2-1 The Cash Basis of Accounting Chapter 2 Electronic Presentation by Douglas Cloud Pepperdine University

2-2 1.Describe the basic elements of a financial accounting system. 2.Describe the cash and accrual bases of accounting. 3.Use the cash basis of accounting to analyze, record, and summarize transactions for a corporation’s first period of operations. 4.Use the cash basis of accounting to prepare financial statements for the first period of operations. Learning Goals After studying this chapter, you should be able to: ContinuedContinued

2-3 5.Use the cash basis of accounting for recording transactions and preparing financial statements for a second period of operations. 6.Describe the advantages and disadvantages of the cash basis of accounting. 7.Describe and illustrate how vertical analysis can be used to analyze and evaluate a company’s performance. Learning Goals

2-4 1 Learning Goal Describe the basic elements of a financial accounting system.

2-5 Balance Sheet Assets = Liabilities Stock- holders’ Equity + The rights of creditors The rights of the stockholders The Accounting Equation

2-6 Describe the cash and accrual bases of accounting. 2 Learning Goal

2-7 Under the cash basis of accounting, a business records only transactions involving increases or decreases in cash.

2-8 Under the accrual basis of accounting, revenue is recorded as it is earned and an expense is recorded when incurred.

2-9 Use the cash basis of accounting to analyze, record, and summarize transactions for a corporation’s first period of operations. 3 Learning Goal

2-10 On September 1, 2003, Dr. Lee Landry organized a professional corporation to practice general medicine.

2-11 a. Dr. Landry deposits $6,000 in a bank account in the name of Family Health Care, P.C. in return for shares of stock in the corporation. Capital Stock 6,000Investment by Dr. Landry Cash 6,000 a. Assets Stockholders’ Equity =

2-12 b. Family Health Care borrowed $10,000 from First National Bank. Capital Stock 6,000 Cash 6,000 a. Assets Stockholders’ Equity = Liabilities + b. 10,00010,000 Bal.16,00010,0006,000 Notes Payable + =

2-13 c. Family Health Care buys land for $12,000 cash. Capital Stock Cash Assets Stockholders’ Equity = Liabilities + Bal.16,000 10,0006,000 Notes Payable + = c.–12,00012,000 Bal. 4,00012,00010,0006,000 + Land

2-14 d. During the first month of operations, Family Health Care earns patient fees of $5,500, receiving the amount in cash. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = d.5,500Revenue  5,500 Bal.4,00012,00010,0006,000 Retained Earnings Bal.9,50012,00010,0006,0005,500

2-15 e. The expenses for the month were as follows: wages, $1,125; rent, $950; utilities, $450; interest, $100; miscellaneous, $275. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = e.–2,900Wages expense  –1,125 Rent expense  –950 Utilities expense  –450 Interest expense  –100 Misc. expense  –275 Retained Earnings Bal.9,50012,00010,0006,0005,500 Bal.6,60012,00010,0006,0002,600

2-16 f. Family Health Care pays $1,500 to stockholder (Dr. Landry) as dividends. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = f.–1,500Dividends  –1,500 Retained Earnings Bal.6,60012,00010,0006,0002,600 Bal.5,10012,00010,0006,0001,100

2-17 The following apply to all types of businesses: 1.The effect of every transaction is an increase or a decrease in one or more of the accounting equation elements. 2.The two sides of the accounting equations are always equal. 3.The stockholders’ equity is increased by amounts invested by stockholders and by revenues. It is decreased by expenses and dividends. Let’s visualize this.

2-18 S TOCKHOLDERS’ E QUITY Capital StockRetained Earnings Stockholders’ Investments Revenues Expenses Expenses Dividends Dividends

2-19 Use the cash basis of accounting to prepare financial statements for the first period of operations. 4 Learning Goal

2-20 Fees earned$5,500 Operating expenses: Wages expense$1,125 Rent expense950 Utilities expense450 Interest expense100 Miscellaneous expense 275 Total operating expenses 2,900 Net income$2,600 Family Health Care, P.C. Income Statement For the Month Ended September 30, 2003 Revenue and expense amounts taken from the Retained Earnings column in Exhibit 2 of the textbook.

2-21 Net income for September$2,600 Less dividends 1,500 Retained Earnings, September 30, 2003$1,100 Family Health Care, P.C. Retained Earnings Statement For the Month Ended September 30, 2003 The net income is taken from the income statement (previous slide) and the amount of dividends from the Retained Earnings column in Exhibit 2 of the textbook.

2-22 Assets Cash$ 5,100 Land 12,000 Total assets$17,100 Liabilities Notes payable$10,000 Stockholders’ Equity Capital stock$6,000 Retained earnings 1,100 7,100 Total liabilities and stockholders’ equity$17,100 Family Health Care, P.C. Balance Sheet September 30, 2003 All account balances were taken from the bottom row of Exhibit 2, except Retained Earnings. Retained Earnings balance is taken from the retained earnings statement.

2-23 Assets Cash$ 5,100 Land 12,000 Total assets$17,100 Liabilities Notes payable$10,000 Stockholders’ Equity Capital stock$6,000 Retained earnings 1,100 7,100 Total liabilities and stockholders’ equity$17,100 Family Health Care, P.C. Balance Sheet September 30, 2003 Total assets equal total liabilities plus stockholders’ equity.

2-24 Cash flows from operating activities: Cash received from customers$ 5,500 Deduct cash payments for expenses 7,900 Net cash flow from operating activities$ 2,600 Cash flows from investing activities: Cash payments for acquisition of land(12,000) Cash flows from financing activities: Cash from sale of cap. stock$ 6,000 Cash from notes payable 10,000$16,000 Deduct cash dividends 1,500 Net cash flow from financing activities 14,500 Net increase in cash$ 5,100 September 1, 2003 cash balance 0 September 30, 2003 cash balance$ 5,100 Family Health Care, P.C. Statement of Cash Flows For the Month Ended September 30, 2003

2-25 Use the cash basis of accounting for recording transactions and preparing financial statements for a second period of operations. 5 Learning Goal

2-26 a. Received fees of $6,400 in cash. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = a.6,400Revenue  6,400 Retained Earnings Bal.5,10012,00010,0006,0001,100 Bal.11,50012,00010,0006,0007,500

2-27 b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = e.–3,180Wages expense  –1,370 Rent expense  –950 Utilities expense  –540 Interest expense  –100 Misc. expense  –220 Retained Earnings Bal.11,50012,00010,0006,0007,500 Bal.8,32012,00010,0006,0004,320

2-28 c. Family Health Care pays $1,000 to stockholders (Dr. Landry) as dividends. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = c.–1,000Dividends  –1,000 Retained Earnings Bal.8,32012,00010,0006,0004,320 Bal.7,32012,00010,0006,0003,320

2-29 Fees earned$6,400 Operating expenses: Wages expense$1,370 Rent expense950 Utilities expense540 Interest expense100 Miscellaneous expense 220 Total operating expenses 3,180 Net income$3,220 Family Health Care, P.C. Income Statement For the Month Ended October 31, 2003 To review the source of this amount, click the green button below. Revenue To review the source of expenses, click the orange button below. Expenses

2-30 Describe the advantages and disadvantages of the cash basis of accounting. 6 Learning Goal

2-31 The primary advantage of the cash basis of accounting is its simplicity.

2-32 The primary disadvantage of the cash basis is that revenues and expenses may not be properly matched on the income statement.

2-33 Describe and illustrate how vertical analysis can be used to analyze and evaluate a company’s performance. 7 Learning Goal

2-34 Statements can be compared by computing a percentage of each item within a statement to a total within the statement.

2-35 This type of analysis is called vertical analysis.

2-36 Vertical Analysis—Balance Sheet Assets: Cash and cash equivalents$ 307,785 Short-term investments25,450 Accounts receivable239,885 Inventories278,981 Property, plant, and equipment684,379 Other assets 229,168 TOTAL ASSETS$1,765,648 $307,785 $1,765, %

2-37 Assets: Cash and cash equivalents$ 307,785 Short-term investments25,450 Accounts receivable239,885 Inventories278,981 Property, plant, and equipment684,379 Other assets 229,168 TOTAL ASSETS$1,765,648 $25,450 $1,765, % 1.4 Vertical Analysis—Balance Sheet

2-38 Assets: Cash and cash equivalents$ 307,785 Short-term investments25,450 Accounts receivable239,885 Inventories278,981 Property, plant, and equipment684,379 Other assets 229,168 TOTAL ASSETS$1,765, % % Vertical Analysis—Balance Sheet

2-39 Liabilities: Accounts payable$ 91,225 Dividends payable42,741 Income and other taxes payable68,467 Long-term liabilities157,127 Other liabilities 129,891 Total liabilities$ 489,451 Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E.$1,765,648 $91,225 $1,765, % Vertical Analysis—Balance Sheet

% % % Liabilities: Accounts payable$ 91,225 Dividends payable42,741 Income and other taxes payable68,467 Long-term liabilities157,127 Other liabilities 129,891 Total liabilities$ 489,451 Stockholders’ equity: Total stockholders’ equity 1,276,197 TOTAL LIAB. & S.E.$1,765,648 Vertical Analysis—Balance Sheet

2-41 Vertical Analysis—Comparative Balance Sheets Assets: Cash and cash equivalents Short-term investments Accounts receivable Inventories Property, plant, and equipment Other assets TOTAL ASSETS 17.4% % % % 2000

% % % Liabilities: Accounts payable Dividends payable Income and other taxes payable Long-term liabilities Other liabilities Total liabilities Stockholders’ equity: Total stockholders’ equity TOTAL LIAB. & S.E. Vertical Analysis—Comparative Balance Sheets % % % 2000

2-43 Vertical Analysis—Income Statement Net sales$2,429,646 Cost of sales 997,054 Gross profit$1,432,592 Selling and administrative exp. 919,236 Operating income$ 513,356 Other income (expense) 14,010 Income before income taxes$ 527,366 Income taxes 164,380 Net income$ 362, % $997,054 $2,429,

2-44 Net sales$2,429,646 Cost of sales 997,054 Gross profit$1,432,592 Selling and administrative exp. 919,236 Operating income$ 513,356 Other income (expense) 14,010 Income before income taxes$ 527,366 Income taxes 164,380 Net income$ 362, % $1,432,592 $2,429, % Vertical Analysis—Income Statement

2-45 Net sales$2,429,646 Cost of sales 997,054 Gross profit$1,432,592 Selling and administrative exp. 919,236 Operating income$ 513,356 Other income (expense) 14,010 Income before income taxes$ 527,366 Income taxes 164,380 Net income$ 362, % % % % % Vertical Analysis—Income Statement

2-46 Vertical Analysis—Income Statement Net sales Cost of sales Gross profit Selling and administrative exp. Operating income Other income (expense) Income before income taxes Income taxes Net income 100.0% % % % % % % % % % 2000

2-47 The End Chapter 2

2-48

2-49 a. Received fees of $6,400 in cash. Capital Stock Cash + Land Assets Stockholders’ Equity = Liabilities + Notes Payable + = a.6,400Revenue  6,400 Retained Earnings Bal.5,10012,00010,0006,0001,100 Bal.11,50012,00010,0006,0007,500 Return to income statement

2-50 b. Paid expenses in cash as follows follows: wages, $1,370; rent, $950; utilities, $540; interest, $100; miscellaneous, $220. Cash + Land Assets e.–2,900Wages expense  –1,370 Rent expense  –950 Utilities expense  –540 Interest expense  –100 Misc. expense  –220 Capital Stock Stockholders’ Equity = Liabilities + Notes Payable + = Retained Earnings Bal.11,50012,00010,0006,0007,500 Bal.8,32012,00010,0006,0004,320 Return to income statement