Relationship between the Reports
Retained earning links the profit and loss account to the balance sheet, as the figure
below show:
Balance
Sheet
.
.
.
Year 2012
Balance
Sheet
.
Profit and Loss Account
Year
2013
.
.
Year
2014
The Package of accounting below shows how these two different reports are linked
together.
A “PACKAGE” OF ACCOUNTING REPORTS
Balance Sheet as of
December 31, 2012
Income Statement
For the Year 2013
ASSETS
Current assets
Fixed assets
Other assets
Total Assets
$ 23,839,904
14,255,720
180,535
$38,276,159
EQUITIES
Current liabilities $ 12,891,570
Other liabilities
3,000,000
Common stock
15,000,000
Retained earnings
7,384,589
Total Equities $ 38,276,159
Net sales
Less: Cost of sales
Gross margin
Less: Expenses
$ 75,478,221
52,227,004
$ 23,251,217
$10,784,830
Income before taxes
$ 12,466,387
Provision for income taxes 6,344,000
Net income
$ 6,122,387
Retained earnings,
Beginning
7,384,589
$ 13,506,979
Less: Dividends
4,390,000
Retained Earnings, Ending $ 9,116,976
1
Balance Sheet
As of December 31,2013
ASSETS
Current assets
Fixed assets
Other assets
Total Assets
$22,561,072
13,411,779
173,214
$36,236,065
EQUITIES
Current liabilities
Other liabilities
Common stock
Retained earnings
Total Equities
$ 9,119,089
3,000,000
15,000,000
9,116,976
$ 36,236,065
The package of accounting above shows that the balance sheet for the beginning of
the period i.e. year 2013, is linked to the profit and loss account for the period, by the
“retained earning” item that is in this case $7,384,589 for the begin of year 2013. The
amount of retained earning for the end of year 2003 is then calculated in the profit
and loss account for the same year, producing $9,116,976 that is used in compilation
of the balance sheet for the end of the period. The two main accounting reports are
hence linked in this way using alternately the balance sheets and the profit and loss
accounts.
CASE STUDY 4
In 2010, Eric Jones opened his own retail store. At the end of 2011 his first full year
of operation, he thought he had done moderately well and he was therefore somewhat
disappointed and even angry when his nominated accountant sent him figures which
indicated that he had operated at a loss.
Mr Jones had been employed as manager of the local unit of Tesco chain stores for
several years. In 2010 he received an inheritance. This, together with his savings,
2
provided him with enough funds to buy a small store building on the main street of
his town for $75,000.
Exhibit 1
Income statement for 2011, as prepared by Mr Jones
Gross sales …………………………………………………………..
Less: Returns and allowances to customers………………………..
Net Sales……………………………………………………………..
Cost of merchandise sold…………………………………………….
Gross margin…………………………………………………………
Expenses:
Salaries and wages…………………………………… $ 10,848
Advertising……………………………………………
1,773
Supplies and postage……………………………………
1,189
Taxes, insurance, repairs, and depreciation on building… 2,020
Heat, light, and power…………………………………..
639
Business and social security taxes………………………
1,488
Insurance ………………………………………………..
708
Depreciation on equipment………………………………
562
Interest expense………………………………………….
360
Miscellaneous expense………………………………….
2,640
Income taxes…………………………………………….
1,830
Net Income……………………………………………
$ 102,891
3,639
99,252
64,129
$ 35,123
$ 24,057
11,066
Early in 2012 the accountant sent Mr Jones a standard form and requested that he
report his revenue and expenses on this form and return it. Exhibit 1 shows the
figures which, with some difficulty, Mr Jones entered on this form. Subsequently, he
received a request from the accountant for information on his salary and on the rental
value of his building. Mr Jones answered substantially as follows:
I own my own business, so there is no point in my charging myself a salary. I drew
$14,000 from the business in 2011 for my personal use. My annual salary as a
manager of a Tesco store in recent years was $12,000, although I don’t see what
bearing this has on the figures for my own store. I thought I made it clear in my
original submission that I own my own building. It would cost me $5,400 a year to
rent a similar building and you can see from the figures that I save a considerable
amount of money by not being forced to rent.
3
On the basis of the information in this letter, the accountant revised Mr Jones’s
figures and sent him the income statement shown in Exhibit 2. Mr Jones was quite
upset by this revised statement.
Exhibit 2
Income statement for 2011, as revised by accountants
Gross sales………………………………………………………
Less: Returns and allowances to customers …………………..
Net sales…………………………………………………………
Cost of merchandise sold………………………………………..
Gross margin ……………………………………………………
Expenss:
Salaries and wages ………………………….. $ 22,848
Advertising …………………………………..
1,773
Supplies and postage…………………………
1,189
Rent…………………………………………..
5,400
Heat, light, and power………………………..
639
Business and social security taxes……………
1,488
Insurance……………………………………..
708
Depreciation on equipment…………………..
562
Interest expense………………………………
360
Miscellaneous expenses………………………
2,640
Net Loss ……………………………………..
$ 102,891
3,639
99,252
64,129
$ 35,123
37,607
$ 2,484
He showed it to a friend and said:
These fancy accountants have gotten my figures all mixed up. I want to know the
profit I have made by operating my own business rather than by working for
somebody else. They have turned my profit into a loss by calling part of it salary and
part of it rent. This is merely shifting money from one pocket to another. On the other
hand, they won’t even let me show my income tax as an expense. I realize that the tax
is levied on me as an individual rather than on the business as such, but my only
source of income is my store, and I therefore think the tax is a legitimate expense of
my store.
Question
1- How much profit did Mr Jones’s store earn in 2011? How do you explain the
difference between the profit shown on Exhibit I and the loss shown on Exhibit 2?
What, if any, accounting principles are violated in either statement?
4
2- From business strategy point of view, should Mr Jones continue to operate his
store? Has he been successful?
CASE STUDY 5
After six months of operation, Victor Peterson and Harold Corning met to decide
what to do next with their “baby,” Vitar Electronics, Inc. The company seemed to be
off to a profitable start, and they were intrigued by the possibility of changing it from
a part-time to a full-time venture.
Mr Peterson, 29, was a production engineer for the Davis Machine Company, a large
manufacturer; Mr Corning, 32, was on the sales promotion staff of the same
company. Each earned a salary of $12,000 per year. They were neighbors the close
friends. Mr Peterson had an inventive bent, and among his ideas was a now type of
stepping switch. A stepping switch is a device, which activates a number of electrical
circuits in sequence automatically, one after other. One of its uses is in product
inspection and testing. On his own time, Mr Peterson developed a working model and
applied for a patent. He interested the Davis quality control department in his
stepping switch, and after tests and negotiation, the Davis Company, on May 1,
agreed to purchase 20 units at $565 each.
Messrs Peterson and Corning thereupon formed Vitar Electronics, Inc. Each took 200
shares of stock in exchange for $3,000 cash, a sizable fraction of their savings. Mr
Peterson also assigned his rights in the invention to the corporation in exchange for a
non interest-bearing 10-year note in the amount of $7,500.
5
Exhibit 1
VITAR ELECTRONICS, INC.
Financial Statements as October 31
Balance Sheet
ASSETS
Current Assets:
Cash
Accounts receivable
Inventory of parts and components
Completed stepping switches
Total Current Assets
Equipment (at cost)
Patent rights
Tiotal Assets
$
610
1,130
3,543
1,752
$
$
4,319
7,500
7,035
11,819
$ 18,854
=======
EQUITIES
Liabilities:
Accounts payable
Notes payable
Total Liabilities
Capital:
Capital stock
Retained earning
Total Capital
Total Equities
$ 1,480
7,500
$ 8,980
$ 6,000
3,874
9,874
$18,854
Income Statement for Six Months
Sales
Cost of sales
Gross margin
Advertising
Other expenses
Net Income
$ 14,125
7,203
$ 6,922
$ 2,193
855
$
6
3,048
3,874
The manufacture of the stepping switch involved principally assembly and wiring.
The two men did this themselves in Mr Corning’s basement, working evenings and
weekends. The 20 units were completed, and payment received, by September.
Meanwhile, Mr Corning wrote and placed free “product announcements” and a small
amount of paid advertising in trade publications. These resulted in inquiries that led
to orders for additional units from other companies. The owners were thereby
encouraged to seek sales more vigorously, so in September they placed larger
advertisements costing a total of approximately $1,500. In order to be able to fill
promptly the orders expected to result from this advertising, they continued to
assemble stepping switches in September and October, and by the end of October had
six completed units on hand. They also had on hand a supply of printed circuits and
other component parts, most of which were made to Vitar’s specifications by outside
companies.
During the entire six-month period from May 1 to October 31, Messrs. Peterson and
Corning each worked about 10 hours a week making stepping switches, plus some
additional time in preparing promotional material, answering inquiries, talking with
prospective customers, and handling other Vitar problems. During this time they had
paid themselves no salary, since Vitar’s available cash was needed to buy
components and to pay for equipment, most of which was built to their design in a
local machine shop. They decided that the time had come to think about devoting full
time to vitar. As part of their appraisal of where they stood, Mr Corning prepared the
financial statements shown in Exhibit 1. In addition to the component parts shown on
the balance sheet, Vitar had also ordered $2,731 of printed circuits and other
components, with delivery expected some time in November.
Mr Peterson, upon seeing these statements, remarked: “Not bad for a starter. Even
with our organization costs and advertising expenses deducted, we show an excellent
profit and a very gratifying return on our investment.”
Questions
1. Comment on the performance of Vitar Electronics, Inc., and its status on October
31.
2. What additional information, if any, would you need before recommending a
course of action for Messrs Peterson and Corning.
7
CASE STUDY 6
John Bartlett was the inventor of a hose-clamp for automobile hose connections. The
clamp would soon be give a patent, whose legal life was 17 years. Having confidence
in the clamp’s commercial value, but possessing no excess funds of his own, he
sought among his friends and acquaintances for the necessary capital to put the hoseclamp on the market. The proposition which he placed before possible associates was
that a corporation, Bartlett Manufacturing Company, should be formed with capital
stock of $25,000.
The project looked attractive to a number of the individuals to whom the inventor
presented it, but the most promising among them-a retired manufacturer-said he
would be unwilling to invest his capital without knowing what uses were intended for
the cash to be received from the proposed sale of shares in the new company. He
suggested that the inventor determine the probable costs of experimentation and of
special machinery, and prepare for him a statement of the estimated assets and
liabilities of the proposed company when ready to begin actual operation. He also
asked for a statement of the estimated transactions for the first year of operations, to
be based on studies the inventor had made of probable markets and costs of labor and
material. This information Mr Bartlett consented to supply to the best of his ability.
After consulting the engineer who had aided him in constructing his patent models,
Mr Bartlett drew up the following list of data relating to the transactions of the
proposed corporation during its period of organization and development:
1. The retired manufacturer would pay the corporation $10,000 cash for which he
would receive share with a nominal value of $10,000. The remaining shares
(nominal value, $15,000) would be given to Mr Bartlett in exchange for the patent
on the hose-clamp.
2. Probable cost of incorporation and organization, including estimated officers’
salaries during developmental period, $1,650.
3. Probable cost of developing special machinery, $5,000. This sum includes the cost
of expert services, materials, rent of a small shop, and the cost of power, light, and
miscellaneous expenditures.
4. Probable cost of raw materials: $500, of which $300 is to used in experimental
production.
On the basis of the above information, Mr Bartlett prepared the estimated balance
sheet shown in Exhibit 1.
8
Exhibit 1
BARTLETT MANUFACTURING COMPANY
Estimated Balance Sheet as of the Date Company Begins Operations
ASSETS
Cash……………………………. $ 2,850
Inventory……………………….
200
Machinery……………………… 5,000
Organization costs……………… 1,650
Experimental costs…………….. 1,300
Patent …………………………. 15,000
Total Assets………………….. 25,000
EQUITIES
Shareholders’ equity ……. $ 25,000
Total Equities ………….. $ 25,000
Mr Bartlett then set down the following estimates as a beginning step in furnishing
the rest of the information desired:
1. Expected sales, all to be received in cash by the end of the first year of operation,
$84,000.
2. Expected additional purchases of rew materials and supplies during the course of
this operating year, all paid for in cash by end of year, $27,000.
3. Expected borrowing from the bank during year $2,000. Interest on these loans,
$150.
4. Expected payroll and other cash expenses and manufacturing costs for the
operating year: $23,000 of manufacturing costs (excluding raw materials and
supplies) plus $6,000 for selling and administrative expenses, a total of $39,000.
5. New equipment to be purchased for cash, $1,000.
6. Expected inventory of raw materials and supplies at close of period, at cost,
$5,000.
7. No inventory of unsold hose-clamps expected as of the end of the period. All
products to be manufactured on the basis of firm orders received; none to be
produced for inventory.
8. All experimental and organization costs, previously capitalized, to be charged
against income of the operating year.
9. Estimated depreciation of machinery, $600.
10.Dividends paid in cash, $3,000.
11.Estimated tax expense for the year, $4,225. This amount would not be due until
early in the following year.
9
It should be noted that the transactions summarized above would necessarily take
place in the sequence indicated. In practice, a considerable number of separate events,
or transactions, would occur throughout the year, and many of them were dependent
on one another. For example operations were begun with an initial cash balance and
inventory of materials, products were manufactured, and sales of these products
provided funds for financing subsequent operations. Then, in turn, sales of the
product subsequently manufactured yielded more funds.
Questions
1. Trace the effect on the balance sheet of each of the projected events appearing in
Mr Bartlett’s list. Thus, item 1, taken alone, would mean that cash would be
increased by $84,000 and that (subject to reductions for various costs covered in
later items) shareholders’ equity would be increased by $84,000. Notice that in
this question you are asked to consider all items in terms of their effect on the
balance sheet.
2. Prepare an income statement covering the first year of planned operations and a
balance sheet as of the end of that year.
3. Assume that the retired manufacturer received capital stock with a nominal value
of $8,000 for the $10,000 cash he paid to the corporation, John Bartlett still
receiving shares with a nominal value of $,000 in exchange for his patent. Under
these circumstances, how would the balance sheet in Exhibit 1 appear?
4. Assume that the management is interested in what the results would be if no
products were sold during the first year, even though production continued at the
level indicated in the original plans. The following changes would be made in the
11 items listed above: Items 1, 6, 7, 10 and 11 are to be disregarded. Instead of
Item 3, assume that a loan of $78,000 is obtained, that the loan is not repaid, but
that interest thereon of $9,350 is paid during the year. Prepare an income
statement for the year and a balance sheet as of the end of the year. Contrast these
financial statements with those prepared in Question 2.
10
CASE STUDY 7
James Stanton took his savings, some money his parents had left him, some material
he found in his parent’s garage, and started business for himself. It wasn’t a large
business, but if did give him the pleasure of being his own boss, and combined the
inside work of manufacturing with the outside work of selling. His product was a
painted wooden toy train the was priced at retail at $35.20 each. It was a well-built
toy, designed to be reminiscent of the hand –made toys of his grandfather’s
generation. Stanton was an energetic person and he soon had output rolling. This had
been accomplished despite difficulties, chiefly with paint, but at last Mr. Stanton had
found a supplier who promised to provide him with the necessary quality.
At the end of the first six months’ experience, James Stanton took pride in his first
profit and loss statement. He hoped it would be the forerunner of a long series of
reports showing operations “in the black.”
Income Statement for Six Months Ending December 31
Net Sales …………………………….
Beginning inventory, July 1 …………
Purchases of material ………………..
Labor…………………………………
Rent of machines and space …………
$11,620.49
$ 210.00
$ 7,007.00
11,347.63
2,926.14
Less: Inventory at end of period, December 31
Cost of goods sold …………………………
Gross margin ……………………………….
Advertising and other selling expenses ……. $ 2,114.32
Interest ……………………………………..
73.50
Net Income ………………………………...
21,280.77
$21,490.77
16,086.70
5,404.07
$ 6,216.42
$ 2,187.82
$ 4,028.60
Mr. Stanton’s “balance sheet” as of December 31 appeared as follows:
Assets:
Cash ………………………………………………
Inventory, at cost …………………………………
Less: Liabilities:
Note payable, L.K. Stanton ………………………
Accounts payable …………………………………
Leaving James Stanton’s Net Worth as ………………
11
$ 428.26
16,086.70 $16,514.96
$4,200.00
3,835.30
8,035.30
$ 8,479.66
Questions
1) Comment on Mr Stanton’s performance to date on his prospects for the future.
2) How much would you be prepared to pay for the business as a going concern?
CASE STUDY 8
Mr Smith of the ABC Company started the year in fine shape. His company made
widgets-just what the customer wanted. He made them for $0.75 cash, sold them for
$1. He kept an inventory equal to shipments of the past 30 days, paid his bills
promptly and billed his customers 30-days net. The sales manager predicted a steady
increase of 500 widgets each month. It looked like his lucky year and it began this
way:
January 1. Cash, $875; receivables, $1,000; inventory, $750
JANUARY
In January, he sold 1,000 widgets; shipped them at a cost of $750;
collected his receivables-winding up with a tidy $250 profit.
February 1. Cash, $1,125; receivables, $1,000; inventory, $750.
FEBRUARY
This month’s sales jumped, as predicted, to 1,500. With a corresponding
step-up in production to maintain his 30-day inventory, he made
2,000 units at a cost of $1,500. All receivables from January sales were
collected. Profit so far, $625.
12
March 1. Cash, $625; receivables, $1,500; inventory, $1,125.
MARCH
March sales were even better: 2,000 units. Collections: On time.
Production, to adhere to his inventory policy: 2,500 units. Operating
results for the month, $500 profit. Profit to date: $1,125. His books:
April 1. Cash, $250; receivables, $2,000; inventory, $1,500. His books therefore
showed:
APRIL
During April sales rose again to 2500 units. All strategies remained as
Planned before. Profit for the month was $625. Total profit so far for the
is $1,750. It looked like his lucky year.
It was, however, near the end of April that the business ran out of cash. It could not
pay for its operating costs. Production could therefore cease soon and together with
that, a corresponding sharp drop in sales and hence revenue. It seemed to have run
out of luck!
Questions
1) Could the disasterous situation have been predicted, how?
2) What exactly caused the seemingly prosperous business to fail?
3) Can you think of a survival plan?
13
Statement of Changes in Financial Position (SCFP)
Another accounting report that, although is not compulsury from legal point of view
but it can be very useful to the management. Medium and top managers are the most
likely users of the report. The statement has nothing what-so-ever to do with either
financial position or profitability. It merely concerns itself with cash flow movements
in the company during a certain period of time, hence a flow report.
The report is sometimes called “Cash Flow Statement”. Its main virtues are:
1) Since liquidity of any firm is a major determinant of its general health, the
report helps the management to optimize the liquidity/profitabilty trade-off.
2) The statement in effect lists sources and uses of cash in any given period. It can
therefore be used to assess availability and the amount of cash for future
investment projects.
There are numerous methods for its construction. It can be deduced from a set of two
balance sheets and one profit and loss account. The profit and loss account should be
the one for the year whose SCFP is required and the two balance sheets relate to to
beginning and end of the year. The example below demonstrate a simple way for
construction of an SCFP.
Example:
MBM company started its business in the beginning of year 2013. At the end of the
year the compny produced its income statement (Profit and Loss Account) for year
2013 as follow:
Profit and Loss Account for Year 2013
Revenues……………………………………..
Cost of sales………………………………….
Gross margin……………………………..
Other expenses:
Rentals……………………………………
Depreciation……………………………..
14
$ 48,150
35,800
$ 12,350
$
5,400
600
Utilities ………………………………….
Miscellaneous supplies………………….
Interest…………………………………..
Income before taxes…………………………
Income tax expense…………………………
Net income………………………………….
2,200
1,000
180
9,380
$ 2,970
$ 650
$ 2,320
======
The Balance Sheets for the beginning and the end of year 2013 are also provided as
can be seen below:
Balance Sheets for the Beginning and End of 2013
Assets
As of 1.1.2013
Cash
Accounts Receivable
Notes Receivable
Machinery and Equipment at cost
Less Depreciation
Total Assets
As of 31.12.2013
$1,200
$3,750
0
150
0
500
0
3,000
0
(600)
---------------------------------------------$1,200
$6,800
Claims
Accounts Payable
Deferred Income
Loan Unpaid Interest
Notes Payable
Initial Capital
Retained Earnings
Total Claims
$0
$1,000
0
100
0
180
0
2,000
1,200
1,200
0
2,320
-----------------------------------------------$1,200
$6,800
Using these three reports the SCFP report for the year 2013 on cash basis can be
written. The first construction method simply goes through the three reports looking
for sources and uses of cash during the period, making adjustments whenever
necessary. These can be checked against each other. This method is illustrated below:
15
Sources of Cash
From operations:
Revenues ………………………………………
Adjustments to convert to cash basis:
Increase in accounts receivable ……………….
Increase in deferred revenue …………………
Cash generated from revenues ……………….
Expenses…………………………………………
Adjustments to convert to cash basis:
Depreciation expense …………………………
Increase in accounts payable …………………
Increase in accrued interest ……………………
Cash disbursed for expenses……………………
Net cash generated by operations ………………….
From other sources:
Mortgage note …………………………………
Total sources of cash ………………………………
Uses of Cash
Notes receivable ……………………………….
Acquisition of equipment ……………………..
Total uses of cash ……………………………….
Net Increase in Cash ………………………………
$ 48,150
(150)
100
$ 48,100
$ 45,830
(600)
(1,000)
(180)
44,050
$ 4,050
2,000
$ 6,050
$ 500
3,000
$ 3,500
$ 2,550
Summary of the cash basis Receipts and Disbursements for the year 2013 can
therefore be produced:
Receipts:
Sales ……………………………….
Deferred income ……………………
Total Receipts ……………………
Disbursements:
Cost of sales ……………………….
Rentals …………………………….
Utilities ……………………………
Miscellaneous supplies ……………
Tax estimate payments ……………
Equipment down payment ………..
Notes Receivable………………….
Total disbursements …………….
Increase in Cash Balance …………….
$ 48,000
100
$ 48,100
$ 34,800
5,400
2,200
1,000
650
1,000
500
45,550
$ 2,550
16
=======
Another method to construct the SCFP for MBM company is to start at the beginning
of the profit and loss account and consider and note down each and every figure
(while avoiding direct or indirect double counting). Each figure must be inserted in
either the receipts or in the disbursements column, unless if its inclusion would
represents an obvious double counting.
Having dealt with all items in the profit and loss account of year 2013, the two
balance sheets as of the beginning and end of year 2013 are then considered
simultaneously. Again, all items are taken into account and simplest possible
assumption are adopted. All the values in the two balance sheets are added to either
side of the SCFP exactly as for the entries in the profit and loss account.
If these instructions are followed, these entries will rectify any possible mistakes
made in the previous part. As for the cash entry, if for the moment, it is omitted from
inclusion, then the difference between the sum of the two columns should equal the
net increase or decrease of cash during the period, which is calculated using the two
balance sheets provided.
In the compilation of the SCFP in this way, althoght the simplest assumptions are
made but the mathematical link between the three reports automatically corrects any
possible mistakes made in any of the previous stages.
Statement of Changes in Financial Position for year 2013
Receipts
Revenues
Change in depreciation
Change in accounts payable
Change in deferred income
Change in accrued interest
Change in mortgage payable
Total
Disbursements
$48,150
600
1,000
100
180
2,000
$52,030
Cost of sales
$35,800
Other expenses
9,380
Income tax expense
650
Change in accounts receivable
150
Change in notes receivable
500
Cange in equipment
3,000
$49,480
Table above in effect indicates that the amount of $52,030 of cash was received by
the company during year 2013 and the amount of $49,480 in cash was paid out
during the same period. Net remaining cash for the end of the year is therefore
17
$2,550. This is verified by the two cash entries in the two balance sheets for the
beginning and the end of the period that also show an increase of $2,550.
18