Scribd Logo
Upload

Welcome to Scribd!

  • Constructing Financial Statements

    Uploaded by

    suruth242
    101 views32 pages
    Constructing financial statements

    Original Title

    constructing-financial-statements

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document
    Constructing financial statements

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    101 views32 pages

    Constructing Financial Statements

    Uploaded by

    suruth242
    Constructing financial statements

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 32
    CHAPTER Constructing Financial Statements More than a hundred years have passed since Charles R. Walgreen, Sr. purchased his frst pharmacy in 1901. In that time, the company that bears his name—Walgreen Co.—has grown remarkably, open- ing its 7,000th drugstore in the fall of 2009. Walgreens operates drugstores in 50 states, the District ‘of Columbia, Guam, and Puerto Rico; it has more than 28,000 employee: and fis more than 18% A ebetiuatatbsed of the retail prescriptions in the United States. The com year 2008 marked the 6th consecutive time that Walgreens was named to Fortune's list of Most ‘Admired Companies in America, Even with such a significant presence, Walgreens faces a number of challenges. The economic ‘changes of the recent past have made consumers more cautious and cost-conscious. Pharmacy sales Constitute 65 percent of Walgreens’ sales, and it faces rising costs for pharmaceuticals and increasing competition from other drugstore chains like CVS Caremark Corporation and discount retailers ike Wal-Mart Stores, Inc. Government health care reforms have the potential to reshape the landscape for Providers of health products and services like Walgreens. These factors contributed to a drop in profits in 2009, even though sales revenue increased by 7%. New Chief Executive Otficer, Gregory D. Wasson, must find a strategy for profitable growth, The: company has slowed the rate of new store openings and tumed its focus to cost control and operat- ing efficiencies, ‘As we discovered in Chapter 1, companies ike Walgreens prepare financial statements annually ‘These financial statements allow investors and creditors to assess the impact of changing economic. conditions on the company’s financial health and performance, This chapter wil introduce and explain financial statements using Walgreens as its prime example. The chapter also introduces some key accounting procedures such as transaction analysis, journal tenntries, and posting. The general ledger, key accounting assumptions, and basic accounting defini- tions are also introduced Sources: “nthe begining..." Walyreens history onthe corporate Web site; Walgreen Co, an Subsidiaries 2009 anmuat repor: Fortune magasine Website 30 40 cHapTER2 CHAPTER ORGANIZATION Consinctng FrancieStatemerts ‘Constructing Financial Statements Recording Balance ‘Sheet Transactions = Financial ‘Statoment Efocts Template Ing Financial el Roporting on Equity = Revenue ‘= Recording Equty | | = T-Account Net Working Recognition ‘Transactions ‘= Debit and Crecit Capital ‘= Accrual Accounting | | m Statement of System = Current Ratio = Retained Earnings Stockholders’ f= Journal Entry 1 Quick Ratio ‘= Recording income ad Analyze, Statement slouralize, and Transactions Post 101 Describe ‘and construct the balance sheet and understand how itean be used for analysis In Chapter 1, we introduced the four financial statements—the balance sheet, the income statement, the cash flow statement, and the statement of stockholders’ equity. In this chapter and in Chapter 3, we tun our attention to how the balance sheet and income statement are prepared. The state- ‘ment of cash flows is discussed in detail in Chapter 4, and the statement of stockholders’ equity is, discussed in detail in Chapter 11. REPORTING FINANCIAL CONDITION ‘The balance sheet reports on a company’s financial condition and is divided into three components: assets, liabilities, and stockholders’ equity. It provides us with information about the resources. available to management and the claims against those resources by creditors and shareholders. At the end of August 2009, Walgreens reports total assets of $25,142 million, total liabilities of $10,766 million, and equity of $14,376 million. Drawing on the accounting equation, Walgreens" balance sheet is summarized as follows ($ million). ‘The balance sheet is prepared at a point in time. Itis a snapshot of the financial condition of the company at that instant. For Walgreens, the above balance sheet amounts were reported at the close of business on August 31, 2009. Balance sheet accounts carry over from one period to the next; is, the ending balance from one period becomes the beginning balance for the next period. ‘Walgreens’ 2009 and 2008 balance sheets are shown in Exhibit 2.1. These balance sheets re- port the assets and the liabilities and shareholders’ equity amounts as of August 31, the company’s fiscal year-end, Walgreens had $25,142 million in assets at the end of August 31, 2009, with the same amount reported in liabilities and shareholders’ equity. Companies report their audited fi nancial results on a yearly basis.' Many companies use the calendar year as ther fiscal year. Other companies prefer to prepare their yearly report at a time when business activity is at a low level. ‘Walgreens is an example of the latter. Assets ‘An asset i a resource that is expected to provide a company with future economic benefits. When ‘company incurs cost to acquire future benefits, that cost is capitalized and an asset is recorded, ‘An asset must possess two characteristics to be reported on the balance sheet: 7 Companies also por quarterly financial trent, and these are reviewed by the independent acount, burnt auited, CHAPTER 2 | Corcincirg Franca Siasrnent |. Itmust be owned or controlled by the company. 2. Ttmust possess expected future benefits that can be measured. The first requirement, thatthe asset must be owned or controlled by the company, implies that the company has legal title o the asset or has the unrestricted right to use the asset, This requirement presumes thatthe cost to acquire the asset has been incurred, either by paying cash, by trading other assets, or by assuming an obligation to make future payments, ‘The second requirement indicates that the company expects to receive some future benefit from ownership of the asset. Benefits can be the expected cash receipts from selling the asset or from selling products produced by the asset. Benefits can also refer to the receipt of other noncash assets, such as accounts receivable or the reduction of a liability e.g. when assets are given up 10 settle debts), It also requires that a monetary value can be assigned tothe asset, Companies acquire assets to yield a retum for their shareholders. Assets are expected to pro- duce revenues, either directly (e.. inventory that is sold) or indirectly (e.g. a manufacturing plant that produces inventories forsale) To create shareholder value, assets must yield income that isin ‘excess ofthe cost of the funds utilized to acquire the assets Snr oc : WALGREEN Co. AND SUBSIIAR Consoldntad Balance Shots ‘gun 3,200 and 2808 (raion -— Asste Cash and cath equilnts, Teco weds | Guage Storm nvostons converted to cash |» Current Accounts receivable, net wathin ane year Assets Inventories. foeeere iar caer asi Total cent asses. : a [Property ard ecipos too ios accurate | Assets not used depreciation and amortization . | Seorconvored |. Nonourent —] ood " iScaninone soos ter moncar anais year L_ Total noncurrent assets. Total sets... Lsbies an Shareholders’ Equity Sort tom borowinge [saneseaas | cumm | eazmbaronngs payment wininone [-» Curent | Aceeed expenses and otter faites 4 income tree Total current bition Labiites not | Long-term debt ae |. Noncurrent | Deferred income taxes oe Litt Other noncurrent liabilities eeeE —— _ Total noncurrent liabilities Preferred stock; none issued Common stock Pld-in capital Employee stock loan receivable Retained earings Accumulated other comprehensive income (loss) Treasury stock, at cost Total shareholders’ equity otal abilities and shareholders’ equity at 2008 8 4g 2807 7249 _ina 70,408 9775 1.498, 764 ne77 $22,410 sag 4.209 272 6a 14,337 150 1410 2.897 0 578 0) oye ° 1881) 800 Szaai0 42 CHAPTER? {TI can mans ar stor term, igi baud investments that mate los and canbe easy convo cash wi Locus to sat-dealoped, krowledge sed ares ko ‘tectivenese and technology. This sone season that knowing based incustries ae 50 det wo analyze. Yet, chided acco ae presumabyreecto in ‘company mark vals. This foctean excian vey the i's market captalzton (ts share ice mstitiod bythe umber of shares) is ‘ten greater than the ook value shown on Current Assets _ Inthe United States, the assets section of a balance sheet is presented in order of liquidity, which refers to the ease of converting noncash assets into cash. The most liquid assets, are called current assets, Current assets are assets expected fo be converted into cash or used in ‘operations within the next year, or within the next operating cycle. Some typical examples of current assets include the following accounts, which are listed in order of their liquidity: ‘ash—currency, bank deposits, certificates of deposit, and other cash equivalents; 1 Marketable securities—short-term investments that can be quickly sold to raise cash; Accounts receivable—amounts due to the company from customers arising from the sale of products or services on credit; _ Inventory—goods purchased or produced for sale to customers: Prepaid expenses—eosts paid in advance for rent, insurance, or other services, “The amount of current assets is an important measure of liquidity. Companies require a degree of liquidity to effectively operate on a daily basis. However, current assets are expensive to hold— they must be insured, monitored, financed, and so forth—and they typically generate returns that are less than those from noncurrent assets. AS a resull, companies seek to maintain just enough current assets to cover liquidity needs, but not so much so as to reduce income unnecessarily. Noncurrent Assets The second section ofthe asset side ofthe balance sheet reports noncur- rent (long-term) assets, Noneurrent assets include the following asset accounts: § Long-term financial investments—investments in debt securities or shares of other firms that management does not intend to sellin the near future: Property, plant, and equipment (PPE)—includes land, factory buildings, warchouses, of- fice buildings, machinery, office equipment, and other items used in the operations of the company; \d other assets—ineludes patents, tridemarks, franchise rights, goodwill, and other items that provide future benefits, but do not possess physical substance. Noncurrent assets are listed after current assets because they are not expected to expire or be con verted into cash within one year. Measuring Assets Assets that are intended to be used, such as inventory and property, plant, and equipment, are reported on the balance sheet at their historical cost (with adjustments for depreciation in some cases). Historical cost refers tothe original acquisition cost. The use of historical cost to report asset values has the advantage of reliability. Historical costs are reliable because the acquisition cost (the amount of cash paid to purchase the asset) can be objectively determined and accurately measured. The disadvantage of historical costs is that some assets ean be significantly undervalued on the balance sheet. For example, the land in Anaheim, California, ‘on which Disneyland was built more than SO years ago, was purchased for a mere fraction of its current market value. Some assets, such as marketable securities, are reported at current market value or fair market value, The market value of these assets can be easily obtained from online price quotes or from reliable sources such as The Wall Street Journal. Reporting certain assets at fair market value increases the relevance ofthe information presented inthe balance sheet. Relevance refers to how useful the information isto those who use the financial statements for decision making. For example, marketable securities are intended to be sold for cash when cash is needed by the company 10 pay its obligations, Therefore, the most relevant value for marketable securities is the amount of cash thatthe company expects to receive when the securities are sod. Only those asset values that can be accurately measured are reported on the balance sheet. For this reason, some of a company's most important assets are often not reflected among the reported assets of the company. For example, the well-recognized Walgreens logo does not appear as an asset on the company’s balance sheet, The image of Mickey Mouse and that of the Aflac Duck CHAPTER 2 | Connuctra rua Stacents ae also absent from The Walt Disney Company's and Aflac Incorporated’s balance sheets. ‘These items are referred to as an unrecognized intangible asset. These intangible assets and the Coke bottle silhouette, the Kleenex name, an excellent management team, or a well-designed supply chain, are measured and reported on the balance sheet only when they are purchased from 4 third party, As a result, internally created intangible assets, such as the Mickey Mouse image, lire not reported on a balance sheet, even though many of these internally created intangible as sets are of enormous value. Liabilities and Equity Liabilities and equity represent the sources of capital to the company that are used to finance the acquisition of assets. Liabilities represent te firm’s obligations for borrowed funds from lenders or bond investors, as well as obligations to pay suppliers, employees, tax authorities, and other parties. These obligations can be interest-bearing or non-inteest-bearing, Equity represents capital that has been invested by the shareholders, ether directly via the purchase of stock, or indirectly in the form of eamings that are reinvested in the business and not paid out as dividends (retained eamings). We discuss liabilities and equity inthis section. The liabilities and equity sections of Walgreens’ balance sheets for 2009 and 2008 are repro- duced in the lower section of Exhibit 2.1. Walgreens reports $10,766 million of total liabilities and 514,376 million of equity as ofits 2009 fiscal year-end. The total of liabilities and equity equals $25,142—the same as the total assets—because the shareholders have a residual claim on the company. A liability isa probable future economic sacrifice resulting from a current or past event. The «economic sacrifice can be a future cash payment toa creditor, or it can be an obligation to deliver 00d or services to a customer ata future date. A liability must be reported in the balance sheet ‘hen each ofthe following three conditions is met: 1. The future sacrifice is probable. 2. ‘The amount of the obligation is known or can be reasonably estimated, 3, The transaction or event that caused the obligation has occurred. ‘When conditions 1 and 2 are satisfied, but the transaction that caused the obligation has not occurred, the obligation is called an executory contract and no liability is reported. An example of such an obligation is a purchase order. When a company signs an agreement to purchase materials from supplier, it commits to making future cash payment of a known amount. However, the obligation to pay for the materials is not considered a liability until the materials are delivered. Therefore, even though the company is contractually obligated to make the cash payment to the supplier, a liability is not recorded om the balance sheet. However, information about purchase commitments and other executory contracts is useful to investors and creditors, and the obligations should be disclosed inthe footnotes to the financial statements. In its annual report, Walgreens reports open inventory purchase orders of $1,477 million at the end of fiscal year 2009 Current Liabilities Liabilities on the balance sheet are listed according to maturity ‘ions that are due within one year or within one operating cycle are called current ‘Some examples of common current liabilities include - Obliga- abilities, © Accounts payable—amounts owed to suppliers for goods and services purchased on credit | Accrued liabilities—obligations for expenses that have been recorded but not yet paid Examples include accrued compensation payable (wages earned by employees but not yet Paid). accrued interest payable (interest on debt that has not been paid), and accrued taxes. (taxes due). Short-term borrowings—short-term debt payable to banks or other creditors. © Deferred (unearned) revenues—an obligation created when the company accepts payment in advance for goods or services it will deliver in the future, Sometimes also called advances from customers or customer deposits. a3 a4 Jcorow CHAPTER 2 i008 se often ted Notes i, When 2 ‘ompany borrows. troney orally sens [promissory note seyoeing tay tho af | payable. 4 | L Current maturities of long-term debt—the current portion of long-term debt that is due to be paid within one year. Noncurrent Liabilities | Noncurrent fi amples of noncurrent liabilities include: es are obligations (o be paid alter one year. Ex- Long-term debt—amounts borrowed from creditors that are scheduled to be repaid more than one year inthe future. Any portion of long-term debt that is due within one year is reclas- sified as a current liability called current maturities of long-term debt. Other long-term liabilitiex—various obligations, such as warranty and deferred compensa- tion liabilities and long-term tax liabilities, that will be satisfied at least a year in the future. These items are discussed in later chapters. Detailed information about a company's noncurrent liabilities, such as payment schedules, interest rates, and restrictive covenants, are provided in the footnotes to the financial statements, BUSINESS INSIGHT How Much Debt Is Reasonable? Walgreens reports total assets of $25,142 milion, fi- abilities of $10,766 million, and equity of $14,376 milion. This means that Walgreens finances 43% of its assets with borrowed funds and 57% with shareholder investment. Liabilities represent claims for fixed amounts, while shareholders’ equity represents a flexible claim (because shareholders have a residual claim). Companies must monitor their financing sources and amounts because borrowing too ‘much increases risk, and investors must recognize that companies may have substantial obligations (lke Walgreens’ inventory purchase commitment) that do not appear on the balance sheet. Stockholders’ Equity quity reflects capital provided by the owners of the company. It is often referred to as a residual interest, That i, stockholders have a claim on any assets that are not needed to meet the company’s obligations to creditors, The following are examples of items that are typically included in stockholders” equity’ Common stock—the capital received from the primary owners of the company. Total com- mon stock is divided into shares. One share of common stock represents the smallest frac- tional unit of ownership of a company. Additional paid-in capital—amounts received from the primary owners in addition to the par value or stated value of the common stock. Treasury stock—the amount paid for its own common stock that the company has reacquired, Retained earnings—the accumulated earnings that have not been distributed to stockholders as dividends. Accumulated other comprehensive income or toss—accumulated changes in equity that are not reported in the income statement; discussed in Chapters 11 and 12. The equit 1e sheet consists of two basic components: contributed capital and eamed capital. Con pital is the net funding that a company has received from issuing, and reacquiring its equity shares. That is, the funds received from issuing shares less any funds paid to repurchase such shares, Walgreens” equity section reports $14,376 million in equity. Its contributed capital is a negative $988 million ($80 million in common stock plus $605 million in [additional] paid-in capital minus $140 million in an employee stock loan receivable minus $1,533 ‘any companies’ common sare hive a pat value, but that ale has Hite economic significance, For instanse, Walteens stares hayes par value of 078125 per share while te market pic ofthe tock s about $39 athe time ofthis writing fn Inont cise, the sum of common stock a pa) and tional paid-in capital epesets the vale of stockholders” contributions tothe business in exchange for shares. chapter 2 | million in treasury stock). The negative balance indicates that Walgreens has returned more cash to its shareholders (by buying its own stock) than it has received in cash from its shareholder capital contributions, Earned capital is the cumulative net income (and losses) retained by the company (not paid ‘out to shareholders as dividends). Earned capital typically includes retained earnings and accumu- lated other comprehensive income or loss. Walgreens’ earned capital is $15,364 million ($15,327 million in retained earnings plus $37 million in accumulated other comprehensive income). Other comprehensive income is discussed in Chapters 11 and 12. RETAINED EARNINGS There is an important relation for retained earnings that reconciles its beginning and ending balances as follows: Beginning retained eamings + Net income (or — Net loss) ~ Dividends = Ending retained eamings ‘This relation is useful to remember, even though there are other items that sometimes impact re- tained earnings. We revisit this relation after our discussion of the income statement and show how it links the balance sheet and income statement. Donktnuctrg nance Statements as FATT coven ‘rm used o dese ‘uner' claims on the company. For ‘corporations the toms and stockholders | Sauty are leo used to doceribe owners’ claims. Wo use al thee toms interchangeably, MID-CHAPTER REVIEW 1 Assume Schaefer's Pharmacy, Inc. has the following detailed accounts as part of ts accounting system. Enter the letter of the balance sheet category A through E in the space nex othe balance sheet items numbered | through 20, Enter an X in the space if the item is not reported onthe balance sheet, A. Current assets Current liabilities E. Equity B. Longe-term assets D. Long-term liabilities —— |. Accounts receivable 1. Rentexpense © Shor-term notes payable 12. Cash —— 3 Land — 13. Buildings —— 4 Retained earings = 14. Accounts payabie —— 5. Imangible asets 15. Prepaid rent — 6 Common stock = 16. Borrowings (due in 25 years) = T. Repairs expense 17. Marketable securities —— 8 Equipment —— 18. Inventories — 9. Treasury stock 19. Additional paid-in capital — 0. —_ Investments (noncurrent) 20. Uneamed revenue The solution to this review problem can be found on page 88. Analyzing and Recording Transactions for the Balance Sheet ‘The balance sheet is the foundation of the accounting system, Every event, of transaction, that is recorded in the accounting system must be recorded so that the following accounting equation is ‘maintained: Assets = Liabilities + Equity ‘We use this fundamental relation throughout the book to help us assess the financial impact of trans- actions. This is our “step 1” when we encounter a transaction. Our “steps 2 and 3” are to journalize those financial impacts and then post them to individual accounts to emphasize the linkage from centries to accounts (steps 2 and 3 are explained later in this chapter). AG CHAPTER | Concivcing Peoncnistaements ‘Stop 1: Analyze ‘Stop 2: Joumalize ‘Step 3: Post ‘each transaction ‘each transaction journal ‘rom source {rom the FSET information to ‘socuments ‘analysis ledger accounts Financial Statement Effects Template _To analyze the finat ‘we employ the following financial statement effects template (FSE ial impacts of transactions, D, Balance Shoot Income Statement sbi, Contb. , Eamed ‘Net Revenues = Expenses Cash, Noncash : + ‘Transaction ‘Asset * Assets = ites * Capital * Capital ‘The template accomplishes several things. First and foremost, it captures the transaction that must be recorded in the accounting system, That “recording” function will be our focus for the next few pages. But accounting is not just recording financial data; it i also the reporting of information that is useful to financial statement readers. So, the template also depicts the effects ofthe transaction on the four financial statements: balance sheet, income statement, statement of stockholders’ equity, and statement of cash flows. For the balance sheet, we differentiate between cash and noneash assets ‘so as to identify the cash effects of transactions, Likewise, equity is separated into the contributed ‘and earned capital components (the latter includes retained earnings as its major element). Finally, income statement effects are separated into revenues, expenses, and net income (the updating of retained earings is denoted with an arrow line running from net income to earned capital). This template provides a convenient means to represent financial accounting transactions and events in ‘a simple, concise manner for analyzing, journalizing, and posting. The Account An account is a mechanism for accumulating the effects of an organization's transactions and events. For instance, an account labeled “Merchandise Inventory” allows a re- tailer’s accounting system to accumulate information about the receipts of inventory from suppliers and the delivery of inventory to customers, Before a transaction is recorded, we first analyze the effect of the transaction on the accounting, ‘equation by asking the following questions: What accounts are affected by the trans What is the direction and magnitude of each effect? To maintain the equality of the accounting equation, each transaction must affect (at least) two accounts. For example, a transaction might increase assets and increase equity by equal amounts ‘Another transaction might increase one asset and decrease another asset, while yet another might dectease an asset and decrease a liability. These dual effects are what constitute the doubl 1s system, CHAPTER 2 | ConineinghrenctiShiterans a7 The account is a record of increases and decreases for each important asset, liability, equity, revenue, or expense item. The chart of accounts isa listing ofthe titles (and identification codes) of all accounts for a company. Account titles are commonly grouped into five categories: assets, liabilities, equity, revenues, and expenses. The accounts for Natural Beauty Supply, Inc. (introduced. below), follow: Assets Equity 110.Cash {310 Common Stock 120 Accounts Receivable 320 Retained Eamings 180 Other Receivables Revenues and income 140 Inventory 410 Sales Revenue 160 Prepaid Insurance 420 interest Revenue 160 Security Deposit 170 Fixtures and Equipment Expenses 175 Accumulated Depreciation—Fixtures and 510 Cost of Goods Sola Equipment 520 Wages Expense 590 Rent Expense Liablitios 540 Advertising Expense 210 Accounts Payable 220 heron Pron 50 Depreciton Expense —Fatures and 230 Wages Payable 1560 Ineurance Expense 240 Taxes Payable 570 Interest Expense 250 Unsamed Revenue 260 Notes Payabio 1580 Tax Expense Each transaction entered in the template must maintain the equality of the accounting equation, and the accounts cited must correspond to those in its chart of accounts. Transaction Analysis Using FSET To illustrate the effect of transactions on the account- ing equation and, correspondingly, the financial statements, we consider the business activities of Natural Beauty Supply, Inc. Natural Beauty Supply was established to operate as a retailer of organic beauty and health care products, though the owners hoped that they also would become a wholesale provider of such products to local salons. The company began business on November 1, 2010. The following transactions occurred on the first day of business: (D)Nov. 1 Investors contributed $20,000 cash to launch Natural Beauty Supply, Inc. (NBS), in ‘exchange for 10,000 shares of NBS stock. (2) Nov. 1 NBS borrowed $5,000 cash from a family member of the company’s founders by signing a note. The $5,000 must be paid back on November 30 with interest of $50. (3) Nov. 1 NBS arranged to rent storefront location and began to use the property. The landlord requires payment of $1,500 at the end of each month. NBS paid a $2,000 security deposit that will be returned at the end of the lease. (4) Nov. 1 NBS purchased, on account, and received $17,000 of inventory consisting of natural soaps and beauty products, Let’s begin by analyzing the financial statement effects ofthe first transaction. At the beginning of its life, Natural Beauty Supply has accounts that are empty of entries, so the financial statements would be filled with zeroes. In the company’s very first transaction, shareholders invested $20,000 cash in Natural Beauty Supply, and the company issued 10,000 shares of common stock, which increased equity (contributed capital). This transaction is reflected in the following financial state- ‘ments effects template counting stems at lane organization wil have much more dealin tir account structures than We will use ete. The ‘account structs deta allows management © accumulate infarmtion by responsibility centro by prodt ine or by Loz Use the financial statement effects template (FSET) to analyze transactions. 48 CHAPTER 2 | Cowincing Franti Stim Balance Sheot Income Statement Labi, Conti. , Eamed s = = het Tranction ities * Capital * Capital — Revenues - Expenses = income (1 ssue stock for 20,000 $20,000 cash. peer - = Assets (cash) and equity (common stock) increased by the same amount, and the accounting equa- tion remains in balance (as it always must) Inthe second transaction, Natural Beauty Supply borrowed cash by signing a note (loan agree~ ment) with a family member. This transaction increased cash (an asset) and increased notes payable (a liability) by the same amount, The notes payable liability recognizes the obligation to repay the family member. (2) Sign a note and 5.000 5.000 receive $5,000 cash, = = - At this point, Natural Beauty Supply would not record anything for the interest that will eventu- ally be paid. Interest expense occurs with the passage of time, and at the moment of borrowing on November 1, there is no interest obligation to be r ‘Also on November 1, 2010, Natural Beauty Supply arranged for rental ofa location and paid a security deposit which it expects to be returned at a future date, This transaction decreased cash an asset) and increased security deposits (another asset). We'll assume that Natural Beauty Sup- ply hopes to move to a more upscale location within a year, so the security deposit is considered a current asset (9) Sign rental agreement 9.099 42,000 ‘and pay $2,000 securty cas - = deposit Like the case of interest expense, Natural Beauty Supply would make no entry for rent expense on November 1, because the obligation to pay for the use of the location occurs with the passage of time. Finally, Natural Beauty Supply purchased and received $17,000 of inventory on credit. Thi transaction incteased inventory (an asset) by $17,000 and increased accounts payable (a liability) by $17,000, recognizing the obligation to the supplier. This transaction is recorded as follows: (3) Purchase $17,000 17,000 +17,000 inventory on account. wate = hee - = ‘To summarize, the description of each transaction appears in the first column of the template. Then the financial statement effects of that transaction are recorded with a + or a— in the appropriate columns of the template, Under each number, the account title within that column of the balance sheet or income statement is entered. So far, Natural Beauty Supply's activities have not affected the revenue or expense accounts of the income statement. ‘After each transaction, the equality of the accounting equation is maintained. If we so choose, we can prepare a balance sheet at any time, reflecting the transactions up to that point in time. [At the end of the day on November 1, 2010, Natural Beauty Supply's balance sheet appears as Follows: CHAPTER 2 | CorsiucinghrencilSutemens — a@) NATURAL BEAUTY SUPPLY, ING. Balance Sheet November 1, 2010 ‘Assets Liabilities and Equity CASH eee eeeceeeceeeeee $28,000 Notes payable... Inventory 22.2. mo 17,000 Accounts payable ‘Security deposit .... 2.000 Total current abies, Total curent 88618 ..-seseeeecssess 42000 geuity Common stock... sss. c++ 20,000 Total assets $42,000 Total lablities and equity. $42,000 MID-CHAPTER REVIEW 2 Assume that Schaefer's Pharmacy. Inc. enters into the following transactions. Record each of the flo lwansactions in the financial statement effets template. Issued common stock for $20,000 cash Purchased inventory costing $8,000 on credit Purchased equipment costing $10,000 for cash Paid suppliers $3,000 cash for part ofthe inventory purchased in. The solution to this review problem can be found on page 69. REPORTING FINANCIAL PERFORMANCE While balance sheets provide useful information about the structure of a company's resources and the claims on those resources at a point in time, they provide little sense of recent move- ‘ment or trajectory. The retained earnings balance represents the amount earned (but not paid out in dividends) over the entire life of the company. Looking at the difference between points in time doesn’t give a clear picture about what happened between those points in time, For that perspective, we need the income statement to see whether our business activities gener- ated more resources than they used. For instance, Walgreens’ retained earnings increased by $1,535 million over fiscal year 2009, but that amount does not convey the volume of activity that occurred to accomplish it. Walgreens’ fiscal year 2009 Statement of Earnings is shown in Exhibit 2.2, Walgreens reported net income of $2,006 million on revenues of $63,335 million, or about $0,032 of each revenue dol- lar ($2,006 million/S63,335 million). The remaining $0,968 of that revenue dollar relates to costs incurred to generate the revenues, such as the costs of products sold and equipment used, wages, advertising and promotion, interest and taxes. Interpretation of this $0.032 amount requires further analysis, as shown in Chapter 5, but we can compare it to previous amounts of $0,037 in fiscal year 2008, and $0.038 in fiscal year 2007. To analyze an income statement, we need to understand some terminology. Revenues result from increases in net assets (assets minus liabilities) that are caused by the company’s operating activities. Expenses result from decreases in net assets (assets minus liabilities) that are caused by the company’s revenue-generating activities, including costs of products and services sold, operating costs like depreciation, wages and advertising, nonoperating costs like interest on debt and, finally, taxes on income. The difference between revenues and expenses is net income when revenues exceed expenses, or net loss when expenses exceed revenues. The connection to the bal- ance sheet can be seen in that reporting net income means that revenues exceeded expenses, which in tu means that the company’s business activities increased its net assets. Operating expensesare the usual and customary costs that a company incurs to support its main business activities. These include cost of goods sold, selling expenses, depreciation expense, amorti- 803 Describe and construct the income statment {and discuss how it can be. sed to evaluate management performance. “ALA Te income ale he statement ‘of eamings oho talomont of oparaions ortho prot an oss statement Walgreens 509 a three tems (prof, ncome ane ‘amings) in Exhibit 22. | Tete revenues and sa sr often used teterchangeaby. 30 CHapTER2 oa Explain recognition, ‘accrual accounting, and their effects on retained earnings. WALGREEN CO. AND SUBSIDIARIES Consolidated Statement of Eamings Year ended August 31, 2009 (Smillions) Net sales Costof sales». Gross profit Solling, goneral and administrative expenses ‘Operating Income Interest expense) income, net Earnings before income tax provision Income tax provision... Net earings .- zation expense, and research and development expense. Not all ofthese expenses are recognized in te period in which cash is disbursed. For example, depreciation expense is recognized in the time period during which the asset is used, not in the period when it was first acquired in exchange for ash. In contrast, other expenses, such as compensation expense, are recognized inthe period when the services are performed, which is often helore cash is actualy paid to employees, Walgreens’ ‘operating expenses in 2009 were $60,088 million ($45,722 million + $14,366 million). ‘Nonoperating revenues and expenses relate 10 the company’s financing and investing ac~ tivities, and include interest revenue and interest expense. Business decision makers and analysts usually segregate operating and nonoperating activities as they offer different insights into company performance and condition, Walgreens” income statement reports net nonoperating expenses in 2009 of $83 million, followed by tax expense of $1,158 million, Ttis helpful to distinguish income trom continuing operations from nonrecurring items, Many readers of financial statements are interested in forecasting future company performance and focus, their analysis on sources of operating income that are expected to persist into the future, Nonrecur- ring revenues and expenses are unlikely to arise in the future and are largely irretevant to predic- tions of future performance. Consequently. many decision makers identify transactions and events that are unlikely to recur and separate them from operating income in the income statement. These nonrecurring items are described in greater detail in Chapter 6. Accrual Accounting for Revenues and Expenses ‘The income statement’s ability to measure a company’s periodic performance depends on the proper timing of revenues and expenses, Revenue should be recorded when itis eared, even if not yet re- ceived in cash, This is called revenue recognition, Similarly, expenses are recorded by matching them with revenues when incurred, even if not yet paid in ash, as asses are used or obligations ere- ‘ated. Accrual accounting refers 10 this practice of recognizing revenues when eamed and matching, ‘expenses when incurred. {An important consequence of accrual accounting for revenues and expenses is that the balance sheet depicts the resources of the company (besides cash) and the obligations which the company ‘must fulfill in the future. Accrual accounting is required under U.S. GAAP and IFRS because it is considered to be the most useful information for making business decisions and evaluating business performance. (That is not to say that information on cash flows is not important—but itis conveyed by the statement of cash flows discussed in Chapter 4.) Walgreens’ total revenues in 2009 were $63,335 million, Cost of goods sold (cost of sales) is an expense item in the income statements of manufacturing and merchandising companies. It represents the cost of products that are delivered to customers during the period. The difference between revenues (at selling prices) and cost of goods sold (at purchase price or manufacturing cost) is called gross profit. Gross profit for merchandisers and manufacturers is an important number as it represents the remaining income available to cover all of the company’s overhead and other expenses (selling, general and administrative expenses, interest, and so on). Walgreens’ gross profit in 2009 is calculated as total net revenues less cost of sales, which equals $17,613 million ($63,335 million ~ $45,722 million) ‘The principles of revenue and expense recognition are crucial to income statement reporting. ‘To illustrate, assume a company purchases inventories for $100,000 cash, which it sells tater in that ‘same period for $150,000 cash, The company would record $150,000 in revenue when the inventory is delivered to the customer, because at that point, we say that it has been eamed. Also assume that the company pays $20,000 cash for sales employee wages during the period. The income statement is designed to tell how effective the company was at generating more resources than it used, and it would appear as follows: Revenues ssess $180,000 Cost of goods sold... 100,000 Gross prot. ++ 50,000 Wages expense. Not income (earings). In thisillustration, there is a correspondence between each of the revenues/expenses and a cash. inflow/outflow. Net income was $30,000 and the increase in cash was $30,000, However, that need not be the case under accrual accounting, Suppose that the company sells its product on eredit (also called on account) rather than for cash. Does the seller still report sales revenue? The answer is yes. Under GAAP, revenues are reported when a company has eared those sales. Eamed means that the company has done everything required under the sales agreement — ‘no major contingencies remain—and cash is realized or realizable. The seller reports an accounts receivable asset on its balance sheet, and revenue can be recognized without cash collection, Credit sales mean that companies can report substantial sales revenue and assets without receiv ing cash. When such receivables are ultimately collected, no further revenue is recorded because it was recorded earlier when the revenue recognition criteria were met. The collection of a receivable merely involves the decrease of one asset (accounts receivable) and the increase of another asset (cash), with no resulting increase in net assets. Next consider a different situation, Assume that the company sells gift cards to customers for $89,500. Should the $9,500 received in cash be recognized as revenue? No. Even though the gift cards were sold and cash was collected, the revenue has not been eared. The revenue from gift cards is recognized when the product or service is provided. For example, revenue can be recognized when @ customer purchases an item of merchandise using the gift card for payment. Hence, the $9,500 ‘would be recorded as an increase in cash and an increase in unearned revenue, a liability, with no resulting increase in net assets. ‘The proper timing of revenue recognition suggests that the expenses incurred in eaming that revenue be recognized in the same fiscal period. Thus, if merchandise inventory is purchased in ‘one period and sold in another, the cost of the merchandise should be retained in the accounting records until the items are sold. It would not be proper to recognize expense when the inventory was purchased or the cash was paid. Accurate income determination requires the proper timing of revenue and expense recognition, and the exchange of cash is nor the essential ingredient. We have already seen that when a company incurs a cost to acquire a resource that will produce ‘benefits in the future (for example, merchandise inventory for future sale), itrecognizes an asset. That asset represents costs that are waiting to be recognized as expenses in the future, based on the matching principle, When inventory is delivered to a customer, we recognize that the asset no longer belongs to the selling company. The inventory asset is decreased, and cost of goods sold is recognized. The same principle applies when employees eam wages for work in one period, but are paid in the next period. Wages expense must be recognized when the cost is incurred, regardless of when they ate paid. Ifthe company in the illustration doesn’t pay its employees until the following report- ing period. it would recognize a wages payable liability of $20,000 and, because this decreases net assets, a wage expense of the same amount. ‘When wages are paid in the next reporting period, both cash and the wages payable liability are decreased. No expense is reported when the wages are paid, because the expense was recognized When the employees worked 10 generate sales in the prior period. st So] Purchae ot inventors on erect ‘hat the buyer does not ay ta salle at te time of purchase. The buyer repos tbilty (accounts payable) on is balance shoot nat {slater removed when payment is made. The slr eporte an asset facoounta receivabe) on Isbalance sheet wt itis removed when the buyer pays [RECT sates on creat wil not always bo calected. The potential for uncolctabie Adctonal ik othe scountng recognizes revenues only when receivedin cath and expenses only aon palo ash ‘This approach not sceeptab under nae. s2 cHapreR 2 Accrual accounting principles are crucial for reporting the income statement revenues and. expenses in the proper period, and these revenues and expenses provide a more complete view of the inflows and outflows of cash for the firm, Was an outflow of cash supposed to produce benefits in the current period or in a future period? Was an inflow of cash the result of past operations or current operations? The accrual accounting model uses the balance sheet and income statement to answer such questions and to enable users of financial statements to make more timely assessments of the firm’s economic performance. However, accrual accounting’s timeliness requires management to estimate future events in determining the amount of expenses incurred and revenue earned. The precise amount of cash 10 be received of disbursed cannot be known until a later date. In the case of wages, the amount of the accrual is known with certainty. In other cases (c-g., incentive bonuses), it may not. Retained Earnings [Net income for the period is added to the company’s retained earnings, which, in tum, is part of stockholders’ equity. The linkage between the income statement and the beginning- and end-of-period balance sheets, which we called articulation in Chapter 1, is achieved by tying net income to retained earnings because Net Income is, by definition, the change in Retained Earnings resulting from busi- ness activities during an accounting period. This link is highlighted by the red arrow at the top of the financial statement effects template (FSET). There are typically other adjustments to retained earn ings. The most common adjustment is for dividend payments to stockholders. Exhibit 2.3 provides the annual adjustments to retained earnings for Walgreens. ears Se WALGREEN CO. AND SUBSIDIARIES. | ‘Year Ended August 31, 2008, | ‘Srilions) | Retained eamings, August 9, 2008. coe seeeeeeee soceeee S870 Add: Net eamings mon 2008 15798 Less: Cash dividends dectared, Retained earings, August $1, 2009... Analyzing and Recording Transactions for the Income Statement Earlier, we introduced the financial statement effects template as a tool to illustrate the effects of transactions on the balance sheet. In this section, we show how this template is used to analyze transactions that may affect the current period’s income statement. To do so, we extend ourillustra- tion of Natural Beauty Supply (NBS) to reflect the following events: (5) Nov.2_ NBS paid $670 to advertise in the local newspaper for November. (6) Nov. 18 NBS paid $13,300 cash tits suppliers in partial payment forthe earlier delivery of inventory. (1) Nov.— _ During the month of November, NBS sold products to retail customers. The custom- ers paid $7,000 cash for products that had cost $4,000, (8) Nov.— During the month of November, sales to wholesale customers totaled $2,400 for ‘merchandise that had cost $1,700. Instead of paying cash, wholesale customers are required to pay for the merchandise within ten working days. “inthe FSET, we show hat ach transaction thi fects the come ttement aso impacts etsned eamings. Tiss weft for ‘analysing the effect ofthe transaction on both the income satement and balance sheet. However. the impact of et income on ‘Risined earings is recorded only once each acountng period, after alo the evenues and expenses have heen recorded. This fecotding procedure is explained Tater i his chapter and in Chapter 3. CHAPTER 2 | CorsinninarinuncelStsenenis (9) Nov.— NBS employed a salesperson who eamed $1,400 for the month of November and ‘was paid that amount in cash, (LO)Nov. 24 NBS received an order from a wholesale customer to deliver products in December, ‘The agreed price of the products to be delivered is $700 and the cost is $450, (LDNov. 25 NBS introduced holiday gift certificates, which entitle the recipient to a one-hour consultation on the use of NBS’s products. $300 of gift certificates were sold for cash, but none were redeemed before the end of November. (12)Nov. 30 NBS received $1,450 in partial payment from customers billed in (8). (13)Nov. 30 NBS repaid the loan and interest in (2). (14)Nov. 30 NBS paid $1,680 for a twelve-month fire insurance polic: December 1 (15)Nov. 30. NBS paid $1,500 to the landlord for November rent, Coverage begins on {In the fifth transaction, Natural Beauty Supply gave cash in return for advertising for the month of November. This payment does not create a benelit for future periods, so it does not create an asset, Nor does the payment discharge an existing obligation. Therefore, it decreases NBS’s net assets {assets minus liabilities). The purpose of this decrease in net assets is to generate revenues for the company, so it is matched by an expense in the income statement. We begin by entering the decrease in cash and an increase in expenses, (The minus sign in front of expenses insures that the accounting equation still holds. ) Recording the expense allows the income statement to keep track of the flows of assets and liabilities that result from the company’s operations. Balance Shot BS OST Cash, Noncash _ Liable, Conti. , Eamea Transaction Asset * Assets = ities * capital * Capital (91 Pay $870 cash tor 670 November advertising. However, the FSET goes further than recording the accounting entry. It also depicts the effects of the ‘expense on net income and of net income on retained earnings. So, the complete FSET description of transaction (5) is as follows. The FSET uses color to differentiate between the accounting entry {in blue) and the resulting effect on income and retained earnings (in black). (©) Pay $870 cash for oro 70 November advertsing, ne - In the sixth transaction, Natural Beauty Supply made a partial payment of $13,300 in cash to the suppliers who delivered inventory on November 1. This transaction decreases cash by $13,300 and decreases the accounts payable liability by $13,300, The income statement is not affected by this payment. The cost of merchandise is reflected in the income statement when the merchandise is sold, not when it is paid for (as we will see shortly). ~670 (6) Pay $19,800 cash in partial paymentto 13.000 = 733% suppliers from [= - transaction 4 In transaction seven, Natural Beauty Supply sold products to customers who paid $7,000 in cash. ‘This cash receipt is an increase in net assets resulting from NBS"s revenue-generating activities, so it results in revenue being recognized in the income statement. As in transaction 5, the FSET also depicts the impact of these sales on net income and on the retained earings balance. 54 cHaPreR2 no Francia Statements Balance Shest Income Statement So OW cash, Noneash _ Liabils , Conti, , Eamied = het Transaction Asset * Assets = ities * Capital * Capita — Revenues = EAP=NS®S = Income (7a) Sel $7,000 of +7,000 “47,000 +7,000 7,000 productstorcash, ngs Roeree = _Atthe same time, NBS must recognize that these sales transactions involved an exchange, and cash was received while inventory costing $4,000 was delivered, Transaction (7b) recognizes that NBS no longer hhas this inventory and that this decrease in net assets produces an expense called cost of goods sold. In this way, the income statement portrays the increases in net assets (revenues) and the decreases in net assets (expenses like cost of goods sold and advertising) from the company’s operating activities. (Again, the minus sign in front of all expenses insures thatthe accounting equation remains balanced.) (76) Record $4,000 forthe “4000 4000 cao _a000 cost of merchandise vaney = ‘ane - cee = 9d in transaction 7a toms pot ‘The eighth transaction is very similar to the previous one, except that Natural Beauty Supply's customers will pay for the products ten days after they were delivered, Should NBS recognize rev- enue on these sales? The products have been delivered, so the revenue has been eamed.* Therefore, NBS should recognize that it has a new asset—accounts receivable—equal to $2,400, and that it hhas eamed revenue in the same amount. As above, NBS would also record cost of goods sold to recognize the cost of inventory delivered to the customers. (0) Set $2,400 of 2,400 $2400 +2800 products on account ions, La = +2400 (8b) Record $1,700 forthe 1.700 1700 44700 cost of mercnandiso iowa aes = HP = -1700 sod ln transaction Ba ‘The ninth entry records wage expense. In this case, wages were paid in cash. Cash is decreased by $1,400, and this decrease in net assets results in a recognition of wages expense in the income statement (with resulting decreases in net income and retained earnings). (9) Record $1,400 in wages. — 1,400 =1,400 +1400 —1.400 toomployees. = paar - oes Transaction ten involves a customer order for products to be delivered in December. This is an example of an execurory contract, which does not require a journal entry, NBS has not earned revenue, because it has not yet delivered the products. (10) Receive customer bee Memorandum entry for customer order In transaction eleven, Natural Beauty Supply sold gift certificates for $300 cash, but none were redeemed. In this case, NBS has received cash, but revenue cannot be recognized because it has not yet been eared. Rather, NBS has accepted an obligation to provide services in the future when the sift certificates are redeemed. This obligation is recognized as a liability titled uneamed revenue. (11) Sel git cersfcates for 200 +300 $300 cash on = unas - = Sia Chapcr 6, we wil consider the possiblity that a customer might ot pay te resivable. For the time beng, we will sume that the ecivabes collet is ased CHAPTER 2 | angFrerctaStterents SS In transaction twelve, NBS received $1,450 cash as partial payment from customers billed in trans- action eight. Cash increases by $1,450 and accounts receivable decreases by $1,450. Recall that revenues are recorded when eared (transaction 8), not when cash is received, Balance Shoot Income Statement oom Gash, Noncash Liab | Conti. Eamied = Nat Transaction Ascot * Assets = ities * Capital * Capita —Mevenues = Expenses = income (12) Roceive $1,450 cash | sparta payment +1.450—1,460) trom customers biled ie - in transaction 6 In transaction thirtcen on November 30, Natural Beauty Supply paid back the family member who hhad loaned money tothe business. The cash payment was the agreed-upon $5,050 ($5,000 principal and $50 interest). The repayment of the principal does not change the net assets of NBS; cash goes down by $5,000 and the note payable liability goes down an equal amount, However, the payment of $50 interest does cause the net assets to decrease, and this net asset decrease creates an interest expense in the income statement. (19) Pay interest of 505.059 5.000 —80 50 “30 ‘and repay principal of Gusn toe aed = emt = 35,000. Pie Earns ers In the fourteenth transaction, NBS paid an annual insurance premium of $1,680 for coverage begin- ning December 1. NBS will receive the benefits of the insurance coverage in the future, o insurance expense will be recognized in those future periods. At this time, a noncash asset titled prepaid insur- ance is increased by $1,680, and cash is decreased by the same amount. (19)Pay$1.680 erone- 1,600 +1.680 yearinsuranenpotey, C= - = In the last transaction of the month of November, Natural Beauty Supply paid $1,500 cash to the landlord for November's rent. This $1,500 reduction of net assets is balanced by rent expense in the income statement, (15}Pay 1 200"ent ior ~aaop 200 m0 0 Novo ww = = - os ‘We can summarize the revenue and expense entries of these transactions to prepare an income statement for Natural Beauty Supply for the month ended November 30, 2010. NATURAL BEAUTY SUPPLY, INC. Income Statement For Month Ended November 30, 2010 Sales revenue .. $9,400 Cost of goods sold». 5,700 Gr088 profit... 3,700 Wages expense... 2. 1,400 Rent expense. 1,500 Advertising expense 670 Operating income 180 Interest expense .. 50 Net income. s_%0 S6 cHapTeR2 os tustrate ‘equity transactions land the statement ‘of stockholders equity REPORTING ON EQUITY Analyzing and Recording Equity Transactions Earlier we recorded the effect of issuing common stock on the balance sheet of Natural Beauty Sup- ply. To complete our illustration, we illustrate one final equity transaction—a dividend payment. (16) Nov. 30 Natural Beauty Supply paid $50 cash dividend to its shareholders. To record the dividend payment, we decrease cash and decrease retained earnings. Balance Shoot Noncash _ Liabil , Contib. , Eamed. sos = Not ‘Transaction + assets = ities * Capital * Capita Revenues ~ Expenses = income (16) Pay $50 cash dividend 50 to sharoholdors. = seme 5 = No revenue or income is recorded from a stock issuance. Similarly, no expense is recorded from a dividend, This is always the case. Companies cannot report revenues and expenses from capital transactions (transactions with stockholders” relating to their investment in the company). ‘The FSET entries can be accumulated by account to determine the ending balances for assets, li abilities and equity, Natural Beauty Supply's balance sheet for Novemiber 30, 2010, appears in Exhibit 2.4, The balance in retained earings is $30 (net income of $80 less the cash dividend of $50). Eee NATURAL BEAUTY SUPPLY, INC. Balance Sheet November 30, 2010 Assois abilities Cash ea $8,100 Accounts payable. $3,700 ‘Accounts receivable .. 1950 Unoamed revenue. 300 Inventory 11,300 Total curent liabilities “4,000 Prepaid insurance .. 1,880 Equity Security deposit 2.000 EY ock Total current assets. . 24.030 Retained earings... Total equity... Total assots... Total Habilties and equity Statement of Stockholders’ Equity ‘The statement of stockholders’ equity is a reconciliation of the beginning and ending balances of selected stockholders” equity accounts. The statement of stockholders’ equity for Natural Beauly ‘Supply for the month of November is in Exhibit 2.5, This statement highlights three main changes to Natural Beauty Supply's equity during November. 1. Natural Beauty raised $20,000 in equity capital during the month. 2. Natural Beauty Supply eared net income of $80. That is, its business activities increased the company’s net assets by $80 during the month, Natural Beauty Supply declared a $50 cash dividend, Pte eee NATURAL BEAUTY SUPPLY, INC. Statement of Stockholders’ Equity For Month Ended November 30, 2010 jockhoiders’ Equity Contributed Eamod Capital Capital Balance, November 1, 2010... ...-+eeee+e so so ‘Common stock issued .. : 20,000 = Not income. Serene - 80 Cash dividends 0000 200000200202 = 60) $20,000, $30 YOU MAKE THE CALL You are an Analyst Callaway Golf Company reported a balance in retained earnings of $518.9 milion at December 31, 2008. This amount compares to $470.5 one year eartier at the end of 2007. In 2008, Callaway reported net income of $66.2 milion. Why did the company's retained eamings go up by less than this amount? jancwer on page 70) MID-CHAPTER REVIEW 3 Part 1. Assume that Schaefer's Pharmacy, Inc.'s records show the following amounts at December 31,2011. Use ‘his information, as necessary 1o prepare its 2011 income statement (ignore income taxes). cash... $ 31000 Cash dividends $ 1,000 Accounts receivable 12,000 Revenues. 25,000 Office equipment. 32,280 Rent expense. 5,000 ‘ 36,000 Wages expense. 8,000 7,500 Usiiies expense 2,000 45,750 Other expences. 4,000 Part 2. Assume tht Schaefer's Pharmacy, Ine. reports the following selected financial information forthe year ‘ended December 31, 2011 Retained earings, Dec. 31, 2011... Not income... $30,000 Dividends. we 8 1,000 $6,000 Retained eamings, Dec. 31,2010. $25,000 Prepare the 2011 calendar-year retained earings reconciliation fr this company. Part 3. Use the listing of accounts and figures reported in part 1 along with the ending retained earings from part 2 to prepare the December 31, 2011, balance sheet for Schaefer's Pharmacy, Ine. The solution to this review problem can be found on pages 89-90. JOURNALIZING AND POSTING TRANSACTIONS ‘The financial statement effects template is a useful tool for illustrating the effects of a transaction. ‘on the balance sheet, income statement, statement of stockholders’ equity, and statement of cash flows. However, when representing individual transactions or analyzing individual accounts, the accounting system records information in journal entries (step 2) that are collected in individual accounts. This section introduces the basics of that system. It also introduces the T-account as a useful tool for learning debits and credits and for representing accounts in the ledger (step 3). 08 Use journal entries ana T-accounts to analyze and record transactions. s8 CHAPTER? ese, ot nereaces and ‘creases i Koy aot, Naty, equity, verve terme meaning lof and right respective. ae oman ars oneece eae corsinsctng France Saternents T-Account Accountants commonly use a graphic representation of an account called a T-account, so named because it looks like a large T. The typical form of a T-account is ns Debits Crests (Or) (or Abwaye the left side | Always the right side One side of the T-account is used to record increases to the account and the other side is used to record decreases. Accountants record individual transactions using the journal entry. journal entry is an ac counting entry in the financial records (journals) of a company. This is the bookkeeping aspect of accounting. Even if we never make a journal entry for a company, we will interact with account- ing and finance professionals who do, and who will use this language. Further, journal entries and TT-accounts can help in reconstructing transactions and interpreting their financial effects. Debit and Credit System Accountants describe increases and decreases in accounts using the terms debit and credit. The left side of each account is the debit side (abbreviated Dr.) and the right side of each account is, the credit side (abbreviated Cr.) In some accounts, increases are recorded on the debit (left) side of the account and decreases are recorded on the credit (right) side of the account. In other accounts, just the opposite is true—increases are credits and decreases are debits. An easy way to remember ‘what the words debit and credit reflect isto visualize a balance sheet in “T” account form with as- sets on the left and liabilities and equity on the right as follows: Balance Sheet in Accounting Equation Form Debit side | Croat Side Debit side | Croait sido Increases | Decreases Decreases | Increases ‘Thus, assets are assigned a normal debit balance because they are on the left side. Liabilities and equity are assigned a normal credit balance because they are on the right side. So, to reflect an increase in an asset, we debit the asset account. To reflect an increase ina liability or equity account ‘we credit the account. Conversely, to reflect a decrease in an asset account, we credit it, To reflect a decrease in a liability or equity account we debit it. (There are exceptions to these normal balances; one case is accumulated depreciation, which is explained in Chapter 3.) ‘The balance sheet must always balance (assets = liabilities ++ equity). So too must total deb- its equal total credits in each journal entry, There can, however, be more than one debit and one credit in an entry, These so-called compound entries still adhere to the rule: foral debits equal total credits for each entry. This important relation is extended below to show the expanded ac- counting equation in T-account form with the inclusion of debit (Dr.) and credit (Cr.) rules. Equity is expanded to reflect increases from stock issuances and revenues, and to reflect decreases from dividends and expenses. varcalSwemerts — S® Assis = Lisbilities + Equity Assets = __Liabltles + “Common Stock ~ Dividends + — Revenues - —_—Expenses. Dutor | crtor — ontor | crtor —ovtor | cx tor —Dntor | Crier brtor | Geir Ontor | Guten ‘weroases|decreases decroasos| increases decrease |incrasos neresses[decrauesdacronses| Increases nareanes | docrosces s ? Sjif iit? Income (revenues less expenses) feeds directly into retained earnings. Also, anything that increases eq- uity is a credit and anything that decreases equity isa debit, So, to reflect an increase in revenues (which increases retained earings and, therefore, equity), we credit the revenue account, and to reflect an increase in an expense account (which reduces retained earnings and, therefore, equity), we debit it. ‘To summarize, the following table reflects the use of the terms debit and credit to reflect in- ‘creases and decreases to the usual balance sheet and the income statement relations, ‘Accounting Relation Debit Creat Balance sheet ASSOUS eee ese Increase Decrease Liabilities 220000277 Soi Decrease Increase Equity (Se). — Si Decrease Increase Income statement Revenue (F) Decrease Increase Expense (6)... Increase Decrease T-Account with Debits and Credits To illustrate use of debits and credits with a T-account, we use a Cash T-account shown below. ‘There is a beginning balance of $2,500 on the left side (which is also the ending balance of the previous period), Increases in cash have been placed on the left side of the Cash T-account and the decreases have been placed on the right side, Transactions (a) and (d) increased the cash balance, while transactions (b), (c), and (e) decreased it ‘The ending balance of cash is $3,700. An account balance is determined by totaling the left side and the right side money columns and entering the difference on the side with the larger total ‘The T-account is an extremely simple record that can be summarized in terms of four elements: (1) beginning balance, (2) additions, (3) deductions, and (4) ending balance. Dates and other related data are usually omitted in T-accounts, but it is customary to key entries ‘with a number or a letter to identify the similarly coded transaction. The number or letter is keyed to the joumal entry (discussed next) that identifies the transaction involved. The type and number ‘of accounts used by a business depend on the complexity of its operations and the degree of detail demanded by managers, The Journal Entry ‘The journal entry records each transaction (step 2) by summarizing the debits and credits. To illustrate the use of journal entries and T-accounts (step 3), assume that Walgreens: (1) Paid em \+ t\2 TY the noemat balsnen of any account ison the ede on which 60 CHAPTER 2 | CorstusingFrancilStatements ployees $1,200 cash wages, and (2) Paid $9,500 cash to acquire equipment. The journal entries and ‘T-accounts reflecting these wo transactions follow. The T-accounts can be viewed as an abbreviated representation of the company ledger, which is listing of all accounts and their dollar balances, Journal Entries o, @ Goneral Ledger Effects in T-Account Form > For journal entries, debits are recorded first followed by the credits, Credits are commonly indented. ‘The dollar amounts are entered in both the debit (let) column and credit (right) column. In practice, recordkeepers also enter the date. An alternative presentation isto utilize the abbreviation Dr to denote debits and Cr to denote credits that precede the account ttle. We use the first approach in this book. Analyze, Journalize, and Post ‘To illustrate the use of journal entries and T-accounts to record transactions, we retum to Natural Beauty Supply and reexamine the same transactions recorded earlier in the financial statement effects template. The following layout illustrates our 3-step accounting process of analyzing, jouralizing, sping. asset nae Saar ee com Nove 2 Ube, Go, cana ie ‘Transaction Asset * Assets = ities Capital Capital Aevernna = Expenses Income 2 Twimwsoer ~ “aio — Soon = ee : : 0 20,000 20,000-—— = (9) 20,000 20,000 (1) <———_————! © @)Signanote and receive 9,000 = 09 = $5,000 cash. race - a @ ae 5,000 Borrow $5,000 on a one-month, 12% (per annum) note. contiued CHAPTER 2 | ConstusingrrancaStaoments 64 ‘contin from previous page —— eee Cash, Noncash _ Labi, Contrib, , Eamed = + + Revenues ~ Expenses = ,,Net Transaction Asset * Assets. = ites * Capital * Capital = income { @)Sign rental agreement — 2.099 2,000 ‘and pay $2,000 security Siew Secnty) = S = 2 deposit. eset 2 Purchase $17,000 417.000 _ £17,000 ; inaney == hasan 5 = {ewentory on account ore (8) tewentory (+4). ‘Account payabe (+4) 17,000 2 (Pay $670 cash for eo

    You might also like