lecture notes chapters 1-4

7/28/2019 Lecture Notes Chapters 1-4

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Chap ter 1

COMM 2010 Lecture Notes

Chapters 1-4

Why do we need accounting?

o Firms prepare financial statements to present in a meaningful way theresults 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 positiono Income statement or statement of profit and losso Statement of cash flows

o Statement of shareholders equityo Notes to the financial statements

o Key Players Managers

Board of Directors

Auditors

COMM 2010 Intro to Financial Accounting 1 of 28Ann Backof


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Example Balance Sheet Accounts



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Practice Problem #1

o Lonski Company reports current assets of $500,000, noncurrentassets of $400,000, current liabilities of $200,000, and noncurrentliability of $200,000 at the conclusion of 2012.

o Compute the amount of shareholders equity on the balance sheetat the end of 2012.

Practice Problem #2

o The Isabel Company began operations on January 1, 2012. Thecompany issued 1,000 shares of common stock for $48,000 and thecompany borrowed $36,000 from a bank. The bank loan is due infull on January 1, 2015, with interest at 10 percent per year. OnJanuary 1, the company paid $12,000 for a one-year lease of abuilding and $15,000 for equipment. Rent is due on the 1

stof each

month. The company purchased $8,000 of inventory on accounton 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 operatingexpenses of $1,200,000, a gain of $100,000 on the sale of anairplane, 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 December31, 2012

Practice Problem #4

o Backof Company earned $190,000 during 2012 and the beginningretained 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 toshareholders 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 statement

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 DSWon May 23

rd. DSW received the order on May 28

th, but

DSW did not pay for that order until April 5

th

. Assume thatthe sale is considered complete when Nike ships the goods.When can Nike recognize the revenue? When is therevenue realized?

Recognize: 23rd

Realize 5th

o Materiality Quantitative or Qualitative: qualitative, the notion that small, meaninglessitems 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 revenueo 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 orrenders services and recognizes expenses in the period when the revenues thatthe expenses were used to produce the goods were used.

Example:

In September, Sinclair Inc. made sales of $310,000, ofwhich $260,000 were on credit and the rest in cash. Thesold merchandise had cost Sinclair $120,000 when itpurchased it last month. In September, Sinclair acquiredmerchandise inventory of $78,000, payable next month tothe supplier. Finally, Sinclair incurred salary and rent costsfor September of $24,000 and $13,000, respectively; thesewere paid in cash. Calculate net cash flow and net incomefor September. Which method of accounting better

measures Sinclairs operating performance?Accural


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Chap ter 2

Basic terminology

Transactions Accounts Financial statements

The Accounting Cycleo Analyze Transactionso Record Transactionso Determine and Record Adjusting Entrieso Prepare Income Statemento Close Temporary Income Statement Accountso 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 individualaccounto Capture all transactions that make up ending balance

o Assets = Liabilities + Shareholders Equity

Balance Sheet



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Journal entries

o Capture allof the accounts and amounts affected by a transactiono Easier to find error in booking a transaction using journal entry

than T-accounto 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 tocustomers over the next year.

Debit CashCredit Advances from Customers

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

Debit Prepaid RentCredit Cash

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

Debit PPECredit Cash

4. Paid $15,000 to an advertising agency for a promotional campaign that

will start in one month.

Debit Prepaid ExpenseCredit Cash

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

Debit InventoryCredit AP



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6. Paid $65,000 to the supplier for inventory purchase in (5) and gave a notefor the remaining $50,000.

Debit APCredit NPCredit Cash

7. Loaned $30,000 to an officer and accepted a 90-day note as evidence ofthe loan.

Debit NRCredit Cash

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

Debit InventoryCredit Cash

9. Borrowed $75,000 from the bank.

Debit CashCredit NP

10. Issued ten shares of $100 par value common stock in settlement of anaccount payable of $26,000.

Debit APCredit Common Stock at ParCredit 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 r evenues?(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 thecash is actually received.

o When do you recognize ex penses? 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 ofnet 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 increaseliabilities (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.

CoGSInventory

Adjusting Entries: adjust due to the passage of time

o Unearned Revenue: On December 1, a customer pays $500 cash inadvance for goods not yet received. On December 31, ABCCompany ships part of order valued at $200.

Dec 1Cash 500

Advance from Customer (L increases) 500

Dec 31Advance from Customer

Revenue

o Depreciation: ABC Company purchased a piece of equipment 2years 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 10kCash 10k

Dec 1Depreciation Exp 1000 (SE down)

Acc. Depreciation 1000 (A down)


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Lets put it all together

o ABC reported a balance in inventory of $21 million at thebeginning of 2012 and $22 million at the end of 2012. Assume thatall of ABCs inventory purchases are made on account. During2012, ABC reported $114 million in cost of goods sold. How much

inventory did ABC purchase during 2012?

$115

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

$7.5



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Chap ter 3

Understanding the Balance Sheet

Nike (US GAAP)

BP (IFRS)



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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 orexchange

Future benefit has a relevant measurement attribute that canbe 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 anarms 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 futurecash 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


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

NoR&D Exp

Cash


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

PPECash

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

PrepaidCash

o Rainbolt Ranchers exchanges common shares for a patent on a newweighing machine for cattle. The value of the common sharesexchanged is $60,000.

PatentCommon 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 bequantified with sufficient reliability

Alternative Ways to Measure Liabilities

Amount required to discard the obligation (stated dollar amount)AP, advances

Present value of future cash flowsDebt obligation with payment dates more than one year in the future

EstimateAccrued liabilities for utilitiesWarranty liability

COMM 2010 Intro to Financial Accounting 19 of 28


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Ann Backof


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Liability or not?

o Rainbolt Ranchers agrees to sell 100 head of cattle for $500,000 toanother rancher when the cattle reach the age of 12 months. Thecalves are currently two months of age.

Exe Promise

o The rancher above pays Rainbolt Ranchers $200,000 in advance onthe agreement.

CashAdv. From customer

o Rainbolt Ranchers borrows $150,000 from the local bank topurchase additional feed. The terms of the loan call for the loan tobe paid in equal installments over the next three years.

CashNotes Payable

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

CashCommon Stock

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

PPEAP

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 twoyears after a calf is purchased.

Yes

o A competitor files a patent infringement lawsuit, requestingdamages of $3 million, for the Rainbolts invention of a newfeedstock.

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 issuedshares

o Amounts generated by operations that have not been distributed toowners

Externally generated: Contributed CapitalInternally 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)/shareholderequityGreater than 1: growth potential

How does a company finance its operations?

Debt ratio

Debt-to-equity ratio


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COMM 2010 Intro to Financial Accounting 22 of 28


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Chap ter 4

Understanding the Income Statement

Nike (US GAAP)

BP (IFRS)



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Typical Format for Income Statement

RevenueCost of goods sold

Gross profitSelling, general, and administrative expenses

Other operating expensesOperating profit

Interest expenseGains/losses (sale of assets)

Profit before income taxesIncome tax expenseDiscontinued operations (net of income tax)

Net Income

Revenues (Sales)

o Revenue recognition criteria Completion of the earnings process a n d

Receipt of assets from customers

Revenue or not?

o Crazy Critters build and delivered a custom doghouse for $500 to acustomer on credit.

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

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

o The individual holding the gift card purchased and received acustom dog bed for her very large dog. The bed cost $225 and thecustomer 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-yearwarranty. 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 afterthe 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 inJanuary, $100,000 collected in February, and the remainderin March.

A theatrical company sells $600,000 of season tickets to itsplays, which the company will perform the secondSaturday in each month for 10 months beginning in

January. Also, the company sells $80,000 of tickets forJanuary's play.

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

Bonilla, Co., an owner of office buildings, collected$1,800,000 in January for office rental fees for the 12-month 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 customdoghouse that it sold for $500.

o Crazy Critters spent $5,000 on advertisements in local newspapersaround 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 Augustto be delivered in September. Customers placed orders andreceived goods with a cost to the wholesale company of$450,000 in September. In September, customers orderedgoods with a cost of $225,000 to be delivered in October.The remaining portion of September's purchases wasmaintained for future orders.

An accounting firm leases its office space. The annual leasepayment 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 producefull-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 apercentage of each sales dollar the sales staff generates.The company pays the commission at the end of each three-month period. In September, the company paidcommissions of $105,000 for July, August, and Septembersales. Sales related to commissions for the 3-month periodwere as follows: July, $262,500; August, $367,500;September, $420,000.

Accumulated Other Comprehensive Income

o Changes in net assets NOT captured net incomeo 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

lecture notes chapters 1-4

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