Accounting Clinic I McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-1 Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Introduction Accounting clinic I contains the following: A brief review of the four financial statements Examples of how each financial statement is prepared A summary of the principles of measurement in financial statement McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-3 The Financial Statements 1. Balance Sheet 2. Income Statement 3. Cash Flow Statement 4. Statement of Shareholders’ Equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-4 The Balance Sheet: Dell Computer Corporation February 1, 2002 ------------ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts receivable, net Inventories Other $ Total current assets Property, plant and equipment, net Investments Other non-current assets 3,641 273 2,269 278 1,416 -----7,877 826 4,373 459 -----Total assets $ 13,535 -----LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable Accrued and other $ Total current liabilities Long-term debt Other Commitments and contingent liabilities (Note 7) Total liabilities Stockholders equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares authorized: 7,000; shares issued: 2,654 and 2,601, respectively Treasury stock, at cost; 52 shares and no shares, respectively Retained earnings Other comprehensive income Other Total stockholders equity Total liabilities and stockholders equity 5,075 2,444 -----7,519 520 802 - $ 4,910 525 2,424 400 1,467 -----9,726 996 2,418 530 -----$ 13,670 ------ $ 4,286 2,492 -----6,778 509 761 - -----8,841 ------ -----8,048 ------ - - 5,605 4,795 (2,249) 1,364 38 (64) -----4,694 -----$ 13,535 ------ McGraw-Hill/Irwin February 2, 2001 ------------- © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 839 62 (74) -----5,622 -----$ 13,670 ------ Clinic 1-5 The balance sheet reports the resources the firm controls at a point in time and the claims against those resources. That is, it is a detailed description of the firm's assets, liabilities and owners' equity. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-6 The Form of the Balance Sheet Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities Assets are economic resources that produce future earnings. Liabilities are obligations to transfer assets or provide services to parties other than the owners. Equity is the owners' residual interest in the assets of an entity that remains after deducting the liabilities. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-7 Example - Balance Sheet Preparation Presented below are selected accounts of Biking Corporation at December 31, 2004: Patent Interest payable Bonds payable Common stock, $5 par value Preferred stock, $10 par value Prepaid insurance Accounts payable Trading securities Land Accounts receivable Rent payable Retained earnings $150,000 30,000 450,000 400,000 150,000 89,000 283,000 117,000 520,000 143,000 45,000 ? Income taxes payable Notes payable (short-term) Equipment Discount on bonds payable Refundable federal and state income taxes Accumulated depreciation – equipment Inventory Cash Accumulated depreciation – building Long-term loan from bank Building $93,000 264,000 950,000 25,000 97,630 232,000 242,000 360,000 450,000 640,000 1,200,000 Required: Prepare a classified balance sheet. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-8 Solution $ 360,000 117,000 143,000 242,000 89,000 951,000 Current assets Cash Trading securities Accounts receivable Inventory Prepaid insurance Total current assets Property, plant and equipment Land Buildings Less acc. depreciation Equipment Less acc. depreciation Total Property, plant and equipment Intangible assets Patent Total assets 520,000 1,200,000 (450,000) 950,000 (232,000) 750,000 718,000 1,988,000 150,000 3,089,000 $ 283,000 264,000 30,000 93,000 45,000 715,000 Current liabilities Accounts payable Notes payable Interest payable Income taxes payable Rent payable Total current liabilities Long-term liabilities Long term loan from bank Bonds payable Less discount on bonds payable Total long term liabilities Total liabilities 450,000 (25,000) Stockholders’ equity Capital stock Preferred stock, $10 par; Common stock, $5 par Retained earnings Total stockholders’ equity 150,000 400,000 Total liabilities and stockholders’ equity 640,000 425,000 1,065,000 1,780,000 550,000 759,000 3,089,000 Retained earnings are calculated as a plug number. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-9 The balance sheet reports assets and the claims on those assets at a point in time. The other three financial statements summarize the effects of transactions and economic events occurring between two balance sheets dates. The income statement reports revenues less expenses (earnings) that increase owners' equity between two balance sheet dates. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-10 The Income Statement: Dell Computer Corporation Net revenue Cost of revenue Gross margin Fiscal Year Ended ------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------$ 31,168 $ 31,888 $ 25,265 25,661 25,445 20,047 ---------------5,507 6,443 5,218 ---------------- Operating expenses: Selling, general and administrative Research, development and engineering Special charges Total operating expenses Operating income Investment and other income (loss), net Income before income taxes and cumulative effect of change in accounting principle Provision for income taxes Income before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net Net income Earnings per common share: Before cumulative effect of change in accounting principle: Basic Diluted After cumulative effect of change in accounting principle: Basic Diluted Weighted average shares outstanding: Basic Diluted McGraw-Hill/Irwin $ 2,784 3,193 2,387 452 482 374 482 -----3,718 -----1,789 (58) 105 -----3,780 -----2,663 531 194 -----2,955 -----2,263 188 -----1,731 -----3,194 -----2,451 485 -----1,246 958 -----2,236 785 -----1,666 - 59 - -----1,246 ------ $ -----2,177 ------ $ $ 0.48 -----$ 0.46 ------ $ 0.87 -----$ 0.81 ------ $ $ $ $ 0.48 -----$ 0.46 -----2,602 2,726 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 0.84 -----$ 0.79 -----2,582 2,746 -----1,666 ------ 0.66 -----$ 0.61 ------ 0.66 -----$ 0.61 -----2,536 2,728 Clinic 1-11 The Form of the Income Statement Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax – Interest Expense = Income before Taxes Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income – Preferred Dividends = Net Income Available to Common McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-12 Example - Income Statement Preparation below are selected ledger accounts of Grant Corporation at December 31, 2005: Merchandise Inventory Office salaries Sales Purchases Insurance expense Sales commission Sales returns Purchase discounts 409,000 282,000 5,000,000 2,548,000 26,000 76,000 42,000 31,000 Accounting and legal services Shipment-in Advertising Depreciation of office Depreciation of sales equipment Sales salaries Extraordinary loss (before tax) Interest expense 24,000 81,000 108,000 62,000 58,000 257,000 96,000 176,000 A physical inventory indicates that the ending inventory is $547,000. Assume a tax rate of 35%. Required: Prepare a condensed income statement McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-13 Solution Net Sales (1) Cost of goods sold (2) Gross profit Selling expense (3) Administrative expense (4) Income from operations Other expense Income before taxes Income taxes (35%) Income before extraordinary item Extraordinary loss, net of $33,600 taxes Net income 4,958,000 2,460,000 2,498,000 499,000 394,000 893,000 1,605,000 176,000 1,429,000 500,150 928,850 62,400 866,450 (1) 5,000,000-42,000 (2) 409,000+(2,548,000+81,000-31,000)-547,000 (3) 257,000+76,000+108,000+58,000 (4) 282,000+26,000+24,000+62,000 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-14 The Statement of Cash Flows : Dell Computer Corporation Fiscal Year Ended ------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------- Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Tax benefits of employee stock plans Special charges (Gains)/losses on investments Other Changes in: Operating working capital Non-current assets and liabilities Net cash provided by operating activities Cash flows from investing activities: Investments: Purchases Maturities and sales Capital expenditures Net cash used in investing activities Cash flows from financing activities: Purchase of common stock Issuance of common stock under employee plans Other Net cash used in financing activities Effect of exchange rate changes on cash Net (decrease) increase in cash McGraw-Hill/Irwin $ 1,246 $ 2,177 $ 1,666 239 487 240 929 742 17 178 105 (307) 135 194 (80) 56 826 62 642 274 812 82 -----3,797 -----4,195 -----3,926 ------ ------ ------ (5,382) 3,425 (303) -----(2,260) (2,606) 2,331 (482) -----(757) (3,101) 2,319 (401) -----(1,183) ------ ------ ------ (3,000) 295 (2,700) 404 (1,061) 289 3 -----(2,702) (9) -----(2,305) 77 -----(695) -----(104) -----(32) -----35 -----(1,269) -----1,101 -----2,083 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 156 1,040 Clinic 1-15 The statement of cash flows explains the change in cash during the period in terms of cash provided by or used for operating, investing and financing activities. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-16 The Form of the Cash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-17 The Form of the Cash Flow Statement The primary purpose of a statement of cash flows is to provide relevant information about the cash inflows and outflows of an enterprise during a period. The statement has three main sections: Cash Flows from Investing Activities - Investing activities involve acquiring and disposing of debt or equity investments, property, plant and equipment and other productive assets used in the production of goods or services by the enterprise (other than materials that are part of the enterprise's inventory). McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-18 The Form of the Cash Flow Statement Cash Flows from financing Activities - Financing activities involve obtaining resources from owners and providing them with a return on their investment; borrowing money and repaying amounts borrowed, and obtaining and paying for other resources obtained from creditors on long-term credit. Cash Flows from operating Activities - Operating activities involve all transactions and other events that are not defined as investing or financing. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-19 Example – Preparation of a cash flow statement Presented below are the balance sheets of Scientific Instruments, Ltd. for December 31, 2005 and 2004 Scientific Instruments, Ltd. Balance Sheet December 31, 2005 and 2004 2005 Cash Accounts receivables Inventories Loan to company B Land Equipment Acc. Depreciation 70 170 200 1,500 500 500 (190) 2004 110 300 240 550 (200) 2,750 Accounts Payable Bonds Payable Deferred tax liability Common Stock Retained Earnings 120 1,000 380 1,220 30 200 300 250 250 2,750 McGraw-Hill/Irwin 1,000 1,000 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-20 Additional Information: Equipment with original cost of $50 was sold for $35 Dividend declared and paid in cash was $300 Stocks and Bonds were issued for cash Net income reported was $80. Required: Prepare a statement of cash flow for 2005 Note: Cash from operating activities involves adjusting net income for all the non-cash items in net income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-21 Solution Scientific Instruments, Ltd. Statement of Cash Flow For the year ended December 31, 2005 Cash flows from operating activities Net Income Adjustments to reconcile net income to net cash provided by operating activities: Gain on sale of equipment Depreciation Increase in deferred tax liability Decrease in accounts receivables Decrease in inventories Decrease in accounts payable Net cash provided by operating activities 80 (10) 15 80 130 40 (80) Cash flows from investing activities Loan to B Purchase of Land Sale of Equipment Net cash used by investing activities (1,500) (500) 35 Cash flows from financing activities Issuance of common stock Issuance of bonds payable Payment of cash dividend Net cash provided by financing activities 970 1,000 (300) (1,965) Net decrease in cash Cash, December 31, 2004 Cash, December 31, 2005 McGraw-Hill/Irwin 175 255 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 1,670 (40) 110 70 Clinic 1-22 The Statement of Stockholders’ Equity: Dell Computer Corporation Common stock And Capital in Excess of Par Value Balances at February 2, 2001 Net income Change in unrealized gain on investments, net of taxes Foreign currency translation adjustments Net unrealized gain on derivative instruments, net of taxes Total comprehensive income for fiscal 2002 Stock issuances under employee plans, including tax benefits Purchases and retirements Others Balances at February 1,2002 McGraw-Hill/Irwin Treasury Stock Other Comprehensive Income Other Shares Amount Shares Amount Retained Earnings 2,601 - 4,795 - - - 839 1,246 62 - (74) - - - - - - (65) - (65) - - - - - 2 - 2 - - - - - 39 - __39 - - - - - - - 1,222 69 843 - - - - 10 (16) ____ 2,654 (30) (3) ____ $5,605 52 __ 52 (2,249) _______ $(2,249) (721) ______ $1,364 ___ $38 ___ $(64) © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Total 5,622 1,246 853 (3,000) (3) _____ $4,694 Clinic 1-23 Shareholder’s Equity has two primary components: contributed capital which represents stockholders’ investment – common stock (par value) and additional paid in capital, and retained earnings which equals cumulative net income minus cumulative dividends since the formation of the company. (Dividends are distributions of assets to stockholders.) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-24 Comprehensive Income To avoid earnings fluctuations some of the unrealized gains/losses are reported in “other comprehensive income” and not included in net income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-25 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-26 The Stocks and Flows Equation Ending equity = Beginning equity + Total (comprehensive) income – Net payout to shareholders Comprehensive income = Net income + Other comprehensive income Net payout to shareholders = Dividends + Share repurchases -Share issues McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-27 The Articulation of the Financial Statements Cash Flow Statement Cash from operations Cash from investing Beginning Balance Sheet Ending Balance Sheet Cash from financing Net change in cash Cash + Other Assets Cash + Other Assets Statement of Shareholders’ Equity Total Assets Total Assets Investment and - Liabilities disinvestment by owners - Liabilities Net income and other earnings Owners’ equity Net change in owners’ equity Owners’ equity Income Statement Revenues Expenses Net income McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-28 Principles of Measurement Two types of measurement are used in financial statements Mark-to-market accounting Assets and liabilities are reported at their “fair value” and gains and losses from revaluing them are reported in the income statement or as part of other comprehensive income in the equity statement. Fair value is either market value or an estimate of value. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-29 Historical cost accounting Assets and liabilities are reported at their historical cost (the dollar amount paid when they were acquired or incurred). In subsequent periods, those costs are amortized to the income statement as the assets are deemed to have been used up in operations or as liabilities accrue costs. GAAP accounting uses both types of measurement. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-30 Mark-to Market Accounting Under U.S. GAAP, the following assets and liabilities are approximately at market value: Cash and Cash Equivalents Short-term Payables Short-term and Long-term Borrowings Long-term Debt Securities Equity Investments The following assets and liabilities are measured at an estimate of their fair value rather than their market value: Net Accounts Receivables (net of estimate of likely bad debt.) Accrued and Estimated Liabilities McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-31 Historical Cost Accounting The following assets and liabilities are at (amortized) historical cost on the balance sheet: Long-term Tangible Assets Recorded Intangible Assets Goodwill These assets can be written down if their value is deemed to have been impaired, but are never written up (in the U.S.). McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-32 Mixed Accounting Measurement The following assets are sometimes measured at historical cost and sometimes at fair values: Inventories: Lower of cost or market rule applies Debt investments • Trading • Available-for-sale • Held to maturity Equity investments • Trading • Available-for-sale See Accounting Clinic III McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-33 Historical Cost Accounting in The Income Statement Revenue recognition principle - value added is recognized when: The earnings process is substantially accomplished Receipt of cash is reasonably certain Matching principle Expenses are recognized in the income statement by their association with revenues for which they are incurred. The earnings number reflects net value added from revenues, that is, net of matched expenses. Go to Accounting Clinic II for more on matching McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-34 Cost of Goods Sold: An Application of Matching Cost of goods sold is an accrual concept, calculated in the following way: Inventory, beginning XXX + Purchases XXX Goods available for sale XXX - Inventory, ending (XXX) Cost of Goods Sold XXX The beginning balance of inventory and purchases of goods during the year sum up to the total goods that the firm could have sold during the year. The ending balance of inventory (usually available from physical count) is subtracted to get the cost of the goods actually sold. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-35 In the income statement preparation example total purchases were 2,598,000 (after adding shipment and subtracting discounts). The beginning of inventory was 409,000 and the ending of inventory was 547,000. Therefore total cost of goods sold was: 409,000+2,598,000-547,000=2,460,000 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-36 The cash outflow equivalent to the cost of goods sold is payment to suppliers. Accrual accounting performs two main adjustments to this amount to arrive at the cost of goods sold: Accounts Payable adjustment – payment might not reflect the entire expenditure on inventories. Some inventories were purchased on account. Inventory adjustment – inventory is a pure accrual concept and is recognized in order to match the expense (COGS) with revenue (the amount we received for the goods sold). More about the matching concept in Accounting Clinic II. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-37 R&D accounts: An Example of Poor Matching Peabody Co. produces operating income of $30,000 from operations each year. The company invested $20,000 in an R&D project in December 31, 2004. The investment will produce an incremental income of $7,000 in each of the following 5 years. Calculate operating income for the years 20042009 1. if the firm expenses R&D immediately (as GAAP requires) 2. if the firm capitalizes R&D and amortize it using straight line method. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-38 (1) R&D is expensed immediately Operating income before R&D Incremental income from R&D R&D expense Operating income 2004 $30,000 __0 30,000 (20,000) 10,000 2005 $30,000 2006 $30,000 2007 $30,000 2008 $30,000 2009 $30,000 7,000 37,000 __0 37,000 7,000 37,000 __0 37,000 7,000 37,000 __0 37,000 7,000 37,000 __0 37,000 7,000 37,000 __0 37,000 (2) R&D is capitalized using straight line The total R&D expenditure is 20,000. It is amortized 20,000/5=4,000 per year for 5 years. Operating income before R&D Incremental income from R&D R&D expense Operating income McGraw-Hill/Irwin 2004 $30,000 2005 $30,000 2006 $30,000 2007 $30,000 2008 $30,000 2009 $30,000 ______ 30,000 __0 30,000 7,000 37,000 (4,000) 33,000 7,000 37,000 (4,000) 33,000 7,000 37,000 (4,000) 33,000 7,000 37,000 (4,000) 33,000 7,000 37,000 (4,000) 33,000 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-39 Fully expensing R&D in the year in which it was incurred results in poor matching in operating income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. Clinic 1-40