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Week 2 Creating Financial Statements From Transactions
I.O.U. I.O.U. The Fundamental Accounting Equation Assets = Liabilities + Stockholders’ Equity = +
Economic Events • Relevant events have economic significance to a company and include any occurrence that affects its financial condition. • The dollar values assigned these events must be determined in an objective manner.
Two Methods To Record Transactions • Traditional (Hard!) way used by accountants/bookkeepers • Debits • Credits • T-accounts • Our methods • Spreadsheet based on accounting equations • Increases and decreases
The Journal Entry Box 1. What accounts are affected? Liabilities and Stockholders’ Equity = Assets Asset Accounts Liab/Stock Eq. Accounts Increase $Debit (left) $Credit (right) 2. What is the direction of the effect? 3. What is the dollar value of the transaction? Asset Accounts Liab/Stock Eq. Accounts Decrease $Credit (right) $Debit (left)
Recording Transactions • Accounting equation (A = L + OE) • Debits = credits • Journal entries • T-accounts
The Balance Sheet • Depicts net worth at a point in time • Assets • Resources with future value • Liabilities • Obligations to non-owners • A source of the resources • Owners’ Equity • The difference between assets and liabilities • Another source of the resources • Two forms • Contributed Capital (Common Stock) • Earned Capital (Retained Earnings)
Assets • Something owned • Has future value (otherwise expense in current period) • Current versus long-term • Examples include: cash, accounts receivable, notes receivable, marketable securities, prepaid expense, property plant and equipment, intangibles • Appears on balance sheet • Permanent account • Normal balance is a debit
I.O.U. Liabilities • Something owed • Current versus long-term • Examples include: accounts payable, notes payable, other payables, unearned revenue • Appears on balance sheet • Permanent account • Normal balance is a credit
Equity • Difference between assets and liabilities • Net worth (book value) • Stock (Paid-in-capital) • Retained Earnings (accumulated net earnings less dividends distributed) • Income statement and dividends are closed to retained earnings • Appears on balance sheet and separate statement • Permanent account • Normal balance is a credit
The Income Statement • A measure of entity performance for a period of time. • Based on accrual accounting • Ties to the Balance Sheet through retained earnings • Major components • Revenues and gains • Expenses and losses • Closed to R/E and starts new period with a clean sheet
Revenue • Usually results in an increase to assets • Results from the sale of merchandise, performance of service, rental of property, or lending of money • Appears on income statement • Temporary account closed to R/E • Normal balance is a credit
Gains • Similar to revenues • Results when an assets is sold for more than book value (cost – accumulated depreciation) • Temporary account appears on income statement and closed to R/E • Normal balance is a credit
Expenses • Asset used or service consumed • If it had future value then it is ‘capitalized’ as an asset • Expected or actual cash outflows • Examples include: salaries, interest expense, COGS, utilities, rent, supplies, and taxes • Appears on income statement • Temporary account closed to R/E • Normal balance is a debit
Losses • Opposite of gains • Similar to expenses • Results when an assets is sold for less than book value (cost – accumulated depreciation) • Temporary account appears on income statement and closed to R/E • Normal balance is a debit
Dividends • Distribution to shareholders (return of capital) • NOT AN EXPENSE! • Does not appear on the income statement, instead a temporary account closed straight to R/E • Normal balance is a debit
Sample Transactions 1.Purchase inventory for cash (4 @ $25 each) 2. Purchase inventory on account (2 @ $25 each) 3. Sell inventory for cash (3 @ $50 each) 4. Sell inventory on account (3 @ $50 each) 5. Pay for inventory purchased on account 6. Receive remaining receivables 7. Pay in cash other expenses of $80
Arcadia Company Review Problem • Smith contributed $250,000 in cash • The firm purchased a shop for $150,000 • The firm borrowed $120,000 • Interest only of 6% paid semi-annually • $150,000 of inventory purchased with $120,000 cash and $30,000 credit • $80,000 (cost) of the inventory was sold for $160,000 in cash • The shop is depreciated over 20 years on a straight-line basis • Smith withdrew $20,000 of his capital contribution
Recognizing Gains and Losses • Often investments and non-current assets are sold for more or less than the amounts at which they are carried on the balance sheet • In such cases a gain or loss must be recognized • Example: Purchase a truck 1/1/01 for $10,000, 5 year life, sell 7/1/04 for $7,000
Periodic Adjustments • Accruals • Accruals refer to amounts in asset and liability accounts that build up over time • Adjustments to record accruals are made at the end of an accounting period • The term accrue means to build up gradually • Examples include accrued wages and accrued interest • Cost expirations • Expirations refer to the write down of an already established account over time • One example is depreciation
Problem 2.2 • Received $50,000 in cash from investors as an equity investment. • Borrowed $40,000 from a bank. • Purchased two parcels of land, each costing $15,000, for a total of $30,000 cash. • Paid $10,000 cash to rent office equipment for the year. • Provided real estate appraisal services valued at $25,000, receiving $20,000 in cash and an account receivable for an additional $5,000. • Paid miscellaneous expenses totaling $11,000 in cash. • Sold one parcel of land, costing $15,000, for $22,000 cash. • Paid a $5,000 cash dividend to shareholders.
Some Useful Ratios • Profitability • Why not just consider net income? • Return on Assets (ROA) • Considers how will you did with what you invested. • Both income statement and balance sheet.
ROA • Tells us what is available for all investors (both debt and equity). • Return of equity (ROE) similar for just shareholders. • Can be decomposed into two components in order to shed more light on performance.
ROA • ROA = Return on sales (ROS) x Asset Turnover (AT)
Return on Equity • Only considers return to shareholders • Therefore no need to add back interest expense • Also only divide by shareholders’ equity rather than total assets
ROE • Like ROA, ROE can also be decomposed • Sometimes called the Dupont Model • ROE = ROS x AT x Leverage
Evaluating Risk • Debt to equity • Interest coverage
What Number Do You Want? • Accounting is a political process, not an exact science. • There is a great deal of discretion available to managers.
Earnings Management • Reasons to manage earnings • ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS
Earnings Management - Why • Compensation contracts • Debt contracts • Political considerations
Question? Why might a company’s stockholders want its managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary?
Debt Contracts • Firms that are near violation of their debt contracts have incentives to manage earnings upward.
Question? The following excerpt was taken from a recent financial statement of Cummins Engine Company: Loan agreements contain covenants which impose restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. Why would a creditor such as a bank impose such restrictions when making a loan?
Political Reasons • Firms may wish to portray a certain image to the public, government, or regulatory body.
Common Earnings Management • Smoothing earnings • Managing earnings upward • Taking a bath • Off balance sheet financing
Problem 2.11 • See handout