CHAPTER 1: Financial Statements and Business Decisions | ACCOUNTING

FINANCIAL STATEMENTS AND BUSINESS DECISIONS

I. OVERVIEW: FOUR BASIC FINANCIAL STATEMENTS

Balance sheet: Report of the economic resources a company owns, and sources of financing for those resources

Income Statement: Reports ability to sell goods for more than cost to produce and sell

Statement of stockholders equity: Report of additional contributions or payments to investors, amount of income the company
reinvested for future growth

Statement of cash flows: Reports ability to generate cash and how it was used
BASIC ACCOUNTING EQUATION (BALANCE SHEET EQUATION)
ASSETS = LIABILITIES + STOCKHOLDERS EQUITY
1.

BALANCE SHEET

Purpose: To report the financial position (amount of assets, liabilities, and stockholders equity) of entity at any given time;
Financial snapshot of entitys financial position at a specific point in time

Structure: Heading: name of entity, title of statement, specific date of statement, and unit of measure
o Order: Assets (listed by liquidity), Liabilities (order of maturity), Stockholders Equity

Elements: (1) Assets; (2) Liabilities; (3) Stockholders Equity

A. ASSETS
o Definition: Economic resources owned by the entity
o Value: Every asset on balance sheet initially measured at the total cost incurred to acquire it, not its
present value
o Examples: Cash, accounts receivable, inventories, property and equipment
B. LIABILITIES
o Definition: Amount of financing provided by creditors; companys debts/obligations
o Examples: Accounts payable, notes payable to banks
C. STOCKHOLDERS EQUITY
o Definition: Amount of financing provided by owners of business and reinvested earnings
o Examples: Common stock (investment of cash/assets in business by stockholders)
Retained earnings (amount of earnings (profits) reinvested in business, and not distributed
to stockholders in dividends

INCOME STATEMENT EQUATION

REVENUES EXPENSES = NET INCOME
2.

INCOME STATEMENT

Purpose: Report of performance of a business, revenues less expenses during accounting period
o Revenues minus expenses during accounting period

Structure: Heading: Entity, title of the report, unit of measure, acct period (time period covered by statement)1
o Order: Revenues, Expenses, Net Income

Elements: Revenues, Expenses, Net Income

A. REVENUES
o Includes accounts receivable (amounts expected to be received that have been delivered, regardless of
whether they have been paid for)
B. EXPENSES
o Dollar amount of resources entity used to earn revenues during this period

Expenses reported here may actually be paid for in another accounting period
C. NET INCOME (Net Earnings)
o Excess of total revenues over total expenses

Net income does not generally equal the net cash generated by operations

1 Comp. with balance sheet, which provides a specific date rather than a specified period of time

CHAPTER 1: Financial Statements and Business Decisions | ACCOUNTING

RETAINED EARNINGS EQUATION

BEGINNING RETAINED EARNINGS + NET INCOME DIVIDENDS = ENDING RETAINED EARNINGS
3.

STATEMENT OF STOCKHOLDERS EQUITY

Purpose: Report of way that net income and distribution of dividends affected financial position over acct. period

Elements: Previous period retained earnings, Net income, Dividends, Current period retained earnings

CHAPTER 1: Financial Statements and Business Decisions | ACCOUNTING

CASH FLOW STATEMENT EQUATION

+/- CASH FLOWS FROM OPERATING ACTIVITIES (CFO)
+/- CASH FLOWS FROM INVESTING ACTIVITIES (CFI)
+/- CASH FLOWS FROM FINANCING ACTIVITIES (CFF)
_______________________________________________
CHANGE IN CASH
+ BEGINNING CASH BALANCE
_______________________________________________
ENDING CASH BALANCE
4.

STATEMENT OF CASH FLOWS

Purpose: Reports inflows and outflows of cash during accounting period

o Describes the causes of the change in cash reported on the balance sheet from the end of last period to
the end of the current period
o Income statement does not provide information concerning cash flows; thus, accountants must prepare
statement of cash flows

Structure: Division of cash inflows & outflows (receipts and payments) into 3 categories of:
o (1) operating, (2) investing, (3) financing
o Heading: Entity, title of report, unit of measure, coverage of specified period (similar to income
statement)
Of note: Reported revenues do not always equal cash collected from customers, since some sales may be on credit; Expenses
reported may not be equal to cash paid out, since expenses may be incurred in a different period
Elements: Cash flows from: operating activities, investing activities, financing activities
A. CASH FLOWS FROM OPERATING ACTIVITIES
o Definition: Cash flows directly related to earning income
B. CASH FLOWS FROM INVESTING ACTIVITIES
o Definition: Includes cash from acquisition or sale of companys equipment, investments, etc.
C. CASH FLOWS FROM FINANCING ACTIVITIES
o Definition: Directly related to financing of enterprise
o Examples: Receipt or payment of money to investors and creditors (though not suppliers) and payout for
dividends to stockholders

II. RELATIONSHIPS AMONG THE STATEMENTS

1. Net income from the income statement results in an increase in ending retained earnings on the statement of SE
2. Ending retained earnings from the statement of SE is one of the two components of SE on the balance sheet
3. The change in cash on the cash flow statement added to the beginning-of-the-year balance in cash equals the end-of-year
balance in cash on the balance sheet

CHAPTER 2: Investing and Financing Decisions and the Accounting System | ACCOUNTING

INVESTING AND FINANCING DECISIONS AND THE ACCOUNTING SYSTEM

I. OVERVIEW: RECOGNITION AND MEASUREMENT CONCEPTS
3 assumptions and measurement concept:
1. Separate-Entity Assumption: Each businesss activities must be accounted for separately from the activities of its
owners
2. Continuity Assumption (Going-concern assumption): Unless there is evidence to the contrary, we assume that
the business will continue operating into the foreseeable future
3. Stable Monetary Unit Assumption: Each business entity accounts for and reports financial results primarily in
terms of national monetary unit
4. Mixed-Attribute Measurement Model: Elements are recorded at cash-equivalent value on the date of the
transaction. Historical cost principle/cost principle
Other Terminology I Really Ought to Know but Dont Really
Contributed capital: Financing provided by owners
Earned capital/Retained Earnings: Financing provided by operations. Portion of profits reinvested
Par value: Legal amount per share established by board; represents minimum amount a stockholder must contribute. No
relationship to market price of stock
Common stock: Account equal to the number of shares issued by a corporation times the par value per share
Additional paid-in capital: Amount of capital contributed by the shareholders less the par value of the stock
NATURE OF BUSINESS TRANSACTIONS
Transactions: Only economic resources and debts resulting from past transactions are recorded on the balance sheet
2 types of events recorded on balance sheet:
1. External Events: Exchanges of assets, goods, services by one party for assets, services, or liabilities from other
parties
o Examples: Purchase of a machine from a supplier, sale of merchandise to customers, borrowing cash
from a bank, investment of cash in the business by owners
2. Internal Events: Events that are not exchanges between other businesses, but have a direct and measurable
effect on entity
o Examples: Using insurance paid in advance, using buildings and equipment over several years

ACCOUNT BALANCING in ACCOUNT CYCLE

[During Period]
1. Analyze transactions
2. Record journal entries in general journal
3. Post amounts to the general ledger
[At the End of Period]
4. Prepare trial balance (check if debits = credits)
5. Adjust revenues and expenses (record in journal and post to ledger)
6. Prepare financial statements and disseminate to users
7. Close revenues, expenses, gains, and losses to Retained Earnings (record in journal and post to ledger)
II. PRINCIPLES OF TRANSACTION ANALYSIS

CHAPTER 2: Investing and Financing Decisions and the Accounting System | ACCOUNTING

TRANSACTION ANALYSIS
Definition: Process of studying a transaction to determine its economic effect on the entity
2 Principles:
1. Every transaction affects at least two accounts (dual effects concept)
2. The accounting equation must remain in balance after each transaction
Direction of Transaction Effects:
o Increases in asset accounts on the left = Increases in liability and SE accounts on the right
o [Debit: left side; Credit: right side]
o The total dollar value of all debits will equal the total dollar value of all credits in a transaction
o Compound Entry: Any journal entry affecting more than two accounts
1. TRIAL BALANCE SPREADSHEET
Definition: List of all accounts with their balances to provide a check on the equality of debits and credits
Purpose: For internal purposes before composing one for external users
Structure: Lists T-accounts in one column, in financial statement order (A, L, SE)
o Debits Left, Credits on Right
2. CLASSIFIED BALANCE SHEET
Purpose: Listing of accounts into current and noncurrent classifications
Structure: Most recent balance sheet will be listed to left
o Includes comparative data: compares account balances of two periods.
3. RATIO ANALYSIS
Purpose: Analyzing a companys past performance and financial condition in predicting future potential
CURRENT RATIO
Definition of Current Ratio: Used to measure ability of the company to pay its short-term obligations with shortterm assets
o Higher the ratio, more cushion a company has to pay its current obligations in harder times
o Ratio above 1.0 suggests good liquidity
CURENT RATIO EQUATION
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES

HOMEWORK:
E2-5, E2-7, E2-15, P2-3, P2-4, P2-5, CP2-5, CP2-6

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

CHAPTER 3: OPERATING DECISIONS AND THE ACCOUNTING SYSTEM

I.

HOW DO BUSINESS ACTIVITIES AFFECT THE INCOME STATEMENT?

I.1. The Operating Cycle
Key Terms
Operating (cash-to-cash) cycle: Time it takes for a company to pay cash to suppliers sell goods and services to
customers, and collect cash from customers
Time Period Assumption: Indicates that the long life of a company can be reported in shorter time periods
I.2. Elements of the Income Statement
A. Operating Revenues
Revenues: Increases in assets or settlements of liabilities from ongoing operations of business

B. Operating Expenses

Expenditure: Any outflow of cash for any purpose

Expense: Outflows/using of assets/increases in L from ongoing operations incurred to generate revenues
during period
o Not all cash expenditures are expenses, but expenses are necessary to generate revenues

C. Other Items

Definition: Any revenues, expenses, gains, or losses from other activities not included as operating income
Examples: Inv. income (inv. revenue, interest revenue, dividend revenue), interest expense, gain (loss) on disposal of
assets
Gains: Increases in assets or decreases in liabilities from peripheral transactions
Losses: Decreases in assets or increases in liabilities from peripheral transactions
D. Income Tax Expense
o All corporations required to compute income taxes owed
E. Earnings per Share
Definition: Ratio used to evaluate operating performance and profitability of a company
o Requisite disclosure of earnings per share on the income statement or notes
Formula: Net income / weighted average number of shares of stock outstanding

II. HOW ARE OPERATING ACTIVITIES RECOGNIZED AND MEASURED?

II.1. Cash Basis Accounting
Definition: Records revenues when cash is received and expenses when cash is paid
o Problem: Might lead to incorrect interpretation of future company performance
II.2. Accrual Basis Accounting
Definition: Records rev. when earned and expenses when incurred, regardless of the timing of cash receipts or
payments
o Revenues recognized when they are earned and expenses when they are incurred
A. Revenue Realization Principle
Definition: Revenues are recognized when (1) goods/services delivered; (2) persuasive evidence of an
arrangement for customer payment; (3) price is fixed/determinable; (4) collection is reasonably assured
o 5 necessary criteria in order for an item of revenue to be recognized
o Conditions are met at point of delivery of goods/services, regardless of when cash is
received (before, after, or during period of delivery)
B. Revenue Matching Principle
C. Expense Matching Principle
Definition: Requires that expenses be recorded when incurred in earning revenue in same period
Examples: Salaries and wages to employees who worked during the period, utilities used during period, food
beverage and packing products used during period, facilities rental during period, equipment used during
period

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Expenses are recorded as incurred, regardless of when the cash is paid (before, during, or
after expense is incurred)

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

III. THE EXPANDED TRANSACTION ANALYSIS MODEL

III.1. Transaction Analysis Rules
Key Concepts
o Revenues increase net income and stockholders' equity
o Go up with credits
o Accounts have credit balances

o
o
o

Expenses decrease net income and stockholders' equity

Go up with debits
Accounts have debit balances

IV. HOW IS THE INCOME STATEMENT PREPARED AND ANALYZED?

Unadjusted: No end-of-period adjustments have been made yet to reflect all revenues earned and expenses incurred
during the quarter
CLASSIFIED INCOME STATEMENT
NET PROFIT MARGIN RATIO
Definition: Net Income / Net Sales (or Operating Revenues) measure the profit generated per dollar of sales (operating
revenues)
o Higher the ratio, the more effective the company at generating revenues/controlling costs

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

CH. 4: ADJUSTMENTS, FINANCIAL STATEMENTS, AND THE QUALITY OF EARNINGS

I. ADJUSTING REVENUES AND EXPENSES

Accounting Cycle: Process to analyze and record transactions, adjust records at end of period, prepare financial statements, and
prepare records for next cycle
Adjusting Entries: Entries necessary at the end of the accounting period to measure all revenues and expenses of that period

I.1. Types of Adjustments

4 types of adjustments, each requiring two entries:
1. Cash receipt or payment either before or after the end of the period
2. Adjustment to record the revenue or expense in the proper period (adjusting entry)

4 Types Adjustments

Deferred Revenues: Previously recorded L that were created when cash was received in advance
o Must be reduced for amount of revenue actually earned during period

Accrued Revenues: Revenues that have been earned but not yet recorded because cash will be received after the services are
performed or goods are delivered

Deferred Expenses: Previously recorded assets (e.g., prepaid rent, supplies, equipment, created when cash was paid in
advance
o Must be reduced for the amount of expense actually incurred during period through use of asset

Accrued Expenses: Expenses that have been incurred but not yet recorded because cash will be paid after the goods or
services are used

I.2. Adjustment Process

1. Was revenue earned or an expense incurred that is not yet recorded?
a. YES: Credit revenue account, or debit expense account in adjusting entry
2. Was the related cash received or paid in the past, or will it be received or paid in the future?
a. RECEIVED IN PAST: Deferred revenue (liability) account was recorded in past
i. Reduce liability account (usually unearned revenue) that was recorded when cash was received, since
some/all of liability has been earned since then
b. WILL BE RECEIVED IN FUTURE:
i. Increase receivable account (e.g., interest receivable, rent receivable) to record what is owed by others to
the company (creating accrued revenue)
c. PAID IN PAST: Deferred expense account (asset) was created in past
i. Reduce the asset account (e.g., supplies or prepaid expenses) recorded in the past, since some/entire asset
has been used since then
WILL BE PAID IN FUTURE:
i.
Increase payable account (e.g., interest payable, wages payable) to record what is owed by the company to
others (creating accrued expense)
*CASH IS NEVER INCLUDED IN ADJUSTING ENTRY, BECAUSE IT WAS RECORDDED ALREADY IN PAST/WILL BE RECORDED
IN THE FUTURE
3. Compute the amount of revenue earned or expense incurred
DEFERRED REVENUE
Unearned Revenue (-L)-----------------XX
Revenue (+R, +SE)------------------XX
ACCRUED REVENUE
Receivable (+A)---------------------------XX
Revenue (+R, +SE)------------------XX

DEFERRED EXPENSE
Expense (+E, +SE)----------------------XX
Prepaid Expense (-A)---------------XX
ACCRUED EXPENSE
Expense (+E, -SE)-----------------------XX
Payable (+L)--------------------------XX

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Factor

ADJUSTINGREVENUESANDEXPENSES
AccountingCycle
Transactionsthatresultinexchangesareanalyzedandrecordedingeneraljournalinchronologicalorder(journalentries(
Relatedaccountsareupdatedingeneralledger(Taccounts)
Endofperiodstepstoadjustrecordingrevenuesandexpensesintheproperperiod,andupdatethebalancesheetaccountsfor
reportingpurposes
PurposeofAdjustments
Whenonetransactionneededtorecordacashreceiptorpayment,andanothertransactionneededtorecordrevenuewhenits
earned/expensewhenitoccurred
Adjustingentriesattheendofeachaccountingperiod
TypesofAdjustments
4typesofadjustments
2inwhichcashalreadyreceivedorpaid
2inwhichcashwillbereceivedorpaid
DEFERREDREVENUE(Cashreceivedandpreviouslyrecorded)
UnearnedRevenue(L0.XX
Revenue(+R,+SE)XX
ACCRUEDREVENUE(Ifcashwillbereceived)
Receivable(+A)XX
Revenue(+R,+SE)XX
DEFERREDEXPENSE(Expensepaidandpreviouslyrecorded)
Expense(+E,SE)XX
PrepaidExpense(E)XX
ACCRUEDEXPENSE(Cashwillbepaid)
Expense(+E,SE)XX
Payable(+L)XX
2entries:
1. Cashreceiptorpaymenteitherbeforeoraftertheendoftheperiod
2. Adjustmenttorecordtherevenueorexpenseintheproperperiod(adjustingentry)
AdjustmentProcess(3steps)
1. Wasrevenueearned,oranexpenseincurred,thatisnotyetrecorded?
Ifyes,creditrevenueaccountordebittheexpenseaccountintheadjustingentry
2.

Wastherelatedcashreceivedorpaidinthepast,orwillitbereceivedorpaidinthefuture?
a. Ifcashwasreceivedinpast,deferredrevenue(L)accountwasrecordedinthepast.
Reduceliabilityaccount(usuallyunearnedrevenue)recordedwhencashwasreceived,sincesome
liabilityearnedsincethen
b. Ifcashwillbereceivedinthefuture,increasethereceivableaccount(interestreceivable,rent
receivable)torecordwhatisowedtoothersincompany(createsaccruedrevenue)
c. Ifcashwaspaidinpast,deferredexpenseaccount(asset)wascreatedinpast
Reducetheassetaccount(suchassuppliesorprepaidexpenses)thatwasrecordedinthepast,since
someassetshavebeenusedsincethen.

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

d.

Ifcashwillbepaidinfuture,increasethepayableaccount(e.g.,interestpayable,wagespayable)to
recordwhatisowedbythecompanytoothers(createsanaccruedexpense)

Tryingtogivestructuretoadjustingentries
Dontneedtomemorizethegroupings,etc.
Bottomline:youregoingtobelearningjusthowtodotheadjustingentry
Dontreallyneedtoknowthecategories
ClosingProcess:Mechanicalprocess,seeingitonincomestatements
Closingprocessissynonymouswithincomestatement
Whenyouprepareincomestatement,youredoingthat
Earningspershare:FYItype
Totalassetturnover(activityratio)
Ch.3:grossmargin,netmargin,operatingmargin(butcheckthehandouttomakesureitsright)
AfterallthechaptersandbeforeCh.9,nextweekwillbeinreviewofratios
Mechanicallyfollowingwhattheyare
Whereadjustingentriescomeintothepicture
ThemostimportantthingtokeepinmindwithCh.3and4,thesequence:
Thissequenceisverycritical
1. Transactiontakesplace
Accountingisreactiontotherealworld
AskselfwhatImjustabouttodo
Verbalizewhatjusthappened
2. Recordjournalentriesinthegeneraljournal
3. Postamountstothegeneralledger(Taccount)
Realworld:journalentryalwayscomesbeforeTaccounts.Inrealworldalljournalentries,notTaccounts.Taccountsareforown
mentalframework
4. Prepareasummaryofallthebalancesintheaccount(trialbalance)
Todetermineifdebitsequalcredits(willalwaysequalthatifitsproperlydone)
5. Adjustrevenuesandexpensesandrelatedbalancesheetaccounts(recordinjournalandposttoledger)
6. Prepareacompletesetoffinancialstatementsanddisseminateit
7. Closerevenues,gains,expenses,andlossestoRetainedEarnings
PREPARINGFINANCIALSTATEMENTS
NORMALANDADJUSTINGENTRIES
Ifsomeonejustsaysjournalentries,theyrehappeningthroughtheyear,happeningasthingshappeninreallife(JE)
Anythingisnotareactioniscalledadjustingentries,tobelumpedattheendoftheyear(AJE)
- Adjustmentsbeingmadeasanafterthoughtbytheaccountanttomakethingsright
Adjustingentriesmadeattheend,authorizedonlybytoplevelexecutives
- Mostlikelyplaceformanipulationisinadjustingentries
- Thisisallfigurative,doneoutside.
Typicalregularnormalentriescouldbeinthethousands
- Butadjustingentries:lookingathardly25or30
- Relativelylookingatanegligiblenumber
- Criticaltounderstandtheresveryfewadjustingentries
Revenue:

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Microsoftwillbookrevenuesoverthreeyearsasunearnedrevenue
- Completelyaccountingdriven.
Adjusting:thisentryisnotbeingmadeinresponsetoreceivingthecash.Whencashpaid,itwasdebitedincashflow.
Overtheyears,theydebitcashandcreditrevenues
Expense:
Samestoryasrevenue.Anythingmorethanamonthwillinitiallybecalledanasset.
Rentexpense:attheendoftheyear,recognizesexpirationofrentused,andthebenefitswecalledanassetaredepleted
Typically,howweguaranteethatthisisgoingtohappeniswhenprepaidrent,systemispreprogrammedsoastohowmanymonthsit
goes,sothecomputerjustrunsthroughachecklistofthings
- Anytimeenteringanasset,alsonotingdepreciationanddepletion
- Notgoingtowaitlaterintheproblemtodotheadjusting
- Systemalreadyincorporatesitatthetime
Depreciation:
Thefixedassetmodulecomingup,thescreenimmediatelysayswhatthedepreciationmdoelisgoingtobe
- Regularentryismadesimultaneously
Inbothcases,wehaveanassetthatisbeingconsumed(withexceptionofcash)
- Whateverassetis,itwillbeusedup.Itwilleitherbeusedupordepreciated.Any
assetyoupurchasetobeusedovertime,morethanayear,putindepreciationexpnse
- Whatisusedinshortertimespan,likeprepaidinsurance,willallbegoinginepx
- Debitexpense,creditanasset
Costofsales:havelotsofexamples.Allusesupplies.Debitsuppliesexpense,andcreditinventoryexpenses.Thisiswhatthebook
has.Thoughmoregenerically,thisistrueforallinventory.Therealinventoriesaretheproductsbuyingtosell,ormaterialstobe
manufacturedintoaproducttosell.*Bookdoesntbringitindirectly
Interestexpense:Anytimeyouseeanexampleofcompanyborrowedmoneymakeanotethatyouhavetonoteinterestexpense
aswell.Thisisanaccountingconcept,notlegal.Sooftentimestheproperterminologytouseisnotinterestpayable.Itsaccruednot
legalobligationbutdemonstratingthatitsdue
- Ideaisthatitsaccruedandaccountantsarerecognizingit,butnotpastduedate
typedeal
Assoonasyoucalculatepretaxincome,thenyoumakeajournalentryforaccruedincometax
Baddebtexpense:havealltheseloans.BasedonwhatIknownow,presentlooking,thingsthathavealreadyhappenedthisyear,are
thereanyloansthatarepotentiallynotgoingtobepaid?
- Lookingtoday,notnecessarilyspeculate.Mostcommonexamplewouldbemaking
lotofloanstorealestateindustry.SlowdowninfourthquarterinSeptember,soon
December31ontheloansIvemadeinNYandManhattan,somealreadycollected,
thesearethequestionstoaskandbookingtheexpense
- Entrybeingmadehereisacontraaccounttothecontractsreceivable
- Lessallowanceforuncollectable(creditallowanceforuncollectable)
- Nodifferencewithdepreciation.Justthatindepreciationdecidealltherulesonthe
daywebuytheasset.Thesystemisalreadysetup.Butwithloans,thisentryisbeing
madeexclusivelyattheyearend.
- Insteaditstheaggregateportfoliooftheloan
Warrantyexpense:Whatwillitcostmeinthefuturetotakecareofthewarranties
Justlookingathistoricalfacts,andthenstatingwhatsprobablygoingtohappen
- Sellingacar,bookingexpenses,etc.
- Notforecastingwhichcarswillcostme,justalready
- Debitwarrantyexpense,creditwarrantypayable

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Bulkwillbefirstthreelistedinppt
Alwaystrytododebitentriesfirst,thencreditentries
Dontinvolvereallifeitems(Credit/debitcashshouldnevershowup)
Noreasontomakeadjustingentriesthatpurelyaffectthebalancesheet
- Onlytimeyouddothiswouldbewithanaccountingerror
Shouldanticipatewhetheritsarevenueorexpenseentry
Tryingtogetyourincomeright,sowhateverfixedtomakeincomecorrect
All4entries(categories)havedebittoanexpenseorcredittoarevenue
Noneshouldeverhavedebitorcredittocash
EPS
EPS:Therewillbetwosetsofnumbers:
1. BasicEPS
2. DilutedEPS
Dilutedreferstothefactthatstockoptionsareissued,sotheseoptionsarepotentiallyexercisable,andwilldilutetheearnings
pershare
Earnings/Numberspershare.Butprocedurallylotsofrulestocalculatesincethisistheultimatenumberforpublic
disclosure.Bottomdenominatorisjustthenumberofshares.PotentiallydilutedstockoptionsSoinsteadshouldalwayslook
fordiluted.WheneverlookingatEPSdisclosure,lookatdilutedalways.

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

LIABILITIES AND OFF-BALANCE SHEET FINANCING

LIABILITIES DEFINED AND CLASSIFIED
Liability
Definition: Probable debts or obligations resulting from past transactions, which will be paid with assets or services
Recorded: First recorded in terms of current cash equivalent
Current cash equivalent: Def: cash amount a creditor would accept to settle liability immediately
Current Liability
Def: Short-term obligations to be paid within current operating cycle, or one year of balance sheet date (whichever is longer)
Liquidity: If it has the ability to meet its current obligations
Measurements useful in evaluating liquidity: Current ratio, working capital (current assets current liabilities)
Margin of safety ensuring a company can meet its short-term obligations
o Excess money in checking account/inventory is not productive, because it doesnt generate profits
CURRENT LIABILITIES
Many current liabilities have direct relationship to the operating activities of a business
Specific operating activities financed in part by related current liability
Accounts Payable
Typically, transactions create accounts payable (trade accounts payable)
Accrued Liabilities
Expenses that have been incurred before end of an accounting period, but have not been paid
Accrued Taxes Payable
Accrued Compensation and Related Costs
Payroll Taxes
Notes Payable
Interest is an expense of the period in which the money is used
Current Portion of Long-Term Debt
Current debt must be paid within year, companies must have sufficient case to repay it
Long-term debt must be reclassified as a current liability within a year of its maturity date
Contingent Liabilities: Potential liabilities created as a result of a past event
A contingent liability may or may not become a recorded liability depending on future events
Whether situation produces a recorded or contingent liability depends on:
a. Probability of a future economic sacrifice
b. Ability of management to estimate the amount of the liability
Working Capital Management
Working capital: Dollar difference between total current assets and total current liabilities
Significant impact on health and profitability of a company
Changes in working capital amounts important, as they have a direct impact on cash flows from operating activities reported on
statement of cash flows

LONG-TERM LIAIBILITES

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

ROADMAP
9: all about liabilities, most of the focus on current liabilities
11: But Chapter 11 is about institutional details: lots of details about whats going on out there in the real world, and how to account for it
As you read chapters, 1. Intro to institutional framework. Not accounting.
We only care about how to account for them
In the exam, focus is accounting for transactions, not questions of finance-oriented nature (e.g., stock split)
Chapter 9: asking the question of how to account for certain obligations that arise in the course of business, mainly focusing on current
liabilities
In the process, all other aspects of the process that come in the way (that are not on the exam?)
EXAM: Mainly testing on current liabilities. Longterm liabilities, minimum that you need to know, but rest of chapter is for FYI

LIABILITIES: CONCEPT REVIEW

Oftentimes liabilities not very controversial. Concrete documentation regarding liabilities.
Overall, liabilities are relatively easy. Companies dont have a lot of issues in figuring them out
Liabilities are probable debts or obligations of the entity that result from past transactions
Hypo with note payable: The fact that were ordered to pay interest isnt a liability because the time hasnt passed yet, time needs to
pass before interest is reported as a liability
*Unlike assets, longterm liabilities are split up
Always splitting up into current and longterm liabilities
With liabilities, we always split into current portion, payable in 12 months, then into longterm liabilities
Ideally, want to think about current liabilities as the key measure of liquidity
In many bankruptcy cases, defining what is a measure of solvency or bankruptcy. In general, that would be from 90 days 1
year
o Viewed as insolvent if insufficient funds to pay obligations as they come due (and is defined as 90 days)
o From accounting perspective, we use one year
Courts as well as accountants view as important the breakup between current and noncurrent liabilities
EXAMPLE CURRENT LIABILITIES
Accounts payable: most are shortterm or current. Unless see longterm it will be current/short-term
Accrued Liabilities
e.g., interest paid at end of year
*Dont get too hung up on label, just make sure its a liability. Put in bracket what it is
Only discussing the principal portioninterest is never recorded as current portion of longterm debt
CRITICAL TRIPPING POINTS.

CONTINGENT LIABILITIES
Uncertainnormally liabilities are nondisputable, you know what you owe. This is true for vast majority of liabilities. But enter situation in
which the amount is not knownnot only not known but is in dispute.
e.g., lawsuit claiming for injuries. When theres two completely variance disputed sum.
Past event is still an important concept, but never talking about speculative future. ALREADY OCCURRED EVENT.
o Already a spill, already an injury. Uncertainty is what your future obligations are that are needed to be paid to take
care of the consequence
o We are never talking about simply providing for things that might happen in the future.

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Environmental and litigation are the most common ones

Ask two questions:
1.
2.

Is a loss probable? Liability/obligation probable?

Can the amount be estimated?

If meet first test, then called estimated L

*WORKING CAPITAL: The excess of current assets over current liabilities

Basic idea: if the working capital is negative, you have liquidity issues
Learn to calculate this. ID the items given as current A or current L, then subtract
*CURRENT RATIO: Take the ratio. Current assets / Current liabilities
Probably one of the most used in banking
Often impose a lower limit on the current ratio
TUROVER RATIOS: The turnover is quick, quickly paying off payable. Bigger the turnover number is, the quicker youre paying off your
payable.
In exam, not that much to test on longterm liability, bc book doesnt have much and skipping numbercrunching.
All current liabilities. Keep in mind while reading chapter

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

REPORTING AND INTERPRETING OWNERS EQUITY

CHAPTER ROADMAP
11-1 Explain role of stock in capital structure of corporation
11-2 Analyze earnings per share ratio
11-3 Describe characteristics of common stock, analyze transactions affecting common stock
11-4 Discuss dividends and analyze transactions
11-5 Analyze the dividend yield ratio
11-6 Discuss purpose of stock dividends and stock splits, report transactions
11-7 Describe characteristics of preferred stock and analyze transactions affecting preferred stock
11-8 Discuss impact of capital stock transactions on cash flows
OVERVIEW
2 primary sources of stockholders equity:
1. Contributed capital from the sale of stock: Amount of money stockholders invested through purchase of shares
2. Retained earnings: generated earnings from companys profit-making activities
o Most companies generate significant portion of SE from retained earnings

I. OWNERSHIP OF A CORPORATION
I.1. Authorized, Issued, and Outstanding Shares
Charter outlines maximum number of shares that can be sold to public
Terminology
Authorized number of shares: Max. number of shares a corporations capital stock that can be issued as specified in the charter
Issued Shares: Stock that has been sold to the public
Treasury Stock: Stock that has been bought back
Outstanding shares: Total number of shares of stock owned by stockholders
EARNINGS PER SHARE RATIO (EPS) FORMULA
Earnings per share = Net income / Average number of common shares outstanding
*Preferred dividends should be subtracted from net income
Purpose: widely used measure of profitability

II. COMMON STOCK TRANSACTIONS

Terminology
Common stock: Basic voting stock issued by a corporation
o Common stock dividends may increase with increase in companys profitability
Par value: Nominal value per share of capital stock, serves as basis for legal capital
No-par value stock: Capital stock that has no par value specified in corporate charter

I.1. Initial Sale of Stock

Terminology
IPO: Initial public offering, very first sale of companys stock to the public
Seasoned new issues: Additional sales of new stock to the public
I.2. Repurchase of Stock
Treasury Stock

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

Def: Corporations own stock that has been issued but subsequently reacquired, & is still being held by that corporation
o No voting, dividend, or other stockholder rights while held as treasury stock
o Most companies record purchase of treasury stock based on cost of shares that were purchased
Recording Purchase of Treasury Stock
Cost method: Recording purchase of treasury stock based on cost of shares that were purchased *Most companies follow this
Note: Treasury stock is NOT AN ASSET
o Actually a contra-equity accountsubtracted from total stockholders equity
When a company sells its treasury stock, it does not report an accounting profit or loss on the transaction, regardless of selling
stock for more or less than it paid

CHAPTER 3: Operating Decisions and the Accounting System | ACCOUNTING

STOCKHOLDERS EQUITY: TOPICS

Difference between finance and accounting: if asking why, then its finance
Most are cumulative dividends