Financial Accounting 02

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tHere'sWhereYou've eenInChopter , you eornedhoto businessddsvolue o moke profitYou eornedthot usinessronsoctionsonbe clossif iedsoperoting,nvesting,r inoncing.hefourbosic inonciol totements-thencome totement,hestotementf chonqesnshoreholders'quily,hebolonce heet, nd hestotementf cosh lows-provideinformotionbout hese usinessrocesses

| | / \ A i l \ / tr- lere vvnereYou e uotnoWhenyouore inished ithChopter , youshould nderstondhequolltiesf theinformotionn he inoncioltotements.ou hould e oble o recognizendexplointhedifferenceeMeen ccruol osis ccountinqndcosh osis ccountinq.

frenrnirytW{#*fivpsWhen you are finished studying this chapter, you should be able to:1. Definegenerallyaccepted ccountingprinciplesandexplainwhy theyarenecessary.2. Explain the objective offinancial reporting and the qualities necessaryo achievethis objective.3. Identify the elementsof the financial statements nd describe heir characteristics.4. Define accrual accounting,explain how it differs from cashbasis accounting,and

identify examplesof accrualaccountingon actual financial statements.5. Compute and explain the meaning of the current ratio.6" Identify the risks and potential frauds related o financial accounting ecords,andexplain the controls needed o ensure heir accuracy.

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CHAPTER o QUALITIES F ACCOUNTINGNFORMATION

#{dtss;V{affersIn Apri l 2006,with just wo weeksunti l he startof his r ial , Com-puter Associates nternational 's ormer CEO, Sanjay KumaLpleadedguil ty o securi t iesraud and obstruction f justice.Notonly did Kumarengage n a conspiracyo inflate he firm's2000and 2001 alesevenue, e alsoauthor ized $3.2mil l ionpaymentto buy the si lence f potentialwitnesses.n November 006,he

* was sentencedo 12years n prisonand fined $8 mil l ion or hispart in the $2.2bi l l ion raud.Why woulda smartandwealthyman alsify ccountingecords,aking he riskof a long prison entence? ometimes eople n powerbegin o feel nvincible.tis mportant or every ndividualo havea strongsense f ethicalbehavior nd oapplyhigh moralstandardso everybusinessecision, o matter how small.Toooften a numberof seemingly malldecisionsanadd up to one big crime.

Informationor Decision akingAfter Tom sold his first batch of T-shirts, he had some decisions o make. The biggest onewas whether or not to continue n business.What he needed o know to evaluate hat deci-sion was whetheror not the companymade a profit in January.Net profit is the amount eftafter all expenses rededucted rom all revenues.

For Tom's Wear, he accountingperiod is the first month of doing business, anuary1through January31. Information about he month's operations s summarizedon the incomestatement-one of the four basic inancial statements. he revenues or the periodamountedto $900; hat s the otal amount hecompanyearnedwhen t sold90 shirts.The expenses erethe cost ofthe T-shirtssold, he costofthe advertising,and he interestpaid on the oan fromTom's mom. The cost of the 90 T:shirts sold was$360,advertisingexpensewas $50,and hecost of borrowing the money-interest expense-was $5. When those expenses, otaling$415, are deducted rom the sales evenueof $900, the remaining $485 is net profit. Tom'sWearadded alueby orderingshirtswith the special ogo andproviding them o Tom's friendsat a convenient ime andplace.And Tom'sWear achieved ts goal-to make a profit.

On the income statementn Exhibit 2.l,you will see$485 shownas net ncome,an-other name or profit. The term profit can be applied to a single sale,a group of sales,or allthe transactions or a period of time of businessactivity, whereasnet income s a more spe-cific term for describing a company'sentire profit for a specific time period. The companymadea grossprofit of $540on the saleof 90 t-shirts,andTom's Wear'snet ncome or hisf,rrstmonth of businessactivity was $485.Financial reporting provides information for decision making. An income statement,like the one shownfor Tom's Wear, s one source of information. When the secondmonthof businessactivity is complete,Tom will prepareanother ncome statementand will beable to compare he two statements. o make such a comparisonmeaningful, Tom needs ouse the same ules for preparing the two statements. f Tom wanted to compare his com-pany's performance o the performanceof another T-shirt company,he would need to besure hat the other company was using the same ules to prepare ts income statement.Forfrnancial nformation to be useful for evaluating he performanceof a businessacross imeor for comparing two different companies, he same ules must be used consistently.

As you learnedn Chapter1, here s a setofguidelinescalledgenerallyaccepted ccount-ing principles (GAAP) that a company must follow when preparing its financial statements,which help ensure onsistency. heseguidelines-usually known as accountingprinciples-were historicallydeveloped hroughcommon usage.A principlewas acceptablef it was usedand acknowledged y most accountants. oday heprocess f establishingGAAP is more or-mal, with the SEC and the FASB responsible or setting accounting standards.

L"{}.1Def negeneraly acceptedaccountingr inciplesndexplain hy heyarenecessary.Net prof i t equals l l revenuesminusall expenses.


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CHAPTER . CHARACTERISTICSF ACCOUNTINGNFORMATIONEXHIBIT2.1

Tom'sWear, nc.Income StatementFor the Month Ended January 31, 2006Income tatementorTom'sWear or JanuaryThis is a simple incomestatement for one month ofbusiness.

RevenueSa]es .ExpensesCostofgoodssold.. . . . . . . . . . . . $ 360Advertising expense 50ffi i l#:3] :::::::::::: :::::::::::=::::::::::$ 900

4r5$ 485t0m!sweal

1. WhatdoesGAAP tand or?2. Why areguidelines eededor financial eporting?

Characteristicsf AccountingnformationWhat Makes nformationUseful?The most generaland the most mportant objectiveof financial reporting is to provide use-ful information for making decisions.What makes nformation useful? According to theFASB, the information must be relevant, eliable, comparable,and consistent.Relevant. For information to be relevant, it needs o be significant enough to influencebusinessdecisions.The information shouldhelp confirm or correct he users'expectations.No matter how significant the information is, however, t mustbe timely to be relevant.Forexample, he price of fuel is extremely mportant information to an airline such as South-westor JetBlue,and amanagerneeds his information to makedecisionsabout icket prices.However, f the firm reports fuel prices only monthly, the information will not be timelyenough o be relevant.To be relevant, nformation must be useful in predicting the future.Currently, the SEC requires firms to submit their financial information within 60 days ofthe end of the firm's fiscal year.Reliable, When information is reliable, you can dependon it and you can verify its accu-racy. The information is completely independentof the person eporting it. To be reliable,the information in the financial statementsmust be a faithful representationof what it in-tends o convey,For example,Borders Group Inc. reported$4.04billion in sales or its fis-cal year ended January28,2006. This amount must be true and verifiable; otherwise, heinformation could be misleading to investors.As you learned n Chapter 1, t is part of theauditors' ob to make sureBorders has the documentation o confum the accuracyof itssalesamount.Anyone who examinesBorders' sales ecords shouldcome up with the sameamount.Comparable. In addition to being relevant and reliable, useful information possessescomparability. This means nvestorswill be able o comparecorresponding inancial infor-mation betweentwo similar companies-how one company's net income compareswithanother company's net income. In putting together inancial statements, ccountantsmustallow for meaningful comparisons.Because here are often alternativeways to account orthe same ransactionwithin GAAP, companiesmust disclose he methods hey select.Thisdisclosure allows educated nvestors o adjust the reportedamounts o make them compa-rable. For example, Searsmay account or its inventoriesby averaging he cost of its pur-chases,whereasWal-Mart may use a methodthat assumeshe first items purchasedare he

Your Turn2-lWwmmw.mmmw[,.{}.2Explainhe objective ff inancialeportingnd hequalities ecessaryoachievehi sobjective.


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52 CHApTER o eUALtTtEsF AccouNTINGNFoRMATtoNEXHIBIT2.2

:1

Relevance:Information that willprovide a basis forforecasts of futurefirm performanceby the CEO andCFO, among others.What's ahead forthis company?

Quali tat iveCharacter ist ics fAccounting nformation

Your Turn2-2''F,r"''',lllT,fi,.,t}'' .tT'li."1pi'r,l'"$

Reliability:Information that isneutral and verffiableIs the informationindependent ofthespecifc person whoprepared it?

Comparability:Different companiesuse the same set ofaccounting rules.Does the informationallow meaningfulcomparisons of twodifferent companies?

Consistency:A company usesthe same rules fromyear to year.Doesthe informationallow meaningfulcomparisons ofa company'sperformance atdifferent points intime?

The separate-entityassumptionmeans hat thefirm's inancial ecords nofinancial tatements recompletely eparateromthoseof the f rm'sownersThe monetary-unitassumptionmeanshat the itemson thef nancial tatementsremeasuredn monetary nits(dol lar n the U.5.) .

first items sold. As a requirementof GAAP, SearsandWal-Man will disclose hesechoicesin the notes o their financial statements o that investorscan compare he inventory infor-mation of the companies.Consistent. To be useful,accounting nformationmustbe consistent.Consistencys the char-acteristic hat makes t possible o track a company'sperformanceor financialcondition romoneyear o the next.Only if a companyuses he sameaccountingmethods rom period o pe-riod arewe able o makemeaningfulcomparisons. or example, otal revenuesor Thrgetwere$51.3billion for the fiscal yearendedJanuary28,2006, and $46.7billion for the fiscal yearendedJanuary29,2005. Only when these wo numbersarebasedon the samesetof account-ing methodscan nvestorsdeterminewhy salesncreased.f the ncreasewas caused artly orsolely by the change n the way the companymeasured ales, hen nvestorswould be misledabout he company'sactualperformance. inancialstatement serswant to rely on the firm'sconsistent pplicationof accounting tandards. xhibit 2.2 summaizes he desiredqualitativecharacteristics ccountingnformation musthave o be considered sefulby the FASB.

1. What s he purpose f financial tatements?2. What four characteristicsxplainwhat the FASBmeansby "useful,,information?Assumptionsnd Principles nderlying inancial eport ingFinancial information pertains o only the firm, not to any other parties such as the firm'sowners.This distinction between he financial information of the firm andthe hnancial in-formation of other hrms or people s called the separate-entity assumption. It means hatthe financial statements f a businessdo not include any information about he financesofindividual owners or other companies.Look at the income statementn Exhibit 2.1, whichsummarizes he company'srevenuesand expenses. ou will notice that the tems on the fi-nancial statementsare expressed n amountsof money. This is called the monetary-unitassumption. When you observe hat Tom's Wear had expensesof $415 during January2006,you know that the amount ncludesonly companyexpenses.SupposeTom took a va-cation to Hawaii at a cost of $3,000.No part of that transactionwould be part of Tom'sWear's hnancial reportsbecauseof the separate-entity ssumption.


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CHAPTER. ELEMENTSFTHEAt a minimum, firms preparenew financial statementseveryyear. For internal use, inan-

cial statementsarepreparedmore frequently.The SECrequirespublicly traded rms to preparea new set of financial statementseachquarler,which enablesusers o compare he company'sperformance rom one quarter (every threemonths) to the next. Accountantsdivide the life ofa businessnto time periods so they canprepare eportsaboutthe company'sperformancedur-ing those ime periods.This creationof time periods s called the time-period assumption.Although most companies eport financial information every threemonths, only the annual i-nancial information is audited.Most companiesuse he calendaryear as heir fiscal year.Assets are recorded at their original cost to the company. This is known as thehistorical-cost principle. Accountantsuse cost because he cost of an asset s a reliableamount-it is unbiasedand verifiable. Accountantsassumea companywill continue o re-main n business or theforeseeableuture,unless hey haveclear evidence t will either closeor go bankrupt.This is called the going-concern assumption. With this assumption, inan-cial statement alues aremeaningful.Would the bank lend moneyto a frrm if the frm werenot going to continue operating n the foreseeableuture? fthe firm expects o liquidate, hevalueson the financial statementsose their meaning. f a company s not a going concern,the valueson the flnancial statementswould need o be liquidation values o be useful.

As you have ead about he four financial statements nd henotes o the statements, ouhave earnedabout hequalities of financial information and he assumptions ndprinciplesthatprovide the foundation of financial reporting.Without theseassumptions ndprinciples,managers, nvestors,and analystscould not rely on the information to make decisions.

To complete the foundation for financial reporting and to enableyou to gain a full un-derstandingof the information contained n the financial statements, ou will need o knowabout two constraints hat apply to the preparationof the statements.A constraint n finan-cial accounting s a limit or control imposedby GAAP. There are two constraints:materi-ality and conservatism.

Materialie refers o the sizeor significance f an temor transactionn relation o the com-pany's overall financial performanceor financial position. An item is material f it is largeenough o influence nvestors'decisions. or example, he costof fueL he amounts aid o em-ployees,and he costof buying or leasingairplanes reall material tems or JetBlueor South-west Airlines. In contrast,an item is considered mmaterial if it is too small to influenceinvestors.GAAP doesnot have o be strictly applied o immaterial tems (measuredn total).For example,suppose etBlueAirlines madean solatederror and ailed to record herevenuefrom your $350 ticket purchased ndused n 2005. Because etBlue's otal revenuewas over$1.6billion for its fiscalyearendedDecember31,2005, the companywould not need o cor-rect this singleenor. The item is consideredmmaterial. However, f there were ots of theseerrors, he total amountcouldbe material.)

Conservatismrefers to the choices accountantsmake when preparing the financialstatements.When there s any question abouthow to account or a transaction, he accoun-tant should select he treatment hat will be least ikely to overstatencome or overstateas-sets.Accountants believe it is better to understate ncome or assets han it is to overstateeither.For example, etBlue'sDecember3I,2005, balance heet hows otal propertyandequipmentof over$2.9billion. GAAP requiresJetBlue o evaluate heseassets o make surethey are not overstatedwith respect o their future revenue-generating otential.

Elementsf the Financial tatementsAs you learned n Chapter 1, a completeset of financial statementsncludes he:

1. Income statement2. Balance sheet sometimescalled the statementof ftnancial position)3. Statementof changes n shareholders'equity (also called the statementof changes nowners'equity)4. Statementof cash lows5. Notes to thefinancial statements

GAAP describe he individual items that are ncluded in the financial statements. o learnwhat is shown on each inancial statement.we will look at the secondmonth of business or

FINANCIAL TATEMENTS 53

The ime-period ssumptionmeans hat the l i fe of abusinessan be divided ntomeaningful ime per iodsorfinancial eport ing.The historical-costr inciplemeans hat transactions rerecordedat actual cost.Th egoing-concernassumptionmeans hat,unlesshere sobviousevidence o the contrary,afirm is expected o cont inueoperat ing n the foreseeablefuture.

{,"{}.3ldentify he elementsof thef inancial tatements nddescr ibeheircha acterist ics.


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54 CHAPTERo eUALtTtEsF AccoUNTtNGNFoRMATtoNTom's Wear.We will take the secondmonth's transactionsand seehow they affect the ac-counting equationand he inancial statements. hen,we will relate he statementso thequal-itative characteristicsdescribed by GAAP.At the beginning of the secondmonth, on February l,2006, Tom's Wear hasa balancesheet hat s identical to the balancesheetdatedJanuary31,2006. Recall that the company'sassets,iabilities, and shareholder's quity balances oll forward when the new period starts.Transactionsor the SecondMonthof BusinessThe transactionsor Tom'sWear'ssecondmonth of business re shown n Exhibit 2.3.Thefirst transaction n February is the purchaseof 200 T-shirts,costing $4 each. Last month,Tom'sWearpaid cash or the purchaseof theT-shirts. This month, the companybuys themon credit, also known as on account. This meansTom's Wear will pay for them later. Thepurchase ncreases he company's assets-$8O0 worth of T:shirts-and the $800 claim be-longs to the vendor.When a company owesa vendoq accounts payable are the amountsthe company owes.This is the first traasactionshown n Exhibit 2.4,where the transactionsare presentedn the accounting equation worksheet.Next, Tom hires a company o advertisehis businessmmediately.This cost s $150 fora service.Tom's Wear pays $100 when the service s provided, so the company still owes$50.Like the first transaction, his one alsopostpones ayment.However, n this transaction,Tom's Wear has ncurred an expense. n the first transaction-when the inventory was pur-chased-Tom's Wear gainedan asset.The cost of the shirts will becomean expensewhenthe shirts are sold. In contrast, he work donerelated o the advertising s complete,and hatsignalsan expense. The timing of recognizingexpenses an be tricky; the next chapterwilldiscuss iming in detail.)The $150expense,ike all expenses,educes he owner'sclaimsto theassets f the irm. Assetsdecreasey $100, he cashpaid for theadvertising; nd heremaining $50 increasescreditors' claims-liabilities-because it will be paid later. It isshown asotherpayablesbecauseaccountspayable s generallyreserved or amountsa firmowes ts vendors. This is the second ransactionshown n Exhibit 2.4. Notice that the ex-pense s recorded even hough all of the cashhas not yet beenpaid.As his business rows,Tom decideshis companyneedssome nsurance. om'sWearpays $150 for 3 months' worth of coverage,beginning February 14.When a companypays for something in advance, he item purchased s something of future value to thecompany.Becausesuch an item provides uture value, t is classifiedas an asset. temspurchasedn advancemay seem ike unusualassets, ndoften have he wordprepaid withthem to provide information about what sort of assets hey are.Common prepaid temsare nsurance, ent, and supplies. n this case,Tom'sWear has purchased n asset alledprepaid insurance. Cash s decreased y $150,and he new asset-prepaid insurance-is increased y $150.Notice that nsurance xpense asnot been ecorded.Until someofthe insurance s used up-and it can be usedup only from one point in time to a subse-quent point in time-there is no expense. his is anothercaseof the cash low being dif-ferent than the expense.

On accountmeanson credlt.Th eexpression pplies oei therbuyingor sel l ing ncred t.Accountspayableareamounts ha t a companyowes tsvendors. he yar el iabi l i t ies nd areshownonth e balance heet.

Prepaidnsurances he namefor insurance business aspurchasedbut not yet used. tis an asset.

EXHIBIT2.3 Date TlansactionTransactionsor Tom'sWear or February February I

Febmary 5

February 14

February 23

February 28

Tom'sWearpurchases200 Ashirts at $4 each.They are purchased on credit.Tom's Wearbuys advertising for $150,paying $100 n cash and theremainder on account. The ad runs immediately.Tom's Wearpurchases3 months' worth of insurance for $150cash,with the policy begiruringon the date of purchase.Tom's Wear sells 185 Tshirts for $10 each. 170of these are soldfor cash and the remainder on account.Tom's Wear declaresand pays a dividend of $100.


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Accounts eceivableareamounts ustomers we acompany or goodsor servicespurchased n credit.

Adjusting the books means omakechangesn th eaccounting ecords, t the endof the per iod, ust before hefinancial tatements reprepared,o makesure heamounts ef ect he financialconditionof the company tthat date.

55 CHAPTER o QUALITIES F ACCOUNTINGNFORMATIONThe company's success ontinueswith the sale of 185 more T-shirts at $10 each.Al-though Transaction4 shows hesesalesas a single ransaction,hey could havebeen ndivid-ual sales.They are grouped ogetherhere o makethe presentation imple.Of the 185shirtssold, T0weresoldforcashof$1,700(170shir tsat$10each)and15weresoldoncredi t for

$150 (15 shirts at $10 each).When a sale s made on credit, accounts receivable are theamountsowed to the firm by customers.Accountsreceivableare assets-things of value toa business.This is the fourth transactionshown n Exhibit 2.4. Notice that the rest of thistransaction ncludes he decreasen inventory of $740 (185 shirts at $4 each)with a corre-spondingexpense-cost of goodssold of $740-which decreasesetainedearningsby $740.At the end of the secondmonth of business,Tom'sWearpays a dividend of $100 to itsonly stockholder,Tom. This transaction educesassets-cash-by $100, and t reduces e-tainedearningsby $100.This is the fifth transactionshown n Exh1bit2.4.The financial statements or Februarycan be preparedwith the information from thesetransactions.However, here s still one more stepbefore accurate inancial statements anbe prepared.This step s called adjusting the books. You need o review the amount thathasbeen ecorded or eachassetand eachclaim to makesureeveryamountcorrectlyreflectsthe financial situation of thecompany on the specificdateof the balancesheet-the last dayof the fiscalperiod (month,quarter,or year).After reviewing he transactionsor Tom's Wearduring the month, can you identify any amount hat seems ncorrect to you? Start at the be-ginning of the accountingequation worksheet n Exhibit 2.4 and ook at each tem that hasbeen ecorded. he assets recash,$6,695;accountseceivable, 150; nventory, 100;andprepaid nsurance,$150. Are theseamountsaccurateat February 28,2006, the end of thesecondmonth of Tom's Wear? s any asset ikely to communicate ncorrect nformation?Yes-prepaid insurance,as t currently appears n the company'srecords,will not ex-presswhat it should. Because he balancesheetwill have hedateFebruary28, 2006,Tom'sWear wants he amountof prepaid nsurance o be accurateat that date.What is the amountof the asset-insurance that s still unused-at the date of the balancesheet?The $150,paidon February14,applied o 3 months.On February28,half amonth'sworth haspassed. o,approximatelyone-sixth (half a month's worth) of the prepaid nsurancehas beenused.Anadjustmentmust be made to make surethe correct amount of prepaid insurance s shownon the balancesheet.Like routine transactions,adjustmentsmust keep he accountingequa-tion in balance.To record this adjustment n the accountingequation, subtract$25 (l/6 x$150) from the prepaid insurancecolumn, reducing the amount of prepaid insurance,andthen educeowner'sclaimsby the same$25 amount.This reduction n the owner'sclaimsis an expense-insurance expense-so it will be shown in the red-boxed area n the ac-counting equationworksheet.This adjustment s shown as Al on the worksheet n Exhibit2.4. The correct amount of the asset-the unusedportion-will be shown on the balancesheetat February28,2006,as $125.A review ofthe other items on the balancesheetdoes not revealany other neededad-justments on this particular balance sheetdate. In the next chapter,you will learn aboutother situations equiring adjustmentsbefore the financial statements an be prepared.Fornow, this adjustmentmakes he accounting ecordsready for the preparationof the finan-cial statements t the end of February.The income statement,prepared irst, lists the revenuesand expenses or the period;you can ind those n the red-boxedarea n Exhibit 2.4. Allrevenues ncrease etainedearn-ings; all expenses ecrease etainedearnings.The only item that we regularly find under re-tained earnings hat s nor ncluded on the income statements a distribution to the owners,dividends n a corporation.GAAP says hat distributions are not expenses.All of the items for the income statementare n the red-boxedareaof the worksheet.We can simply take the amounts n the red box in the retainedearningscolumns and groupthe transactions nto revenuesand expenses o form an income statement.The sales ev-enue,often simply calledsales, s $1,850.There are hree ypes of expensesisted. One s the cost of goodssold-also known ascost of sales.Recall, this is the expenseassociatedwith selling somethingpurchased romsomeone lse.Tom'sWearhascostof goodssoldof $740.The other wo expenses re$150for the advertisingand $25 for insurance.Be sureyou seeand understand hat the nsuranceexpense s not the amountTom's Wear actually paid to the insurancecompany. nstead, t


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CHAPTER . ELEMENTS FTH E

Tom's Wear, nc.Income StatementFor the Month Ended February 28,2006

FINANCIAL TATEMENTSEXHIBIT2.5lncome Statementfor Tom'sWearThis is the income statement orthe secondmonth of business orTom's Wear.

57

RevenueSales . . . . . $ 1'850ExpensesCost of goods soldAdvertising expenseInsurance expense740lbu25

Totalexpenses .. . . vt-DNet income $ 935

is the cost of the insurance hat was used during the period. The amount that has not beenused as of February 28 remains on the balance sheetas an asset.

The net income or the period s $935-revenues of $1,850minusexpenses f $915.Check t out in Exhibit 2.5,the income statementorTom's Wear or the month of February.The statement f changesn shareholder's quity s prepared ext (shown n Exhibit 2.6).

This statement rovides hedetailsof the changesn shareholder's quity during the year.The information for this statement s found in the shareholder'sequity columns of theworksheet n Exhibit 2.4, shown n the yellow-boxedarea.Tom'sWear began he monthwith $5,000 in contributedcapital. No new stock was issued during the month. Thatmeans no new contributions were made during the month. Retained earnings began themonth with a balanceof $385.Net incomeof $935 ncreases etainedearnings,and thedividend of $100 decreasesetainedearnings.Becausewe have alreadyprepared he in-come statement o summarize what happened n the red-boxed area n the retained earn-ings column,we do not need o list all of the individual items again.We ust need o addnet income as a single amount. The amount of retained earnings at the end of the periodis $1,220 $385+ 935 - 100).Next, Tom's Wear prepares he balance sheet.The balancesheetwas really preparedas the transactionswere put in the accounting equation worksheet-but not in a way tocommunicate he nformation most effectively.The transactions eed o be summarizedandorganized o communicate he nformation clearly andeffectively.Eachassetownedat Feb-ruary 28 is listed, along with the claims to thoseassets.Notice the similarity between helist of transactionson the worksheet n Exhibit 2.4 and he balancesheet n Exhlbit2.T .

Tom's Wear, nc.Statementof Changes n Shareholder'sEquityFor the Month Ended February 28,2006

Beginning common stock $5,0000ommon stock issued during the month .Ending common stock $5,oooBeginningretainedearnings ....... $ 38 5Net income for the month 935Dividendsdeclared .. .. (100)

EXHIBIT2.6Statement f Changesin Shareholder'squityfor Tom'sWearfor FebruaryThe Statement f ChangesnShareholder'sEquity shows howall of the equity accountshavechangedduring the month.

Ending retained earningsTotal shareholder's equityr,220$6,220 t0m'swGal


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58 CHAPTER . QUALITIES F ACCOUNTINGNFORMATION

Tom'sWear, nc.Balance SheetAt February 28,2006

EXHIBIT2.7Balance heet or Tom'sWearat February 8The balancesheetat February 28has ncorporated he newretainedearningsbalance. Assets Liabilities and Shareholder'sEouitv

Cash .. . . . . $6,695Accounts receivable 150Inventory .. 100Prepaidinsurance .. 125

AccountspayableOtherpayables .. . .Common stockRetained earningsTotal liabilities andshareholder's equlty .

$ 800505,000r,220

$ 7,070

The ul l-disclosurerinciplemeans hat the f i rm mustdisclose ny circumstancesndevents hat would make adi f ferenceo the users f thef inancial tatements.

Totalassets .. . . . . . . $7,070

The assets re isted at their amountson February 28,2006. There s $6,695cash. Thedetailsof how this number was calculatedwill be shown on the statementof cash lows.)Tom's Wear also has accounts eceivableof $150-the amount customersstill owe the com-pany for T-shirtspurchasedduring the month but the cashhas not been collectedyet.Thereare 25 shirts eft in the inventory, eachhaving cost $4, for a total of $100.The ast assets prepaid nsurance, nd he amountshown s $125-the unused ortionat February 28. The adjustment educedprepaid nsuranceby $25 for the amountused upduring the last half of February.There are two liabilities at February 28,2006-accounts payableof $800 and otherpayablesof $50.Theseamountsare still owed by Tom's Wear to creditors.The last tem is the amount of shareholder's quity. Becausewe havealreadypreparedthe statement f changes n shareholder's quity,we know that$5,000 s the total contributedcapital-in the form of stock-and $7,220 s the amount of retainedearnings.Together, heliabilities plus shareholder's quity add up to $7,070-the sameamountas he total assets.The statement f cash lows (shown n Exhibit 2.8) showsevery cashcollection andevery cash disbursement or the month. Each cash ransaction s classifiedas one of threetypes: operating, nvesting, or financing. To preparethis statement,you need to use theitems from the transactions n the cashcolumn of the worksheet in Exhibit 2.4, shownboxed n green.For each cash amount, askyourself if it pertains o operatingactivities, n-vesting activities, or financing activities.

The first cashamount n Exhibit2.4 is thepaymentof $100 n cash or advertising; hatwas he second ransaction. his $100 s an operating ash low becauset is a cashexpenserelated o routine businessactivities.The next cash ransaction s the $150 paid to the insurancecompany.The purchaseofinsurance s an operating cash flow. Notice the statementof cash flows shows the cashpaid-with no regard or when the insurance s used.Transaction involvescash nflows,for a total of $1,700.This transactionwas a sale,

which is an operat ing cash flow. Notice the cash n Transaction4 is $1,700,representing170T-shirts old or cash.Although 185were actuallysold, he cash or 15 ofthem hasnotbeencollectedyet. In the statementof cash lows, every tem must be cash only.The final cash ransaction s the distribution of $100 to the owner as dividends.This isclassified as a financing cash low becauset relates o how the business s financed.Be sureyou see hat the statementof cash lows includes every cash nflow and everycash outflow shown on the accounting equationworksheet.Also notice nothing else s in-cluded on this financial statement.The net amount s the change n the amountof cashdur-ing the period.The bottom of the statementof cash lows adds he beginning cashbalanceof $5,345 o the ncrease f $1,350 o get he endingcashbalanceof $6,695,shownon theFebruary 28,2006, balance sheet.Notes to the financial statements re not included here or Tom'sWear,but you shouldnever orget that they are a crucial part of the financial statements. here is an accountingprinciple called the full-disclosure principle, which means hat companiesshould disclose


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EXHIBIT2.960 CHAPTER r QUALITIES F ACCOUNTINGNFORMATION

ComparativeBalanceSheets orThe Home DepotThis is a recentbalancesheettaken from the Home Depot'sannual reoort.

The Home Depot,Inc. and SubsidiariesConsolidated Balance Sheets

anxounts i,n mi,llions, erceptper share d,ataAssetsCurrentassets:Cash and cash equivalents . . . . . . . . . . $Short-term investmentsReceivables,net

Other current assets

BuildingsF\rmiture, ixtures, and equipment .....Leasehold mprovementsConstruction in progressCapital leasesLess accumulated depreciation and amoftization . . .Net property and equipmentNotes receivable

Accounts payableAccrued salaries and related expensesSales axespayable . . .. .Deferred revenueIncome taxes payableCurrent installments of long-term debtOther accrued e4gensesTotal current liabilitiesLong-term debt, excluding current installmentsOther long-term liabilitiesDeferred income taxesStockholder's EquityCommon stock, par value $0.05;authorized: 10,000 hares; ssued2,401 shares at January 29,2006 and 2,385shares at January 30,

2005; outstanding 2,724shares at January 29, 2006and 2,185shares at January 30,2005Paid-in capitalRetained earningsAccumulated other comprehensive incomeUnearned compensationTheasurystock, at cost,277 sharesat January 29, 2006and200 shares at January 30, 2005

Jantaty29, JanuaryS0,2006 2005

31,5306,62924,901348

6,93212,3256,1951,191I,40439028,4375,7rr22,726369r,394258

$ 5061,6591,499

$39,020

5,7661,0554r27,546161111,504r0,4552,L4887r1,388

793L42,896Merchandise nventories 11,401 10,076742 533Totalcurrentassets . 15,346 14,273Property and equipment, at cost:Land 7,92414,0567,O73L,207843427

Cost n excess fthe fairvalue ofnet assets cquired . . 3,286Otherassets 601Total assets .... $ 44,482Liabilities and Stockholder's EquityCument liabilities:Short- termdebt . . . . . . . . . . . . $ 900

6,0321,L76488L,7673886rB1,64712,9012,67297 71,023

L20 1197,287 6,65028,943 23,962409 227(138) (108)(9,7t2) (6,692)

Total stockholder's equity 26,909Total liabiHties and stockholder's equity ... $ 44,482 $ 39,020SeeaccompanEing Notes o Consolid,atedFi,nancial Statenxents.


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CHAPTER . ELEMENTS F THE FINANCIAL TATEMENTS 61t iabil i t iesThe January2,2006, balancesheet,shown n Exhibit 1.6, ndicated hat Tom's Wear owed$500 o Tom's mom. On February 28,2006, that s no longer the case.The debt waspaid offin January.On February 28,2006, the only liabilities Tom's Wearhas are accountspayableand other payables.Liabilities are amounts hat the businessowes.They are the claims ofcreditors.Usually, heseclaims will be paidto creditors n cash.Liabilities, like assets, re heresultof past fansactions r events.For example,a purchase f inventory temson credit cre-atesa iability called accounts ayable.The balancesheeton February28,2006 waspreparedafter the purchaseof the shirtsbut beforeTom paid for them, so thebalancesheetshows hecost ofthe shirts as accountspayable.Once ncurred,a liability continuesasan obligation ofthe companyuntil the companypays or it. The accountspayableamount or the T:shirtsre-mains on the balancesheetuntil Tom pays he bill for the shirts.Often, iabilities involve n-terest-payment of an additional amount or the right to delay payment.When Tom's Wearrepaid Tom's mom in January, e paid $5 interest or the use of her money.Liabilities can also be cunent or noncurrent. f a liability will be settled with a currentasset, t is called a current tiability. For practicalpurposes, ou can think about a current i-ability as a liability that will be paid off in the next year.Noncurrent liabilities, or long-term liabilities, will be paid off over a period longer than one year. Most balance sheetsshow a subtotal or current assets nd a subtotal or current iabilities. That format is calleda classified balance sheet.Look at the balancesheet or Home Depot, shown n Exhibit 2.9.See f you can find the subtotals or current assets nd current iabilities. This is a classifiedbalance sheet because t has two classificationsof assetsand liabilities-short term andlone term.

1. What s he difference etween current sset nda long-term sset?2. What s a classifiedalance heet?

Shareholders'quityShareholderstequity, sometimes alled net assets,s the owners'claims o the assets fthe company.There are two ways owners can createequity in a company.The first way isby making capital contributions-contributed capital. Usually, the capital is cash, but itcould be equipment or other items of value.When Tom startedhis T-shitt business,he in-vested$5,000 of his own money. Sometimes his is called the owner's investment n thecompany.The term investmentmay be confused with investments hat the company tselfmakes with its extra cash. For example, GeneralMotors may invest some of its extra cashin the stock of Google, which GeneralMotors would call an nvestment.To avoid that con-fusion, we will refer to owners' nvestments n the firm as capital contributions.The secondway to createequity in a businesss to makea profit. (That is thepreferredway.) When Tom's Wearsells a shirt, theprofit from that shirt increasesTom's equity in thecompany.Revenuesncrease hareholders'equity; xpenseseduceshareholders'equity;and dividends,when declared, educe shareholders'equity.

In corporations, he two types of equity are separated n the balancesheet.The first iscontributed capital, alsoknown aspaid-in capital; the second s retained earnings. In asoleproprietorshipor partnership,both types of equity are ogethercalled capital. Separat-ing these amounts or corporationsprovides nformation for potential investorsabout howmuch the owners have actually invested n the corporation.Measurementnd Recognit ionn Financial tatementsWe will now take a closer ook at someof the featuresof the balancesheetand ncome state-ment.Recall, he balancesheet s simply the accountingequation:Assets = Liabilities* Shareholders' equity. The three elementsare major categories,each divided intosubcategories.Measuring Assets. We will starl with assets. he most well-known asset s cash. t islisted frst on the balancesheet.As you will notice on Home Depot's balancesheet,all other

Liabil i t ies re obligations hecompanyha s ncurredoobtain he assetst hasacouired.

Current iabi l i t ies rel iabi l i t ieshe companywi l lsettle-pay off-in the nextfiscal ear.Noncurrent iabi l i t ies, r long -term l iabi l i t ies,are iabi l i t iesthat wi l l take onger han ayear to settle.A classifiedbalancesheetshowsa subtotal or manyitems, ncluding urrentassetsand current iabi l i t ies.

Your Turn 2-4' i ' r

Shareholders' quity is hename or owners 'c laimsothe assets f the firm. l tincludes oth contr ibutedcapitaland retainedearnings.Contributed capital,sometimes al ledpaid-incapital, s he amount heownershaveput into thebusiness.

Retained arnings scapi talthe companyhasearnedan dhasnot beendistr ibuted sdividends.Capital s he combinedcontr ibuted aoitalan dearnedcaoital-retainedearnings-of a soleproprietorship r par tnership.


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62 CHAPTER o QUALITIES F ACCOUNTINGNFORMATIONassetsare listed in order of their liquidity-how easily they can be converted o cash. Amonetary value s computed or eachasset.Cash, or example, s the total amountof moneyin checking and savingsaccounts.The next assetcould be short-term nvestments,ones hecompanycan easily sell for cash at any time. The next asseton the balancesheet s usuallyaccounts eceivable-the total amount hat customersowe the company or credit sales. n-ventory is another asset,measuredat its cost.We saw that Tom's Wear'sbalance sheet n-cluded the cost of the T-shirts still in the inventory on the balancesheetdate.

Earlier you learned wo characteristicsof the way things are measuredor the financialstatements.First, they are measured n monetaryunits. For us, that meansdollars. For ex-ample, he actual number of T-shirts n the nventory is not shown on the balancesheet;onlythe cost of the inventory is shown. Second, the items on the financial statementsarerecordedat historical cost-what the company paid for them. They are not recorded at theamount the company hopes to sell them for. Some assets ontinue to be shown at cost onthe balancesheet,and others are revalued o amore current amount or eachbalancesheet.You will learn the details of which assetsare revaluedand which assetsare not revalued nthe chapters o come.Recognizing Revenue and Expenses. When should evenue e includedon an ncomestatement?GAAP says when it is earned, hat is when revenue s recognized-meaningthat is when revenue s included on the income statement.When Tom delivers a shirt to acustomer,Tom's Wear has earned he revenue.This is called the revenue-recognition prin-ciple. When one of Tom's friends sayshe is going to buy a T-shirt next week, no revenue srecognized.When an exchangeactually takesplace,or when the earningsprocess s com-plete or "virtually complete," that is the time for revenue ecognition. When Tom's Wearand a customer exchange he cashand the T-shirt, there s no doubt the transaction s com-plete.However, even when Tom's Wear only delivers heT-shirt and he customeragrees opay for it later (the sale s on credit), the companywill consider he earningsprocessvirtu-ally complete.Tom'sWearhas done ts part, so he sale s includedon the ncome statement.What about expenses?When an expense s recognized dependson when the revenuethat results rom that expenses recognized.Expensesare recognized-included on the in-come statement-when the revenue hey were incurred to generate s recognized.This iscalled the matching principle, and it is the basis of the income statement.Expensesarematchedwith the revenue hey helped to generate.An example s the cost of goods sold.Only the cost of the T-shirts sold is recognized-included as an expenseon the incomestatement.The expense s matched with the revenue rom the sale of thoseshirts.The costof the unsold T-shirts s not an expense-and will not be an expense-until those shirts aresold. An expense s a cost hat has beenused o generate evenue. f a cost hasbeen ncurredbut it has not beenusedup, it is classifiedas an asset ntil it is used.Prepaid nsurancesan exampleof a cost hat s classifiedas an asset ntil it is used;and when t is used, t be-comes nsuranceexpense.

Must the customer actually pay the company in cash before a sale canbe counted asrevenue?No. Notice that the salesof all theshirts are ncluded n the sales otal, even hough15 of the shirts have not beenpaid for yet. When a customerpurchasesan item on credit,the earningsprocess s consideredvirtually complete,even though the cash has not beencollected.Similarly, a cost ncurred in the generationofrevenue need not be paid to be in-cluded on the income statement. n calculating the revenueand exoenses or an income

Recognized evenue srevenue ha t ha sbeenrecorded o hat i t wil l showup on the income tatement.The revenue-recognitionprinciple ay shat revenueshouldbe recognized hen itis earnedand collection sreasonably ssured.

The matching principlesaysthat expenseshouldberecognized-shownon theincome tatement-i n th esameperiodas he revenuethey helpedgenerate.

IIIIt r-- 7

'hewsfhsAAccountingnformationeal ly atters! i l lsCorporation,shopping-malleal-estateinvestmentrust, isclosedhat he SEC as nvestigatingtsaccountingractices,n-cludingheway he irm recognizesevenue.n analystor Banc f Americasecuri-t ies owngradedi l ls hareso "sel l" tatus ecauseheannouncementuggestedhefirmoverbookedevenuendmayhave nderstatedxpenses.ha thappened?hefirm's hare rice ropped y 12%.


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CHAPTERo ELEMENTSFTHEstatement,accountantsdo not follow the cash. nstead, hey use the time when the "eco-nomic substance"of the transaction s complete.Accountants use the expressionsvirtually complete and economic substance o de-scribe he same dea-that a transactiondoesnot need o be technically complete o recog-rize the resulting revenue. If the transaction is substantially complete, the revenue isrecognized.When Tom's Wear sells the T-shirts, delivering them and receiving the cus-tomers' promise o pay is considered he economic substance f that transaction.Cash maycomebefore the transaction s completeor it may come afterward.This way of accountingfor revenuesand expenses-using the economic substance f the transaction o determinewhen to include t on the income statement nsteadof using the exchangeof cash-is calledaccrual accounting.

When to recognize evenue s easy or somebusinesses nd extremely diffrcult for oth-ers. There s a lot of disagreementamong accountantsabout he timing of revenue ecogni-tion. They agree hat revenue should be recognizedwhen the revenue has actually beenearnedand t is reasonable o assume he customerwill pay.That is, the transaction s vir-tually complete. But they often cannot agreeon exactly when that has happened.This is animportant topic that is regularly debated n the financial community. Unfortunately, im-proper revenue ecognition has causedseriousproblemsfor many companies.Many of theaccountingscandalswith the earnings eportedby major corporations n the last few yearsare related o revenue ecognition.Exhibit 2.10 summarizes he assumptions, rinciples,and constraints f accountinginformation.

FINANCIAL TATEMENTS 63

Accrualaccounting efers othe way we recognizerevenues no expenses,Accountants o not relyon theexchange f cash o deter minethe timing of revenuerecognition. irms ecognizerevenuewhen t isearnedan dexpenses hen they areincurred-no matter when thecash s received r disbursed.Accrual ccountingollows hematching rinciple.

EXFIIBIT .10Assumptions, rinciples,nd Constraintsf Financial eport ing

Assumptions:

Principles:

Time-period assumption The life of a business can be divided into artiflcialtime periods for financial reporting.Separate-entityassumptron Financial statements of a flrm contain financialinformation about only that firm.

Monetary-unit assumption Only items that can be measured n monetaryunits are included in the flnancial statements.Going-concernassumption A company wiII remain in business for theforeseeable uture.

Historical-cost principle Assets are recorded at cost.Revenue-recognitionprinciple Revenue s recognized when it is earned andcollection is reasonablyassured.Matching principle Expenses are recognized n the sameperiod asthe revenue they helped generate.

F\rll-disclosureprinciple A company should provide information aboutany circumstances and events that would make adifference to the users of the financial statements

Materiality Materiality refers to the size or significance of anitem or transaction on the company's financialstatements.

ConservatismWhen there is any question about how to accountfor a transaction, the accountant should selectthe treatment that will be least likely to overstateincome or overstate assets.

Constraints:


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$T+1ffi,.fli,ie*+f,J,#.,Ff14;l$:"lF{F'runq.Hlf#$',q$When to recognize evenue-record it so hat it appears n the period'Sn-come statement- is one of the most diff icult udgmentsa companymustmake.A 2005 study of 400 businesseaders y RevenueRecognit ion.comand International ataCorporationound that more han half of at l publ iccompanies ave changed heir revenue ecognit ionpol icies s a resultofSarbanes-Oxley.ut i t is changingbusiness odels hat account or morechangesn revenue ecognit ion ol icieshan any other single actor.Newbusiness odels an be quitecomplex, nvolving undledproducts nd ser-vices el ivered ver ong periods f t ime. When to recognize evenue anbe diff cult o determine.

Vour Turn2-s[.,.{ .;$Def ne accrual ccount ing,explainhow i t d i f fers romcashbasis cco unt ing, ndident i fyexamples f accrualaccount ing n actualf inancial tatements.An accrual ransaction sonein which he revenue searnedor the exoensesincurredbefore he exchanqeof cash.A deferral transaction sonein which he exchange f cashtakesplacebefore herevenue searnedor theexpensencurred.

f f iH&{flf f i$T.SAccrualAccountingAccrual accounting nvolvesboth accruals nddeferrals.

Give an example of the matching principle rom the incomestatementfor Tom'sWear for February.AccrualsndDeferralsAccrual asis ccountingThe term accrual basisaccountlng ncludes wo kinds of transactionsn which the exchangeof cashdoesnot coincide with the economic substance f the transaction.The revenuesandexpenses re recognizedat a time other hanthe time when the cash s collectedor paid.

One kind of accrual basis transaction s an accrual and the other is a deferral. Themeaningof eachkind of accrualbasis ransactions shown n Exhibit 2.11.

When heactioncomes efore hecashitis anaccrual.WhenTom'sWearmadea creditsale, t was an accrual ransaction. o accruemeans o "build up" or "accumulate."n ac-counting,we arebuildingup our sales r ourexpenses ven hough hecashhasnot beenex-changed.The sale s completed irst-merchandise is delivered to the customer-and thecashpayment will come later. Instead of receiving the assetcash from the purchaser, hecompany records an asset called accounts receivable-meaning cash due from the pur-chaser.Accounts receivables the amount owed to the companyby customers.BecauseGAAP is basedon accrualaccounting, he necessary art ofthe transaction or recording herevenue s the actual sale of goods or services,not the cash eceipt from the customers.

When the dollars come beforethe action, t is called a defenal. When Tom's Wearpaidfor the nsurance,t was an advance urchase-as we all pay nsurance remiumsup front,not after the expiration date of the policy. But the amount paid for the insurance was notconsidered n expense ntil it wasactuallyused.To defersomething,n common anguage,means o put it off-to delayor postpone t. In the languageof accounting,a deferralmeansthat the company will postpone ecognizing he expense ntil the nsurance s actually used.When Tom's Wearpaid the cash n advanceof theperiod coveredby the nsurance, he com-pany recorded he cash disbursement. n other words, Tom's Wear recorded t in the busi-ness ecordsas cash hat had been spent.However, he expensewas not recognizedwhenthe cashwaspaid. It will berecognized-and remember, hatmeans ncludedon the ncomestatement-when the cost s actually used.

I AccrualAccounting :

Action r DollarsFirst

...*Later


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CashBasis ersus ccrualBasis ccountingThere is another ype of accounting called cash basis accounting-revenue is recognizedonly when the cash s collected,and expenses re recordedonly when the cash s paid. Thisis not a generally acceptedmethodof accounting according o the FASB and theSEC. Us-ing the exchangeof cash as he signal for recognizing revenueand expensedoes not com-municate the performance of the business in a way that allows us to evaluate itsachievements. he cash flows are important, but alone they do not provide enough nfor-mation or decisionmakers.This doesnot stop somebusinessesrom using t as he basisof their own accounting records.Remember, some businessesare not required to followGAAP. For example, doctors who are sole proprietors may use cash basis accounting ntheir businesses. his means hey recognize only the cash hey receive as revenue. f theyprovide services o someonewho has not yet paid for those servicesat the time an incomestatement s prepared, hey would not include the fee notyet received as evenue or that n-come statement.That is not GAAP. If the doctors were following GAAP, they would countit as revenueand as a receivable accounts eceivable).Accounting eriods nd Cutoff ssuesWhy does t matter-for accounting purposes-if there is a difference between the timewhen the goods or servicesare exchanged-the economic substanceof the transaction-and the time when the cash related to that transaction s received or disbursed? f a com-pany makes a saleon credit and he cash s collected ater, why does t matterwhen the saleis recognized-included as revenueon the income statement?Studying Tom's Wear willhelp you see he answerso thesequestions.When Tom beganhis businessn 2006,he chose he calendar ear as his company'sfiscal year.Each of his annual ncome statementswill cover the period from January 1 toDecember31 of a specific year. t is important that what appearson the income statementfor a specific year s only the revenueearnedduring those 12 months and only the expensesincurred to generate hat revenue.What is includedas a saleduring the period?Accountantshave decided o use the exchangeof goods and services,not the cashexchange, o definewhen a sale has taken place.Expensesare matched with revenues,also without regard towhen the cash s exchanged.This makes he financial statements f all companies hat fol-low GAAP consistent nd comparable.Exhibit 2.12 shows he relationshipbetween he balance heetand the income state-ment and he time periods nvolved.Recall, he balance heet s a snapshot iew of the as-sets, iabilities, and shareholders' quity on a specific date.For a companywith a fiscalyear-endon December3 1, that is the date of the balancesheet.Remember, he end-of-the-year balance sheet or one year becomes he beginning-of-the-yearbalancesheet or thenext year.When you are out celebrating New Year's Eve, nothing is happening o the bal-ancesheet.When Tom goes o sleepon December31,2006, he cashon the December31,2006, balancesheetof Tom's Wear is exactly the amount of cash that the company willhaveon January , 2007 So the final balancesheet or one year simply rolls forward to thenext year.

Then, transactionsstart happening-exchanges takeplace.The revenuesand expensesfor the period of time are shown on the income statement.The income statementcovers a

1t1/06Balance

CHAPTER . ACCRUALS ND DEFERRALS 65

Cashbasisaccounting sasystembasedon the exchangeof cash. n hissystem,revenue srecognized nlywhen cash scollected. nd anexpenses recognized nl ywhen cash sdisbursed. hi s sno t an acceotablemethod ofaccounting nderGAAP.

12t31/06Balance

12131107Balance

12/31108Balance

12t31/09Balance

lncomeStatementfor he YearEnded12131/09

: EXFIIBIT . ' I2The BalanceSheetand IncomeStatementEvery balancesheetpresentsheassets,iabilities. andshareholders'equityf a businessfirm at a moment n time. Theincome statementdescribeswhathappenedbetween wo balancesheetdates.

sneet\ l/ sheet\ ft sheet\ l/ sheer\ 71 sneetlncomeStatementfor the YearEnded12131tO6

IncomeStatementfor the YearEnded12t31t07

IncomeStatementfor heYearEnded12t31t08


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Your Turn2-6ffi i*,irr',llililrl,iut

Financial tatementsprovide nformationabout the risk related oinvest ingn a company.Wil lyou get a good returnon your investment?Howlongwil l i t take?

period of time. A company may construct weekly, monthly, quarterly,or annual hnancialstatements.Many companiespreparemonthly andquarterly financial statements; ll com-paniesprepareannual inancial statements. he income statement or a speciltcyear givesthe revenuesand expensesor that year. It gives nformation abouthow the balance sheethas changedbetween he beginning of the year and the end of the year.The revenues n-crease wners'claims;expenseseduceowners'claims. f the difference etween evenuesandexpensess positive-if revenuesare greater han expenses-the company has a net n-come. fthe expenses regreater hanrevenues, he companyhasa net oss. The net ncomeor net loss s sometimescalled the bottom line.

What is he difference etweencashbasisand accrual asisaccounting?

How nvestors-Ownersand Creditors-UseAccrualAccounting nformationOwners and creditors are both considered nvestors n a business.Both invest their moneyto make money, and they both take a risk in investing their money in the business. n thiscontext, you can think of risk as the uncertainty associatedwith the amount of future re-turns and the timing of future returns.Some nvestmentsare riskier than others are. For ex-ample, when a bank makes a loan to a company, the banker evaluates he ability of thecompany to repay the loan amount-the principal-plus interest-the cost of borrowingthe money. If the bank makes a loan to a company that does not do well enough to repaythe debt, he company may need o sell noncashassets o raise cash o pay off the loan plusinterestdue.When lending money, he bank must compare he risk with the expected eturn.

Most often, the risk andreturn of an investmentchangevalue n the samedirection-we say hey arepositively correlated.Positive ly correlatedmeans hey move n the samedi-rection-higher risk means higher expected return for taking the higher risk; lower riskmeans ower expected eturns.For higher investment isk, the potential for a higher returnis needed o attract nvestors.

Investing n a company asan owner is riskier than investing as a creditor. A creditor'sclaim to the assetsof a company has priority over an owner's claim. (Creditorshave firstclaim to the assets.) f a company has ust enoughmoney either to pay its creditors or tomake a distribution to its owneror owners, he creditorsmustbe paid,and theyalwaysmustbepaidbefore anything-if there s anything eft-is distributed o the owners.That trans-Iates nto less isk for a creditor.The owner's risk is that he companywill go out of business.

However, he owner, who takesmore risk, has the right to share he profit. So the riskfor the owner is accompaniedby the potential for a higher return. A creditor, on the otherhand, will never receivemore than the amount of the loan,plus the amount of interest hatis agreedon when the loan is made.

Financial nformation is useful for someonedeciding whether or not to invest n a com-pany.SupposeTom's Wearwantedto borrow money to expand.A bank would want to ex-amine Tom's Wear's ncome statement, alancesheet,and he statementof cash lows. Thereason s to evaluatepotential risk-the company's ability to make the required principaland nterestpayments.

The balancesheet howsa company'sassets nd who hasclaim to them.A bank oanofficer would use the information on the balance sheet o evaluate Tom's Wear's abilityto repay the loan. He would want to be sure hat the company did not have oo many debts.The more debt a company has, he more cash t must generate o make the loan payments.

The information on the balancesheetwould not be enough o assure he bank loan of-ficer thatTom's Wear would be ableto repaythe loan. Becausea loan is repaidover severalmonths or years, nformation about he future earningpotentialof the business s important.Studying the past performance of a businesshelps predict its future performance.Thatmakes he profit the company earnedduring the past year relevant to the banker.Detailsabout he sales evenueandexpensesncured to generate hat revenuewould help the bankevaluate he company'spotential to generateenough cash o repay a loan.


19/48

CHAPTERo ACCRUALSNDDEFERRALSStill, the information on these wo financial statements, o matter how relevant o thebank's evaluation,would not be enough.Another piece of thepuzzle is the way the com-pany managests cash.A company may have ittle debt and ots of earningpotential.How-ever, if the company does not have enough cash, the loan payments cannot be made.Because ashcollection is the bank'sprimary concern, hestatementof cash lows providesadditional nformation for the bank.

An Exampleo l l lustratehe Information inancial tatements rovideWe will compare wo companies,each starting ts fiscal year with identicalbalancesheets.Then, during the first month of the year, they have very simi lar transactions.We will lookat only a few of the transactions,and we will see hat their income statements or the firstmonth are the same.As you study the example, try to figure out why their income state-mentsare the same.Their ending balancesheetsand statementsof cashflows are not thesame.Where do the differencesshow up in the financial statements?The two companies re Clean Sweepand Maids-R-Us.Both are cleaningbusinessesand both are soleproprietorships.Judy Jonesowns Clean Sweep, and Betty Brown ownsMaids-R-Us.On January1,2007, the two companies ave denticalbalancesheets. ookat each tem on thebalance heet n Exhibit 2.13 andbe sureyou know what t means.Dothis beforeyou go on.

Studyeach ransactionand ook at its effect on the accounting equation.Follow alongusingExhibits2.14an d2.15.Transaction1; Each companyearns$750 worth of revenue.CleanSweepcollects thecash,but Maids-R-Us extendscredit to its customers.Clean Sweep ecords he assetcash,whereasMaids-R-Us ecords he assetaccounts eceivable. oth companies

67

Clean Sweep or Maids-R-UsBalance SheetAtJanuary L,2007

AssetsCash .. . . . $ 900Supplies .. 200Totalassets .. $1,100LiabilitiesNotespayable .. . . . $ 400Owner's equityOwner, Capital 700Total l iabi l i t ies ndowner 'sequrff . . . . . . $ 1,100

BothCleanSweep ndMaids-R-Us1. Clean 0housesora feeof$75perhouse.

Clean Sweep

Collects he fees in cashat the time the servicesare rendered.

Paysoff the entire oan plus$40 nterest

Maids-R-Us

Agrees o extend redi tto th e customers. eeswil l be collected fter30 days,Paysonly$100of th eloanplus$4 0 nterest.

EXFIIEIT.13BeginningBalanceSheet or CleanSweepand Maids-R-UsAt the beginning of the month,both companieshave he samebalance heet.

EXFIIBIT .14Transactionsor January2OO7 or Clean Sweepand Maids-R-UsBe sure o study how thetransactionsare different for thetwo comoanies.2. Make loanpaymentplus nterest.

3. Countth'eupplies nJanuary3l nd ind$25worth efton hand.Both will make an adjustment o show$175worthofsuppliesused.


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O QUALITIES F ACCOUNTINGNFORMATION2.T5

or CleanSweep and Maids-R-Usthe transactionsbetween he two companiesare reflected n the accounting equationworksheet.

Clean Sweep

Statement , Statement of Changes n Owner's Equity * Balance Sheet - Statement of Cash FlowsB: Maids-R-Us

have earned he sameamountof revenue,so eachwill show $750revenueon its in-come statementor the month.Transaction2: Each company makes a loan payment. Clean Sweep pays the entireamount of the notepayable,$400,plus interestof $40.Maids-R-Us paysonly $100of principal on the notepayable,plus interestof $40.The only expensen this trans-

action s the nterestexpense f $40.Both companieshave ncurred he sameamountof interestexpense, o eachwill show $40 nterestexpenseon its income statement.The repaymentof the principal of a loan doesnot affect the income statement.


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CHAPTER . ACCRUALS ND DEFERRALS 69EXHIBIT2.16

Clean Sweep or Maids-R-UsIncome StatementFor the Month EndedJanuary 31,2007IncomeStatement orCleanSweep andMaids-R-Usor JanuaryLook back at Exhibit 2.15 to theaccountingequation worksheet,where you will see hetransactionsn the red boxedatea are the same for bothcompanies. hat means heirincome statementsare dentical.

RevenueCleaningfees $ 750ExpensesSuppliesInterest $ 17540Total expensesNet income 215$ 535

Adjustment: At the end of the period, each company will record suppliesexpenseof$175, eaving $25 as supplieson hand on the January31 balancesheet,Both incomestatements ill showsupplies xpense f $175.

We canconstruct an ncome statement or each company rom the numbers n the red-boxed area n Exhibit 2.15. Revenuesor the month of JanuaryErmountedo $750;expenseswere $215; so net income was $535.This is the case or both companies, s shown nExhibit 2.l6.Even though one companyextendedcredit to its customersand he other col-lected cash for its services, he income statementsare identical. The income statement sonly concernedwith revenuesearnedand expensesncurred, not with the timing of the re-lated cash lows.The balancesheetat January31 for each company canbe constructedby simply orga-nizing the details of the ending balancesof the accounting equation for eachcompany inExhibit 2.15. For a sole proprietorship, all owner's equity-contributed and earned-isaddedtogether and called owner's capital. The two balance sheetsare shown in Exhibit2.17. Notice the differences.Assetsand liabilities are different for the two comoanies.butthe owner's equity amountsare the same.

EXHtBtT .17Balance heet or CleanSweep nd Maids-R-Ust January 1,2007The balancesheetsare not the same.The total assetsare different becauseClean Sweeppaid $300 more than Maids-R-Us on the notepayable.They have different assetsalso. Maids-R-Us has accounts eceivableof $750, revenue t earnedbut did not collect in January.

Clean SweepBalanceSheetAt January 3I,2007

Liabilities and Owner's Equity

Maids-R-UsBalance SheetAt January 3L,2007

Assets Liabilities and Owner's EquityCashSupplies $ 1,210zt) Capital,Jones .. .. . . $ 1,235

Total liabilities andowner'sequity . .. $ I,235

CashAccountsreceivable ..Supplies

$ 760 Notespayable .. . . . $ 300Capi tal ,Brown .. . . . $ 1,235Total liabilities andowner'sequity .. $1,535

750z5otalassets ... $1,235Totalassets ... $1,535


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CHAPTER o QUALITIES F ACCOUNTINGNFORMATIONEXHTBTT.18Statementsof CashFlow for CIeanSweepand Maids-R-UsThe differences n the cash ransactions esult in differences n the statements f cash low.

Clean SweepStatement of Cash FlowsFor the Month Ended January 31,2007

Maids-R-UsStatementof CashFlowsFor the Month Ended January 31,2007

Cash from operating activitiesCash collected from customersCash paid for interestNet cash from operationsCash from investing activitiesCash from financing activities

Repaymentof loan .. . . . . (400)Netcashfromfinancing .. . . . . . (400)Netincreaseincash .. . . . . . . . . $ 310

Cash from operating activitiesCashpaid for interestNet cash from operationsCash from investing activities

$ (40)0

Cash from financing activitiesRepaymentof loan . . . . . . (100)Netcashfromfinancing . . . . . . . (100)Net increase (decrease) in cash .. ... . $ (140)

$ 750(40) $ 7100

Your Turn2-7Wm-mw"fiww,wru

It is important to understandwhy both companieshave he sameamount of owner's eq-uity. Both had beginning equity of $700 plus net income for the month of $535, for a totalof $1,235.That is the numberyou find on the January 31 balance sheet or owner's equity.The timing of cash receiptsand disbursements oes not affect owner's equity.

Finally, look at the statementof cash flows. As you have seen, he cashreceipts anddisbursements or the two companieswere not the same. This shows up clearly on thestatementof cash lows. The cash low statement or eachcompany shows all the cash re-ceived and all the cash disbursed or the month. The cash flow statementsare shown inExhibit 2.18.

1. Explain ow the revenuesecognizedn the ncome tatement ifferfrom the revenues hownon the statementof cash lows.2. Suppose company arns$50,000n sales evenue, 0o/of which sprovided n acount. ow much evenuewill be shownon the pe 'riod's ncome tatement? ow muchwill be shown on the period's

statement f cash lows?How much evenue ill be ncludedn theretained arningsotal on the end-of-the-periodalance heet?Putting t All Together-the Objectives f Financial tatementsFinancial nformation shouldbe useful. What makes t useful is the way the transactionsofthe businessare organized nto the four basic financial statements:

The income statementThe statementof changes n owner's equityThe balancesheetThe statementof cash lows

1.J3.4.


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CHAPTER . ACCRUALS ND DEFERRALS 71

L-i"J:3l:-q;,,l\il) n,j'ilBusine SSAccountingsAccrual ut Cashs KingIn thischapter,ou have earnedha t rnancialtate-ments repreparedn an occruol asis, ut hat doesno tmean ash snot mportant. ereswhatTheMot-leyFool aid bout ash n a June 006article,TheNext nron:

Cashsking.Despite ha tsome usinessxecswant you to believe, ashpays he bills-accountingarningso not.Asa matter f fact,cash udgetingsoneof the mosttmportant ctivitiescompany erforms.hestartingpoint or avoiding cash risiss o develop compre-hensiveash lowbudget.f you ead bout he allofEnron,ouwil l earnhat hecompanyidnothavecashlowbudget. nronimplyanoutof cash, nd tsproblemsi th he SEC r ied p their ines f creditswi th heir anks.Smart usinesswnersevelopnnual revenmul-tiyear ashlowprojectionso make urehey anmeetongoing usinesseeds. usinesswners lso repareandusehistoricqlash lowstatementso gainan un-derstandingboutwhere llof thecash ameromandwhere ll hecashwent.Byestimatingou rcash nflows ndoutflows, ouLdI I

. Make ure ouhave nough asho purchaseuf -ficientnventoryor plannedales.

. Take dvantagef purchaseiscountsndspecialoffers.o Plan quipmenturchases,epairs,nd eplacements.. Bepreparedor any inancingoumayneed npe-riodsof cashshortages-short-termredit ines,smalloans, r ong-termebt.Fo ra newor growing usiness,ccurateashlowprojectionsanmake he differenceetween uccessand arlure.oran ongoing usiness,ood ash ud-geting anmake he differenceetweenmovingor -

ward ndstandingti l l .How do you prepare cash low projectionTc-cordingo the Women Businessenter, reparingcash rojections ike reparingbudget ndbalancingyourcheckbookt the same ime,First, ou estimateyour ashnflows. ashsgeneratedr imari lyysales.But n manybusinesses,ome f the sales reon ac-countcharge ccounts,ermpayments,ayaway,ndtrade redit). oyou mustestimate hen hose reditsales i l l urn ntoactual ashnflows.hen, ouesti-mate l l hecash isbursementsouneedo make ndwhen ouneedo makehem.The goal of cashbudgetings to alwayshaveenough asho keep our usinessunningmoothly.fit turnsou t thatyou havemorecashhanyou need,thenyou must igureout how best o use hat extracash-how o investt.That sacashlowproblemha tyoudefinitely ant!

The ongoing life of a business s broken into discreteperiodsso that performancecanbe evaluated or a specific period. For our cleaning businessexamples, he period is amonth.Income s measured n a way that captures he economicsubstance f earningrev-enueand ncurring expenses;t is not basedon cashcollectionsand cashdisbursements.Notice, the net incomes or Maids-R-Us and Clean Sweep or January are exactly thesame, n spiteof the differences n when the cash s collectedand disbursed.Those im-ing differencesare reflectedon the balancesheetby the differences n cashand both re-ceivables and payables; and differences are also shown on the statement of cashflows-the statement hat provides the details of the timing of cash receipts and


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72 CHAPTER . QUALITIES F ACCOUNTINGNFORMATIONdisbursements. he four statements ave been designed o be relevant, eliable, consis-tent, and comparable.In addition to thesequalities, accounting nformation relies on the basic assumptionsand principles we discussedearlier, shown in Exhibit 2.10. We can relate each of the as-sumptionsand principles to the financial statements f Maids-R-Us.

. The separate-entity ssumptionmeans hat only the business ransactionsof Maids-R-Us are shown in the financial statements-none of the owner's personal transactionsare ncluded.. The going-concernassumptionmeanswe may assume hat Maids-R-Us is an ongoing,viable business.According to GAAP, if it werenot ongoing, the company would needto have all its assetsappraisedand isted at liquidation value.. The monetary-unitassumptionmeanseverythingshown on the financial statements smeasuredn monetaryunits, heredollars.. The historical-costprinciple means he items on the financial statements revalued atcost. For example, he supplieson the balance sheetare not valuedat what they mightbe worth if resold or at the current cost, which might be higher than the amount thatMaids-R-Us paid for them. They are valued at the price Maids-R-Us paid when theywere purchased.. The revenue-recognitionprinciple means the revenue on the income statementhasbeenearned.The relatedcash may not havebeen collected, but the work of earning thas beencompletedand collection of the receivabless reasonablyassured.. The matchingprinciple means elated evenuesandexpenses houldbe on the same n-come statement.Only the supplies hat areused o earn the revenueduring the periodarecountedas suppliesexpense.The unusedsuppliesarereportedon the balancesheetuntil they are actually used.

Accrual accounting s an accountingsystem n which the measurementof income is notbasedon cash eceipts and cashdisbursements.nstead, evenue s included in the calcula-tion of income when it is earned,and expenses re ncluded as hey arematched o revenue.Timing differencesbetween he economic substance f a transactionand the related cashflows do not affect income.That is why both companieshave the same net income eventhough the timing of the cash lows is different.RealCompany inancial tatementsEven though Tom's Wear is a small, start-up company, ts financial statementsnclude thesame types of financial statement tems as large, well-established corporations. WhenTom's Wear sold shirts to customerson credit, the balance sheetshowedaccounts eceiv-able.Look at the balancesheetof Polo Ralph Lauren Corporation, shown n Exhibit 2.19.In the assetsection,Polo Ralph Lauren Corporation'sbalancesheetshowsaccounts eceiv-able of $455,682,000 t April 2, 2005, ts fiscal year-end.Customersowe Polo RalphLauren Corporation his amount or productsand services he companyprovidedto its cus-tomers on credit.

Canyou find anotherasset n the balancesheet hat reflects he useof accrual, ather hancashbasis,accounting?n the cunent assetsection, he balancesheet ists prepaidexpensesof $102,693,000.Although the detailsof Polo Ra$h Lauren Corporation'sprepaidexpensesare not shown, he ncluded temswill be similar to prepaid nsuranceor prepaid ent-itemsthe companyhaspaid for but hasnot usedyet. On the other side ofthe balancesheet,PoloRalph Lauren Corporationhas accountspayableof $184,394,000.This representswhat thefirm owes to vendorsfor inventory items the companyhaspurchasedbut has not yet paid for.

Check out the other things you learned n this and the previouschapter about the bal-ancesheet.First, it balances-assets : liabilities * shareholders'equity. Polo Ralph Lau-ren Corporation has a classified balance sheet. Current assets are shown first, with asubtotal; and current liabilities are also shown with a subtotal. Look at the stockholders'equity section.There is common stock and additional paid-in capital-both contributedcapital amounts.Then, thebalancesheetshows etainedearnings, he amount of equity theshareholders aveearned lessdividends) by Polo Ralph Lauren Corporation's operations.


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Polo Ralph LaurenConsolidatedBalanceSheets

CHAPTER . ACCRUALS ND DEFERRALS 73EXHtBtT2.19BalanceSheetofPolo RalphLaurenCorporationCompare he balancesheetofPoIo to that of Tom's Wear. Seehow many similarities you canfind.April2,2005 April 3,2004(As restated,seeNote 2)Dollars in thousmds, except share data)

AssetsCurrentassets:Cashandcashequivalents. . . . . . . . . . . . . . . . . $Accounts eceivable, et of allowances f$111,042 nd.$97,292InventoriesDeferred tax assets .Prepaid expensesand otherTotal current assetsProperty and equipment, netDeferred tax assetsGoodwill, netIntangibles, netOther assetsTotal assetsLiabilities and Stocldrolders'EquityCurrent liabilities:Accounts payableIncome tax payableDeferredtaxl iabi l i t ies .. . . . .Accrued expensesand otherTotal current liabilitiesLong-term debt

350,485$ 352,335455,682 44r,724430,082 373,17074,821 2t,565102,693 99,3571,413,763 l,2g7,r5r487,89435,973558,85846,991183,190$2,726,669

$ 184,39472,L48365,868622,4t0

409,74L65,542341,60317,640L76,875$ 2,297,552

$ 188,91977,7361,82t236,724505,200Other noncurrent liabilitiesCommitments and contingencies (Note 14)Stockholders' EquityCommon stockClassA, par value $0.01per share;500,000,000 hares authorized: 64,016,034 nd61,498,183 hares ssued and outstandingClassB, par value $0.01per share;100,000,000hares authorized: 43,280,02Ishares ssued and outstandinA 433Additional paid-in-capital 664,279Retainedearnings 1,090,310Theasurystock, Class A, at cost (4,177,600 nd 4,145,800 hares) (80,027)

Accumulated other comprehensive ncome 29,973Unearnedcompensation .. (2g,gL2)Total stockholders' equity 1,6?5,?08Total l iabi l i t iesandstockholders'equity . . . . . . . $ 2,726,669

290,960 277,345r37,59r 99,560

620

433563,457921,602(78,975)23,104(r4,794)r,4L5,447g._?zelw_

652

Seeaccom4tangingotes o Consolid,atedinanci,alStatem,ents.

Also, there are two balance sheetsshown, which you will recall are called comparativebalance sheets.Take notice of the dates of the balance sheets.This financial statementshows he financial position of the company at a single point in time. For Polo Ralph Lau-ren Corporation, the last day of the fiscal year is the Saturdaynearest o March 3 1, nfor-mation disclosed n the notes o the financial staremenrs.


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{,.s.5Compute nd explain hemeaningof the currentratio.Applying ourKnowledge:atioAnalysisEvery businessmust pay its bills. Suppliers, n particular,want to evaluatea company'sability to meet its current obligations. Simply looking at how much cash a company hasdoesnot provide enough nformation. Using ratios often provides additional nsights.A fi-nancial ratio is a comparisonof different amountson the financial statements.Several a-tios measure he short-term iquidity of a company.The most common s the current ratio,which accountantscompute by dividing the total amount of current assetsby the totalamount of current iabilities. The ratio gives nformation about a company'sability to fundits currentoperations n the short run.Using the currentratio, investorscan compare he liquidity of one company o thatof other companiesof different ypesand sizes.Recall that iquidity is a measure f howeasily a companycan turn its current assetsnto cash o pay its debtsas hey come due.This information would be important to a supplier considering extending credit to acompany. The current ratio also provides information about the liquidity of a companyover time.

Look at thebalancesheet or Home Depot n Exhibit 2.9. The current atio atJanuary29,2006, was

$15,346mill ion+ $12,901mill ion : 1.19The current assetsat January 30,2005, totaled $14,273million, and the current liabilitieswere $10,455million. So the current ratio at January30, 2005, was

$14,273mill ion+ $10,455mill ion : 1.37Another way to think about he current ratio is to say hat Home Depot had, at January

30, 2005,$1.37of cunentassetswith which to pay off each$1.00of its current iabilities.Can you seewhy companiesoften strive to have a current ratio of 1 or greater?That wouldmean a firm has enoughcurrent assets o pay off its current liabilities. When using ratioanalysis, t is often nteresting o comparea firm's ratios o thoseof a competitor n the sameindustry.Lowe's, for example,had a current atio of 7.34at February3,2006, ar,d1.22atJanuary28,2005.The firm's current atio has ncreased lightly while Home Depot'shasdecreased.However, or both companies, he currentratio hasbeen above1 for thepast woyears.

Looking at the current ratio for two consecutiveyears gives some nformation aboutHome.Depot or Lowe's, but you would need much more information to reach any conclu-sions.As you learn more about financial statements, ou will learn additional ratios andseveralways to analyzea company'sfinancial statements.You might be surprised o know that some irms actually try to keep heir currentratiobelow I.If a firm generates greatdeal of cash, t may know that it will generate ufficientcashto pay its current liabilities as they come due. Darden Restaurants,owners of OliveGarden,Red Lobster,and SmokeyBones,had a current atio of 0.39 at May 29,2005.Here's what Darden's managementhad to say about the current ratio in the firm's annualreport:

Cash flows generated from operating activities provide us with a significantsourceof liquidity, which we use o finance he purchases f land, buildings andequipmentand to repurchase haresof our common stock. Since substantiallyall our salesare for cash and cash equivalentsand accountspayable are gener-ally due in five to 30 days, we are able to carry current liabilities in excess ofculTentassets.

Businessisk,Control, ndEthicsNow that we havediscussed he generalcharacteristicsof accounting nformation and theinformation shownon the four basic financial statements,we will take a look at how com-paniesmake sure he information in those statementss reliable.

Current atio sa l iquidityratio hat measures f i rm'sabil i ty o meet ts short- termobligations.

r".t)"6ldentify he risks ndpotential raudsrelated of inancia l ccountingrecords, nd explain hecontrolsneeded o ensuretheir accuracy.


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CHAPTER . BUSINESS ISK.lnternalControls-Definitionand ObjectivesInternal controls are he policies and procedures he managersof a hrm use o protect thef,rrm'sassets nd to ensure he accuracyand reliability of the firm's accounting ecords. n-ternal controls a"re company's rules to help it keep ts assetssafe and to make sure ts fi-nancial recordsare accurate.By adhering o those ules, a firm minimizes the risks of beingin business.These ules are called internal controls because hey areput in place and con-trolled within the company.Controls mposed rom outside he firm-laws and regulations,for example-are not internal controls because hey arenot rules that originated within thecompany.SpecialnternalControl ssues elatedo Financ ial tatementsAccountantsare particularly concernedwith the financial statements.Whether you are n-volved in preparingthem or using them to make decisions,you must have confrdence hatthe information in them is accurateand reliable. When you seecash on a company'sbal-ance sheet,you should be confrdent his is actually the amountof cash he company had onthe balancesheetdate. The salesshown on the income statementshould be sales hat havebeen completed-goods delivered o the customers.Inaccurate nformation createsenormousproblems.The SEChas been especiallycon-cerned with the information contained n financial statements.For example, recently theSEC filed chargesagainstComputron or improperly recordingmore than $9 million in rev-enue on its financial statementscontained n its reports to the SEC. Improperly recordedrevenuewas he focus of a recent SEC nvestigationof the Mexican unit of Xerox Corp. Xe-rox officials in Mexico failed to setup appropriateallowances or bad debts and mproperlyclassified sales, eases,and rentals,violating GAAP. The causescited were (1) failure (ofthe Mexican executives) o adhere o Xerox's corporatepolicies and procedures,and (2) in-adequate nternal controls.Exhibit 2.20 summarizes hree types of controls a company can use to minimize therisk oferrors in the accounting system:preventivecontrols, detectivecontrols, and correc-tive controls.Preventive Controls. These ypes of controlshelp preventerrors n an accountingsys-tem. When you order something rom Amazon.com, he companygives you more than onechance o review and confirm your order. The computer program is designed o automati-cally insert heprice of each tem you order.Theseare controls hat Amazon hasput in placeto help preventerrors from entering ts accounting system.

CONTROL, ND ETHICS

Internalcontrols are acompany's ol icies ndprocedureso protect theassets f the firm and toensure he accuracy ndreliabi l i ty f the accountingrecords.

75

EXHIBIT2.20Types f InternalControlsA company'saccountinginformation system consistsofthree major types of controls:ones hat preventenors, onesthat detect errors, and ones hatcorTectelTors.

ControlsI Fix the errors!1l

Example of a control:Use passwords so that onlyauthorized users can enterdata in the accountingsystem.

Example of a control:Reconcile the companybank statement each monthwith the accounting records.

Example ofa control:Have the companyaccounta.nt reviewthe accounting recordsand make correctionsat the end of each month.


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IIII


'hewsf&sACA previouslynown sComputer ssociatesnternationalnc.) as eenn he newsfor severalears. recent evelopmentas ormerCEO anjay umar'suilty leaorfraudandobstructionf usticen 2006.Unfortunatelyor CA, here smore.New i-nancial ccountingoes, ccordingo IAeWall Streetournol(June, 2006), re heresult f "holesn nternalontrols."he irmsaccountingystemllegedlyl lowedmult ipleeopleo geta commissionroma singleale.

Detective Controls. Detectivecontrols are those hat help a company ind errors. For ex-ample, at the end of every work day, a cashierat Targetwill count the money,ATM receipts,and credit card receipts n his or her drawer and compare he total to the total salesenteredin the computer.This control will help Target ind errors n its salesand receipts.Once theerrors are found, they must be corrected.Corrective Controls. Correctivecontrols arepolicies and procedures hat correct any er-rors that have been discovered.Tiarget as a policy for handling cash shortages-perhapsthe cashiermust make up any shortage.

As you learn more about accounting,you will see examples of preventive,detective,and correctivecontrols. Keep n mind that to be effective,a systemof internal control mustrely on the peoplewho perform the duties assigned o them. An internal control system sonly as effective as he people who execute t. Human error, collusion-two or more peo-ple working together o circumvent a policy or procedure-and changing conditions can allweaken a systemof internal control.

Chapter ummary ointsTo make the financial statementsuseful, we need to understand he rules and thechoicesused o construct hem.These ules are called Generally Accepted AccountingPrinciples (GAAP).Accounting according o GAAP is accrualbased.That means hat revenuesare recog-nized when they are earned,not when the cash s collected. Costs are matched o rev-enuesso that they are recognized-put on the income statementas expenses-at thesame ime as he revenues hey helped generate.Accrual accountingconsistsof two types of transactions-accruals and deferrals-inwhich the exchangeof cash akesplace at a different time than the exchangeof goodsor servlces.With accruals, he action takes place before the exchange of cash. An example is acredit sale.The sale s recorded,but the cashwill be collected ater. Remember,accruemeans o "build up." When Tom's Wear makes a sale on account, he company buildsup sales,even hough the cashhas not been collectedyet.With deferrals, he dollars areexchangedbefore he action occurs.An example s pay-ing for something n advance.When Tom's Wearpaid for the nsurance n advance, hatwas a deferral. Remember,defer means o "postpone." When Tom's Wear purchasesinsurance n advance,prepaid nsurance, he companypostpones ecognition ofthe ex-pense.The action, n this case, s thepassingof the time to which the nsuranceapplies.Adjustments are made before financial statements reprepared.The amounts ecordedthroughout the year may need o be adjusted o make sure hey accurately eflect theassets,iabilities, shareholders'equity, evenues,and expenses n the date ofthe state-ments. How we actually adjust the amounts o correctly reflect the financial positionof a company dependson how we keep track of our business ransactions.


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CHAPTER . CHAPTER UMMARYPROBLEMS 77

Chapter ummary roblemsThe following transactions ook placeduring the first year of business or SW2 Company.(Dollars given are n millions. Use the numbers asshown, but make a note on your state-ments that the dollars are n millions.) The firm's year end is June30.

1. Issued SW2 stock (receivedcontributionsfrom owners) n the amount of $2502. Borrowed $850 from a local bank with a 6-yearnote (ignore interest expense)3. Purchased and for 5650 cash4. Paid$25 for operatingexpenses5. Purchased ew equipment or cashof $3006. Collected $800 from customers or servicesprovided7. Paid sala

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Financial Accounting 02