FA 3
FINANCIAL ACCOUNTING
Session 3 - Chapter 3
Income Statement
Adjusting Accounts for Financial Statements
Learning Objective
Examine and interpret an income statement.
Income Statement
The income statement reports:
Revenues earned during a period
Expenses incurred to produce those revenues
Net income or loss calculated as (Revenue – Expenses)
The general structure of the income statement typically includes:
Also referred to as Earnings Before Interest and Taxes (EBIT).
Apple’s Income Statement
Operating Expenses: The usual and customary costs that a company incurs to support its operating activities.
Nonoperating Expenses: Expenses related to the company’s financing and investing activities.
Example: Presented in millions of dollars.
Accrual Accounting
Revenues and expenses recognized on the income statement are determined not by cash received or paid.
Two foundational principles of accrual accounting:
Revenue Recognition Principle:
Expense Recognition Principle (also known as the matching principle).
Revenue Recognition Principle
Revenue is recognized when a performance obligation is satisfied, which occurs upon the transfer of a promised good or service to a customer.
Transfer of good/service occurs when the customer obtains control of it.
Revenue recognized is based on the amount the company expects to receive.
Revenue recognition does not necessarily coincide with cash received, resulting in various scenarios:
Revenue recognized and cash received simultaneously.
Revenue recognized in the current period, cash received later.
Cash received in advance, revenue recognized later.
Expense Recognition Principle – The Matching Principle
Expenses should be recognized when incurred, matching expenses with the revenues they generate.
Like revenue recognition, expense recognition may or may not coincide with cash payment, allowing various scenarios:
Expense recognized and cash paid simultaneously.
Cash paid in advance and expense recognized later.
Expense recognized in the current period and cash paid later.
Analyzing the Income Statement Two Important Margins
Gross Profit Margin:
Calculated as (Gross Profit / Sales).
Influenced by both the selling price of the company's products and the cost to manufacture or acquire those products.
Operating Expense Margins:
Analyzed in relation to sales over time and compared with peer companies.
Analyst Adjustments
Common Size Income Statement
Analysts create common-size income statements for analysis; each item in the income statement is expressed as a percentage of net sales.
Allows for three types of comparisons:
One company across different years (time-series analysis).
Many companies during one year (cross-sectional analysis).
Comparison against industry averages.
Common-size analysis is also referred to as vertical analysis, where the percentages for the income statement add up to 100% of total sales.
Common Size Income Statement
What: Each line item on the income statement is divided by total revenue, converting the income statement into percentage terms.
Why:
Compare a company across two or more years.
Compare two or more companies, correcting for size and currency differences.
Compare a company with an industry or other benchmarks.
EXHIBIT 3C.2 Boston Scientific Common-Size Income Statements
Various common-size income statements presented with percentages for net sales, cost of products sold, gross profit, and various expenses.
Learning Objective
Examine and interpret a statement of stockholders' equity.
Statement of Stockholders’ Equity
The statement reconciles beginning and ending balances of stockholders’ equity accounts.
Common Stock and Additional Paid-In Capital: Increase through proceeds from the sale of stock.
Retained Earnings:
Increase by net income and decrease by dividends paid to shareholders and stock repurchased.
Accumulated Other Comprehensive Income: Changes in asset and liability fair values not reported in the income statement result in increases and decreases in this account.
Apple's Statement of Stockholders' Equity
A detailed representation for Apple Inc. for the year ended September 29, 2018
Common Stock and Additional Paid-in Capital: $35,867 million
Retained Earnings: $98,330 million
Accumulated Other Comprehensive Income: (Loss of $150 million)
Total Equity: $134,047 million
Learning Objective
Describe a statement of cash flows.
Statement of Cash Flows
The income statement measures income utilizing GAAP principles and provides insights into the economic viability of company products and services, while the statement of cash flows reveals the company’s capacity to generate cash from transactions.
Statement of Cash Flows Format
Cash Flows from Operating Activities: Involves transactions and events related to daily operations.
Cash Flows from Investing Activities: Involves acquisition and divestiture of investments and long-term assets.
Cash Flows from Financing Activities: Involves issuances and payments regarding borrowings and equity.
Apple's Statement of Cash Flows
A dataset for Apple Inc. for the year ending September 29, 2018:
Cash generated by operating activities: $77,434 million
Cash from investing activities: $16,066 million
Cash used in financing activities: ($87,876) million
Net change in cash: $5,624 million
Cash balance from the prior year (September 30, 2017): $20,289 million
Cash balance as of September 29, 2018: $25,913 million.
Learning Objective
Apply linkages among the four financial statements.
Financial Statement Linkages (or, Financial Statement Articulation)
What: This describes the interconnections among the four financial statements linking activity during the period to balances at the beginning and end of the period.
So What: Highlights the relationships among profit, cash flow, and the balance sheet, aiding stakeholders in assessing potential transaction impacts.
Financial Statement Linkages Summary
Summation of how information flows between financial statements, particularly connecting cash flows, balance sheet items, and income statements for Apple Inc. for the year ending September 29, 2018.
Learning Objective
Adjusting the Accounting
Time-Period Assumption
Definition: This assumption postulates that the economic life of a business can be divided into artificial time periods.
Accounting periods are typically a month, quarter, or year.
Most businesses observe a fiscal year typically aligned with the calendar year (January 1 to December 31).
Accrual Basis of Accounting
Utilizes revenue recognition and matching principles. Under cash-basis accounting, revenue is recorded only upon cash receipt and expenses upon cash payment.
GAAP mandates accrual basis for accurate financial statements as cash basis can mislead financial information.
Revenue Recognition Principle
This principle underscores that revenue should be acknowledged in the accounting period it is earned.
Revenue is considered earned when the service is rendered or goods delivered.
The Matching Principle
Dictates that expenses should correlate with revenues generated, stating that expenses must be recorded in the same period as the revenues they help produce.
Adjusting Entries
These entries are essential for ensuring:
Revenues recorded in the period they are earned
Expenses recognized in the period they are incurred.
Types of Adjustments
Deferrals
Also known as prepayments, include:
Unearned Revenues
Prepaid Expenses
These deal with amounts previously recorded in balance sheet accounts and result in a decrease in a balance sheet account while increasing an income statement account.
Accruals
Includes:
Accrued Revenues
Accrued Expenses
These concern amounts not previously recorded in balance sheet accounts and lead to an increase in both balance sheet and income statement accounts, ensuring accurate measurement of a period’s revenues and expenses.
Deferred Revenue
Definition: Amounts received in advance recorded as liabilities due to the obligation to provide future services or assets, such as inventory or refunds.
Adjusting Situations: - Example includes prepaid property casualty insurance earned over time and subscriptions received in advance earned later.
Allocating Unearned Revenue to Revenue
Example:
Scenario: In May, customers prepaid $300 for a three-month membership in an online health program. One month of the membership was earned in June.
Balance Sheet Impact:
Adjust to recognize earned revenue from online membership as follows:
-100 Unearned Revenue (Liability)
+100 Sales Revenue (Income)
Prepaid Expenses
Process: Allocating prepaid assets to expenses involves adjusting for amounts paid in advance for benefits extending beyond one period.
Examples: Insurance, advertising, rent, supplies, and intangible assets requiring allocation over time.
Allocating Assets to Expenses — Prepaid Insurance
Example:
Scenario: One month of Jana Juice’s $800 insurance payment expired in June, covering June through September.
Adjustments: -200 to Prepaid Insurance and +200 to Insurance Expense to recognize the expiration.
Depreciation
Definition: Allocating equipment, buildings, and vehicles to expenses over time is necessary as these assets assist in generating revenues.
Annual Straight-Line Depreciation: Annual Depreciation Expense =
Example of Depreciation
Example: On January 1, 2022, a company purchased a truck for $110,000 with a 5-year useful life and a $10,000 salvage value.
Calculation: Annual Depreciation Expense = per year.
Allocating Assets to Expenses — Example for Jana Juice
Assumed equipment cost $10,200, benefiting the company over five years.
Transaction:
Allow for monthly depreciation:
Accrued Revenues
Recognizing amounts earned before receiving cash creates increases in assets and revenues.
Examples of Adjusting Entries: Include services delivered not yet billed or interest earned from bank deposits not yet recorded.
Accruing Revenues — Example
Example: Jana Juice earned $60 in interest in June, payable in July.
Adjustments entail increasing Interest Receivable (+$60) and Interest Income (+$60).
Accruing Expenses
Recognizing expenses before cash is paid; relevant examples include unrecorded utility bills, wages earned yet unpaid, and accrued interest.
Accruing Expenses–Wages Example
Example: Jana Juice employees earned $550 in the last week of June, slated for payment in July.
Adjusting entries include increasing Wages Expense and Wages Payable by $550.
Accruing Expenses–Interest Example
Loan example: A $12,000 loan at a 12% interest rate accrued interest of $120 for June.
Adjustments involve increasing Interest Expense and Interest Payable by $120 in the accounting records.
Ethics and Adjusting Entries
Concern: Adjusting entry estimates depend on managerial interpretations shaped by external pressures, including expectations from analysts and impacts of intentional misrepresentation.
Practice Problem – Solo Company
Scenario: Hans Solo initiated a consulting firm on June 1, 2021, leading into an adjusting entries scenario with a trial balance at June 30, highlighted in various accounts.
Adjusting Entries for Solo Company
Example adjustments and processes are provided for June 30, showing various entries for utilities, salaries, and unearned revenue.
Closing Temporary Accounts
Closing process occurs at fiscal period ends, transferring temporary account balances into permanently updating Retained Earnings.
Closing Temporary Accounts—Transactions
Close revenue accounts:
Debit each revenue account for its balance; credit Retained Earnings for total revenues.
Close expense accounts:
Credit each expense account for its balance; debit Retained Earnings for total expenses.
Summarizing the Accounting Cycle
Systematic process for accumulating and reporting a company's financial data across each fiscal year.
Learning Objective
Analyze changes in balance sheet accounts.
Using Information on Levels and Flows
The balance sheet represents levels of resources and claims, showcasing a point in time, whereas the income statement denotes flows and changes over periods.
Example of Resource Flow Analysis
Given an inventory count of supplies and purchasing events, the analysis requires recognition of supply expenses accordingly.
Example Numerics
Scenario:
Starting Inventory: $2,400
Purchased: $5,700
Ending Inventory: $1,900
Supply Expense Calculated as follows:
Practical Application
Campbell Soup Company transactions involve analysis and understanding the inflow/outflow of accounts in terms of changes.