ACCOUNTING PRINCIPLES
The understanding of the structure and integration of financial statements is crucial to
the ability to construct comprehensive proforma projections and forecast cash flows. Even
when a firm has the option of using cash basis accounting for tax purposes, lenders and
investors generally prefer accrual accounting since it more accurately reflects the economic
performance experienced by the firm. Moreover, in the endeavor to attract capital, the integrity
of the proforma financial statements is often used as a surrogate (rightly or wrongly) of the
integrity of the financial performance projections themselves. If the basic accounting figures
are not correct, why should the projections market share, costs, etc., be considered any better?
While the cash flows are of tantamount importance from an investment/valuation
perspective, the generation of the cash flows is relatively simple once the income statements
and balance sheets have been generated. The initial focus will, therefore, concentrate on these
two items and the construction of the actual cash flows will conclude.
Income Statements
The first question that must be asked of each economic occurrence is whether or not
the transaction is an item that appears on the income statement. Two important concepts are
involved in this determination.
Revenue Recognition -- The Revenue Recognition Principal states that revenue is recognized,
and recorded on the income statement, when it is reasonably assumed that the sale has
occurred and the proceeds will be collected.
Any bad debt expense (i.e., that portion of the revenues that is not expected to be
collected is ultimately deducted as an expense item. (Estimated bad debt expense is
maintained in the Allowance for Doubtful Accounts category until that time at which it is actually
deducted.)
Matching Principal -- The matching principal states that expenses will be recognized and
matched to the revenues (or benefits) generated by the incurrence such expense.
The most obvious category with regard to matching expenses to the revenues is that of
Cost of Goods Sold, a variable expense. Fixed expenses, such as rent, are more directly
related to the benefit aspect of this definition, for example the benefit of using the building that
the firm occupies is recognized during the period and not related to the revenues generated.
In general, a firm keeps at least two sets of books; one is for tax accounting purposes
while the other is for financial accounting (or managerial) purposes. Tax structures represent
government attempting to accomplish two primary objectives. First, the tax structure is trying to
set up broad categories to represent the "average" of all taxpayers affected when the reality is
there are millions of individual, specialized circumstances. Consequently, the statutory rates of
depreciation on equipment is based upon average use and does not allow for differences
between the firm that operates eight hours per day, five days per week and the firm that
operates twenty-four hours per day and seven days per week. The differences are ultimately
adjusted for upon the disposal of the asset, just as inventory adjustments are made at the end
1
of the period when a physical count is made. The second purpose of tax policy is for
social/economic engineering purposes. The graduated tax rate is an example where small
companies are encouraged through lower tax rates until they reach a certain level of
profitability, at which point the tax rate is increased to an above-average level to actually
recover the taxes at the lower rate until to the total taxes on all companies amounts to 34%.
Personal tax rates, on the other hand, are designed to redistribute wealth from higher income
earners to lower income earners. From a financial perspective, the objective is to avoid taxes
(first) or at least delay taxes. There is nothing wrong with utilizing the tax code to its fullest in
order to avoid taxes (as opposed to evade taxes, which is illegal) since there is an underlying
social/economic purpose behind the rules.
Taxation is a complex area. UTSA offers a Masters of Taxation and it is beyond the
scope of this note or this course to cover it in any detail. For purposes of the remainder of this
note, it will be assumed that the tax and financial reporting sets of books are one and the same.
Balance Sheets
The balance sheet is not nearly as difficult to construct as it may appear. There is a
simple rule that must be kept in mind -- that it is called a balance sheet because the total assets
side of the balance sheet must equal (balance) the total liabilities and equity side of the balance
sheet. That means that the following rules apply:
(1)
Any increase (decrease) in an asset account must be exactly matched by an increase
(decrease) in a liability/equity account OR matched by a decrease (increase) in another
asset account.
Conversely,
(2)
Any increase (decrease) in a liability/equity account must be exactly matched by an
increase (decrease) in an asset account OR matched by a decrease (increase) in
another liability/equity account.
The confounding feature here is when a transaction occurs that appears on the income
statement. Keep in mind that the income statement ultimately flows through to the retained
earnings account. Thus, any revenue item which adds to net income also adds to retained
earnings while any expense item that deducts from net income also deducts from retained
earnings. (Remember, also, that there is a tax consequence associated with changes in net
income, but this is easy to deal with through the income statement.)
Every double-entry must result in the balance sheet remaining balanced. Consider the
expenditure of $100 of cash for 1) inventory; 2) payment of accounts payable; or 3) repair and
maintenance. In any event, cash is decreased by $100. The offsetting entry occurs on the
balance sheet as indicated in the following diagram (where the superscript represents which
account is affected by the second entry and the { } signifies the effect of the entry):
2
Balance Sheet
Cash
Accounts Receivable
Inventory
Total Current Assets
Income Statement
-
100
Revenues
Cost of Goods Sold
Gross Profit
+ 1001
Net Fixed Assets
Net Goodwill
Total Assets
{ 0 }1or -100
Accounts Payable
Notes Payable
Taxes Payable
Total Current Liabilities
-
1002
Gen. & Adm. Expense
Salaries
Rent
Repairs & Maintenance
Utilities
Depreciation
Operating Income
+ 1003
Interest Expense
Taxable Income
Taxes
Long-term Debt
Net Income
Common Stock
Retained Earnings
Total Common Equity
Total Liabilities & Equity
{-100}3
Impact on Retained Earnings
via Income Statement
{-100}2
The first thing that lenders and investors look at in proformas (as do finance and
accounting professors) is whether or not the retained earnings figures on balance sheets and
the income statements between successive balance sheets are consistent with one another.
The relationship is easy:
Beg. Retained Earnings + Net Income - Dividends = End. Retained Earnings
The retained earnings account is simply a history of all income of the company since its
inception, less any income paid out as dividends to shareholders.
A Simple Example
Let's illustrate some basic principles of accounting with a simple example of starting a
company and following the impact on the financial statements that occurs as various events
transpire.
3
January 1, 2002
Gary has in mind starting a company that will produce and sell clocks. The first thing he
does is to incorporate his company (after conducting a name search) by filing the articles of
incorporation with the Secretary of State and paying a fee of $300.00 for the filing and $600.00
to an attorney for drawing up the papers. These fees are not a deductible expense in full
immediately since they are costs incurred in organizing the firm which has a perpetual life. The
internal revenue code allows amortization of capitalized organizational costs over a fifteen-year
period. Although it is common for companies to wait until year-end to recognize depreciation
and amortization expense, it should be recognized at the end of each month to more accurately
depict economic performance. The first entry recognizes the organization of the firm and its
source of financing. (Note that the term "Common Equity" will be employed for all forms of
external contributions of equity.) Accountants would actually make two separate entries in
order to recognize that this represents two separate transactions, one with the state as payment
of the filing fee, and the second with the lawyer as payment for the legal services involved in
organizing the firm.
Entries
Capitalized Organizational Costs
Common Equity
+900
+900
Assets
Organizational Costs
900
Total Assets
900
Liabilities & Equity
Common Equity
900
Tot. Liab. & Equity
900
4
(0+900)
(0+900)
January 2, 2002
Gary next opens a checking account and deposits $49,100 so that he can issue himself
an even 50,000 shares of stock ($1 par).
Entries
Cash
Common Equity
+49,100
+49,100
Assets
Cash
Organizational Costs
Accum. Amortization
Net Organizational Costs
49,100
900
( 0)
(0+49,100)
(This category is utilized later.)
900
Total Assets
50,000
Liabilities & Equity
Common Equity
Retained Earnings
Total Equity
50,000
( 0)
50,000
Total Liab. & Equity
50,000
5
(900+49,100)
January 3, 2002
Gary signs a lease to rent industrial space for manufacturing the clocks and housing the
corporate offices. The lease requires a deposit of $1,000 and monthly rent of $2,500 dollars
due at the end of each month. In addition, he arranges for utility and telephone connections
requiring deposits totalling $300. These transactions are recorded as follows (again, this is
really two transactions):
Entries
Cash
Deposits
- 1,300
+1,300
Assets
Cash
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
47,800
1,300
900
( 0)
900
Total Assets
50,000
Liabilities & Equity
Common Equity
Retained Earnings
Total Equity
50,000
( 0)
50,000
Total Liab. & Equity
50,000
6
(49,100-1,300)
(0+1,300)
January 4, 2002
Gary next buys $8,000 worth of clock parts (faces, hands, mechanisms) and clock
bases.
Entries
Cash
Materials Inventories
- 8,000
+8,000
Assets
Cash
Inventories
Materials
Total Current Assets
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
39,800
(47,800-8,000)
8,000
47,800
(0+8,000)
1,300
900
( 0)
900
Total Assets
50,000
Liabilities & Equity
Common Equity
Retained Earnings
Total Equity
50,000
( 0)
50,000
Total Liab. & Equity
50,000
The deposits are not recorded as a current asset since they will not be refunded until Gary's
business has established itself, a period of two to three years.
7
January 5-18, 2002
Gary hires a secretary for $1,500 per month and a salesperson for $1,200 plus a 10%
commission to help run operations. Since Gary anticipates that there will be an occasional bad
debt expense from customers who do not pay, the commissions payment will only be made
after the collection of an account He also hires two individuals to assemble the parts into
clocks ready to sell to retailers. In the following few days, he incurs $2,250 in labor costs for
assembly and determines that the average cost of the finished clocks represents 70% of the
average wholesale price he will utilize (40% parts and 30% labor). Since the assembly labor is
paid hourly (at the end of the month), Gary will include this cost as a part of the Cost of Goods
Sold. The balance sheet on January 18 includes the wages payable but not the salaries of the
secretary and salesperson since they represent a "fixed" cost paid at the end of the month.
The assembly wages are recognized as a liability since they have been incurred and represent
the additional value added to $3,000 of inventories converted to finished goods but not yet paid
for.
Entries
Finished Goods
Wages Payable
+2,250
+2,250
Finished Goods
Materials
+3,000
- 3,000
Assets
Cash
Inventories
Materials
Finished Goods
Total Current Assets
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
Total Assets
Liabilities & Equity
Wages Payable
Total Current Liabilities
39,800
5,000
5,250
50,050
(8,000-3,000)
(0+2,250+3,000)
1,300
900
( 0)
900
52,250
2,250
2,250
Common Equity
Retained Earnings
Total Equity
50,000
( 0)
50,000
Total Liab. & Equity
52,250
8
(0+2,250)
Many firms simply include the wage component as a part of the Income Statement
under the category of Wages & Salaries. Strictly speaking, however, it is a part of the Cost of
Goods Sold, just as it would be included in the purchase price were the clocks to have been
purchased already assembled. Including the assembly wages as a part of the Cost of Goods
Sold, a direct cost, is very useful for managerial purposes. Specifically, it helps in distinguishing
those costs that are fixed costs from those that are variable costs.
January 21, 2002
The salesperson reports that an order for $5,000 has been placed by a contact that was
made and who provided references for purchasing on credit terms of net 30. At this point, the
income statement begins to reflect the transactions as well as the balance sheet:
Entries
Revenues
Accounts Receivable
+5,000
+5,000
Finished Goods
Cost of Goods Sold
- 3,500
+3,500 (results in a decrease in retained earnings)
Commissions Payable
Commission Expense
+ 500
+ 500
(results in a decrease in retained earnings)
Taxes Payable
Tax Expense
+ 200
+ 200
(results in a decrease in retained earnings)
(results in an increase in retained earnings)
Revenues
Cost of Goods Sold
Gross Profit
5,000
3,500
1,500
(0+5,000)
(0+3,500)
General & Administrative Expense
Commissions
Amortization
Taxable Income
500
0
1,000
(0+500)
200
800
(0+200)
Taxes (20%)
Net Income
9
Assets
Cash
Accounts Receivable
Inventories
Materials
Finished Goods
Total Current Assets
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
Total Assets
Liabilities & Equity
Wages Payable
Commissions Payable
Income Taxes Payable
Total Current Liab.
39,800
5,000
5,000
1,750
51,550
(0+5,000)
(5,250-3,500)
1,300
900
( 0)
900
53,750
2,250
500
200
2,950
(0+500)
(0+200)
Common Equity
Retained Earnings
Total Equity
50,000
800
50,800
(0+800)
Total Liab. & Equity
53,750
10
January 22-31, 2002
During the ensuing ten days, the following transactions occur:
1.
2.
3.
4.
5.
6.
7.
An additional $15,000 of parts are purchased for cash
$16,000 of parts are assembled into finished clocks with labor costs of $12,000
Sales of $30,000 are made on credit of net 30
All employees are paid on the 31st of the month
Utility bills totalling $750 arrive on the 30th and are due by the 15th of February
Rent is paid
Amortization of Organizational Costs is recognized (straight-line over 15 years or 180
months)
Entries
Cash
Materials
- 15,000
+15,000
Materials
Finished Goods
- 16,000
+16,000
Wages Payable
Finished Goods
+12,000
+12,000
Revenues
Accounts Receivable
+30,000
+30,000
Finished Goods
Cost of Goods Sold
- 21,000
+21,000
Commissions Payable
Commission Expense
+ 3,000
+ 3,000
Wages Payable
Cash
- 14,250
- 14,250
Salaries
Cash
+ 2,700
- 2,700
Utilities Payable
Utility Expense
+
+
Rent Expense
Cash
+ 2,500
- 2,500
Amortization Expense
Accumulated Amortization
+
+
(Secretary 1,500 plus salesman base 1,200)
750
750
5
5
11
The January income statement and January 31 balance sheet appear as follows:
Revenues
Cost of Goods Sold
35,000
24,500
Gross Profit
10,500
General & Administrative Expense
Commissions
Salaries
Rent
Utilities
Amortization
Taxable Income
3,500
2,700
2,500
750
5
1,045
Taxes (20%)
209
Net Income
836
Assets
Cash
Accounts Receivable
Inventories
Materials
Finished Goods
Total Current Assets
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
Total Assets
Liabilities & Equity
Wages Payable
Utilities Payable
Commissions Payable
Income Taxes Payable
Total Current Liab.
(5,000+30,000)
(3,500+21,000)
(500+3,000)
(0+2,700)
(0+2,500)
(0+750)
(0+5)
5,350
35,000
(39,800-15,000-14,250-2,700-2,500)
(5,000+30,000)
4,000
8,750
53,100
(5,000+15,000-16,000)
(1,750+16,000+12,000-21,000)
1,300
900
( 5)
(0+5)
895
55,295
0
750
3,500
209
4,459
Common Equity
Retained Earnings
Total Equity
50,000
836
50,836
Total Liab. & Equity
55,295
12
(2,250+12,000-14,250)
(0+750)
(500+3,000)
(Cumulative from Income Stmt)
(Cumulative from Income Stmt)
Statement of Cash Flows
The Statement of Cash Flows reconciles the difference between accrual accounting
figures and the actual inflows and outflows of cash. From a financial perspective, the relevant
figures for investment and valuation purposes is the cash flows generated by a firm since
accounting profits are more conceptual in nature.
Creating the January Statement of Cash Flows for Gary's company is relatively simple
due to the fact that the beginning balance sheet (i.e., prior to inception of the firm) consisted of
all zeroes. The statement itself is comprised of three sections representing the sources and
uses of cash to the firm. The first section, From Operating Activities, considers the net income
of the firm during the period and adds back the non-cash expenses such as amortization and
depreciation. Included in this section are changes in working capital accounts (current assets
and current liabilities) other than the cash account since these accounts are most directly
related to the day-to-day operations of the company. The From Investment Activities section is
looking at the investment in, or disposal of (disinvestment), those assets that are more related
to the long-term ongoing operations of the firm. The section From Financing Activities
considers the sources of long-term (permanent) financing of the company.
When calculating the cash flow resulting from a change in a balance sheet item, one
needs to keep in mind whether the balance sheet account is an asset account or a
liability/equity account. (Contra-asset and contra-liability accounts are really on the "wrong"
side of the balance sheet but are listed in such a manner as to associate them with the account
that is directly affected by them.) A source of funds is either a decrease in an asset account
from one period to the next (such as selling off some inventories) or an increase in a
liability/equity account (such as borrowing money from a bank). A source of funds will appear
as a positive number on the Statement of Cash Flows. A use of funds is just the opposite: A
use of funds is either an increase in an asset account (such as buying inventories) or a
decrease in a liability/equity account (such as paying off some debt).
A special point should be made of the retained earnings account. From the relationship
noted above, the two factors affecting the change in retained earnings are the net income and
dividends paid. Since the net income is reflected in the From Operating Activities section, only
the dividend payments are considered when calculating the cash flows From Financing
Activities section. As the relationship between beginning retained earnings and ending retained
earnings indicates, and change that is not equal to the amount of net income must be a
consequence of cash dividends paid.
13
The January Statement of Cash Flows for Gary's company appears as:
From Operating Activities:
Net Income
Plus: Amortization
836
5
Operating Cash Flows
(From the Income Stmt)
(From the Income Stmt)
841
Changes in Working Capital
Accounts Receivable
Materials Inventories
Finished Goods
Utilities Payable
Commissions Payable
Income Taxes Payable
(35,000)
( 4,000)
( 8,750)
750
3,500
209
From Working Capital
(43,291)
Total From Operating Activities
(0 - 35,000)
(0 - 4,000)
(0 - 8,750)
( 750 - 0)
( 3,500 - 0)
( 209 - 0)
(42,450)
From Investing Activities:
Deposits
Organizational Costs
( 1,300)
( 900)
Total From Investing Activities
(0 - 1,300)
(0 900)
( 2,200)
From Financing Activities:
Equity
50,000
Total From Financing Activities
50,000
Total Cash Flows
5,350
Plus: Beginning Cash Balance
(50,000 - 0)
0
Ending Cash Balance
5,350
As indicated by the Ending Cash Balance figure of the Statement of Cash Flows, it is identical
to the cash balance determined on the balance sheet. Just as Total Assets can be compared
to Total Liabilities & Equity as a check figure when preparing proforma statements to ensure the
correctness in the modeling, the Ending Cash Balance figure from the Statement of Cash Flows
is a handy check figure as well.
14
February 1-28, 2002
Continuing the example of Gary's clock company for February, the transactions that
occurred are as follows:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Sales of $80,000 were made on thirty days' credit.
A six-month bank loan of $10,000 was acquired at month-end and secured by
receivables.
Collection of receivables amounted to $42,000.
Commissions on the collected receivables were paid ($4,200).
Purchases of $53,000 of clock parts were made on thirty days' credit (now that a credit
history is being developed).
$36,000 of parts were assembled into clocks.
$27,000 of assembly wages were incurred and paid at month end.
The previous month's utility bills were paid and new billings of $1,150 arrived.
The two salaried employees were paid at the end of the month.
Due to a dispute over some minor finish-out work that the landlord had promised but
failed to make, rent was withheld by Gary and not paid for February. (Note: Bad move - this is illegal; but if you did it, this is how you would recognize it!)
Having used up most of his savings and not drawing a salary, Gary paid himself a
$5,000 dividend.
15
Entries
Revenues
Accounts Receivable
+80,000
+80,000
Finished Goods
Cost of Goods Sold
- 56,000
+56,000
Commissions Payable
Commission Expense
+ 8,000
+ 8,000
Cash
Bank Note
+10,000
+10,000
Cash
Accounts Receivable
+42,000
- 42,000
Cash
Commissions Payable
- 4,200
- 4,200
Materials
Accounts Payable
+53,000
+53,000
Materials
Finished Goods
- 36,000
+36,000
Wages Payable
Finished Goods
+27,000
+27,000
Cash
Wages Payable
- 27,000
- 27,000
Cash
Utilities Payable
-
Utilities Payable
Utility Expense
+ 1,150
+ 1,150
Cash
Salary Expense
- 2,700
+ 2,700
Rent Expense
Rent Payable
+ 2,500
+ 2,500
Cash
Retained Earnings
- 5,000
- 5,000
Amortization Expense
Accumulated Amortization
+
+
750
750
5
5
16
The February Income Statement would look as follows:
Revenues
Cost of Goods Sold
80,000
56,000
Gross Profit
24,000
General & Administrative Expense
Commissions
Salaries
Rent
Utilities
Amortization
8,000
2,700
2,500
1,150
5
Taxable Income
9,645
Taxes (20%)
1,929
Net Income
7,716
17
(0+80,000)
(0+56,000)
(0+8,000)
(0+2,700)
(0+2,500)
(0+1,150)
(0+5)
(0+1,929)
The February 28 Balance Sheet is:
Assets
Cash
17,700
Accounts Receivable
Inventories
Materials
Finished Goods
Total Current Assets
Deposits
Organizational Costs
Accum. Amortization
Net Organizational Costs
Total Assets
73,000
21,000
15,750
127,450
(5,350+10,000+42,000-4,200
-27,000-750-2,700-5,000)
(35,000+80,000-42,000)
(4,000+53,000-36,000)
(8,750-56,000+36,000+27,000)
1,300
900
( 10)
(5+5)
890
129,640
Liabilities & Equity
Wages Payable
Accounts Payable
Utilities Payable
Rent Payable
Commissions Payable
Income Taxes Payable
Bank Loan
Total Current Liab.
0
53,000
1,150
2,500
7,300
2,138
10,000
76,088
Common Equity
Retained Earnings
Total Equity
50,000
3,552
53,552
Total Liab. & Equity
129,640
18
(0+27,000-27,000)
(0+53,000)
(750-750+1,150)
(0+2,500)
(3500+8,000-4,200
(209+1,929)
(0+10,000)
(836+7,716-5,000)
The Statement of Cash Flows that results for February is
From Operating Activities:
Net Income
Plus: Amortization
Operating Cash Flows
Changes in Working Capital
Accounts Receivable
Materials Inventories
Finished Goods
Accounts Payable
Utilities Payable
Rent Payable
Commissions Payable
Income Taxes Payable
From Working Capital
Total From Operating Activities
7,716
5
7,721
(38,000)
(17,000)
( 7,000)
53,000
400
2,500
3,800
1,929
( 371)
(From the Income Stmt)
(From the Income Stmt)
(35,000 - 73,000)
( 4,000 - 21,000)
( 8,750 - 15,750)
(53,000 0)
( 1,150 - 750)
( 2,500 0)
( 7,300 - 3,500)
( 2,138 - 209)
7,350
From Investing Activities:
Total From Investing Activities
0
From Financing Activities:
Bank Loan Payable
Dividends Paid
10,000
( 5,000)
Total From Financing Activities
5,000
Total Cash Flows
12,350
Plus: Beginning Cash Balance
Ending Cash Balance
5,350
17,700
19
(10,000 - 0)
(836 + 7,716 - 3,552)