Financial Accounting LECTURE 2
FINANCIAL ACCOUNTING
Session 2 - Chapter 2: Constructing Financial Statements
Learning Objectives
Examine and interpret a balance sheet.
What Information is Included in the Balance Sheet
Recognition and Measurement Concepts
Three Assumptions Underpinning Financial Statement Elements:
Separate Entity Assumption: Each business must account for its activities separately from those of its owners, other individuals, and entities.
Going Concern Assumption (Continuity Assumption): It is assumed that the business will continue operating into the foreseeable future and will be able to meet its contractual commitments and plans.
Monetary Unit Assumption: Financial statements are reported using the national monetary unit (e.g., dollars in the United States).
Measurement Concept
Historical Cost: Balance sheet elements are initially recorded at their cost.
Balance Sheet Basics
The balance sheet has three main sections:
Assets
Liabilities
Stockholders’ Equity
The balance sheet reports assets, liabilities, and equity at a point in time.
Balance sheet accounts are permanent accounts since their balances carryover from period to period.
Fundamental Equation
Assets
Definition of Asset
An ASSET is defined as something that confers expected future economic benefits. To be reported on the balance sheet, an asset must meet two criteria:
It must be owned or controlled by the company.
It must arise from a past transaction or event.
Apple, Inc. Balance Sheet: Assets
Exhibit 2.1: Asset Section of Apple's Balance Sheet (in millions)
APPLE INC. Balance Sheet as of September 29, 2018
Current Assets
Cash and cash equivalents: $25,913
Short-term marketable securities: $40,388
Accounts receivable, net: $23,186
Inventories: $3,956
Other current assets: $37,896
Total Current Assets: $131,339
Long-Term Assets
Property, plant, and equipment, net: $41,304 (includes $170,799 million of long-term marketable securities)
Other long-term assets: See balance details.
Total Assets: $365,725
Current Assets
Cash: Currency and bank deposits.
Cash Equivalents: Investments with an original maturity of 90 days or fewer.
Short-term Investments: Marketable securities the company expects to sell within the year.
Accounts Receivable, Net: Amounts due from customers from sales on credit ("net" implies the subtraction of uncollectible accounts).
Inventories: Goods bought or produced for sale to customers.
Prepaid Expenses: Costs paid in advance for rent, insurance, advertising, and other services.
Long-Term Assets
Property, Plant, and Equipment (PPE), Net: Includes land, buildings, and equipment ("net" denotes the deduction of accumulated depreciation).
Long-term Investments: Investments not intended to be sold within the year.
Intangible and Other Assets: Assets lacking physical substance such as patents, trademarks, franchise rights, and goodwill.
Measuring Assets
Most assets are reported at historical cost, which reflects the original acquisition cost rather than current market value.
If the valuation of an asset cannot be reasonably determined, it is not recognized on the balance sheet.
Significant "assets" that are often excluded relate to knowledge-based or intellectual property (IP) such as management expertise, supply chain efficiency, or technological superiority.
Effects of "Missing" Assets
Examines how the lack of certain assets affects financial performance representation.
Graph: Stock Price and Book Value per Share
Annual trend observed depicting stock price vs. book value per share.
Liabilities
Definition of Liabilities
Liabilities are future obligations that entail economic sacrifices. Characteristics of liabilities include:
It is an unavoidable obligation for the company.
It must arise from a past transaction or event.
Description of Liabilities
Represents an amount that must be repaid.
Can be classified as:
Interest Bearing: Such as bank loans.
Non-Interest Bearing: Due to vendors or partners.
Stockholders’ Equity
Definition
Stockholders’ equity indicates the capital invested by stockholders in two forms:
Contributed Capital: Direct investment through stock purchase.
Retained Earnings: Indirect investment reflecting earnings reinvested in the business unrelated to dividends.
Apple’s Liabilities and Equity
Exhibit 2.2: Liabilities and Equity Sections of Apple's Balance Sheet ($ millions)
APPLE INC. Balance Sheet as of September 29, 2018
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable: $55,888
Accrued expenses (liabilities): $40,230
Other current liabilities: $20,748
Total Current Liabilities: $116,866
Long-Term Debt:
$93,735
Other long-term liabilities: $47,977
Total Long-Term Liabilities: $141,712
Total Liabilities: $258,578
Shareholders' Equity
Common stock and additional paid-in capital: $40,201
Retained earnings: $70,400
Other shareholders' equity: $(3,454)
Total Shareholders' Equity: $107,147
Total Liabilities and Shareholders’ Equity: $365,725
Current Liabilities
Description
Accounts Payable: Amounts owed to suppliers for purchased goods and services on credit.
Accrued Liabilities: Obligations for incurred expenses that remain unpaid (e.g., salaries, utilities).
Unearned Revenues: Cash received in advance for goods or services yet to be delivered.
Short-term Debt: Short-term loans to be repaid within a year.
Current Maturities of Long-Term Debt: Principal repayment due within a year.
Net Working Capital
Definition
Net Working Capital is defined as the difference between current assets and current liabilities, indicating operational liquidity:
Example with Walgreens: Net working capital shifted positively from $3,100 in 2015 to $8,870 in 2016, and decreased to $1,206 in 2017.
Cash Operating Cycle
Describes how companies use cash and supplier credit to purchase or manufacture inventories intended for resale.
Cycle Process
Purchase or manufacture inventories.
Sell inventories for cash or on credit (accounts receivable).
Collect receivables, repay accounts payable.
Maintain cash for the next operating cycle.
Objective
Striving to shorten the cash cycle enhances operational efficiency.
Noncurrent Liabilities
Description
Obligations that are due beyond one year:
Long-Term Debt: Loans scheduled for repayment greater than one year.
Includes bonds, notes, debentures, and mortgages.
Other Long-Term Liabilities: Include pension and tax liabilities due in over a year.
Stockholders' Equity: Contributed and Earned Capital
Contributed Capital
Common Stock: Par value received from the original stock sale.
Additional Paid-In Capital: Amounts received from investors beyond the par value of stock.
Preferred Stock: Amount received from the original sale of preferred stock.
Treasury Stock: Amounts paid by the company to reacquire its common stock from shareholders.
Earned Capital
Retained Earnings: Net income not distributed via dividends.
Accumulated Other Comprehensive Income/Loss: Cumulative changes in asset/liability fair values not included in the income statement.
Analyst Adjustments: Common-Size Balance Sheet
Definition
A Common-Size Balance Sheet presents each item as a percentage of total assets, aiding comparative analyses across companies or time periods.
Uses
Facilitates year-over-year comparisons despite size changes.
Enables comparisons across firms of different sizes or currencies.
Assists in benchmarking against industry averages.
Benefits
Adjusts for size and currency differences enables clearer financial assessments.
Market Value vs. Book Value
Definitions and Differences
Book Value: Reflects assets and liabilities reported under GAAP, often at historical cost.
Market Value: Estimated by multiplying outstanding shares by current stock price.
Reasons for Differences
GAAP uses historical costs; market valuations consider fair market values.
GAAP omits unmeasurable resources or prospective performance predictions.
Learning Objective
Use journal entries and T-accounts to analyze and record transactions.
T-Accounts
Description
Graphic representation of accounts divided into debits and credits.
Left side records increases and right side records decreases.
Debit-Credit System
Principles
Debits and Credits: Reflect increases or decreases in accounts.
In double-entry accounting, total debits must equal total credits.
Normal balance: Each account has a natural side of increase: Debits for assets, Credits for liabilities and equity.
Expanded Accounting Equation
Definition
The equity section is expanded to include:
Increases from common stock and revenues.
Decreases from dividends and expenses.
Expanded Accounting Equation
Summary of Debits and Credits
Accounting Relations
Account Type | Debit Increase | Debit Decrease | Credit Increase | Credit Decrease |
|---|---|---|---|---|
Assets (A) | Increase | Decrease | ||
Liabilities (L) | Increase | Decrease | ||
Equity (SE) | Increase | Decrease | ||
Revenue (R) | Decrease | Increase | ||
Expense (E) | Increase | Decrease |
Posting to T-Accounts
Example Transactions
Cash Account:
Beginning balance is $2,500.
Increases noted from transactions (listed by letter reference).
Consolidates to end balance of $3,700.
Steps in the Recording Process
Analyze each transaction regarding its effect on accounts.
Enter transaction in a journal as original record.
Transfer journal entries to the ledger accounts.
The Journal
Description
Transactions are recorded chronologically in a journal before being moved to accounts. Each journal should include:
Date
Account titles and explanations
References
Two amount columns for debits and credits.
Contributions to Recording
Provides comprehensive effects of transactions.
Maintains chronological record of all transactions boosting error detection.
Journalizing
Definition
The process of entering transaction data into the journal, requiring separate entries for each transaction. A complete entry consists of:
The transaction date.
Relevant accounts and amounts debited and credited.
A brief transaction explanation.
General Ledger
Definition
The ledger is the complete set of accounts maintained by a company comprising:
All assets
All liabilities
All stockholder's equity accounts.
Trial Balance
Definition
A Trial Balance is a listing of all accounts and their balances at a specific time to verify debits and credits' equality. Steps to prepare a trial balance:
List account titles with respective balances.
Total debit and credit columns.
Verify the two columns are equal.
Example: Trial Balance for Pioneer Advertising Agency (as of October 31, 2020)
Account | Debit | Credit |
|---|---|---|
Cash | $15,200 | |
Advertising Supplies | $2,500 | |
Prepaid Insurance | $600 | |
Office Equipment | $5,000 | |
Notes Payable | $5,000 | |
Accounts Payable | $2,500 | |
Unearned Revenue | $1,200 | |
Common Stock | $10,000 | |
Dividends | $500 | |
Service Revenue | $10,000 | |
Salaries Expense | $4,000 | |
Rent Expense | $900 | |
Total | $28,700 | $28,700 |
Limitations of a Trial Balance
A trial balance does not ensure all transactions are recorded or that the ledger is correct, as errors may exist even when columns balance.
Examples of errors that still permit a balanced trial balance:
Some transactions not journalized.
Incorrect journal entries not posted.
Duplication of journal entries.
Use of incorrect accounts.
Offsetting errors in recording amounts.
Practice Problem – The JarJar Theater
Scenario
JarJar Theater Inc. commenced operations on April 1. Opening ledger balances included:
Cash #101: $10,000
Land #140: $10,000
Buildings #145: $8,000
Equipment #157: $6,000.
Accounts Payable #201: $2,000.
Mortgage Payable #275: $9,000.
Common Stock #311: $23,000.
Transactions in April
Paid $1,000 for the first film rental.
Ordered additional films at $1,000 total.
Received $2,100 from admissions.
Payments made for mortgage and creditors, totaling $3,500.
Advertising expenses of $600 paid.
Received $4,600 cash from admissions.
Salaries paid: $1,900.
Instructions
(a) Fund ledgers with opening balances and complete transactions.
(b) Journalize entries for April transactions.
(c) Post journal entries to the ledger. (d) Prepare a trial balance for April 30, 2002.
General Journal Entries for JarJar Theater
Example Entries
Film Rental Expense: Paid $1,000
Debit Film Rental Expense: $1,000
Credit Cash: $1,000
Admission Revenue: Received $2,100
Debit Cash: $2,100
Credit Admission Revenue: $2,100
Mortgage Payment: Payment of $3,000
Debit Mortgage Payable: $3,000
Credit Cash: $3,000
Additional Transactions and Details
Detailed entries for subsequent activities, including purchases, revenue collection, and overall expenses, should also be recorded in this manner for clarity and accuracy.
Learning Objective: Compute Net Working Capital, Current Ratio, and Quick Ratio
Definitions
Net Working Capital: Difference between current assets and current liabilities, displaying liquidity.
Current Ratio: The ratio of current assets to current liabilities reflecting short-term liquidity.
Quick Ratio: Ratio of quick assets (cash, market securities, and receivables) to current liabilities.
Example: Walgreens Net Working Capital
Highlighted yearly changes from 2015 to 2017, focusing on liquidity trends.
Evaluating Public Financial Information
SEC Filings:
Form 10-K: Comprehensive annual report.
Form 10-Q: Quarterly updates on financial performance.
Additional forms (e.g., Form 8-K) detail special corporate events.
Data Services: Access to simplified financial statements for analysis.
Analysts often provide objective evaluations but consider potential biases and influences.
Global Accounting: GAAP vs. IFRS
Differences Summary
Presentation of balance sheets: IFRS often lists by liquidity.
Income Statement data: GAAP requires three years whereas IFRS requires only two, allowing more flexibility in data classification.
Conclusion
Financial statements provide crucial data for assessment across financial crisis evaluations, establishing fiscal health and potential forecasts.