Accounting & Financial Reporting

Accounting & Financial Reporting
BUSG 503 Michael Dimond

Financial Statements for Sysco (SYY)

Financial Statements How much profit did the company make?
How much did they invest in assets? Was the purchase of equipment an expense? How are the assets allocated? How did they finance their assets? How did cash change during the period? How did owners’ wealth (equity) change during the period? What return did the owners get on their investment?

Initial questions about the balance sheet
Some companies carry high levels of cash. Why is that? Is there a cost to holding too much cash? Is it costly to carry too little cash? The relative proportion of short-term and long-term assets is largely dictated by companies’ business models. Why is this the case? Why is the composition of assets on balance sheets for companies in the same industry similar? By what degree can a company’s asset composition safely deviate from industry norms? What are the trade-offs in financing a company by owner versus non-owner financing? If non-owner financing is less costly, why don’t we see companies financed entirely with borrowed money? How do shareholders influence the strategic direction of a company? How can long-term creditors influence strategic direction? Most assets and liabilities are reported on the balance sheet at their acquisition price, called historical cost. Would reporting assets and liabilities at fair market values be more informative? What problems might fair-value reporting cause?

Initial questions about the income statement
Assume a company sells a product to a customer who will pay in 30 days. Should the seller recognize the sale when it is made or when cash is collected? When a company purchases a long-term asset such as a building, its cost is reported on the balance sheet as an asset. Should a company, instead, record the cost of that building as an expense when it is acquired? If not, how should a company report the cost of that asset over the course of its useful life? Manufacturers and merchandisers report the cost of a product as an expense when the product sale is recorded. How might we measure the costs of a product that is sold by a merchandiser? By a manufacturer? If an asset, such as a building, increases in value, that increase in value is not reported as income until the building is sold, if ever. What concerns arise if we record increases in asset values as part of income, when measurement of that increase is based on appraised values? Employees commonly earn wages that are yet to be paid at the end of a particular period. Should their wages be recognized as an expense in the period that the work is performed, or when the wages are paid? Companies are not allowed to report profit on transactions relating to their own stock. That is, they don’t report income when stock is sold, nor do they report an expense when dividends are paid to shareholders. Why is this the case?

Initial questions about the statement of cash flows
What is the usefulness of the statement of cash flows? Do the balance sheet and income statement provide sufficient cash flow information? What types of information are disclosed in the statement of cash flows and why are they important? What kinds of activities are reported in each of the operating, investing and financing sections of the statement of cash flows? How is this information useful? Is it important for a company to report net cash inflows (positive amounts) relating to operating activities over the longer term? What are the implications if operating cash flows are negative for an extended period of time? Why is it important to know the composition of a company’s investment activities? What kind of information might we look for? Are positive investing cash flows favorable? Is it important to know the sources of a company’s financing activities? What questions might that information help us answer? How might the composition of operating, investing and financing cash flows change over a company’s life cycle? Is the bottom line increase in cash flow the key number? Why or why not?

The company has a present obligation
Defining Liabilities The company has a present obligation Because of a past event . . . . . . For future sacrifices A liability is a present obligation that grew out of a past event and will require a future sacrifice to extinguish the obligation. Past Present Future 9-7

Classifying Liabilities
Current Liabilities Expected not to be paid within one year or the company’s operating cycle, whichever is longer Long-Term Liabilities Expected to be paid within one year or the company’s operating cycle, whichever is longer Part One Current liabilities, also called short term liabilities, are expected to be paid within one year or the normal operating cycle of the company, whichever is longer. Current liabilities are usually extinguished by payment of current assets. Part Two Long-term liabilities are not expected to be paid or extinguished within one year. In this chapter, we will concentrate on current liabilities. The relationship between total liabilities and current liabilities depends upon the nature of business operations. The ratio between the two varies widely among industries and companies. 9-8

Current Liabilities Obligation that will be satisfied within one year or within current operating cycle Normally recorded at face value and are important because they are indications of a company’s liquidity Examples: Accounts payable Notes payable Current portion of long-term debt Taxes payable Other accrued liabilities LO 1

Accounts Payable Amounts owed for inventory, goods, or services acquired in the normal course of business Usually do not require the payment of interest, but terms may be given to encourage early payment Example: 2/10, n/30 A 2% discount is available if payment occurs within the first ten days If payment is not made within ten days, the full amount must be paid within 30 days

Notes Payable Amounts owed that are represented by a formal contract
Formal agreement is signed by the parties to the transaction Arise from dealing with a supplier or acquiring a cash loan from a bank or creditor The accounting for notes depends on whether the interest is paid on the note’s due date or is deducted before the borrower receives the loan proceeds

Uncertainty in Liabilities
Uncertainty in whom to pay Uncertainty in when to pay Uncertainty in how much to pay Before we can determine the nature of a liability and properly classify it, we must examine three major uncertainties. First, we must determine whether we know who will be paid to extinguish the liability. Second, we must know when the amount must be paid, and third, we must know exactly how much must be paid to extinguish the liability. If we don’t know all three, we do not have a known liability. 9-12

Short-Term Notes Payable Multi-Period Known Liabilities
Accounts Payable Sales Taxes Payable Unearned Revenues Short-Term Notes Payable For the accounts shown, we have been able to determine all three variables discussed on the previous screen, so these are known, or determinable, liabilities. Let’s begin our discussion of current liabilities. Payroll Liabilities Multi-Period Known Liabilities 9-13

Note Given to Extend Credit Period
On August 1, 2011, Matrix, Inc. asked Carter Co. to accept a 90-day, 12% note to replace its existing $5,000 account payable to Carter. How would this affect Matrix’s accounts? Let’s spend some time looking at short-term, or current, notes payable. A note payable is a written promise to pay a specific amount at a definite future date. Short-term notes normally bear interest. Part One In our first example, Matrix asked Carter Company to accept a 90 day, 12% note to replace its current account payable of $5,000. If Carter accepts this offer, we will need to make an entry on the books of Matrix. Part Two On August 1, Matrix would debit, or reduce, its Account Payable to Carter and credit, or increase, its Note Payable to Carter. Matrix is exchanging one current liability for another. 9-14

Recording the Interest on Notes Payable
Assume that Hot Coffee Inc. receives a one-year loan from First National Bank on January 1. The face amount of the note of $1,000 must be repaid on December 31 along with interest at the rate of 12%

Recording the Interest on Notes Payable (continued)
The company could identify and analyze the effect of the repayment as follows:

Note Given to Extend Credit Period
On October 30, 2011, Matrix, Inc. pays the note plus interest to Carter. Interest expense = $5,000 × 12% × (90 ÷ 360) = $150 Part One On October 30, Matrix pays the note and all interest to Carter. Let’s prepare the journal entry on the books of Matrix. Part Two We debit, or decrease, the Notes Payable to Carter for $5,000 and debit Interest Expense for $150. The $150 is interest at 12% annual rate for 90 days. Finally, we will credit, or decrease, the Cash account for the total of $5,150. 9-17

Note Given to Borrow from Bank
P1 PROMISSORY NOTE Face Value Date after date promise to pay to the order of American Bank Nashville, TN Dollars plus interest at the annual rate of $20,000 Sept. 1, 2011 Ninety days I Twenty thousand and no/ 6% Jackson Smith Instead of replacing an account payable with a note payable, let’s look at a promissory note issued to borrow money from the bank. This is a typical promissory note. Notice that we have a definite payee, American Bank in Nashville, Tennessee, a determinable amount of the payment, $20,000 plus interest at 6% for 90 days. The entire amount is to be paid on November 30, 2011, the date the note matures. Let’s look at the accounting involved over the life of this note payable. 9-18

Face Value Equals Amount Borrowed
P1 Face Value Equals Amount Borrowed On September 1, 2011, Jackson Smith borrows $20,000 from American Bank. The note bears interest at 6% per year. Principal and interest are due in 90 days (November 30, 2011). On September 1, the date the note was signed, Jackson Smith will debit the Cash account for $20,000 dollars and credit the current liability, Notes Payable, for the same amount. 9-19

Face Value Equals Amount Borrowed
P1 On November 30, 2011, Smith would make the following entry: $20,000 × 6% × (90 ÷ 360) = $300 Part One Let’s prepare the journal entry at November 30, 2011, when the note matures and is paid by Jackson Smith. Part Two We will debit Notes Payable for $20,000 and debit interest expense for $300. The $300 of interest expense is calculated by multiplying $20,000 times 6% and modifying this amount for the length of time the note was outstanding during the year (90 days divided by 360). To complete the entry, we need to credit Cash for the total amount paid of $20,300 . 9-20

End-of-Period Adjustment to Notes
Note Date End of Period Maturity Date An adjusting entry is required to record interest expense incurred to date. If a short-term note payable is issued in one accounting period but is not payable until the following accounting period, it is necessary to make an adjusting entry at year-end to record the interest expense. Let’s look at a specific example. 9-21

Dec. 31, 2011 Dec. 16, 2011 Feb. 14, 2012 Note Date End of Period Maturity Date On December 16, 2011, James Burrows borrows $8,000 and agrees to repay that amount plus interest at 12% annual rate in 60 days. First, let’s prepare the journal entry to record the issuance of the note. James Burrows borrowed $8,000 on Dec. 16, 2011, by signing a 12%, 60-day note payable. 9-22

On December 16, 2011, James Burrows would make the following entry: On December 31, 2011, the adjustment is: Part One On December 16, we will debit the Cash account for $8,000 and credit the current liability account, Notes Payable, for the same amount. Part Two See if you can prepare the adjusting journal entry on December 31, 2011, before going to the next screen. Part Three How did you do? We need to accrue $40 in interest expense for The entry is to debit the Interest Expense account and credit a liability account, Interest Payable, for $40. We calculate the $40 by multiplying $8,000 times 12% annual interest and multiply that amount by 15 days divided by 360 days. It is necessary to adjust the annual interest or the number of days from the date the note was issued until the end of the year, 15 days. Now let’s complete our example by making the entry to record the payment of the note and interest. Be careful, many students miss this entry. $8,000 × 12% × (15 ÷ 360) = $40 9-23

On February 14, 2012, James Burrows would make the following entry. $8,000 × 12% × (45 ÷ 360) = $120 The note falls due, and is paid in full on February 14, James owes $8,160 for the principal and interest. The total interest is calculated by multiplying $8,000 by 12% and adjusting this amount for the 60-day life of the note. The total interest of $160 is divided between the amount incurred in 2011, and the amount to be recorded in 2012. The journal entry is to debit Notes Payable for $8,000, eliminate the Interest Payable amount of $40, debit the Interest Expense account for $120, and credit Cash for the total amount due of $8,160. We think it will be a good idea to go over this example when you study for the next exam. 9-24

Discounting a Note Suppose that on January 1, 2014, First National Bank granted to Hot Coffee a $1,000 loan, due on December 31, 2014, but deducted the interest in advance and gave Hot Coffee the remaining amount of $880 ($1,000 face amount of the note less interest of $120)

Discounting a Note (continued)
The Discount on Notes Payable account should be treated as a reduction of Notes Payable. If a balance sheet was developed immediately after the January 1 loan, the note would appear in the Current Liability category as follows:

The original balance in the Discount on Notes Payable account represents interest that must be transferred to interest expense over the life of the note. Refer to Example 9-2. Before Hot Coffee presents its year-end financial statements, it must make an adjustment to transfer the discount to interest expense

Thus, the balance of the Discount on Notes Payable account is zero and $120 has been transferred to interest expense. When the note is repaid on December 31, 2014, Hot Coffee must repay the full amount of the note

Recording Current Maturities of Long-Term Debt
The portion of a long-term liability that will be paid within one year Assume that on January 1, 2014, your firm obtained a $10,000 loan from the bank. The terms of the loan require you to make payments in the amount of $1,000 per year for ten years payable each January 1 beginning January 1, On December 31, 2014, an entry should be made to classify a portion of the balance as a current liability

Recording Current Maturities of Long-Term Debt
On January 1, 2015, the company must pay $1,000

Current Liabilities—Other Accrued Liabilities
Include any amount that has been incurred but has not yet been paid Suppose that your firm has a payroll of $1,000 per day Monday through Friday and that employees are paid at the close of work each Friday. Also, suppose that December 31 is the end of your accounting year and that it falls on a Tuesday

Recording Accrued Liabilities
Assume that you received a one-year loan of $10,000 on December 1. The loan carries a 12% interest rate. On December 31, an accounting entry must be made to record interest even though the money may not actually be due.

Sales Taxes Payable On May 15, 2011, Max Hardware sold building materials for $7,500 that are subject to a 6% sales tax. Part One On May 15, 2011, Max Hardware sold building materials to a customer for $7,500. The amount of the sale is subject to 6% sales tax and Max Hardware is responsible for collecting and paying the tax to the state government. Let’s make the journal entry to record this sale. Part Two We begin with a debit to the Cash account for $7,950, the amount of the sale and the tax collected. We credit the Sales account for $7,500 and credit the current liability account, Sales Taxes Payable, for $450. The sales tax is 6% of the total sale of $7,500. Max Hardware will extinguish the Sales Taxes Payable account when payment is made to the taxing authority. $7,500 × 6% = $450 9-33

Unearned Revenues On May 1, 2011, A-1 Catering received $3,000 in advance for catering a wedding party to take place on July 12, 2011. Part One We previously studied unearned revenues in the chapter on adjusting entries. Unearned revenues are usually current liabilities. In our example, A-1 Catering received $3,000 as an advance payment for catering a wedding party scheduled for July 12. Part Two On May 1, when the cash is received, the company would debit, or increase, its Cash account, and credit Unearned Revenue, a current liability, for $3,000. The $3,000 will not be recognized as revenue until the company completes its obligation to provide catering for a wedding party. Part Three On July 12, the party was catered and the company debited, or reduced, its current liability, Unearned Revenue, and credited, or increased, Revenue for $3,000. 9-34

Employers incur expenses and liabilities from having employees.
Payroll Liabilities Employers incur expenses and liabilities from having employees. Most of you have probably worked at some time in your life. You know that amounts are withheld from your paycheck, and you may have wondered how this money is handled by your employer. You may not know that your employer pays payroll tax expenses in connection with having you on the payroll. These are not amounts withheld from your paycheck but are costs to your employer. 9-35

Employee Payroll Deductions
Gross Pay Gross pay is the amount you actually earn during a pay period. Out of your gross pay, amounts are withheld for Social Security (FICA) taxes, Medicare taxes, and federal income taxes. If you live in a state or locality that has an income tax, additional amounts will be withheld. In addition to this mandatory withholding, you may elect to have amounts withheld from your gross pay. For example, you may be eligible to participate in a contributory retirement plan or a medical reimbursement plan. Your gross pay less all withholdings, mandatory and voluntary, is your net pay. This is the amount of cash you can put in the bank. Medicare Taxes Federal Income Tax State and Local Income Taxes Voluntary Deductions FICA Taxes Net Pay 9-36

Employee FICA Taxes Federal Insurance Contributions Act (FICA)
FICA Taxes — Soc. Sec. FICA Taxes — Medicare 2010: 6.2% of the first $106,800 earned in the year ( Max = $6,622). 2010: 1.45% of all wages earned in the year. The rate of withholding for FICA taxes and Medicare taxes varies from year to year, but in 2010, the FICA rate was 6.2% on the $106,800 of gross pay. The Medicare rate of one point 1.45% was applied on all of your gross pay in 2010, as well. Your employer is required to match the amounts withheld for FICA and Medicare on a dollar-for-dollar basis. For every $10 withheld from your paycheck, your employer must pay $10 on your behalf to the Internal Revenue Service. Employers must pay withheld taxes to the Internal Revenue Service (IRS). 9-37

State and Local Income Taxes
Employee Income Tax State and Local Income Taxes Federal Income Tax Amounts withheld depend on the employee’s earnings, tax rates, and number of withholding allowances. The amount of income taxes withheld from your gross pay usually depends on how much you earn during the pay period and the number of withholding allowances you claimed on the W4 form you completed when you first went to work. Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency. 9-38

Employee Voluntary Deductions
Amounts withheld depend on the employee’s request. Examples include union dues, savings accounts, pension contributions, insurance premiums, and charities. The amount withheld from gross pay for voluntary deductions depends upon which plans you participate in at your place of employment. Your employer makes payments to the proper designated agencies for amounts you have withheld as voluntary deductions. Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency. 9-39

Recording Employee Payroll Deductions
The entry to record payroll expenses and deductions for an employee might look like this. $4,000 ´ 6.2% = $248 $4,000 ´ 1.45% = $58 Here is an example of a typical payroll entry to record the employees’ withholdings and net pay. The amount of net pay is credited to Accrued Salaries Payable when the payroll is prepared. When the paychecks are written, the journal entry is to debit, or eliminate, Accrued Salaries Payable for $3,126 dollars and credit Cash for the same amount. 9-40

Employer Payroll Taxes
Medicare Taxes Federal and State Unemployment Taxes FICA Taxes Employers pay amounts equal to that withheld from the employee’s gross pay. Your employer must match your contributions for FICA and Medicare taxes. 9-41

Federal and State Unemployment Taxes
2010: 6.2% on the first $7,000 of wages paid to each employee (A credit up to 5.4% is given for SUTA paid, therefore the net rate is .8%.) Federal Unemployment Tax (FUTA) 2010: Basic rate of 5.4% on the first $7,000 of wages paid to each employee (Merit ratings may lower SUTA rates.) State Unemployment Tax (SUTA) In addition to matching your contributions for FICA and Medicare, your employer must pay all federal and state unemployment taxes. The federal and state unemployment tax rates are subject to change. In 2010, the federal rate was a maximum of 6.2% on the first $7,000 of earnings for each employee. The federal tax can be reduced by as much as 5.4% if your employer has a very good employment record. Therefore the resulting net rate used for most FUTA calculations is 0.8%. The state portion of the rate is 5.4% on the first $7,000 of earnings by each employee. Most states reduce this rate to employers with excellent employment records. 9-42

Recording Employer Payroll Taxes
The entry to record the employer payroll taxes for January might look like this: FICA amounts are the same as that withheld from the employee’s gross pay. SUTA: $4,000 ´ 5.4% = $216 FUTA: $4,000 ´ (6.2% - 5.4%) = $32 Here is a typical entry to record the payroll tax expenses paid by employers. Notice that we debit Payroll Tax expense for the total amount involved. We record (credit) current liabilities for the FICA and Medicare Taxes Payable, and for the Federal and State Unemployment Taxes Payable. 9-43

Estimated Liabilities
An estimated liability is a known obligation of an uncertain amount, but one that can be reasonably estimated. In addition to our known liabilities, we also have to estimate certain liabilities. To estimate a liability, we must know that we have an obligation but are uncertain as to exactly how much will have to be paid or when it will be paid. The amounts involved must be subject to reasonable estimation before we may actually record an estimated liability. 9-44

Health and Pension Benefits
Employer expenses for pensions or medical, dental, life, and disability insurance Assume an employer agrees to pay an amount for medical insurance equal to $8,000, and contribute an additional 10% of the employees’ $120,000 gross salary to a retirement program. Part One An employer may agree to pay a portion of your medical, dental, life, or disability insurance. In this case, the employer agrees to pay $8,000 toward employee medical insurance coverage and 10% of gross salaries for a pension program. The employee may have to make contributions to each of these plans, but at this time, we are interested in the employer costs. Let’s look at the journal entry we make in connection with the employer’s payments. Part Two We debit, or increase, the Employee Benefits expenses for $20,000, credit Medical Insurance Payable for $8,000, and the Retirement Program Payable for $12,000. Contributions made by the employer are an additional cost of having you as an employee. 9-45

Employer expenses for paid vacation by employees
Vacation Benefits Employer expenses for paid vacation by employees Assume an employee earns $62,400 per year and earns two weeks of paid vacation each year. $62,400 ÷ 52 weeks = $1,200 $62,400 ÷ 50 weeks = $1,248 Weekly vacation benefit $ Part One Most employers have an expense for amounts paid to employees who are on vacation. Assume you make $62,400 per year, and earn two weeks’ paid vacation each year. Part Two If you work the full f52 weeks of the year, your weekly gross pay is $1,200. However, you only work 50 weeks per year and get the other 2 weeks off. If we spread your salary over the 50 weeks you work, the effective cost to the company is $1,248 per week. So, your weekly vacation benefits are $48. Let’s look at the entry your employer will make each week. Part Three We debit the Vacation Benefits expense account for $48 per week and credit the Vacation Benefits Payable for the same amount. When you take your vacation, your employer will reduce (debit) the Vacation Benefits Payable liability and credit Cash for the payment made to you. 9-46

Contingent Liabilities
Existing condition for which the outcome is not known but depends on some future event Recorded if the liability is probable and the amount can be reasonably estimated Accrued and reflected on the balance sheet if it is probable and if the amount can be reasonably estimated Examples: Premiums or coupons Lawsuits and legal claims Warranties and guarantees LO 4

Warranty Liabilities Seller’s obligation to replace or correct a product (or service) that fails to perform as expected within a specified period. To conform with the matching principle, the seller reports expected warranty expense in the period when revenue from the sale is reported. A dealer sells a car for $32,000, on December 1, 2011, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car. Part One Many products sold are covered by a warranty. The seller is liable for replacing or repairing the product while it is under warranty. To make sure we follow the matching principle, we must report the estimated warranty liability in the year in which the sale is made. In this way, we are matching expense with revenues. Part Two A dealer sells a car for $32,000 on December first, The car is covered by a 12-month or 12,000 mile warranty. Based upon past experience, the dealership estimates average warranty costs at 3% of the selling price of each car. Let’s look at the proper accounting for the estimated warranty expense. 9-48

Warranty Liabilities A dealer sells a car for $32,000, on December 1, 2011, with a warranty for parts and labor for 12 months, or 12,000 miles. The dealership experiences an average warranty cost of 3% of the selling price of each car. On February 15, 2012, parts of $200 and labor of $250 covered under warranty were incurred. Part One On the date of sale, December 1, the dealership will debit Warranty Expense and credit the current liability account, Estimated Warranty Liability, for $960. The amount of the estimated liability is determined by multiplying the $32,000 cost of the car times the 3% historical warranty cost percent. Part Two On February 15, 2012, the dealership paid $200 for parts and $250 for labor covered by the warranty. Can you prepare the proper journal entry? It is a little tough, so take your time. Part Three On February 15, the dealership will debit, or reduce, the Estimated Warranty Liability for total costs incurred of $450. We will credit the Auto Parts Inventory for $200, and Salaries Payable for two $250. 9-49

Recording a Liability for Warranties
Assume that Quickkey Computer sells a computer product for $5,000 with a one-year warranty in case the product must be repaired. Assume that in 2014, Quickkey sold 100 computers for a total sales revenue of $500,000 Using an analysis of past warranty records, Quickkey estimates that repairs will average 2% of total sales

Reasonably Possible Contingent Liabilities
Potential Legal Claims – A potential claim is recorded if the amount can be reasonably estimated and payment for damages is probable. Debt Guarantees – The guarantor usually discloses the guarantee in its financial statement notes. If it is probable that the debtor will default, the guarantor should record and report the guarantee as a liability. If it is probable that a company will have a future sacrifice as the result of current litigation, and if the amount of the sacrifice can be estimated, we will record a liability for potential loss from litigation. If we cannot estimate the amount involved, we will disclose the legal claim in the notes to the financial statements. In these litigious times, many companies are being sued for a wide variety of reasons. When a company guarantees the debt of an affiliated company, it may eventually have to pay the obligation. If the original debtor fails to pay, the obligation becomes the responsibility of the guarantor. 9-51

Current Liabilities on the Statement of Cash Flows

Coverage Ratio: Times Interest Earned
Income before interest and income taxes Interest expense = If income before interest and taxes varies greatly from year to year, fixed interest charges can increase the risk that an owner will not earn a positive return and be unable to pay interest charges. Companies that loan money to a business want to be assured that the principal and interest will be paid when due. One measure that helps creditors assess the risk of a loan is the times interest earned ratio. We calculate the ratio by dividing income before interest and income taxes by interest expense. Income before interest and income taxes is sometimes referred to as operating income. A high times interest earned ratio usually means that the risk of nonpayment is low. 9-53

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