Finance: Chapter 1


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Finance: Chapter 1

  1. 1. Chapter 1 Introduction to Corporate Financial Accounting INTRODUCTION Modern market economies are driven by hundreds of millions of daily decisions by individuals and businesses—from whether to buy a soft drink in a can or plastic bottle to whether or not to merge multi-billion-dollar corporations. All such decisions hinge on weighing the future consequences of choosing one alternative over the others in any given decision situation. When comparing the soft drink in a bottle to the same drink in a can, we consider which will bring us the most (immediate) future consumption satisfaction for the price. In weighing a merger decision, the parties consider the future wealth-making prospects with or without the merger. In any case, it is the future consequences of the alternatives that drive economic decisions. When it comes to making decisions about whole businesses, for example, whether to buy or sell stock in a business or whether to lend it money, projections of future consequences can be complex and fraught with considerable risk. However, like almost all such projections into the future, we base projections about businesses in part on past experience. Financial accounting tracks businesses’ financial activities and provides a financial history of a business that serves as a basis for judging its past performance and making projections into the future. It is not the only relevant input into projections of the future consequences of business decisions, but it is a very important building block for useful projections. Financial statements themselves can be intricate and complex. The purpose of this book and accompanying materials is to give you a straightforward introduction to corporate financial statements. This chapter begins the process by giving you an overview of the elements of corporate financial accounting and a description of corporate financial statements. It also starts you on the path of understanding the uses and limitations of financial accounting as a source of information for projections. LEARNING OBJECTIVES 1. Define or describe the basic elements of financial accounting. 2. Apply the financial accounting equation and the double-entry technique to processing business transactions. 3. Describe the four basic financial statements. 4. Analyze the profitability of a business from an owner's perspective. 5. Recognize the limitations of accounting information for decision making. Copyright © 2000, Robert G. May Page 1
  2. 2. LO 1 THE FOUNDATION OF FINANCIAL ACCOUNTING Records similar to those of modern accounting were used in Northern Italy as early as the Middle Ages–at least a century before Columbus discovered America.1 Begun as a means of keeping track of what a merchant owed and what was owed to a merchant, accounting has evolved over several centuries into a more sophisticated way of capturing and transforming data. Its objectives are to report on the financial position and performance of any business and to support the varied management decisions of that business. Generally Accepted Accounting Principles However, since the business world is ever-changing and increasing in complexity each year, authorities, whom the government designates directly or indirectly, continuously adapt accounting to the changing environment. Financial statements that a U.S. business publishes and distributes to outsiders must conform to professional standards called Generally Accepted Accounting Principles (GAAP). Before the mid-1930s, GAAP consisted of relatively few foundation elements, including broad assumptions, concepts, and definitions, that had evolved over several centuries. Much judgment was required to apply GAAP to individual businesses and circumstances. In fact, managers of U.S. firms made most judgments regarding what constituted GAAP and how to conform financial statements with them.2 The Stock Market Crash of 1929 and the ensuing Great Depression, however, uncovered many abuses of management’s' discretion.3 Although the Crash and Depression were not caused by accounting abuses, such abuses apparently were considered contributing factors. In the mid-1930s, the U. S. government passed the Securities Act of 1933 and the Securities Exchange Act of 1934. Both acts gave the newly formed Securities and Exchange Commission (SEC) the authority to set accounting standards for financial statements filed with the SEC, that is, for financial statements of virtually all large, publicly-owned U.S. corporations. Interestingly, the SEC has exercised its authority only indirectly. In 1938, the SEC turned to the accounting profession, represented by the American Institute of Certified Public Accountants (AICPA). The AICPA's Committee on Accounting Procedure (CAP) and later its Accounting Principles Board (APB) set standards for financial statements until 1973. In 1973, the Financial Accounting Standards Board (FASB), a new body and independent of the AICPA, was formed to bring representatives of businesses and users of financial statements, as well as CPAs, directly into the standard-setting process. The CAP issued 51 Accounting Research Bulletins, the APB issued 31 Opinions, and the FASB had issued over 130 Statements of Financial Accounting Standards by the late 1990s.4 As a consequence, Generally Accepted Accounting Principles now include the original foundation elements, those that evolved over centuries, plus an ever-expanding set of authoritative pronouncements on how to apply GAAP to specific situations. 1 A. C. Littleton, Essays on Accountancy (Urbana: University of Illinois Press, 1961), p. 22 Littleton notes the existence of the 500- year old account books of the Florentine merchant, Francesco di Marco, 1358-1412. 2 Companies whose securities were listed on the New York Stock Exchange had to conform to some financial reporting requirements imposed by the Exchange in its listing agreement. 3 A colorful description of some of the pre-Depression abuses of financial reporting in the United States is given in William Z Ripley, Main Street and Wall Street (Lawrence, Kansas: Scholars Book Co., 1972). pp. 162-164. The book was published originally in 1927. 4 CAP and APB standards are still considered authoritative, unless superceded by FASB statements Copyright © 2000, Robert G. May Page 2
  3. 3. Key Financial Accounting Concepts In spite of all the complexities in the business world - and the related complexities in setting accounting standards - a small and cohesive set of concepts, simple equations, definitions, measurement principles, and assumptions form the foundation of GAAP. These foundation elements guide accountants in recording the activities of businesses and in preparing their financial statements. To understand financial accounting, you must begin with the most fundamental of elements. Three key concepts of financial accounting are: the accounting entity, the accounting period, and monetary measurement. These concepts give the accounting process its focus. The Accounting Entity Concept. The accounting entity concept states that the accounting process focuses on specific, separate economic entities. The focus of financial accounting is on specific business entities, separate from other entities, including their owners. For example, if Dr. Jessica Brown purchased a new car for her personal use, she would account for the expenditure as a personal expenditure, not as an expenditure of her medical practice. In the United States, business entities are organized into three basic forms: proprietorships, partnerships, and corporations. A proprietorship is a business owned by an individual. Proprietorships have no legal status apart from their owners; their relationships to other parties (customers, suppliers, employees, etc.) are all interpreted legally as relationships between the owner, as an individual, and the other parties. For example, if the government found that a proprietorship had not paid all of its payroll taxes on time, it would bring legal action against the owner, not the business itself. However, for accounting purposes, the proprietor is a separate entity from the business. For example, the proprietor should keep personal funds separate from business funds. This way, the proprietor would know how much cash is available for business expenses and how much is available for personal spending. Partnerships are businesses conducted by two or more entities acting as co- owners. Like proprietorships, partnerships are not separate, legal entities. The relationships between partnerships and others are interpreted legally as relationships between the partners, individually and collectively, with the other entities. For example, if a customer is injured by a product purchased from a partnership, he or she would sue the partners "jointly and severally" to recover damages for the injury. Nevertheless, for accounting purposes, partnerships are treated as entities that are separate and distinct from the partners. Corporations are business entities that are legally separate from their owners. Corporations are nonpersons; they do not exist naturally. A person may not simply begin a business and call it a corporation; a corporation must be chartered under a state’s corporation statutes. Corporations can have any number of owners (including one) and still be corporations. Since corporations are separate legal entities, no inconsistency exists between their legal status and their treatment as separate business entities in accounting. In this book, we emphasize the corporate form of business organization. The Accounting Period Concept. The accounting period concept states that financial statements or other reports should be prepared at regular intervals such as every month, quarter, or year. Virtually all businesses prepare annual financial statements. Many also prepare statements at more frequent intervals because users of financial statements, particularly managers, need information more frequently to make decisions. Copyright © 2000, Robert G. May Page 3
  4. 4. The Monetary Measurement Concept. An almost infinite variety of information could appear in accounting reports-from the business's physical characteristics and appearance to its personnel to the specific ways it provides services or products to customers. Accounting cuts through the infinite set of possibilities and focuses on the business's financial essentials. A business is a pool of financial resources provided by its owners and creditors (lenders). Accounting focuses on the flow of resources through a business and only measures and reports on those business events, resources, and obligations that can be expressed in money terms. This idea is known as the monetary measurement concept that underlies GAAP. Accounting Equations and Definitions5 Fundamental equations bind the elements of financial accounting together into a logical whole. The definitions of the elements tell us what aspects of a business are actually recognized and measured by the financial accounting process. The Accounting Equation. The accounting equation states that assets equal liabilities plus stockholders' equity and governs the relationship between these three elements. It is expressed as follows: Assets = Liabilities + Stockholders' Equity Assets. Assets are future economic benefits a business owns or controls. In a word, an asset is a resource of the business. Assets include anything that can be used for the business's benefit or any right to receive benefits. Examples of assets are cash, accounts receivable, land, buildings, and equipment. Accounts receivable are payments due from customers for products or services previously provided on a credit basis. An account receivable is an asset because it represents a right to receive a future payment. Liabilities. Liabilities are the business's debts and other obligations to transfer cash, other assets, or services to other entities at some time in the future. Debts to lenders are liabilities because they require payment of specific, future amounts to repay and erase the debts. Accounts payable, amounts owed to suppliers for goods purchased on credit (charged), are also liabilities. Stockholders' equity. The stockholders' equity of a corporation is the residual interest owners have in the business's assets after deducting its liabilities. Both creditors and owners supply the funds to buy assets. According to the accounting equation, the total assets of a business are matched by the combined claims of the owners and creditors. However, the claims of creditors come before the claims of owners. For example, if a business is liquidated (say, in bankruptcy proceedings), the creditors' claims must be paid in full before the owners can receive any of the business's assets. Therefore, stockholders' equity is a residual amount. It equals the net assets of the business, or the difference between the assets and the liabilities. Stockholders' Equity = Net Assets = Assets - Liabilities 5 To avoid unnecessary abstraction, definitions in this section are not direct quotes from Statement on Financial Accounting Concepts, No. 6, “Elements of Financial Statements of Business Enterprises,” (Stamford, Connecticut: FASB 1985)), but are based on the FASB definitions. Copyright © 2000, Robert G. May Page 4
  5. 5. Stockholders' equity changes when the owners make investments in or receive dividends from the business. When owners contribute cash or other assets to the business, we call the contributions investments. Owners of a corporation make investments in the business by purchasing shares of stock. For this reason, the owners of a corporation are called stockholders. Investments increase stockholders' equity because they increase assets without increasing liabilities. When a corporation gives cash or other assets to the owners (except in liquidation), we call the assets given dividends. Dividends decrease stockholders' equity because they decrease assets without decreasing liabilities. In addition, stockholders' equity is increased by revenues and decreased by expenses as defined below. Stockholders' equity has two components. Capital stock is the amount of the investments in the business that stockholders make. Retained earnings is the cumulative amount of net income (defined below) less dividends paid to the stockholders since the corporation began operations. The assets, liabilities, and stockholders' equity of a corporation make up its financial position. The financial position of a business is communicated in the balance sheet (formally known as a statement of financial position). The balance sheet takes its name from the accounting equation, which guarantees that assets will be balanced exactly by liabilities and stockholders' equity. We present a balance sheet later in the chapter as one of the outputs of the financial accounting process. The Income Equation. Net income is defined by a very important equation in accounting: Revenues - Expenses = Net Income Revenues. Revenues are the increases in net assets (stockholders' equity) that result directly from providing products or services to customers during a specific period. In most cases, the assets received for providing products or services to customers are cash or the rights to receive cash in the future (accounts receivable). Thus, for example, when you buy clothing from a department store, the amount of the sale is revenue to the store, regardless of whether you pay cash or charge your purchase. Expenses. Expenses are decreases in net assets (stockholders' equity) caused by the revenue-producing activities during a specific period. Examples of expenses are employees' wages, supplies, utilities, and rent. Many expenses represent decreases in cash. However, not all expenses are direct decreases in cash. For example, wages earned by employees during a period but not yet paid as of the end of the period are an obligation to pay. The increase in the liability, called salaries and wages payable, is an expense of the period in which the wages are earned. The revenues, expenses, and net income of a business are communicated in the income statement. The income statement follows the income equation–expenses are subtracted from revenues to derive net income. We present an income statement later in the chapter. Copyright © 2000, Robert G. May Page 5
  6. 6. Measurement Principles Several measurement principles have evolved over many years of financial accounting practice. The most pervasive is the cost principle, which guides us in deciding the values to assign to assets, liabilities, revenues, and expenses. We introduce additional measurement principles in later chapters. According to the cost principle, the amounts of assets recorded in the accounting records should be the amounts paid (or promised to be paid) for them when acquired. Also, the amounts of liabilities recorded should be the amounts of assets received when the liabilities are incurred. Suppose, for example, that a convenience store such as 7- Eleven purchases a piece of land for a new store site at a cost of $100,000. For accounting purposes, the value of the land is $100,000, which is also the "fair value" of the land at the date it is acquired. That is, the business presumably paid no more or less than necessary to acquire it. The land may increase in fair value over time, and while its later fair value will be a matter of opinion, its cost remains unchanged and is more objective. Because various users of financial statements such as owners and creditors have different interests in a business, objectivity is an important criterion for accounting information. Thus, the cost principle is often favored over alternatives such as "fair value." LO 2 TRANSACTION ANALYSIS USING THE ACCOUNTING EQUATION The financial accounting process consists of capturing transaction data, recording transactions, summarizing their effects on financial position, and, ultimately, transforming their effects into financial statements. Transactions consist of purchases, sales, and other exchanges that change the business's financial position. When a business purchases a piece of equipment, its financial position changes–equipment increases and cash decreases. When a business borrows money, its financial position changes–cash increases and a liability increases. Maintaining the Equality Condition Since transactions change the business's financial position, they are subject to the accounting equation, which defines the relationship between the elements of financial position. Therefore, transactions are recorded according to the equation, and the equation holds both before and after each transaction is recorded. Before a business comes into being, its financial position consists of all zeros: Assets = Liabilities + Stockholders' Equity 0 = 0 + 0 Since the accounting equation is satisfied by the all-zero beginning position, we know that the business's future financial positions will satisfy the equality condition if, and only if, all of the changes recognized from this point meet the equality condition. Thus, the rule for recording transactions is: Each change in an element of the accounting equation must be matched by at least one change that has an equal, but opposite, effect. Hence, the rule is often called the double-entry rule, and financial accounting is often referred to as double-entry accounting. Copyright © 2000, Robert G. May Page 6
  7. 7. Suppose, for example, that a house painter buys a paint sprayer for $1,250 on credit. To record the transaction, the asset, equipment, is increased by $1,250; and the liability, accounts payable, is increased by $1,250. The change in assets equals the change in liabilities with no change in stockholders' equity., thus, the equation is satisfied. Assets = Liabilities + Stockholders' Equity +$1,250 = +$1,250 + 0 Processing Transactions Now, let us address PhotoCopy, Inc. Photocopy Inc. is a new corporation started at the beginning of January 20X1 by college friends, Judy, Shannon and Paul. They need to prepare financial statements for the month of January 20X1, both for their own information and possibly to convince a bank to loan them money for expansion of the business. The business had no assets, no liabilities, and no stockholders' equity just before the co-founders make their initial investment. Assets = Liabilities + Stockholders' Equity 1/1/X1 0 = 0 + 0 We now apply the double-entry rule to the transactions and events that took place during January 20X1. Transaction 1–Owners' Investments. On January 2, 20X1, the three co-founders invested $2,000 each of their own money in the new business, PhotoCopy, Inc. They opened a separate checking account for the business at the bank and deposited their personal checks in the company's account. These investments immediately give life to the business by endowing it with an asset, cash. The corresponding change is an increase in stockholders' equity. Stockholders' Transaction Cash = Equity 1/1/X1 0 = 0 (1) 6,000 = 6,000 Investment New Bal. 6,000 = 6,000 The equality condition is satisfied by this change in the business's financial position. The new financial position consists of $6,000 cash and $6,000 stockholders' equity. Transaction 2–Rental of Building Space and Copying Equipment. On January 2, 20X1, PhotoCopy completed the rental of building space and copying equipment from Asset Management Co. The rental agreement is for 12 months from the beginning of January, and PhotoCopy paid the rent for January in the amount of $1,000. This transaction decreased an asset, cash, due to the business's revenue-producing activities-in other words, an expense. Therefore, it is recognized with a decrease to cash and an equal decrease to stockholders' equity. Copyright © 2000, Robert G. May Page 7
  8. 8. Stockholders' Transaction Cash = Equity Prev. Bal. 6,000 = 6,000 (2) (1,000) = (1,000) Rent Expense New Bal. 5,000 = 5,000 Notice the result of processing every change so that it satisfies the double-entry rule. The equality condition is met by the new financial position each time. After Transaction 2, the asset cash is $5,000 and stockholders' equity is $5,000. Transaction 3–Purchase of Copying Supplies for Cash. PhotoCopy purchased $800 of copying supplies, paper and toner, for cash. These supplies are an expense because they are used in the business's revenue-producing activities during January. This transaction decreased cash and decreased stockholders' equity by $800. Stockholders' Transaction Cash = Equity Prev. Bal. 5,000 = 5,000 (3) (800) = (800) Copy Supply Expense New Bal. 4,200 = 4,200 Expense Transaction 4–Revenues Received in Cash. During January, PhotoCopy earned $4,000 in cash revenues from customers for copying services. These transactions increase cash and increase stockholders' equity by the amount of revenues earned. Stockholders' Transaction Cash = Equity Prev. Bal. 4,200 = 4,200 (4) 4,000 = 4,000 Revenues New Bal. 8,200 = 8,200 Transaction 5–Salaries Expense. The three owners of PhotoCopy manage the business and perform copying services for customers. They agreed to pay themselves salaries of $1,000 each per month for the services they provide. On January 20, they wrote themselves checks from the PhotoCopy's checking account for January salaries. When owners of a corporation are paid for services performed for the business, these payments are not classified as dividends. This is a decrease in the asset, cash, due to an expense of the business. Therefore, it is recognized with a decrease to cash and an equal decrease to stockholders' equity for salaries expense. Stockholders' Transaction Cash = Equity Prev. Bal. 8,200 = 8,200 (5) (3,000) = (3,000) Salaries Exp. New Bal. 5,200 = 5,200 Copyright © 2000, Robert G. May Page 8
  9. 9. Transaction 6–Uncollected Revenues. On January 25, PhotoCopy received and produced an order for 2,000 student orientation handouts from the College of Liberal Arts and Sciences at the University. The price agreed to for the handouts is $1,000. The College agreed to pay by February 15. We record the revenues for January, because they were earned in January and the right to receive payment in February is an asset as of January 31. To record the revenues earned, we increase a new asset, accounts receivable, and increase stockholders' equity by $1,000. Accounts Stockholders' Transaction Cash + Receivable = Equity Prev. Bal. 5,200 + = 5,200 (6) + 1,000 = 1,000 Revenue New Bal. 5,200 + 1,000 = 6,200 Transaction 7–Advertising Expense. During January, PhotoCopy ran the following ad daily in the campus newspaper: NOW OPEN-PhotoCopy, Inc., 1503 University Avenue. Open 8:00 a.m. to 10:00 p.m. daily. We provide all copying services, both black and white and color. Binding available. Convenient to dorms, apartment complexes, and all of main campus. The bill for $100 is due February 15. This transaction results in a decrease in stockholders' equity for advertising expense and an increase in the liability, accounts payable. Accounts Accounts Stockholders' Transaction Cash + Receivable = Payable + Equity Prev. Bal. 5,200 + 1,000 = + 6,200 (7) + = 100 + (100) Advertising Expense New Bal. 5,200 + 1,000 = 100 + 6,100 Transaction 8–Purchase of Office Equipment. On January 31, PhotoCopy purchased a computer system for $1,200 cash. PhotoCopy purchased the computer system to use in keeping the company's records. The computer system is an asset of the company. We record the transaction by increasing a new asset, office equipment, and decreasing the asset cash. Accounts Office Accounts Stockholders' Transaction Cash + Receivable + Equipment = Payable + Equity Prev. Bal. 5,200 + 1,000 + = 100 + 6,100 (8) (1,200) + + 1,200 = + Off. Equip. Purch. New Bal. 4,000 + 1,000 + 1,200 = 100 + 6,100 Illustration 1-1 summarizes all of the transactions of PhotoCopy, Inc., for January 20X1. It starts with a hypothetical financial position that satisfies the equality condition with all zeros as of January 1, 20X1. Each transaction of January is processed to satisfy the equality condition (double entry). Copyright © 2000, Robert G. May Page 9
  10. 10. Illustration 1-1 Accounting History of PhotoCopy Inc.—January 20X1 STOCKHOLDERS’ ASSETS = LIABILITIES + EQUITY Accounts Office Accounts Stockholders’ Transaction Cash + Receivable + Equipment = Payable + Equity 1/1/X1 0 + 0 + 0 = 0 + 0 (1) 6,000 + + = + 6,000 (2) (1,000) + + = + (1,000) (3) (800) + + = + (800) (4) 4,000 + + = + 4,000 (5) (3,000) + + = + (3,000) (6) + 1,000 + = + 1,000 (7) + + = 100 + (100) (8) (1,200) + + 1,200 = + 1/31/X1 4,000 + 1,000 + 1,200 = 100 + 6,100 │ │ 6,200 = 6,200 After the last transaction of January, we draw a line. Down each column of PhotoCopy's accounting equation, we sum the beginning balance and the effects, if any, of Transactions 1 through 8. The results shown below the line are the balances in the equation elements as of January 31, 20X1. Below the balances, note that the sum of the assets ($6,200) does indeed equal the sum of the liability ($100) and stockholders' equity ($6,100). LO 3 BASIC FINANCIAL STATEMENTS The four basic financial statements–income statement, retained earnings statement, statement of cash flows, and balance sheet–can be prepared directly from the transaction analysis summary in Illustration 1-1. Income Statement The income statement displays the business's revenues, expenses, and net income for a specific time period. Transactions 2-7 represent revenues and expenses of PhotoCopy, Inc. for January 20X1. They are increases and decreases, respectively, in the Stockholders' Equity column of Illustration 1-1. To prepare the income statement of PhotoCopy, Inc. for January 20X1, we format the revenues and expenses from the Stockholders' Equity column of Illustration 1-1 into the statement shown in Illustration 1-2. The income statement lists revenues first, followed by expenses, which are summed and subtracted from revenues to derive net income. Copyright © 2000, Robert G. May Page 10
  11. 11. Illustration 1-2 Income Statement PhotoCopy, Inc. Income Statement For the Month Ended January 31, 20X1 Revenues: $ 5,000 Expenses: Advertising expense $ 100 Copying Supplies Expense 800 Rent expense 1,000 Wages and Salaries expense 3,000 Total expenses 4,900 Net Income $ 100 We label every financial statement with a heading that gives three items of information: the name of the business, the type of statement, and either the date for which it was prepared or the period it covers. Notice that the heading on the income statement in Illustration 1-2 indicates that it covers the month of January 20X1. This label is appropriate because an income statement reports about events that happened during a period. The Retained Earnings Statement Illustration 1-3 shows the retained earnings statement. The retained earnings statement reflects the effects on the business of net income and dividends for a period of time. Earlier we said that revenues increase stockholders' equity and dividends and expenses decrease stockholders' equity. These changes affect stockholders' equity through the retained earnings component of stockholders' equity as distinct from the capital stock component. The retained earnings statement reflects these changes. It can be prepared from the detail of the Stockholders' Equity column of Illustration 1-1, except that it is customary to offset revenues and expenses and show net income as a single change in retained earnings. Thus, we add net income of $100 to the beginning balance of zero. For January, PhotoCopy did not distribute dividends to the stockholders. If PhotoCopy had distributed dividends to the stockholders, we would next subtract them to arrive at the net change in retained earnings for the period. Illustration 1-3 Retained Earnings PhotoCopy, Inc. Retained Earnings Statement For the Month Ended January 31, 20X1 Retained earnings, January 1, 20X1 $ 0 Add: Net Income for January 20X1 100 Retained earnings, January 31, 20X1 $100 Copyright © 2000, Robert G. May Page 11
  12. 12. Statement of Cash Flows A statement of cash flows explains the change in the business's cash balance for the period by presenting the increases and decreases in cash due to the company's operating, investing, and financing activities. The definitions of these activities, the techniques for preparing the statement, and the perceived usefulness of the statement are subjects of a later chapter. However, the statement for PhotoCopy, Inc. for January 20X1 appears in Illustration 1-4. While you may not know how to format such a statement at this time, you can trace all figures in it to the Cash column of Illustration 1-1. Illustration 1-4 Statement of Cash flows PhotoCopy Inc. Statement of Cash Flows For the Month Ended January 31, 20X1 Operating Activities: Cash collections for copying services $4,000 Expenditure for rent (1,000) Expenditure for copying supplies (800) Expenditures for salaries (3,000) Cash provided by operations $ (800) Investing activities: Purchase of office equipment (1,200) Financing activities Owners’ Investments 6,000 Net increase in cash $4,000 Balance Sheet The balance sheet presents a business's financial position as of a specific date. A balance sheet is like a snapshot, presenting a picture of the business's financial position at an instant in time. In this case, the point in time is January 31, 20X1. Illustration 1-5 contains PhotoCopy, Inc.'s balance sheet as of January 31, 20X1. To prepare the balance sheet in Illustration 1-5, we format the January 31, 20X1, balances at the bottom of the transaction analysis worksheet in Illustration 1-1. The cash balance of $4,000 from Illustration 1-1 is the cash figure in Illustration 1-5; and the accounts receivable balance from Illustration 1-1 is the accounts receivable balance in Illustration 1-5. Likewise, the office equipment, accounts payable, and stockholders' equity figures in Illustration 1-5 are all from the bottom line of Illustration 1-1. Copyright © 2000, Robert G. May Page 12
  13. 13. Illustration 1-5 Balance Sheet PhotoCopy, Inc. Balance Sheet January 31, 20X1 Assets Cash $4,000 Accounts Receivable 1,000 Office Equipment 1,200 Total Assets 6,200 Liabilities: and Stockholders’ Equity Accounts Payable $ 100 Stockholders’ equity 6,100 Total liabilities and stockholders’ equity $6,200 LO 4 INTERPRETATION OF FINANCIAL STATEMENTS What can be learned from the financial statements that represent PhotoCopy, Inc. for January? First, the business's cash position improved from a zero balance at the beginning of January to a balance of $4,000 at the end of January. Second, the balance sheet shows that the business's total assets equal $6,200 at the end of January and its stockholders' equity equals $6,100. Third, seemingly the business was profitable. It earned $100 in net income in one month with an original investment of $6,000. But just how profitable is this? Profitability from the Owners' Perspective-Rate of Return To judge profitability, we like to use a relative measure–one that can be compared to alternative uses of the owners' money. One of the important relative measures of profitability is rate of return (ROR) on stockholders' equity: Rate of Return on Stockholders' Equity = Net Income Average Stockholders' Equity By this measure, PhotoCopy's rate of return for January was: $100 = $100 = 1.65% ($6,000 + $6,100) ÷ 2 $6,050 The annual equivalent rate of return is 1.65% x 12 (months) = 19.8%, which is very impressive indeed when compared with the likely interest rate on the savings accounts from which the owners of PhotoCopy withdrew their investment funds. However, it is important to recognize the nature and limitations of the accounting information used in the calculation. PhotoCopy's income for the month of January is unique to this first month of business. For example, January required no maintenance of the copying equipment, whereas future months will surely see some expenditure for maintenance. Copyright © 2000, Robert G. May Page 13
  14. 14. LO 5 LIMITATIONS OF ACCOUNTING INFORMATION AS A BASIS FOR DECISIONS The lesson is that financial accounting information does not provide direct answers for all decisions by itself. It merely tracks the history of a business. To make decisions, a user of financial statements must learn to analyze historical accounting information, understand it in the context of the business, and then use it as a basis for projections into the future. It is the projections of past results into the future (with appropriate modifications for expected changes) that are the foundation for making choices among business alternatives.. For example, PhotoCopy may find that, not only will the maintenance costs of the business be substantial in the future, but that it will also incur additional costs such as the wages of employees hired to handle increasing numbers of customers. Thus, the business may face higher wages expenses as well as significant maintenance expenses in the future. Such projected differences from the brief past history of the business should influence: 1. The owners' projections about the business in the future. 2. Whether they choose to expand their business. 3. Whether they choose to start a second location across campus. When they compare the rates of return that they project for the business for these alternatives to the rate on, say, a savings account, they should also consider the risk of their expanded business relative to the safety of a savings account. SUMMARY Define or describe the basic elements of financial accounting. Financial accounting is built on concepts of the accounting entity, the accounting period, and monetary measurement; on definitions of assets, liabilities, stockholders' equity, revenues, and expenses; on the cost principle; and on two central equations: Assets = Liabilities + Stockholders' Equity Revenues - Expenses = Net Income Apply the financial accounting equation and the double-entry technique to processing business transactions. Transactions are processed from the business's inception according to the double-entry rule that says for each change in one element of the accounting equation one or more changes must be made in other elements that equal it in total and have the opposite effect. Describe the four basic business financial statements. The four basic financial statements of businesses are the income statement, the retained earnings statement, the statement of cash flows, and the balance sheet (statement of financial position). Analyze the profitability of a business from an owner's perspective. Owners wish to know whether a business is relatively as profitable as other alternatives that they may have for investing funds. The rate of return on stockholders' equity (net income ÷ average stockholders' equity) for a period is a relevant measure of profitability. Copyright © 2000, Robert G. May Page 14
  15. 15. Recognize the limitations of accounting information for decision making. Accounting information tracks the history of a business. As such, it does not provide answers to business decision problems directly. Rather, accounting information provides a basis for the projections of future consequences of decisions necessary to decide about which courses of action to take. REVIEW PROBLEM John Crown, the owner of Crown’s Dental Clinic, Inc. started his practice after graduating from dental school on July 1, 20X1. At that time, the practice had no assets, liabilities, or stockholders’ equity. The transactions for the month are given below: July 1 John Crown invested $28,000 of his own money in Crown’s Dental Clinic by purchasing capital stock in the corporation. 3 John paid $800 for July’s office rent. 5 John rented used dental equipment and paid $400 for July. 31 John billed his patients $5,200 during July. $4,000 of fees were received in cash at the time that the services were performed, and the remaining $1,200 was still owed by patients at July 31. 31 John was billed $1,100 for utilities. 31 John paid wages of $1,400 to himself, the receptionist and the hygienist. 31 John purchased $1,200 of used dental equipment, signing a note payable for the amount. 31 Crown’s Dental Clinic, Inc. paid John a $1,000 cash dividend. REQUIRED: a. Determine the effect of each transaction on the accounting equation for Crown’s Dental Clinic, Inc. and total each part of the equation for July. b. Prepare the Income statement for the month of July. c. Prepare a retained earnings statement for the month of July. d. Prepare a balance sheet as of July 31. SOLUTION: Planning and Organizing Your Work 1. Analyze each transaction 2. Enter the effect of each transaction in the appropriate columns of the accounting equation following the double entry rule 3. Total each column. 4. Verify that the equation is in balance. 5. Select the items to include on the income statement. 6. Prepare the income statement. 7. Select the items to include on the retained earnings statement. 8. Prepare the retained earnings statement. 9. Select the items to include on the balance sheet. 10. Prepare the balance sheet. Copyright © 2000, Robert G. May Page 15
  16. 16. (a) Determine the effect of each transaction. Accounts Accounts Notes Stockholders' Transaction Cash + Receivable + Equipment = Payable + Payable + Equity 1. 28,000 28,000 Investment 2. (800) (800) Rent exp. 3. (400) (400) Rent exp. 4. 4,000 1,200 5,200 Revenue 5. 1,100 (1,100) Utilities exp. 6. (1,400) (1,400) Wages and salaries exp. 7. 1,200 1,200 Notes payable 8. (1,000) (1,000) Dividend 7/31 Total 28,400 + 1,200 + 1,200 = 1,100 + 1,200 + 28,500 (b) Prepare the Income statement for the month of July. Crown’s Dental Clinic, Inc. Income Statement For the Year Ended July 31, 20X1 Fee revenue: $5,200 Expenses: Rent expense office $ 800 Rent expense, equipment 400 Utilities expense 1,100 Wages and salaries expense 1,400 Total expenses 3,700 Net Income $1,500 (c) Prepare a Retained earnings statement. Crown Dental Clinic, Inc. Retained Earnings Statement For the Year Ended July 31, 20X1 Beginning Balance $ 0 Add: Net Income 1,500 Less: Dividends 1,000 Ending Balance $500 Copyright © 2000, Robert G. May Page 16
  17. 17. (d) Prepare a balance sheet. Crown Dental Clinic, Inc. Balance Sheet July 31, 20X1 Assets Cash $28,400 Accounts Receivable 1,200 Equipment 1,200 Total assets 30,800 Liabilities: and Stockholders’ Equity Accounts Payable $ 1,100 Notes Payable 1,200 Capital stock 28,000 Retained earnings 500 Total liabilities and stockholders’ equity $30,800 KEY TERMS accounting period double-entry rule rate of return on stockholders’ equity accounting equation expenses retained earnings accounting period concept financial position retained earnings statement accounts payable Generally Accepted Accounting revenues accounts receivable Principles statement of cash flows assets income statement statement of financial position balance sheet investments stockholders capital stock liabilities stockholders’ equity corporations monetary measurement transactions cost principle net income withdrawals distributions partnerships dividends proprietorships SELF-QUIZ a. Income Statement b. Statement of cash flows LO 1 1. Which accounting concept requires accountants to c. Liability statement separate the owners from their business entities? d. Retained Earnings Statement a. Individual concept LO 2 5. What items in the accounting equation (assets, liabilities, b. Accounting period concept stockholders’ equity) are increased or decreased as a c. Monetary concept result of an owner investing $15,000 cash in the d. Accounting entity concept business? LO 1 2. Which accounting relationship is incorrect? LO 2 6. What items in the accounting equation are increased or a a. Assets = Liabilities + Stockholders’ equity decreased as a result of paying wages of $1,500? b. Net Income – Expenses = Revenue LO 2 7. What items in the accounting equation are increased or c. Net Assets = Assets – Liabilities decreased as a result of receiving $9,000 cash for d. Stockholders’ Equity = Assets - Liabilities services performed? LO 1 3. Which type of business entities are legally separate from LO 2 8. What items in the accounting equation are increased or their owners? decreased as a result of a corporation paying its a. Corporations stockholders’ a dividend of $3,900? b. Proprietorships LO 4 9. How is the rate of return on stockholders’ equity c. Partnerships calculated? d. Both b and c a. Dividing cash from operating activities by total LO 3 4. Which of the following is not one of the basic financial assets. statements of a business? Copyright © 2000, Robert G. May Page 17
  18. 18. b. Dividing net income by 2 and adding a. Presents revenues and expenses stockholders’ equity b. Presents cumulative amount of net income less dividends c. Dividing net income by average stockholders’ c. Presents assets, liabilities, and stockholders’ equity equity. d. Presents operating investing and financing cash flows. d. Dividing net income by average assets LO 1 13. Match the definitions with the different types of LO 5 10. True or False? A decision maker can rely solely on business entities. accounting information to make a decision. ___ Partnership ___ Proprietorship ___ Corporation LO 1 11. Match the definitions with these terms that appear on a. A business legally separated from its owners. the income statement. b. A business not legally separated from its several owners ___ Revenues ___ Net Income ___ Expenses c. A business not legally separate from the single owner a. Decrease in net assets caused by generating revenues LO 1 14. The balance sheet is also known as the ______ of b. Increases in net assets from providing goods or services to ______ ______. customers LO 1 15. The _____ _____ is the only basic statement prepared c. Revenues minus expenses. as of a specific time instead for a period of time. LO 1 12. Match these definitions with the different financial LO 1 16. Distributions of proprietorships are called _____, statements. whereas distributions of corporations are called _____. ___Balance Sheet ___Retained Earnings LO 2 17. The __________ rule states that at least two elements ___Statement of cash flows ___Income Statement of the accounting equation must be increased for each transaction. SOLUTIONS TO SELF-QUIZ 1. d 2. b 3. a 4. c 5. assets increase, stockholders’ equity increases 6. assets decrease; stockholders’ equity decreases 7. assets increase,; stockholders’ equity increases 8. assets decrease; stockholders’ equity decreases 9. c 10. False 11. revenues = b; net income = c; expenses = a 12. Balance sheet = c; retained earnings = b; statement of cash flows = a 13. partnership = b; proprietorship = c; corporation; corporation = a 14. statement of financial position 15. balance sheet 16. withdrawals, dividends 17. double-entry Copyright © 2000, Robert G. May Page 18