Introduction to Financial Accounting

Types of Businesses
Manufacturing Business
Product

General Motors Intel Boeing Nike Coca-Cola Sony

Cars, trucks, vans Computer chips Jet aircraft Athletic shoes and apparel Beverages Stereos and television

Types of Businesses
Merchandising Business
Product

Wal-Mart Toys “R” Us Circuit City Lands’ End Amazon.com

General merchandise Toys Consumer electronics Apparel Internet books, music, video retailer

Types of Businesses
Service Business
Product

Disney Delta Air Lines Marriott Hotels Merrill Lynch Sprint

Entertainment Transportation Hospitality and lodging Financial advice Telecommunication

There are three types of business organizations
 Proprietorship
 Partnership

 Corporation

A proprietorship is owned by one individual.

Advantages
• Ease in organizing • Low cost of organizing
Disadvantage • Limited source of financial resources • Unlimited liability

Joe’s

A partnership is owned by two or more individuals.

Advantages • More financial resources than a proprietorship. • Additional management skills. Disadvantage • Unlimited liability.

Joe and Marty’s

A corporation is organized under state or federal statutes as a separate legal entity.

Advantage • The ability to obtain large amounts of resources by issuing stocks. Disadvantage • Double taxation.

J & M, Inc.

What is Accounting?
Identifying

Measuring

Economic Information

to various users

Communicating

Internal and External Users of Accounting Information
Bankers Current and Potential Owners

Creditors

Internal Users – Management

Financial Analysts

Suppliers Trade Associations Government Agencies
LO1

Decisions Made with Financial Information

Invest?? Borrow $$??

Add new product line?? Build new plant??
Loan $$?? Sell stocks or bonds??

Extend credit $$??
Start new business??

What is a business transaction?

A business transaction is an economic event or
condition that directly changes an entity’s financial condition or directly affects its results of operations.

The Accounting Equation
Assets = Liabilities + Owner’s Equity
The resources owned by a business

The Accounting Equation
Assets = Liabilities + Owner’s Equity
The rights of the creditors, which represent debts of the business

The Accounting Equation
Assets = Liabilities + Owner’s Equity
The rights of the owners

Balance Sheet
Assets
FE RALRE RVENOT DE SE E

– snapshot of financial position Liabilities

THE UNITED STATES OF AMERICA THE UNITED STATES OF AMERICA
T IS N T IS L G L T N E H OE E A E DR FO A L D B S, PU L C A D PR V T R L ET BI N I AE

L70744629F
WASHINGTON, D.C.

12

12

A
H 293

=

L70744629F
12
SE I E R S 1985

12

ONE DOLLAR ONE DOLLAR

+
Stock Certificate

Owners’ Equity
(or Stockholders’ Equity)

On November 1, 2005, Chris Clark begins a business that will be known as NetSolutions.

a. Chris Clark deposits $25,000 in a bank account in the name of NetSolutions.
Assets = = Owner’s Equity Chris Clark, Capital 25,000 Investment by Chris Clark

a.

Cash 25,000

b. NetSolutions exchanged $20,000 for land.
Owner’s Equity Chris Clark, Capital 25,000

Assets

=

Cash + Land Bal. 25,000 b. –20,000 +20,000 Bal. 5,000 20,000

=

25,000

c. During the month, NetSolutions purchased supplies for $1,350 and agreed to pay the supplier in the near future (on account).
Assets Cash + Supplies + Land Bal. 5,000 c. Bal. 5,000 20,000 = = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 25,000

+ 1,350 1,350

20,000

+ 1,350 1,350

25,000

d. NetSolutions provided services to customers, earning fees of $7,500 and received the amount in cash.
Assets Cash + Supplies + Land Bal. 5,000 1,350 20,000 d. + 7,500 Bal. 12,500 1,350 20,000 = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 1,350 25,000 + 7,500 Fees earned 1,350 32,500

=

e. NetSolutions paid the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275.
Assets Cash + Supplies + Land Bal. 12,500 1,350 20,000 e. – 3,650 = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 1,350 32,500 –2,125 Wages – 800 Rent – 450 Util. – 275 Misc. 1,350 28,850

=

Bal.8,850

1,350

20,000

f. NetSolutions paid $950 to creditors during the month.
Assets Cash + Supplies + Land Bal. 8,850 1,350 20,000 f. – 950 Bal. 7,900 1,350 20,000 = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 1,350 28,850 – 950 400 28,850

=

g. At the end of the month, the cost of supplies on hand is $550, so $800 of supplies were used.
Assets Cash + Supplies + Land Bal. 7,900 1,350 20,000 g. – 800 Bal. 7,900 550 20,000 = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 400 28,850 – 800 Supplies expense 400 28,050

=

h. At the end of the month, Chris withdrew $2,000 in cash from the business for personal use.
Assets Cash + Supplies + Land Bal. 7,900 550 20,000 h. –2,000 Bal. 5,900 550 20,000 = Owner’s Liabilities + Equity Accounts Chris Clark, Payable Capital 400 28,050 –2,000 Withdrawal 400 26,050

=

Accounting reports, called financial statements, provide summarized information to the owner.

Financial Statements
• Income statement—A summary of the revenue and expenses for a specific period of time. • Statement of owner’s equity—A summary of the changes in the owner’s equity that have occurred during a specific period of time. • Balance sheet—A list of the assets, liabilities, and owner’s equity as of a specific date. • Statement of cash flows—A summary of the cash receipts and disbursements for a specific period of time.

Top of the World A = L + SE Balance Sheet June 30, 2007
Assets
Current assets: Cash Accounts receivable

A
$ 200 600
800

Non current assets: Land Lodge, lifts and equipment

4,000 2,500 6,500 $7,300

Total assets

Top of the World Balance Sheet June 30, 2007
Liabilities and Stockholders’ Equity
Liabilities: Accounts payable Salaries and wages payable Notes payable Total liabilities Stockholders’ equity: Capital stock Retained earnings

A = L + SE

=L
$ 700 400 3,000 $4,100

+ SE
$2,000 1,200

Total stockholders’ equity
Total Liabilities and Stockholders’ Equity

$3,200
$ 7,300

Income Statement

Revenues Less: Expenses Net income

$$ ($$) $$

Top of the World Income Statement For the Year Ended June 30, 2007
Revenues – Expenses = Net Income Revenues: Lift tickets Revenues Equipment rentals Total revenues Expenses: Salaries and wages Depreciation Water, gas, and electricity Expenses Insurance Interest Income taxes Total expenses Net income
$5,800 2,200

$8,000
$2,000 100 1,500 1,100 300 1,000 6,000

Net Income

$2,000

Relationships among Financial Statements – Top of the World Example
Income Statement for 2007
Revenues Less: Expenses Net income Beginning balance, retained earnings Add: Net income Deduct: Cash dividends Ending balance, retained earnings $ 8,000 ( 6,000) $ 2,000 $ 0 2,000 (800) $1,200 2007 $7,300 4,100 2,000 1,200 $7,300 2006 $ 0 0 0 0 $ 0

Statement of Retained Earnings for 2007

Balance Sheets
Total assets Liabilities Capital stock Retained earnings Total liabilities and stockholders’ equity

Financial Statement Assumptions
Economic Entity Concept

Time Period Assumption

Cost Principle

Going Concern

Monetary Unit
LO3

Economic Entity Concept
 Each entity has its own books, records, and financial statements that are separate from owners  No intermingling of personal and business assets and liabilities or income and expenses
Business Books and Records

Cost Principle
 Record assets at cost paid to acquire them
 Continue to value assets at historical cost until sold  More objective than market value

Going Concern
 Assume business will continue indefinitely into the future
 Justifies use of historical cost

Monetary Unit
 How we measure amounts in the financial statements (e.g., U.S. dollar, Japanese yen, Mexican peso, etc.)  Assumes economic measure is relatively stable; no adjustment for inflation made in financial statements

Time Period Assumption
 Assumes it is possible to break up an entity’s earnings in discrete time periods (a month, quarter, year)  Necessary to provide users with financial results on a timely basis  Requires use of estimates
1 2 3 4 5 6 7 8 9 10 17 24 31 11 18 25 12 19 26 13 20 27 14 21 28 15 22 29 16 23 30

Relationship between the income statement and the balance sheet

Assets

=

Capital

+ (–)

Profit (Loss)

+ Liabilities

The above equation can be extended to:

Assets

=

Capital

+

Sales revenue

– Expenses

+ Liabilities

Better-Price Stores Income statement for the year ended 31 October 2007
£

Sales revenue
Cost of sales Gross profit Salaries and wages Rent and rates Heat and light Telephone and postage

232,000
154,000 78,000 (24,500) (14,200) (7,500) (1,200)

Insurance
Motor vehicle running expenses Depreciation – fixtures and fittings Depreciation – motor van Operating profit Interest received from investments Loan interest

(1,000)
(3,400) (1,000) (600) 24,600 2,000 (1,100)

Profit for the year

25,500

Elements of the income statement
 Gross profit
 The difference between revenue and cost of sales

 Operating profit
 Gross profit less expenses (overheads) incurred in operating the business  Represents the wealth generated from operating (trading) activities

 Profit for the year
Operating profit + any non-trading income - Costs of financing the business

Cost of sales
 This represents the cost of goods SOLD by the business (not cost of goods BOUGHT) during the accounting period  Part of goods bought during the accounting period may remain in the business as inventories  To calculate the cost of goods sold, we need to know the amount of any opening and closing inventories, as well as purchases made

Cost of sales example
1 Jan 2008 Inventory Purchases during 2008 31 Dec 2008 Inventory
Cost of sales Opening inventory Purchases Less: Closing inventory

£ 20,000 £140,000 £ 45,000
£ 20,000 140,000 160,000 (45,000) 115,000

Classification of expenses
 These are often a matter of judgement by the company, depending on how useful the information may be to users  Large items will be shown separately (concept of materiality)  Finance costs are shown below operating profit  Limited companies have to follow Company Law for their classification

Activity: Prepare an Income Statement
 The adjacent information relates to Sankey Ltd  Prepare an income statement for the year ended 30.9.08  N.B. Not all the information is relevant
£’000 Sales 210 Purchases 109 Inventory: 1.10.07 9 Salaries & Wages 42 Motor expenses 2 Rent 7 General expenses 3 Motor vehicles 14 Cash at bank 5 Loan interest payable 2 Loan 20 Inventory: 30.9.08 11

Profit measurement and the recognition of revenue
Basic criteria that must be met before revenue is recognised:

The amount of revenue can be measured reliably.

It is probable that the economic benefits will be received.

An additional criterion to be applied where the revenue comes from the sale of goods: Ownership and control of the item should pass to the buyer.

The effect of trading operations on the balance sheet

The balance sheet equation can be extended as follows:

equals

plus (minus)

plus

Assets

Capital

Profit (Loss)

Liabilities.

The classification of assets

The classification of assets may vary according to the nature of the business:

Current assets

Non-current assets.

Current Assets
 Assets that are held for the short term  Have ANY of the following characteristics:
 Held for sale or consumption in the normal course of business  Expected to be sold within the next year  Held primarily for trading  Cash or near cash

 Common examples
 Inventories (stock)  Trade receivables (debtors)  Cash

The circulating nature of current assets

Inventories

Cash

Receivables

Profit measurement and inventory costing methods

Common assumptions used are:

First in, first out (FIFO) Last in, first out (LIFO) Weighted average cost (AVCO)

Valuation of inventories
 Each method is theoretical, and doesn’t reflect the physical movement of inventory  In times of rising prices:
 FIFO will give the highest profit and inventory value  LIFO will give the lowest profit and inventory value  AVCO will be in between

Example
Nelson Ltd has the following inventory records for October 2008: Number Price/unit Oct 1 Purchase 1,000 £3.00 Oct 3 Purchase 500 £3.20 Oct 4 Sale 700 Oct 6 Purchase 300 £3.50 Oct 8 Sale 900
Required: Calculate the amounts for cost of sales and for closing inventory for each of FIFO, LIFO and AVCO

FIFO
1 Oct 3 Oct 4 Oct 6 Oct 8 Oct 1,000@£3.00 500@£3.20 (700)@£3.00 300@£3.50 (300)@£3.00 (500)@£3.20 (100)@£3.50 200 £1,050 Purchase cost £3,000 £1,600 £2,100 Cost of sales Balance Inventory £3,000 £4,600 £2,500 £3,550

Clg

£5,650

£2,850 £4,950

£ 750 £ 700

LIFO
1 Oct 3 Oct 4 Oct 6 Oct 8 Oct Clg 1,000@£3.00 500@£3.20 (500)@£3.20 (200)@£3.00 300@£3.50 (300)@£3.50 (600)@£3.00 200 Purchase cost £3,000 £1,600 Cost of sales Balance Inventory £3,000 £4,600

£2,200 £1,050

£2,400 £3,450

£5,650

£2,850 £5,050

£ 600 £ 600

AVCO
1 Oct 3 Oct 4 Oct 6 Oct 8 Oct Clg 1,000@£3.00 500@£3.20 (700)@£3.07 300@£3.50 (900)@£3.18 200 £5,650 £1,050 £2,862 £5,011 Purchase cost £3,000 £1,600 £2,149 Cost of sales Balance Inventory £3,000 @£3.00 £4,600 @£3.07 £2,451 £3,501 @£3.18 £ 639 @£3.18 £ 639

Valuation of inventories
 Usually valued at cost  In some circumstances, may need to be valued at NET REALISABLE VALUE:
 The estimated selling price less any further costs

 Examples:
 Goods have deteriorated or become obsolete  Fall in market price  ‘loss leadership’ promotions

Allowances for trade receivables
 We recognise revenue at the point when the sale is made
 Even if the customer won’t pay the money owing for another 30 days  Trade receivables shown as an asset on the balance sheet

 There is always a risk that the customer won’t pay
 Assets will then be overstated on the balance sheet  Profits will have been overstated on the income statement

Allowances for trade receivables – specific bad debts
 If there is news about a specific customer
 Eg they have gone bankrupt

 Then:
 Decrease trade receivables by the amount owing  Increase expenses (bad debts) by that amount

 Note: we don’t just cancel out the sale
 This way more information is given on

Allowances for trade receivables – general provision
 Usually there won’t be specific information available at the end of the accounting period  However, past experience tells us that a proportion of trade receivables are never going to be paid  We therefore make a provision for ‘doubtful debts’ as follows:
 Decrease trade receivables by the required provision  Increase expenses (allowances for trade receivables) by that same amount

Example
In the year ended 30.9.07 Callands Ltd has trade receivables of £90,000. It recently heard that one of its customers, Bewsey, has gone bankrupt, owing Callands £3,000. After careful checking of its other customers, Callands considers other trade receivables totalling £1,800 to be doubtful. Required: Show the extracts from the income statement and balance sheet for y/e 30.9.07

Callands Ltd
Income statement extract Bad debts written off 3,000 Allowances for trade receivables 1,800
Balance sheet extract Trade receivables [90000-3000] 87,000 Allowances for trade receivables

£

Non-current Assets
 Assets that are held for the long term  Examples
     Land Buildings Plant &equipment Vehicles Computers

The classification of claims

Current liabilities

Non-current liabilities

Current Liabilities
 Amounts due to be paid in the short term  Have ANY of the following characteristics:
 Expected to be settled in the normal course of business  Expected to be settled within the next year  Held primarily for trading

 Examples
 Trade payables (creditors)  Bank overdraft

Non-current Liabilities
 Amounts due to be paid after more than 1 year  Examples
 Long term loans  Debentures

Activity
 Delivery van  Label each item as one  Bank loan to be repaid in of: 2 year’s time  Current asset  Money owed by  Non-current asset customers  Current liability  Cash in the office safe  Non-current liability  Electronic parts to be  Capital used in production process  Bank overdraft  Money the owner put into the business  Office computer  Unpaid electricity bill

Brie Manufacturing: balance sheet as at 31 December 2006
£000 Non-current assets Property Plant and equipment Motor vans 45 30 19 94 23 18 12 53 147

Current assets Inventories Trade receivables Cash at bank
Total assets Capital (owner’s equity)

Opening balance Add Profit Less Drawings
Non-current liabilities Long-term borrowings Current liabilities Trade payables Total equity and liabilities

50 14 64 4 60
50 37 147

Purpose of the Statement of Cash Flows
 Explains changes in cash over a period of time  Summarizes cash inflows and outflows from: Operating
Activities Investing Activities

Financing Activities
LO1

FEDERALRESERVENOTE

THE UNITED STATES OF AMERICA THE UNITED STATES OF AMERICA
T IS N T IS L G L T N E H OE E A E DR FO A L D B S, PU L C A D PR V T R L ET BI N I AE

L70744629F
WASHINGTON, D.C.

12

12

A

Cash Equivalents

H 293

L70744629F
12
SE I E R S 1985

12

ONE DOLLAR ONE DOLLAR

1 4 11 18 25 5 12 19 26 6 13 20 27 7 14 8 15

2 9 16

3 10 17

1 7 8 15 4 22 11 29 18 25

2 9 16 5 23 12 30 19 26

3 10 17 6 24 13 31 20 27

4

5

6

1 7 14 21 28 8 15 22 29

2 9 16 23 30

3 10 17 24 31

2111 2212 23 13 2414 2818 2919 30 20 3121 25 26 27 28

Examples:
 Commercial paper  U.S. Treasury bills  Certain money market funds

 Readily convertible to cash  Little risk of price change  Original maturity to investor of three months or less

LO2

Statement of Cash Flows Format
inflows

Cash

outflows

+

Beginning Cash and Cash Equivalents

Classified by: Operating activities Investing activities Financing activities Increase or decrease in cash and cash equivalents

=
= Ending Cash and Cash Equivalents
LO3

Statement of Cash Flows Format
Cash flows from operating activities: Inflows Outflows Net cash provided (used) by operating activities Cash flows from investing activities: Inflows Outflows Net cash provided (used) by investing activities Cash flows from financing activities: Inflows Outflows Net cash provided (used) by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $ xxx (xxx) $xxx $ xxx (xxx) xxx $ xxx (xxx) xxx $xxx xxx $xxx

from balance sheets

Operating Activities
Payment to suppliers for inventory Collection of Cash customer accounts transactions

concerned with acquiring and selling products and services
Payment of taxes Payment of wages

Investing Activities
Cash transactions concerned with acquiring and disposing of longterm assets
Capital expenditures

Sale of property, plant, and equipment

Purchase/sale of another company

Financing Activities
Issuance/repurchase of stock
FEDERALRESERVENOTE

Issuance/repayment Cash of bank note transactions concerned with the raising and repayment of funds in the form of debt and equity Issuance/retirement
THE UNITED STATES OF AMERICA THE UNITED STATES OF AMERICA
T IS N T IS L G L T N E H OE E A E DR FO A L D B S, PU L C A D PR V T R L ET BI N I AE

L70744629F

12

WASHINGTON, D.C.

12

A

H 293

L70744629F

12

SE I E R S 1985

12

ONE DOLLAR ONE DOLLAR

of bonds

Payment of dividends

Categorizing Cash Flow Activities
Operating Activities Current
assets and current liabilities

Investing Activities

Long-term assets

Financing Activities

Long-term liabilities or stockholders’ equity

£ Non Current Assets Car: Cost Less Depreciation Equipment: Less Depreciation Current Assets Inventories Receivables Prepayments Cash Total Assets Less Current Liabilities Payables Accruals Less Long Term Liabilities Bank loan Total Liabilities 8000 (2000)

£

6000 3000 (500) 2500 8500

300 275 585 190

1350 9850

325 180 505 3500 4005 5845

Share Capital and Reserves Share Capital Retained profit

3500 2345

5845

Balance Sheet Adjustments
a.Merlin bought the car and the equipment on his first day of trading.

b. All depreciation is calculated on a straight line basis. c. Merlin rents a room in a local nursery at a cost of £225 per month, which is paid monthly in advance on the last day of each month.

d. The prepayments are made up of (i) prepaid rent and (ii) prepaid council tax (local taxes) of £360. e. The accrued expenses relate to (i) an unpaid telephone bill for £50 and (ii) wages for Guinevere, Merlin’s bookkeeper, who prepares the accounts and maintains the records for Archimedes Ltd at a salary of £130 per month which she is paid in arrears on the 1st of each month. f. Interest on the bank loan is charged at a rate of 7% per annum and is paid on 31 December each year.

Income Statement Adjustment
On 31st July, Merlin’s rent was increased by £25 per month. On 1st January, Guinevere’s wages were increased to £135 per month.

Wages paid to Guinevere during the year totalled £1,585.

Tutoring sessions where the customer paid cash totalled £13,500. Tutoring sessions provided to customers on credit totalled £12,000. Inventories of books and stationery costing £1,200 were bought on credit during the year. The year-end inventory count identified that Merlin had inventory to the value of £425. Cash received in respect of receivables totalled £11,800.

Payments to suppliers of inventory totalled £1,100. Electricity was paid in cash during the month the electricity was used. A total of £420 was paid for electricity during the year. Council tax (local taxes) of £600 for 1 April 2009 to 31 March 2010 was paid.

Cash paid in relation to telephone bills during the year totalled £375. At the end of the year, £45 was owed to the telephone company in relation to the year to 30 June 2009. Running expenses for the car were £950 and were paid for as they were incurred. Other expenses averaged £50 per month and were paid for as they arose. Merlin withdrew £1,450 every month for his personal expenses.

Market Value vs. Book Value
In general, the market value of either equity or assets is not the same as book value. Book value is based on the cost principle and reflects the cost of a transaction which has occurred or is reasonably certain to occur. Book value is an accounting number. Market value, on the other hand, represents the market’s estimate of the value of assets or equity. Market value is forward looking; that is, market value reflects expectations about the future of the company. Market value and book value may differ because: • book value does not reflect reputation, brand names, customer loyalty • book value does not reflect expected future growth • book value does not reflect management talent • book value does not reflect the fact the whole is greater than the sum of the parts.

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