Chapter 01 – Introducing Financial Accounting
1-9
Chapter Outline
Notes
Transaction 11: Payment of cash dividend
– Assets (Cash) = – Equity (Dividends)
The company declared and paid a dividend to its owner. Dividends
(decreases in equity) are not reported as expenses because they are
not part of the company’s earnings process, and they are not used in
computing net income.
IV. Financial Statements
A Income Statement
Reports on operating revenue and expense activities over a period of
time. Net income (or loss) is computed as sales less all costs and
expenses. Revenues are reported first followed by expenses.
Expenses reflect the costs to generate the revenue reported.
B. Statement of Retained Earnings
Reports changes in retained earnings of the business over a period of
time. Changes result from net income, which increases retained
earnings. A net loss and dividends decrease retained earnings.
Ending retained earnings is reported on the balance sheet.
C. Balance Sheet
Reports a listing of amounts for assets, liabilities, and equity at a
point in time.
D. Statement of Cash Flows
Reports on cash flows for operating, investing, and financing
activities over a period of time.
V. Global View
A. Basic Principles – both U.S. GAAP and IFRS include broad and
similar guidance for financial accounting. However, neither system
specifies particular account names nor the detail required.
B. Transactions Analysis – both U.S. GAAP and IFRS apply transaction
analysis identically as shown in this chapter. Some variations exist in
revenue and expense recognition and other principles.
C. Financial Statements – Both U.S. GAAP and IFRS prepare the same
four basic financial statements.
D. Status of IFRS – IFRS is now adopted or accepted in over 115
countries.
VI. Decision Analysis—Return on Assets (ROA)
A. Return on assets, also called return on investment (ROI), is a
profitability measure; useful in evaluating management, analyzing
and forecasting profits, and planning activities.
B. It is calculated by dividing net income by average total assets.
VII. Return and Risk Analysis (Appendix 1A)
A. Net income is often linked to return. Return on assts (ROA) is stated
in ratio form as income divided by assets invested.
B. Risk is the uncertainty about the return we will earn. All business
investments involve risk, but some involve more risk than others.
C. The lower the risk of an investment, the lower is our expected return.
Chapter 01 – Introducing Financial Accounting
1-10
Chapter Outline
Higher risk implies higher, but riskier, expected returns.
D. The trade-off between risk and return is a normal part of business.
We use accounting information to assess both return and risk.
Notes
VIII. Business Activities and the Accounting Equation (Appendix 1B)
There are three major types of business activities:
A. Financing Activities—provide the means organizations use to pay
for resources such as land, buildings, and equipment to carry out
plans.
B. Investing Activities—the acquiring and disposing of resources
(assets) that an organization uses to acquire and sell its products or
services.
C. Operating Activities—involve using resources to research, develop,
purchase, produce, distribute, and market products and services.
Chapter 01 – Introducing Financial Accounting
1-11
VISUAL #1-1
WARNING: NO MATTER WHAT HAPPENS
ALWAYS KEEP THIS SCALE
IN BALANCE
ASSETS L + E
Basic Accounting Equation
ASSETS = LIABILITIES + EQUITY
TRANSACTION ANALYSIS RULES
1) Every transaction affects at least two items.
2) Every transaction must result in a balanced equation.
TRANSACTION ANALYSIS POSSIBILITIES:
A
=
+
E
(1)
and
+
or (2)
and
–
or (3)
and
No change
or (4)
and
+ and –
Chapter 01 – Introducing Financial Accounting
1-12
Chapter 1 – Alternate Demonstration Problem #1
One spring, Jane Smith decided to earn money as a lawn service
professional. After discussions with neighbors, she obtained enough
commitments for lawn servicing jobs that she thought she could be
successful at it. On June 1, 2013, on the basis of these commitments,
Jane personally invested $2,000 in the business in exchange for
common stock. She deposited the cash in a business bank account
opened under the name of Ultimate Lawn Care, Inc.
On August 31, 2013, Jane noted the following events which occurred
during the first three months of business:
▪ On June 1, Jane personally invested $2,000 in the business by
depositing the $2,000 in the business’s bank account.
▪ Deposits during the first three months, all from customer
collections, totaled $11,400.
▪ Checks written during the three month period included the following:
▪ Truck and equipment rental, $1,800
▪ Gas, oil, and lubrication, $880
▪ Miscellaneous supplies used, $90
▪ Helpers, $4,700;
▪ Payroll taxes, $500;
▪ Insurance, $175;
▪ Telephone, $100
▪ Dividend (transferred to personal bank account), $2,000.
Jane also had business records that showed:
▪ Customers still owed $600 for services that were performed.
▪ The business owed another $100 to a vendor for gas and oil.
Chapter 01 – Introducing Financial Accounting
1-13
Chapter 1 – Alternate Demonstration Problem #1, continued
Required:
1. Show the effect of each transaction on the accounting equation.
2. Prepare an income statement for Ultimate Lawn Care, Inc. for the
three months ended August 31, 2013.
3. Prepare a balance sheet for Ultimate Lawn Care, Inc. at August 31,
2013.
4. Explain why the company’s cash balance at the end of the summer
does not agree with the amount of net income earned during the
summer.
Chapter 01 – Introducing Financial Accounting
1-14
Solution: Chapter 1 – Alternate Demonstration Problem #1
1.
Item
Assets
=
Liabilities
+
Equity
a.
Issuance of common stock
for cash
+
2,000
+
2,000
b.
Revenue received
+
11,400
+
11,400
c.
Truck and equipment rental
–
1,800
–
1,800
d.
Truck expenses
–
880
–
880
e.
Miscellaneous supplies used
–
90
–
90
f.
Helpers
–
4,700
–
4,700
g.
Payroll taxes
–
500
–
500
h.
Insurance
–
175
–
175
i.
Telephone
–
100
–
100
j.
Dividend
–
2,000
–
2,000
k.
Revenue earned
+
600
+
600
l.
Oil and gas bill not yet paid
+
100
–
100
3,755
100
3,655
2.
ULTIMATE LAWN CARE, INC.
Income Statement
For the three months ended August 31, 2013
Total revenue (11,400 + 600) ………………………………
$12,000
Expenses:
Truck expenses (880 + 100) …………………………..
$ 980
Truck and equipment rental ………………………….
1,800
Supplies ………………………………………………………
90
Helpers ………………………………………………………..
4,700
Payroll taxes ………………………………………………..
500
Insurance …………………………………………………….
175
Telephone ……………………………………………………
100
Total expenses …………………………………………….
8,345
Net income ………………………………………………………..
$ 3,655
Chapter 01 – Introducing Financial Accounting
1-15
Solution: Chapter 1 – Alternate Demonstration Problem #1, continued
3.
ULTIMATE LAWN CARE, INC.
Balance Sheet
August 31, 2013
Assets
Liabilities
Cash …………………………….
$3,155
Accounts payable ………..
$ 100
Accounts receivable …….
600
Equity
Common stock …………….
2,000
Retained earnings
(3,655 – 2,000) …………..
1,655
Total assets ………………….
$3,755
Total liabilities and
owner’s equity ………….
$3,755
The cash balance can be determined as follows:
Cash inflows …………………………………………………..
(a) Issuance of common stock for cash …………
$ 2,000
(b) Fees received ………………………………………….
11,400
Total inflows ……………………………………………
$13,400
Cash outflows …………………………………………………
(c) Truck and equipment rental ……………………..
$ 1,800
(d) Truck expenses ……………………………………….
880
(e) Buy supplies ……………………………………………
90
(f) Pay salaries …………………………………………….
4,700
(g) Pay taxes ………………………………………………..
500
(h) Buy insurance …………………………………………
175
(i) Pay phone bill ………………………………………….
100
(j) Dividend to owner ……………………………………
2,000
Total outflows ………………………………………….
10,245
Ending cash balance ……………………………………….
$ 3,155
4.
First, note that the issuance of common stock for cash (transaction a)
and the cash dividend (transaction j) affect the cash balance, but do not
enter into the determination of net income. In addition, an expense
(transaction i) is reflected in net income, but has not yet been paid and,
as such, did not impact the cash balance. Finally, a revenue (transaction
k) is reflected in net income, but has not yet been received, and, as such,
did not impact the cash balance.