1. Week 2 Creating Financial Statements From Transactions

2. A Little Review  The Accounting Equation Assets = Liabilities plus Owners’ Equity

3. The Balance Sheet  Assets Resources with future value  Liabilities Obligations to non-owners A source of the resources  Owners’ Equity The difference between assets and liabilities Another source of the resources Two forms  Contributed Capital (Common Stock)  Earned Capital (Retained Earnings)

4. The Income Statement  A measure of entity performance for a period of time.  Based on accrual accounting  Ties to the Balance Sheet through retained earnings  Major components Revenues and gains Expenses and losses

5. Two Methods To Record Transactions  Traditional (Hard!) way used by accountants/bookkeepers Debits Credits T-accounts  Our methods Spreadsheet based on accounting equations  Increases and decreases

6. Journal Entries

7. Transaction Analysis

8. Credit Sales Transaction

9. Expense Payment Transaction

10. Accrued Expense Transaction

11. Deferred Revenue Transaction

12. Asset Write-Down (Impairment) Transaction

13. Arcadia Company Review Problem 1. Smith contributed $250,000 in cash 2. The firm purchased a shop for $150,000 3. The firm borrowed $120,000 1. Interest only of 6% paid semi-annually 4. $150,000 of inventory purchased with $120,000 cash and $30,000 credit 5. $80,000 (cost) of the inventory was sold for $160,000 in cash 6. The shop is depreciated over 20 years on a straight-line basis 7. Smith withdrew $20,000 of his capital contribution

14. Problem 2.2  Received $50,000 in cash from investors as an equity investment.  Borrowed $40,000 from a bank.  Purchased two parcels of land, each costing $15,000, for a total of $30,000 cash.  Paid $10,000 cash to rent office equipment for the year.  Provided real estate appraisal services valued at $25,000, receiving $20,000 in cash and an account receivable for an additional $5,000.  Paid miscellaneous expenses totaling $11,000 in cash.  Sold one parcel of land, costing $15,000, for $22,000 cash.  Paid a $5,000 cash dividend to shareholders.

15. Some Useful Ratios  Profitability Why not just consider net income?  Return on Assets (ROA) Considers how will you did with what you invested. Both income statement and balance sheet.

16. ROA  Tells us what is available for all investors (both debt and equity). Return of equity (ROE) similar for just shareholders.  Can be decomposed into two components in order to shed more light on performance.

17. ROA  ROA = Return on sales (ROS) x Asset Turnover (AT)

18. Return on Equity  Only considers return to shareholders  Therefore no need to add back interest expense  Also only divide by shareholders’ equity rather than total assets

19. ROE  Like ROA, ROE can also be decomposed  Sometimes called the Dupont Model  ROE = ROS x AT x Leverage

20. Evaluating Risk  Debt to equity  Interest coverage

21. What Number Do You Want?  Accounting is a political process, not an exact science.  There is a great deal of discretion available to managers.

22. Earnings Management  Reasons to manage earnings ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS

23. Earnings Management - Why  Compensation contracts  Debt contracts  Political considerations

24. Question? Why might a company’s stockholders want its managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary?

25. Debt Contracts  Firms that are near violation of their debt contracts have incentives to manage earnings upward.

26. Question? The following excerpt was taken from a recent financial statement of Cummins Engine Company: Loan agreements contain covenants which impose restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. Why would a creditor such as a bank impose such restrictions when making a loan?

27. Political Reasons  Firms may wish to portray a certain image to the public, government, or regulatory body.

28. Common Earnings Management  Smoothing earnings  Managing earnings upward  Taking a bath  Off balance sheet financing

29. Problem 2.11  See handout