Chapter 4

1. Chapter 4 Using Financial Statements

2. 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.

3. 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.

4. 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.

5. 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.

6. 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

7. 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

8. 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.

9. 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

10. 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.

11. 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

12. 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

13. 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.

14. 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

15. 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.

16. 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

17. 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.

18. 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

19. 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

20. 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.

21. 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.

22. 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 Financial Statements Adjusted Trial Balance

23. 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

24. 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

25. 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

26. 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

27. 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

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

29. 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 Owner’s Equity Total plant assets 16,255 Stevens, capital 9,255 Total liabilities and Total assets $22,820 owners' equity $22,820 ============= =============

30. 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

31. 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.

32. 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

33. 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 entity’s solvency. • Solvency - an entity’s ability to meet its immediate financial obligations with cash and near-cash assets as they become due

34. 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.

35. 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.

36. 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.

37. Income Statements • Most users of financial statements are concerned about the entity’s 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.

38. 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

39. 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 ================

40. 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 =============

41. 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 firm’s 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

42. Profitability Evaluation Ratios • Income statements are most useful in evaluating an entity’s 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

43. 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

44. Profitability Evaluation Ratios

45. 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.

46. 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

47. 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.

48. 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.

49. 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 FASB’s 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.