Understanding and Preparation of Financial Statements MBA Kathmandu University School of Management (KUSOM) harigopal@kusom.edu.np

Primary Objective of Financial Reporting Provide information for decision making Loan $$?? Extend credit $$?? Sell stocks or bonds?? Borrow $$?? Start new business?? Invest?? 2 2

Secondary Objectives of Financial Reporting Reflect the company’s equity and claims to its resources Reflect prospective cash receipts to investors and creditors Reflect prospective cash flows to the company Assets = Liabilities + OE 2 2

Qualitative Characteristics Understandability – Relevance – Reliability – To those willing to take the time to understand it Has capacity to make a difference Represents what it purports 3 3 3

Qualitative Characteristics From one period to the next Comparability between companies Consistency From one period to the next 3 4 4

Qualitative Characteristics Materiality Will it make a difference To the decision maker? Conservatism All else equal, choose Least optimistic estimate 3 5 5

Basis of Recording Transactions harigopal@kusom.edu.np

External and Internal Events External events: interaction between entity and outside environment Internal events: Interaction within entity harigopal@kusom.edu.np

Source Documents Evidence needed in an accounting system to record Purchase Invoice Sales Invoice Evidence needed in an accounting system to record transactions Checks Cash Register Tape Receiving Document Shipping Document Payroll Records harigopal@kusom.edu.np

Analyzing the Effects of Transactions on the Accounting Equation harigopal@kusom.edu.np

Issue Capital Stock for Cash 1/12 Transactions for Glengarry Health Club Assets = Liabilities + Stockholders’ Equity Cash Capital Stock + $ 100,000 = + $ 100,000 The accounting equation must always remain in balance harigopal@kusom.edu.np 3

Purchase of Property in Exchange for Notes Payable Assets = Liabilities + Stockholders’ Equity Land Notes Payable + $50,000 = + $200,000 Building + $150,000 Increase on left has corresponding increase on right harigopal@kusom.edu.np 4

Purchase of Equipment on Account Assets = Liabilities + Stockholders’ Equity Equip. Accts. Pay. + $20,000 = + $20,000 At least two accounts affected by every transaction harigopal@kusom.edu.np 5

Effect of Revenue and Expenses on Retained Earnings Statement of Retained Earnings Income Statement Beg. R/E + Net Income (or – Net Loss) – Dividends = End. R/E Revenue – Expenses = Net Income (Loss) harigopal@kusom.edu.np 7

Sell Monthly Memberships on Account Assets = Liabilities + Stockholders’ Equity Accts. Rec. Retained Earnings + $15,000 = + $15,000 Revenues increase retained earnings harigopal@kusom.edu.np 6

Sell Court Time for Cash Assets = Liabilities + Stockholders’ Equity Cash Retained Earnings + $5,000 = + $5,000 Revenues increase retained earnings harigopal@kusom.edu.np 6

Payment of Wages and Salaries Assets = Liabilities + Stockholders’ Equity Cash Retained Earnings – $10,000 = – $10,000 Expenses decrease retained earnings harigopal@kusom.edu.np 8

Expenses also decrease assets or increase liabilities Payment of Utilities Assets = Liabilities + Stockholders’ Equity Cash Retained Earnings – $3,000 = – $3,000 Expenses also decrease assets or increase liabilities harigopal@kusom.edu.np 8

Collection of Accounts Receivable Assets = Liabilities + Stockholders’ Equity Cash + $4,000 = (no change in Liab. or S/E) Accts. Rec. – $4,000 Assets were traded: accounts receivable for cash harigopal@kusom.edu.np 10

Dividends directly reduce retained earnings Payment of Dividends Assets = Liabilities + Stockholders’ Equity Cash Retained Earnings – $2,000 = – $2,000 Dividends directly reduce retained earnings harigopal@kusom.edu.np 10

Cumulative Effect of Transactions for Glengarry Health Club Assets = Liabilities + S/E Sold stock + $100,000 = + $100,000 Bought prop. with note + 200,000 = + $200,000 Bought equip. on acct. + 20,000 = + 20,000 Sold memberships + 15,000 = + 15,000 Sold court time + 5,000 = + 5,000 Paid wages – 10,000 = – 10,000 Paid utilities – 3,000 = – 3,000 Collected A/R + 4,000 = (no change in Liabilities + SE) – 4,000 Paid dividends – 2,000 = – 2,000 + $325,000 = + $220,000 + $105,000 harigopal@kusom.edu.np 11

Glengarry Health Club Balance Sheet January 31, 2012 Assets Cash $ 94,000 Accts. Rec. 11,000 Equipment 20,000 Building 150,000 Land 50,000 Total assets $325,000 Liabilities and Stockholders’ Equity Accounts payable $ 20,000 Notes payable 200,000 Capital stock 100,000 Retained earnings 5,000 Total liabilities and stockholders’ equity $325,000 harigopal@kusom.edu.np

Glengarry Health Club Income Statement For the Month Ended January 31, 2012 Revenues: Memberships $15,000 Court fees 5,000 $20,000 Expenses: Wages and Salaries $10,000 Utilities 3,000 13,000 Net income $ 7,000 Net increase to retained earnings harigopal@kusom.edu.np

Representation of one account in the general ledger The T Account Account Name Debits are entered on left Credits are entered on right Representation of one account in the general ledger harigopal@kusom.edu.np 17

The T Account Account Name 400 dr. 900 cr. 500 cr. Debits and credits are netted to obtain balance in account 500 cr. harigopal@kusom.edu.np 17

Debits/Credits and the Accounting Equation STOCKHOLDERS’ EQUITY Dr. Cr. + – + LIABILITIES Dr. Cr. – = ASSETS Dr. Cr. + – Opposite sides of the accounting equation are increased/decreased in an opposite way harigopal@kusom.edu.np

Link Between Revenues and Retained Earnings Cr. Both accounts are increased with credits + – Revenues increase retained earnings (part of stockholders’ equity) REVENUES Dr. Cr. – + harigopal@kusom.edu.np

Link Between Expenses and Dividends and Retained Earnings Retained earnings is decreased with debits DR. CR. – + Expenses and dividends decrease retained earnings DR. CR. EXPENSES AND DIVIDENDS + – Use debits to record (increase) expenses and dividends harigopal@kusom.edu.np

Normal Account Balances Debit Credit Assets Expenses Dividends Liabilities Stockholders’ Equity Revenues all increased with debits all increased with credits harigopal@kusom.edu.np 22 21

Transactions and T Accounts Cash Capital Stock (1) 100,000 100,000 (1) (1) Issue capital stock for cash harigopal@kusom.edu.np 3 22

Transactions and T Accounts Land (2) 50,000 Notes Payable Building 200, 000 (2) (2) 150,000 (2) Purchase property in exchange for a promissory note. harigopal@kusom.edu.np 3 23

Transactions and T Accounts Equipment Accounts Payable (3) 20,000 20,000 (3) (3) Purchase equipment on account harigopal@kusom.edu.np 3 24

(4) Sell monthly memberships on account Transactions and T Accounts Accounts Receivable Membership Revenue (4) 15,000 15,000 (4) (4) Sell monthly memberships on account harigopal@kusom.edu.np 3 25

(5) Sell court time for cash Transactions and T Accounts Cash Court Fee Revenue 5,000 (5) (1) 100,000 (5) 5,000 T Accounts reflect current and previous postings to the account for each period (5) Sell court time for cash harigopal@kusom.edu.np 3 25

(6) Pay employees wages for the month (7) Pay utilities for the month Transactions and T Accounts Wage & Salary Expense Cash (1) 100,000 (5) 5,000 (6) 10,000 10,000 (6) 3,000 (7) Utilities Expense (7) 3,000 (6) Pay employees wages for the month (7) Pay utilities for the month harigopal@kusom.edu.np 3 25

Transactions and T Accounts (8) Collection of accounts receivable Cash Accounts Receivable 4,000 (8) (1) 100,000 (5) 5,000 (4) 15,000 10,000 (6) 3,000 (7) (8) 4,000 (8) Collection of accounts receivable harigopal@kusom.edu.np 3 24

Transactions and T Accounts Cash Dividends (1) 100,000 (5) 5,000 10,000 (6) 3,000 (7) (9) 2,000 (8) 4,000 2,000 (9) (9) Pay dividends harigopal@kusom.edu.np 3 24

Determine the Balance of the T Accounts Cash Accounts Receivable (4) 15,000 4,000 (8) 10,000 (6) 3,000 (7) (1) 100,000 (5) 5,000 11,000 2,000 (9) (8) 4,000 94,000 harigopal@kusom.edu.np 3 26

The Journal that equals Transactions normally recorded in A chronological record of transactions The book of original entry Each entry has a debit and a credit that equals Transactions normally recorded in general journal harigopal@kusom.edu.np

Posting from Journal Transactions are entered in: And then posted to: Ledger Accounts Cash Capital Stock And then posted to: Journal (via journal entries): Dr. Cr. Cash 100,000 Capital Stock 100,000 To record the issuance of 10,000 shares harigopal@kusom.edu.np

Journal Entries Dr. Cr. Building 150,000 Land 50,000 Notes Payable 200,000 To record acquisition of property in exchange for note Equipment 20,000 Accounts Payable 20,000 To record the acquisition of equipment on open account Accounts Receivable 15,000 Membership Revenue 15,000 To record sale of monthly memberships on account harigopal@kusom.edu.np

Journal Entries Dr. Cr. Cash 5,000 Court Fee Revenue 5,000 To record sale of court time for cash. Wage and Salary Expense 10,000 Cash 10,000 To record payment of wages and salaries. Utilities Expense 3,000 Cash 3,000 To record payment of utilities. harigopal@kusom.edu.np

Journal Entries Dr. Cr. Cash 4,000 Accounts Receivable 4,000 To record collection of accounts receivable. Dividends 2,000 Cash 2,000 To record payment of dividends. harigopal@kusom.edu.np

Glengarry Health Club Trial Balance January 31, 2012 Debits Credits Cash Accounts Receivable Equipment Building Land Accounts Payable Notes Payable Capital Stock Membership Revenue Court Fee Revenue Wage and Salary Expense Utility Expense Dividends Totals $ 94,000 11,000 20,000 150,000 50,000 $ 20,000 200,000 100,000 15,000 5,000 10,000 3,000 2,000 $340,000 $340,000 harigopal@kusom.edu.np

Basic Structure of a Classified Balance Sheet Current assets + Noncurrent (long-term) assets Total assets Current liabilities + Noncurrent (long-term) liabilities + Stockholders’ equity Total liabilities and stockholders’ equity 5 7 7

Dixon Sporting Goods Balance Sheet A = L + SE Dixon Sporting Goods Balance Sheet Realized, sold, or consumed in one year or operating cycle A Assets Current assets Cash $ 5,000 Marketable securities 11,000 Accounts receivable 23,000 Merchandise inventory 73,500 Prepaid insurance 4,800 Supplies 700 Total current assets $118,000 Non Current Assets Investments Land held for future office site 150,000 Property, plant, and equipment Land $100,000 Buildings $150,000 Less: Accumulated depreciation (60,000) 90,000 Store furniture and fixtures $ 42,000 Less: Accumulated depreciation (12,600) 29,400 Total property, plant and equipment 219,400 Intangible assets Franchise agreement 55,000 Total assets $542,400

Dixon Sporting Goods Balance Sheet A = L + SE Satisfied within one year or operating cycle Liabilities and Stockholders’ Equity = L Current liabilities Accounts payable $ 15,700 Salaries and wages payable 9,500 Income taxes payable 7,200 Interest payable 2,500 Bank loan payable 25,000 Total current liabilities $ 59,900 Long-term debt Notes payable $ 120,000 Total liabilities $179,900 Contributed capital Capital stock, $10 par, 5,000 shares issued and outstanding $ 50,000 Paid-in capital in excess of par value 25,000 Total contributed capital $ 75,000 Retained earnings 287,500 Total stockholders' equity $ 362,500 + SE Total liabilities and stockholders’ equity $542,400

Of particular interest Analysis of Liquidity Of particular interest to bankers and other creditors Ability of company to pay debts as they become due Working Capital 7 8 8

Dixon Sporting Good’s Liquidity What's the trend?? Current assets $2,000 Current liabilities 1,600 Working = Current Assets Capital (Current Liabilities) $58,100 Current = Current Assets Ratio Current Liabilities 1.97:1 8 9 9

Single-Step Income Statement Revenues $$ Less: expenses ($$) Net income $$ 16 16

Multiple-Step Income Statement Sales – Cost of Goods Sold = Gross Profit Operating expenses: – General and administrative expenses – Selling expenses = Income from operations +/– Other revenues and expenses = Income before taxes – Income tax expense = Net income Four important subtotals 6 13 13

Dixon Sporting Goods Multiple Step Income Statement For the Year Ended December 31, 2012 Sales $357,500 Cost of Goods Sold 218,300 Gross Profit $139,200 Operating expenses: Selling expenses Depreciation on store furniture and fixtures $ 4,200 Advertising 13,750 Salaries and wages 22,000 Total selling expenses $ 39,950 General and administrative expenses Depreciation of buildings and amortization of trademark $ 6,000 Salaries and wages 15,000 Insurance 3,600 Supplies 1,050 Total general and administrative expenses 25,650 Total operating expenses 65,600 Income from operations $ 73,600 Other revenues and expenses: Interest revenue $ 1,500 Interest expense 16,900 Excess of other revenues over other expenses 15,400 Income before taxes $ 58,200 Income tax expense 17,200 Net income $ 41,000

Analysis of Profitability particular interest to current and potential investors Profit Margin % 14 14

Dixon Sporting Goods Profit Margin Profit Margin % = Net Income Operating Revenues Profit Margin % = $41,000 = 11% $357,500 (The amount of every sales dollar that results in income)

Statement of Cash Flows Basic Format for the Statement of Cash Flows Cash flows from operating activities: $$ Cash flows from investing activities: Cash flows from financing activities: Net increase in cash $$ Cash at beginning of year $$ Cash at end of year $$ Involves the purchase and sale of products or services Involves the acquisition and sale of long-term or noncurrent assets Involves the issuance and repayment of long-term liabilities and stock 20 20

Financial Statements for a Real Company: General Mills

General Mills’s Liquidity (in millions) 2010 2009 Current assets $ 3,480.0 $ 3,534.9 Current liabilities 3,769.1 3,606.0 Working capital $ ( 289.1) $( 71.1) Current = Current Assets Ratio Current Liabilities (How many $ of current assets for every $ of current liabilities) Current ratio = 0.92:1 0.98:1 15 15

General Mills’s Profitability (in million’s) 2010 2009 2008 Net sales $14,796.5 $14,691.3 $13,652.1 Net income $ 1,530.5 $ 1,304.4 $ 1,294.7 Profit margin % = 10.3% 8.9% 9.5% Profit Margin % = Net Income Sales (How many cents on every dollar of sales are left over after covering all expenses) 16 16

Elements of an Annual Report Letter to stockholders Description of company’s products and markets Financial statements Notes to financial statements Report of independent accountants Management discussion and analysis Summary of significant accounting policies 21 21

Recognition and Measurement I know I need to record this... Recognition: formally recording an item in the financial statements of an entity Measurement: quantification of the economic effects of the item on the entity ...but at current value or historical cost?

Cash vs. Accrual Basis Cash basis: revenues and expenses are recorded only when cash is received or paid Accrual basis: revenues are recognized when earned; expenses are recognized when incurred

Accrual basis statement Cash basis statement Accrual basis statement Income Statement Net income: $ 7,000 Statement of Cash Flows Cash flows from operating activities: $(4,000) What accounts for the difference?

Revenue Recognition Principle Revenue is recognized when realized and earned—usually at time of sale Exceptions: Long-term contracts Franchises Commodities Installment sales Rent and interest

Match expenses with associated revenues Matching Principle Match expenses with associated revenues Directly Indirectly over period they provide benefits Simultaneously upon their acquisition e.g., Inventory e.g., Buildings e.g., Utilities

Expense Recognition Balance Sheet Income Statement ASSETS: EXPENSES: PP&E Intangibles ASSETS: EXPENSES: when sold Cost of goods sold Inventory Supplies Prepaid assets as used Supplies expense Insurance expense Rent expense Depreciation expense Amortization expense over period they provide benefits l Other expenses (as incurred)

Types of Adjusting Entries Deferred expense Accrued liability RECOGNIZE REVENUE OR EXPENSES BEFORE OR AFTER CASH IS EXCHANGED Accrued asset Deferred revenue

Deferred Expense Cash paid before expense is incurred Examples: Prepaid rent Prepaid insurance Office supplies Property and equipment Costs are initially recorded as assets and allocated to expenses in future periods

Deferred Expense Example #1 Prepay insurance for one year on September 1 Initial journal entry: 9/1 Prepaid Insurance 2,400 Cash 2,400 Monthly adjusting journal entry: 9/30 Insurance Expense 200 Prepaid Insurance 200 ($2,400 annual × 1/12 = $200 per month for 12 months)

Deferred Expense Example #2 Purchase new store fixtures on January 1 for $5,000. Estimated useful life is 5 years (60 months); estimated salvage value is $500 Deferred Expense Example #2 Initial journal entry: 1/1 Store fixtures 5,000 Cash 5,000 Monthly adjusting journal entry: 1/31 Depreciation Expense 75 Accumulated Depreciation 75 ($5,000 – $500) × 1/60 = $75 per month for 60 months)

Deferred Revenue Cash received before revenue is earned Examples: Insurance collected in advance Subscriptions collected in advance Gift certificates Receipts are initially recorded as liabilities (unearned or refundable receipts) and recorded as revenues in future periods when earned

Deferred Revenue Example Received $2,400 for an insurance policy in advance on September 1 Initial journal entry: 9/1 Cash 2,400 Insurance Collected in Advance 2,400 Monthly adjusting journal entry: 9/30 Insurance Collected in Advance 200 Insurance Revenue 200 ($2,400 annual × 1/12 = $200 per month for 12 months)

Accrued Liability Expense incurred before cash is paid Examples: Payroll Taxes Interest Record expense (and corresponding liability) in period incurred; pay for it in a future period No cash flow on recording, only when paid

Accrued Liability Example #1 Pay biweekly wages of $280,000 At end of month, between pay periods: Wages Expense 40,000 Wages Payable 40,000 Next payday: Wages Payable 40,000 Wages Expense 240,000 Cash 280,000

Accrued Liability Example #2 On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank Initial journal entry: 3/1 Cash 20,000 Notes Payable 20,000 Monthly adjusting journal entry: 3/31 Interest Expense 150 Interest Payable 150 ($20,000 principal × 9% × 3/12 = $450 for 3 months or $450/3 = $150 per month)

Accrued Liability Example #2 (continued) To record payment of a 9%, 90-day, $20,000 loan with interest due on May 30 5/30 Interest Payable 300 Interest Expense 150 Notes Payable 20,000 Cash 20,450

Accrued Asset Revenue earned before cash is received Examples: Rent Interest Record revenue (and corresponding receivable) in period earned; receive payment in a future period

Accrued Asset Example First day of the month: Rent Receivable 2,500 Rent payment of $2,500 due within first 10 days of month First day of the month: Rent Receivable 2,500 Rent Revenue 2,500 Upon receipt of cash: Cash 2,500 Rent Receivable 2,500

Adjusting Entry Summary Examples: Deferred Expense cash paid before expense is incurred Deferred Revenue cash received before revenue is earned Accrued Liability expense incurred before cash is paid Accrued Asset revenue is earned before cash is received Adjusting Entry Summary

Steps in the Accounting Cycle 1. Collect and analyze info 7. Close the accounts 2. Journalize transactions 6. Record and post adjusting entries 3. Post transactions to general ledger 5. Prepare financial statements 4. Prepare work sheet

The Closing Process Purpose: To return the balance of revenue, expense, and dividend accounts to zero to begin the next period to transfer the net income of the period to Retained Earnings

Nominal Accounts Revenues Expenses Dividends Zero out nominal accounts Normal balance Expenses Normal balance Close to Income Summary $ XX Close to Income Summary $ XX $ XX $ XX Dividends Zero out nominal accounts to start accumulation of next period’s results Close to Retained Earnings Normal balance $ XX $ XX

(Net loss) or net income closed to Retained Earnings Closing Entries (Net loss) or net income closed to Retained Earnings Income Summary $XX from revenue accounts from expense

Accounting Tools: Work Sheets Appendix Accounting Tools: Work Sheets

Unadjusted Trial Balance Columns Begin by filling in the trial balance accounts and amounts

The Adjusting Entries Columns Make adjustments; formal journal entries are prepared later

Adjusted Trial Balance Columns Add or subtract adjustments for adjusted account balances

The Income Statement Columns Extend revenue and expense account balances to the income statement

The Balance Sheet Columns Extend asset, liability, and equity accounts to the balance sheet

Contingent Liabilities Obligation involving existing condition Outcome not known with certainty Dependent upon some future event Actual amount is estimated harigopal@kusom.edu.np 11

Contingent Liabilities Accrue estimated amount if: Liability is probable Amount can be reasonably estimated In year criteria are met: Expense (loss) XXX Liability XXX harigopal@kusom.edu.np 12

Typical Contingent Liabilities Product warranties and guarantees Premium or coupon offers Lawsuits harigopal@kusom.edu.np 13

Recording Contingent Liabilities Example: Quickly Computer sells a computer product for $5,000 with a one-year warranty. In 2012, 100 computers were sold for a total sales revenue of $500,000. Analyzing past records, Quickly estimates that repairs will average 2% of total sales. harigopal@kusom.edu.np

Recording Contingent Liabilities Probable liability has been incurred? Amount reasonably estimable? YES YES Record in 2012: Warranty Expense 10,000 Estimated Liability 10,000 (2% X $500,000 sales) harigopal@kusom.edu.np

Disclosing Contingent Liabilities IF not probable but reasonably possible OR amount not estimable Disclose in Financial Statement notes harigopal@kusom.edu.np 16

Contingent Assets Contingent gains and assets are not recorded but may be disclosed in financial statement notes Conservatism principle applies harigopal@kusom.edu.np

IFRS and Contingencies International standards use the term “provision” for those items that must be reported on the balance sheet International standards have a lower threshold for those items that must be reported so thus more items will be recorded on the balance sheet. International standards require the amount of the recorded liability be discounted (recorded at present value). The term “contingent liability” is only used for those items that are footnoted but not for those liabilities reported on the balance sheet. harigopal@kusom.edu.np

Thank You! harigopal@kusom.edu.np