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Accounting Clinic I

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
With contributions by
Stephen H. Penman Columbia University

Clinic I-2
Accounting clinic I contains the following:
A brief review of the four financial
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
The Balance
Sheet: Dell Inc.

Clinic I-5
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

Clinic I-6
The Form of the Balance Sheet
Assets = Liabilities + Shareholders Equity
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 ?

Prepare a classified balance sheet.

Clinic I-8
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.

Clinic I-10
The Income Statement:
Dell Inc.

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


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

Clinic I-12
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%.
Prepare a condensed income statement

Clinic I-13
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

Clinic I-14
The Statement of
Cash Flows : Dell Inc.

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

Clinic I-16
The Form of the Cash Flow Statement
Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

Clinic I-17
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).

Clinic I-18
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.:

Clinic I-20
Example Preparation of a cash flow
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.
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.
Clinic I-22
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
Shareholders 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.

Clinic I-26
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

Clinic I-28
The Articulation of the Financial
Cash Flow Statement

Cash from operations

Cash from investing

Beginning Balance Sheet Ending Balance Sheet

Cash from financing

Cash Net change in cash Cash

+ Other Assets + Other Assets

Statement of Shareholders Equity
Total Assets Total Assets
Investment and disinvestment
- Liabilities by owners - Liabilities
Net income and other earnings
Owners equity Net change in owners equity Owners equity

Income Statement


Net income
Clinic I-29
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
Clinic I-30
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
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
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)
Clinic I-32
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
Held to maturity
Equity investments
See Accounting Clinic III

Clinic I-34
Historical Cost Accounting in The Income
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
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
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.

Clinic I-36
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

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 I-38
R&D accounts: An Example of Poor
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-
1. if the firm expenses R&D immediately (as GAAP
2. if the firm capitalizes R&D and amortize it using
straight line method.

Clinic I-39
(1) R&D is expensed immediately

2004 2005 2006 2007 2008 2009

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

2004 2005 2006 2007 2008 2009

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

Clinic I-40
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)

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

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

Clinic I-42
How Should You Deal with the Accounting
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

Clinic I-43
Who Sets the Rules (in the U.S.)?
U.S. Congress

Securities and Exchange Commission (SEC)

Financial Accounting Standards Board (FASB)

From the past:

Accounting Principles Board (APB)
General Acceptance

In the future:
How will the International Accounting Standards Board (IASB)
influence accounting principles? The SEC Roadmap (Box 2.5)

Clinic I-44