Week 3, Chap 3 Accounting 1A, Financial Accounting. Instructor: Michael Booth

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1 Week 3, Chap 3 Accounting 1A, Financial Accounting Instructor: Michael Booth

2 The Debit-Credit Framework A = L + SE ASSETS LIABILITIES EQUITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase Debit for Decrease Credit for Increase Remember that Stockholders Equity includes Contributed Capital and Retained Earnings.

3 Balance Sheet Preparation: American Eagle It is possible to prepare a balance sheet at any point in time from the balances in the accounts.

4 This is the asset section of American Eagle balance sheet.

5 This is the liability and stockholders equity section of American Eagle s balance sheet.

6 Learning Objectives Prepare and analyze a simple balance sheet using the financial leverage ratio.

7 Change in Balance Sheet Amounts; Americian Eagle Stockholders' Assets = Liabilities + Equtiy End of Fiscal 2011 $ 1,950,802 $ 533,951 $ 1,416,851 End of Fiscal ,879, ,927 1,351,071 Change $ 70,804 $ 5,024 $ 65,780

8 Key Ratio Analysis Financial Leverage Ratio = Average Total Assets Average Stockholders Equity (Beginning Balance + Ending Balance) 2 The 2011 financial leverage ratio for Ascent was: ($1,879, ,963,802) 2 ($1,351, ,416,8511) 2 1,921,900 1, = = The ratio tells us how management is using debt to increase assets the company employs to earn income. =1, no liabilities =2, equal use of equity & debit >2, greater on debit

9 Business Background How do business activities affect the income statement? How are these activities recognized and measured? How are these activities reported on the income statement?

10 Typical business operating cycle and the necessity for the time period assumption.

11 The Operating Cycle Begin Purchase or manufacture products or supplies on credit. Pay suppliers. Receive payment from customers. Deliver product or provide service to customers on credit.

12 The Operating Cycle Time Period: The long life of a company can be reported over a series of shorter time periods. Recognition Issues : When should the effects of operating activities be recognized (recorded)? Measurement Issues: What amounts should be recognized?

13 The Time Period Assumption To meet the needs of decision makers (investors and creditors), reporting of financial information is for relatively short time periods (monthly, quarterly, annually). Life of the Business Annual Accounting Periods

14 How business activities affect the elements of the income statement.

15 Elements on the Income Statement Revenues Increases in assets or settlement of liabilities from ongoing operations. 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.

16 Operating Activities Peripheral Activities

17 AEO Primary Operating Expenses Cost of sales (inventory used for sales) Salaries and benefits to employees Other costs (like Amortization, depreciation, and interest expense)

18 Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding

19 Corporations are taxable entities. Income tax expense is Income Before Income Taxes Tax Rate (Federal, State, Local and Foreign).

20 Accrual basis of accounting and application to revenue and matching principles to measure income.

21 Cash Basis Accounting Revenue is recorded when cash is received. Expenses are recorded when cash is paid.

22 Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Required by - Generally Acceptable Accounting Principles Accrual Accounting

23 Revenue Principle Recognize revenues when... 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.

24 Revenue Principle 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

25 Revenue Principle When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded. Cash received before revenue is earned - Cash Received Company Delivers Cash (+A) Unearned revenue (+L) xxx xxx Revenue will be recorded when earned.

26 Revenue Principle Typical liabilities that become revenue when earned include... CASH COLLECTED (Goods or services due to customers) Rent collected in advance Unearned air traffic revenue Deferred subscription revenue over time will become REVENUE (Earned when goods or services provided) Rent revenue Air traffic revenue Subscription revenue

27 Revenue 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

28 Revenue Principle 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

29 Revenue Principle When the cash is received the ACCOUNTS RECEIVABLE is reduced. Cash received after revenue is earned - Company Delivers Cash Received Accounts receivable (+A) Revenue (+R) xxx xxx Cash will be collected.

30 The Revenue Principle Assets reflecting revenues earned but not yet received in cash include... CASH TO BE COLLECTED (Owed by customers) and already earned as REVENUE (Earned when goods or services provided) Rent receivable Royalties receivable Rent revenue Royalty revenue

31 HomeWork Exercise E3-3 Revenue

32 Revenues are normally recognized when the delivery of goods or services has occurred, there is persuasive evidence of an arrangement for customer payment, the price is fixed or determinable, and collection is reasonably assured. The amount recorded is the cashequivalent sales price. The following transactions occurred in October, Year1: a. A popular off road magazine company receives a total of $23,960 today from subscribers. The subscriptions begin in the next fiscal year. Answer from the magazine company s standpoint. b. On October 1, Year 1, a bank lends $2,400 to a company; the note principal and $288 ($2, percent) annual interest are due in one year. Answer from the bank s standpoint. c. Acura, Inc. sells a truck with a list, or sticker, price of $40,100 for $36,100 cash. d. Belk s department store orders 1,000 men s shirts for $30 each for future delivery from Ralph Lauren Corporation. The terms require payment in full within 30 days of delivery. Answer from Ralph Lauren s standpoint. e. Ralph Lauren Corporation completes production of the shirts described in (d) and delivers the order. Answer from Ralph Lauren s standpoint. f. Ralph Lauren Corporation receives payment from Belk s for the events described in (d) and (e). Answer from Ralph Lauren s standpoint. g. A customer purchases a ticket from Northwest for $1,220 cash to travel the following January. Answer from Northwest s standpoint.

33 h. General Motors issues $40 million in new common stock. i. University of North Carolina receives $36,600,000 cash for 160,000 five-game season football tickets. j. University of North Carolina plays the first football game referred to in (i). k. Home Improvement signs a contract with a customer for the construction of a new $3,000,000 warehouse. At the signing, Home Improvement receives a check for $300,000 as a deposit on the future construction. Answer from Home Improvement s standpoint. l. A customer orders and receives 20 personal computers from Apple; the customer promises to pay $36,800 within three months. Answer from Apple s standpoint. m. JC Penneys, a retail store, sells a $200 lamp to a customer who charges the sale on his store credit card. Answer from JC Penneys s standpoint. Required: For each of the transactions, if revenue is to be recognized in October, indicate the revenue account title and amount. If revenue is not to be recognized in October, explain why.

34 The Matching Principle Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. Revenue Cost & Expense Net Income (profit) Matched to the accounting Period

35 The Matching Principle 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

36 The Matching Principle When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Expense Incurred Prepaid expense (+A) Cash (-A) xxx xxx Expense will be recorded when incurred.

37 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

38 The Matching Principle 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

39 The Matching Principle When cash is paid the PAYABLE is reduced. Cash paid after expense is incurred - Expense Incurred Cash Paid Expense (+E) Payable (+L) xxx xxx Cash will be paid.

40 The Matching Principle Typical assets and their related expense accounts include... CASH PAID FOR Supplies inventory Prepaid insurance Buildings and equipment as used over time becomes EXPENSE Supplies expense Insurance expense Depreciation expense

41 HomeWork Exercise E3-4 Expense

42 Revenues are normally recognized when goods or services have been provided and payment or promise of payment has been received. Expense recognition is guided by an attempt to match the costs associated with the generation of those revenues to the same time period. The following transactions occurred in February, Year 1: a. The Nabisco Companies use $3,000 worth of electricity and natural gas in their headquarters building for which it has not yet been billed. b. At the beginning of February, Home Improvement Company pays $900 for magazine advertising to run in monthly publications each of the first three months of the year. c. Apple pays its computer service technicians $400,000 in salaries for the two weeks ended February 7. Answer from Apple s standpoint. d. The University of North Carolina orders 120,000 season football tickets from its printer and pays $15,220 in advance for the custom printing. The first game will be played in September. Answer from the university s standpoint. e. The campus bookstore receives 1,000 accounting texts at a cost of $90 each. The terms indicate that payment is due within 30 days of delivery. f. During the last week of February, the campus bookstore sold 500 accounting texts received in (e) at a sales price of $140 each. g. General Motors, Inc., pays its salespersons $14,400 in commissions related to December automobile sales. Answer from General Motors standpoint.

43 h. On February 28, General Motors, Inc., determines that it will pay its salespersons $15,500 in commissions related to February sales. The payment will be made in early March. Answer from General Motor s standpoint. i. A new grill is purchased and installed at a Burger King restaurant at the end of the day on February 28; a $13,250 cash payment is made on that day. j. North Point Mall had janitorial supplies costing $5,000 in storage. An additional $4,000 worth of supplies was purchased during February. At the end of February, $1,600 worth of janitorial supplies remained in storage. k. An Arizona State University employee works eight hours, at $12 per hour, on February 28; however, payday is not until March 3. Answer from the university s point of view. l. Fong Company paid $4,800 for a fire insurance policy on February 1. The policy covers 24 months beginning on February 1. Answer from Fong s point of view. m. Benton Incorporated has its delivery van repaired in February for $450 and charges the amount on account. n. Farm Implement Company, a farm equipment company, receives its phone bill at the end of February for $175 for February calls. The bill has not been paid to date. o. Kenworth Company receives and pays in February a $2,500 invoice (bill) from a consulting firm for services received in February. p. Lynx Technology Company pays a $675 invoice from a consulting firm for services received and recorded in December.

44 q. Tommy Bahama Corporation completes production of 500 men s shirts ordered by Macy s department stores at a cost of $15 each and delivers the order. Answer from Tommy Bahama s standpoint. Required: For each of the transactions, if an expense is to be recognized in February, indicate the expense account title and amount. If an expense is not to be recognized in February, indicate why.

45 Depreciation is the process of allocating the cost of long-term assets over their useful lives.

46 The cost of a long-term asset such as equipment... $ COST... is NOT recorded as an expense at the time of purchase. $ EXPENSE

47 Instead the cost is recorded as an asset and charged to expense over the time the asset is used for the business. $ ASSET This expense is called depreciation. Expense Jan Expense Expense

48 Depreciation Methods Straight-Line Declining-Balance Sum-of-the-Years -Digits Units-of-Output

49 Straight-Line Method Formula: Depreciation = Cost Salvage Value Estimated Useful Life The same dollar amount of depreciation is taken each year as an expense.

50 Apply transaction analysis to examine and record the effects of operating activities on the financial statements.

51 Expanded Transaction Analysis Model An expanded transaction analysis model includes the recording of revenues and expenses.

52 A = L + SE ASSETS LIABILITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase How Revenues and Expenses affect Retained Earnings. CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase

53 Expanded Transaction Analysis Model Dividends decrease Retained Earnings. RETAINED EARNINGS Debit for Decrease Credit for Increase Net Income increases Retained Earnings. REVENUES EXPENSES Debit for Decrease Credit for Increase Debit for Increase Credit for Decreas e

54 Application of a complete transaction analysis model to some of Papa John s transactions. All amounts are in $ 000 s

55 Papa John s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months. Identify & Classify the Accounts 1. Cash (asset). 2. Franchise fee revenue (revenue). 3. Unearned franchise fees (liability). Determine the Direction of the Effect 1. Cash increases. 2. Franchise fee revenue increases. 3. Unearned franchise fees increases.

56 Papa John s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months. Assets Cash 400 Unearned franchise revenue = Liabilities + Stockholders' Equity 300 Franchise fees revenue 100 General Journal Description Debit Credit Cash 400 Unearned franchise revenue 300 Franchise fees revenue 100

57 The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600. Identify & Classify the Accounts 1. Cash (asset). 2. Restaurant sales revenue (revenue). 3. Cost of sales- restaurant (expense). 4. Inventories (asset). Determine the Direction of the Effect 1. Cash increases. 2. Restaurant sales revenue increases. 3. Cost of sales- restaurant increases. 4. Inventories decrease.

58 The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600. Assets = Liabilities + Stockholders' Equity Cash 36,000 Restaurant sales 36,000 revenue Inventory (9,600) Cost of sales (9,600) General Journal Description Debit Credit Cash 36,000 Restaurant sales revenue 36,000 Cost of sales - restaurant 9,600 Inventories 9,600

59 In Class Exercise 3

60 Preparation of financial statements.

61 How are Financial Statements Prepared? Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows Revenues Expenses = Net Income Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Stockholders Equity Change in Cash Contributed Capital Retained Earnings = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities

62 Income Statement Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Month Ended January 31, 2010 (In thousands) Revenues Restaurant and commissary sales $ 66,000 Franchise royalties and development fees 2,800 Total revenues 68,800 Costs and expenses Cost of sales 30,000 Salaries and benefits expense 14,000 General and administrative expenses 7,000 Total costs and expenses 51,000 Operating income 17,800 Other revenues and gains (expense and losses) Investment income 1,000 Interest expense - Gain on sale of land 3,000 Income before income taxes 21,800 Income tax expense - Net income $ 21,800 Earnings per share $ 1.21

63 Statement of Retained Earnings PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Statement of Retained Earnings For the Month Ended Janaury 31, 2010 (Dollars in thousands) Beginning balance, December 28, 2009 $ 158,000 Net income 21,800 Dividends (3,000) Ending balance, January 31, 2010 $ 176,800 The net income comes from the Income Statement just prepared.

64 Balance Sheet The ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet. PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands) Assets Jan. 31, 2010 Current assets: Cash $ 37,900 Accounts receivable 16,200 Supplies 16,000 Prepaid expenses 20,000 Other current assets 7,000 Total current assets 97,100 Long-term investments 9,000 Property and equipment, net of depreciation 213,000 Long-term notes receivable 14,000 Intangibles 49,000 Other assets 13,000 Total assets $ 395,100 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 38,000 Dividends payable 3,000 Accrued expenses payable 53,000 Total current liabilities 94,000 Unearned franchise fees 6,300 Long-term notes payable 75,000 Other long-term liabilities 40,000 Total liabilities 215,300 Stockholders' equity: Contributed capital 3,000 Retained earnings 176,800 Total stockholders' equity 179,800 Total liabilities and stockholders' equity $ 395,100

65 Focus on Cash Flows Effect on Nature of Operating Activity Cash Flows Cash received from: Customers + Investments + Cash paid to: Suppliers - Employees - Interest paid - Income taxes paid - Cash Inflows Cash Outflows

66 Statement of Cash Flows The ending cash balance agrees with the amount on the Balance Sheet. PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Statement of Cash Flows For the Month Ended Janaury 31, 2010 (Dollars in thousands) Operating Activities Cash from: Customers $ 69,000 Franchises 3,900 Interest on investments 1,000 Cash to: Suppliers (35,000 Employees (14,000 Net cash provided by operating activities 24,900 Investing Activities Sold land 4,000 Purchased property and equipment (2,000 Purchased investments (1,000 Lent funds to franchisees (3,000 Net cash used in investing activities (2,000 Financing Activities Issued common stock 2,000 Borrowed from banks 6,000 Net cash provided by financing activities 8,000 Net increase in cash 30,900 Cash at beginning of month 7,000 Cash at end of month $ 37,900

67 Asset Turnover Ratio Net Sales Average Total Assets The higher the ratio, the more efficient the business is in utilizing the Economic resource ASSETS to generate Revenue(Sales) Note: Should be compare period to period Within industry With competitors

68 Asset Turnover Ratio Total assets turnover - if asset turnover is high, the firm is presumably using its assets effectively to generate sales - the higher the total asset turnover, the more impact the firm is getting out of its total assets Fixed asset turnover - removes current assets from the total asset turnover calculation. Questions a.) What can we conclude if a clothing retailer has a fixed assets turnover of 10?.we probably can't conclude much of anything even if we compare the ratio to industry averages. Why?.because clothing retailers have very little in the way of fixed assets; therefore, the FAT is not an important financial ratio for them.

69 Asset Turnover Ratio What can we conclude if an automobile manufacturer has a fixed assets turnover of 10?.we can't conclude anything until we compare the ratio to industry averages, but we know that the FAT is an important variable. If the FAT is significantly below industry average, the firm may be in some trouble. What can we conclude if a clothing retailer has a total assets turnover of 10? again, we need to compare to the industry average. The TAT is important for clothing retailers because it includes short-term assets such as inventory.

70 Financial Statement Analysis Financial accounting numbers are only meaningful when compared to other relevant numbers (Is a reported income of $1 billion large or small?). Comparisons across time - GAAP requires disclosure of account numbers for current and preceding years (Balance sheet 2 years, all others 3 years) - Often even longer time-series are published by the companies - Historic trends as indicator of future trends Comparisons within the industry - Compare accounting numbers to those of similar companies (e.g. in same industry) - Industry surveys report information concerning industry averages - Different industries typically have different normal accounting numbers (e.g. retailers have high inventory, pharmaceutical firms have large R&D costs) Comparisons within the Financial Statements - Common-size Financial Statements Facilitates identification of changes in the structure of financial flows and stocks - Financial Ratios Many ratios possible, no fixed rules Typically, averages are used for stock numbers, i.e. balance sheet accounts

71 Net Profit Margin Analysis Net profit margin measures how much of every sales dollar generated during the period is profit. A rising net profit margin signals more efficient management of sales and expenses.

72 The 2011 ratio for Chipotle using actual reported amounts is (dollars in thousands): $215,000 $2,269,500 = or 9.47%

73 Assignments: See web: http//cabrillo.blackboard.com This will be updated weekly as required Update your weekly journal Work weekly on your final project, do the analysis with information learned during the week

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