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 The Balance Sheet: Dell Inc.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 PreparationPresented below are selected accounts of Biking Corporation at December 31, 2008:

Patent $150,000 Income taxes payable $93,000 Interest payable 30,000 Notes payable (short-term) 264,000Bonds payable 450,000 Equipment 950,000Common stock, $5 par value 400,000 Discount on bonds payable 25,000Preferred stock, $10 par value 150,000 Refundable federal and state income taxes 97,630Prepaid insurance 89,000 Accumulated depreciation – equipment 232,000Accounts payable 283,000 Inventory 242,000Trading securities 117,000 Cash 360,000Land 520,000 Accumulated depreciation – building 450,000Accounts receivable 143,000 Long-term loan from bank 640,000Rent payable 45,000 Building 1,200,000Retained earnings ?

Required: Prepare a classified balance sheet.

Clinic I-8

SolutionCurrent assets $ Current liabilities $Cash 360,000 Accounts payable 283,000Trading securities 117,000 Notes payable 264,000Accounts receivable 143,000 Interest payable 30,000Inventory 242,000 Income taxes payable 93,000Prepaid insurance 89,000 Rent payable 45,000Total current assets 951,000 Total current liabilities 715,000

Property, plant and equipment Long-term liabilitiesLand 520,000 Long term loan from bank 640,000Buildings 1,200,000 Bonds payable 450,000Less acc. depreciation (450,000) 750,000 Less discount on bonds payable (25,000) 425,000Equipment 950,000 Total long term liabilities 1,065,000Less acc. depreciation (232,000) 718,000 Total liabilities 1,780,000Total Property, plant and equipment 1,988,000

Stockholders’ equityIntangible assets Capital stockPatent 150,000 Preferred stock, $10 par; 150,000

Common stock, $5 par 400,000 550,000Retained earnings 759,000Total stockholders’ equity

Total assets 3,089,000 Total liabilities and 3,089,000stockholders’ equity

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: The Income Statement: Dell Inc.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 409,000 Accounting and legal services 24,000Office salaries 282,000 Shipment-in 81,000Sales 5,000,000 Advertising 108,000Purchases 2,548,000 Depreciation of office 62,000Insurance expense 26,000 Depreciation of sales equipment 58,000Sales commission 76,000 Sales salaries 257,000Sales returns 42,000 Extraordinary loss (before tax) 96,000Purchase discounts 31,000 Interest expense 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) 4,958,000Cost of goods sold (2) 2,460,000 Gross profit 2,498,000Selling expense (3) 499,000Administrative expense (4) 394,000 893,000 Income from operations 1,605,000Other expense 176,000Income before taxes 1,429,000 Income taxes (35%) 500,150Income before extraordinary item 928,850Extraordinary loss, net of $33,600 taxes 62,400Net income 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 The Statement of Cash Flows : Dell Inc.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 ActivitiesCash 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 ActivitiesCash 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 ActivitiesCash 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

2005 2004Cash 70 110Accounts receivables 170 300Inventories 200 240Loan to company B 1,500 -Land 500 -Equipment 500 550Acc. Depreciation (190) (200)

2,750 1,000

Accounts Payable 120 200Bonds Payable 1,000 -Deferred tax liability 380 300Common Stock 1,220 250Retained Earnings 30 250

2,750 1,000

Scientific Instruments, Ltd.Balance Sheet

December 31, 2005 and 2004

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

Cash flows from operating activitiesNet Income 80

Adjustments to reconcile net income to net cash providedby operating activities:Gain on sale of equipment (10)Depreciation 15Increase in deferred tax liability 80Decrease in accounts receivables 130Decrease in inventories 40Decrease in accounts payable (80) 175Net cash provided by operating activities 255

Cash flows from investing activitiesLoan to B (1,500)Purchase of Land (500)Sale of Equipment 35Net cash used by investing activities (1,965)

Cash flows from financing activitiesIssuance of common stock 970Issuance of bonds payable 1,000Payment of cash dividend (300)Net cash provided by financing activities 1,670 Net decrease in cash (40)Cash, December 31, 2004 110Cash, December 31, 2005 70

Statement of Cash FlowFor the year ended December 31, 2005

Scientific Instruments, Ltd.

Clinic I-23

The Statement of Stockholders’ Equity: The Statement of Stockholders’ Equity: Dell Inc.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.)

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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

Revenues

Expenses

Net income

Income StatementIncome Statement

Investment and disinvestment

by owners

Net income and other earnings

Net change in owners’ equity

Statement of Shareholders’ EquityStatement of Shareholders’ Equity

Cash from operations

Cash from investing

Cash from financing

Net change in cash

Cash Flow StatementCash Flow Statement

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Beginning Balance SheetBeginning Balance Sheet

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Ending Balance SheetEnding Balance Sheet

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 AccountingUnder U.S. GAAP, the following assets and liabilities are approximately at market value:

Cash and Cash Equivalents Short-term investmentsAccounts 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 XXXGoods 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 2004-20091. 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 2004 2005 2006 2007 2008 2009 Operating income before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

Incremental income from R&D

__0

7,000

7,000

7,000

7,000

7,000

30,000 37,000 37,000 37,000 37,000 37,000 R&D expense (20,000) __0 __0 __0 __0 __0 Operating income 10,000 37,000 37,000 37,000 37,000 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. 2004 2005 2006 2007 2008 2009 Operating income before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

Incremental income from R&D

______

7,000

7,000

7,000

7,000

7,000

30,000 37,000 37,000 37,000 37,000 37,000 R&D expense __0 (4,000) (4,000) (4,000) (4,000) (4,000) Operating income 30,000 33,000 33,000 33,000 33,000 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 assetsOff-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, warrantiesAggressive revenue recognitionConservative 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