Accounting Clinic I

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

With contributions by
Stephen H. Penman Columbia University

Clinic I-2

Introduction
Accounting clinic I contains the following:
A brief review of the four financial
statements
Examples of how each financial statement
is prepared
A summary of the principles of
measurement in financial statement

Clinic I-3

The Financial Statements

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders Equity
Clinic I-4

The Balance
Sheet: Dell Inc.

Clinic I-5

The balance sheet reports the assets of the

firm at a point in time and the claims
against those resources. The claims are
broken up into liabilities and shareholders
equity.

Clinic I-6

The Form of the Balance Sheet

Assets = Liabilities + Shareholders Equity
or
Shareholders Equity = Assets Liabilities
Assets are economic resources that produce
future earnings.
Liabilities are obligations to transfer assets or
provide services to parties other than the owners.
Equity is the owners' residual interest in the
assets of an entity that remains after deducting
the liabilities.
Clinic I-7

Example - Balance Sheet Preparation

Presented below are selected accounts of Biking Corporation at
December 31, 2008:
Patent
Interest payable
Bonds payable
Common stock, $5 par value
Preferred stock, $10 par value
Prepaid insurance
Accounts payable
Trading securities
Land
Accounts receivable
Rent payable
Retained earnings

$150,000
30,000
450,000
400,000
150,000
89,000
283,000
117,000
520,000
143,000
45,000
?

Income taxes payable

Notes payable (short-term)
Equipment
Discount on bonds payable
Refundable federal and state income taxes
Accumulated depreciation equipment
Inventory
Cash
Accumulated depreciation building
Long-term loan from bank
Building

$93,000
264,000
950,000
25,000
97,630
232,000
242,000
360,000
450,000
640,000
1,200,000

Required:
Prepare a classified balance sheet.

Clinic I-8

Solution
$
360,000
117,000
143,000
242,000
89,000
951,000

Current assets
Cash
Trading securities
Accounts receivable
Inventory
Prepaid insurance
Total current assets
Property, plant and equipment
Land
Buildings
Less acc. depreciation
Equipment
Less acc. depreciation
Total Property, plant and equipment
Intangible assets
Patent

Total assets

520,000
1,200,000
(450,000)
950,000
(232,000)

750,000
718,000
1,988,000

150,000

3,089,000

$
283,000
264,000
30,000
93,000
45,000
715,000

Current liabilities
Accounts payable
Notes payable
Interest payable
Income taxes payable
Rent payable
Total current liabilities
Long-term liabilities
Long term loan from bank
Bonds payable
Less discount on bonds payable
Total long term liabilities
Total liabilities

450,000
(25,000)

Stockholders equity
Capital stock
Preferred stock, $10 par;
Common stock, $5 par
Retained earnings
Total stockholders equity

150,000
400,000

Total liabilities and

stockholders equity

640,000
425,000
1,065,000
1,780,000

550,000
759,000

3,089,000

Retained earnings are calculated as a plug number.

Clinic I-9

The balance sheet reports assets and the

claims on those assets at a point in time.
The other three financial statements
summarize the effects of transactions and
economic events occurring between two
balance sheets dates.
The income statement reports revenues less
expenses (earnings) that increase owners'
equity between two balance sheet dates.
Clinic I-10

The Income Statement:

Dell Inc.

Clinic I-11

The Form of the Income Statement

Net Revenue Cost of Goods Sold = Gross Margin
Gross Margin Operating Expenses = Operating Income before Tax
(EBIT)
Operating Income before Tax Interest Expense = Income before Taxes
Income before Taxes Income Taxes = Income after Taxes (and before
Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items = Net Income
Net Income Preferred Dividends = Net Income Available to Common
Clinic I-12

Example - Income Statement Preparation

below are selected ledger accounts of Grant Corporation
at December 31, 2008:
Merchandise Inventory
Office salaries
Sales
Purchases
Insurance expense
Sales commission
Sales returns
Purchase discounts

409,000
282,000
5,000,000
2,548,000
26,000
76,000
42,000
31,000

Accounting and legal services

Shipment-in
Advertising
Depreciation of office
Depreciation of sales equipment
Sales salaries
Extraordinary loss (before tax)
Interest expense

24,000
81,000
108,000
62,000
58,000
257,000
96,000
176,000

A physical inventory indicates that the ending inventory is $547,000.

Assume a tax rate of 35%.
Required:
Prepare a condensed income statement

Clinic I-13

Solution
Net Sales (1)
Cost of goods sold (2)
Gross profit
Selling expense (3)
Administrative expense (4)
Income from operations
Other expense
Income before taxes
Income taxes (35%)
Income before extraordinary item
Extraordinary loss, net of $33,600 taxes
Net income

4,958,000
2,460,000
2,498,000
499,000
394,000

893,000
1,605,000
176,000
1,429,000
500,150
928,850
62,400
866,450

(1) 5,000,000-42,000
(2) 409,000+(2,548,000+81,000-31,000)-547,000
(3) 257,000+76,000+108,000+58,000
(4) 282,000+26,000+24,000+62,000

Clinic I-14

The Statement of
Cash Flows : Dell Inc.

Clinic I-15

The statement of cash flows explains the

change in cash during the period in
terms of cash provided by or used for
operating, investing and financing
activities.

Clinic I-16

The Form of the Cash Flow Statement

Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing

Clinic I-17

The Form of the Cash Flow Statement

The primary purpose of a statement of cash flows
is to provide relevant information about the cash
inflows and outflows of an enterprise during a
period. The statement has three main sections:
Cash Flows from Investing Activities - Investing
activities involve acquiring and disposing of debt
or equity investments, property, plant and
equipment and other productive assets used in the
production of goods or services by the enterprise
(other than materials that are part of the
enterprise's inventory).

Clinic I-18

The Form of the Cash Flow Statement

Cash Flows from financing Activities - Financing
activities involve obtaining resources from owners and
providing them with a return on their investment;
borrowing money and repaying amounts borrowed, and
obtaining and paying for other resources obtained from
creditors on long-term credit.
Cash Flows from operating Activities - Operating
activities involve all transactions and other events that are
not defined as investing or financing. Operating activities
generally involve producing and delivering goods and
providing services. Cash flows from operating activities
are generally the cash effects of transactions and other
events that enter into the determination of net income.
Clinic I-19

Direct Method Cash Flow Statement

A few firms report cash flow from operations using the
direct method (see Chapter 10). Here is an example form
Northrop Grumman Corp.:

Clinic I-20

Example Preparation of a cash flow

statement
Presented below are the balance sheets of Scientific Instruments, Ltd.
for December 31, 2005 and 2004

Scientific Instruments, Ltd.

Balance Sheet
December 31, 2005 and 2004
2005
Cash
Accounts receivables
Inventories
Loan to company B
Land
Equipment
Acc. Depreciation

70
170
200
1,500
500
500
(190)

2004
110
300
240
550
(200)

2,750
Accounts Payable
Bonds Payable
Deferred tax liability
Common Stock
Retained Earnings

120
1,000
380
1,220
30

1,000
200
300
250
250

2,750

1,000
Clinic I-21

Additional Information:
Equipment with original cost of $50 was sold for $35
Dividend declared and paid in cash was $300
Stocks and Bonds were issued for cash
Net income reported was $80.

Required:
Prepare a statement of cash flow for 2005
Note: Cash from operating activities involves
adjusting net income for all the non-cash items in
net income.
Clinic I-22

Solution
Scientific Instruments, Ltd.
Statement of Cash Flow
For the year ended December 31, 2005
Cash flows from operating activities
Net Income
Adjustments to reconcile net income to net cash provided
by operating activities:
Gain on sale of equipment
Depreciation
Increase in deferred tax liability
Decrease in accounts receivables
Decrease in inventories
Decrease in accounts payable
Net cash provided by operating activities

80

(10)
15
80
130
40
(80)

Cash flows from investing activities

Loan to B
Purchase of Land
Sale of Equipment
Net cash used by investing activities

(1,500)
(500)
35

Cash flows from financing activities

Issuance of common stock
Issuance of bonds payable
Payment of cash dividend
Net cash provided by financing activities

970
1,000
(300)

Net decrease in cash

Cash, December 31, 2004
Cash, December 31, 2005

175
255

(1,965)

1,670
(40)
110
70

Clinic I-23

The Statement of Stockholders Equity:

Dell Inc.

Clinic I-24

Shareholders Equity
Has two primary components:
contributed capital which represents
stockholders investment common stock (par
value) and additional paid in capital, and
retained earnings which equals cumulative net
income minus cumulative dividends since the
formation of the company. (Dividends are
distributions of assets to stockholders.)

Clinic I-25

Comprehensive Income
Comprehensive income in net income
(from the income statement) plus other
comprehensive income
To avoid earnings fluctuations some of the
unrealized gains/losses are reported in
other comprehensive income and not
included in net income.

Clinic I-26

Clinic I-27

The Stocks and Flows Equation

Ending equity = Beginning equity + Total (comprehensive) income
Net payout to shareholders
Comprehensive income = Net income + Other comprehensive income
Net payout to shareholders = Dividends + Share

repurchases -Share issues

Clinic I-28

The Articulation of the Financial

Statements
Cash Flow Statement

Cash from operations

Cash from investing

Beginning Balance Sheet

Ending Balance Sheet

Cash from financing

Net change in cash

Cash
+ Other Assets

Cash
+ Other Assets

Statement of Shareholders Equity

Total Assets
- Liabilities
Owners equity

Investment and

disinvestment

by owners
Net income and other earnings
Net change in owners equity

Total Assets
- Liabilities
Owners equity

Income Statement
Revenues
Expenses
Net income
Clinic I-29

Principles of Measurement
Two types of measurement are used in
financial statements
Fair value accounting
Assets and liabilities are reported at their
fair value and gains and losses from
revaluing them are reported in the income
statement or as part of other comprehensive
income in the equity statement. Fair value is
either market value or an estimate of value.
Clinic I-30

Historical cost accounting

Assets and liabilities are reported at their
historical cost (the dollar amount paid when
they were acquired or incurred). In
subsequent periods, those costs are
amortized to the income statement as the
assets are deemed to have been used up in
operations or as liabilities accrue costs.
GAAP accounting uses both types of
measurement.
Clinic I-31

Mark-to Market Accounting

Under U.S. GAAP, the following assets and
liabilities are approximately at market value:
Cash and Cash Equivalents
Short-term investments
Accounts payable
Equity Investments considered trading securities or
available for sale. See Accounting Clinic III.

The following assets and liabilities are measured

with estimates of that are usually close to market
value:
Net Accounts Receivables (net of estimate of likely
bad debt.)
Accrued and Estimated Liabilities
Note that debt (short-term and long-term) is at
historical cost but that is typically close to fair value)
Clinic I-32

Historical Cost Accounting

The following assets and liabilities are at
historical cost on the balance sheet:
Long-term Tangible Assets (depreciated)
Recorded Intangible Assets (amortized)
Goodwill (not amortized)

These assets can be written down if their

value is deemed to have been impaired, but
are never written up (in the U.S.).

Clinic I-33

Mixed Accounting Measurement

The following assets are sometimes measured at
historical cost and sometimes at fair values:
Inventories: Lower of cost or market rule applies
Debt investments
Trading
Available-for-sale
Held to maturity

Equity investments
Trading
Available-for-sale

See Accounting Clinic III

Clinic I-34

Historical Cost Accounting in The Income

Statement
Revenue recognition principle - value added is
recognized when:
The earnings process is substantially accomplished
Receipt of cash is reasonably certain

Matching principle Expenses are recognized in the income statement by

their association with revenues for which they are
incurred.
The earnings number reflects net value added from
revenues, that is, net of matched expenses.

Go to Accounting Clinic II for more on matching

Clinic I-35

Cost of Goods Sold: An Application of

Matching
Cost of goods sold is an accrual concept, calculated in the
following way:
Inventory, beginning
+ Purchases
Goods available for sale
- Inventory, ending
Cost of Goods Sold

XXX
XXX
XXX
(XXX)
XXX

The beginning balance of inventory and purchases

of goods during the year sum up to the total goods
that the firm could have sold during the year.
The ending balance of inventory (usually
available from physical count) is subtracted to get
the cost of the goods actually sold.
Clinic I-36

In the income statement preparation

example total purchases were 2,598,000
(after adding shipment and subtracting
discounts). The beginning of inventory was
409,000 and the ending of inventory was
547,000. Therefore total cost of goods sold
was:
409,000+2,598,000-547,000=2,460,000

Clinic I-37

The cash outflow equivalent to the cost of goods sold is

payment to suppliers.
Accrual accounting performs two main adjustments to this
amount to arrive at the cost of goods sold:
Accounts Payable adjustment payment might not reflect
the entire expenditure on inventories. Some inventories were
purchased on account.

Inventory adjustment inventory is a pure accrual concept

and is recognized in order to match the expense (COGS) with
revenue (the amount we received for the goods sold).

More about the matching concept in Accounting Clinic II.

Clinic I-38

R&D accounts: An Example of Poor

Matching

Peabody Co. produces operating income of

$30,000 from operations each year. The company
invested $20,000 in an R&D project in
December 31, 2004. The investment will produce
an incremental income of $7,000 in each of the
following 5 years.
Calculate operating income for the years 20042009

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

requires)
2. if the firm capitalizes R&D and amortize it using
straight line method.
Clinic I-39

Clinic I-40

Fully expensing R&D in the year in which

it was incurred results in poor matching in
operating income.

Clinic I-41

How Financial Reporting Issues Arise

Efficiencies of Generally Accepted Accounting Principles (GAAP)
Examples:
Assets omitted from the balance sheet: R&D and brand assets
Off-balance-sheet obligations not recognized (FIN 46 helps to rectify)
Losses on conversions into common stock and options settled with
common stock are not recognized (SFAS 150 attempts to rectify)
Poor Application of Accounting Principles
Examples:
Excessive restructuring charges (SFAS 146 helps here)
Biased estimates of bad debts, sales returns, warranties
Aggressive revenue recognition
Conservative revenue recognition: Creation of a cookie jar with
unearned revenue
Creative accounting that yields form over substance: using bright
lines in GAAP to obscure; structural engineering
Clinic I-42

How Should You Deal with the Accounting

Issues?
Understand GAAP and its limitations
Appreciate the relevance-reliability tradeoff
Recognize unresolved issues in GAAP
Recognize where choices can be made
Be alert to poor application of GAAP
How sensitive are earnings to estimates?
How would you characterize the revenue recognition aggressive
or conservative?
Does the application of GAAP faithfully represent the business?

These issues will come to the fore as we proceed through

the book
Clinic I-43

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

U.S. Congress

Securities and Exchange Commission (SEC)

www.sec.gov

Financial Accounting Standards Board (FASB)

www.fasb.org
From the past:
Accounting Principles Board (APB)
General Acceptance
In the future:
How will the International Accounting Standards Board (IASB)
influence accounting principles? The SEC Roadmap (Box 2.5)
Clinic I-44