The Role of Accounting
in Business
Reference: Textbook Chapter 1 (Warren)
BUSA 601: Fundamentals of Accounting and Finance
Jason W. Stanfield, PhD, CPA
Adapted from Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage.
Learning Objectives
• Describe the types and forms of businesses, how businesses make money,
•
•
•
•
•
and business stakeholders
Describe the three business activities of financing, investing, and operating
Define accounting and describe its role in business
Describe and illustrate the basic financial statements and how they are
integrated
Describe eight accounting concepts underlying financial reporting
Describe types of metrics and analyze a company’s performance using
return on assets
Learning Objective 1
• Describe the types and forms of businesses, how businesses make money,
and business stakeholders
Types of Businesses
Service business
• Provides services rather than products to customers
Merchandising business
• Sells products purchased from other businesses to
customers
Manufacturing business
• Changes basic inputs into products that are sold to
customers
Forms of Business
Proprietorship
Partnership
Corporation
Limited liability
company (LLC)
Characteristics of Different Forms of Business
How Do Businesses Make Money?
• Businesses earn a profit by providing goods and services to customers
• Strategies used by businesses to gain an advantage over their competitors
• Low-cost strategy
• Premium-price strategy
Exhibit 1: Business Strategies and Industries
Exhibit 2: Business Stakeholders
Learning Objective 2
• Describe the three business activities of financing, investing, and operating
Exhibit 4: Business Activities
Financing Activities: Forms of Liability
• Account payable: Liability when a company borrows from a vendor or
supplier
• Bonds payable: Any bond obligations
• Any interest due is reported as interest payable
• Note payable: Payment of the amount borrowed plus interest
• Issued on a short-term or long-term basis
• Shares of ownership issued in the form of shares of stock
• Include common stock
Investing Activities: Types of Assets
• Tangible assets
• Assets that have physical characteristics
• Intangible assets
• Include assets such as patents, goodwill, and copyrights
• Prepaid expenses are considered as assets until consumed
• Accounts receivable include rights to payments from customers who
purchase merchandise or services on credit
Operating Activities: Revenues and Expenses
• Sources of revenue
• Sales
• Fees earned
• Expenses
• Cost of goods sold, cost of merchandise sold, or cost of sales
• Selling expenses
• Administrative expenses
Learning Objective 3
• Define accounting and describe its role in business
Accounting
• Information system that provides reports to stakeholders about the
economic activities and condition of a business
• Summarizes the financial performance of a business for external
stakeholders
Branches of Accounting
Financial accounting
• Associated with preparing reports for users
external to a business
Managerial accounting
• Used to guide management in making
financing, investing, and operations
decisions for a company
Objectives of Financial Accounting
• To report the financial condition of a business at a point in time
• To report changes in the financial condition of a business over a period of
time
Exhibit 5: Objectives of Financial Accounting
Learning Objective 4
• Describe and illustrate the basic financial statements and how they are
integrated
Financial Statements
Exhibit 6: Income Statement—The Hershey Company
• Summary of revenue and expenses for a specific period of time (month,
quarter, or year)
• Reports the change in financial condition due to the operations of the
company
Exhibit 7: Statement of Stockholders’ Equity
• Reports the changes in financial condition due to changes in stockholders’
equity for a period
Exhibit 8 - Balance Sheet
Balance Sheet: Preparation
• Step 1
• Each asset is listed and added to arrive at total assets
• Step 2
• Each liability is listed and added to arrive at total
• Step 3
• Step 4
• Step 5
liabilities
• Each stockholders’ equity item is listed and added to
arrive at total stockholders’ equity
• Total liabilities and total stockholders’ equity are added
to get total liabilities and stockholders’ equity
•Total assets must equal total liabilities and
stockholders’ equity
Exhibit 9: Statement of Cash Flows
Statement of Cash Flows
• Reports the change in financial condition due to the changes in cash during
a period
• Net cash flows from operating activities
• Primary focus of a company’s stakeholders
• Concerns the employees, managers, suppliers, customers, and other stakeholders
interested in the long-term success of the company
• Net cash flows from investing activities
• Includes cash receipts from selling property, plant, and equipment
• Cash used to purchase property, plant, and equipment is reported as cash payments
Statement of Cash Flows
• Net cash flows from financing activities
• Includes any cash receipts from issuing debt or stock
• Reports any cash payments of debt and dividends
Order of Preparing Financial Statements
• 1. Income statement
• 2. Statement of changes in
stockholders’ equity
• 3. Balance sheet
• 4. Statement of cash flows
Exhibit 10: Integrated Financial Statements
Integrated Financial Statements
• Integrations help analyze:
• Financial statements
• Impact of transactions on the financial statements
Learning Objective 5
• Describe eight accounting concepts underlying financial reporting
Generally Accepted Accounting Principles (GAAP)
• Accounting rules
• Institutions that develop and regulate accounting principles and concepts
• Financial Accounting Standards Board (FASB)
• Securities and Exchange Commission (SEC)
• International Accounting Standards Board (IASB)
Accounting Concepts: Basis of GAAP
• Business entity: Company is viewed as an entity separate from its
owners, creditors, or other companies
• Cost: Assets in the accounting records should be initially recorded at their
cost or purchase price
• Going concern: Assumption that a company will continue in business
indefinitely
Accounting Concepts: Basis of GAAP
• Matching: Expenses are matched against the revenues they generate
• Based on revenue recognition and expense recognition principles
• Objectivity: Entries in the accounting records and the data reported on
financial statements should be based on verifiable or objective evidence
• Unit of measure: All economic data are to be recorded in dollars
Accounting Concepts: Basis of GAAP
• Adequate disclosure: The financial statements, including related notes,
contain all relevant data a stakeholder needs to understand the financial
condition and performance of the company
• Accounting period: Accounting data should be recorded and summarized
in financial statements for periods of time
Exhibit 13: Accounting Frauds
Company
Concept Violated
Result
Adelphia
Business Entity Concept: Rigas family
treated the company assets as their
own.
Bankruptcy. Rigas family members
convicted of fraud and lost their
investment in the company.
AIG
Business Entity Concept: Compensation CEO (Chief Executive Officer)
transactions with an offshore company
resigned. AIG paid out $126 million in
that should have been disclosed on
fines.
AIG’s books.
AOL and
Matching Concept: Back-dated contracts Civil charges filed against senior
PurchasePr to inflate revenues.
executives of both companies. Fined
o
$500 million.
Computer
Associates
Matching Concept: Fraudulently inflating CEO and senior executives indicted.
revenues.
Five executives pled guilty. Fined
$225 million.
Exhibit 13: Accounting Frauds
Company
Concept Violated
Result
Enron
Business Entity Concept: Treated
transactions as revenue, when they
should have been treated as debt.
Bankruptcy. Criminal charges against
senior executives. Over $60 billion in
stock market losses.
Fannie Mae Accounting Period Concept: Managing
earnings by shifting expenses between
periods.
CEO and CFO fired. $9 billion in
restated earnings.
HealthSout
h
Matching Concept: $4 billion in false
entries to overstate revenues.
Senior executives faced regulatory
and civil charges.
Quest
Matching Concept: Improper recognition
of $3 billion in revenue.
CEO and six other executives
charged with “massive financial
fraud.” Fined $250 million by SEC.
Exhibit 13: Accounting Frauds
Company
Concept Violated
Result
Tyco
Adequate Disclosure Concept: Failure to CEO forced to resign and was
disclose secret loans to executives that convicted in
were subsequently forgiven.
criminal proceedings.
WorldCom
Matching Concept: Improperly treated
expenses as assets.
Bankruptcy. Criminal conviction of
CEO and CFO. Over $100 billion in
stock market losses. Directors fined
$18 million.
Xerox
Matching Concept: Recognized $3
billion in revenue in periods earlier than
should have been recognized.
Fined $10 million by SEC. Six
executives fined $22 million.
Factors That Promote Accounting Frauds
Failure of individual character
• Managers and accountants perform ethical violations to
avoid pressures from supervisors
Culture of greed and ethical indifference
• Senior managers create a culture of greed and indifference
to the truth
Guidelines for Ethical Conduct
•
•
•
•
Identify an ethical decision by using your personal ethical standards of
honesty and fairness
Identify the consequences of the decision and its effect on others
Consider your obligations and responsibilities to those that will be affected
by your decision
Make a decision that is ethical and fair to those affected by it
Learning Objective 6
• Describe types of metrics and analyze a company’s performance using
return on assets
Metrics
• Any quantitative measures
• Types: Ratios and amounts
• Metric-based analysis: Use of metrics to assess financial condition,
performance, and decisions
• Level of application
• Financial statement level
• Transaction level
• Managerial decision level
Return on Assets
• Measure of a company’s profitability
• Used to compare a company’s performance over time and with its competitors
•
Expressed as a percentage or as an amount per dollar invested
•
Example: 12% rate of return on assets could also be expressed as $0.12 return per
$1 invested
Rate of Return on Assets
• Apple Inc. is approximately 1.7 (13.9% ÷ 8.2%) times more profitable as
measured by return on assets than is HP Inc.
Basic Accounting
Systems: Cash Basis
Reference: Textbook Chapter 2 (Warren)
BUSA 601: Fundamentals of Accounting and Finance
Jason W. Stanfield, PhD, CPA
Adapted from Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage.
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Elements of a Financial Accounting System
• Rules
• Framewor
k
• Controls
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Rules of an Accounting System
• Derived from accounting concepts, which are the basis of generally
accepted accounting principles (GAAP)
• Transaction: Economic event that under GAAP affects the financial statements
Framework of an Accounting System
• Transactions must be analyzed, recorded, and summarized using a
framework
•
Accounting equation
• Basis for frameworks
• Expressed as follows:
• Assets = Liabilities + Stockholders’ Equity
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 1: Integrated Financial Statement Framework
Controls of an Accounting System
• Include the following points:
• Accounting equation must balance
• Ending cash on the statement of cash flows must equal the cash on the balance sheet
• Net income on the income statement must equal the net effects of revenues and
expenses on retained earnings
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Transaction (a): Investment to Establish Business
• Dr. Landry deposits $6,000 in a bank account in the name of Family Health
Care, P.C., in return for shares of common stock in the corporation
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction (b): Borrowing Money to Finance Operations
• Family Health Care, P.C., borrows $10,000 from First National Bank to
finance its operations
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction (c): Buying Land for Cash
• Family Health Care buys land for $12,000 cash
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction (d): Fees Earned in Cash
• During the first month of operations, Family Health Care earned patient
fees of $5,500, receiving the fees in cash
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction (e): Expenses Paid in Cash
• Family Health Care paid expenses of $2,900 in September
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction (f): Dividends Paid
• Family Health Care paid $1,500 to stockholders (Dr. Lee Landry) as
dividends
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 2: Family Health Care Summary of Transactions for September
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Recording a Corporation’s First Period of Operations: Review
• Balance Sheet column reflects the accounting equation
• Two sides of the accounting equation are always equal
• Every transaction increases or decreases one or more of the balance sheet
elements
• A transaction may or may not affect an element of the statement of cash
flows or the income statement
• Every cash transaction increases or decreases the asset (cash) on the
balance sheet
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Recording a Corporation’s First Period of Operations: Review (continued)
• Ending balance of cash under the Statement of Cash Flows column equals
the ending cash balance shown on the balance sheet
• Change in retained earnings for the period is the net income minus
dividends
• Statement of cash flows is linked to the balance sheet through cash
• Income statement is linked to the balance sheet through revenues and
expenses (net income or loss), which affects retained earnings
Exhibit 3: Effects of Transactions on Stockholders’ Equity
Transaction Metric Effects: September
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Exhibit 4: Family Health Care Financial Statements for September
Exhibit 4: Family Health Care Financial Statements for September
(continued 1)
Exhibit 4: Family Health Care Financial Statements for September
(continued 2)
Exhibit 4: Family Health Care Financial Statements for September
(continued 3)
Exhibit 5: Family Health Care Integrated Financial Statements for
September
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Family Health Care: Transactions in October
• Received cash fees of $6,400
• Paid expenses
• Wages: $1,370
• Rent: $950
• Utilities: $540
• Interest: $100
• Miscellaneous: $220
• Paid cash dividends of $1,000
Exhibit 6: Family Health Care Summary of October Transactions
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction Metric Effects: October
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Exhibit 7: Family Health Care Financial Statements for October
Exhibit 7: Family Health Care Financial Statements for October (continued 1)
Exhibit 7: Family Health Care Financial Statements for October (continued 2)
Exhibit 7: Family Health Care Financial Statements for October (continued 3)
Exhibit 8: Family Health Care Integrated Financial Statements for October
Learning Objectives
• Describe the basic elements of a financial accounting system
• Analyze, record, and summarize transactions for a corporation’s first period
•
•
•
•
of operations
Prepare financial statements for a corporation’s first period of operations
Analyze, record, and summarize transactions for a corporation’s second
period of operations
Prepare financial statements for a corporation’s second period of
operations
Describe and illustrate the use of common-sized income statements in
assessing a company’s performance
Common-Sized Financial Statements
• Express financial statement amounts as a percent of a base amount
• Common-sized income statement: Expresses income statement
amounts as a percent of sales
• Common-sized balance sheet: Expresses each asset as a percent of
total assets
Operating Data of The Kroger Co.
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Common-Sized Income Statement of The Kroger Co.
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Basic Accounting
Systems: Accrual Basis
Reference: Textbook Chapter 3 (Warren)
BUSA 601: Fundamentals of Accounting and Finance
Jason W. Stanfield, PhD, CPA
Adapted from Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage.
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Accrual Basis of Accounting
• Records revenue as it is earned and matches expenses against the
revenue they generate
• Helps avoid misleading information arising from the timing of cash receipts and
payments
• Revenue is recognized when services are provided even though the cash
is to be received later
• Liabilities are recognized when a business incurs the obligation to pay for
services or goods purchased
Revenue and Expense Recognition Principle
• Revenue recognition principle: Revenue is recorded when services have
been provided or when a product has been delivered to a customer
• Expense recognition principle: Expenses are recorded in the same
period that they generate revenue
• Required by the matching concept
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Family Health Care’s November Transactions
• Integrated financial statement framework is used to analyze and record
transactions
• Accounts: Financial statement elements
• Quick assets: Include cash and other assets that can be readily converted
to cash such as receivables and marketable securities
• Normally do not include inventory since inventory must be sold and any related
receivable collected before it is converted to cash
Transaction a: Rent Received in Advance
• On November 1, Family Health Care, P.C., received $1,800 from ILS
Company as rent for the use of Family Health Care’s land as a temporary
parking lot from November 20Y5 through March 20Y6
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction b: Prepaid Insurance
•
On November 1, Family Health Care, P.C., paid a premium of $2,400 for a twoyear general business insurance policy that covers risks from fire and theft
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction c: Insurance Premium
• On November 1, Family Health Care, P.C., paid $6,000 for an insurance
premium on a six-month medical malpractice policy
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction d: Additional Capital Investment
• Dr. Landry invested an additional $5,000 in the business in exchange for
common stock
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction e: Purchases on Account
• Family Health Care, P.C., purchased supplies for $240 on account
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction f: Purchase of Equipment
• Family Health Care, P.C., purchased $8,500 of office equipment
• Paid $1,700 cash as a down payment, with the remaining $6,800 due in five monthly
installments of $1,360 beginning January 1, 20Y6
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction g: Services Provided on Account
• Family Health Care, P.C., provided services of $6,100 to patients on
account
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction h: Services Provided for Cash
• Family Health Care, P.C., received $5,500 for services provided to patients
who paid cash
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction i: Collection of Accounts Receivable
• Family Health Care, P.C., received $4,200 from insurance companies that
paid on patients’ accounts for services that had been provided
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction j: Accounts Payable
• Family Health Care, P.C., paid $100 on account for supplies that had been
purchased
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction k: Expenses Paid in Cash
• Family Health Care, P.C., paid expenses worth $4,690 for the month of
November in cash
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Transaction l: Dividends Paid in Cash
• Family Health Care, P.C., paid dividends of $1,200 to stockholders (Dr.
Landry)
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Adjustment Process
• Process of updating accounting records prior to preparing financial
statements
• Accrual accounting requires updating to match revenues and expenses
• Adjustments are necessary to update elements of the accounting equation
Exhibit 1: Deferrals and Accruals
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Deferrals and Accruals
• Deferrals
• Prepaid or deferred expenses
• Unearned or deferred revenues
• Accruals
• Accrued expenses or liabilities
• Accrued revenues or assets
Adjustment a1: Prepaid Insurance Expired
• Portion of the prepaid insurance purchased on November 1 expired
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjustment a2: Supplies Used
• As of November 30, supplies worth $150 were used in operations, leaving
a balance of $90
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation
• Reduction in the ability of a fixed asset to provide service over time
• Estimated based on the asset’s useful life
• Accumulated depreciation
• A contra asset account
• Added to the Balance Sheet column to maintain a record of the original cost of a fixed
asset for tax and other purposes
Adjustment a3: Depreciation
• Depreciation on office equipment for Family Health Care is assumed to be
$160 per month
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation: Important Points
• Land is not depreciated, because it usually does not lose its
ability to provide service
• The cost of the equipment is a type of deferred expense that is
recognized as an expense over the fixed asset’s useful life
• The cost of the fixed asset less the balance of its accumulated
depreciation is called the asset’s book value, or carrying value
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjustment a4: Unearned Revenue Earned
• Adjustment assumes that of the $1,800 received for rental of the land for
five months (November through March), one-fifth, or $360, would have
been earned as of November 30
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjustment a5: Wages Owed
• Amount owed as wages but not paid to employees is $220
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjustment a6: Services Provided
• Family Health Care provided services worth $750 to patients
• Services were not billed at the end of the month
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 3: Transaction Metric Effects—November
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 3: Transaction Metric Effects—November (continued)
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Exhibit 4: Family Health Care Income Statement for
November
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 5: Family Health Care Statement of Stockholders’ Equity for November
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Classified Balance Sheets: Types of Assets and Liabilities
• Types of assets
•
Current assets, fixed assets, and intangible assets
• Types of liabilities
•
Current liabilities and long-term liabilities
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 6: Family Health Care Balance Sheet for November
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 6: Family Health Care Balance Sheet for November (continued)
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 7: Family Health Care Statement of Cash Flows
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 8: Integrated Financial Statements—Family Health Care
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Exhibit 9: Cash versus Accrual Accounting
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Differences between Accrual and Cash Basis Financial
Statements
Accrual basis of
accounting
• Net income and net cash
flows from operating
activities may be
significantly different
Cash basis of accounting
• Net income and net cash
flows from operating
activities are equal
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Need for Accrual Basis by GAAP
• Accrual accounting is generally a better predictor of the profitability of a
company
• Use of net cash flows from operating activities
• Generally accepted accounting principles (GAAP) require reporting net cash flows
from operating activities as well as net income
• Business is required to generate positive cash flows from operating activities in the
long term in order to survive
• Long-run profitability is best analyzed using accrual accounting and net
income
Accounting Cycle
• Process that begins with analyzing transactions and ends with preparing
financial statements
• Varies based on the type of accounting for which it is used
• Cash basis of accounting
• Accrual basis of accounting
• More complex for a double-entry accounting system
• Double-entry system: Transactions are recorded in separate accounts using rules of
debit and credit
Learning Objectives
• Describe accrual accounting concepts, including the matching concept,
•
•
•
•
•
revenue recognition, and expense recognition principles
Use the accrual basis of accounting to analyze, record, and summarize
transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using the accrual basis of accounting,
including a classified balance sheet
Describe why generally accepted accounting principles (GAAP) require the
accrual basis of accounting
Describe and illustrate the use of the quick ratio in assessing a company’s
liquidity
Metric-Based Analysis
• Quick assets
• Liquidity metric that measures the amount of cash and other assets that a company
has on hand to pay current liabilities
• Quick ratio
• Computed as quick assets divided by current liabilities
• Quick ratio of at least 1.0 is normal for any industry
Computation of Quick Assets and Quick Ratio
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
Computation of Quick Assets and Quick Ratio (continued)
Warren, Survey of Accounting, Ninth Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
cc
4
TIME VALUE OF
MONEY
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duplicated, or posted to a publicly accessible website, in whole or in part.
LEARNING OUTCOMES
1. Identify various types of cash flow patterns
(streams) seen in business.
2. Compute the future value of different cash
flow streams. Explain the results.
3. Compute the present value of different cash
flow streams. Explain the results.
4. Compute (a) the return (interest rate) on an
investment (loan) and (b) how long it takes to
reach a financial goal.
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CFIN6 | CH4
2
LEARNING OUTCOMES (continued)
5. Explain the difference between the Annual
Percentage Rate (APR) and the Effective
Annual Rate (EAR). Explain when it is
appropriate to use each.
6. Describe an amortized loan. Compute (a)
amortized loan payments and (b) the amount
that must be paid on an amortized loan at a
specific date during the life of the loan.
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3
Time Value of Money (TVM)
• The principles and computations used to revalue cash
payoffs from different times so they are stated in dollars
of the same time period.
• Dollar amounts from different time periods should never
be compared; rather, amounts should be compared only
when they are stated in dollars at the same point in
time.
• Dollars from different time periods have opportunities to
earn different amounts (numbers of periods) of interest
(return).
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4
Time Value of Money (TVM) (continued 1)
• At a 10 percent opportunity cost rate, which is
better, receiving $700 today or receiving $935 in
three years?
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5
Time Value of Money (TVM) (continued 2)
• To answer the question, we must revalue the
cash payoffs so they are stated in dollars at the
same time period.
Year (n):
0
Cash flows:
Option A: VA= $700
r = return = 10%
1
2
Translate the current $700 into an
FV amount by adding interest.
3
? = FVA3
OR
Option B: PVB=
?
Translate the future $935 into a
PV amount by taking out interest.
$935 = FVB3
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6
Cash Flow Time Lines
Graphical representations used to show timing of cash flows
0
PVA = 700.00
r = 10%
1
2
3
? = FV3
PV = Present Value—the beginning amount that can be
invested (current value of some future amount).
FV = Future Value—the value to which an amount invested
today will grow at the end of n periods at an opportunity cost
rate equal to r.
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7
Types of Cash Flow Patterns
• Lump Sum Amount—a single payment
(received or made) that occurs either today or
at some date in the future.
• Annuity—multiple payments of the same
amount over equal time periods.
• Uneven Cash Flows—multiple payments of
different amounts over a period of time.
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8
Future Value
• Compounding—to compute the future value of
an amount we push forward the current amount
by adding interest for each period in which the
money can earn interest in the future.
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9
Ways to Solve TVM Problems
• Use a cash flow timeline
• Use an equation
• Use a financial calculator
• Use a spreadsheet
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CFIN6 | CH4
10
FVn Cash Flow Timeline Solution
The Future Value of $700 invested at 10% per
year for three (3) years
0
PVA = 700.00
r = 10%
x 1.10
1
770.00
2
x 1.10
847.00
3
x 1.10
931.70 = FV3
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11
FVn Equation Solution
The cash flow timeline solution can be written in
equation form as:
FV3 = $700(1.10)3
This relationship is generalized as:
FVn = PV(1 + r)n
= $700(1.10)3
= $700(1.33100)
= $931.70
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12
FVn Financial Calculator Solution
Inputs:
Outputs:
3
10
− 700
0
?
N
I/Y
PV
PMT
FV
= 931.70
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13
FVn Spreadsheet Solution—MS Excel
• Set up a table that contains the data used to
solve the problem.
• Click fx and choose the FV function.
• Click the cells containing the appropriate data
to enter the data into the FV function.
• Calculate the answer.
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14
FVn Spreadsheet Solution—MS Excel
(continued)
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15
Future Value of an Annuity—FVA
• Annuity—a series of equal amounts paid at
equal intervals.
• Ordinary (deferred) Annuity—an annuity with
payments that occur at the end of each period.
• Annuity Due—an annuity with payments that
occur at the beginning of each period.
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CFIN6 | CH4
16
What’s the Future Value of a Three-Year
Ordinary Annuity of $400 at 5%?
0
r = 5%
1
2
3
400
400
400
x (1.05)1
x (1.05)2
Value of Each Deposit
at the End of Year 3
x (1.05)0
400
420
441
FVA3 = 1,261.00
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17
FVAn Equation Solution
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CFIN6 | CH4
18
FVAn Equation Solution (continued)
 (105)3 − 1
FVA 3 = 400 

 0.05 
= 400(3.1525)
= 1,261.00
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19
FVAn Financial Calculator Solution
Inputs:
Output:
3
N
5
I/Y
0
PV
− 400
PMT
?
FV
= 1,261.00
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20
FV of an Annuity Due—FVA(DUE)n
Payments are made at the beginning of the year, which
means each payment earns one additional year’s worth
of 5 percent interest.
0
1
2
400
400
r = 5%
400
3
Value of Each Deposit
at the End of Year 3
x (1.05)0 x (1.05)
x (1.05)1 x (1.05)
x (1.05)2 x (1.05)
FVA(DUE)3 =
420.00
441.00
463.05
1,324.05
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21
FVA(DUE)n Equation Solution
Include one additional year’s worth of 5 percent
interest in the computation.
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22
FVA(DUE)n Equation Solution (continued)
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23
FVA(DUE)n Financial Calculator Solution
BGN
Inputs:
Output:
3
N
5
I/Y
0
PV
−400
PMT
?
FV
= 1,261.00
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24
Cash Flow Streams
• Payment = PMT = constant cash flows—that is,
an annuity stream.
• Cash flow = CF = cash flows in general, both
constant cash flows (i.e., annuities) and
uneven cash flows.
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25
Find the FV of an Uneven Cash Flow Stream—
FVCFn
0
r = 5%
1
2
3
400
300
250
x (1.05)1
x (1.05)2
Value of Each Deposit
at the End of Year 3
x (1.05)0
250.00
315.00
441.00
FVCF3 = 1,006.00
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26
FVCFn Equation Solution
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27
FVCFn Equation Solution (continued)
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28
Present Value, PV
• Present value is the value today of a future
cash flow or series of cash flows.
• Discounting is the process of finding the
present value of a future cash flow or series of
future cash flows
• Finding the present value (discounting) is the
reverse of finding the future value
(compounding); i.e., interest is taken out of a
future amount to determine its present value.
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29
PV of a Lump-Sum Amount—PV
Discounting—to compute the present value of an
amount we bring back to the present a future
amount by taking out interest for each period in
which the money can earn interest in the future.
0
PVB = 702.48
r = 10%
1 x
1.10
1
772.73
2
1 x
1.10
850.00
3
1
x
1.10
935.00=FV3
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30
PV of a Lump-Sum Amount—Equation Solution
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31
PV of a Lump-Sum Amount—Equation Solution
(continued)
What is the PV of $935 due in three (3) years if r =
10%?
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32
PV of a Lump-Sum Amount—Financial
Calculator Solution
Inputs:
Outputs:
3
N
10
I/Y
?
PV
0
PMT
935
FV
= −702.48
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33
Present Value of an Annuity (Ordinary)—PVAn
• PVAn = the present value of an annuity with n
payments, each made at the end of the
period.
• Each payment is discounted, and the sum of
the discounted payments is the present value
of the annuity.
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34
PVAn Cash Flow Timeline Solution
What is the PV of a three-year $400 ordinary
annuity if r = 5%?
Value of Each FV
Amount Today
(Year 0)
0
380.95
362.81
345.54
1,089.30 = PVA3
1
2
3
1 x 400
(1.05)1
400
400
r = 5%
1 x
(1.05)2
1 x
(1.05)3
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35
PVAn Equation Solution
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CFIN6 | CH4
36
PVAn Equation Solution (continued)
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37
PVAn Financial Calculator Solution
Inputs:
Outputs:
3
N
5
I/Y
?
PV
400
PMT
0
FV
= −1,089.30
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38
Present Value of an Annuity Due—PVA(DUE)n
Payments are made at the beginning of the year, which
means one less year of 5 percent interest is taken out
of each payment.
PV of Each FV
Amount Today
(Year 0)
(1.05) x
0
2
400
400
r = 5%
1 x 400
(1.05)1
(1.05) x
400.00
380.95
362.81
1,143.76 = PVA(DUE)3
1
1 x
(1.05)1
(1.05) x
3
1 x
(1.05)2
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39
PVA(DUE)n Equation Solution
Include one additional year’s worth of 5 percent interest.
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40
PVA(DUE)n Equation Solution (continued)
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41
PVA(DUE)n Financial Calculator Solution
BGN
Inputs:
Output:
3
N
5
I/Y
?
PV
−400
PMT
0
FV
= 1,143.76
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42
Perpetuities—PVP
Streams of equal payments that are expected to
go on forever; perpetual annuities
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43
Perpetuities—PVP (continued)
This example illustrates a fundamental principle in
finance: Everything else equal, the higher the rate of
return, the lower the value of an investment.
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44
PV of an Uneven Cash Flow Stream—PVCFn
Value of Each FV
Amount Today
(Year 0)
0
380.95
272.11
215.96
869.02 = PVCF3
1
2
3
1 x 400
(1.05)1
300
250
r = 5%
1 x
(1.05)2
1 x
(1.05)3
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45
PVCFn Equation Solution
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CFIN6 | CH4
46
PVCFn Equation Solution (continued)
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47
PVCFn Financial Calculator Solution
• Input in “CF” register:
• CF0 = 0
• CF1 = 400
• CF2 = 300
• CF3 = 250
• Enter I = 5
• Press NPV button to get NPV = -869.02.
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48
Comparison of FV with PV
• FV contains interest, whereas PV does not.
• At an opportunity cost rate of 10 percent:
• a lump-sum payment of $700 today is the
same as a lump-sum payment of $931.70 in
three years.
• The PV of $700 has no interest; the FV of
$931.70 contains three years of interest,
which equals $231.70.
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49
Comparison of FV with PV (continued)
0
1
2
3
FV1 = 770.00
FV2 = 847.00
FV3 = 931.70
r = 10%
PV = 700.00
PV at Year 0 = 700 = PV at Year 0 = 700 = PV at Year 0 = 700 = PV at Year 0 = 700
Total = 70.00
Interest from:
Year 1 = 70.00
Year 2 = 77.00
Interest from:
Year 1 = 70.00
Interest from:
<
Total = 70.00
<
Total = 147.00
<
Interest from:
Year 1 = 70.00
Year 2 = 77.00
Year 3 = 84.70
Total = 231.70
The values given under the tick marks for each year differ
only because they contain different amounts of interest.
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50
Solving for Interest Rates (r)
Suppose you pay $78.35 for an investment that
promises to pay you $100 five years from today.
What annual rate of return will you earn on your
investment?
0
PV = -78.35
r= ?
1
…
4
5
100.00 = FV5
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51
Solving for r—Financial Calculator Solution
Inputs:
Output:
5
N
?
I/Y
−78.35
PV
0
PMT
100.00
FV
= 5.00
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52
Solving for Time (n)
A security that costs $68.30 will provide a return
of 10 percent per year. If you want to keep the
investment until it grows to a value of $100, how
long will you have to keep it?
0
PV = -68.30
r = 10%
1
…
n-1
n=?
100.00 = FVn
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53
Solving for n—Financial Calculator Solution
Inputs:
?
N
10
I/Y
−68.30
PV
100.00
0
PMT
FV
Output: = 4.0
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54
Semiannual and Other Compounding Periods
• Annual compounding is the process of
determining the future value of a cash flow or
series of cash flows when interest is earned
(added) once per year.
• Semiannual compounding is the process of
determining the future value of a cash flow or
series of cash flows when interest is added
twice per year.
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55
FV of a lump sum
• The FV of a lump sum be larger if interest is
compounded more often, holding the stated r
constant? Why?
• If compounding is more frequent than once
per year—for example, semi-annually,
quarterly, or daily—interest is earned on
interest—that is, compounded—more often.
• Compared to annual compounding, a greater
amount of interest is earned when interest is
compounded more than once per year.
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CFIN6 | CH4
56
Distinguishing Between Different Interest Rates
rSIMPLE = Simple (Quoted) Rate
used to compute the interest paid per period
APR = Annual Percentage Rate = rSIMPLE
rEAR = Effective Annual Rate
the annual rate of interest actually being earned
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CFIN6 | CH4
57
Comparison of Different Types of
Interest Rates
• rSIMPLE: Simple, or quoted rate; not used in
calculations.
• rPER: Periodic rat; rate per period (e.g., per
year, per month, etc.); used in calculations.
• rEAR: Effective annual rate; used to
compare returns on investments with
different interest compounding per year.
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CFIN6 | CH4
58
Simple (Quoted) Rate
• rSIMPLE is stated in contracts
Interest periods per year (m) must be given
• Examples:
• 9%, compounded quarterly
• 9%, compounded daily (365 days)
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CFIN6 | CH4
59
Periodic Rate, rPER
• Periodic rate = rPER = rSIMPLE/m, where m is
number of compounding periods per year
• Examples:
• 9%, compounded quarterly: m = 4 and rPER =
9%/4 = 2.25%
• 9%, compounded monthly: m = 12 and rPER =
9%/12 = 0.75%
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CFIN6 | CH4
60
Effective Annual Rate, rEAR
The annual rate that causes PV to grow to the
same FV as it would with multi-period
compounding.
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CFIN6 | CH4
61
Computing rEAR
• What is the effective annual return (EAR) for an
investment that pays 12 percent interest,
compounded monthly?
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CFIN6 | CH4
62
Amortized Loans
• Amortized Loan—a loan that is repaid in equal
payments over its life.
• A portion of the payment represents interest and the
remainder represents repayment of the amount that
was borrowed.
• Amortization schedules show how much of each
payment represents principal repayment and how
much represents interest.
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CFIN6 | CH4
63
Amortization Schedule
An amortization schedule for a $33,000, 6.5
percent loan that requires three equal annual
payments.
Year
0 r = 6.5% 1
15,000
PMT = ?
2
3
PMT = ?
PMT = ?
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CFIN6 | CH4
64
PMT Financial Calculator Solution
Inputs:
Output:
3
N
6.5
I/Y
33,000
PV
?
PMT
0
FV
= −12,460
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CFIN6 | CH4
65
Amortization Schedule (continued)
Year
Beginning of Payment
Year Balance
(2)
(1)
Interest
@ 6.5%
(3) = (1) ×
0.065
Repayment
of Principal
(4) = (2) − (3)
Remaining
Balance
(5) = (1) −
(4)
1
$33,000.00
$12,460
$2,145
$10,315.00
$22,685.00
2
22,685.00
$12,460
1,474.53
10,985.48
11,699.53
3
11,699.53
$12,460
760.47
11,699.53
0.00
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CFIN6 | CH4
66