Using Financial Statements

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Chapter 4

Using Financial Statements
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Learning Objectives

• After studying this chapter, you should be able
  to
• Make adjustments for the expiration or
  consumption of assets.
• Make adjustments for the earning of unearned
  revenues.
• Make adjustments for the accrual of unrecorded
  expenses.
• Make adjustments for the accrual of unrecorded
  revenues.

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Learning Objectives

• After studying this chapter, you should be able
  to
• Describe the sequence of the final steps in the
  recording process and relate cash flows to
  adjusting entries.
• Prepare a classified balance sheet and use it to
  assess solvency.
• Prepare single- and multiple-step income
  statements and use ratios to asses profitability.
• Relate generally accepted accounting principles
  (GAAP) to the accounting practices we have
  learned.

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Adjustments to the Accounts

• Most transactions are recorded when they occur.
• Some transactions might not even seem like
  transactions and are recognized only at the end
  of the accounting period.
• The difference in these transactions depends on
  how obvious or explicit they are.

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Adjustments to the Accounts

• Explicit transactions - events such as cash
  receipts and disbursements, credit purchases, and
  credit sales that trigger nearly all day-to-day
  routine entries
• Entries are supported by source documents.
• These transactions involve
  events that have actually
  happened.

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Adjustments to the Accounts

• Implicit transactions - events such as the
  passage of time that do not generate evidence
  that the transaction happened and are recognized
  via end-of-period adjustments
• Examples include depreciation expense and
  the expiration of prepaid rent.

June 2002
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Adjustments to the Accounts

• Adjustments (adjusting entries) - end-of-period
  entries that assign the financial effects of
  implicit transactions to the appropriate time
  periods
• Adjustments are usually made when
  the financial statements are about to
  be prepared.
• They are made in the form of journal
  entries that are posted to the general
  ledger.

Ledger
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Adjustments to the Accounts

• Most entities use accrual accounting.
• Adjusting entries are at the heart of accrual
  accounting.
• Accrue - to accumulate a receivable or payable
  during a given period even though no explicit
  transaction occurs
• The receivable or payable grows with time, but
  nothing changes hands.

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Adjustments to the Accounts

• The goal of adjusting entries is to assure that
  assets, liabilities, and owners equity are
  properly stated.
• Four basic types of transactions that trigger
  adjusting entries
• Expiration of unexpired costs
• Earning of revenues received in advance
• Accrual of unrecorded expenses
• Accrual of unrecorded revenues

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Expiration of Unexpired Costs

• Originally cash is paid and an asset is created.
• An adjustment recognizes an expense and reduces
  the corresponding asset.
• The cost is expired because of the passage of
  time.
• An explicit transaction has created an asset, and
  an implicit transaction adjusts the value of the
  asset.
• Examples include prepaid rent, prepaid insurance,
  and depreciation expense.

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Earning of Revenues Receivedin Advance

• Unearned revenue (deferred revenue) - revenue
  received and recorded before it is earned
• Payment is received in exchange for a commitment
  to provide services or goods at a later date.
• This commitment is a liability the service or
  goods are owed to someone.
• For example, when a magazine publisher receives
  cash for a subscription, revenue is not earned
  until the publisher provides the subscriber with
  an issue of the magazine even though cash has
  been received

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Earning of Revenues Receivedin Advance

• The transactions regarding prepaid expenses and
  unearned revenues are really mirror images of
  each other.

Seller
Buyer
Liabilities (Unearned Revenues)
Assets (Prepaid Expenses)
Revenues Earned
Expenses Incurred
Adjustments
Adjustments
Appear in Balance Sheet
Appear in Income Statement
Appear in Balance Sheet
Appear in Income Statement
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Accrual of Unrecorded Expenses

• The balances of accrued expenses are only
  important when financial statements are prepared.
• Consequently, adjustments to bring these accounts
  up to date are made at the end of an accounting
  period to match the expenses to the period.

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Accounting for Payment of Wages

• Paying wages is an explicit transaction driven by
  writing a payroll check.
• As wages are paid, wage expense is recorded while
  cash is decreased.
• Wages expense 20,000
• Cash 20,000

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Accounting for Accrual of Wages

• With accrued expenses, the accountant must
  determine if something additional should appear
  in the financial statements but as yet does not.
• Accrued expenses are recorded for amounts that
  are owed at the end of an accounting period but
  have not been paid in that accounting period.

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Accounting for Accrual of Wages

• Calvin Corporation pays its employees 20,000
  during the month. Calvin also owes its employees
  3,000 for services rendered during the last
  three days of January, but the employees will not
  be paid until February 2.
• To ensure that all wages for the month of
  January are recorded, an adjustment must be made.
• Wages expense 3,000
• Accrued wages payable 3,000

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Accounting for Accrual of Wages

• In both the actual payment and in the accrual of
  wages, an expense is created.
• In the payment, an asset (cash)
  is decreased.
• But in the accrual, a liability
  (accrued wages payable) is
  recorded and increased.

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Accrual of Interest

• Interest is much like rent paid for the use of
  money.
• Interest accumulates (accrues) as time goes on,
  regardless of when the interest is actually paid.
• Interest Principal x Interest rate x Fraction
  of a year

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Accrual of Interest

• The entry to record the accrual of interest
  expense is very similar to the entry to record
  the accrual of wage expense.
• Interest expense xxx
• Accrued interest payable xxx

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Accrual of Income Taxes

• As income is generated, income tax expense is
  accrued rather than paid by the company each time
  a dollar comes in.
• The entry to record accrued income
  taxes is similar to the accrual of
  other expenses.

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Accrual of Unrecorded Revenues

• The accrual of unrecorded revenues is the mirror
  image of the accrual of unrecorded expenses.
• The adjusting entries show the recognition of
  revenues that have been earned, but the entity
  has not received cash.
• Examples include unbilled fees. Fees have been
  earned, but the customers have not yet been
  billed.

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The Adjusting Process in Perspective

• The recording process has a final goal - the
  preparation of accurate financial statements
  prepared on the accrual basis.
• The final steps of the process can be shown as

Unadjusted Trial Balance
Journalize Post Adjustments
Ledger
Adjusted Trial Balance
Financial Statements
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The Adjusting Process in Perspective

• The expiration of unexpired costs
• Adjustments are made after the cash flow.

Transformed by Adjustments Into
Create
Advance Cash Payments for Future Services to be
Rendered
Noncash Assets in the Balance Sheet
Expenses in the Income Statement
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The Adjusting Process in Perspective

• Earning of revenues received in advance
• Adjustments are made after the cash flow.

Transformed by Adjustments Into
Create
Advance Cash Collections for Future Services to
be Rendered
Liabilities in the Balance Sheet
Revenues in the Income Statement
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The Adjusting Process in Perspective

• Accrual of unrecorded expenses
• Adjustments are made before cash flows.

Recorded by Adjustments as Increases in
Expenses in the Income Statement
Passing of Time and Continuous Use of Services
and
Decreased by
Liabilities in the Balance Sheet
Later Cash Payments
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The Adjusting Process in Perspective

• Accrual of unrecorded revenues
• Adjustments are made before cash flows.

Recorded by Adjustments as Increases in
Passing of Time and Continuous Rendering of
Services
Revenues in the Income Statement
and
Decreased by
Noncash Assets in the Balance Sheet
Later Cash Collections
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The Adjusting Process in Perspective

• Each adjusting entry affects at least one income
  statement account (revenue or expense) and one
  balance sheet account (asset or liability).
• Never debit or credit Cash in an adjusting entry.

Adjust Cash
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Classified Balance Sheet

• Classified balance sheet - a balance sheet that
  groups the accounts into subcategories to help
  readers quickly gain a perspective on the
  companys financial position
• Assets are usually classified as current assets
  and long-term assets.
• Liabilities are usually classified as current
  liabilities and long-term liabilities.

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Classified Balance Sheet

• STEVENS COMPANY
• Balance Sheet
• December 31, 2002
• Assets Liabilities
• Current assets Current liabilities
• Cash 4,525 Accounts
  payable 9,800
• Accounts receivable 2,040
  Wages payable 3,765
• Total current assets 6,565 Total
  liabilities 13,565
• Long-term assets
• Land 9,755
• Equipment 6,500
  Owners Equity
• Total plant assets 16,255 Stevens,
  capital 9,255
• Total liabilities and
• Total assets 22,820 owners' equity
  22,820

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Current Assets and Liabilities

• Current assets - include cash plus assets that
  are expected to be converted to cash, sold, or
  consumed during the next 12 months or within the
  normal operating cycle if longer than a year
• Current liabilities - include liabilities that
  fall due within the coming year or within the
  normal operating cycle if longer than a year

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Current Assets and Liabilities

• Current assets are listed in the order in which
  they will be converted to cash.
• Cash is always listed first then Accounts
  Receivable, Notes Receivable, and Interest
  Receivable are listed.
• Nonmonetary assets (inventory, prepaid expenses)
  are listed last in the current assets section.
• Current liabilities are listed in the order in
  which they will draw on, or decrease, cash during
  the coming year.

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Current Assets and Liabilities

• Working capital - the excess of current assets
  over current liabilities
• It connects the assets and the liabilities of the
  company.
• Working capital Current assets - Current
  liabilities

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Current Ratio

• Comparing the amount of cash a company will have
  on hand and the amount of debt the company will
  have to pay off with that cash can help readers
  assess an entitys solvency.
• Solvency - an entitys ability to meet its
  immediate financial
  obligations with cash and near-cash
  assets as they become due

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Current Ratio

• The current ratio (working capital ratio) is used
  to evaluate solvency.
• The higher the current ratio, the more assurance
  creditors have that the entity can pay its bills
  on time.

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Current Ratio

• An old rule of thumb was that an acceptable
  current ratio would be greater than 2.0, but
  realistically, a current ratio over 1.0 is
  acceptable.
• One way of assessing the current ratio is to
  compare it to the average current ratio of the
  industry in which the company operates.

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Formats of Balance Sheets

• Balance sheet formats
• Report format - a classified balance sheet with
  assets at the top and liabilities and equity
  below
• Account format - a classified balance sheet with
  assets at the left and liabilities and equity at
  the right
• Regardless of format, balance sheets always
  contain the same basic information.

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Income Statements

• Most users of financial statements are concerned
  about the entitys ability to produce long-run
  earnings and dividends.
• This information can be found in the income
  statement.
• Income statements can be prepared with
  subcategories to make them easier to read and
  more informative.

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Single- and Multiple-Step Income Statements

• Income statement formats
• Single-step income statement - groups all
  revenues together and then lists and deducts all
  expenses together without drawing any
  intermediate subtotals
• Multiple-step income statement - contains one or
  more subtotals that highlight significant
  relationships

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Single- and Multiple-Step Income Statements

• A single-step income statement
• STEVENS COMPANY
• Income Statement
• for the Year Ended December 31, 2002
• Sales 98,600
• Rent revenue 4,000
• Total revenues 102,600
• Expenses
• Wages expense 45,800
• Rent expense 12,000
• Depreciation expense 5,000
• Total expenses 62,800
• Net Income 39,800
• 
  

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Single- and Multiple-Step Income Statements

• A multiple step income statement
• STEVENS COMPANY
• Income Statement
• for the Year Ended December 31, 2002
• Sales 98,600
• Expenses
• Wages expense 45,800
• Rent expense 12,000
• Depreciation expense 5,000
• Total expenses 62,800
• Operating income 35,800
• Other revenues
• Rent revenue 4,000
• Net Income 39,800

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Single- and Multiple-Step Income Statements

• Sections and intermediate subtotals on multiple
  step income statements
• Gross profit (gross margin) - excess of sales
  revenue over the cost of inventory that was sold
• Operating expenses - a group of recurring
  expenses that pertain to a firms routine
  operations
• Operating income (operating profit) - gross
  profit less all operating expenses
• Other revenues and expenses - items not directly
  related to the main operations of a firm

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Profitability Evaluation Ratios

• Income statements are most useful in evaluating
  an entitys profitability, which is the ability
  of a company to provide investors with a
  particular rate of return on their investment.
• Return on investment - the amount
  of money an investor receives
  because of a prior
  investment

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Profitability Evaluation Ratios

• Profitability comparisons are used to compare one
  company over a period of time or to compare
  several companies over the same period of time.
• Three popular profitability ratios
• Gross profit percentage (gross margin percentage)
• Return on sales ratio
• Return on stockholders equity ratio

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Profitability Evaluation Ratios
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Generally Accepted Accounting Principles and
Basic Concepts

• If every accountant used his or her own rules for
  recording transactions, the financial statements
  would be useless in making comparisons.
• Therefore, accountants have agreed to apply a
  common set of measurement principles (a common
  language) to record information on financial
  statements. Otherwise, decision makers could not
  use or compare financial statements.

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Generally Accepted Accounting Principles and
Basic Concepts

• Generally accepted accounting principles (GAAP) -
  a term that applies to the broad concepts or
  guidelines and detailed practices in accounting,
  including all the conventions, rules, and
  procedures that make up accepted accounting
  practice at a given time

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Generally Accepted Accounting Principles and
Basic Concepts

• Accounting principles become generally accepted
  by agreement.
• Experience, custom, usage, and practical
  necessity contribute to a set of principles.
• Accounting conventions
  might be a better way to
  describe these
  rules
  because GAAP are not
  the result of airtight logic.

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Standard Setting Bodies

• In the United States, GAAP is set primarily by
  the private sector with government oversight.
• In many other countries, such as France, the
  government actually sets accounting standards.

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Standard Setting Bodies

• Financial Accounting Standards Board (FASB) -
  responsible for establishing GAAP in the United
  States
• A private sector body consisting of seven
  full-time members and a large support staff
• The FASBs rulings on GAAP are FASB Statements.

50
Standard Setting Bodies

• Accounting Principles Board (APB) - the
  predecessor to the FASB was composed of 18
  accountants who worked part time
• The APB Issued 31 APB
  Opinions, many of which
  are still applicable in
  current GAAP.

51
Standard Setting Bodies

• Securities and Exchange Commission (SEC) - the
  agency designated by the U.S. Congress to hold
  the ultimate responsibility for authorizing GAAP
  for companies whose stock is held by the general
  investing public
• The SEC has informally delegated
  the power to make accounting rules
  to the FASB.

52
Standard Setting Bodies

• Congress can overrule both the SEC and the FASB,
  and the SEC can overrule the FASB.
• Pressure can be exerted on all three tiers by
  constituents if they think an impending standard
  is wrong.
• The standard setting process involves public
  regulators, private regulators, companies, the
  public accounting profession, representatives of
  investors, and other interested groups.

53
Standard Setting Bodies

• International Accounting Standards Board (IASB) -
  an organization representing over 143 accountancy
  boards from 104 countries that is developing a
  common set of accounting standards to be used
  throughout the world

54
Standard Setting Bodies

• Interest in harmonizing accounting standards
  around the world by eliminating differences in
  accounting principles that are not caused by
  cultural or environmental differences has grown.
• Investors are committing more of their money
  worldwide.
• Many multinational companies voluntarily issue
  their financial statements in conformity with the
  IASB standards.

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Concepts and Conventionsof GAAP

• The Entity Concept
• An accounting entity is an organization that
  stands apart from other organizations and
  individuals as a separate economic unit.
• The entity concept helps relate events to a
  clearly defined area of accountability.

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Concepts and Conventionsof GAAP

• The Reliability Concept
• The quality of information that assures decision
  makers that the information captures the
  conditions or events it purports to represent
• Reliable data are supported by convincing
  evidence that can be verified by independent
  parties.
• The impact of events should be measured in a
  systematic, reliable manner.

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Concepts and Conventionsof GAAP

• Going Concern Convention
• The assumption that in all ordinary situations an
  entity persists indefinitely
• This notion implies that a companys existing
  resources will be used to fulfill the business
  needs of the company rather than be sold.
• If the continuity of an entity is in doubt, a
  liquidation approach to the balance sheet is
  taken, and the assets and liabilities are valued
  as if the entity were to be liquidated in the
  near future.

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Concepts and Conventionsof GAAP

• Materiality Convention
• A financial statement item is material if its
  omission or misstatement would tend to mislead
  the reader of the financial statements under
  consideration
• Materiality often depends on the size of the
  organization what is material to one company
  might not be material to another company.

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Concepts and Conventionsof GAAP

• Cost-Benefit Criterion
• A system should be changed when the expected
  additional benefits of the change exceed its
  expected additional costs
• The benefits of information should exceed the
  cost of providing that information.
• Benefits gt Costs

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Concepts and Conventionsof GAAP

• Stable Monetary Unit
• The monetary unit is the principle means for
  measuring assets and equities.
• It is the common denominator for quantifying the
  effects of transactions.
• A stable monetary unit is one that
  is not expected to significantly
  change in value
  over time.

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