Fuqua School of Business, Duke University ACCOUNTG 510: Foundations of Financial Accounting

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1 Fuqua School of Business, Duke University ACCOUNTG 510: Foundations of Financial Accounting Lecture Note: Financial Statement Basics, Transaction Recording, and Terminology I. The Financial Reporting Package (the Annual Report) A. Description of what the company does, pictures of employees and products B. Analytic material supplied by the company 1. 5 or 10 year Financial Summary 2. Management Discussion and Analysis 3. Unwarranted optimism ( it wasn't our fault ) and other self-serving discussion 4. Report by Management and Auditor C. Financial statements 1. Income Statement - usually (but not always) is presented first 2. Balance Sheet 3. Statement of Cash Flows 4. Statement of Shareholders Equity 5. Footnotes and other required disclosures D. Signatures by CFO and CEO attesting to the Annual Report. II. Balance Sheet A. Describes the financial status of a business entity at a particular point in time, usually the end of a time period called fiscal year or fiscal quarter. 1 B. Financial reporting is based on the following accounting equation, which summarizes the balance sheet: Assets = Liabilities + Shareholders equity Productive Creditor Owner claims capacity claims (contributed capital plus undistributed earnings) Note: Shareholders equity is also sometimes called book value (of equity) or owners equity. The balance sheet is an arithmetic equality. In accounting, it is always true that the assets are equal to the sum of the liabilities and shareholders equity. 1 Fiscal just refers to the fact that not all firms have a December year end. By the way, the convention is to describe a firm s financial statement as pertaining to fiscal year T if their fiscal year end is between June and December inclusive. If the fiscal year end is January through May, we say the fiscal year pertains to fiscal year T-1. So, for example, a financial statement dated January 31, 2003 would commonly be interpreted as applying to fiscal

2 Assets are future economic benefits that the firm controls because of a past event or transaction. Examples include: cash, accounts receivable (these are amounts owed to the firm by its customers), inventories, land, investments in other firms, factories. Liabilities are obligations to sacrifice resources. For the most part, accounting liabilities are also legal obligations. Examples include: accounts payable (amounts owed by the firm to its suppliers), bank loans payable (amounts owed to banks). Shareholders equity is the residual, defined as Assets minus Liabilities. Shareholders equity includes capital contributed by owners (common stock) plus the entire cumulative earnings of the firm that has not been distributed as dividends (retained earnings). The balance sheet lists specific items of Assets, Liabilities, and Owners Equity. There are totals (arithmetic sums of the values listed for the various items) displayed as well. C. Assets - economic resources that are expected to generate future cash flows 1. Typically ordered by liquidity or closeness to turning into cash. So, the most liquid assets are listed first, followed by next most liquid, etc. 2. Short Term (or current ) expected to turn into cash within the firm s operating cycle; most firms have operating cycles of one year or less. a. Cash b. Marketable Securities or Short Term Investments c. Accounts Receivable d. Inventories 3. Long Term (or non-current ) expected to turn into cash sometime after one operating cycle. a. Investments b. Property, Plant and Equipment ( PP&E ) c. Intangible Assets d. Other D. Liabilities - economic obligations to outsiders or claims against assets by outsiders 1. Short Term ( current due within one year) 2. Long Term ( non-current due after one year) E. Owners Equity - the residual interest in assets after deducting liabilities 1. Common stock at par value 2. Contributed capital (also called additional paid in capital, APIC ) 3. Retained earnings (earnings not paid out in the form of dividends, but reinvested within the firm) 4. Treasury shares (shares that are bought back) 5. Noncontrolling Interests 6. Accumulated other comprehensive income F. Note that we have not said anything yet about how assets are valued (historical cost, market value, fair value, inflation-adjusted, etc.). 2

3 III. Income Statement A. A measure of performance during a period of time. Income, net income, earnings (often used interchangeably). Negative income = loss or net loss B. Net Income = Revenues - Expenses + Gains/Losses Revenues Expenses + Gains Losses Asset inflows from Expired costs Other asset Other expired selling goods and associated with inflows costs services revenues Revenues = sales prices times quantities generated in the normal ongoing course of business Expenses = all costs associated with normal ongoing operations Gains/Losses = sources of revenue and expense which are not associated with ongoing business operations. Examples include: gains and losses on sales of assets (if not part of normal business) or sale of a business segment. C. Income not declared as dividends increases retained earnings. This concept links the income statement (statement of operations) to the balance sheet: RetainedEarnings RetainedEarnings NetIncome Dividends t t 1 t t t represents the time subscript. If dividends exceed the net income, retained earnings will decrease. Moreover, losses (negative income) decrease retained earnings (or increase accumulated deficit). Losses occur when expenses exceed revenues. 1. Since the balance sheet equation must hold at both the beginning and the end of the period, it also holds for changes in account balances (denoted by ). Assets Liabilities = Owners Equity = Retained Earnings + Contributed Capital = Net Income Dividends + Contributed Capital 2. This reconciliation of the income statement and the change in the shareholders equity account is done in the statement of shareholders equity. D. In the United States, accounting income that you report to shareholders is not the same thing as the income you report to the Internal Revenue Service (IRS) for tax purposes. Stated differently, firms have two sets of books: one for financial reporting (i.e., the financial statements that are filed with the SEC and which form the basis for investors and creditors assessments of value and financial health), and another for tax purposes. We often refer to the first set as the financial reporting books while the other set of books is the tax books. In many other countries, taxable income and book income are much closer than they are in the United States. 3

4 E. Earnings per share 1. Net income is calculated on a total (dollar, in the US) basis as well as on a per share basis. The earnings per share number is calculated by dividing net income by the weighted average number of shares outstanding for the period. So, for example, if the firm had 100 shares outstanding for 10 months of the year and 200 shares outstanding for the other two months, the weighted average number of shares outstanding is: 10 2 (100) (200) We also distinguish between basic and diluted shares outstanding. While this topic is beyond the scope of the course, we briefly comment on it here for those who are exceptionally eager. Some firms have instruments (like stock options, convertible debt, warrants) which, while not currently common stock, have the ability to convert into common stock at either the firm s discretion or the holder s discretion. The diluted number of shares outstanding shows the number of common shares that would be outstanding if all these instruments were to convert into common shares at the date of the balance sheet. 2 The basic number shows the number of common shares without these conversions. IV. Cash Flow Statement A. At the most simplistic level, the statement of cash flows can be viewed as reconciling the beginning and ending balance of the cash account (or cash and cash equivalents). B. More importantly, it separates the effects of operating, investing, and financing activities of the firm on cash flow. C. Sometimes cash inflows and outflows are shown directly on the face of the statement. This is called the direct method. D. Firms more commonly use the indirect method. We investigate both approaches in a later lecture note. Briefly, the indirect method starts with net income and backs into cash flow. E. Note that the cash flow statement totally ignores the future; it looks only at events and transactions that resulted in cash this period. V. Statement of Shareholders Equity A. Provides a summary of what has happened to each of the major shareholders equity accounts during the period. B. For common stock, the firm shows both the number of shares and the dollar value attached to those shares. 2 Note that in calculating diluted Earnings per share, it may be necessary to make adjustments to net income as well. 4

5 VI. Preparation of Financial Statements A. Management is responsible for preparing financial statements and for the fairness of the representation of the financial statements. B. The auditor's role is to examine the financial statements that have been prepared by management and to express an opinion regarding their reliability. C. Accounting statements are constructed according to Generally Accepted Accounting Principles (GAAP). Congress granted the Securities and Exchange Commission (SEC) the authority to decide on the appropriate accounting principles. The SEC has delegated this job to the Financial Accounting Standards Board (FASB), a private rule-setting body. The accounting standard setting process is influenced by political considerations, not just accounting logic. D. Accounting is not just backward looking; the definitions of assets and liabilities are based on future cash flows. E. Because accounting is forward looking (at least somewhat), there is considerable room for judgment in the accounting. F. Management is the most knowledgeable about the firm s financial position, its future plans, what the long term impact of past and current actions is likely to be, etc. G. Management often has the most to gain from misrepresenting the financial statements (i.e., the financial position of the firm and/or the firm s performance for the year). H. Accounting is moving from a mixed attribute (historical cost and fair values) framework toward a fair value framework. VII. Basic Bookkeeping A. Journal entries - Debits and Credits Journal entries represented by debits and credits are mechanisms that accountants use to ensure that the balance sheet maintains its balance. By balance we mean that assets always equal the sum of liabilities plus equity. We can ensure this balance by making sure that whenever we add (or subtract) an asset from the balance sheet, we add (subtract) something else to make sure we stay in balance. Journal entries achieve this by showing (usually in the top lines, and those not indented) the debits with the other lines (usually below, and usually indented) showing the credits. Debits and credits have no meaning outside of accounting, so don t impute a meaning to them that you think they should have. A debit is used to indicate an increase in an asset account and a decrease in a liability or equity account. A credit implies the opposite: a decrease to an asset account and an increase in a liability or equity account. So, for example, if you debit Cash and credit Bank borrowings, what does this mean you did? Journal entry: Cash (Dr) Bank borrowings (Cr) 5

6 It means you borrowed money from the bank (thus increasing your liabilities) and increased your assets by the amount of cash received. Notice that we use (Dr) and (Cr) as short forms for debits and credits in the journal entry. However, it is not necessary to parenthetically indicate which one is a debit or credit because the indentation and placing the credit amounts in an adjacent column is sufficient to indicate which of the accounts is being debited and credited. What if you then took the cash you borrowed and then bought some equipment: what would your journal entry look like? Journal entry: Equipment (Dr) Cash (Cr) You would debit Equipment and credit Cash, as shown above. Note that in the first case you increased an asset account (Cash) and increased a liability account (Bank borrowings) to keep the balance sheet in balance. In the second journal entry, you decreased one asset account (Cash) and increased another asset account (Equipment) to maintain balance. B. T-accounts A t-account is just a picture illustrating the activity in a given account. Consider the asset account for Cash: Cash (A) Dr. Cr. YYY In a t-account, the convention is that the debited amounts are entered on the left and credits are entered on the right. While we will discard indicating the Dr. and Cr. in future t-accounts, it is a useful practice to write Dr. and Cr. each time you open a t-account. Asset accounts typically have a debit balance while liabilities and equity accounts have a credit balance. Because cash is an asset account, debits to it (the s) increase the account, while credits to it (the YYY s) decrease it. Cash would be expected to have, on net, a debit balance at any point in time. We show the ending balance, pictorially, by drawing a line across the bottom and reporting the net debit or credit. For example, suppose the beginning balance in cash is AAA. Then the ending balance in cash, given the transactions that generated an increase in cash of and a decrease in cash of YYY, must be ZZZ = AAA + YYY. Beg. Bal. Cash (A) AAA YYY End. Bal. ZZZ 6

7 Liability and equity t-accounts work the same way, except that the natural 3 beginning and ending balances in these accounts are credits not debits (as was the case for asset accounts). For example, let us consider the liability account for Bank Borrowings: Bank Borrowings (L) AAA Beg. Bal. YYY ZZZ End. Bal. Unlike the cash account, the beginning balance for Bank Borrowings is a credit balance as it represents a liability. Given the transactions that generated an increase in bank borrowings of and a decrease in borrowings of YYY, the ending balance must be ZZZ = AAA + YYY. C. Examples of common transactions (and their t-account journal entries) Transaction Balance Sheet Accounts Affected: Issued debt Cash (A) Bonds Payable (L) Purchased inventory with cash Cash (A) Inventory (A) Purchased inventory on credit Accounts Payable (L) Inventory (A) Paid suppliers Cash (A) Accounts Payable (L) 3 By this we mean that generally Liability (Asset) Accounts will have Credit (Debit) balances. But, on occasion these accounts will have opposite balances. During the course, we will come across some of these unnatural balances in these accounts. 7

8 Purchased PP&E Cash (A) PP&E (A) Sold products for cash Cash (A) Sales revenues (RE) (1) Record revenues (2) Record costs Cost of Goods Sold (RE) Inventory (A) Sold products on credit Accounts Receivable (A) Sales revenues (RE) (1) Record revenues (2) Record costs Cost of Goods Sold (RE) Inventory (A) Collected receivables Cash (A) Accts Receivable (A) Incurred operating expenses Operating Expenses (RE) Accounts Payable (L) Declared a dividend Dividends Declared (RE) Dividend Payable (L) 8

9 Paid the dividend Cash (A) Dividend Payable (L) Recognized depreciation Deprn. Expense (RE) PP&E (A) Expense Accrued interest expense Interest Expense (RE) Interest Payable (L) Paid the interest Cash (A) Interest Payable (L) The above transactions use the notation RE to refer to an item that affects the balance sheet through its effect on retained earnings (which is part of the equity section of the balance sheet). Items affect RE because they affect net income, which comes from the income statement. This is because of the relation (noted earlier) which links the balance sheet and the income statement: RetainedEarnings RetainedEarnings NetIncome Dividends t t 1 t t RE labeled accounts are temporary accounts because they are always closed to retained earnings at the end of the reporting period. By closed we mean that the account is zeroed out, by charging any amount in it to retained earnings. Here is an example closing of sales revenues of $245,000 at the end of the reporting period. For purposes of this example, assume that all of the sales were on credit (just so you can see the entire cycle of journal entries and charges to t- accounts): Revenue earned on credit Sales Sales revenues 245, ,000 Accounts Receivable Cash collected on some A/R Cash Accounts Receivable 200, , ,000 9

10 Reporting period ends Sales revenues Retained Earnings (transfer revenues to retained earnings) 245, ,000 Balances in accounts Sales revenues Retained Earnings 245, , , ,000 Cash Accounts Receivable 200, , , ,000 45,000 Does the Balance Sheet balance? Yes! Note that total assets = Cash of $200,000 plus AR of $45,000, or $245,000. What about the sum of liabilities plus equity? There are no liability accounts here and the only equity account is retained earnings and it has a balance of $245,

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