Accounting Clinic I - Columbia Business School · PDF fileAccounting Clinic I . Prepared by: Nir Yehuda With contributions by ... Examples of how each financial statement is prepared

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 All rights reserved. Clinic 1-1

Accounting Clinic I

Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University


Introduction

Accounting clinic I contains the following:

A brief review of the four financial

statements

Examples of how each financial statement

is prepared

A summary of the principles of

measurement in financial statement


The Financial Statements

1. Balance Sheet

2. Income Statement

3. Cash Flow Statement

4. Statement of Shareholders’ Equity


The Balance

Sheet: Dell Inc.


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’

equity.


The Form of the Balance Sheet

Assets = Liabilities + Shareholders’ Equity

or

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.


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 ?

Required:

Prepare a classified balance sheet.


Solution 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.


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.


The Income Statement:

Dell Inc.


The Form of the Income Statement

Net Revenue – Cost of Goods Sold = Gross Margin

Gross Margin – Operating Expenses = Operating Income before Tax

(EBIT)

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


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%.

Required:

Prepare a condensed income statement


Solution

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


The Statement of

Cash Flows : Dell Inc.


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

activities.


The Form of the Cash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing



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).



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.


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.:


Example – Preparation of a cash flow

statement Presented below are the balance sheets of Scientific Instruments, Ltd. for 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

Scientific Instruments, Ltd.

Balance Sheet

December 31, 2005 and 2004


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.

Required:

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.


Solution

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

Statement of Cash Flow

For the year ended December 31, 2005

Scientific Instruments, Ltd.


The Statement of Stockholders’ Equity:

Dell Inc.


Shareholder’s 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.)


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.



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


The Articulation of the Financial

Statements

Revenues

Expenses

Net income

Income Statement

Investment and disinvestment

by owners

Net income and other earnings

Net change in owners’ equity

Statement of Shareholders’ Equity

Cash from operations

Cash from investing

Cash from financing

Net change in cash

Cash Flow Statement

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Beginning Balance Sheet

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Ending Balance Sheet


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

value.


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

measurement.


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 value:

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)


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.).


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

• Trading

• Available-for-sale

• Held to maturity

Equity investments

• Trading

• Available-for-sale

See Accounting Clinic III


Historical Cost Accounting in The Income

Statement

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

incurred.

The earnings number reflects net value added from

revenues, that is, net of matched expenses.

Go to Accounting Clinic II for more on matching


Cost of Goods Sold: An Application of

Matching 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.


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

was:

409,000+2,598,000-547,000=2,460,000


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.


R&D accounts: An Example of Poor

Matching

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 2004-2009

1. if the firm expenses R&D immediately (as GAAP requires)

2. if the firm capitalizes R&D and amortize it using straight line method.


(1) R&D is expensed immediately

2004 2005 2006 2007 2008 2009

Operating income

before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

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

years.

2004 2005 2006 2007 2008 2009

Operating income

before R&D

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

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


Fully expensing R&D in the year in which

it was incurred results in poor matching in

operating income.


How Financial Reporting Issues Arise

Efficiencies of Generally Accepted Accounting Principles (GAAP)

Examples:

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

Examples:

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


How Should You Deal with the Accounting

Issues?

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


Who Sets the Rules (in the U.S.)? U.S. Congress

Securities and Exchange Commission (SEC)

www.sec.gov

Financial Accounting Standards Board (FASB)

www.fasb.org

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)

http://www.sec.gov/

http://www.fasb.org/

Documents

Accounting Clinic I - Columbia Business School · PDF fileAccounting Clinic I . Prepared by: Nir Yehuda With contributions by ... Examples of how each financial statement is prepared