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COMM 2010 Lecture Notes Chapters 1-4 Chapter 1 Why do we need accounting?

? o Firms prepare financial statements to present in a meaningful way the results of a firm's business activities to external users o Items included in the annual report: Letter from chairperson of the BOD and CEO Management discussion and analysis (MD&A) Financial statements and notes Principal business activities o Establishing goals and strategies o Obtaining financing o Making investments o Conducting operations Financial Statements o Balance sheet or statement of financial position o Income statement or statement of profit and loss o Statement of cash flows o Statement of shareholders equity o Notes to the financial statements o Key Players Managers Board of Directors Auditors

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Example Balance Sheet Accounts

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Practice Problem #1 o Lonski Company reports current assets of $500,000, noncurrent assets of $400,000, current liabilities of $200,000, and noncurrent liability of $200,000 at the conclusion of 2012. o Compute the amount of shareholders equity on the balance sheet at the end of 2012.

Practice Problem #2 o The Isabel Company began operations on January 1, 2012. The company issued 1,000 shares of common stock for $48,000 and the company borrowed $36,000 from a bank. The bank loan is due in full on January 1, 2015, with interest at 10 percent per year. On January 1, the company paid $12,000 for a one-year lease of a st building and $15,000 for equipment. Rent is due on the 1 of each month. The company purchased $8,000 of inventory on account on January 2, agreeing to pay the seller within 30 days. o Prepare Isabels balance sheet as of January 31, 2012.

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Example Income Statement Accounts

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Practice Problem #3 o SkyHigh Airlines reported sales for the year ended December 31, 2012 of $2,700,000, costs of sales of 900,000, other operating expenses of $1,200,000, a gain of $100,000 on the sale of an airplane, interest expense of $56,000 and income taxes of $45,000. o Compute SkyHigh net income for the year ended December 31, 2012

o Prepare SkyHighs income statement for the year ended December 31, 2012

Practice Problem #4 o Backof Company earned $190,000 during 2012 and the beginning retained earnings balance was $400,000. At December 31, 2012, the balance in retained earnings was $560,000. o Compute the amount of dividends declared and paid to shareholders during 2012

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Financial Reporting Process o Who sets acceptable accounting standards? Objective of financial reporting o Provide useful information to current and potential stakeholders Qualitative characteristics of accounting information o Relevant: pertinent to the decisions made by the users of the documents o Reliable: verifiable and free of bias o Comparable: comparable to different firms and over time

Recognition vs. Disclosure: recognition is depiction in words and numbers in the financial statements with the amount included in the total. Disclosure is the notes and schedules, items that are not recognized.

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Key Accounting Concepts o Recognition vs. Realization Example: Nike shipped an order totaling $30,000 to DSW rd th on May 23 . DSW received the order on May 28 , but th DSW did not pay for that order until April 5 . Assume that the sale is considered complete when Nike ships the goods. When can Nike recognize the revenue? When is the revenue realized? Recognize: 23rd Realize 5th o Materiality Quantitative or Qualitative: qualitative, the notion that small, meaningless items need not be included. No precise value. o Two methods of accounting Cash basis of accounting: based on inflow, outflow of cash. Weaknesses: o Doesnt match costs to effort used to generate revenue o Separates recognition of revenue from the process of earning this revenue. o Sensitive to timing Accrual basis of accounting: recognizes revenue when a firm sells goods or renders services and recognizes expenses in the period when the revenues that the expenses were used to produce the goods were used. Example: In September, Sinclair Inc. made sales of $310,000, of which $260,000 were on credit and the rest in cash. The sold merchandise had cost Sinclair $120,000 when it purchased it last month. In September, Sinclair acquired merchandise inventory of $78,000, payable next month to the supplier. Finally, Sinclair incurred salary and rent costs for September of $24,000 and $13,000, respectively; these were paid in cash. Calculate net cash flow and net income for September. Which method of accounting better measures Sinclairs operating performance?

Chapter 2 Basic terminology Transactions Accounts Financial statements The Accounting Cycle o Analyze Transactions o Record Transactions o Determine and Record Adjusting Entries o Prepare Income Statement o Close Temporary Income Statement Accounts o Prepare Balance Sheet Account for Transactions o Analyze the transaction and understand the economics What did the firm receive and what did they give? o Record the transaction Apply GAAP to the transaction What accounts are affected? o Create journal entry Post each part of the journal entry to the relevant account Update t-accounts Think of each account as a separate page in the General Ledger Accounting Equation Assets = Claim to assets Assets = Liabilities + Shareholders Equity

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T-accounts o Reflect the effects of transactions on an individual account o Capture all transactions that make up ending balance o Assets = Liabilities + Shareholders Equity

Balance Sheet

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Journal entries o Capture all of the accounts and amounts affected by a transaction o Easier to find error in booking a transaction using journal entry than T-account o Transfer amounts from journal entry to individual T-accounts Debit (Dr.) Credit (Cr.)

Practice Analyzing and Recording Transactions 1. Received $12,000 for a magazine subscription to be delivered to customers over the next year.
Debit Cash Credit Advances from Customers

2. Paid $7,000 in advance for one year of insurance.

Debit Prepaid Rent Credit Cash

3. Purchased for $500,000 cash a building the firm will use for office space.
Debit PPE Credit Cash

4. Paid $15,000 to an advertising agency for a promotional campaign that will start in one month.
Debit Prepaid Expense Credit Cash

5. Bought $115,000 of merchandise inventory on account.

Debit Inventory Credit AP

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6. Paid $65,000 to the supplier for inventory purchase in (5) and gave a note for the remaining $50,000.
Debit AP Credit NP Credit Cash

7. Loaned $30,000 to an officer and accepted a 90-day note as evidence of the loan.
Debit NR Credit Cash

8. Bought $42,000 of merchandise for cash.

Debit Inventory Credit Cash

9. Borrowed $75,000 from the bank.

Debit Cash Credit NP

10. Issued ten shares of $100 par value common stock in settlement of an account payable of $26,000.
Debit AP Credit Common Stock at Par Credit Additional Paid in Capital

11. The company agrees to buy four trucks six months from now for $178,000.
No transaction

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Income Statement o When do you recognize revenues? (1) delivery has occurred or services have been rendered, (2) there is pervasive evidence of an arrangement for payment, (3) the price is fixed or determinable, and (4) collection is reasonably assured, regardless of when the cash is actually received. o When do you recognize expenses? When incurred in the creation of revenue

How is the BS linked to the IS? Retained earnings

Income Statement

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Relation between BS and IS o When a ABC Company earns revenues, it receives some form of net assets (e.g., cash, accounts receivable).

o To recognize the assumption of assets associated with the revenue, ABC Company would reduce assets (e.g., inventory) or increase liabilities (e.g., accrued salaries).

Practice Analyzing and Recording Transactions 1. Sold goods in the amount of $9,500 to customer A on credit.
AR Revenue

2. The cost of these sales was $6,300.

CoGS Inventory

Adjusting Entries: adjust due to the passage of time o Unearned Revenue: On December 1, a customer pays $500 cash in advance for goods not yet received. On December 31, ABC Company ships part of order valued at $200.
Dec 1 Cash 500 Advance from Customer (L increases) 500 Dec 31 Advance from Customer Revenue

o Depreciation: ABC Company purchased a piece of equipment 2 years ago costing $10,000 that has a useful life of 10 years. Assume the company paid cash and the depreciation expense is $1,000 each year.
PPE 10k Cash 10k

Dec 1 Depreciation Exp 1000 (SE down) Acc. Depreciation 1000 (A down)

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o Prepaid Expense: On November 20, ABC Company pays its rent for December 1 of this year through November 30 of next year. The monthly rent expense is $3,000.
Nov 30 Prepaid 36000 Cash 36000 Dec 31 Expense 3000 Prepaid 3000

o Accrued Revenue: On December 15, ABC Company serviced a machine for a customer. However, ABC Company did not bill the customer until January 2.
Dec 31 AR 90 Revenue 90

o Accrued Expenses: ABC Company has 40 salaried employees that earn a total of $160,000 per month. However, these employees are nd not paid until the 2 of the following month
Dec 31 Salary Exp Salary Receivable Jan 1 Salary Receivable Cash

Prepare Income Statement o Derive the balance of each account using T-account algebra Close Temporary Income Statement Accounts o Revenue XX Expense XX Retained Earnings XX Prepare Balance Sheet o Derive the balance of each account using T-account algebra

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Lets put it all together o ABC reported a balance in inventory of $21 million at the beginning of 2012 and $22 million at the end of 2012. Assume that all of ABCs inventory purchases are made on account. During 2012, ABC reported $114 million in cost of goods sold. How much inventory did ABC purchase during 2012?

o ABC reported a balance in retained earnings of $56 million at the beginning of 2012 and $61 million at the end of 2012. Based on ABCs financial reports, it declared and paid dividends of $2.5 million for 2012. Compute the amount of net income for 2012.

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Chapter 3 Understanding the Balance Sheet Nike (US GAAP)


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What resources does a firm recognize as assets? o Asset: probable future economic benefits that a firm controls because of a past event or transaction Securitize Asset: sale of AR, loses asset status o Criteria for recognition: Company owns or controls use of the item Right to use item comes from a past transaction or exchange Future benefit has a relevant measurement attribute that can be quantified with sufficient reliability Externally developed items without obvious price, not internal

Alternative Ways to Measure Assets o Acquisition (historical) cost: amount paid originally, including all costs associated with acquisition o Current replacement cost: Amount it would cost to replace an asset with something of equal use o Net realizable value: amount that can be hoped to be gained from asset (AR when people cant pay fully) Net cash a firm would receive if it sold the asset today with an arms length transaction. Exit value o Fair value: price at which an asset could be sold in a market transaction, hypothetical Present value of future net cash flows: sum of the present values of individual future cash inflows and outflows associated with an asset

Measurement difference between US GAAP and IFRS o US GAAP: decreases in the value of a nonfinancial asset (land/building/etc) recognized prior to selling, be increases not recognized until a sale is made.
Loss 5000 (NI down, SE down) Land 5000 (A down)

o IFRS: increases may be recognized without first selling the asset

Asset or not? o Rainbolt Ranchers agrees to purchase feedstock in the amount of $156,000 from a local supplier
Executory contract

o Rainbolt Ranchers invests $245,000 in research to develop a new strain of cattle feed that can be produced from cottonseed.

No R&D Exp Cash

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o Rainbolt Ranchers pays $120,000 to purchase a new tractor.

PPE Cash

o Rainbolt Ranchers pays the ranch next door $36,000 in advance for the right to graze his cattle on his neighbors fields for the next three months.
Prepaid Cash

o Rainbolt Ranchers exchanges common shares for a patent on a new weighing machine for cattle. The value of the common shares exchanged is $60,000.
Patent Common Stock

What obligations does a firm recognize as liabilities? o Liability: probable future sacrifice of an economic benefit due to a past event or transaction o Criteria for recognition: Item represents a present obligation Obligation exists as a result of a past transaction Obligation cannot be legally avoided Obligation has a relevant measurement attribute that can be quantified with sufficient reliability

Alternative Ways to Measure Liabilities

Amount required to discard the obligation (stated dollar amount) AP, advances Present value of future cash flows Debt obligation with payment dates more than one year in the future Estimate Accrued liabilities for utilities Warranty liability COMM 2010 Intro to Financial Accounting 19 of 28

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Liability or not? o Rainbolt Ranchers agrees to sell 100 head of cattle for $500,000 to another rancher when the cattle reach the age of 12 months. The calves are currently two months of age.
Exe Promise

o The rancher above pays Rainbolt Ranchers $200,000 in advance on the agreement.
Cash Adv. From customer

o Rainbolt Ranchers borrows $150,000 from the local bank to purchase additional feed. The terms of the loan call for the loan to be paid in equal installments over the next three years.
Cash Notes Payable

o Rainbolt Ranchers sells 10,000 shares of its common stock for $6 per share.
Cash Common Stock

o In exchange for an automatic salt dispenser, Rainbolt Ranchers agrees to pay the vendor of this equipment $260,000 within 60 days.

Contingencies o Probable A recognition criterion for liabilities with uncertain amount, uncertain timing, or both, has a different meaning. IFRS >50% GAAP No practice threshold, 80%

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Liability or not? o Rainbolt Ranchers agrees to provide veterinary services for two years after a calf is purchased.

o A competitor files a patent infringement lawsuit, requesting damages of $3 million, for the Rainbolts invention of a new feedstock.
No, only record if certain of losing and the amount is fixed

Shareholders Equity: owners claims to assets not required to meet the claims of creditors o Amounts company received from owners when it originally issued shares

o Amounts generated by operations that have not been distributed to owners

Externally generated: Contributed Capital Internally generated: RE

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Balance Sheet Analysis o Common-size balance sheet: allows comparison regardless of company size Express each balance sheet item as a % of total assets Look for things that appear out of line with norms or economic conditions Must consider differences in bargaining power or efficiency Year to year comparison o Ratio Analysis How valuable is the company? Market-to-book-value ratio (# of shares of common stock * market price per share)/shareholder equity Greater than 1: growth potential

How does a company finance its operations? Debt ratio

Debt-to-equity ratio

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Chapter 4 Understanding the Income Statement Nike (US GAAP)


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Typical Format for Income Statement Revenue Cost of goods sold Gross profit Selling, general, and administrative expenses Other operating expenses Operating profit Interest expense Gains/losses (sale of assets) Profit before income taxes Income tax expense Discontinued operations (net of income tax) Net Income Revenues (Sales) o Revenue recognition criteria Completion of the earnings process and Receipt of assets from customers

Revenue or not? o Crazy Critters build and delivered a custom doghouse for $500 to a customer on credit.

o A customer sent Crazy Critters a check for $1,000 reflecting a down payment on a deluxe chicken coup that Crazy Critters plans to deliver next month.

o Over the holidays, a customer paid cash for a $200 gift card from Crazy Critters that expires in 2 years.

o The individual holding the gift card purchased and received a custom dog bed for her very large dog. The bed cost $225 and the customer paid the difference in cash.

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Problem Areas o Bundled sales Macho Machines sells a machine to a customer for $5,000 which includes installation, software upgrades, and a 3-year warranty. Gift cards o Sales discounts Macho Machines offers a 2% discount off of the selling price for all credit customers who pay within 10 days after the delivery of the machine. o Sales returns Historically, customers return about 1% of the machines purchased from Macho Machines.

Timing and Amount of Revenue o How much revenue is recognized in January? In January, a company sold its product for a sales price totaling $450,000, of which $270,000 was collected in January, $100,000 collected in February, and the remainder in March.

A theatrical company sells $600,000 of season tickets to its plays, which the company will perform the second Saturday in each month for 10 months beginning in January. Also, the company sells $80,000 of tickets for January's play.

The Laker Gators, a pro football team, receives $6,000,000 as its portion of the gate receipts for the playoffs held in the previous December.

Bonilla, Co., an owner of office buildings, collected $1,800,000 in January for office rental fees for the 12month period, January through December.

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Expenses o Expense recognition criteria Consumption of assets as part of a transaction that leads to the recognition of revenue or Consumption of assets due to the passage of time

Expense or not? o Crazy Critters purchased wood to build future doghouses for $1,000 on credit, promising to pay the supplier next month.

o Crazy Critters used $380 worth of wood to build a custom doghouse that it sold for $500.

o Crazy Critters spent $5,000 on advertisements in local newspapers around the region throughout the month.

Timing of Expenses o How much expense is recognized in September? During September, a wholesale company purchased $1,200,000 of inventory for resale. A portion, $250,000, was the cost of goods ordered by their customers in August to be delivered in September. Customers placed orders and received goods with a cost to the wholesale company of $450,000 in September. In September, customers ordered goods with a cost of $225,000 to be delivered in October. The remaining portion of September's purchases was maintained for future orders.

An accounting firm leases its office space. The annual lease payment of $270,000 was paid on July 1.

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A pro football team incurred in September a cost of $354,000 for an advertising campaign that will produce full-page ads in local papers, as follows: two in September, three in October, two in November, and one in December.

A cosmetics company bases its sales commissions on a percentage of each sales dollar the sales staff generates. The company pays the commission at the end of each threemonth period. In September, the company paid commissions of $105,000 for July, August, and September sales. Sales related to commissions for the 3-month period were as follows: July, $262,500; August, $367,500; September, $420,000.

Accumulated Other Comprehensive Income o Changes in net assets NOT captured net income o Typically arise from remeasurements of assets and liabilities

Income Statement Analysis o Common-size income statement

o Ratio Analysis How profitable is the company? Gross profit margin

Net profit margin

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How efficient is the company? Total Asset Turnover

Return on Assets

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