A = L + OE. Transaction 1 Assets = Liabilitites + Owners equity + 1,000,000 Cash + 1,000,000 Common stock

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1 FINANCIAL STATEMENT ANALYSIS Henry Jarva Aalto University, Spring 2015 Student name: EXERCISE 1. Provide journal entries for Transactions 5 8, Adjusting Entries 2 7, and prepare Exhibit Calculate the amount of income in Exhibit 2 for the Chicago Corporation and fill all remaining empty boxes. REVIEW OF ACCOUNTING PROCEDURES AND T-ACCOUNT ANALYSIS The basic accounting equation is the foundation of financial reporting: A = L + OE The basic accounting equation says that at all times, the euro sum of a firm s assets (A) must be equal to the euro sum of the firm s liabilities (L) plus its owners equity (OE). To understand why this equality must always hold, keep two things in mind: 1. Assets don t materialize out of the air; they have to be financed from somewhere. 2. Only two parties can provide financing for a firm s assets: a. Creditors of the company for example, when a supplier ships inventory to a firm on credit (an asset inventory is received). b. Owners of the company for example, when owners buy newly issued shares directly from the firm (an asset cash is received). Putting these two things together explains why the two sides of the basic accounting equation must be equal. The equation says the total resources a firm owns or controls (its assets) must, by definition, be equal to the total of the financial claims against those assets held by either creditor or owners. We ll now use the basic accounting equation to show how various transactions affect its components. Notice that each transaction maintains the basic equality; for example, any increase in an asset must be offset by (1) a corresponding increase in a liability or owners equity account or (2) decrease in some other asset. Assume that Chicago Corporation sells office furniture and provides office design consulting services. It is incorporated on January 1, 2011, and issues 1 million of stocks to investors for cash. Here s how this and subsequent transactions will affect the basic accounting equation: Transaction 1 Assets = Liabilitites + Owners equity + 1,000,000 Cash + 1,000,000 Common stock On the next day, Chicago Corporation buys a combination office building and warehouse for 330,000, paying 30,000 in cash and taking out a 300,000 loan at 8% interest per year.

2 Transaction 2 Assets = Liabilitites + Owners equity 30,000 Cash + 330,000 Building + 300,000 Loan payable Suppliers ship a wide assortment of inventory costing 97,000 to the firm on credit on January 11. Transaction 3 Assets = Liabilitites + Owners equity + 97,000 Inventory + 97,000 Accounts payable On January 15, Chicago Corporation sells a portion of its inventory costing 50,000 to several customers for 76,000 on account. Transaction 4 Assets = Liabilitites + Owners equity + 76,000 Accounts receivable 50,000 Inventory + 76,000 Sales revenue 50,000 Cost of goods sold A sale causes assets to flow into the company. Who benefits from this inflow of assets? The owners do. That s why owners equity increased by 76,000 in Transaction 4. The source of this increase is labeled; in this case, the source of the increase is Sales revenue. But in making a sale, the firm must relinquish an asset, Inventory. Whose claims are reduced as a result of this outflow of assets? The owners. That s why owners equity decreased by 50,000 in the second part of Transaction 4. Again, the reason for the decrease in owners equity is labeled; in this case, the need to deliver inventory to the customer reduces owners equity claims on the firm s assets by 50,000, the Cost of goods sold. In addition to the sheet (which follows the balancing format of the basic accounting equation), there is another financial statement called the income statement. Recollect that Sales revenue is the top line of the income statement and that Cost of goods sold is deducted from revenues. So Transaction 4, which was illustrated in a basic accounting equation (that is, sheet) format, really includes income statement account. Another way to say the same thing is that the revenue and expense accounts that appear on the income statement are really owners equity accounts. Revenues are owners equity increases; expenses are owners equity decreases. (Later in this assignment, we ll show how these accounts are closed in to Retained earnings, a component of owners equity, as part of the adjusting and closing process.) Understanding Debits and Credits Keeping track of transactions using the basic accounting equation as we did in Transaction 1 4 is cumbersome. For this reason, a streamlined approach is used to record how transactions either increase or decrease financial statement accounts. Increases and decreases on accounts are based on the convention of debits and credits. Debit (abbreviated DR) means left side of accounts, and credit (abbreviated CR) means right side of accounts. We now depict the basic accounting equation in T-account form and show the rules for how debits and credits operate to reflect increases or decreases to various accounts.

3 Asset accounts = Liability accounts + Owners equity accounts Debits Credits Debits Credits Debits Credits (DR) (CR) (DR) (CR) (DR) (CR) increase decrease decrease increase decrease increase Because Transaction 4 showed us that revenue accounts increase owners equity and expense accounts decrease it, the DR and CR rules treat revenue and expense accounts just like any other owners equity account. Let s elaborate on the debit and credit rules for expense accounts. Expense accounts are increased by debits. An increase in an expense decreases owners equity. Owners equity is decreased by debits. That s why increases in an expense account (which decrease owners equity) are debits. The basic accoun ng equa on must always be in that is, the total of the assets must always equal the total of the liabilities plus owners equity. Similarly, for each transaction, the euro total of the debits must equal the euro total of the credits. Adherence to the debit and credit rules for each transaction automatically keeps the basic accounting equation in. To help you visualize how this happens, we redo Transactions 1 4 in debit and credit form and show (in brackets to the right of the account name) what happens to the basic accounting equation: Transaction 1: Stock issued for cash DR Cash [+A] 1,000,000 CR Common stock [+OE] 1,000,000 Transaction 2: Purchase of building DR Building [+A] 330,000 CR Cash [ A] 30,000 CR Loan payable [+L] 300,000 Transaction 3: Purchase of inventory on credit DR Inventory [+A] 97,000 CR Accounts payable [+L] 97,000 Transaction 4: Sale of inventory on account DR Accounts receivable [+A] 76,000 DR Cost of goods sold [ OE] 50,000 CR Sales revenue [+OE].. 76,000 CR Inventory [ A] 50,000 As the pluses and minuses to the right of names show, adherence to the DR/CR rules automatically maintains the of the basic accounting equation. We next introduce four additional transactions for Chicago Corporation. Assume that the company purchases a one-year fire and theft insurance policy on the building and its contents on January 15, 2011, for 6,000. It makes the following entry upon purchasing the policy: Henceforth, names are given in parentheses in alphabetical order: (Cash, Prepaid insurance)

4 Transaction 5: Purchase of prepaid insurance DR Prepaid insurance [+A] 6,000 CR Cash [-A] 6,000 Prepaid insurance is an asset account because the policy provides a valuable benefit to the company: insurance coverage for the ensuing 12 months. Next, assume that the company receives a 10,000 fee in advance from a law firm to help the firm design its new office space. The fee received on January 17, and the consulting/design services are to be provided over the next month. Chicago Corporation makes the following journal entry: (Cash, Fee received in advance) Transaction 6: Receipt of consulting fees in advance DR Cash [+A] 10,000 CR Fee received in advance [+L] 10,000 The credit is the liability account, Fee received in advance, because the firm has an obligation to provide the consulting services (or return the fee). Until the critical event of providing those services occurs, no revenue can be recognized. Further assume that Chicago pays certain suppliers 37,000 for inventory recorded in Transaction 3. Other suppliers will be paid in ensuing periods. (Accounts payable, Cash) Transaction 7: Payment on account DR Accounts payable [-L] 37,000 CR Cash [-A] 37,000 Finally, 30,000 is received from one of the customers to whom inventory was sold on Transaction 4. (Cash, Accounts receivable) Transaction 8: Collections on account DR Cash [+A] 30,000 CR Accounts receivable [-A] 30,000 Adjusting entries Before financial statements are prepared (either monthly, quarterly, or annually), a firm s financial accounts must be reviewed to determine whether all economic events that have occurred are reflected in s. It is usually the case that certain readily identifiable types of events will not be reflected in s. To include these events in s, adjusting entries must be made. The adjusting entries fall into four categories: 1. Adjustments for prepayments. 2. Adjustments for unearned revenues. 3. Adjustments for accrued expenses. 4. Adjustments for accrued revenues. We now assume that Chicago is preparing financial statements for the month ended January 31, Adjusting entries in each of the four categories are necessary and discussed next.

5 Adjustments for Prepayments The insurance policy acquired for 6,000 on January 15 in Transaction 5 has partially expired. One half of one month s coverage has now elapsed; consequently 1/24 of the original annual premium payment is no longer as asset. The passage of time means that past insurance coverage has no future value. So, the following adjusting entry is made: Adjusting Entry A1: DR Insurance expense [ OE] CR Prepaid insurance [ A] ( 6,000/12 months = 500; 500 x 1/2 month = 250) After this entry is made, the in the Prepaid insurance account is 5,750; this is the original 6,000 minus the 250 credit in Adjusting Entry A1. The 5,750 represents the remaining asset, insurance coverage for the 11½ months. The adjusting entry has simultaneously accomplished two things: 1. The DR recognizes that portion of the premium that has expired, that is, the portion that is a January expense. This is the matching principle in action because the expense is matched against January revenues. 2. The CR reduces the carrying amount in the asset account by 250. As a result of this reduction, the Prepaid insurance account is shown at 5,750; this is the portion of the original 6,000 insurance premium that has not yet expired. The building acquired in Transaction 2 also represents a prepayment. Chicago paid for the building in early January 2011, and thus building is expected to be used in operations over a series of future years. As the building is used, a portion of its future service potential declines. This decline in service potential value is an expense of the period called depreciation. Assume that Chicago estimates building depreciation for January totaled 1,250 (various methods for estimating depreciation are not discussed). The following adjusting entry is the made: (Accumulated depreciation, Depreciation expense) Adjusting Entry A2: DR Depreciation expense [-OE] 1,250 CR Accumulated depreciation [-A] 1,250 (The accumulated depreciation account represents a contra-asset account that is deducted from the cost of the building; as we shall see later. A contra account is an account that is subtracted from another account to which it relates. Contra-asset accounts carry credit s because they are subtracted from asset accounts that carry debit s) Adjustments for Unearned Revenues By the end of January, let s assume that 60% of the design work for the law firm has been completed. Consequently, the following adjustment entry is made: (Consulting fees revenue, Fee received in advance) Adjusting Entry A3: DR Fee received in advance [-L] 6,000 CR Consulting fees revenue [+OE] 6,000 Notice that this entry also accomplishes two things. First, the debit lowers the in the liability account. Fee received in advance, to 4,000 (that is, the original 10,000 minus the 6,000 liability

6 reduction arising from the debit). Second, the credit properly recognizes that 60% of the 10,000 advance has been earned in January and thereby increases owners equity. Adjustments for Accrued Expenses Salaries and wages for the month of January totaled 16,000. The paychecks will not be issued to employees until Monday, February 3. Because the expense arose in January, a liability exists for money owed to the employees and the following entry must be made: (Salary and wages expense, Salary and wages payable) Adjusting Entry A4: DR Salary and wages expense [-OE] 16,000 CR Salary and wages payable [+L] 16,000 Adjusting entries such as this one must be made for a wide range of expenses that accrue over the reporting period. Accrual accounting recognizes expenses as the underlying real economic event occurs, not necessarily when the cash flows out. Consequently, adjusting entries for accrued expenses must be made not only for accrued wages payable but also for items such as heat, light, and power used during the month and for interest on amounts borrowed that as accumulated during the period but has not yet been paid. Assume that the utility bill arrives on January 31 but will not be paid until February 9, its due date. If the utility bill for January totaled 9,000, the following adjusting entry is necessary: (Accounts payable, Heat, light, and power expense) Adjusting Entry A5: DR Heat, light, and power expense [-OE] 9,000 CR Accounts payable [+L] 9,000 Furthermore, interest of 2,000 has accrued on the loan principal that was used to buy the building. (The accrued interest is determined as follows: 300,000 x 8% per year = 24,000 x 1/12 of year = 2,000.) The following entry is made: (Accrued interest payable, Interest expense) Adjusting Entry A6: DR Interest expense [-OE] 2,000 CR Accrued interest payable [+L] 2,000 Adjustments for Accrued Revenues During the last week in January, Chicago Corporation provides design consulting services to a physician who is remodeling her office. The physician is billed for the 2,100 due. The adjusting entry is: (Accounts receivable, Consulting fees revenue) Adjusting Entry A7: DR Accounts receivable [+A] 2,100 CR Consulting fees revenue [+OE] 2,100 Again, the adjusting entry simultaneously accomplished two things: 1. The DR reflects the asset that the firm expects to collect as a result of consulting services rendered in January. 2. The CR shows the corresponding increase in the owners equity that arises when the asset (Accounts receivable) is recognized. Posting Journal Entries to Accounts and Preparing Financial Statements

7 We use journal entries as a mechanism for showing you how economic events affect financial statement accounts. Next, we provide a terse overview if how professional accountants use journal entries as the building blocks for preparing financial statements. We use T-accounts to demonstrate this. We also show how analysis of T-accounts can be used to infer what transactions (and euro amounts) a firm entered into between two sheet dates. The DRs and CRs in each journal entry that is made are posted to T-accounts. Posting means the DR and CR is entered in the appropriate left (or right) side of the affected T-account. A separate T-account is maintained for each asset, liability, and owners equity account. (Remember: Revenue and expense accounts are effectively owners equity accounts, too. The s accumulated in these accounts for a particularly reporting period will be closed out, or transferred to owners equity at the end of the period.) Exhibit 1 shows all T-accounts that arise from Chicago s transactions during January The journal entry DR or CR that gave rise to the amount posted in the T-account is indicated by a number to the left of each item. For example, in the Cash T-account, the (1) to the left of the DR of 1,000,000 indicates that this item arose from the 1,000,000 DR in Transaction 1. The (1) to the left of the 1,000,000 credit to common stock indicates that this item resulted from the balancing CR in Transaction (1). Posting both the DR and CR to the T-accounts reflected in the original entry maintains the equality of the basic accounting equation.

8 EXHIBIT 1 Posting to T-accounts Assets = Liabilities + Owners equity Cash Accounts payable Common stock (1) 1,000,000(2) 30,000 (7) 37,000(3) 97,000 (1) 1,000,000 (6) 10,000(5) 6,000 (A5) 9,000 (8) 30,000(7) 37,000 Bal. 967,000 Bal. 69,000 Bal. 1,000,000 Accounts receivable Salary and wages payable Consulting fees revenue (4) 76,000(8) 30,000 (A4) 16,000 (A3) 6,000 (A7) 2,100 (A7) 2,100 Bal. 48,100 Bal. 16,000 Bal. 8,100 Inventory Accrued interest payable Sales revenue (3) 97,000(4) 50,000 (A6) 2,000 (4) 76,000 Bal. 47,000 Bal. 2,000 Bal. 76,000 Prepaid insurance Loan payable Cost of goods sold (5) 6,000(A1) 250 (2) 300,000 (4) 50,000 Bal. 5,750 Bal. 300,000 Bal. 50,000 Building Fee received in advance Insurance expense (2) 330,000 (A3) 6,000(6) 10,000 (A1) 250 Bal. 330,000 Bal. 4,000 Bal. 250 Accumulated depreciation Depreciation expense (A2) 1,250 A2) 1,250 Bal. 1,250 Bal. 1,250 Salary and wages expense A4) 16,000 Bal. 16,000 Heat, light, and power expense A5) 9,000 Bal. 9,000 Interest expense A6) 2,000 Bal. 2,000 Retained earnings (Revenues and expense account s will be closed out to this account at the end of the accounting period.)

9 The adjusting entries are also posted to the T-accounts shown in those entries. For example, in Exhibit 1, the (A1) to the left of the 250 DR to the Insurance expense T-account tells us that this item arose from adjusting entry A1. (Notice the CR from that entry was posted as a credit to the Prepaid insurance account, with the A1 designation to the left of the posting.) EXHIBIT 2 Chicago Corporation Income Statement for the Month Ended January 31, 2011 Revenues Sales revenue 76,000 Consulting fees revenue 8,100 Total revenue 84,100 Expenses Cost of goods sold 50,000 Salary and wages expense 16,000 Heat, light, and power expense 9,000 Depreciation expense 1,250 Insurance expense 250 Interest expense 2,000 Total expense 78,500 Pretax income 5,600 Statement of Financial Position, January 31, 2011 Assets Liabilities and Equity Cash 967,000 Liabilities Accounts receivable 48,100 Accounts payable 69,000 Inventory 47,000 Fees received in advance 4,000 Prepaid insurance 5,750 Salary and wages payable 16,000 Building 330,000 Accrued interest payable 2,000 Less: Accumulated depreciation (1,250 ) 328,750 Loan payable 300,000 Equity Common stock 1,000,000 Retained earnings 5,600 Total assets 1,396,600 Total liabilities and equity 1,396,600 The accountant preparing the financial statements would use the s in the revenue and expense accounts (highlighted in Exhibit 1) to prepare the January 2011 income statement. As shown in Exhibit 2, income for January (ignoring taxes) is 5,600. This amount represents the net increase in owners equity for the month arising from operations [This is true because revenues increase owners equity and expenses decrease owners equity (review Transaction 4). So, the excess of revenues over expenses represents the net increase in owners equity]. Consequently, the 5,600 appears again in the sheet as an owners equity increase labeled Retained earnings. The asset, liability, and common stock T-accounts compose the other sheet accounts. (Notice that the credit in Accumulated depreciation is deducted from the Building account. That s why this is a contra-asset account.) Closing Entries After the income statement for the month of January 2011 has been prepared, the revenue and expense accounts have served their purpose. So, s in these accounts are zeroed out (or closed) to get them ready to reflect February transactions. The get the revenue and expense account s to zero, a

10 closing journal entry is made. All revenue account s (which are credits) are debited (to get them zero); all expense account s (which are debits) are credited (to get them zero). The difference between the closing entry debits and credits in this case, a debit/credit of 5,600 is made to Retained earnings. Here s the entry: DR Sales revenue.. 76,000 DR Consulting fees revenue... 8,100 CR Cost of goods sold 50,000 CR Salary and wages expense. 16,000 CR Heat, light, and power expense. 9,000 CR Depreciation expense 1,250 CR Insurance expense CR Interest expense 2,000 CR Retained earnings 5,600 After this entry has been posted to s, all revenue and expense accounts will have zero s. The accounts are now clear to receive February income statement transactions.