1. Understanding and Preparation of Financial Statements
MBA
Kathmandu University
School of Management (KUSOM)

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

3. 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

4. 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

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

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

7. Basis of Recording Transactions

8. External and Internal Events
External events: interaction between entity
and outside environment
Internal events:
Interaction within
entity

9. 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

10. Analyzing the Effects of Transactions on the Accounting Equation

11. 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 3

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

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

14. 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) 7

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

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

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

18. 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 8

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

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

21. Cumulative Effect of Transactions for Glengarry Health Club
Assets = Liabilities S/E
Sold stock + $100, = $100,000
Bought prop.
with note , = + $200,000
Bought equip.
on acct , = ,000
Sold
memberships , = ,000
Sold court time , = ,000
Paid wages – , = – ,000
Paid utilities – , = – ,000
Collected A/R , = (no change in Liabilities + SE)
– ,000
Paid dividends – , = – ,000
+ $325,000 = + $220, $105,000 11

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

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

24. 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 17

25. The T Account Account Name 400 dr. 900 cr. 500 cr. Debits and credits
are netted to obtain
balance in account
500 cr. 17

26. 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

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

28. 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

29. Normal Account Balances
Debit
Credit
Assets
Expenses
Dividends
Liabilities
Stockholders’ Equity
Revenues
all increased with debits
all increased with credits 22 21

30. Transactions and T Accounts
Cash Capital Stock
(1) 100, ,000 (1)
(1) Issue capital stock for cash 3 22

31. Transactions and T Accounts
Land
(2) 50,000
Notes Payable
Building , 000 (2)
(2) 150,000
(2) Purchase property in exchange
for a promissory note. 3 23

32. Transactions and T Accounts
Equipment Accounts Payable
(3) 20, ,000 (3)
(3) Purchase equipment on account 3 24

33. (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 3 25

34. (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 3 25

35. (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 3 25

36. 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 3 24

37. 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 3 24

38. 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 3 26

39. 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

40. 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 ,000
Capital Stock ,000
To record the issuance of 10,000 shares

41. Journal Entries Dr. Cr. Building 150,000 Land 50,000
Notes Payable ,000
To record acquisition of property in exchange for note
Equipment ,000
Accounts Payable ,000
To record the acquisition of equipment on open account
Accounts Receivable ,000
Membership Revenue ,000
To record sale of monthly memberships on account

42. Journal Entries Dr. Cr. Cash 5,000 Court Fee Revenue 5,000
To record sale of court time
for cash.
Wage and Salary Expense ,000
Cash ,000
To record payment of wages
and salaries.
Utilities Expense ,000
Cash ,000
To record payment of utilities.

43. Journal Entries Dr. Cr. Cash 4,000 Accounts Receivable 4,000
To record collection of accounts
receivable.
Dividends ,000
Cash ,000
To record payment of dividends.

44. 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, $340,000

45. 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

46. 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 ,000
Accounts receivable ,000
Merchandise inventory ,500
Prepaid insurance ,800
Supplies
Total current assets $118,000
Non Current Assets
Investments
Land held for future office site ,000
Property, plant, and equipment
Land $100,000
Buildings $150,000
Less: Accumulated depreciation (60,000) ,000
Store furniture and fixtures $ 42,000
Less: Accumulated depreciation (12,600) ,400
Total property, plant and equipment ,400
Intangible assets
Franchise agreement ,000
Total assets $542,400

47. 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 ,500
Income taxes payable ,200
Interest payable ,500
Bank loan payable ,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 ,000
Total contributed capital $ 75,000
Retained earnings ,500
Total stockholders' equity $ 362,500
+ SE
Total liabilities and stockholders’ equity $542,400

48. 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

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

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

51. 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

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

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

54. 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)

55. 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

56. Financial Statements for a Real Company: General Mills

57. General Mills’s Liquidity
(in millions)
Current assets $ 3, $ 3,534.9
Current liabilities , ,606.0
Working capital $ ( ) $( )
Current = Current Assets
Ratio Current Liabilities
(How many $ of current assets for
every $ of current liabilities)
Current ratio = : :1 15 15

58. General Mills’s Profitability
(in million’s)
Net sales $14, $14, $13,652.1
Net income $ 1, $ 1, $ 1,294.7
Profit margin % = % % %
Profit Margin % = Net Income
Sales
(How many cents on every dollar of sales are left
over after covering all expenses) 16 16

59. 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

60. 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?

61. 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

62. 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?

63. 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

64. 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

65. 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)

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

67. 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

68. 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
Prepaid Insurance
($2,400 annual × 1/12 = $200 per month for 12 months)

69. 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
Accumulated Depreciation
($5,000 – $500) × 1/60 = $75 per month for 60 months)

70. 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

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

72. 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

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

74. 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 ,000
Notes Payable ,000
Monthly adjusting journal entry:
3/31 Interest Expense
Interest Payable
($20,000 principal × 9% × 3/12 = $450 for 3 months or $450/3 = $150 per month)

75. 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
Interest Expense Notes Payable 20,000
Cash 20,450

76. 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

77. 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 ,500
Rent Revenue ,500
Upon receipt of cash:
Cash ,500
Rent Receivable ,500

78. 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

79. 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

80. 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

81. 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

82. (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

83. Accounting Tools: Work Sheets
Appendix
Accounting Tools:
Work Sheets

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

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

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

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

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

89. Contingent Liabilities
Obligation involving existing condition
Outcome not known with certainty
Dependent upon some future event
Actual amount is estimated 11

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

91. Typical Contingent Liabilities
Product warranties and guarantees
Premium or coupon offers
Lawsuits 13

92. 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.

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

94. Disclosing Contingent LiabilitiesIF
not probable but reasonably possible OR
amount not estimable
Disclose in
Financial
Statement
notes 16

95. Contingent Assets
Contingent gains and assets are not recorded but may be disclosed in financial statement notes
Conservatism principle applies

96. 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.

97. Thank You!