Accounting Clinic I

Basic
Accounting Principles

Introduction
Accounting clinic I contains the following: ▪ A brief review of the four
financial statements
▪ Examples of how each financial statement is prepared
▪ A summary of the principles of measurement in financial statement
Clinic I-3

The Financial Statements

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders’ Equity Clinic I-4

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 Clinic I-5

The Balance Sheet

The balance sheet reports the assets

of the firm at a point in time and the
claims against those resources. The
claims are broken up into liabilities
and shareholders’ equity.

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The Form of the Balance Sheet
Assets = Liabilities + Shareholders’ Equity
or
Shareholders’ Equity = Assets – Liabilities
▪ Assets are economic resources that produce
future earnings.
▪ Liabilities are obligations to transfer assets or
provide services to parties other than the owners. ▪
Equity is the owners' residual interest in the assets of
an entity that remains after deducting the liabilities.

Clinic I-7

Example - Balance Sheet Preparation

Presented below are selected accounts of Biking Corporation at
December 31, 2008:

Patent $150,000 Income taxes payable $93,000 Interest payable 30,000 Notes payable (short-term)
264,000 Bonds payable 450,000 Equipment 950,000 Common stock, $5 par value 400,000 Discount on
bonds payable 25,000 Preferred stock, $10 par value 150,000 Refundable federal and state income taxes
97,630 Prepaid insurance 89,000 Accumulated depreciation – equipment 232,000 Accounts payable
283,000 Inventory 242,000 Trading securities 117,000 Cash 360,000 Land 520,000 Accumulated
depreciation – building 450,000 Accounts receivable 143,000 Long-term loan from bank 640,000 Rent
payable 45,000 Building 1,200,000 Retained earnings ?

Required:
Prepare a classified balance sheet.

Clinic I-8

Solution
Current assets $ Current liabilities $ Cash 360,000 Accounts payable 283,000 Trading securities 117,000 Notes payable
264,000 Accounts receivable 143,000 Interest payable 30,000 Inventory 242,000 Income taxes payable 93,000 Prepaid
insurance 89,000 Rent payable 45,000 Total current assets 951,000 Total current liabilities 715,000

Property, plant and equipment Long-term liabilities

Land 520,000 Long term loan from bank 640,000 Buildings 1,200,000 Bonds payable 450,000 Less acc. depreciation (450,000)
750,000 Less discount on bonds payable (25,000) 425,000 Equipment 950,000 Total long term liabilities 1,065,000 Less acc.
depreciation (232,000) 718,000 Total liabilities 1,780,000 Total Property, plant and equipment 1,988,000
Stockholders’ equity
Intangible assets Capital stock
Patent 150,000 Preferred stock, $10 par; 150,000 Common stock, $5 par 400,000 550,000
Retained earnings 759,000
Total stockholders’ equity

Total assets 3,089,000 Total liabilities and 3,089,000 stockholders’ equity

Retained earnings are calculated as a plug number.

Clinic I-9

▪ The balance sheet reports assets and the

claims on those assets at a point in time.
▪ The other three financial statements
summarize the effects of transactions and
economic events occurring between two
balance sheets dates.
▪ The income statement reports revenues less
expenses (earnings) that increase owners'
equity between two balance sheet dates.

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 Clinic
I-11

The Form of the Income Statement

Net Revenue – Cost of Goods Sold = Gross Margin
Gross Margin – Operating Expenses = Operating Income before
Tax (EBIT)
Operating Income before Tax – Interest Expense = Income before
Taxes
Income before Taxes – Income Taxes = Income after Taxes (and
before Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items = Net
Income
Net Income – Preferred Dividends = Net Income Available to
Common Stocks

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Example - Income Statement Preparation
below are selected ledger accounts of Grant Corporation at
December 31, 2008:
Merchandise Inventory 409,000 Accounting and legal services 24,000 Office salaries 282,000 Shipment-in
81,000 Sales 5,000,000 Advertising 108,000 Purchases 2,548,000 Depreciation of office 62,000 Insurance
expense 26,000 Depreciation of sales equipment 58,000 Sales commission 76,000 Sales salaries 257,000
Sales returns 42,000 Extraordinary loss (before tax) 96,000 Purchase discounts 31,000 Interest expense
176,000

A physical inventory indicates that the ending inventory is $547,000.

Assume a tax rate of 35%.
Required:
Prepare a condensed income statement

Clinic I-13

Solution
Net Sales (1) 4,958,000 Cost of goods sold (2) 2,460,000 Gross profit 2,498,000
Selling expense (3) 499,000
Administrative expense (4) 394,000 893,000 Income from operations 1,605,000
Other expense 176,000 Income before taxes 1,429,000 Income taxes (35%) 500,150
Income before extraordinary item 928,850 Extraordinary loss, net of $33,600 taxes
62,400 Net income 866,450

(1) 5,000,000-42,000
(2) 409,000+(2,548,000+81,000-31,000)-547,000
(3) 257,000+76,000+108,000+58,000
(4) 282,000+26,000+24,000+62,000

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 Clinic I-15

The statement of cash flows

explains the change in cash during
the period in terms of cash
provided by or used for operating,
investing and financing activities.

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The Form of the Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

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The Form of the Cash Flow Statement

The primary purpose of a statement of cash flows is

to provide relevant information about the cash
inflows and outflows of an enterprise during a period.
The statement has three main sections:
Cash Flows from Investing Activities - Investing
activities involve acquiring and disposing of debt or
equity investments, property, plant and equipment
and other productive assets used in the production of
goods or services by the enterprise (other than
materials that are part of the enterprise's inventory).
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The Form of the Cash Flow Statement
Cash Flows from financing Activities - Financing activities
involve obtaining resources from owners and providing
them with a return on their investment; borrowing money
and repaying amounts borrowed, and obtaining and paying
for other resources obtained from creditors on long-term
credit.
Cash Flows from operating Activities - Operating activities
involve all transactions and other events that are not
defined as investing or financing. Operating activities
generally involve producing and delivering goods and
providing services. Cash flows from operating activities are
generally the cash effects of transactions and other events
that enter into the determination of net income.

Clinic I-19

Direct Method Cash Flow Statement

A few firms report cash flow from operations using the
“direct method” (see Chapter 10). Here is an example form
Northrop Grumman Corp.:
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Example – Preparation of a cash flow statement
Presented below are the balance sheets of Scientific Instruments, Ltd. for
December 31, 2005 and 2004
Scientific Instruments, Ltd.
Balance Sheet
December 31, 2005 and 2004

2005 2004
Cash 70 110
Accounts receivables 170 300
Inventories 200 240
Loan to company B 1,500 -
Land 500 -
Equipment 500 550
Acc. Depreciation (190) (200)
2,750 1,000

Accounts Payable 120 200

Bonds Payable 1,000 -
Deferred tax liability 380 300
Common Stock 1,220 250
Retained Earnings 30 250
2,750 1,000

Clinic I-21

Additional Information:
◦ Equipment with original cost of $50 was sold for $35
◦ Dividend declared and paid in cash was $300
 ◦ Stocks and Bonds were issued for cash
◦ Net income reported was $80.
Required:
Prepare a statement of cash flow for 2005
Note: Cash from operating activities involves
adjusting net income for all the non-cash items in
net income.

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Solution
Scientific Instruments, Ltd.
Statement of Cash Flow
For the year ended December 31, 2005
Cash flows from operating activities
Net Income 80 Adjustments to reconcile net income to net cash provided
by operating activities:
Gain on sale of equipment (10) Depreciation 15 Increase in deferred tax
liability 80 Decrease in accounts receivables 130 Decrease in inventories
40 Decrease in accounts payable (80) 175 Net cash provided by operating
activities 255

Cash flows from investing activities

Loan to B (1,500) Purchase of Land (500) Sale of Equipment 35 Net cash
used by investing activities (1,965)

Cash flows from financing activities

Issuance of common stock 970 Issuance of bonds payable 1,000 Payment
of cash dividend (300) Net cash provided by financing activities 1,670

Net decrease in cash (40) Cash, December 31, 2004 110 Cash, December
31, 2005 70

Clinic I-23

The Statement of Stockholders’ Equity: Dell

Inc.
 Clinic I-24

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Shareholder’s Equity
Has two primary components:
◦ contributed capital which represents
stockholders’ investment – common stock (par
value) and additional paid in capital, and
◦retained earnings which equals cumulative net
income minus cumulative dividends since the
formation of the company. (Dividends are
distributions of assets to stockholders.)

Clinic I-25

Comprehensive Income
Comprehensive income in net income
(from the income statement) plus “other
comprehensive income”
To avoid earnings fluctuations some of the
unrealized gains/losses are reported in
“other comprehensive income” and not
included in net income.

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Clinic I-27

The Stocks and Flows Equation

 Ending equity = Beginning equity + Total (comprehensive)
income – Net payout to shareholders

Comprehensive income = Net income + Other comprehensive

income

Net payout to shareholders = Dividends + Share repurchases -

Share issues

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The Articulation of the Financial Statements

Cash Flow Statement

Cash from operations

Cash from investing

Statement of Shareholders’ Equity
Investment and disinvestment by owners Total Assets
Net income and other earnings
Beginning Balance Sheet Cash Net change in owners’ equity - Liabilities
+ Other Assets
Owners’ equity
Total Assets
Income
- Liabilities Statement
Revenues
Owners’ equity Expenses

Cash from financing Net income

Net change in cash

Ending
Balance Sheet Cash
Clinic I-29
+ Other Assets

Principles of Measurement
Two types of measurement are used in financial
statements
Fair value accounting
Assets and liabilities are reported at their “fair
value” and gains and losses from revaluing them
are reported in the income statement or as part of
other comprehensive income in the equity
statement. Fair value is either market value or an
estimate of value.

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Principles of Measurement
Historical cost accounting
Assets and liabilities are reported at their
historical cost (the dollar amount paid when they
were acquired or incurred). In subsequent
periods, those costs are amortized to the income
statement as the assets are deemed to have been
used up in operations or as liabilities accrue costs.
GAAP accounting uses both types of
measurement.

Clinic I-31
Mark-to Market Accounting
Under U.S. GAAP, the following assets and liabilities
are approximately at market value:
◦ Cash and Cash Equivalents
◦ Short-term investments
◦ Accounts payable
◦ Equity Investments considered trading securities or
“available for sale.” See Accounting Clinic III.
The following assets and liabilities are measured
with estimates of that are usually close to market
value:
◦ Net Accounts Receivables (net of estimate of likely bad
debt.)
◦ Accrued and Estimated Liabilities
Note that debt (short-term and long-term) is at historical
cost but that is typically close to fair value)

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Historical Cost Accounting
The following assets and liabilities are at
historical cost on the balance sheet: ◦
Long-term Tangible Assets (depreciated) ◦
Recorded Intangible Assets (amortized) ◦
Goodwill (not amortized)
These assets can be written down if their
value is deemed to have been impaired, but
are never written up (in the U.S.).
 Clinic I-33

Mixed Accounting Measurement

The following assets are sometimes measured at
historical cost and sometimes at fair values: ◦
Inventories: Lower of cost or market rule applies ◦ Debt
investments
◦ Trading
◦ Available-for-sale
◦ Held to maturity
◦ Equity investments
◦ Trading
◦ Available-for-sale

See Accounting Clinic III

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Historical Cost Accounting in
The Income Statement

Revenue recognition principle - value added is

recognized when:
◦ The earnings process is substantially
accomplished ◦ Receipt of cash is reasonably
certain

Matching principle -
◦ Expenses are recognized in the income statement by their
association with revenues for which they are incurred. ◦
 The earnings number reflects net value added from
revenues, that is, net of matched expenses.

Go to Accounting Clinic II for more on matching Clinic I-35

Cost of Goods Sold: An Application of Matching

Cost of goods sold is an accrual concept, calculated in the following

way:
Inventory, beginning XXX
+ Purchases XXX
Goods available for sale XXX
- Inventory, ending (XXX)
Cost of Goods Sold XXX

The beginning balance of inventory and purchases of goods during the

year sum up to the total goods that the firm could have sold during the
year.
The ending balance of inventory (usually available from physical count)
is subtracted to get the cost of the goods actually sold.

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In the income statement preparation example total
purchases were 2,598,000 (after adding shipment
and subtracting discounts). The beginning of
inventory was 409,000 and the ending of inventory
was 547,000. Therefore total cost of goods sold
was:
409,000+2,598,000-547,000=2,460,000
 Clinic I-37

The cash outflow equivalent to the cost of goods

sold is payment to suppliers.
Accrual accounting performs two main adjustments
to this amount to arrive at the cost of goods sold: ◦
Accounts Payable adjustment – payment might not
reflect the entire expenditure on inventories. Some
inventories were purchased on account.
◦Inventory adjustment – inventory is a pure accrual
concept and is recognized in order to match the expense
(COGS) with revenue (the amount we received for the
goods sold).
More about the matching concept in Accounting Clinic II. Clinic

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R&D accounts: An Example of Poor Matching

Peabody Co. produces operating income of $30,000

from operations each year. The company invested
$20,000 in an R&D project in December 31, 2004.
The investment will produce an incremental income
of $7,000 in each of the following 5 years.
Calculate operating income for the years 2004-2009
1. if the firm expenses R&D immediately (as GAAP requires)
2. if the firm capitalizes R&D and amortize it using straight
 line method.

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(1) R&D is expensed immediately

2004 2005 2006 2007 2008 2009

Operating income before R&D $30,000 $30,000 $30,000 $30,000 $30,000
Incremental income $30,000

from R&D __0 7,000 7,000 7,000 7,000 7,000 30,000 37,000 37,000 37,000 37,000
37,000
R&D expense (20,000) __0 __0 __0 __0 __0 Operating income 10,000 37,000 37,000
37,000 37,000 37,000

(2) R&D is capitalized using straight line

The total R&D expenditure is 20,000. It is amortized 20,000/5=4,000 per year for 5
years.

2004 2005 2006 2007 2008 2009

Operating income before R&D $30,000 $30,000 $30,000 $30,000 $30,000
Incremental income $30,000

from R&D ______ 7,000 7,000 7,000 7,000 7,000 30,000 37,000 37,000 37,000 37,000
37,000
R&D expense __0 (4,000) (4,000) (4,000) (4,000) (4,000) Operating income 30,000
33,000 33,000 33,000 33,000 33,000

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Fully expensing R&D in the year in which it was
incurred results in poor matching in operating
income.
 Clinic I-41

How Financial Reporting Issues

Arise Efficiencies of Generally Accepted Accounting Principles
(GAAP)
Examples:
◦ Assets omitted from the balance sheet: R&D and brand assets ◦
Off-balance-sheet obligations not recognized (FIN 46 helps to rectify) ◦
Losses on conversions into common stock and options settled with
common stock are not recognized (SFAS 150 attempts to rectify)

Poor Application of Accounting Principles

Examples:
◦ Excessive restructuring charges (SFAS 146 helps here)
◦ Biased estimates of bad debts, sales returns, warranties
◦ Aggressive revenue recognition
◦ Conservative revenue recognition: Creation of a “cookie jar” with
unearned revenue
◦ “Creative accounting” that yields form over substance: using “bright
lines” in GAAP to obscure; structural engineering

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How Should You Deal with the Accounting Issues?

Understand GAAP and its limitations

 ◦ Appreciate the relevance-reliability tradeoff
◦ Recognize unresolved issues in GAAP
◦ Recognize where choices can be made
Be alert to poor application of GAAP
◦ How sensitive are earnings to estimates?
◦ How would you characterize the revenue recognition
– aggressive or conservative?
◦ Does the application of GAAP “faithfully represent”
the business?

These issues will come to the fore as we proceed through

the book

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