1. Chapters 2 and 3: Financial Statements and Transaction Analysis1

2. Course Overview Financial Accounting Managerial Accounting
External users
Emphasis on decision making of users
Subject to regulation
Publicly available
Managerial Accounting
Internal users (within the company)
Emphasis on use to plan activities, make pricing decisions, and measure performance
Proprietary information 2

3. Chapter 2
Financial statements report the company activity during the year and the financial condition of the company at the end of the year.
The required financial statements are:
Income Statement
Statement of Stockholders’ Equity
(Statement of Owner’s Equity)
Statement of Cash Flows
Balance Sheet

4. The Balance Sheet
The balance sheet reports the financial position at a point in time (end of the quarter or year).
The balance sheet is divided into three major categories:
Assets
Liabilities
Stockholders’ equity (Owner’s equity)

5. The Balance Sheet
The balance sheet is represented by the fundamental accounting equation:
Assets = Liabilities + Equity
A = L E
The effects of all described business transactions may be represented in this formula.

6. The Balance Sheet (B/S)
Assets - represent future benefit to the company, and are classified in order of liquidity (current assets; property and equipment; long-term investments; intangibles)
Liabilities - represent obligations of the company, and are classified according to payment date (current liabilities, long-term liabilities)
Equity - represents the residual claims of the owners
Corporations: common stock and retained earnings
Proprietorships: owner’s capital account

7. B/S Assets: Current Assets
Current assets include
Cash: checking and savings accounts; petty cash.
Short-term investments: investments in stocks and bonds of other companies.
Accounts receivable: amounts owed to a company from its customers.
Inventory: products on hand designated for sale to customers.
Prepaid expenses: amounts paid for future expenses.

8. B/S Assets: Property and Equipment
Property and equipment are assets that are used in the production of goods and services. These productive assets are long-term in nature, and include the following:
Land: property upon which the productive facilities are located.
Building: the physical structure of the company’s operations.
Machinery and Equipment: include operating machinery, vehicles, computers, copy machines, etc.

9. B/S Assets: Long-term Investments
Long-term investments are assets acquired by the company to provide long-term benefits to the company. Long-term investments include:
Long-term notes receivable owed to the company (from customers or others).
Investments in stock of other companies: held for expectation of dividends and/or stock price increase.
Investment in bonds of other companies: held for expectation of dividends and/or stock price increase.
Other assets, like land, held for the long term, but not part of operations.

10. B/S Assets: Intangible Assets
Intangible assets are long-lived assets that have no physical substance. Examples include:
Patents: legal claim to produce and sell a product.
Copyrights: legal claims to books, art, music and other created works.
Goodwill: recognized when one company buys another company, and the purchase price is greater than the fair value of the identifiable net assets.

11. B/S Liabilities: Current Liabilities
Current liabilities are obligations expected to be paid (or services expected to be performed) within the next year or operating cycle. The elimination of the current liabilities requires the use of current assets (most commonly cash). Examples include:
Accounts payable
Wages payable
Interest payable
Short-term notes payable
Current maturities of long-term debt
Deferred (unearned) revenues

12. B/S Liabilities: Long-term Liabilities
Long-term liabilities are obligations expected to require payments beyond the current year. Examples of long-term liabilities include:
Notes payable: amounts owed to banks and other creditors beyond the current year.
Mortgage payable: amounts owed to mortgage company beyond the current year.
Bonds payable: amounts owed to investors holding bond investments issued by the company, where payments of principal and interest are beyond the current year.

13. B/S Owner’s Equity
Owner’s equity is generated when owner (or owners for partnership) contribute cash and other assets into the company.
Owner’s equity or, capital account, is affected by the income earned by the proprietorship, and by the withdrawals of the owner.
Owner’s equity equation:
Beginning owner’s equity
Plus: net income
Less: withdrawals
=Ending owner’s equity
OEBegin + NI Draws = OEEnd

14. B/S Stockholders’ Equity: Contributed Capital
Contributed capital is generated when owners (shareholders) of the company contribute cash and other assets into the company. Components of contributed capital include
Common stock: shares of stock issued to owners to to reflect ownership.
Additional paid in capital: excess amounts contributed by shareholders for various activities.

15. B/S Stockholders’ Equity: Retained Earnings
Retained earnings represent the excess earnings retained in the company after dividends have been paid to shareholders. This represents the equity generated by the company for the shareholders.

16. The Statement of Stockholders’ Equity (SSE)
The following formula represents the basic SSE:
Beginning stockholders’ equity
Plus: Issuance of stock
Plus: Net income
Less: Dividends
=Ending stockholders’ equity
SEBegin + Issue + NI Div = SEEnd

17. The Statement of Retained Earnings
The statement of retained earnings is a subset of the SSE, and calculates the changes in the retained earnings component.
Beginning retained earnings
Plus: Net income
Less: Dividends
=Ending retained earnings
REBegin + NI Div = REEnd

18. The Income Statement (I/S)
The income statement shows the components of net income in detail.
Revenues represent the inflow of assets (or decrease in liabilities) due to a company’s operating activities.
Expenses represent the outflow of assets (or increases in liabilities) due to a company’s operating activities.
The general formula for the I/S is:
Revenues - Expenses = Net Income

19. The Income Statement Format
Operating revenues
Sales
Fees earned
Other revenues
Less: Operating expenses
Cost of goods sold
Wage expense
Rent expense
Selling expense
Depreciation expense
Other expenses
Net Income

20. The Statement of Cash Flows
Cash flows from operating activities:
Collections from sales, rent, interest, etc.
Cash paid to suppliers and employees, and for rent, selling activities, interest, and taxes etc.
Cash flow from investing activities:
Proceeds from sale of investment securities, land, buildings, equipment, etc.
Purchase of investment securities, land, buildings, equipment, etc.
Cash flow from financing activities:
Proceeds from issuance of notes, debt, sale of equity, etc.
Payments on notes, debt, dividends, etc.

21. Relationships Among the Financial Statements
Beginning
Balance Sheet
Ending
Balance Sheet
Statement of
Cash Flows
Assets
(Cash)
Assets
(Cash)
Income
Statement = =
Liabilities
Liabilities + +
Equity
Statement of
Stockholders’ Equity
(Owner’s Equity)
Equity

22. Assets = Liabilities + Equity
Chapter 3
The first step in the accounting process is transaction analysis.
This process examines relevant, objectively measurable economic events through their effect on the accounting equation:
Assets = Liabilities + Equity 22

23. Spreadsheet Analysis
Using a spreadsheet template, analyze the transactions on the next slide. (Full-size spreadsheet at the back of your handouts.)
Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions. 23

24. Transactions
Anna Corporation began on Dec. 1, 2008, and had the following activity during its first month:
1. Investors contributed $30,000 to start up the company.
2. The company purchased land for a future building site for $20,000.
3. The company borrowed $9,000 from the bank.
4. The company completed a consulting contract, and billed the customer $8,000 (provided services on account).
5. The company paid $5,500 for salaries to employees.
6. The company distributed $500 of cash dividends to its investors. 24

25. Cash + A/R + Land = N/Pay + C.Stock + Ret. Earn. 1. = 2. = 3. = 4. =
Spreadsheet Template
Cash + A/R Land = N/Pay + C.Stock + Ret. Earn. = = = = =
6. ____ ____ ____ = _____ _____ _____ 25

26. Statement of Stockholders’ Equity CS RE Beginning $ 0 $ 0
Financial Statements
Income Statement
Revenues $8,000
Expenses 5,500
Net Income $2,500
Statement of Stockholders’ Equity
CS RE
Beginning $ $
Issue CS ,000
Net Income ,500
Less: Dividends
Ending $30, $2,000 26

27. Financial Statements Balance Sheet Assets Cash $13,000 A/R 8,000
Land 20,000
Total $41,000
Liabilities and S.E.
N/P $ 9,000
CS 30,000
RE (ending) 2,000 27

28. Double Entry System
Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.
Therefore accountants use a “double entry” system based on debits and credits. 28

29. Double Entry Accounting
Debit (dr) - means an entry to the left hand side of an account.
Credit (cr) - means an entry to the right hand side of an account.
Note that a debit or credit, per se, does not indicate increase or decrease.
To decide the effect of a debit or credit, the type of account must be considered. 29

30. Effect of Debits and Credits
Based on the accounting equation, we can increase or decrease various accounts depending on their classification:
Assets = Liabilities + Equity
Increase DR = CR CR
Decrease CR = DR DR
Note that we use debits and credits instead of plusses and minuses. 30

31. The following rules can be derived from the basic formula:
Assets have normal debit balances and are increased with a debit.
Liabilities and equities have normal credit balances and are increased with a credit.
Revenues (a part of equity) have normal credit balances and are increased with a credit.
Expenses (which decrease equity) have normal debit balances and are increased with a debit.
Dividends (which decrease equity) have a normal debit balance and are increased with a debit. 31

32. The Format of a Journal Entry
To initially record transactions, we use a journal entry to represent the debits and credits.
For example, in Item 1:
Debit Credit
Cash ,000
Common Stock ,000
Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount. 32

33. Now back to Anna Corp., and prepare the other journal entries:
2: Purchased land for $20,000 cash.
3: Borrowed $9,000 cash from bank. 33

34. Now back to Anna Corp. and prepare the other journal entries:
4: Consulting services (on account) $8,000.
5: Paid $5,500 cash for expenses. 34

35. Now back to Anna Corp., and prepare the other journal entries:
6: Paid $500 cash dividend to investors.
Note that dividends is a contra equity and reduces retained earnings. 35

36. The Accounting Cycle Components of the accounting cycle include:
A. Preparation of General Journal Entries
-Post to the General Ledger
-Unadjusted Trial Balance
B. Preparation of Adjusting Journal Entries
-Adjusted Trial Balance
C. Financial Statements
D. Closing Journal Entries (or closing process)
-Final Trial Balance 36

37. A. General Journal Entries (GJEs)
The first step in the accounting process.
Prepared for daily activity.
Usually journalized in special journals for efficiency, but we will record in “General Journal” format.
Identified through a document flow:
cash receipt, record a cash sale
charge receipt, record a credit sale
bank note, record a notes payable
employee time card, record wages
The transactions on Slide 23 are general journal entries. 37

38. The General Ledger (G/L)
The G/L serves as a place to “total” amounts by account titles.
After GJEs and AJEs are recorded, they are posted (by account) to the G/L.
We will use “T” accounts to represent G/L accounts where needed.
Note that most G/L printouts have detailed information on left side of ledger, and 2 columns (or DR and CR notation) on the right side of the printout. Our T-account represents the right side. 38

39. Posting to G/L Now post transactions (for cash) to “T” account:39

40. Unadjusted Trial Balance
Trial balances are prepared throughout the accounting cycle.
The list resembles the Chart of Accounts (usually organized with account codes).
The Unadjusted Trial Balance represents G/L totals (by account) at a particular point in time.
For the GJEs, the Unadjusted Trial Balance would consist of a list of all of the ending debit or credit balances taken from the various account totals (illustrated on the next slide).
The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter). 40

41. Unadjusted Trial Balance - Anna Corp
Unadjusted Trial Balance - Anna Corp. (after posting and totaling G/L accounts)
Debit Credit
Cash 13,000
Accounts Receivable 8,000
Land 20,000
Notes Payable ,000
Contributed Capital 30,000
Retained Earnings
Dividends
Revenues ,000
Expenses ,500
Totals , ,000 41

42. B. Adjusting Journal Entries (AJEs)
Prepared at the end of the accounting period to align revenues and expenses (matching).
Usually NO document flow to trigger recording.
Based on the accrual system of accounting which records revenues as earned and expenses as incurred (rather than based on cash flows).
Types of AJEs
1. Accrual of expenses
2. Accrual of revenues
3. Prepaid expenses
4. Unearned revenues 42

43. 1. Accrual of Expenses Probably the most common type of AJE.
Ex: accrue wages of $100at the end of the period:
Wages Expense 100
Wages Payable 100
Other examples of expense/payable include interest, rent, taxes. 43

44. 2. Accrual of Revenues
For revenues that have not yet been recorded at the end of the period.
Ex: accrue interest revenue of $50:
Interest Receivable 50
Interest Revenue 50
Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received. 44

45. 3.Prepaid Expenses
This category of AJE relates to the concept of asset capitalization and the matching principle.
Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset is recognized at that time.
As the asset is “used up” in the generation of revenue, the related cost is recognized as an expense (matching).
Some expenses are deferred for a short period of time (Supplies Expense), and some expenses are deferred for many years (Depreciation Expense). 45

46. 3.Prepaid Expenses Example: Purchase 1 year, $1,200 insurance policy.
General JE at time of purchase:
Prepaid Insurance 1,200
Cash 1,200
AJE at end of the first month (for the portion that has been used):
Insurance Expense
Prepaid Insurance 46

47. 4.Unearned Revenues
Cash is received from customer before goods/services are delivered (before revenue can be recognized).
Ex: Received a 3-year subscription of $360 in advance.
General JE at time cash received:
Cash
Unearned Revenues
AJE at end of the first quarter (for 3 mos.):
Unearned Revenues 30
Subscription Revenues 30 47

48. Adjusted Trial Balance
The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger.
The balance sheet accounts reflect the end-of-year balances, and the income statement accounts reflect the proper revenues and expense to be recognized for the year.
This list of accounts and amounts is used to prepare the balance sheet and income statement. 48

49. D. Closing Journal Entries (CJEs)
Prepared after the financial statements have been completed.
Close temporary accounts to retained earnings, so that the balances in those accounts at the start of the next accounting period will be zero.
Temporary accounts include revenues, expenses and dividends.
The final trial balance after closing will display only permanent, balance sheet accounts. 49

50. D. Closing Journal Entries (CJEs)
Back to Anna Corp. Trial Balance. To close Revenues and Expenses and Dividends:
Close Net Income to RE:
Service Revenue 8,000
Salary Expense 5,500
Retained Earnings 2,500
Close Dividends to RE:
Retained Earnings
Dividends 50