not change as a result of writing-off an
account.
Page | 3
Class Notes 09: Accounting Estimates – Allowance Accounts
01-23-2019
Revised 01-14-2023
A. Recoveries of allowances previously established and/or written-off by companies using
specific receivables identification method to estimate ADA
For companies like Activecare which use the specific receivables identification method to estimate ADA, the recovery of an amount previously written off can be viewed as the “correction” of a misestimate.
1. Using the previous example, assume it is now the end of the company’s next fiscal year.
Assume also that the customer who owed the $6,000 at the end of the previous fiscal year
recovers from its financial difficulties and pays the company the $6,000 in the subsequent
fiscal year. Using T-accounts, the entries to record the collection of the $6,000 would be as
follows:
a. To record the collection of cash of $6,000 for the outstanding accounts receivable:
Asset Account
Accounts Receivable
------------------+
|
Bal 6,000|
|6,000 a.
Asset Account
Cash
------------------+
|
|
a. 6,000|
b. To record the reversal of the “misestimate” of the allowance for doubtful accounts:
Income Statement T-account
----------------------------------|
+
Expenses
|
Revenues
|
|6,000 Other income b.
|(not Revenue since Revenue
| recognized in previous year)
“Contra” Asset Account
Allowance for
Doubtful Accounts (ADA)
----------------------|
+
|
|
b.
6,000|
|
|
2. Using the first example, assume it is now the end of the company’s next year. Assume also
that the customer who owed the $6,000 at the end of the previous year partially recovers
from financial difficulties and pays the company the $3,000 in the current year. The company concludes that it is no longer realistic to attempt to collect the remaining $3,000 of the
accounts receivable because the customer has gone out of business. Using T-accounts, the
entries to record the collection of the $3,000 and the write-off of the remaining $3,000
would be as follows:
a. To record the collection of cash of $3,000 of the $6,000 outstanding accounts receivable
and to record, b., the write-off of the remaining $3,000 accounts receivable:
Asset Account
Accounts Receivable
------------------+
|
Bal 6,000|
|3,000 a.
|3,000 b.
Page | 4
Asset Account
Cash
------------------+
|
|
a. 3,000|
|
01-23-2019
Revised 01-14-2023
Class Notes 09: Accounting Estimates – Allowance Accounts
Income Statement T-account
----------------------------------|
+
Expenses
|
Revenues
|
|3,000 Other income a.
|(not Revenue since Revenue
| recognized in previous year)
|
Allowance for
Doubtful Accounts (ADA)
----------------------|
+
|
|6,000 Bal
a.
3,000|
b.
3,000|
|
|
Management Estimates and Reported Earnings
The amount of bad debt expense from period-to-period is impacted by management’s outlook of
the future. The more pessimistic the outlook, the greater the amount that needs to be added to
ADA, which in turn increases bad debt expense.
In addition, the amount of bad debt expense from period-to-period is impacted by how good prior period estimates prove to be. For example, assume that the $23,000 estimate proves to be
overly pessimistic and write-offs in the next period prove to be lower than anticipated. This
would result in the need to add a smaller amount to ADA in the subsequent period, which would
reduce bad debt expense and improve profitability.
So, the estimate impacts the amount of profitability in the current period and may impact the profitability of future periods. As a result, the ADA account and similar accounts are often referred to
as management “cookie-jar reserves.” This term comes from situations where management’s addition to the ADA is more than needed, which negatively impacts net income in the current period.
In a subsequent period, the amount added is unusually low, resulting in a spike in profitability.
This is not unique to ADA accounting. Most accounts that are subject to significant management
estimates and assumptions create the opportunity to manage earnings from period-to-period.
Other Areas Involving Significant Management Estimates
Revenue and related product cost recognition: As discussed in previous sessions, management
estimates have a significant impact under certain revenue recognition models. Examples include
%-of-completion, accounting for motion picture producers, and revenue recognition involving
contracts with multiple deliverables.
Sales returns: In certain industries where the right-of-return is permitted, sales returns are significant. Examples include retail and book publishing. When the right of return exists, at the end of
each reporting period, management is required to estimate the amount of returns on recorded
sales. These estimates result in the reduction of reported revenue, partially offset by a reduction
of reported COGS (the inventory will be returned) and a reduction in reported profits.
Contingent liabilities: When management is faced with contingent liabilities related to such
things as lawsuits or EPA remediation, it is required to recognize a liability with a corresponding
charge to the income statement. At the end of each reporting period, management is required to
reassess the potential liability based on the most current information available.
Warranties; Depreciation lives for PP&E; Mark-to-market accounting for certain investments
which are fair valued; Reserves for obsolete and slow-moving inventory
Page | 5
Class Notes 09: Accounting Estimates – Allowance Accounts
01-23-2019
Revised 01-14-2023
APPENDIX A
The Percentage of Sales Method for Estimating ADA
The following are the allowance for doubtful accounts footnotes for Laboratory Corporation of America
(NYSE:LH) as of the year ended December 31, 2020. The Company uses the percentage of sales method for estimating ADA.
The Company has a formal process to estimate and review the collectibility of its receivables
based on the period of time they have been outstanding. Bad debt expense is recorded within
selling, general and administrative expenses as a percentage of sales considered necessary to
maintain the allowance for doubtful accounts at an appropriate level. The Company’s process for
determining the appropriate level of the allowance for doubtful accounts involves judgment, and
considers such factors as the age of the underlying receivables, historical and projected collection
experience, and other external factors that could affect the collectibility of its receivables. Accounts are written off against the allowance for doubtful accounts based on the Company’s writeoff policy ( e.g., when they are deemed to be uncollectible). In the determination of the appropriate level of the allowance, accounts are progressively reserved based on the historical timing of
cash collections relative to their respective aging categories within the Company’s receivables.
The following table presents the percentage of the Company’s net accounts receivable outstanding by aging category at December 31, 2020 and 2019 :
Days Outstanding
0 – 30
31 – 60
61 – 90
91 – 120
121 – 150
151 – 180
181 – 270
271 – 360
Over 360
2020
46.4%
19.3%
11.5%
7.1%
3.4%
3.8%
7.3%
0.9%
0.3%
2019
48.9%
18.6%
11.7%
6.5%
3.9%
3.3%
6.1%
0.8%
0.2%
The following “Valuation and Qualifying Accounts and Reserves” Schedule is provided by the Company
in its 10-K Annual Report filing with the SEC.
LABORATORY CORPORATION OF AMERICA
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Years Ended December 31, 2020 , 2019 and 2018
Balance at
beginning
of year
(Dollars in millions)
Additions
Charged to Costs
and Expense
(1)
Other
(Deductions)
Balance
at end
of year
Year ended December 31, 2020:
Allowance for doubtful accounts
$
191.5
$
254.8
$
(248.0 )
$
198.3
Year ended December 31, 2019:
Allowance for doubtful accounts
$
197.6
$
246.0
$
(252.1 )
$
191.5
Year ended December 31, 2018:
Allowance for doubtful accounts
$
149.2
$
255.1
$
(206.7 )
$
197.6
(1) Other (Deductions) consists of write-offs of accounts receivable amounts.
Page | 6
01-23-2019
Revised 01-14-2023
Class Notes 09: Accounting Estimates – Allowance Accounts
In its income statement, the Company recorded a “provision for doubtful accounts” (“bad debt expense”)
of $254.8 million , $246.0 million and $255.1 million in 2020, 2019 and 2018 respectively (see table on
previous page).
In its balance sheet, the Company showed the following for its gross and net accounts receivable:
December 31,
2020
December 31,
2019
Gross accounts receivable
Less allowance for doubtful accounts
$
983.0
(198.3)
$
910.0
(191.5)
Net accounts receivable
$
784.7
$
718.5
In its cash flow statement, the Company uses the indirect method format in arriving at cash flow from
operating activities. As a result, it adds back to net income the provision for doubtful accounts of $254.8
million , $246.0 million and $255.1 million in 2020 , 2019 and 2018 respectively because the provision
does not involve cash. For example, using T-accounts for 2020, the entry to record the provision for
doubtful accounts is:
Income Statement T-account
----------------------------------|
+
Expenses
|
Revenues
|
Provision for
|
doubtful accounts $254.8|
|
“Contra” Asset Account
Allowance for
Doubtful Accounts (ADA)
----------------------|
+
|
|
|
|$254.8
|
While the provision is a deduction in the income statement because it is an expense, it has to be added
back to net income (using the indirect method) because it is not a cash deduction.
Page | 7
Class Notes 09: Accounting Estimates – Allowance Accounts
01-23-2019
Revised 01-14-2023
APPENDIX B
The Percentage of Receivables Method for Estimating Allowance for Doubtful Accounts
The following are the allowance for doubtful accounts and discounts for Tootsie Roll Industries, Inc. (TR)
as of the year ended December 31, 2021, 2020 and 2018. The Company uses the percentage of receivables method for estimating doubtful accounts.
Allowances for Receivables and Discounts
The allowances for receivables are as follows (in thousands, except percentages):
December 31, 2021
Allowance for bad debts and discounts
Accounts receivable trade, gross
$
$
Percentage of gross accounts receivable
2,281
57,202
December 31, 2020
$
$
4.0%
1,694
41,209
December 31, 2019
$
$
1,949
45,044
3.9%
4.1%
The following Schedule II – “Valuation and Qualifying Accounts” is provided by the Company in its
10-K Annual Report filing with the SEC (in thousands):
December 31, 2021
Reserve for bad debts and discounts
Balance at beginning of fiscal year
Additions charged to expenses
Write-offs and allowance to customers
Balance at end of fiscal year
$
$
1,694
10,571
(9,984)
2,281
December 31, 2020
$
$
1,949
8,627
(8,882)
1,694
December 31, 2019
$
1,820
10,158
(10,029)
1,949
$
In its income statement, Tootsie Roll records a “provision for doubtful accounts and discounts” (“bad debt
expense” of $21 million, $55 million and $56 million in 2021, 2020 and 2019 respectively (see “provisions” in table above).
In its balance sheet, Tootsie Roll shows the following for its accounts receivable:
December 31, 2021
Accounts receivable trade, less allowances of $2,281, $1,694 and $1,949
$
54,921
December 31, 2020
$
41,209
December 31, 2019
$
In its cash flow statement, the Company uses the indirect method format in arriving at cash flow from
operating activities. As a result, it adds back to net income the provision for doubtful accounts of $10.571
million, $8.627 million and $10.158 million in 2021, 2020 and 2019 respectively because the provision
does not involve cash.
Page | 8
45,044
Class Notes 09: Accounting Estimates – Allowance Accounts
01-23-2019
Revised 01-14-2023
APPENDIX C
Allowance for Credit Losses on Bank Loans (“ACLL”)
HERITAGE COMMERCE CORP (HTBK) – 2021 10-K
As a result of our January 1, 2020, adoption of the new accounting standard, Topic 326, Measurement of Credit Losses on Financial Instruments, our methodology for estimating the allowance for credit losses changed significantly from December 31, 2019. The standard replaced the
“incurred loss” method with an “expected loss” method known as current expected credit loss
(“CECL”). Prior to January 1, 2020, we calculated ACLL using incurred losses methodology.
Beginning January 1, 2020, we calculated allowance for ACLL using CECL methodology. As of
January 1, 2020, the Company increased the ACLL by $8.6 million since the Topic 326 covers
credit losses over the expected life of a loan as well as considering future changes in macroeconomic conditions. The ACLL at December 31, 2021, was $43.3 million, or 1.40% of total loans.
The ACLL at December 31, 2020, was $44.4 million, or 1.70% of total loans.
The allowance for credit losses on loans represents management’s estimate of all expected credit
losses over the expected contractual life of the loan portfolio. The ACLL is a valuation amount
that is deducted from the amortized cost basis of loans, and is adjusted each period by an expense
or credit for credit losses, which is recognized in earnings, and reduced by loan charge-offs, net
of recoveries. Determining the appropriateness of the ACLL is complex and requires judgement
by management about inherently uncertain factors.
Qualitative factors are evaluated each period and applied in instances when management assesses
that additional risks not captured in the quantitative estimate should be factored into the overall
ACLL estimate. These risks include loan performance trends, collateral value risk and portfolio
growth characteristics. Changes in the assessment of these qualitative factors could significantly
impact the calculated estimated credit loss.
Loans are charged-off against the allowance when management determines that a loan balance
has been uncollectible. Subsequent recoveries, if any, are credited to the allowance for credit
losses on loans.
The following table summarizes the Company’s loan loss experience, as well as provisions and
charges to the allowance for credit losses on loans and certain pertinent ratios for the periods indicated:
(Dollars in thousands)
Beginning of year balance
Charge-offs
Recoveries
Net (charge-offs) recoveries
Impact of adopting Topic 326
Provision for credit losses on loans (bad debt expense)
End of year balance
2021
2020
2019
2018
2017
$44,400
$23,285
$27,848
$19,658
$19,089
-3,134
-1,880
-6,623
-2,026
-2,239
1,504
1,192
1,214
2,795
2,709
-1,630
-688
-5,409
769
470
—
8,570
—
—
—
520
13,233
846
7,421
99
$43,290
$44,400
$23,285
$27,848
$19,658
Page | 9
Class Notes 09: Accounting Estimates – Allowance Accounts
01-23-2019
Revised 01-14-2023
For 2021:
To record the charge-offs:
Asset Account
Loans Receivable
------------------+
|
| $3,134 a.
Contra-Asset Account
Allowance for Credit Losses
------------------|
+
a. $3,134 |
To record recoveries of loans previously provisioned for credit losses:
Asset Account
Cash
------------------+
|
b. $1,504 |
Contra-Asset Account
Allowance for Credit Losses
------------------|
+
| $1,504 b.
NOTE: Credit loss Recoveries for bank loans are not included in the income statement as “Other
Income” (the way they are for non-bank Accounts Receivable). They are added back to the contra-asset account, Allowance for Credit Losses. Indirectly, this accounting treatment has an effect
on the income statement since it reduces the current amount recognized as an expense in the
“Provision for Credit Losses” on the income statement.
To record the provision for credit losses (“bad debt expense”) for the year:
Income Statement T-account
----------------------------------|
+
Expenses
|
Revenues
|
c. $520
|
Contra-Asset Account
Allowance for Credit Losses
------------------|
+
| $44,400 Beginning balance
a. $3,134 |
| $1,504 b.
| $ 520 c.
------------------$43,290 Ending balance
Page | 10
“Contra” Asset Account
Allowance for
Doubtful Accounts (ADA)
----------------------|
+
|
|
|
$520
c.
FSI
Financial Statement Investigation
05-10-2013
Revised 01-14-2023
Class Notes 10: Deferred Income Taxes
The major objective of accounting rules under both U.S. GAAP and IFRS is to measure the underlying
economic results of an entity during a specified time frame. The financial reporting Under U.S. GAAP
and IFRS is often referred to as “book” accounting.
Governments use tax accounting rules primarily to achieve public policy considerations that help to stimulate investment, jobs, and the overall economy.
As a result, although some of the accounting rules for book and tax purposes are the same, many significant ones are not. The differences between book and tax accounting create two types of differences: temporary differences (referred to as timing differences; see Appendix A) and permanent differences (see
Appendix B). Appendix C uses Apple and Microsoft as examples of how companies disclose their temporary and permanent differences
Timing Differences
Timing differences are temporary in that they “reverse” over time. The major timing differences relate to
the following (see pages 6 & 7 of this note for a summary of examples of timing differences):
•
•
•
•
•
Companies may use straight-line depreciation for book purposes and accelerated depreciation for
tax purposes. This is very common and creates a deferred tax liability.
Many expenses that need to be accrued for book purposes are only deductible for tax purposes
when they are paid. Examples include warranty expense, losses related to contingent liabilities
and restructuring charges. These differences create deferred tax assets.
Provisions for bad debts are not deductible based on book amounts. For tax purposes, a deduction for uncollectible accounts is allowed only when the taxpayer can demonstrate that a receivable is not collectible. This difference creates a deferred tax asset.
Write downs and related book losses for impaired assets and inventory are not deductible for tax
purposes. When the asset is sold, the realized gain or loss is recognized for tax purposes. For
book purposes, the write-down represents an anticipated loss in value. These differences generally create deferred tax assets.
Unrealized gains and losses on investments are usually included in the calculation of net income.
Only realized gains and losses are included for income tax purposes. These differences create
both deferred tax liabilities (unrealized gains) and deferred tax assets (unrealized losses).
Additional income tax terminology:
Earnings before taxes (EBT): Earnings before taxes on the books. Under GAAP and IFRS rules, income tax expense is based on EBT, not the amount of tax reported on the tax return.
Taxable income: Amount reported on the tax return. Calculated as the difference between taxable revenues less deductible expenses. This amount is used to calculate the amount income taxes payable to the
taxing authorities, e.g. Internal Revenue Service in the U.S.
Income tax provision: The term is synonymous with income tax expense. Most corporations refer to it
as income tax provision or provision for income taxes in the financial statements.
Income tax benefit: Represents a negative income tax provision which is a reduction in the total provision.
Left-hand side entries to the income tax provision in the Income Statement T-account increase the provision
Norman J. Bartczak, Columbia University, prepared this note for classroom purposes. Copyright © 2013 Norman J. Bartczak.
1
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
and reduce net income and equity. Right-hand side entries to the income tax provision in the Income Statement T-account are tax benefits, which increase net income and equity.
Deferred income taxes are “formally” referred to as interperiod income tax allocation. DEFERRED
INCOME TAXES OCCUR ONLY WHEN THERE IS A DIFFERENCE BETWEEN HOW A
COMPANY ACCOUNTS FOR AN ITEM FOR FINANCIAL REPORTING (GAAP) PURPOSES
AND HOW IT ACCOUNTS FOR THAT SAME ITEM FOR INCOME TAX PURPOSES.
DEFERRED INCOME TAXES CANNOT OCCUR FOR ANY OTHER REASON.
The following table, from a sample of 600 firms, lists the major categories of timing differences:
Depreciation
Other employee benefits
Inventory valuation
Pensions
Discontinued operations
Unremitted earnings
Number of Companies
1992 1991 1990 1989 1988 1987
456 425 444 454 462 465
266 162 161 134 146 131
199 166 162 164 146 131
118 121 109 111 119 118
100
85
83
81
92
92
57
50
48
47
63
59
Deferred Income Taxes
When identical transactions are treated differently for book purposes than for tax purposes either a deferred
income tax liability or a deferred income tax asset is created.
Deferred Income Tax Liability
A deferred income tax liability is initiated when the difference in accounting for the transaction results
in profit before income taxes being greater for book purposes than for tax purposes. In formula form, for
any individual difference between book and tax accounting, if it causes PBTBOOK > PBTTAX it initiates a
DTL, e.g. when a company uses straight line depreciation for book purposes (as most companies do) and
accelerated depreciation for tax purposes (as is usually required by the tax code1), initially the company
will take lower depreciation for book purposes than for tax purposes resulting in higher profit before income taxes for book purposes during the early life of the depreciable asset. However, as the depreciable
asset ages, the deferred income tax liability timing difference will reverse (it will be paid).
Deferred Income Tax Liability Example: A trucking company buys a new truck today for $90,000. For
book purposes, it uses straight-line depreciation over a useful life of three years, so it takes depreciation
expense of $30,000 a year for three years. For tax purposes, the company is allowed to use accelerated depreciation and it takes the full $90,000 of depreciation in the first year. The difference between the way in
which the company accounts for depreciation is the only difference between its book and tax accounting.
For both book and tax purposes, the company earns $100,000 before depreciation and income taxes. The
company’s summary income statements for book and tax purposes over the three-year period would be as
follows (assuming a tax rate of 20%):
Year 1
Profit before depreciation
and income taxes
Depreciation expense
Profit before income taxes
Income taxes @ 20%
Net Income
$100,000
30,000
70,000
14,000
$ 56,000
Book Accounting
Year 2
Year 3
$100,000
30,000
70,000
14,000
$ 56,000
$100,000
30,000
70,000
14,000
$ 56,000
Year 1
$100,000
90,000
10,000
2,000
$ 8,000
Tax Accounting
Year 2
Year 3
$100,000
0
100,000
20,000
$ 80,000
$100,000
0
100,000
20,000
$ 80,000
946 (March 2022) from the Internal Revenue Service states, “The Modified Accelerated Cost Recovery System
(MACRS) is used to recover the basis of most business and investment property placed in service after 1986. MACRS consists of
two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Usually,
these systems provide different methods and recovery periods to use in figuring depreciation deductions. You must generally use
GDS unless you are specifically required by law to use ADS or you elect to use ADS.
1Publication
2
05-10-2013
Revised 01-14-2023
Class Notes 10: Deferred Income Taxes
Year 1:
For book purposes, the balance sheet would show a deferred income tax liability of $12,000 (the timing
difference between taxes of $14,000 for book purposes and $2,000 for tax purposes at the end of Year 1).
The $2,000 of taxes payable would be paid and the deferred income tax liability account would show a
balance at the end of year 1 of $12,000. Note that the deferred income tax liability represents a real liability that must be paid to the taxing authority as the timing difference between book and tax accounting
“reverses”. The “advantage” to the company of a deferred tax liability is the time value of money. Instead of having to pay the taxing authority $14,000 in year 1, it pays $2,000 and gets to use the $12,000
“savings” in year 2. It is not unlike a $12,000 interest-free loan from the government.
Taxes Payable
--------------------------|
+
|
2,000 a.
b.
2,000
|
Deferred Income Tax Liability
----------------------------|
+
|
12,000
Income Statement T-Account
------------------------------|
+
a.
14,000
|
Cash
--------------------------+
|
|
2,000 b.
Year 2:
Taxes actually payable in year 2 would be $20,000 while taxes recognized for book purposes would be
$14,000. At the end of Year 2, the balance sheet would show a deferred income tax liability of only $6,000
because $6,000 of the original $12000 timing difference deferred income tax liability reverses (is paid
back) in Year 2, i.e. the company pays back $6,000 of the $12,000 deferred income tax liability in Year 2.
Taxes Payable
--------------------------|
+
|
20,000 a.
b. 20,000
|
Deferred Income Tax Liability
----------------------------|
+
|
12,000 Bal
a.
6,000
|
----------------------------|
6,000 Bal
Income Statement T-Account
------------------------------|
+
a.
14,000
|
Cash
--------------------------+
|
|
20,000 b.
Year 3:
Taxes actually payable in year 3 would be $20,000 while taxes recognized for book purposes would be
$14,000. At the end of Year 3, the balance sheet would show a deferred income tax liability of only $0 because the remaining $6,000 of the original $12,000 timing difference deferred income tax liability reverses
(is paid back) in Year 3, i.e. the company pays back $6,000 of the remaining $6,000 deferred income tax
liability in Year 3.
Taxes Payable
--------------------------|
+
|
20,000 a.
b. 20,000
|
Deferred Income Tax Liability
----------------------------|
+
|
6,000 Bal
a.
6,000
|
----------------------------|
0 Bal
Income Statement T-Account
------------------------------|
+
a.
14,000
|
Cash
--------------------------+
|
|
20,000 b.
3
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
At the end of year 3, there is no further timing difference for the truck purchased three years earlier because it is now fully-depreciated for both book and tax purposes, i.e. its book value for both book and tax
purposes at the end of Year 3 is $0. Note that the company recognizes and pays the same amount of tax
over the three-year period. The only difference is one of timing when it recognizes the tax for book and
when it pays it for tax. The major benefit to a company of this timing disparity is the time value of money.
Note also that, over the three years, if the company used its actual taxes payable to the taxing authority, its
book and tax income statements would look like:
Year 1
Profit before depreciation
and income taxes
Depreciation expense
Profit before income taxes
Income taxes @ 20%
Net Income
$100,000
30,000
70,000
2,000
$ 68,000
Book Accounting
Year 2
Year 3
$100,000
30,000
70,000
20,000
$ 50,000
$100,000
30,000
70,000
20,000
$ 50,000
Year 1
$100,000
90,000
10,000
2,000
$ 8,000
Tax Accounting
Year 2
Year 3
$100,000
0
100,000
20,000
$ 80,000
$100,000
0
100,000
20,000
$ 80,000
Using actual taxes to be paid in the book accounting income statement would not only violate the matching
principle of book accounting, but it would also likely cause investors to be confused regarding a company’s net income. In this example, an investor might wonder why the company performed so well in year 1
and then did so poorly in years 2 and 3. In addition, use of actual taxes to be paid would bring into question the value of net income as an indicator of company performance.
Deferred Income Tax Asset
A deferred income tax asset is initiated when the difference in accounting for the transaction results in
profit before income taxes being less for book purposes than for tax purposes. . In formula form, for any
individual difference between book and tax accounting, if it causes PBTBOOK < PBTTAX it initiates a
DTA, e.g. when a company recognizes bad debt expense and an allowance for doubtful accounts
receivable for book purposes but is required to wait to recognize the same expense for tax purposes until the company actually “writes off” the same accounts receivable; or, when, for book
purposes, the company accrues (recognizes) an expense like a heating bill in the current period,
but is not allowed to recognize the expense for tax purposes until it is paid; or, for book purposes
the company defers the recognition of revenue from advance payments for products or services,
but is required to recognize them as revenue for tax purposes when it receives the cash. Initially,
the company will either record more expense or less revenue for book purposes than for tax purposes resulting in lower profit before income taxes for book purposes. However, over time, the deferred
income tax asset timing difference will reverse (it will be recognized) for book purposes.
Deferred Income Tax Asset Example: A luxury resort in Hawaii receives a $100,000 advance
payment from a company in December (of Year 1) for the company’s annual conference in February (of Year 2). The resort’s fiscal year for book purposes as well as for tax purposes ends on
December 31. Since, at December 31, the resort has not yet provided the conference to the company, it would not be allowed to recognize the $100,000 advance payment as revenue until the
following February when it provides the conference service to the company. On December 31, it
would show the $100,000 as an increase in cash on its balance sheet as well as a $100,000 increase in an advance payment liability on its balance sheet (i.e. it owes the company $100,000 of
4
05-10-2013
Revised 01-14-2023
Class Notes 10: Deferred Income Taxes
conference services in February). However, for tax purposes2, since the company had received
the cash in December, it would be required to show the $100,000 as taxable revenue in December. Excluding all other revenue and expense items, the company’s summary income statements for
book and tax purposes over the two-year period would be as follows (assuming a tax rate of 20%):
Revenue
Profit before income taxes
Income taxes @ 20%
Net Income
Book Accounting
Year 1
Year 2
$
0
$100,000
0
100,000
0
20,000
$
0
$ 80,000
Tax Accounting
Year 1
Year
$100,000
$
100,000
20,000
$ 80,000
$
2
0
0
0
0
Year 1:
For book purposes, the balance sheet would show a deferred tax asset of $20,000 (the timing difference
between taxes of $0 for book purposes and $20,000 for tax purposes at the end of Year 1.
Deferred Tax Asset
--------------------------+
|
a. 20,000
|
|
Taxes Payable
----------------------------|
+
|
20,000 a.
b. 20,000
|
Income Statement T-Account
------------------------------|
+
a.
0
|
Cash
--------------------------+
|
|
20,000 b.
Year 2:
In Year 2, the balance sheet would show a deferred income tax asset of $0 because the $20,000 timing difference deferred income tax asset reverses in Year 2. At the end of Year 2, there is no further
timing difference because the advance payment has been fully-recognized for both book and tax
purposes. Note that the company recognizes and pays the same amount of tax over the two-year period. The only difference is one of timing when it pays the tax and when it recognizes the tax for
book. In the deferred income tax asset case, it’s like the company has “prepaid” its taxes; however,
the prepayment is not voluntary. The company is paying the taxes in compliance with the tax code.
Deferred Tax Asset
--------------------------+
|
Bal 20,000
|
|
20,000 a.
--------------------------Bal
0
|
Taxes Payable
----------------------------|
+
|
0 a.
b.
0
|
Income Statement T-Account
------------------------------|
+
a.
20,000
|
Cash
--------------------------|
+
|
0 b.
538 (January 2022) from the Internal Revenue Service states, “Generally, you report an advance payment for goods,
services, or other items as income in the year you receive the payment. You are considered to receive an item of gross income if
you actually or constructively receive it or it is due and payable to you.
2Publication
5
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
Appendix A
Temporary (aka Timing) Differences between Book and Tax Accounting
Reversals of Deferred Income Tax Liabilities and Deferred Income Tax Assets: Deferred income tax
liabilities and deferred income tax assets always reverse because they are timing differences. However,
the reversals can be confusing. When a deferred income tax liability reverses, the reversal looks like a
deferred income tax asset, even though its is not. The same is true for the reversal of a deferred income
tax asset. The reversal looks like a deferred income tax liability, even though it is not.
Fortunately, in analyzing the income statement effect of deferred income taxes, companies simplify the
procedure by merely reporting the net impact of deferred income tax liabilities and deferred income tax
assets. The companies offset their deferred income tax liabilities with their deferred income tax assets
(they net them) and the income statement affect only involves the net change in deferred income taxes. If
the periodic impact in deferred income tax liabilities is greater than the periodic impact in the deferred
income tax assets, companies report a net increase in deferred income tax liabilities and vice versa. For
examples, see the income tax footnotes for Apple and Microsoft on pages 9 through 12 of this note.
The most common book and tax accounting differences that create deferred income taxes are:
a. Depreciation differences. Most companies use straight-line depreciation for book purposes and accelerated depreciation for tax purposes. In general, if the company is profitable and growing, the depreciation differential leads to lower profit before tax for income tax purposes than for book purposes. This leads to an increase in the deferred tax
liability. For each individual fixed asset, i.e. building, piece of machinery, etc., the differential is only temporary and the deferred tax liability reverses as the depreciable asset
ages and the accelerated depreciation for the individual asset becomes less than the
straight line depreciation. However, if the company is growing, the deferred tax liability
that is reversed in the latter situation is more than offset by the new deferred tax liability
created by the depreciation differential for the larger dollar number (because of growth)
of newly acquired fixed assets. On the other hand, if the company is not growing or
contracting, (and spending less on its fixed asset expenditures), the deferred tax liability
will decline as it reverses.
b. Bad debt expense. For book purposes, companies record bad debt expense and an allowance for doubtful accounts when they consider an account receivable to be in considerable jeopardy of being collected. For tax purposes, companies are not allowed to expense
such potential bad debts until they “write off” the account receivable as uncollectible, i.e.
they give up attempting to try to collect the account receivable. In general, if the company is profitable and growing, the differential bad debt treatment leads to a lower
profit before taxes for book purposes than for tax purposes. This leads to an increase in
the deferred tax asset. Once again, the differential is only temporary and the deferred tax
asset reverses if and when the company writes off bad debts for book purposes. However,
if the company is growing, the deferred tax asset that is reversed in the latter situation is
more than offset by the new deferred tax asset created by the bad debt differential for the
increased dollar amount (because of growth) of accounts receivable. On the other hand, if
the company is not growing and/or its bad debts are contracting, the deferred tax asset will decline as it reverses.
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05-10-2013
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Class Notes 10: Deferred Income Taxes
c. Prepaid assets. For book purposes, a prepaid asset is an item for which the company has
already paid but has not yet received the benefit, e.g. prepaid insurance. The item is not
treated as an expense by the company until it actually receives and uses up the benefit for
which it has prepaid. For tax purposes, in the vast majority of cases, companies are allowed to deduct the amounts they prepay at the time they make the prepayment. In general, if the company is profitable and growing, the differential prepaid treatment leads
to a lower profit before taxes for income tax purposes than for book purposes. This lead
to an increase in the deferred tax liability. For each individual prepaid asset the differential is only temporary and the deferred tax liability reverses as the prepaid asset gets used
up. However, if the company is growing, the deferred tax liability that is reversed in the
latter situation is more than offset by the new deferred tax liability created by the new
differential for the larger dollar amount (because of growth) associated with the new prepaid asset. On the other hand, if the company is not growing or contracting, (and
spending less on its prepaid assets), the deferred tax liability will decline as it reverses.
d. Accrued liabilities, advances, and deferred revenues. For book purposes, accrued liabilities are items for which the company has already received a benefit (and, therefore, has recognized the expense) but has not yet paid for it, e.g. accrued utility costs payable. Advances
are cash received by the company for services it has not yet provided. Deferred revenues (essentially the same as advances) represent cash already received by the company for goods
and/or services it has not yet provided. For tax purposes, in the vast majority of cases, companies are not required to recognize the expense associated with the creation of accrued liabilities until they actually pay the cash for the accrued liability. Likewise, for tax purposes, in
the vast majority of cases, the cash a company receives for advances and deferred revenues is
required to be recognized as revenue for tax purposes at the time the company receives the
cash. In general, if the company is profitable and growing, the differential accrued liability, advances, and deferred revenues treatment leads to a higher profit before taxes for income tax purposes than for book purposes. This leads to an increase in the deferred tax asset.
Once again, the differential is only temporary and the deferred tax asset reverses when the
accrued liabilities are paid, and the advances and deferred revenues are recognized as revenue for book purposes (in general, these differentials occur at the end of a quarter and fiscal
year and reverse fairly quickly after the close of the quarter or fiscal year). However, if the
company is growing, the deferred tax assets that are reversed in the latter situation are more
than offset by the new deferred tax assets created by the new (and larger) differentials for the
increased dollar amount (because of growth) of accrued liabilities, advances and/or deferred
revenues. On the other hand, if the company is not growing or contracting, the deferred
tax asset will decline as it reverses.
NOTE: A new standard FASB issued Friday, November 20, 2015, is designed to improve
the way deferred taxes are classified on organizations’ balance sheets.
Under current GAAP, an entity is required to separate deferred income tax liabilities and
assets into current and noncurrent amounts in a classified statement of financial position.
Stakeholders have informed FASB that this requirement results in little or no benefit to
financial statement users and is costly for financial statement preparers.
The amendments issued Friday, November 20, 2015, are designed to simplify the presentation of deferred income taxes. The new standard requires deferred tax liabilities and assets
to be classified as noncurrent in a classified statement of financial position.
7
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
Appendix B
Permanent Differences between Book and Tax Accounting
Although permanent differences can have a significant effect on the amount of income taxes a company
has to pay, they are not as common as timing differences. Below are some examples that cause permanent
differences between book and tax accounting:
•
Foreign earnings taxed at lower rates decrease a company’s effective tax rate; conversely, although
less common, foreign earnings taxes at higher rates increase a company’s effective tax rate.
•
Interest received on state and municipal bonds is not subject to federal or state tax but is included in
book income. This causes an decrease in a company’s effective tax rate.
•
If a company pays fines or expenses resulting from violations of the law (for example, environmental
damages), these payments are not deductible for tax purposes but would be deducted from book income. This causes an increase in a company’s effective tax rate.
•
Goodwill write-offs generally are not deductible for tax purposes unless they meet certain special conditions. Goodwill writedown as a result of impairment is subtracted in determining book income. This
causes an increase in a company’s effective tax rate.
•
Premiums for life insurance on executives paid for by a company that is the designated beneficiary on
these policies are deducted for book purposes but are not deductible for tax purposes. This causes an
increase in a company’s effective tax rate.
•
Compensation expense associated with certain employee stock options is not deductible for tax purposes but is deductible in determining book income. This causes an increase in a company’s effective
tax rate.
•
State income taxes are deducted as part of a company’s total income tax expense in arriving at net
income for book purposes but are not deductible for federal income tax purposes. This causes an increase in a company’s effective tax rate.
8
05-10-2013
Revised 01-14-2023
Class Notes 10: Deferred Income Taxes
Appendix C
Disclosure of Temporary and Permanent Differences Using Apple, inc. and Microsoft Corporation
Apple Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except number of shares which are reflected in thousands and per share amounts)
September 25,
2021
Net sales:
Products
Services
Total net sales
Cost of sales:
Products
Services
Total cost of sales
Gross margin
Operating expenses:
Research and development
Selling, general and administrative
Total operating expenses
Operating income
Other income/(expense), net
Income before provision for income taxes
Provision for income taxes
Net income
$
297,392
68,425
365,817
$
Years ended
September 26,
2020
$
220,747
53,768
274,515
September 28,
2019
$
213,883
46,291
260,174
192,266
20,715
212,981
152,836
151,286
18,273
169,559
104,956
144,996
16,786
161,782
98,392
21,914
21,973
43,887
108,949
258
109,207
14,527
94,680
18,752
19,916
38,668
66,288
803
67,091
9,680
57,411
16,217
18,245
34,462
63,930
1,807
65,737
10,481
55,256
$
$
Note 5 – Income Taxes
Provision for Income Taxes and Effective Tax Rate
The provision for income taxes for 2022, 2021 and 2020, consisted of the following (in millions):
2022
Federal:
Current
Deferred
Total
State:
Current
Deferred
Total
Foreign:
Current
Deferred
Total
Provision for income taxes
$
$
7,890
(2,265)
5,625
2021
$
8,257
(7,176)
1,081
2020
$
6,306
(3,619)
2,687
1,519
84
1,603
1,620
(338)
1,282
455
21
476
8,996
3,076
12,072
19,300
9,424
2,740
12,164
14,527
3,134
3,383
6,517
9,680
$
$
The foreign provision for income taxes is based on foreign pretax earnings of $71.3 billion, $68.7 billion
and $38.1 billion in 2022, 2021 and 2020, respectively.
9
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate (21% in 2022, 2021 and 2020) to income before provision for income taxes for 2022,
2021 and 2020, is as follows (dollars in millions):
Computed expected tax
State taxes, net of federal effect
Impacts of the Act
Earnings of foreign subsidiaries
Foreign-derived intangible income deduction
Research and development credit, net
Excess tax benefits from equity awards
Other
Provision for income taxes
Effective tax rate
$
$
2022
25,012
1,518
542
(4,366)
(296)
(1,153)
(1,871)
(86)
19,300
$
$
16.2 %
2021
22,933
1,151
—
(4,715)
(1,372)
(1,033)
(2,137)
(300)
14,527
$
$
13.3 %
2020
14,089
423
(582)
(2,534)
(169)
(728)
(930)
111
9,680
14.4 %
Deferred Tax Assets and Liabilities
As of September 24, 2022 and September 25, 2021, the significant components of the Company’s deferred tax assets and liabilities were (in millions):
2022
Deferred tax assets:
Amortization and depreciation
Accrued liabilities and other reserves
Lease liabilities
Deferred revenue
Unrealized losses
Tax credit carryforwards
Other
Total deferred tax assets
Less: Valuation allowance
Total deferred tax assets, net
Deferred tax liabilities:
Minimum tax on foreign earnings
Right-of-use assets
Unrealized gains
Other
Total deferred tax liabilities
Net deferred tax assets
$
$
1,496
6,515
2,400
5,742
2,913
6,962
1,596
27,624
(7,530)
20,094
1,983
2,163
942
469
5,557
14,537
2021
$
$
As of September 24, 2022, the Company had $4.4 billion in foreign tax credit carryforwards in Ireland
and $2.5 billion in California R&D credit carryforwards, both of which can be carried forward indefinitely. A valuation allowance has been recorded for the credit carryforwards and a portion of other temporary
differences.
10
5,575
5,895
2,406
5,399
53
4,262
1,639
25,229
(4,903)
20,326
4,318
2,167
203
565
7,253
13,073
05-10-2013
Revised 01-14-2023
Class Notes 10: Deferred Income Taxes
Microsoft Corporation
Statements of Operations for the Years Ended June 30,
(In millions, except per share amounts)
Year Ended June 30,
Revenue:
Product
Service and other
Total revenue
Cost of revenue:
Product
Service and other
Total cost of revenue
2022
$
Gross margin
Research and development
Sales and marketing
General and administrative
Operating income
Other income, net
Income before income taxes
Provision for income taxes
Net income
$
72,732
125,538
198,270
2021
$
71,074
97,014
168,088
2020
$
68,041
74,974
143,015
19,064
43,586
62,650
18,219
34,013
52,232
16,017
30,061
46,078
135,620
24,512
21,825
5,900
83,383
333
83,716
10,978
115,856
20,716
20,117
5,107
69,916
1,186
71,102
9,831
96,937
19,269
19,598
5,111
52,959
77
53,036
8,755
72,738
$
61,271
$
44,281
NOTE 12 — INCOME TAXES
Provision for Income Taxes
The components of the provision for income taxes were as follows:
(In millions)
Year Ended June 30,
2022
2021
2020
Current Taxes
U.S. federal
U.S. state and local
Foreign
Current taxes
$
8,329
1,679
6,672
16,680
$
$
$
(4,815 )
(1,062 )
175
(5,702 )
$
10,978
$
$
$
3,285
1,229
5,467
9,981
$
$
3,537
763
4,444
8,744
Deferred Taxes
U.S. federal
U.S. state and local
Foreign
Deferred taxes
Provision for income taxes
$
$
25
(204 )
29
(150 )
9,831
$
$
$
58
(6 )
(41 )
11
8,755
U.S. and foreign components of income before income taxes were as follows:
(In millions)
Year Ended June 30,
U.S.
Foreign
Income before income taxes
2022
$
$
47,837
35,879
83,716
2021
$
$
34,972
36,130
71,102
2020
$
$
11
24,116
28,920
53,036
Class Notes 10: Deferred Income Taxes
05-10-2013
Revised 01-14-2023
Effective Tax Rate
The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our
effective rate were as follows:
Year Ended June 30,
2022
2021
2020
Federal statutory rate
Effect of:
Foreign earnings taxed at lower rates
Impact of intangible property transfers
Foreign-derived intangible income deduction
State income taxes, net of federal benefit
Research and development credit
Excess tax benefits relating to stock-based compensation
Interest, net
Other reconciling items, net
21.0 %
21.0 %
21.0 %
(1.3) %
(3.9) %
(1.1) %
1.4 %
(0.9) %
(1.9) %
0.5 %
(0.7) %
(2.7) %
0%
(1.3) %
1.4 %
(0.9) %
(2.4) %
0.5 %
(1.8) %
(3.7) %
0%
(1.1) %
1.3 %
(1.1) %
(2.2) %
1.0 %
1.3 %
13.1 %
13.8 %
16.5 %
Effective rate
The components of the deferred income tax assets and liabilities were as follows:
(In millions)
June 30,
2022
2021
Deferred Income Tax Assets
Stock-based compensation expense
Accruals, reserves, and other expenses
Loss and credit carryforwards
Amortization
Leasing liabilities
Unearned revenue
Other
Deferred income tax assets
Less valuation allowance
Deferred income tax assets, net of valuation allowance
Deferred Income Tax Liabilities
$
Book/tax basis differences in investments and debt
Leasing assets
Depreciation
Deferred tax on foreign earnings
Other
Deferred income tax liabilities
Net deferred income tax assets
Reported As
$
Other long-term assets
Long-term deferred income tax liabilities
Net deferred income tax assets
$
$
$
$
$
601
2,874
1,546
10,656
4,557
2,876
461
23,571
(1,012 )
22,559
$
(174 )
(4,291 )
(1,602 )
(3,104 )
(103 )
(9,274 )
13,285
$
13,515
(230 )
13,285
$
$
$
$
$
Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets
and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid
or recovered.
As of June 30, 2022, we had federal, state, and foreign net operating loss carryforwards of $318 million, $1.3 billion,
and $2.1 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from
fiscal 2023 through 2042, if not utilized. The majority of our foreign net operating loss carryforwards do not expire.
Certain acquired net operating loss carryforwards are subject to an annual limitation but are expected to be realized
with the exception of those which have a valuation allowance. As of June 30, 2022, we had $1.3 billion federal capital
loss carryforwards for U.S. tax purposes from our acquisition of Nuance. The federal capital loss carryforwards are
subject to an annual limitation and will expire in various years from fiscal 2023 through 2025.
The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards, federal
capital loss carryforwards, and other net deferred tax assets that may not be realized.
12
502
2,960
1,090
6,346
4,060
2,659
319
17,936
(769 )
17,167
(2,381 )
(3,834 )
(1,010 )
(2,815 )
(144 )
(10,184 )
6,983
7,181
(198 )
6,983