Constructing Financial

Statements

The Accounting Cycle

1. Analyze transactions
2. Record the effect of transactions in a
journal entry
3. Summarize the effects of transactions
a. Post journal entries to the ledger
b. Prepare a trial balance
4. Prepare reports
a. Make adjusting entries
b. Prepare financial statements
c. Close the books

The Balance Sheet

The Classified Balance Sheet

The Classified Balance Sheet

Elements of the Balance Sheet

Current Assets
Assets expected to be converted to cash within one year or the
current operating cycle

Long-Term Assets
Expected to last longer than one year

Current Liabilities
Obligations expected to be paid out of current assets within the
coming year

Long-Term Liabilities
Obligations not expected to be paid or satisfied within the coming
year

Stockholders Equity
Contributed capital
Earned capital
6

Current Assets
Assets expected to be converted to cash within
one year or the current operating cycle
The operating cycle involves the use of cash to
purchase inventories, sell inventories to create
accounts receivable, collect the accounts receivable

Includes

Cash
Investments in securities
Accounts receivable
Inventories
Prepaid expenses
7

Long Term Assets

Expected to last longer than one year
Includes
Investments
To exercise influence over other companies
To earn interest and dividends, or for capital appreciation

Property, plant, and equipment

Includes depreciation

Intangible assets
Patents, copyrights, trademarks, franchises, goodwill

Other assets
Assets not included in the previous categories

Current Liabilities
Obligations expected to be paid out of
current assets within the coming year
Includes
Accounts payable
Accrued liabilities
Short term loans payable
Current portion of long term debt
Unearned revenue

Long Term Liabilities

Obligations not expected to be paid or satisfied
within the coming year
Includes
Long term debt
Notes and mortgages payable

Bonds payable
Capital lease obligations
Leases of plant assets which are equivalent to debt-financed
purchases

Deferred tax liabilities

Pension obligations and other post-retirement
obligations
10

Stockholders Equity
Contributed Capital:
1.
2.
3.

Common stock - the capital received from the primary owners of the
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 common stock that the company
has reacquired

Earned Capital:
1.
2.

Retained earnings - the accumulated earnings that have not been

distributed to stockholders as dividends
Accumulated other comprehensive income or loss - accumulated
changes in equity that are not reported in the income statement

Accumulated other comprehensive income

Foreign currency translation adjustments

Unrealized gains and losses on available-for-sale securities
Unrealized gains and losses on derivatives

11

The Income Statement

12

The Operating Cycle

Begin
Purchase or
manufacture
products or
supplies on
credit.
Receive payment
from customers.

Pay
suppliers.
Deliver product
or provide service
to customers on
credit.

13

The Operating Cycle: Key Issues

Time
Time Period:
Period: The
The long
long life
life of
of aa company
company can
can be
be
reported
reported over
over aa series
series of
of shorter
shorter time
time periods.
periods.
Recognition
Recognition Issues
Issues :: When
When should
should the
the effects
effects of
of
operating
operating activities
activities be
be recognized
recognized (recorded)?
(recorded)?
Measurement
Measurement Issues:
Issues: What
What amounts
amounts should
should be
be
recognized?
recognized?

14

Key Elements on the Income Statement

Revenues
Increases in assets or settlement of liabilities from
ongoing operations.
Expenses
Decreases in assets or increases in liabilities from
ongoing operations.
Gains
Increases in assets or settlement of liabilities from
peripheral transactions.
Losses
Decreases in assets or increases in liabilities from
peripheral transactions.
15

Income
Statement
Operating Activities

Peripheral Activities

16

Measuring Income

the difference
between sales
of the product
and the cost of
sales of the
product

Sales
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Miscellaneous revenues and expenses, gains
and losses
Income before taxes
Income tax expense
Income from continuing operations
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net income
Unrealized gains and losses not included in
net income
Comprehensive income
17

Measuring Income
gross profit
minus operating
expenses;
measures the
performance of
the central
operations of
the company

Sales
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Miscellaneous revenues and expenses, gains
and losses
Income before taxes
Income tax expense
Income from continuing operations
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net income
Unrealized gains and losses not included in
net income
Comprehensive income
18

Measuring Income

operating
income minus
interest
expense,
income tax
expense, and
other
miscellaneous
items

Sales
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Miscellaneous revenues and expenses, gains
and losses
Income before taxes
Income tax expense
Income from continuing operations
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net income
Unrealized gains and losses not included in
net income
Comprehensive income
19

Gains and Losses

Created by activities peripheral to a
companys primary operations
For example,
Sale of long-term assets
Restructuring charges

20

Measuring Income

income from
continuing
operations
adjusted for
below the
line items

Sales
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Miscellaneous revenues, expenses, gains,
and losses
Income before taxes
Income tax expense
Income from continuing operations
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net income
Unrealized gains and losses not included in
net income
Comprehensive income
21

Below the Line Items

In addition to recurring items, companies may have
nonrecurring items.
These items are reported separately because they are not useful
in predicting future income of the company.
Below the line items are shown net of applicable income taxes

These nonrecurring items may include:

1. Income or loss from discontinued operations

results from the disposal of a major business segment

Includes income or loss on segments operation for the period,
and the gain or loss on disposal of the segment

2. Extraordinary gains and losses

unusual in nature and infrequent in occurrence

3. Cumulative effect of accounting changes

a catch-up adjustment for a change to a new accounting method

The change must be to a preferable method and must be
disclosed in notes to financial statements
22

Measuring Income
net income
plus (minus)
changes in
market
condition
unrelated to
business
operations,
reflecting
overall
changes in a
companys
wealth in a
given period

Sales
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Miscellaneous revenues, expenses, gains,
and losses
Income before taxes
Income tax expense
Income from continuing operations
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net income
Unrealized gains and losses not included in
net income
Comprehensive income
23

Unrealized Gains and Losses

Changes in the dollar value of foreign
subsidiaries caused by movement of
foreign currency exchange rates
Changes in the value of investment
securities that are not actively traded
Changes in the value of certain derivative
financial instruments

24

Individual Income Statement Items

Revenue

The value of the goods and services provided by a company in its business operations

Non-operating revenue

Interest revenue: earned from extending credit or loaning money

Other revenue: comprised of revenues that come from different sources

Expenses

The value of resources used in generating reported revenue, including

Cost of goods sold

the expenses directly associated with the sales revenue for the period

Selling General, & Administrative Expense

Wages and salaries
Marketing and advertising
Facilities

Research and development

Bad debts

Depreciation

Allocation of the cost of long-lived assets

Interest expense

The cost of borrowing money

Income tax expense

The sum of all income tax consequences of all transactions during a year

25

Earnings Per Share

The amount of net income associated with
each share of stock
Two earnings per share numbers:
Basic EPS reports earnings based solely on
shares actually outstanding during the year
Diluted EPS reflects the existence of stock
options and other potentially dilutive
securities, such as warrants

26

Expense Recognition
Based on the matching principle

An expense should be recognized in the same period in which the revenue it generates is
recognized

Three bases of expense recognition:

1. Direct Matching (or cause and effect)
The expense is directly traceable to the revenue it generates (cause and effect), for
example
Cost of goods sold matched with sales
Sales commissions matched with sales

2. Systematic Allocation
The expense is associated more with the passage of time than a specific revenuegenerating activity, for example
Depreciation expense
Insurance expense

3. Immediate Recognition
An expenditure is expensed currently because there is no future benefit or the future
benefit is uncertain
Advertising expense
Research and development expense
27

Recording Transactions

28

The Fundamental Accounting Equation

Assets = Liabilities + Owners Equity

29

30

Transaction Analysis: Stock Issuance

(1) On April 1, investors contributed $10,000 cash to
start Jana Juice which sells energy drinks to retailers
and individuals, in exchange for 500 shares of stock.

Balance Sheet

Transaction
Issued stock
for $10,000
cash

Cash
+
Asset
+10,000
Cash

Income Statement

Nonca
Contrib
Net
Liabiliti
Earned Revenu
Expens

= Incom
sh =
+
.
+
es
es
es
Capital
e
Asset
Capital
=
+10,000

=
Common
Stock

Both assets (cash) and equity (common stock) increase and

the accounting equation is in balance.

Cambridge Business Publishers, 2011

31

Transaction Analysis: Note Acquired

(2) On May 1, Jana Juice borrowed $4,000 cash by
signing a note to be repaid on May 31 plus interest of $40.

Balance Sheet

Transaction

Cash
+
Asset

Income Statement

Nonca
Contrib
Net
Liabiliti
Earned Revenu
Expens

= Incom
sh =
+
.
+
es
es
es
Capital
e
Asset
Capital

Signed a
+4,000
note and
Cash
received
$4,000 cash

= +4000
Note
Payable

Both assets (cash) and liabilities (note payable) increase

and the accounting equation is in balance.

Cambridge Business Publishers, 2011

32

Transaction Analysis: Rental Agreement

(3) Jana Juice signed a rental agreement for a store
location and paid $1,800 as a security deposit.

Balance Sheet

Transaction

Cash
+
Asset

Signed a
1,800
rental
Cash
agreement
and paid an
$1,800
deposit

Income Statement

Nonca
Contrib
Net
Liabiliti
Earned Revenu Expens
sh =
+
.
+
es es =Incom
es
Capital
Asset
Capital
e
+1,800 =

=
Securit
y
Deposit

Because the security deposit will likely be returned to Jana

Juice in the future, it is an asset. Assets (cash and security
deposit) increase and decrease by the same amount. The
accounting equation is in balance.

Cambridge Business Publishers, 2011

33

Transaction Analysis: Purchase Inventory

(4) Jana Juice purchased $2,000 of inventory on
account, consisting of energy drinks.

Balance Sheet

Transaction
Purchase
Inventory
on account
for $2,000

Cash
+
Asset

Income Statement

Nonca
Contrib
Net
Liabilitie
Earned Revenu Expens
sh =
+ .
+
es es =Incom
s
Capital
Asset
Capital
e

=
+2,00 +2,000

0
=Accounts
Payable
Invento
ry

Both assets (inventory) and liabilities (accounts

payable) increase and the accounting equation
is in balance.
Cambridge Business Publishers, 2011

34

Jana Juices Balance Sheet

Assets

Liabilities
$12,20
0

Cash
Inventory

2,000

Accounts payable
Note payable
Total current
liabilities

$
2,000
4,000

Security deposit 1,800

6,000
Total current
assets
20,000
Equity
Assets
= Liabilities + Equity
Common stock
10,000
$16,00 Total liabilities &
No
income
transactions
have occurred
so
Total
assetsstatement 0
equity
$16,000

there is no income statement.

Cambridge Business Publishers, 2011

T-Accounts

ACCOUNT TITLE
DEBIT

CREDIT

(Left Side)

(Right Side)

35

Debits and Credits The Balance Sheet

ASSET

LIABILITY

EQUITY

DEBIT

CREDIT

DEBIT

CREDIT

DEBIT

CREDIT

36

Debits and Credits The Income Stmt

REVENUE
DEBIT

CREDIT

EXPENSE
DEBIT

CREDIT

DIVIDEND
DEBIT

CREDIT

37

Debits and Credits All

Assets
Dr.

Cr.

Liabilities
Dr.
-

Owners
Equity

Cr.

Dr.
-

Retained
Earnings

Paid-in
Capital
Dr.
-

Cr.
+

Cr.
+

Dr.
-

Expenses
Dr.
+

Cr.
+

Revenues

Cr.
-

Dr.
-

Cr.
+

Dividends
Dr.
+

Cr.
-

38

Recording Transactions
The journal is a book in which all transactions are recorded
in chronological order
DR = CR
Each journal entry has its debit amounts equal to its credit
amounts to ensure that the accounting equation remains
in balance
Journalizing involves a three-step process:
1. Identify which accounts are involved
2. For each account, determine if it is increased or decreased
3. For each account, determine by how much it changed
39

Accounts
An account is a record of increases and decreases for each asset,
liability, equity, revenue, or expense
Types of accounts:
1.

Asset: economic resource with probable future benefit.

2.

Liability: probable future sacrifices of economic resources.

3.

Stockholders Equity: financing provided by owners and operations.

4.

Revenue: increase in assets or settlement of liabilities from ongoing

operations.

5.

Expense: decrease in assets or increase in liabilities from ongoing operations.

6.

Gain: increase in assets or settlement of liabilities from peripheral activities.

7.

Loss: decrease in assets or increase in liabilities from peripheral activities

40

Transaction 1
Investment of
$700,000 cash
into the business.

Tx #
Account Titles
1 Cash
Paid-In Capital

Ref

Debit
700,000

Credit
700,000

41

Transaction 2
Borrowed
$300,000 cash
from the bank.

2 Cash
Bank Loan Payable

300,000
300,000

42

Transaction 3
Purchased land costing
$50,000 and buildings
costing $400,000. Paid
$100,000 in cash and
signed a mortgage for the
balance.
3 Land
Buildings
Cash
Mortage Payable

50,000
400,000
100,000
350,000
43

Transaction 4
Purchased
equipment for
$650,000 in cash.

4 Equipment
Cash

650,000
650,000

44

Transaction 5
Purchased inventory
costing $90,000 for
$10,000 in cash and
the remaining $80,000
on account.
7 Inventory
Cash
Accounts Payable

90,000
10,000
80,000

45

Transaction 6
Paid $15,000 cash for
an insurance policy.

8 Prepaid Insurance
Cash

15,000
15,000

46

Transaction 7
Sold inventory costing $800,000
to customers for $1,100,000.
The customers paid $200,000 in
cash and the remaining $900,000
was put on the customers
accounts.
10 Cash
Accounts Receivable
Sales
Cost of Goods Sold
Inventory

200,000
900,000
1,100,000
800,000
800,000
47

Transaction 8
Performed
landscaping
consulting services
and billed clients
$200,000 for these
services.
11 Accounts Receivable
Consulting

200,000
200,000

48

Transaction 9
Collected $820,000
cash from customers
as payment on their
accounts.

14 Cash
Accounts Receivable

820,000
820,000

49

Transaction 10
Paid $1,200,000 in
cash to suppliers as
payment on account.

15 Accounts Payable
Cash

1,200,000
1,200,000

50

Transaction 11
Paid cash of $150,000 for
advertising, utilities, and
office supplies.

18 SG&A Expense
Cash

150,000
150,000

51

Transaction 12
Paid cash
dividends of
$5,000.

23 Dividends
Cash

5,000
5,000

52

Posting to the Ledger

Posting involves transferring the the debits
and credits from the journal entries to the
individual accounts
Posting is purely mechanical in nature and
requires no analysis
The collection of all of a companys
accounts is called a ledger

53

Example: Posting Transaction 1

Cash

700,000

Paid-in Capital

Cash

700,000

700,000

Paid-in Capital

700,000

54

Trial Balance
A trial balance is a listing of all of the ledger
accounts and their balances
The total of the debit balance accounts should
equal the total of the credit balance
accounts
The equality of the debits and credits provides
some assurance that the posting process
has been completed correctly
55

Veda Landscape Solutions

Trial Balance
December 31, 2006
Debit
$130,400
120,000
490,000
0
50,000
380,000
520,000

Cash
Accounts receivable
Inventory
Prepaid insurance
Land
Buildings
Equipment
Accounts payable
Wages payable
Unearned franchise revenue
Interest payable
Bank loan payable
Mortgage payable
Paid-in capital
Retained earnings (beginning of year)
Sales revenue
Consulting revenue
Landscaping revenue
Cost of goods sold
800,000
Landscaping supplies expense
100,000
Wages expense
500,000
Selling, general, and administrative expense
174,600
Interest expense
58,000
Depreciation expense
150,000
Dividends
5,000
Totals
$3,478,000

Credit

$180,000
40,000
50,000
58,000
300,000
350,000
700,000
0
1,100,000
200,000
500,000

$3,478,000

56

Financial Analysis

57

Evaluating Liquidity
Liquidity
Ability to pay debts when due
The larger current assets are when compared to
current liabilities, the more liquid a company is
Measured by
1.Net working capital
2.Current ratio
3.Quick ratio
58

59

Net Working Capital

Net working capital is defined as the difference
between current assets and current liabilities.
Net Working Capital = Current Assets Current Liabilities

Targets Working Capital

2010: $18,424 M $11,327 M = $7,097 million
2009: $17,488 M $10,512 M = $6,976 million
Targets net working capital increased moderately from
2009 to 2010!

Cambridge Business Publishers, 2011

60

Current Ratio
The current ratio is defined as the ratio of current
assets to current liabilities.
Current Ratio = Current Assets Current Liabilities

Targets Current Ratio

2010: $18,424 M $11,327 M = 1.63 or 163%
2009: $17,488 M $10,512 M = 1.67 or
167%
Targets current ratio is deemed to represent a strong
current liquidity position since it exceeds 1.0 for both
years. Target is less liquid in 2010 compared to 2009.
Cambridge Business Publishers, 2011

61

Quick Ratio
The ratio of quick assets to current liabilities
Quick assets include cash and cash equivalents
Quick Ratio = Quick Assets Current Liabilities

Targets Quick Ratio

2010: $9,166 M $11,327 M = 0.81 or 80.9%
2009: $8,948 M $10,512 M = 0.85 or
85.1%
Based on its quick ratio, Target is more liquid in 2010
compared to 2009.
Cambridge Business Publishers, 2011