Chapter 1 - Introduction to Financial Statements
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Forms of Business-Discussed last week by Dr. G
Users of Financial Statements (Internal and External)
Ethics- Enron, etc. Fraudulent Financial Reporting
Business Activities- Financing, Investing, Operating
Communication with users – 4 Financial Statements
Income Statement- Better one in Basic Training
Retained Earnings Statement
Balance Sheet- Better one in Basic Training
Statement of Cash Flows- Not emphasizing yet
Interrelationships of Statements- Study this
Do it! YES
Tootsie Roll Financial Statements
Comprehensive Do It! Study problem and solution
Chapter 2 - A Further Look at Financial Statements
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A classified balance sheet - commit this to memory- even
better than the one in Basic Training due to additional
classifications.
Ratio Analysis- Profitability ratios, Liquidity ratios, and
Solvency ratios
Earnings per Share (a profitability ratio)
Working Capital and Current Ratio (liquidity ratios)
Debt to Total Asset Ratio (a solvency ratio)
Free Cash Flow (a liquidity ratio)
Financial Reporting Concepts- The standard- setting
environment- The SEC, FASB, IASB
Characteristics of Useful Info- Relevant, Reliable,
Comparable, Consistent
Assumptions and Principles- Similar to those found in Basic
Training- Monetary Unit Assumption, Entity assumption,
Time Period assumption, Going Concern, Cost principle, Full
disclosure
Constraints in Accounting- Materiality, Conservatism
Comprehensive Do it! Circuit City Income Statement and
Balance Sheet
Chapter 3 -The Accounting Information System
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The Accounting Equation (again)
The Accounting Equation with details on Stockholders’ Equity
Transaction Analysis for Sierra Corporation- like done with
New Co. problem
Study summary of transactions on page 109
T account
Transactions in cash in tabular form and account form
Rules of Debit and Credit- Very, very important
Rules of Dr. & Cr. Summarized in T accounts
Steps in the Recording Process- Analyze transaction, record
transaction in journal, post from journal to ledger
Three journal entries recorded
Individual transactions presented in both transaction
spreadsheet and T accounts
Summary of entire chapter- entries recorded in the general
journal, posted to T accounts, account balances determined,
and trial balance prepared for Sierra Corporation
Chapter 4- Accrual Accounting Concepts
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Time period assumption, revenue recognition, expense
recognition, matching principle, accrual accounting
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Accrual accounting vs. cash basis of accounting
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Basics of adjusting entries- start with trial balance, adjust
accounts to match revenues and expenses, usually affect a
balance sheet account and income statement account
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Prepaid expenses- rent, insurance, supplies
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Depreciation- Allocate an asset’s cost, not valuing an asset
Debit Depreciation Expense and credit Accumulated
Depreciation
Straight-line depreciation = (cost – salvage) / years
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Unearned revenue- Balance in Unearned Revenue account (a
liability). Adjust by debiting Unearned Revenue and crediting
revenue by amount earned this period
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Accrue revenue or expense means to record it this period.
Accruals are UNRECORDED revenues or expenses that must
be recorded.
Defer revenue or expense means to put it off to a later period.
Deferrals have been recorded but must be adjusted
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Accrued revenue- Debit AR and credit Revenue
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Accrued expense- Debit appropriate Expense and credit
appropriate Liability
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Examples of accrued expenses include accrued interest,
accrued salaries, accrued taxes, etc.
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Calculate interest – Principal x Rate x Time in terms of 1 year
166
Trial Balance for Siera Corp.
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Adjusting entries for Siera Corp.
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Ledger for Siera after adjustments are posted
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Adjusted Trial Balance for Siera
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Financial statements for Siera
184
Closing entries:
1) Close Revenues to Income Summary
2) Close all Expenses to Income Summary
3) Close Income Summary to Retained Earnings
4) Close Dividends to Retained Earnings
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Temporary accounts and permanent accounts
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Closing entries for Siera Corp.
Post Closing Trial Balance
Chapter 5 – Merchandising Operations and the Multiple-Step Income
Statement
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Topic
We’re switching our studies from a service company to a
merchandising company
Periodic vs perpetual inventory systems. Text emphasizes
perpetual.
Single-Step Income Statement for Wal-Mart
Multiple-Step Income Statement for PW Audio- Please commit
this to memory
Calculation of cost of goods sold under periodic inventory
system
Profitability ratios- Gross Profit Ratio (gross profit/net sales)
Profit Margin Ratio (net income/net sales)
(aka, return on sales)
Quality of Earnings (cash from operating activities/net
income)
Journal entries involving the purchase of merchandise
Purchase merchandise on credit
Freight costs on merchandise purchased
Purchase returns and allowances
Purchase discounts
Summary of purchase transactions
Recording sale of merchandise
Sale on account and related cost of goods sold
Sales returns and allowances- reversing prior two entries
Sales discounts
Sales transactions – Do it!
Periodic Inventory System-You are not responsible for this
Comprehensive Do it! Put a star on this!!
Chapter 10 – Reporting and Analyzing Liabilities (Long-term liabilities,
pages 494-520)
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Current liabilities will be discussed later in the course
Types of bonds- secured and unsecured, convertible, callable
Terms-bond certificate, face value, maturity date, contractual
(stated) interest rate, effective interest rate
Value of a bond- pv of $ plus pv of A
Accounting for bond issues- entries to issue, pay or accrue
interest, amortize premium or discount, retire
Balance sheet presentation
Ratios- current ratio, debt to total assets, times interest
earned
Off balance sheet financing- contingent liabilities (record if
probable and reasonable estimate can be made. If possibly, a
footnote disclosure may be appropriate. If remote possibility,
ignore.
Enron
Leasing- operating lease vs. capital lease
SKIP THIS SECTION
Appendix 10A- Straight-line amortization of bond premium or
discount. We will use effective-interest method
Appendix 10B- Effective-interest amortization.
Straight-line and effective interest methods yield the same
amount of interest expense over the term of the bond but the
amount reported each year differs
Schedule for Bond Discount Amortization
Journal entries for recording bond interest expense and bond
discount amortization
Schedule for Bond Premium Amortization
Journal entries for recording bond interest expense and bond
premium amortization
Accounting for long-term notes payable
Mortgage installment payment schedule and journal entries
Effective interest rate=
(interest paid – premium amortization) / carrying value of
bond or
(interest paid + discount amortization) / carrying value of
bond
Chapter 11 – Reporting and Analyzing Stockholders’ Equity
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Characteristics of a Corp.
Advantages- separate legal existence (sue, be sued,
ownership, enter into contracts), limited liability (personal
assets of owners not at risk), transferability of ownership (sell
shares), ability to acquire capital (stock and bonds), unlimited
life, professional management (due to size)
Disadvantages – government regulations, additional taxes,
management decisions that favor management rather than the
corporation
Rights of Common Stockholders
Right to vote, share profits (receive dividends), preemptive
right, share assets upon liquidation
Rights of Preferred Stockholders
Same as above but no right to vote, and no preemptive right
Preference to dividends and sharing assets upon liquidation
Authorized (in charter), Issued (actually sold), and outstanding
shares (issued minus treasury stock)
Franklin Life Insurance stock certificate
Par value, no-par stock, no-par with a stated value
Journal entries for common stockSale of common stock at par, sale at a premium, treasury
stock
Stockholders’ equity on the balance sheet
Journal entries for preferred stock
Similar to entries for common stock
Dividends on preferred stock- cumulative and noncumulative
Dividends in arrears
Cash dividends prerequisites- available cash, adequate
retained earnings, declaration by board of directors
Entries for cash dividend (date of declaration, date of record,
date of payment)
Stock dividends (dividend paid in shares of co’s stock rather
than cash)
Stock splits
Retained earnings and restrictions (Amazon balance sheet )
Stockholders’ equity on balance sheet- Graber, Inc.
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Payout Ratio = cash dividends / net income
Return on common stockholders’ equity =
(net income – preferred stock dividends)/ average number of
common shares outstanding
Illustration 11-23 Finance by issue of stock vs. issue of bonds
Chapter 7 – Internal Control and Reporting Cash
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Minding the Money in Moose Jaw- Stephanie probably has good
control over food, supplies, and equipment. Read this section
carefully after reading the rest of the chapter and note the internal
control weaknesses over cash.
326
Fraud-A dishonest act by an employee that results in a personal
benefit to the employee at a cost to the employer- bookkeeper
diverts cash from his employer to his personal bank account;
shipping clerk ships merchandise to himself; computer operator
embezzles cash; church treasurer “borrows” church funds. Chapter
tends to stress the theft of assets (employee fraud), but fraudulent
reporting (management fraud) is also significant.
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Fraud Triangle- Incentive (financial pressure), Opportunity,
Rationalization (attitude). Our Internal Control system attempts to
minimize opportunity (cost/benefit considerations)
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Sarbanes-Oxley Act of 2002 (SOX). Auditors must now audit both
the financial statements and the system of internal controls.
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Internal Control- Methods and measures adopted to safeguard
assets, enhance reliability of accounting records, increase
efficiency of operations, and ensure compliance with laws and
regulations.
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Principles of Internal Control- Establish responsibility; segregation
of duties; documentation procedures; physical controls;
independent internal verification (audits); human resource control.
INTERNAL CONTROL FEATURES (see link on accounting
assignment sheet)
SEPARATION OF DUTIES-AUTHORIZATION, ACCOUNTING, &
1
CUSTODY
2
COMPETENT, HONEST EMPLOYEES
3
BOND EMPLOYEES
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EXTENDED VACATION, ROTATION OF JOBS
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PROCEDURES MANUALS
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ASSIGN AUTHORITY AND RESPONSIBILITY
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PHYSICAL CONTROL OF ASSETS
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PHYSICAL CONTROL OF ACCOUNTING RECORDS
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GOOD ACCOUNTING SYSTEM AND FINANCIAL STATEMENTS
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AUDIT-INTERNAL AND EXTERNAL
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UNANNOUNCED PHYSICAL COUNTS
REASONABLENESS TESTS (ratio analysis)
PERFORMANCE EVALUATIONS
330
Anatomy of a Fraud
Lawrence Fairbanks- purchased items for self- missing control was
segregation of duties
Angela Bauer- issued company checks to herself—missing control
was segregation of duties
Multiple employees submitted vouchers for reimbursement for
same trip- missing control was documentation procedures
Alex Parviz received commissions for sales he didn’t makemissing control was physical control over mailroom and insurance
applications
Bobbi Jean filed expense reimbursement reports for purchase of
her own clothes- missing control- segregation of duties and
independent verification
Ellen and Josephine never took vacations. Embezzled funds by
keeping cash paid by hotel guests- missing control was human
resource control as Ellen had been fired by previous employer for
same scheme
Limitations on Internal Control- reasonable assurance, not absolute
assurance
Internal Controls over Cash
INTERNAL CONTROL OVER CASH (see same link on accounting
assignment sheet)
ALL OF ABOVE FEATURES APPLY
CHECKING ACCOUNT
BANK RECONCILIATION
PETTY CASH FUND
Must consider control over cash receipts and controls over cash
disbursements
Journal entry for cash sale where there is a shortage or overage
(Cash Short or Over)
Use of the Voucher System- Verify purchase order, purchase
invoice, and receiving report- attach all three to voucher.
Responsible individual then authorizes payment.
Petty Cash Fund (Journal entries illustrated in Appendix- page 358359)
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Proper use of a checking account is a good control over cash
Illustration of Laird Company Bank Statement from the National
Bank & Trust
Bank Reconciliation procedure
Laird Company’s Bank Reconciliation and required journal entries
Cash account, bank reconciliation, and Cash balance on Balance
Sheet should all agree- Laird Company, $12,204.85
Principles of good Cash Management1. Increase speed of cash collections (offer cash discount)
2. Keep inventory levels low (Just-in-Time Inventory system)
3. Delay payment of liabilities (take advantage of cash discounts
but pay on last day to receive discount, e.g., 2/10, n/30)
4. Plan the timing of major expenses (Capital Budget)
5. Invest idle cash (Prepare cash budget to determine funds
available to invest or funds needed to borrow.
Cash Budget for Hayes Company
Journal entries for Petty Cash (establish the fund, replenish it, and
enlarge fund)
Chapter 8 – Reporting and Analyzing Receivables
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Topic
Types of Receivables- Name those that we have used
previously
Note entry for accrued interest earned.
Valuing Accounts Receivable- we won’t collect all that is
owed to us
Direct write-off method. Simple and useful if there are few
bad debts (aka, uncollectible accounts). However, it doesn’t
provide a good matching of revenues and expenses. You
are not responsible for this
Allowance method- provides a good matching of revenues
and expenses by estimating bad debts at the end of a
period.
How do we estimate bad debts? Look at past experience.
Apply a percentage of net sales or percentage of
receivables that occurred in the past. Better yet, age the
accounts receivable.
Adjusting entry to record estimated bad debts
Entry to actually write off a bad debt in the following period
Entries to collect an account that had been previously
written off
Aging Schedule, Journal entry, and T account presentationSTUDY THIS!
Notes Receivable. Illustration of a promissory note
Computing interest- we’ve been doing this since Basic
Training
Recognizing notes receivable- loan money and receive a
note; make a sale and receive a note; receive a note as an
extension of a past due account receivable.
Journal entries for the collection of a note and another
entry to accrue interest on a note at the end of the period.
Managing Receivables:
1. Determine to whom to extend credit
2. Establish a payment period (COD, n/20, 2/10, n/30)
3. Monitor collections
4. Evaluate the liquidity of receivables (aging schedule)
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5. Accelerate cash receipts when possible
Ratios for evaluating receivables
1) Receivables turnover ratio (net sales/average
receivables)
(Some use net credit sales/average receivables)
2) Average collection period (aka, days in receivables)
365 / Receivables Turnover Ratio
We’ll compute similar ratios to evaluate inventory in the
next chapter
Review the “Comprehensive Do It!”
Chapter 6 – Reporting and Analyzing Inventory
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Classifying inventory- For a merchandising firm, we refer to
items for resale as “inventory” or “merchandise inventory.”
For a manufacturing firm, inventory is classified as raw
materials, work in process, and finished goods.
Valuing inventory- 1) determine inventory quantities, 2) price
the inventory
Determining ownership- goods in transit, consigned goods
Inventory costing methods- 1) Specific identification, 2)
First-in, first-out (FIFO), Last-in, first-out (LIFO), and
Average Cost (aka, weighted average)
Use text problem (E6-5) to illustrate calculations
Goods Available – Ending Inventory = Cost of Goods Sold
$12,000
- $5,400
= $6,600
Effects of inventory methods on income statement (cost of
goods sold and income tax expense), balance sheet
(inventory, taxes payable, retained earnings)
Use of Inventory methods in US (FIFO=44%)
Effects on taxes this year and next year
Effects on cash due to taxes paid
Consistency required once a method is chosen
Mention the Lower-of-Cost-or-Market method- Very
conservative
Inventory Turnover Ratio – Cost of Goods Sold / Average
Inventory
Days in Inventory – 365 / Inventory Turnover Ratio
These are similar to the Receivables Turnover Ratios
Mention the use of the LIFO Reserve – the difference
between the ending inventory using LIFO and FIFO.
Required footnote disclosure for companies using LIFO.
Chapter 10 – Reporting and Analyzing Liabilities (Current Liabilities pages 486-494)
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Topic
Long-term liabilities were covered earlier- Long-term notes
payable and bonds payable. Our discussion today focuses
on current liabilities.
A current liability is one that is paid out of current assets
(usually cash) or creation of other current liability (AP
converted into NP), and paid within one year or the
company’s operating cycle (the longer). Most operating
cycles are for far less than one year.
Entries for Notes Payable and Interest Payable
Entry for Sales Tax Payable
Entry for Unearned Revenue
Current maturity of long-term debt
Payroll Taxes Payable- entry to record the payroll and entry
to record the employer’s payroll tax expense
Chapter 9 – Reporting and Analyzing Long-Lived Assets
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Topic
Plant assets (Property, Plant, & Equipment) –
 Determining cost of a plant asset
 Accounting for PP&L including depreciation and
disposal
 Analyzing plant assets (ratios)
Intangible assets (no physical characteristics)
 Types of intangible assets
 Accounting for intangible assets
 Financial statement presentation
Determining the cost of a plant asset- Cost includes all
expenditures necessary to acquire the asset and get it ready
for use
Land cost includes purchase price, realtor, attorney, and
other fees associated with the acquisition, removal of old
building, etc. We do not depreciate the land.
Land improvements- driveways, parking lots, fences, outside
lighting, sprinkling systems. Depreciate land improvements
over their useful life.
Buildings- Capitalize the purchase price, closing cost,
remodeling, renovations (everything it costs to get the asset
in place and ready to use.
Trucks, Autos - Cost includes cash price, sales tax, painting
& lettering, special additions to asset
Equipment – Cost includes cash price, sales tax, insurance
during shipping, installation and testing.
To buy or lease? Considerations include obsolescence,
down payment, tax considerations, affect on financial
statements
Operating lease not reported as an asset nor is a liability
reported- Debit Rent Expense; Credit Cash
Capital lease- Record leased asset at present value of lease
payments and credit an account called Obligations under
Capital Lease.
Depreciation- A process of allocating to expense the cost of
a plant asset over its useful life in a rational and systematic
manner.
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447
Depreciation is a cost allocation process, not an asset
valuation process (i.e., emphasis on getting a good matching
on the income statement rather than a proper value for the
asset on the balance sheet.
Factors needed to compute depreciation:
1. Cost – As discussed on pages 436-437
2. Estimated Useful life – not physical life
3. Salvage Value (aka, scrap value, residual value)
Pie chart indicates that straight-line method is used 83% of
the time.
Straight-line = (Cost – Salvage) / Estimated useful life
Look at Depreciation schedule (Illustration 9-9)
Double Declining-Balance = (Cost – Accumulated
Depreciation) x Twice the Straight-line Rate
See Appendix, page 461 for illustration. You are responsible
for this!
Straight-line rate for a five year life is 1/5, so we’ll use a rate
of 2/5 for the Double Declining-Balance method
Look at Depreciation schedule (Illustration 9-10)
Units-of-Activity = (Cost – Salvage) / Estimated units in life.
Look at Depreciation schedule (Illustration 9-11)
See Appendix, page 462 for illustration. You are responsible
for this!
Illustration 9-12- Comparison of methods.
 Notice that total depreciation is the same over the five
year life.
 What differs is that SL writes asset off evenly, DDB
writes a large amount of the asset off in the early years
 Unit-of-activity methods depreciation differs due to
usage (physical wear and tear)
 Repair Expense increases as asset ages, so total
depreciation under DDB + repair expense might be
similar over the years of the asset use
For tax purposes, taxpayers must choose between straightline and Modified Accelerated Cost Recovery System
(MACRS). But this isn’t tax class!
Disposal of plant asset – scrap, sell, or trade-in
Notice journal entries to record depreciation and sale of
asset: Record cash received, eliminate Accumulated
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456
Depreciation account, eliminate asset account, and show
balance as a gain or loss.
If the cash received is greater than the asset’s book value,
you have a gain (credit Gain on Sale).
If the cash received is less than the asset’s book value, you
have a loss (debit Loss on Sale)
Analyzing Plant Assets
Return on Assets (ROA) = Net Income / Average Total Assets
Asset Turnover Ratio =
Net Sales / Average Total Assets
Profit Margin Ratio = Net Income / Net Sales
ROA = Profit Margin Ratio x Asset Turnover Ratio
Accounting for Intangible Assets – Patents, Copyrights,
Franchises, Trademarks, Trade Names, Goodwill, Research
and Development costs.
Amortization is the process of writing off an intangible asset.
We depreciate tangible assets and amortize intangibles.
Goodwill is capitalized but not amortized (subject to an
annual impairment test)
R & D is expensed and never capitalized
Compute amortization on a patent- straight-line method
used.
International Accounting Standards differ from US GAAP
 Research is expensed but Development is capitalized.
Chapter 12 – Statement of Cash Flows
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616 or
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Topic
We briefly looked at the Statement of Cash Flows in Basic
Training and in Chapter 1.
We know the three sections: Cash from Operating
Activities, Financing Activities, and Investing Activities.
We know that we are looking at sources and uses of CASH.
This statement is necessary because the other three
statements use accrual accounting and don’t necessarily
stress cash.
By looking at comparative Balance Sheets, we can see the
beginning and ending cash for the current year, but can’t
explain the changes to cash.
Usefulness of Statement of Cash Flows:
 Company’s ability to generate future cash
 Company’s ability to pay debt and dividends
 Opportunity to evaluate differences between net
income and cash from operating activities
 Concise list of cash investing activities and financing
activities
Noncash financing and investing activities:
 Issuance of stock for assets
 Issuance of long-term debt for assets
 Conversion of long-term debt for stock
 Exchange of plant assets (e.g., land for building)
Usage of Methods – 99% use the indirect method
Information needed to prepare statement the statement of
cash flows– Comparative Balance Sheets, Income
Statement, Other Information
STATEMENT OF CASH FLOWS
Cash from Operating Activities
 Start with Net Income
 Make conversions needed to change from accrual
basis to cash basis.
 This statement follows the Indirect Method.
Cash from Investing Activities
 Purchase and Sale of Long-term Assets (Investments
Assign.
Sheet
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619
621
622
625
and PP&E)
Cash from Financing Activities
 Changes in Common Stock, Preferred Stock,
Dividends, LT Debt, Bonds Payable
Combine OA, IA, and FA to determine change in cash for
period
Add Cash at beginning of period to change in cash to get
Cash at end of period.
Report Noncash Investing and Financing Activities
Examine the Study Aid provided on the Assignment Sheet
Complete P12-9A together- Cipra Corp.
Illustration 12-3 - Corporate (Product) life cycleIntroductory phase, Growth phase, Maturity phase, and
Decline Phase
Ratios:
 Free Cash Flow = Cash from Operating ActivitiesCapital Expenditures – Cash Dividends
 Current Cash Debt Coverage Ratio –
Cash from Operations / Average Current Liabilities
A measure of liquidity
 Cash Debt Coverage Ratio –
Cash from Operations / Average Total Liabilities
A measure of Solvency
Statement of Cash Flows – Direct Method
You are not responsible for the Direct Method
Chapter 13 – Financial Analysis: The Big Picture
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Topic
Sustainable Income- most likely level of income to be
obtained. That is, income before discontinued operations,
extraordinary items, and other comprehensive income (all net
of tax).
Discontinued operations-division, product line
Extraordinary items- event that is unusual and infrequent such
as a flood or fire, expropriation (takeover) be foreign
government, condemnation
Ordinary items- natural casualty, not uncommon in area, write
down of inventory, loss due to labor strike, sale of PPE
Changes in Accounting Principle (Inventory, depreciation)For consistency, apply new principle to current and prior
period.
Comprehensive income- Gains and losses that are reported in
stockholders’ equity rather than on the income statement
such as gain or loss on sale of available-for-sale securities.
Report on Income Statement after Net Income.
Illustration 13-7- Complete Income Statement including
irregular items.
Comparative Analysis- intracompany (compare current to
prior year), intercompany (compare to competition), industry
averages.
Horizontal analysis of Kellogg’s 06 & 07 Balance Sheets
Horizontal analysis of Kellogg’s 06 & 07 Income Statements
Vertical analysis of Kellogg’s 06 & 07 Balance Sheets
Vertical analysis of Kellogg’s 06 & 07 Income Statements
Ratio Analysis- We’ve seen them in prior chapters
Liquidity Ratios
Solvency Ratios
Profitability Ratios
These ratios are reported on a single page after the subject
index at the back of your text. This page will be photocopied
and included on your final exam so you don’t have to
memorize the ratios for the exam.