Accounting Clinic I
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
With contributions by
Stephen H. Penman – Columbia University
Clinic I-2
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
Clinic I-3
The Financial Statements
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders’ Equity
Clinic I-4
The Balance
Sheet: Dell Inc.
Clinic I-5
The balance sheet reports the assets of the
firm at a point in time and the claims
against those resources. The claims are
broken up into liabilities and shareholders’
equity.
Clinic I-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.
Clinic I-7
Example - Balance Sheet Preparation
Presented below are selected accounts of Biking Corporation at
December 31, 2008:
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.
Clinic I-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.
Clinic I-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.
Clinic I-10
The Income Statement:
Dell Inc.
Clinic I-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
Clinic I-12
Example - Income Statement Preparation
below are selected ledger accounts of Grant Corporation at
December 31, 2008:
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
Clinic I-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
Clinic I-14
The Statement of
Cash Flows : Dell Inc.
Clinic I-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.
Clinic I-16
The Form of the Cash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing
Clinic I-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).
Clinic I-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.
Clinic I-19
Direct Method Cash Flow Statement
A few firms report cash flow from operations using the
“direct method” (see Chapter 10). Here is an example form
Northrop Grumman Corp.:
Clinic I-20
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
1,000
200
300
250
250
2,750
1,000
Clinic I-21
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.
Clinic I-22
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)
Net decrease in cash
Cash, December 31, 2004
Cash, December 31, 2005
175
255
(1,965)
1,670
(40)
110
70
Clinic I-23
The Statement of Stockholders’ Equity:
Dell Inc.
Clinic I-24
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.)
Clinic I-25
Comprehensive Income
Comprehensive income in net income
(from the income statement) plus “other
comprehensive income”
To avoid earnings fluctuations some of the
unrealized gains/losses are reported in
“other comprehensive income” and not
included in net income.
Clinic I-26
Clinic I-27
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
Clinic I-28
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
Clinic I-29
Principles of Measurement
Two types of measurement are used in
financial statements
Fair value 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.
Clinic I-30
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.
Clinic I-31
Mark-to Market Accounting
Under U.S. GAAP, the following assets and
liabilities are approximately at market value:
Cash and Cash Equivalents
Short-term investments
Accounts payable
Equity Investments considered trading securities or
“available for sale.” See Accounting Clinic III.
The following assets and liabilities are measured
with estimates of that are usually close to market
value:
Net Accounts Receivables (net of estimate of likely
bad debt.)
Accrued and Estimated Liabilities
Note that debt (short-term and long-term) is at
historical cost but that is typically close to fair value)
Clinic I-32
Historical Cost Accounting
The following assets and liabilities are at
historical cost on the balance sheet:
Long-term Tangible Assets (depreciated)
Recorded Intangible Assets (amortized)
Goodwill (not amortized)
These assets can be written down if their
value is deemed to have been impaired, but
are never written up (in the U.S.).
Clinic I-33
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
Clinic I-34
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
Clinic I-35
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.
Clinic I-36
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
Clinic I-37
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.
Clinic I-38
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.
Clinic I-39
(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
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
Clinic I-40
Fully expensing R&D in the year in which
it was incurred results in poor matching in
operating income.
Clinic I-41
How Financial Reporting Issues Arise
Efficiencies of Generally Accepted Accounting Principles (GAAP)
Examples:
Assets omitted from the balance sheet: R&D and brand assets
Off-balance-sheet obligations not recognized (FIN 46 helps to rectify)
Losses on conversions into common stock and options settled with
common stock are not recognized (SFAS 150 attempts to rectify)
Poor Application of Accounting Principles
Examples:
Excessive restructuring charges (SFAS 146 helps here)
Biased estimates of bad debts, sales returns, warranties
Aggressive revenue recognition
Conservative revenue recognition: Creation of a “cookie jar” with
unearned revenue
“Creative accounting” that yields form over substance: using “bright
lines” in GAAP to obscure; structural engineering
Clinic I-42
How Should You Deal with the Accounting
Issues?
Understand GAAP and its limitations
Appreciate the relevance-reliability tradeoff
Recognize unresolved issues in GAAP
Recognize where choices can be made
Be alert to poor application of GAAP
How sensitive are earnings to estimates?
How would you characterize the revenue recognition – aggressive
or conservative?
Does the application of GAAP “faithfully represent” the business?
These issues will come to the fore as we proceed through
the book
Clinic I-43
Who Sets the Rules (in the U.S.)?
U.S. Congress
Securities and Exchange Commission (SEC)
www.sec.gov
Financial Accounting Standards Board (FASB)
www.fasb.org
From the past:
Accounting Principles Board (APB)
“General Acceptance”
In the future:
How will the International Accounting Standards Board (IASB)
influence accounting principles? The SEC Roadmap (Box 2.5)
Clinic I-44