Financial Reporting Slides PDF

Session 1 F. Reporting FINANCIAL REPORTING SESSION 1 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023 ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohib...

Session 1 F. Reporting FINANCIAL REPORTING SESSION 1 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023 ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohibited. 1 Agenda Session 1 F. Reporting ✓The Accounting system ✓The Financial Statements ✓The GAAP ✓Management responsibility and auditing ✓Accounting Strategy and Financial Disclosure 2 Session 1 F. Reporting 3 The Accounting System Session 1 F. Reporting 4 The Accounting System Session 1 F. Reporting 5 The Accounting System Session 1 F. Reporting 6 The Accounting System Session 1 F. Reporting 7 The Accounting System Session 1 F. Reporting Measurement Principles IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. • Historical cost principle (or cost principle): dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. • Fair value principle: states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). 8 The Accounting System Session 1 F. Reporting Qualities of useful information The IASB conceptual framework states that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities: Relevance Faithful representation 9 The Accounting System Session 1 F. Reporting Qualities of useful information 10  The Accounting System Session 1 F. Reporting Assumptions They provide a foundation for the accounting process Monetary unit Economic entity Time period Going concern 11  The Accounting System Session 1 F. Reporting Assumptions 12  The Accounting System Session 1 F. Reporting Assumptions 13  Session 1 F. Reporting The Financial Statements The Financial Statements Session 1 F. Reporting General purpose: to provide information about the financial position, performance and cash flows of a firm that is useful to a wide range of users in making economic decisions The Financial Statements Session 1 F. Reporting Information in the Financial Statements What is the accumulated wealth of the company at the end of a particular period? Balance Sheet (BS) How much wealth was generated by the company over a particular period? Income Statement (IS) What cash movements took place over a particular period? Cash Flow Statement (CFS) 16  The Financial Statements Session 1 F. Reporting BALANCE SHEET/STATEMENT OF FINANCIAL POSITION – reports the amount of assets, liabilities, and shareholders/stockholders’ equity of an accounting entity at a specific date INCOME STATEMENT – reports the revenues less the expenses and resulting net income or net loss for a specific period of time STATEMENT OF SHAREHOLDERS’ / STOCKHOLDERS’ EQUITY / RETAINED EARNINGS STATEMENTS – reports the changes in each of the company’s shareholders’ / stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends during a specific period of time STATEMENT OF CASH FLOWS – reports inflows (receipts) and outflows (payments) of cash for a specific period of time in the categories of operating, investing, and financing COMPREHENSIVE INCOME STATEMENT – presents other comprehensive income items that are not included in the determination of net income 17  The Financial Statements Session 1 F. Reporting 18  The Financial Statements Session 1 F. Reporting 19  The Financial Statements Session 1 F. Reporting The Balance Sheet / Statement of Financial Position Elements Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Liabilities Accounts Payable Accrued Expenses Notes Payable Interest Payable Taxes Payable Unearned Revenue Loans/Bonds Payable Shareholders’/Stockholders’ Equity Common Stock/Share Capital 20  Retained Earnings Session 1 F. Reporting 21  The Financial Statements Session 1 F. Reporting The Accounting Equation A = L + SE Assets Economic Resources Liabilities Shareholders’ / Stockholders’ Equity Sources of Financing for Economic Resources Liabilities: From Creditors Equity: From Shareholders/Stockholders 22  Session 1 F. Reporting 23  The Financial Statements Session 1 F. Reporting The Income Statement Elements Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense 24  Session 1 F. Reporting 25  The Financial Statements Session 1 F. Reporting The Statement of Cash Flows Elements Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities /- Note that each of the three cash flow sources can be positive (net cash inflow) or negative (net cash outflow). 26  Session 1 F. Reporting 27  The Financial Statements Session 1 F. Reporting The Statement of Shareholders’ / Stockholders’ Equity or Retained Earnings Statement Elements Share capital / Common Stock Retained Earnings Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings 28  Session 1 F. Reporting 29  The Financial Statements Session 1 F. Reporting Relationships among the statements Income Statement Net income is computed first and is needed to determine the ending balance in retained earnings. Retained Earnings Statement The ending balance in retained earnings is needed in preparing the statement of financial position. BS/Statement of Financial Position The cash shown on the statement of financial position is needed in preparing the statement of cash flows. Statement of Cash Flows 30  The Financial Statements Session 1 F. Reporting The Notes Did you notice a sentence at the bottom of each financial statement? All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company. 31  Session 1 F. Reporting 32  The Financial Statements Session 1 F. Reporting 33  Session 1 F. Reporting The GAAP 34  The GAAP Session 1 F. Reporting Our accounting system has a long and distinguished history. An Italian monk and mathematician, Fray Luca Pacioli, published the first elements of doubleentry bookkeeping in 1494.* Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices. * Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality) 35  The GAAP Session 1 F. Reporting In order to assure high-quality financial reporting, accountants present financial statements in conformity with accounting standards issued by standard-setting bodies. Generally Accepted Accounting Principles (GAAP) 36  The GAAP Session 1 F. Reporting 37  The GAAP Session 1 F. Reporting Two sets of standards accepted for international use: ▪ U.S. GAAP, issued by the FASB http://www.fasb.org/home ▪ International Financial Reporting Standards (IFRS), issued by the IASB http://www.ifrs.org/ Different jurisdictions Different rules US GAAP (FASB – SEC) IFRS & IAS (IASB) – National bodies - Governments 38  The GAAP Session 1 F. Reporting Securities Act of 1933 Securities and Exchange Act of 1934 The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements in the USA 39  The GAAP Session 1 F. Reporting The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate US GAAP which are applied by most companies in the U.S.A. 40  The GAAP Session 1 F. Reporting IASB (International Accounting Standards Board): ▪ Private institution; ▪ Issuer of IFRS (former IAS); ▪ Interpretations IFRICs (International Financial Reporting Interpretations Committee) and SICs (Standards Interpretations Committee) 41  The GAAP Session 1 F. Reporting 42  http://www.ifrs.org/Pages/default.aspx The GAAP Session 1 F. Reporting Global Convergence of Accounting Standards Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). They are used in more than 130 countries Examples of jurisdictions requiring the use of IFRS : • European Union (2005, 2008) • Israel, Turkey & S Africa (2008) • Australia and New Zealand (2005), Canada (2009-11) • Brazil (2010), Chile (2009), Mexico & Perú (2012), Colombia (2016) • UAE, Saudi Arabia (2008), Hong Kong, Malaysia &South Korea (2016) In the United States, the SEC allows foreign companies whose stock is traded in the U.S.A. to use IFRS. Japanese companies also can use IFRS. You can find the use of IFRS by jurisdiction via the following link: https://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs 43  The GAAP Session 1 F. Reporting Differences in Accounting Methods 44  Session 1 F. Reporting Management responsibility & auditing 45  Management responsibility and auditing Session 1 F. Reporting Companies incur the cost of preparing the financial statements and bear the following economic consequences of their publication . . . ✓ Effects on the selling price of stock. ✓ Effects on the amount of bonuses received by managers and other employees. ✓ Loss of competitive information to other companies. 46  Management responsibility and auditing Session 1 F. Reporting Ethical Conduct 47  Management responsibility and auditing Session 1 F. Reporting Ensuring the Accuracy of Financial Statements To ensure the accuracy of the company’s financial information, management: • Maintains a system of controls • Hires external independent or external auditors • Forms a committee of the Board of Directors to review these other two safeguards. 48  Management responsibility and auditing Session 1 F. Reporting External Audit An audit is an examination of the financial reports to ensure that they represent what they claim and conform with GAAP 49  Overall, I believe these financial statements are fairly stated Management responsibility and auditing Session 1 F. Reporting 50  Management responsibility and auditing Session 1 F. Reporting Ethics, reputation and legal liability 51  Session 1 F. Reporting Accounting Strategy & Financial Disclosure 52  Accounting Strategy and Financial Disclosure Session 1 F. Reporting 53  Source: The World Bank & UNODC Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Parent Company stand alone Financial Statements or/and Consolidated Financial Statements ▪ Where to get this information? ▪ Be aware of Financial Statements Annexes. • Financial Statements (Conceptual Framework): ▪ The Balance Sheet ▪ The Income Statement ▪ Cash Flow Statement ▪ The statement of owners’ or stockholders’ equity. • Auditor’s Report: Limiting their responsibility: Has The company performed an auditor change? 54  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Notes to Financial Statements: cross references to Financial Statements. • How are reflected in Financial Statements relevant issues published? • Collaboration of Accounting and Financial Analysis Department with the different Company Areas: Legal & Compliance Department, Tax Department, Finance Department, Management Control, Controller office, Marketing and Sales, Operations, Procurement and Logistics. • Implication (coherence) of financial risk coverage policy in Financial Statements. • Consequences of potential or actual tax/financial inspections. 55  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Accounting Rules: ▪ Identify key accounting policies: Analyze policies and estimates the firm uses to measure its critical factors and risks ▪ How the firm’s accounting policies compare to the norms in the industry? • Comparative Information: two/three years for Balance Sheet & two/three years for Income & Cash Flow Statement • Financial KPI’s for decision making: “non gaap measures”: ▪ Gross Margin ▪ EBITDA (Earnings Before Interests Taxes Depreciation & Amortization). ▪ Net Financial Debt 56  Accounting Strategy and Financial Disclosure Session 1 F. Reporting Economic Entity Financial Information Accounting Identifies Measures & Communicates Financial Statements Additional Information Balance Sheet President’s letter Income Statement Prospectuses, Statement of Cash Flows SEC Reporting Statement of Owners’ or Stockholders’ Equity Note Disclosures GAAP 57  News and Press releases Forecasts Environmental Reports Non-GAAP measures Not GAAP Accounting Strategy and Financial Disclosure Session 1 F. Reporting Quality of Financial Disclosures: ▪ Do disclosures show the firm’s business strategy and its economic consequences? ▪ Do the financial statements explain the key accounting policies and assumptions? ▪ Does the company explain its current performance? ▪ When accounting rules restrict the firm from measuring its key success factors, does the firm provide adequate additional disclosure to help outsiders how these factors are managed? ▪ Quality of segment disclosure ▪ How good is the Investor Relations program/team? ▪ Do managers face strong incentives to use accounting discretion to manage earnings? Debt covenants, bonus targets, stock options plans, reducing tax payments? ▪ Realistic estimations in the past? Is there a justification? 58  Accounting Strategy and Financial Disclosure Session 1 F. Reporting • Some companies sacrifice value creation to get short term targets. • Moderate and constant growth is much more valued by the market than strong & volatile growth, surprises affect negatively to share value of quoted companies • Lack of transparency may “under price” shares Trade-off between offering additional information or compulsory disclosures: Good because….. Bad because…. Once you offer additional information you can not cease on it. But sometimes, it may not be easy to get the same information Legal risks Information for competitors Additional information may reduce risk in terms of understanding Reduce costs for analysts Sign of “quality” 59  Session 1 F. Reporting 60  Session 2 F. Reporting FINANCIAL REPORTING SESSION 2 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023. ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohibited. 1 Session 2 F. Reporting AGENDA ✓The Balance Sheet ✓Exercise BS P2-1 ✓Accrual vs Cash ✓Exercise Accrual P1-3 ✓Recording Transactions ✓What is next? 2 The Balance Sheet Session 2 F. Reporting PURPOSE OF THE BALANCE SHEET ✓ To set out the financial position of an enterprise at a given date, i.e. to report the ASSETS and CLAIMS of an company ✓ The Balance Sheet / Statement of Financial Position (BS) has two counterbalancing sections: ✓ the left side: assets (the resources of an enterprise) ✓ the right side: liabilities and Shareholders’ equity (claims against those resources). ✓ It is a status report rather than a flow report. Because the BS shows the financial status at a particular point in time, it is always dated 3 The Balance Sheet Session 2 F. Reporting ELEMENTS OF THE BALANCE SHEET A = L + SE (Assets) Economic resources with probable future benefits owned or controlled by the entity. They are expected to benefit the company by producing cash inflows or reducing cash outflows They are measured by the historical cost principle or fair value (depending on the regulation). (Liabilities) Liabilities or debts are probable future sacrifices of economic benefits arising from present obligations of a business to transfer cash or other assets or to provide services as a result of past transactions or events. Entities that a company owes money to are called creditors. 4 (Shareholders’ Equity) The financing provided by the owners (also referred to as contributed capital) and by business operations (also referred to as earned capital or retained earnings). The Balance Sheet Session 2 F. Reporting In a classified Balance Sheet assets and liabilities are classified into two categories: current and non current Current assets are those to be used or turned into cash within the upcoming year or the operating cycle, whichever is longer Current liabilities or Short Term liabilities are those obligations to be paid or settled within the next 12 months Non Current assets or Long Term assets or Fixed Assets are those that will last longer than one year or the operating cycle Non Current liabilities or Long Term liabilities are those obligations to be paid or settled after the next 12 months 5 Session 2 F. Reporting 6 The Balance Sheet Session 2 F. Reporting Current Assets ✓ Cash & Cash Equivalents: Money in the form of cash or bank deposits (e.g., checking and/or money market account). ✓ Short-term investments: An entity’s S-T investment in another entity’s stock or debt (i.e., bonds). Sometimes called “Marketable Securities”. ✓ Accounts Receivable: The amounts due from customers for goods they purchased on credit. Because all customers do not pay their bills, the balance is reduced by an “allowance” (an estimate of what will not be collected). 7 The Balance Sheet Session 2 F. Reporting Current Assets (II) ✓ Inventories: The goods an entity has on hand is referred to as a finished goods. The material that it needs to make the goods is referred to as raw materials. The raw material in process of being completed (i.e., finished) is referred to as work in process (WIP). ✓ Prepaid expenses: The amounts an entity has already paid for services/goods to be delivered in the future (e.g., car insurance). ✓ Others… 8 The Balance Sheet Session 2 F. Reporting Non Current or Fixed Assets ✓ Property, Plant, and Equipment: The land, buildings, equipment, furniture and fixtures that are used in operating the business ✓ Others: ✓L-T financial investments ✓Intangible Assets 9 The Balance Sheet Liabilities Session 2 F. Reporting ✓ The probable future sacrifice of economic benefits arising from an entity’s obligations to transfer assets or provide services as a result of a past transaction or event • Current Liabilities: Liabilities that are expected to be paid by the business within a short period of time, usually one year. Current liabilities are listed in order of callability (the ability to pay the company obligations) • Non-Current Liabilities: Debts expected to be paid after one year 10  The Balance Sheet Current Liabilities Session 2 F. Reporting ✓ Accounts payable: The amount an entity owes to suppliers for goods previously delivered. Sometimes referred to as “trade payables” ✓ Accrued liabilities: The amounts an entity owes for taxes, rent, wages, … ✓ Short-term borrowings: Monetary amounts due within one year for repayment of bank loans, notes payable, … ✓ Dividends payable: The amount owed by a corporation to its shareholders when dividends declared by the board of directors have not yet been paid 11  The Balance Sheet Current Liabilities (II) Session 2 F. Reporting Unearned revenues: The monetary amounts received by an entity that accepts up-front payments of cash in exchange for future delivery of its products. ✓ Example: Your advance cash payment for a three-year subscription to Financial Times requires their sacrifice of future economic benefits (they are liable) to provide the magazine. It is termed “unearned” as it represents a service (i.e., the subscription) that has NOT yet been completed (i.e., delivered to your door). It will be “earned” as delivery takes place. 12  The Balance Sheet Session 2 F. Reporting Non-Current Liabilities ✓ Bonds payable – The amount due to bond purchasers under terms of the bond issue. ✓ Long-term borrowings/loans/financial debt – Monetary amounts for bank loans, notes payable and other commercial paper that does not have to be repaid within one year. ✓ Others … 13  The Balance Sheet Session 2 F. Reporting Shareholders/Stockholders’ Equity ✓The difference between total assets and total liabilities. ✓Contributions of owners: Common stock/Shared Capital; Additional paid-in capital; Preferred stock ✓Retained Earnings: equity (net income = revenues – expenses) generated from operations less what has been returned to the shareholders in dividends. The adjective “retained” reveals that these earnings have not been distributed to shareholders in the form of dividends 14  The Balance Sheet Session 2 F. Reporting Constructing the Balance Sheet Analyze the effect of business transactions on the basic accounting identity: Assets = Liabilities + Shareholders’ Equity Remember: The Accounting Identity must always balance 15  The Balance Sheet Session 2 F. Reporting Constructing the Balance Sheet Each item of the Balance Sheet will be represented by an Account The type of account determines how increases and decreases are recorded: Accounting Equation Rules of Debit and Credit Assets Debit + Credit - Normal Debit Balance = Liabilities Debit - Credit + + Shareholders’ Equity Debit Credit - + Normal Credit Balance 16  The Balance Sheet Session 2 F. Reporting 17  Exercise BS P2-1 Session 2 F. Reporting ✓Identifying accounts on a classified BS and their normal debit or credit balances Delta Corporation explores, produces and refines, markets and supplies crude oil, natural gas, and petroleum products around the world. The following are accounts from a recent balance sheet of Delta Corporation: 18  Exercise BS P2-1 BS Classification 1 Notes and loans payable (S/T) 2 Materials and supplies 3 Contributed capital 4 Patents (an intangible asset) 5 Income tax payable 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 19  Session 2 Debit or Credit F. Reporting Balance Exercise BS P2-1 1 Notes and loans payable (S/T) 2 Materials and supplies 3 Contributed capital 4 Patents (an intangible asset) 5 Income tax payable 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 20  BS Classification Debit or Credit F. Reporting Balance CL Credit Session 2 Exercise BS P2-1 Session 2 BS Classification Debit or Credit F. Reporting Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital 4 Patents (an intangible asset) 5 Income tax payable 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 21  Exercise BS P2-1 Session 2 BS Classification Debit or Credit F. Reporting Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) 5 Income tax payable 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 22  Exercise BS P2-1 Session 2 BS Classification F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 23  Exercise BS P2-1 BS Classification Debit or Credit F. Reporting Balance Session 2 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 24  Exercise BS P2-1 Session 2 BS Classification F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 25  Exercise BS P2-1 BS Classification Debit or Credit F. Reporting Balance Session 2 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 26  Exercise BS P2-1 Session 2 BS Classification Debit or Credit F. Reporting Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 27  Exercise BS P2-1 Session 2 BS Classification F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 28  Exercise BS P2-1 Session 2 BS Classification Debit or Credit F. Reporting Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 29  Exercise BS P2-1 BS Classification Session 2 F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit NCA Debit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 30  Exercise BS P2-1 Session 2 BS Classification F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit NCA Debit CA Debit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 12 Cash and Cash equivalents 13 Accounts payable 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 31  Exercise BS P2-1 Session 2 BS Classification F. Reporting Debit or Credit Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit NCA Debit 12 Cash and Cash equivalents CA Debit 13 Accounts payable CL Credit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 14 Crude Oil products & merchandise 15 Additional Paid-in Capital 32  Exercise BS P2-1 BS Classification Debit or Credit F. Reporting Balance Session 2 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit NCA Debit 12 Cash and Cash equivalents CA Debit 13 Accounts payable CL Credit 14 Crude Oil products & merchandise CA Debit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 15 Additional Paid-in Capital 33  Exercise BS P2-1 Session 2 BS Classification Debit or Credit F. Reporting Balance 1 Notes and loans payable (S/T) CL Credit 2 Materials and supplies CA Debit 3 Contributed capital SE Credit 4 Patents (an intangible asset) NCA Debit 5 Income tax payable CL Credit 6 Long-Term debt NCL Credit 7 Marketable securities (S/T) CA Debit 8 Property, Plant and Equipment NCA Debit 9 Retained Earnings SE Credit CA Debit NCA Debit 12 Cash and Cash equivalents CA Debit 13 Accounts payable CL Credit 14 Crude Oil products & merchandise CA Debit SE Credit 10 Notes and Accounts Receivable (S/T) 11 Investments (L/T) 15 Additional Paid-in Capital 34  Accrual vs Cash Session 2 F. Reporting Accrual logic Different! Cash flow logic 35  Accrual vs Cash Session 2 F. Reporting The accrual principle The effects of transactions and other events are recognised when they occur (and not when cash or its equivalent is received or paid) and they are recorded in the accounting books and reported in the financial statements of the periods to which they relate IASB Framework 36  Accrual vs Cash Session 2 F. Reporting Cash Flow versus accrual ✓ Accounting focuses on the economic effects of transactions, not on the cash flow ✓ Classic examples where cash flow and accrual logic do not coincide: • Purchase of long lived pieces of equipment • Sale of goods and/or services on credit • Purchase of goods and/or services on credit 37  Exercise Accrual P1-3 Session 2 F. Reporting ✓Comparing income with Cash Flow ✓Huang Trucking Company was launched on January 1. At the end of the first quarter (3 months) of operations, the owner prepared a summary of its activities ✓Based on these transactions, explain if they generate: • An income (+ revenue) or an (- expense) • a cash inflow (+) or a cash outflow (-) 38  Exercise Accrual P1-3 Session 2 F. Reporting a) Services performed for customers $66,000 of which $11,000 remained uncollected at the end of the quarter 39  Exercise Accrual P1-3 Session 2 F. Reporting a) Services performed for customers $66,000 of which $11,000 remained uncollected at the end of the quarter b) Cash borrowed from the local bank, $56,000 (one-year note) 40  Exercise Accrual P1-3 Session 2 F. Reporting b) Cash borrowed from the local bank, $56,000 (one-year note) c) Small service truck purchased at the end of the quarter to be used in the business for 2 years starting the next quarter: cost $12,500 cash 41  Exercise Accrual P1-3 Session 2 F. Reporting c) Small service truck purchased at the end of the quarter to be used in the business for 2 years starting the next quarter: cost $12,500 cash d) Wages earned by employees $25,000, of which one-half remained unpaid at the end of the quarter 42  Exercise Accrual P1-3 Session 2 F. Reporting d) Wages earned by employees $25,000, of which one-half remained unpaid at the end of the quarter e) Service supplies purchased for use in the business $3,800 cash, of which $900 were unused (still on hand) at the end of the quarter 43  Exercise Accrual P1-3 Session 2 F. Reporting e) Service supplies purchased for use in the business $3,800 cash, of which $900 were unused (still on hand) at the end of the quarter f) Other operating expenses $38,000, of which $6,500 remained unpaid at the end of the quarter 44  Exercise Accrual P1-3 Session 2 F. Reporting f) Other operating expenses $38,000, of which $6,500 remained Req. 1at the end of theReq. 2–Explanation unpaid quarter Transaction (a) Income Cash +$66,000 +$55,000 All services performed increase income; cash received during the period was, $66,000 – 11,000 = $55,000. (b) –0– +56,000 Cash borrowed is not income. (c) –0– –12,500 Purchase of the truck does not represent an expense until it is used (it is an asset); cash outflow was $12,500. All of the wages incurred reduce income, $25,000; cash paid during the quarter was, $25,000 x 1/2 = $12,500. The $12,500 owed will be paid on the next payroll date. (d) –25,000 –12,500 (e) –2,900 –3,800 Not all of the supplies were used; expense is the amount used, $3,800 – 900 = $2,900. Cash paid during the quarter was $3,800. (f) –38,000 –31,500 All expenses incurred reduce income; cash expended was, $38,000 – 6,500 = $31,500. 45  Session 2 F. Reporting But… how do we record transactions? 46  Recording Transactions Session 2 F. Reporting Accounts An individual accounting record of increases and decreases in a specific Asset, Liability, or Shareholders’ Equity item. Account Title Three parts : 1) the Title of the account Debit 2) a left or Debit side 3) a right or Credit side 47  Credit Recording Transactions Session 2 F. Reporting Accounts 48  Recording Transactions Session 2 F. Reporting How accounts work? Every business transaction involves both a debit and a credit The type of account determines how increases and decreases are recorded: Accounting Equation Rules of Debit and Credit Assets Debit + Credit - = Liabilities Debit - Normal Debit Balance Credit + + Shareholders’ Equity Debit Credit - + Normal Credit Balance 49  Recording Transactions Session 2 F. Reporting The Accounting Cycle: steps in the transaction process Start of new period During the Period 1. Analyze transactions 2. Record journal entries in the general journal 3. Post amounts to the general ledger via the Taccounts 4. 5. 6. 7. At the End of the Period Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger) 50  Recording Transactions Session 2 F. Reporting How companies keep track of account balances General Ledger General Journal T-accounts A = L + SE 51  The Balance Sheet Session 2 F. Reporting WHAT BUSINESS ACTIVITIES CAUSE CHANGES IN THE FINANCIAL STATEMENT AMOUNTS? Nature of Business Transactions External Events: Exchanges between entity and one or more parties Ex: Purchase of a machine from a supplier Internal Events: Events that are not exchanges between parties but that have a direct and measurable effect on the entity Ex: Using up insurance paid in advance 52  Recording Transactions Session 2 F. Reporting Double-Entry accounting ✓ Every transaction affects at least two accounts (duality of effects) ✓ The accounting equation must remain in balance after each transaction A = L + SE (Assets) (Liabilities) 53  (Stockholders’ Equity) Recording Transactions Session 2 F. Reporting Balancing the Accounting Equation Step 1: Ask--What was received and what was given? ▪ Identify the accounts (by title) affected and make sure at least two accounts change. ▪ Classify them by type of account. Was each account an asset (A), a liability (L), or a shareholders’ equity (SE)? ▪ Determine the direction of the effect. Did the account increase [+] or decrease [-]? Step 2: Verify--Is the accounting equation in balance? ▪ Verify that the accounting equation (A = L + SE). 54  Recording Transactions Session 2 F. Reporting Analytical Tool: the journal entry Companies initially record transactions in chronological order. Thus, the journal is referred to as the book of original entry. The journal makes several significant contributions to the recording process: 1. It discloses in one place the complete effects of a transaction. 2. It provides a chronological record of transactions. 3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared. 55  Recording Transactions Session 2 F. Reporting Analytical Tool: the journal entry Assume: On September 1, 2020, Softbyte SA shareholders invested €15,000 cash in the corporation in exchange for ordinary shares, and Softbyte purchased computer equipment for €7,000 cash. Demonstrate: How do you enter the transaction data in the journal? 56  Recording Transactions Session 2 F. Reporting Analytical Tool: the journal entry Date of the transaction. Debit account title. Credit account title. Brief explanation of the transaction. Reference column, which is left blank when the journal entry is made. This column is used later when the journal entries are transferred to the individual accounts. 57  Recording Transactions Session 2 F. Reporting Analytical Tool: the journal entry Simple entry: Involves one debit and one credit account. Compound entry: An entry that requires three or more accounts. The standard format requires that all debits be listed before the credits, for example. 58  Recording Transactions Posting transaction effects Ledger: The entire group of accounts maintained by a company. Provides the balance in each of the accounts as well as keeps track of changes in these balances. Companies may use various kinds of ledgers, but every company has a general ledger. 59  Session 2 F. Reporting Recording Transactions Posting transaction effects The General Ledger 60  Session 2 F. Reporting Recording Transactions Transferring information to T-Accounts After journal entries are prepared, the accountant posts (transfers) the amounts to each account affected by the transaction 61  Session 2 F. Reporting Recording Transactions Chart of Accounts Session 2 F. Reporting Lists the accounts and the account numbers that identify their location in the ledger. Numbering system: Usually starts with the statement of financial position accounts and follows with the income statement accounts. Number of accounts: Depends on the amount of detail management desires. Companies leave gaps to permit the insertion of new accounts as needed during the life of the business. 62  Recording Transactions Chart of Accounts 63  Session 2 F. Reporting Recording Transactions Session 2 F. Reporting Trial Balance The trial balance is a listing of all accounts in the general ledger and their balance at a given time The purpose of the trial balance is to make sure the debits and credits are equal before we prepare the balance sheet Three steps of preparation: 1) List the account titles and their balances in the appropriate debit or credit column. 2) Total the debit and credit columns. 3) Verify the equality of the two columns. 64  Recording Transactions Session 2 F. Reporting Trial Balance 65  Recording Transactions Session 2 F. Reporting You can practice with… Exercises Session 2 66  Session 2 F. Reporting What is next? 67  What is next? Session 2 F. Reporting ✓Working on a continuous basis: ✓Please, check the solutions of exercises posted on IE Campus Online – Sessions 1 & 2 ✓Session 3: Income Statement. The Accounting Cycle. ✓Session 4: The Accounting Cycle (II) Check detailed instructions via Announcement on IE Campus. 68  Session 2 F. Reporting 69  Session 3 & 4 F. Reporting FINANCIAL REPORTING SESSIONS 3 & 4 Original by professor Álvaro García Soto at IE Business School. Original version: May 2011. Last revised: September 2023. ©2023 IE Business School. Total or partial publication of this document without the express, written consent of IE is prohibited. 1 Session 3 & 4 F. Reporting AGENDA ✓The Income Statement ✓Key Principles: the revenue recognition and matching principles ✓Recording Transactions ✓The Accounting Cycle (I) ✓Exercise Adjustments E4-9 ✓The Accounting Cycle (I) ✓What is next? 2 The Income Statement Session 3 & 4 F. Reporting UNDERSTANDING THE BUSINESS How do business activities affect the income statement? How are these activities recognized and measured? How are these activities reported on the income statement? 3 The Income Statement Session 3 & 4 F. Reporting PURPOSE OF THE INCOME STATEMENT ✓Reports success or failure of the company's operations during the period ✓Summarizes all revenue and expenses for the period (day, month, quarter, or year…) ✓Net Income: excess of total revenues over total expenses (also called Net Earnings or Net Profit) ✓If revenues > expenses → Net Income ✓If revenues < expenses → Net Loss 4 The Income Statement Session 3 & 4 F. Reporting Elements of the Income Statement Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense 5 The Income Statement Session 3 & 4 F. Reporting ELEMENTS OF THE INCOME STATEMENT Operating Revenues Increases in assets or settlement of liabilities from ongoing operations Operating Expenses Decreases in assets or increases in liabilities from ongoing operations Gains Increases in assets or settlement of liabilities from peripheral transactions Losses Decreases in assets or increases in liabilities from peripheral transactions 6 Session 3 & 4 F. Reporting Operating Activities Peripheral Activities 7 The Income Statement Session 3 & 4 F. Reporting OPERATING ACTIVITIES 8 The Income Statement Session 3 & 4 F. Reporting + Gross Sales Revenues Gross Margin/Profit = Net Sales Revenues – COGS or Cost of sales - Discounts/rebates/returns = Net Sales Revenues - Cost of Good Sold or Cost of Sales + Other operating income EBITDA (Earnings Before Interests Taxes Depreciation & Amortization) or Gross Operating Income/earnings = Net Sales Revenues – All operating expenses except Depreciation & Amortization expenses - Personal expenses - Other operating expenses - Depreciation & Amortization expense = Net Operating Income/Earnings +/- Financial Results = Income Befores Taxes - Tax Income = Net Income/earnings 9 The Income Statement Session 3 & 4 F. Reporting Gross Margin/Profit + Gross Sales Revenues - Discounts/rebates/returns EBITDA (Earnings Before Interests Taxes Depreciation & Amortization) or Gross Operating Income/earnings = Net Sales Revenues - Cost of Good Sold or Cost of Sales + Other operating income - Personal expenses EBIT (Earnings Before Interests and Taxes) or Net Operating Income/earnings = Net Sales Revenues – All Operating expenses - Other operating expenses - Depreciation & Amortization expense = Net Operating Income/Earnings +/- Financial Results = Income Befores Taxes - Tax Income = Net Income/earnings 10  Extraordinary results/items not allowed by IFRS but do allow by USA GAAP (although restricted) Session 3 & 4 F. Reporting Cost of Sales (used inventories) Operating Expenses Non Operating Expenses Financial Expenses Income Tax Expenses 11  Session 3 & 4 F. Reporting Net Income EPS = Net Income / Weighted Average Number of Shares outstanding EPS 12  The Income Statement Session 3 & 4 F. Reporting INTERNATIONAL PERSPECTIVE 13  Key Principles Session 3 & 4 F. Reporting HOW ARE OPERATING ACTIVITIES RECOGNIZED AND MEASURED? Accrual Accounting versus Cash Accounting THE REVENUE RECOGNITION PRINCIPLE THE MATCHING PRINCIPLE 14  Key Principles Session 3 & 4 F. Reporting CASH BASIS ACCOUNTING Revenue is recorded when cash is received Expenses are recorded when cash is paid 15  Key Principles Session 3 & 4 F. Reporting ACCRUAL ACCOUNTING Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received 16  AA P Generally Acceptable Accounting Principles G Required by - Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE ✓ Recognized revenues when (4 criteria): ✓ Delivery has occurred or services have been rendered ✓ There is persuasive evidence of an arrangement for customer payment ✓ The price is fixed or determinable ✓ Collection is reasonably assured If any of the criteria are not met, revenues normally are not recognized and cannot be recorded 17  Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE Why do we care about revenue recognition? ✓ Revenues have a BIG impact on bottom-line profitability – Managers may be tempted to manage revenues ✓ Large Sample Evidence: over 40% of SEC enforcement actions on accounting issues deal with Revenue Recognition 18  Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE Ten things about financial statement fraud –third edition.  A Review of SEC Enforcement19Releases 2000-2008 (Deloitte) Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE Company accounts. Truthful top lines New global rules aim to make it harder for firms to fib about their revenues May 31st 2014 | NEW YORK | From the print edition WHEN companies should recognize revenues on their books is one of the most contentious and consequential issues in the staid profession of accounting. For simple sales of goods the timing is usually straightforward, but in the areas of services and long-term contracts it gets murky fast. Companies may manipulate the “top line” of their accounts—their revenues—say, by booking sales they are not yet sure of (to boost their reported profits) or not booking sales that they are certain of (to postpone profits, and the taxes on them).…. Revenue recognition is perhaps the biggest headache for investors trying to compare companies in different countries. The GAAP standard used in the United States is Byzantine, with more than 100 different protocols for various permutations of transactions and industries, whereas the IFRS rules applied in most of the rest of the world offer only broad guidance. Following 12 years of consultation, on May 28th the boards that control the two accounting systems released a new joint standard they hope will put these issues to rest. Scheduled to take effect in 2017, it represents a neat middle ground, adopting the IFRS’s principle of one size to fit all industries, but with GAAP-style clarity. It spells out how companies will have to break down sales contracts into their component obligations and allocate the total value among them, estimating the worth of any variable fees they expect, like performance bonuses. Firms will then recognize the revenue assigned to each individual element as it is completed. The biggest impact will be felt in industries that rely on bundled product-plus-service contracts, such as software and telecoms. In the 1990s Microsoft was accused of “cookie-jar accounting”, holding back revenue so as to recognize it during weak quarters, to smooth its reported earnings…. 20  Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE When cash is received on the date the revenue is earned, the following entry is made: Company Delivers and Cash Received Cash (+A) Revenue (+R) xxx xxx 21  Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – UNEARNED REVENUE If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded Cash received before revenue is earned Cash Received Cash (+A) Unearned Revenue (+L) xxx xxx 22  Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – UNEARNED REVENUE When the company delivers the goods or services, UNEARNED REVENUE is reduced and REVENUE is recorded Cash received before revenue is earned Cash Received Cash (+A) Unearned Revenue (+L) Company Delivers xxx xxx Revenue will be recorded when earned Unearned Revenue (-L) Service Revenue (+R) 23  xxx xxx Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – UNEARNED REVENUE Typical liabilities that become revenue when earned include… 24  Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – ACCOUNTS RECEIVABLE If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded Cash received after revenue is earned Company Delivers Accounts Receivable (+A) Revenue (+R) xxx xxx 25  Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – ACCOUNTS RECEIVABLE When the cash is received the ACCOUNTS RECEIVABLE is reduced Cash received after revenue is earned - Cash Received Company Delivers Accounts Receivable (+A) Revenue (+R) xxx xxx Cash will be collected. Cash (+A) Accounts Receivable (-A) 26  xxx xxx Key Principles Session 3 & 4 F. Reporting REVENUE PRINCIPLE – ACCOUNTS RECEIVABLE Assets reflecting revenues earned but not yet received in cash include… 27  Key Principles Session 3 & 4 F. Reporting REVENUE RECOGNITION PRINCIPLE http://www.mossadams.com/articles/2014/september/new-revenue-recognition-rules-for-technology 28  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE 29  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE ✓ The matching principle: ✓ is the basis for recording expenses ✓ requires that expenses incurred to generate revenues be recognized in the same period in which these revenues are recorded – a matching of expenses with profits ✓ Direct accountants to: ✓ Identify all expenses incurred during the accounting period ✓ Measure the expenses ✓ Match expenses against revenues during the same period 30  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE When cash is paid on the date the expense is incurred, the following entry is made: Expense Incurred AND Cash Paid Expense (+E) Cash (-A) xxx xxx 31  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE: PREPAID EXPENSES If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded Cash is paid before expense is incurred - $ Paid Prepaid Expense (+A) Cash (-A) xxx xxx 32  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE: PREPAID EXPENSES When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded Cash is paid before expense is incurred $ Paid Prepaid Expense (+A) Cash (-A) Expense Incurred xxx xxx Expense will be recorded when incurred Expense (+E) Prepaid Expense (-A) 33  xxx xxx Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE: PAYABLE If cash is paid after the company receives goods or services, a liability PAYABLE is recorded Cash paid after expense is incurred Expense Incurred Expense (+E) Payable (+L) xxx xxx 34  Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE: PAYABLE When cash is paid the PAYABLE is reduced Cash paid after expense is incurred Cash Paid Expense Incurred Expense (+E) Payable (+L) xxx xxx Cash will be paid. Payable (-L) Cash (-A) 35  xxx xxx Key Principles Session 3 & 4 F. Reporting THE MATCHING PRINCIPLE Typical Assets and their related expense accounts include… 36  Recording Transactions Session 3 & 4 F. Reporting EXPANDED TRANSACTION ANALYSIS MODEL Assets = Liabilities + Stockholder’s Equity ASSETS LIABILITIES Debit Credit for for Increase Decrease Debit Credit for for Decrease Increase Next, let’s see how Revenues and Expenses affect Retained Earnings CONTRIBUTED CAPITAL RETAINED EARNINGS Debit Credit for for Decrease 37Increase  Debit Credit for for Decrease Increase Recording Transactions Session 3 & 4 F. Reporting EXPANDED TRANSACTION ANALYSIS MODEL Dividends decrease Retained Earnings RETAINED EARNINGS Debit Credit for for Decrease Increase Net Income increases Retained Earnings REVENUES EXPENSES Debit Credit for for Decrease Increase Debit Credit for for Increase Decrease 38  Recording Transactions Session 3 & 4 F. Reporting HOW ARE FINANCIAL STATEMENTS PREPARED AND ANALYZED? Income Statement Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows Revenues – Expenses = Net Income Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Shareholders’ Equity Capital Retained Earnings Change = Cash from Operating Activities in + Cash from Investing Activities Cash + Cash from Financing Activities Recording Transactions Session 3 & 4 F. Reporting HOW ARE FINANCIAL STATEMENTS PREPARED AND ANALYZED? Income Statement Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows Revenues – Expenses = Net Income Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Shareholders’ Equity Capital Retained Earnings Change = Cash from Operating Activities in + Cash from Investing Activities Cash + Cash from Financing Activities Session 3 & 4 F. Reporting The Accounting Cycle 41  http://www.soc.hawaii.edu/leonj/leonj/leonpsy16/g16reports-instructions.html The Accounting Cycle Session 3 & 4 F. Reporting STEPS IN THE TRANSACTION PROCESS Start of new period During the Period 1. Analyze transactions 2. Record journal entries in the general journal 3. Post amounts to the general ledger via the Taccounts 4. 5. 6. 7. At the End of the Period Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger) 42  The Accounting Cycle Session 3 & 4 F. Reporting UNADJUSTED TRIAL BALANCE A listing of individual accounts, usually in financial statement order Ending debit or credit balances are listed in two separate columns Total debit account balances should equal total credit account balances 43  The Accounting Cycle Session 3 & 4 F. Reporting THE ADJUSTMENT PROCESS Summary of the Accounting Cycle January 1 December 31 Transactions are recorded all during the period Adjustments are made at the end of the period, but before the financial statements are prepared 44  The Accounting Cycle Session 3 & 4 F. Reporting THE ADJUSTMENT PROCESS ✓Accountants make adjusting entries at the end of the period to enter adjustments into the accounting records ✓Adjusting entries: ✓Assign revenues to the period in which they are earned and expenses to the period in which they are incurred ✓Update the asset and liability accounts ✓Every adjusting entry will affect an IS account and a BS account. The BS account NEVER will be CASH 45  The Accounting Cycle Session 3 & 4 F. Reporting THE ADJUSTMENT PROCESS Revenues are recorded when earned Expenses are recorded when incurred Matching Principle Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues and expenses into the “right” period 46  The Accounting Cycle Session 3 & 4 F. Reporting FOUR TYPE OF ADJUSTMENTS Revenues 1. Deferred (Unearned) Revenues 2. Accrued Revenues Expenses 47  3. Deferred (Prepaid) Expenses 4. Accrued Expenses The Accounting Cycle Session 3 & 4 F. Reporting FOUR TYPE OF ADJUSTMENTS 48  Session 3 & 4 F. Reporting Let’s do some examples… 49  Exercise Adjustments E4-9 Session 3 & 4 F. Reporting ✓ Ibiza Ltd., is completing the accounting process for the year ended, December 31. The transactions for the past year have been journalized and posted. ✓ The following data with respect to adjusting entries are available pending to be recorded. Identify the: • entries, • accounts involved and • the impact on the Balance Sheet & the Income Statement. 50  Exercise Adjustments E4-9 Session 3 & 4 F. Reporting a) A) Ibiza Ltd’s winterized (cleaned and covered) three boats for customers at the end of December, but did not record the service for $3,300 b) B) On November 1, Ibiza Ltd’s paid $2,400 to