CMA

FINANCIAL STATEMENTS

PART 2Unit 2

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Topics covered

A. Balance SheetB. Income StatementC. Statement of cash flowsD. Statement of retained earnings

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BALANCE SHEET

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Components of Financial Statements

Financial statements comprise of: Balance Sheet (statement of financial position) Income statement Statement of cash flows Statement of retained earnings Notes

Balance SheetThe balance sheet provides information about an entity’s assets, liabilities and their relationships to each other at a moment in time.

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The balance sheet provides information about an entity’s assets, liabilities and equity and their relationships to each other at a moment in time.

Balance sheet help users to assess: Entity’s liquidity Financial flexibility and ability Profitability and risk Capital structure

The basic financial statements include: Balance sheet (statement of financial position.) Income statement Statement of cash flaws Statement of retained earnings or shareholders’ equity

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Elements of Financial Statements

Assets - liabilities = equity

Equity = Contribution by owners - Distributions to owners + Comprehensive Income

Comprehensive income = Revenue - Expenses + Gain - Losses

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Balance sheet equation

Assets - liabilities + owners’ equity The above equation is based on the proprietary theory. Equity in an

enterprise is what remains after the economic obligations of the enterprise are deducted from its economic resources.

Assets Economic resources that are expected to benefit future cash inflows or help reduce future cash outflows.

Liabilities Economic obligations of the organization to outsiders, or claims against its assets by outsiders.

Owners’ equity The residual interest in the organizations’ assets after deducting liabilities.

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Balance Sheet classification

Balance Sheet accounts a re-classified so that similar items are grouped together to arrive at significant subtotals.

Individual items should be reported separately and in sufficient details to make the balance sheet useful.

It is not acceptable to report a balance sheet in total figures as follows;

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Balance Sheet classification

Current assets XXXFixed assets XXOther assets 1

XXXCurrent liabilities XXXLong-term liabilities XXEquity XXX

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Also, assets are usually presented in descending order Liquidity. In the Balance Sheet cash is reported first because it is more more

liquid. Liabilities are shown in ascending order of time to maturity. Notes payable is reported first because it should be paid In first. Accounting payable should be paid reported after notes payable to

banks because it should be paid after notes payable to banks. Items in the equity section should be reported according to which item

is permanent. The capital account is reported before earning Account.

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Presentation Formats:- The format of the balance sheet is not standardized, and any method

that promotes full disclosure method and understandability is acceptable. The account (or horizontal) form presents assets on the left and

liabilities and equity on the right. The report (or vertical) form is also commonly used. It differs from

the account form only in that liabilities and equity are presented below rather than beside assets.

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Classification of Balance Sheet

AssetsCurrent assets

Cash, cash equivalent, inventories, receivables, prepaid expenses and held to maturity securities.

Non current assetsLong term investments and funds, property, plant and equipment, intangible assets,Other non current assetsdeferred charges

LiabilitiesCurrent liabilities

Obligations whose liquidation is reasonably expected to require the classifiable as current assets or the creation of other current liability.

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Non current liabilitiesLiabilities not qualifying as current are non-current such as:Pensiondeferred revenuedeferred taxadvance from affiliated entitiesLiabilities under capital leaseAdvance for long term commitmentOwners’ equityContributed capital retained earningsReservesOther accumulated comprehensive incomeOwners equity is the residual after total are dedicated from total assets.

Assets are classified as current if they are reasonably expected to be realized in cash or consumer during the normal operating cycle.

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Current Assets:- Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer.

Example of operating cycle: You have $100,000 by.which you purchase inventory of $100,00 and you sell it

all to customers. The operating cycle is the time between purchasing inventory and collecting

money from customers.

Cash$ 100,000

AccountsReceivable$ 160,000

MerchandiseInventory$ 100,000

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Long-Term Investment:- Long-term investments, often referred to simply as investments, normally consist of one of four types:

Investments in securities, such as bonds, common stock, or long-term notes. Investments in tangible fixed assets not currently used in operations, such

as land hold for speculation. Investments set aside in special funds such as a sinking fund, pension fund,

or plant expansion fund. Long-term investments are to be held for many years. Note that if a security can be sold in a short term (e.g six months) but the

company has no intention to sell it then it is reported as investment. However, if the company intend to sell it in theshort run then it is reported as current asset

Also, see how long-term investment is presented in (ABC Co.)

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Property, Plant and Equipment (P.P & E):- These assets are tangible items used in operations. They are recorded at cost and are shown net of accumulated depreciation if depreciable

They include: Land and depletable natural resources, e.g., oil and gas reserves. Buildings, machinery, equipment, furniture, fixtures, leasehold

improvements, land improvements, leased assets held under capital leases, and other depreciable assets

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Intangible means not physical e.g. patents, copyrights, trademarks. These assets are used in operations. There is uncertainty about their future benefits e.g. the Company has

not got benefit from its goodwill in future Intangibles are recorded at cost less accumulated amortization.

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Other Assets:- Include assets which are - not suitably classified in the above classifications. Examples: Bond issue cost Long-term prepayments

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The resources Structure

Property, Plant, and equipment

(PP7E)Assets

IntangibleAssets

Other noncurrentAssets

DeferredCharges

CurrentAssets

Non current Assets

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The Financing Structure Current Liabilities:- Current liabilities are obligations that are reasonably expected to be

liquidated (paid) either through the use of current assets or the creation of other current liabilities.

Example if liquidation by use of current assets:- Pay your creditor by cash.

Example of liquidating by creation of current liability Give your creditor a note payable within one year.

A liability payable next year is not included in the current liability section.

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Long-Term Liabilities:- Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but, instead, are payable at some date beyond that time. Examples:

Bond payable Pension obligations

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Owners' Equity Section include:- Capital Stock. The par or stated value of the shares issued. Additional Paid-In Capital. The excess of amounts paid in over

the par or stated value. Retained Earnings. The corporations' undistributed earnings. The following illustration demonstrates the owner's equity for different

organizations

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Owner’s Equity for Different OrganizationsOwners’ Equity for a Proprietorship(Assume George Smith is the sole owner)

George Smith, capital $ 400,000Owner’s Equity for a Partnership(Assume Smith has two partners)

George Smith, capital $ 320,000Alex Handl, capital 40,000Susan Eastma, capital 40,000Total partners’ capital $ 400,000Owners’ Equity for a Partnership

Stockholders’ equity:Paid-in capital

Capital stock, 10,000 shares issued at par value of $ 10 per share $ 100,000paid-in capital in excess of par value of capital stocks 300,000Total paid-in capital $ 400,000

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Most states require stock certificates to have some dollar amount printed on them. This amount called par value or stated value.

This amount is determined by the board of directors. Usually the stock is sold at a price higher than its par value. The difference between the total amount received and the par value is called paid-in-capital

in excess of par value or additional paid in capital. In the above illustration the company sold 10000 shares of $ 40 per share. The par value is

$ 0 per share. So, total paid in capital = capital stock at par + paid-in capital in excess of par

or

$ 400,000 = $ 100,000 + $ 300,000

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ABC CompanyBalance sheet

Current assetsCashAvailable-for-sale securities-at fair valueAccount receivable

Less: Allowance for doubtful accountsNote receivableInventories-at average costSupplies on handPrepaid expenses

Total current assetsNon-current assets

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Long-term investmentsInvestment in Warren Co.Pre-operating expensesProperty, plant, and equipment, netIntangible assets

GoodwillTotal assets

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Liabilities and stockholders’ equity

Current liabilitiesNotes payable to banksAccounts payableAccrued interest on notes payableIncome taxes payableAccrued salaries, wages, and other liabilitiesDeposits received from customers

Total current liabilitiesNon-current liabilitiesLong-term debtTwenty-year 12% debentures, due January 1, 2011

Total liabilities

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Stockholders’ equityPaid in on capital stock

Preferred, 7%, cumulativeAuthorized, issued, and outstanding, 30,000 shares of $ 10 par valueCommon-Authorized, 500,000 shares of $ 1.00 par value; Issued and outstanding, 400,000 sharesadditional paid-in capitalRetained earnings

Total stockholders’ equityTotal liabilities and stockholders’ equity

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The basic financial statements include a:A. Balance sheet, income statement, statement of retained earnings,

and statement of retained earnings, and statement of changes in retained earnings.

B .Statement of financial position, income statement, statement of retained earnings, and statement of changes in retained earnings.

C. balance sheet, statement of financial position, income statement, and statement of changes in retained earnings.

D. Statement of financial position, income statement, statement of cash flows and statement of retained earnings.

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The correct answer is (D). (CMA,adapted)

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A company decided to sell a line of its business. The assets were sold for $ 100,000 and had a net book value of $70,000. The applicable tax rate was 20%. The result of this transaction will appear on the:

A. balance sheet as a prior-period adjustment.B. Income statement as an extraordinary item.C. Income statement as discontinued operations.D. Income statement as an accounting change.

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The correct answer is (C). (CIA, adapted)

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Income Statement Format

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The results of operations are reported in the income statement (statement of earnings) on the accrual basis using an approach oriented to historical transaction.

The traditional income statement reports revenue from and expenses of the entity’s major activities and gains and losses from other activities, incurred over a period.

Revenue - expenses + gains - losses = income or loss Income is closed to retained earnings at the end of the period

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Earned means revenue will be recorded when the company deliver goods or services to the customer

Realized means that revenue are realized when cash or claims to cash (credit) are received.If you give a customer a tool for trial then this revenue is not realized because there is no promise from the customer to pay you

Revenue may be earned and realized at the same point of time (you sell and receive cash or credit note at the same time)

Or revenue may have been earned and realized at different times Example:- The owner of the building receive rent in advance. This

revenue is realized but will be earned as the time passed.

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The order of income statements is as follows: Revenue Expenses Income from continuing operations Discontinued operations Extra ordinary items Cumulative effect of changes in accounting principles

Net income Comprehensive income must be displayed in a financial statement but no

specific format is required. The format of the balance sheet is not standardized and any method that

provides full disclosure and understandability is acceptable.

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When reporting the discontinuation of a business segment, the gain or loss on discontinued operation should be reported net of Tax as a separate item before extra ordinary items. A loss that is material, unusual and infrequent in occurrence should be

reported as an extra ordinary item. The income or loss from operations of a discontinued operations up to the

measurement date and the gain or loss on disposal should both be shown net of tax.

The measurement date is the date on which management commits itself to a plan to dispose of a segment either by sale or abandonment.

Extraordinary items are those material items that both unusual in nature and infrequent in the environment in which the entity operates.

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The following items are to be reported separately and in the indicated order on the face of the income statement: Pre tax income from continuing operations The provision for income tax on income from continuing operations Income from continuing operations. Discounted operations

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The income or loss from operations of a discontinued segment up to the measurement date and the gain or losses on disposal should both be reported net of tax.

The gain or loss on disposal is estimated on the measurement date (date on which management commits itself to a plan to dispose of a segment either by a sale or abandonment).

Income before extra ordinary items and cumulative effect of accounting changes (if any). Extra ordinary items (material items that are both unusual in nature and infrequent). Cumulative effect of a change in accounting principle (net of tax) Net income

Income from continuing operationsDiscounted operationsExtra ordinary itemsCumulative effect of accounting changesNet income

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single-step income statements Only two groupings exist: revenues and expenses. (Expenses) only a single item is deducted from revenues to arrive at

net income. For that reason it is called (single step) The advantage of a single-step is that it is simple.

The following illustration shows how a single-step income statement is presented.

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DAN DEINES COMPANY Income Statement

For the Year Ended December 31, 2002 Revenue

Net sales $2,972,413Dividends revenue 98,500 Rental revenue 72,910 Total revenues 3,143,823

Expenses Cost of goods sold 1,982,541 Selling expenses 453,028 Administrative expenses 350,771 Interest expense 126,060 Income tax expense 66,934 Total expenses 2,979,334 Net income $ 164,489

Earnings per common share $1.74

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Multiple-step income Statement: This statement separates operating results from non operating. It classified expenses by functions such as cost of goods sold and

selling (e.g. merchandizing or manufacturing) and administrative expenses.

So, it permits comparison with previous years. It also matches expenses with revenues. The following illustration show how a multiple-step is presented:

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DAN DEINIES COMPANY Income Statement

For the Year Ended December 31, 2002 Sales revenue Sales 1972,413 Cost of Goods Sold 1,982,541 Gross profit on Sales 989,872 Operating expenses Selling expenses 453,028Administrative expenses 350,771 803,799 Income from operations Other expenses and Losses 186,073

Interest on bonds and notes 126,060 Income before income tax 231,423 Income tax Net income for the year $ 164,489 Earnings per com on share $1.74

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Comprehensive income:Reporting comprehensive income applied to enterprises issuing a full set of financial statements if they have items of Other Comprehensive Income, (oa) but it does not apply to non-for-profit organizations. OCI, is classified separately into:1. Foreign currency items2. Minimum pension liability adjustments.3. Unrealized gain and losses on available for sale securities expectthose that are hedged items in a fair value Hedge.Comprehensive income and its components use to be displayed in a financial statement given the same prominence of other statements. The possibilities of reporting comprehensive income are:a. Separate statement of comprehensive incomeb. Statement of changes in equity

The total of OCI for a period is transferred to a component of equity separate from retained earnings and additional-paid-in-capital.

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Which one of the following items is included in the determination of income from continuing operations?

A. Discontinued operations.B. Extraordinary loss.C. Cumulative effect of a change in an accounting principle.D. Unusual loss from a write-down of inventory.

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The correct answer is (D). (CMA, adapted)

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In a multiple-step income statement for a retail company, all of the following are included in the operating section except.

A. Sale.B. Cost of goods sold.C. Dividend revenue.D. Administrative and selling expenses.

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The correct answer is (C). (CMA, adapted)

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Statement of Cash Flows

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The primary purpose of a statement of cash flow is to provide relevant information about the cash receipts and payments of an entity during the period The statement of cash flows is required as a part of a full set of financial statements of all business entities and not for profit organizations.

The statement of cash flows is to be presented in general purpose external financial statements by all business enterprises and not for profit organization.

The statement of cash flows is intended to help users of financial statements to evaluate a firm’s liquidity solvency and financial flexibility.

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The direct method of reporting cash flows from operating activities includes disclosing the major classes of gross receipts and gross cash payments. FSAS 95 encourages use of the direct method of reporting cash receipts and payments, but indirect method may be used.

Format of statement of cash flow:+ Cash provided or (used) by operating activities+ Cash provided by investing activities+ Cash provided or (used) by financing activities= Net increase or (decrease) in cash and cash equivalents+ Beginning balance= Ending balance= Operating activities

Direct methodIndirect method

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Operating Activities

Direct Method Indirect Method

+ Interest dividends received + Net income+ Collection from customers - Non cash revenues+ Proceeds from sale of trading activities - Non cash expenses + Other operating cash inflows - Gain on sale of investment- Payment for merchandise + Losses on sale of plant

assets- Payment for expenses - Increase in current assets- Payment for interest

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+ Payment for income tax + Decrease in current assets- Payment to acquire trading securities - Decrease in current liabilities- Other operating cash flow - Increase in current liability= Cash flow from operating activities + Cash flow from operating

activity activities

Investing activities: Principal collections on loans receivable + proceeds from sale of investment (except trading securities.) + proceeds from sale of plant assets

- Loan made- Payments to acquire investment (except Trading Securities)- Payments to acquire plant assets.

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Financing activities

+ Proceeds from borrowing+ Proceeds from issuing stock- Debit principal payments- Payments to reacquire stock- Payments for dividends= Cash flow from financing activities-

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Statement of Cash Flows:- It reports the cash receipts and cash payments of an entity during a

particular period To make statement of cash flows simply follow these steps:- List the activities that increase cash (cash inflows) and those that

decrease cash (cash outflows) Place each cash inflow or- outflow in one of the types of activities that

caused it- Types of activities are:- Operating activities which include sale and purchase of production of

goods and services. Investing activities which include acquiring and selling long-term assets,

securities held for long-term investment purposes.

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Financing activities which include obtaining resources for owners and creditors and repaying amounts borrowed.

Prepare the Cash Flow Statement. Now, go back to Biweel example

Follow the above steps and prepare cash flows statement as follows:

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Exhibit 2-4 Biwheels Company Statement of Cash Flows for the Two Months Ended January 31, 19X2

PART 1: TRANSACTIONS AFECTING CASH

Transaction Amount Type of Activity(1) Initial investment $400,000 Financing (2) Loan from bank 100,000 Financing(3) Acquire inventory for cash (150,000) Operating(5) Acquire store equipment for cash (150,000) Investment(8) Payments to trade creditors (4,000) Operating(9) Sale of store equipment 700 Investing(11) pay rent in cash (6,000) Operating

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Prepare the Cash Flow statementPART II: STATEMENT OF CASH FLOWS

CASH FLOWS FROM OPERATING ACTIVIGIESCash payments to suppliers $ (154,000)Cash payments for rent (6,000)Net cash used for operating activities $ (160,000)

CASH FLOWS FROM INVESTING ACTIVITIESCash payments for purchases of equipment (4,000)Cash receipts from sales of equipment 700

CASH FLOWS FROM FINANCING ACTIVITIESProceeds from initial investment 400,000Proceeds from bank loan 100,000Net cash provided by financing activities 500,000Net increase in cash 336,700

Cash balance, December 1, 19X1 0Cash balance, January 31, 19X2 336,700

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From the above Cash Flow Statement you can know from where cash came and where it went.

For example no cash came from operating activity although there is, net income of $ 57900.

You have to note the difference between income statement and cash flows.

Income statement measure the entity performance in generating net assets

Statement of cash flows will be discussed in detail in a separate unit.

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A statement of cash flows is intended to help user of financial statements.

A. Evaluate a firm’s liquidity, solvency, and financial flexibility.B. Evaluate a firm’s economic resources and obligations.C. Determine a firm’s components of income from operations.D. Determine whether insider have sold or purchased the firm’s stock.

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The correct answer is (A)_. (CMA, adapted)

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Which one of the following transactions should be classified as a financing activity in a statement of cash flows?

A. Purchase of equipment.B. Purchase of treasury stock.B. Sale of trademarks.D. Payment of interest on a mortgage note.

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The correct answer is (B). (CMA, adapted)

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Statement of Retained Earnings

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The following illustration shows how the statement of retained earning is presentedTIGER WOODS INC.

Retained Earnings StatementFor the Year Ended December 31, 2002

Balance, January 1, as reported $ 1,050,000Correction for understatement of net income in prior period(inventory error) 50,000Balance, January 1 as adjusted 1,100,000Add: Net income 360,000

1,460,000Less: Cash dividends $ 100,000

Stock dividends 200,000300,000Balance, December 31 $ 1,160,000

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Statement of retained earnings reconciles the beginning balance of retained earning with the ending balance.

Retained earnings are increased by net income and decreased by net loss.

Both cash and stock dividends decreased retained earnings. Prior period adjustments may increase retained earnings or decrease

retained earnings. Prior period adjustment in a correction of an error in the financial

statement of a prior period.Example: In the year 2000 (prior year) you calculated a depreciation as $ 100,000. In 2001 year concluded that $ 150,000 is the right depreciation

So, the 50000 is the prior period adjustment.