Marshall2e IRM Ch02

8/11/2019 Marshall2e IRM Ch02

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CHAPTER 2 Financial statements and accounting

concepts/principles

CHAPTER OUTLINE

I Financial statements

A. From transactions to financial statements

B. Financial statements illustrated

C. Explanations and definitions

1. Balance sheet

2. Income statement

3. Statement of changes in owners e!uit"

#. Cash flow statement

$. Comparati%e statements in su&se!uent "ears

E. Illustration of financial statement relationships

II Accounting concepts and principles

A. Schematic model of concepts and principles

B. Concepts or principles related to the entire model

C. Concepts or principles related to transactions

$. Concepts or principles related to the accounting process

E. Concepts or principles related to financial statements

F. 'imitations of financial statements

III T!e compan"#s annual report

I$ T!e ROA and ROE ratios

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 2%


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TEACHIN& AN' LEARNIN& O()ECTI$E*

Principal

To have the student:

illustrate the four principal financial statements and their basic form and demonstratetheir relationships

understand and use the terminology of financial statements

understand and use the accounting equation

explain the concepts of financial accounting and financial statement presentation.

*upporting

To have the student:

show that financial statements are the product of financial accounting and that thestatements represent a historical summary of past transactions

explain some of the limitations of financial statements

illustrate the financial statements that are included in the company annual report

explain several business procedures and their terminology.

TEACHIN& O(*ER$ATION* AN' A**I&N+ENT *U&&E*TION*

1. This is the keystone chapter of the text, and the material presented here becomes afoundation for all subsequent financial accounting topics. The instructor must resisttrying to teach the entire course from this one chapter!Instead, try to help students sortout the key ideas that must be learned now from those that they should be acquainted with,but that will really be learned when subsequent material is covered. This is very much anintroduction to the classification system accounting uses. Items to be learned now include:

a. definition of a transaction

b. the name of each financial statement and what it shows

c. the accounting equation

d. financial statement relationships

e. limitations of financial statements.

2. A significant amount of time should be spent illustrating and explaining the purpose and

contentby classification category (asset, liability, owners equity, revenue, expense)of

each financial statement and how the financial statements link together. Some instructors

may wish to discuss gains and losses at this point, but restraint is recommended. The key is

to keep it as simple as possible.

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 22


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3 It is recommended that the following models be emphasised:

a. Balance Sheet:Assets / 'ia&ilities 0 wners E!uit"

Beginning oferiod

Changes $uringeriod

0+4 0+4 0+4

End of eriod

b. Income Statement:

IncomeExpenses

/ 5et profit

c. Statement of Changes in Owners Equity:Beginning Balance of wners E!uit"

0 wners In%estment0 5et profit

$i%idends

/ Ending Balance of wners E!uit"

(As with the discussion of gains and losses, some instructors may wish to acknowledge

other sources of changes in owners equity. It usually based on the extent to which

students have been previously exposed to real-world financial statements. An early dose of

reality can be refreshing for graduate students, but may be distracting or overwhelming to

an undergraduate less-experienced audience.)

4. It is helpful to spend time with the concepts and principles model, explaining what each

concept or principle means and showing how it relates to the Transactions to Financial

Statements process.

5. It is appropriate to emphasise the limitations of financial statements now because students

can create a mindset that helps understand specific accounting principles when they are

covered later. Real-life limitations of the role of estimates in accounting can never be

emphasised enough.

6. The Business In Practice sections are designed to enhance student understanding by

removing some jargon and explanation from the flow of the text material while providing a

context for that material. These provide good class discussion topics. The instructors press

gallery is also a useful source of current topical news items in manageable bite-size

proportions that can usefully be incorporated into lessons.

7. When introducing the material in this chapter, keep in mind the big picture.

8. The Insiders Viewis intended to help students appreciate the relevance of the study of

accounting and can be used to add relevance to the numbers. These are especially helpful

to non-accounting majors. Accounting majors can see the extent of their service industry.

9. So What Do You Think? is intended to personally engage the student and encourage

reflection and association with the essential topics of the chapter.

10. The take-home quiz provided for each chapter is a useful feedback resource that can also

be used as a mini-class quiz. Many of the quizzes are in skeleton format so they can beInstructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 2,


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applied to a variety of companies. This template approach enables you to claim that your

course is current with minimal additional effort. It also enables multiple quizzes to be

generated for multi-campus operations.

11. At this stage, students should have purchased their books and time can usefully be spent

looking at the various features of the textbook and talking about how they can add value aspart of the study program. This is your opportunity to provide guidance as to the

examination relevance of the various features.

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 2-


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P22, 2, 3, # )ed Interpret data Stress the importance of the historical cost principleP22- 2, 3, :, 7 )ed Interpret data See 2.23P22 2, # ard Interpret data

and reports&roup learning pro5lemEmphasises the structure of theincome statement

P220 2, # ard Interpret dataand reports

Explain wh" other income is excluded from gross profit

P221 2, #, 7, 9 ard Excellent conceptual case with personal rele%ance &ut ma>esure to relate student responses &ac> to the terminolog"introduced in the chapter



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*OLUTION*

E2.1

Category Financial Statement

Cash............................................................................ A (*Accounts pa"a&le................... ................ ............. ..... ...

L (*

rdinar" shares........................................................... OE (* and *COE$epreciation expense.................................................. E I*5et sales..................................................................... I I*Income tax expense.................................................... E I*Shortterm in%estments............................................... A (*@ain on sale of land.................................................... & I*(etained earnings....................................................... OE (* and *COE$i%idends pa"a&le....................................................... L (*Accounts recei%a&le..................... ............... ..... ...... ..... A (*Shortterm &orrowings................................................ L (*

E2.2

Category Financial Statement

Accumulated depreciation........... ................ .............. .. 6A (*'ongterm &orrowings................................................. L (*E!uipment................................................................... A (*'oss on sale of shortterm in%estments...................... L* I*rofit for the period..................................................... OE I* and *COEIn%entor"...................................................................... A (*ther accrued lia&ilities.............................................. L (*$i%idends paid............................................................. OE *COECost of goods sold...................................................... E I*

Additional share capital.................. ................ ........... .. OE *COEInterest income............................................................ I I*Selling expenses......................................................... E I*

Trick question! Dividends paid appears only on the Statement of Changes in Owners

Equity. Dividends paid are distributions of earnings that reduce retained earnings on the

balance sheet. Dividends paid are not expenses and do not appear on the income statement.

Accumulated depreciation is a negative asset. It is a set-off amount known technically as a

'contra' account and shown as a deduction of the related non-current asset.

E2.3 The CEO is the Chief Executive Director, also known as the Managing Director. This is a

salaried position. The CFO is the Chief Financial Officer and is usually the mainaccountant. Sometimes this person also acts as the public secretary who takes

responsibility for compliance issues relating to the listing on the stock exchange.



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E2.4 Profit is a function of income earned exceeding expenses incurred. Many of these

transactions are on credit with parties buying now and paying later.

The cash balance is a function of money coming in and money going out. Many cash

transactions do not involve an income or an expense, e.g. a loan received or repaid.While it may be that a profitable business also has money in the bank, this is a function of

efficient management.

A possible reason for a company not having enough cash to pay the bills could occur in the

early set up phase of a business where the company needs to fill their shelves with

inventory and may not have established credible lines of credit with their suppliers. They

may be enticing new customers with offering extended periods of credit. There would be

cash outlays required to provide infrastructure (non-current assets) prior to opening the

business. These would be expensed over their useful lives, likely to exceed a year.

E2.5 Financial statements report quantitative economic data; they do not reflect qualitativeeconomic variables, e.g. value of management team or morale of workforce. Suchqualitative attributes of the firm are frequently relevant to the decisions and informedjudgments that the financial statement user is making, but they are not communicated inthe financial statements because they cannot be measured objectively.

In addition, the money measurement applied to transactions is the original cost. No holding

gains are recognised for changes in the purchase power of the dollar or for economic

appreciation until the asset is sold.

E2.6 Answers will differ between students. Intention of this question is to demonstrate the

wealth of accounting information available. Link this into financial literacy.

E2.7 Many of these transactions need qualification so a story behind the words may help. Showhow the detail makes all the difference to the qualification.

Asset Liability Equity Income Expense

Equipment Share capital

Cost of goods

sold

Rent payable* Dividends

received

Rent*

Stamps Loan payable

Electricity

payable*

Electricity

expense*



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E2.8 Many of these transactions need qualification so a story behind the words may help. Showhow the detail makes all the difference to the qualification.

Asset Liability Equity Income Expense

Equipment Share capital Electricityexpense

Inventory Interest earned

Fixed deposit Dividends paid

E2.9 Use the accounting equation to determine the missing information.Firm A:

A / ' 0 E

A / ' 0 SC 0


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An alternative approach could be to consider the Statement of Changes in Equity anduse a Balance sheet schedule to solve for the missing numbers rather than anequation :

Firm A Firm B Firm CShare Capital 75 000 85 000 (ii) 40 000

Retained Earnings Beginning Bal

78 000 246 000 (iii) 42 000

Plus Profit 102 000 (iii) 83 000 113 000

Less Dividends (50 000) (19 000) (65 000)

Retained Earnings atend of year

130 000 (ii) 310 000 90 000 (i)

Liabilities 215 000 145 000 195 000 (iii)

Total L + OE 420 000 (i) 540 000 (i) 325 000 (ii)

Total Assets 420 000 540 000 325 000

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 2%4


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E2.10 Use the accounting equation to solve for the missing information.

Firm A:

A / ' 0 EA / ' 0 SC 0


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An alternative approach could be to consider the Statement of Changes in Equity anduse a Balance sheet schedule to solve for the missing numbers rather than anequation :

Firm A Firm B Firm CShare Capital 55 000 59 000 140 000

Retained Earnings Beginning Bal

50 000 124 000 122 000 (iii)

Plus Profit 68 000 110 000 81 000

Less Dividends (12 000) (48 000) (ii) (28 000)

Retained Earnings atend of year

106 000 (i) 186 000 175 000 (ii)

Liabilities 80 000 190 000 (iii) 205 000Total L + OE 241 000 (ii) 435 000 (i) 520 000 (i)

Total Assets 241 000 (iii) 435 000 520 000

E2.11

Use Equation for Ret Earnings: 7(eg RE 8 NP 9 'I$ : End RE;

$311 800 - $4700 - $18 500 = $288 600

Alternatively:

Prepare the retained earnings portion of a statement of changes in owners' equity for the yearended 31 December 2008:(etained earnings 31 $ecem&er 2DD9...................................................................................... 311 6DD'essG 5et loss for the "ear ended 31 $ecem&er 2DD6..............................................................


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E2.13 The clue to this is the underlined words net assets in the question

E

A / ' 0 SC 0 (E

BeginningG 12 #DD / 9 DDD 0 D 0 : #DD


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EndingG 931 DDD


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$423 983 the amount of cash available to pay the claims of creditors and shareholders.Liabilities would be paid first (including the amounts that are notshown on the balancesheet) and the balance would be paid to the shareholders:

*otal cash a%ai la&le....... .. ... ... ... .. ... ... .. ... ... .. ... ... .. ... ... .. ... ... ... .. ... ... .. .. .. .. .. .. .. .. .. .. .. . #23 ;63Accounts pa"a&le................... ................ ................ ................ ................ ............. #7 9DD

'oan pa"a&le...................................................................................................... :6 :DDages pa"a&le


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5et profit for the "ear.................................................................................................. 26 DDD$i%idends declared and paid during the "ear..............................................................


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Solving the model, the beginning retained earnings balance must have been $246 100because the account balance increased by $136 100 during the year to an ending balance of$383 000.

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 2%1


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P2.19

(a)

BRENN L!"

#ncome Statement

For the $ear Ended %& "ecember '(()

Sales............................................................................................................................... 2DD DDDCost of goods sold.........................................................................................................


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(d) $12 000 dividends declared and paid / $24 000 net profit = 50%. This assumes that theboard of directors has a policy to pay dividends in proportion to net profit. Before this canbe established, the trend of dividend distributions would need to be studied.

P2.20

(a)S L!"

#ncome Statement


Sales....... .. ... ... .. ... ... ... .. ... ... .. ... ... .. ... ... .. ... ... ... .. ... ... .. ... ... .. ... ... .. ... ... .. .. .. .. .. . 1:D DDDCost of goods sold...................................................................................


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(b) $14 000 income tax expense / $40 000 net profit before tax = 35% average tax rate

(c) $8 000 interest expense / $50 000 notes payable (long term) = 16% interest rate. Thisassumes that the year-end balance of long-term borrowings is representative of the averagelong-term borrowings account balance throughout the year. If large amounts of cash hadbeen borrowed near the end of the year then the interest rate charged on long-termborrowings would be greater than 16% because the average borrowings outstanding wouldhave been less than $50 000. Likewise if large repayments of long-term borrowings hadoccurred near year-end then the interest rate would be less than 16% because the averageoutstanding long-term borrowings would have been greater than $50 000.

(d) $6 500 dividends declared and paid / $26 000 net profit = 25%. This assumes that theboard of directors has a policy to pay dividends in proportion to net profit.

P2.21 Tutors should identify the the accounts affected and how they affect the accounmting

equation. A useful analysis chart is provided below the answer. Income and expenses could be

combined into OE if this is where the astudents are at. Amounts can easily be assumed to

demonstrate the change in the accounting equationssets / Liabilities 0 O+ners,

E-uity

a. Borrowed cash on a &an> loan 0 0 5E&. aid an account pa"a&le 4 4 5Ec. Issued ordinar" shares in the compan" 0 5E 0d. urchased in%entor" on account 0 0 5Ee. $eclared and paid di%idends 4 5E 4f. Collected an account recei%a&le 5E 5E 5Eg. Sold in%entor" on account at a profit 0 5E 0h. aid operating expenses in cash 4 5E 4i. (epaid principal and interest on a &an> loan 4 4 4

Trans Accounts Classification

A, L,OE, Inc, Ex

Inc/ Dec Proof of effecton acc equation

a Cash A Inc + = +

Loan Pay L Inc

b Cash A Dec - = -

Acc Pay L Dec

c Cash A Inc + = +

Share Capital OE Inc

d Inventory A Inc + = +



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Acc Pay L Inc

e Cash A Dec - = -

Ret Earn OE Dec

f. Cash A Inc + - =

Acc Rec A Dec

g. Acc Rec A Inc + = +

Sales Inc Inc

Inventory A Dec - = -

Cost of Goods sold Ex Inc

h Cash A Dec - = -

Operating exp Exp Inc

i Cash A Dec - = - + -

Loan Pay L Dec

Interest expense Ex Inc

P2.22

(a)

ssets / Liabilities

O+ner,s

0 E-uity% August 244 totals


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5ew totals.......................................................................................... #7: DDD 36# DDD 61 DDD2- Augustrepaid 1D DDD to the &an> plus 2DD interest................ 1D 2DD 1D DDD 42DD5ew totals.......................................................................................... #:# 6DD 39# DDD 6D 6DD23 Augustpaid C"nthia )er>in a 2 DDD cash di%idend ................. 2 DDD 2 DDD,% August 244 totals......................................................................


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(c) Assets are reported at original cost not at an assessed or appraised value.

(d) The amount of the loan payable is calculated using the accounting equation A = L + OE.Total assets can be determined based on items (a) (b) and (c); total owners' equity is knownafter considering item (e); and the loan payable is the difference between total liabilitiesand the accounts payable.

Instructor (esource )anual *+aAccounting: What the numbers mean&" )arshall, )cCartne", -an (h"n et al. 22,


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(e) Retained earnings represents, the difference between cumulative net profit and cumulativedividends.

ssets1 Liabilities and O+ners, E-uity1Cash .................................................... 9DD 'oan pa"a&le.................... 2 2DDAccounts recei%a&le.......... ..... ...... ..... ... 3 #DD Accounts pa"a&le........... 3 #DD

'and...................................................... 11 DDD *otal lia&ilities................ : 7DD)otor %ehicle...... ... ... .. ... ... .. .. .. .. .. .. .. .. .. .. 16 DDD Contri&uted capital ..... .. .. 6 DDD'essG Accumulated depreciation..........


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$i%idends declared and paid............................................................. < 4 D

As at 31 $ecem&er 2DD9 and 2DD6, respecti%el"G*otal assets....................................................................................... 2 ;63 #67 3 2D: 926*otal lia&ilities................................................................................... 3 ;1; #2; # 3D# 3D1*otal shareholders deficit.................................................................


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Solution approach: The key to answering part (c) correctly is to reformat the incomestatement data as shown above, remembering to include Other income as a source of non-operating revenue. The Profit before tax line has been added to emphasise the importanceof understanding the difference between operating and non-operating items on the incomestatement. The problem could be solved without calculating this number.

P2.27 In parts (a), (b) and (d) if students are willing to share the different kinds of assets,liabilities, revenues, expenses and cash flows they have identified, this case can be used toreview the basic characteristics of the balance sheet income statement and cash flowstatement.

In part (c), the point is that projected income activity for the current period has a directimpact on theprojectedbalance sheet.

In part (e), the point is that income and cash flow are two different things entirely. Possibleexplanations might include:

Receipt of student loan proceeds (or scholarships grants) towards the end of thesemester.

Certain costs of attending college (i.e. tuition room and board meal plans) might beincurred by the student but not paid yet.

Many students work on a part-time (or full-time) basis throughout the semester,which may generate more cash flow than they were able to accumulate before thesemester.



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TABE6HO+E UID: CHAPTER 2

NA+EOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO I'OOOOOOOOOOOOOOOOO

Presented below is the Cash flow statement for Mystore Ltd for the year ended 31 December2008. Also shown is a partially completed comparative balance sheet as at 31 December 2008and 2007.

4$S!ORE L!"

Cash *lo+ statement


Cas! lo>s rom operating acti=ities5et profit ................................................................................................................................ 23 DDDAdd s rom in=esting acti=itiesurchase of store fixtures....................................................................................................... s rom inancing acti=ities(epa"ment of longterm &orrowings......................................................................................


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TABE6HO+E UID BEY: CHAPTER 2

1.

Use information in the cash flow statement to determine either the beginning orending amounts for assets and liabilities. For example, accounts receivable decreased$8 000 so at the end of 2008 the balance was $31 000.

Based on total assets and total liabilities at the beginning and end of the year,determine total owners' equity at each date.

Using total owners' equity at the end of 2007, solve for retained earnings at that date.

The cash flows from financing activities on the cash flow statement does not showany cash from the sale of additional stock so the ending balance is the same as thebeginning balance. Knowing this, retained earnings at the end of the year can bedetermined.

Alternatively, use information about net profit and dividends from the cash flowstatement and the beginning balance of retained earnings (as determined above) tocalculate ending retained earnings. Then, capital contributed at the end of the yearcan be determined.

4$S!ORE L!"

Balance Sheets! %& "ecember '(() and '((3

&'' &'' &'' &'' Current assetsGCash....... ... ... .. ... ... .. ... ... .. .. 39 DDD 19 DDD Accounts pa"a&le....... .. .. .. . 12 DDD 16 DDD

Accounts recei%a&le......... 31 DDD 3; DDD 'ongterm &orrowings. .. .. 16 DDD 2D DDD*otal current assets......... . 76 DDD :7 DDD *otal lia&ilities................... . 3D DDD 36 DDDStore fixtures.................... 26 DDD 2# DDD Contri&uted capital............ 2D DDD 2D DDD

'essG Accumulated (etained earnings............ . 33 DDD 1: DDDdepreciat ion.... .......... .......

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Marshall2e IRM Ch02

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