Instructor Notes to Accompany
Intermediate Financial Accounting
ACG 3101
Fall 1997
Marilyn T. Zarzeski, Ph.D., CPA
(Cocoa) Room 347 / 632-0098 x65578
(Orlando) BA 466 / 823-2150
Review of Accounting Basics (Chapters 3, 4, & 5)
USING THE VARIOUS TYPES OF ACCOUNTS
To Increase
Assets,DEBIT
Liabilities,CREDITBalance Sheet Accounts
Owners' Equity,CREDIT
Revenue/Income,CREDIT
Expenses,DEBITIncome Statement Accounts
Dividends,DEBITStatement of Retained Earnings Account
To Decrease any of the above, do the opposite.
Try to become friends with ALICE; she will help you to recall the normal balance of the six types of accounts. Question: What is the sixth type of account that is not shown below?
D Assets
LiabilitiesC
Income/RevenueC
Capital/Stk. EquityC
D Expenses
To Do: Draw a large stomach on ALICE so that you now see a large “D” on the above diagram.
HOW TO DO DEBITS AND CREDITS
Step 1:Remember that there is only one meaning of a DEBIT and one meaning of a CREDIT: (In accounting, that is!)
a)DEBIT means LEFT SIDE
b)CREDIT means RIGHT SIDE
c)And.....DEBITS must equal CREDITS in an entry
Step 2:Read the transaction given in words and numbers.
What accounts (Accts) are involved?
* Example:Buy equipment for $10,000 and sign a promissory note for $7,000.
Accts:EQUIPMENT, NOTE PAYABLE, CASH
($10,000) ($7,000)($3,000)
Step 3:What TYPE of Account is each?
* EQUIPAsset
NPLiability
CASHAsset
Step 4:What is the NORMAL BALANCE of above account TYPES?
* EQUIPAssetDEBITThink of:A
NPLiabilityCREDITL
CASHAssetDEBITI
C
E
Step 5:Are we INCREASING or DECREASING each account?
* EQUIP+(increase)DEBIT
NP+(increase)CREDIT
CASH-(decrease)CREDIT
Step 6:To INCREASEany account, do its NORMAL BALANCE Equip 10,000
To DECREASEany account, do opposite of NORMAL BALANCE NP 7,000 Cash 3,000
Understanding the Effect of Accounting Entries
When the accountant records payment of the telephone bill that just arrived today, what effect is there on the following items? (Note: be sure that someone has not already accrued the expense and liability.)
Your Thought Process
1.What is the entry?Telephone Expense
Cash
• Revenue or Gain
• Expense or Loss 2.What kind of account is each Telephone Expense is an
• Dividend part of the entry?EXPENSE
• AssetCash is an ASSET current
• Liability
• Stk. Eqty.
3.Answer the above questions. Always start with NI first . . . since NI affects Stk. Eqty.
HINT:Make up some numbers, if it helps you to understand the situation better.
a)Net Income?Decreases because expenses are higher
NI is lower now.
b)Assets?Decreases because cash is being given away
c)Liabilities?No Effect (neither account is a Liability)
d)Stockholders’ Equity?Decreases because NI decreases
e)Current Ratio? CA =Decr.=Decrease
(CA ) CL NE
( CL ) No Effect
ADJUSTING JOURNAL ENTRIES (AJE'S)
WHY?Because GAAP requires ACCRUAL BASIS of accounting. In order to show proper revenue earned during a period and proper expenses which helped to earn the revenue.
a)Revenue Principle - Normally recognize revenue when the service is rendered or when the title to the product is transferred from seller to buyer.
b)Matching Principle - Within the same time period, recognize the expenses that helped the company to earn the revenues.
WHAT?AJE's are journal entries usually prepared at the end of the each month, prior to preparation of the monthly financial statements. True AJE's contain either an expense or a revenue. NOTE: In the text and on exams, annual AJE's are often required, so read carefully.
TYPES?
I.Accruals (Revenue has been earned or Benefit has been received BUT NO CASH has yet been exchanged.)
Examples:
AJE'sA) Salary ExpenseB) Interest Receivable
Salary PayableInterest Revenue
SubsequentA) Salary PayableB) Cash
entriesCashInterest Receivable
when CASH
is exchanged
II.Deferrals (Cash has been exchanged prior to the AJE BUT the revenue or expense has NOT been journalized until the AJE is written).
Examples:
CashA) Prepaid InsuranceB) Cash
exchangedCashUnearned Revenue
PRIOR to
getting use
or giving a service
AJE'sA) Insurance Expense (Benefit)B)Unearned Revenue
Prepaid InsuranceRevenue
(Service Rendered)
NOTE to Students:The accountant may not record the original entry into prepaid (asset) or unearned (liab.). The accountant may just expense it all or revenue it all at the receipt of CASH.
CASHY) Insurance ExpenseZ) Cash
exchangedCashRevenue
PRIOR to
getting use or
giving a service
AJEY) Prepaid Insurance (not used)Z) Revenue
Insurance ExpenseUnearned Revenue
(service owed)
III.Allocations of Cost (As a long-lived asset is used, some expense must be recognized.)
Examples:
Purchase A) EquipmentB) Franchise
of AssetCashNote Payable
AJE'sA) Depreciation ExpenseB) Amortization Expense
Accumulated depreciationFranchise or Accum. Amort. (contra asset)
STEPS IN THE CLOSING PROCESS
WHAT?A closing entry is an entry that makes an account balance ZERO.
1.Close all revenue-type accounts into the income summary account.
2.Close all expense-type accounts into the income summary account.
3.Close the income summary account into the retained earnings account.
4.Close dividends account into the retained earnings account.
WHY?To start a new operating period with a clean slate, it is necessary to start with zero balances in the revenue and expense and dividends accounts.
Note:•Closing entries are usually prepared annually.
•Only the temporary (nominal) accounts are closed.
•The post-closing trial balance should contain only assets, liabilities, and equity accounts (the permanent accounts).
Note: Many companies do not use the Income Summary Account;
they merely close all temporary accounts directly to the Retained
Earnings account (if a Corporation) or the Capital account(s) (if a Sole Proprietorship or Partnership).
PROBLEM 3 - 7
Beg. = Unadjusted Balance
CASH Unexpired Insurance _____Utilities Exp.___
Beg. 15,000 Beg. 9,000 Beg. 54,000
Dues Receivable Salaries Payable ___Bad Debt Expenses
Beg. 13,000
Rent Receivable Unearned Rev. Salaries Exp. Beg. 80,000
Allowance for
Doubtful Accounts Common Stock Maintenance Exp. 1,100 Beg . 400,000 Beg. Beg. 24,000
Land R.E. Depr. Exp. - Bldg.
Beg. 350,000 72,400 Beg.
Buildings Revenues - Dues Depr. Exp. - Equip
Beg. 120,000 200,000 Beg.
Accum. Depr.-Bldg Revenues - Green Fees Insurance Exp. 48,000 Beg. 8,100 Beg.
Equipment Accum. Depr.-Equip Rental Revenue Beg. 150,000 70,000 Beg 15,400Beg
ERROR CORRECTIONS
Situation: We purchase machinery for $10,000 on March 1, 1995. We anticipate using the machinery for three years and then hope to sell it for $1,000.
I.If Error is discovered prior to closing the books:
(This is NOT a Prior-Period Adjustment.)
Error Done
Ask yourself: "What is Wrong?"
3/17/95Machinery Expense 10,000Incorrect
Cash 10,000OK
Should BeAsk yourself: "What should have
been the entry?"
Machinery 10,000
Cash 10,000
CORRECTION OF ERRORCorrect only the mistake
9/28/95 Machinery 10,000to debit correct account
Machinery expense 10,000to reverse error to zero
(Assumed that depreciation entry is done at year-end.)
II.If Error is discovered after the 1995 books are closed: Two different situations may occur - Situation A or B on next page.
Error Done
3/1 Machinery expense 10,000Incorrect
Cash 10,000OK
Should Have Been
Machinery 10,000The difference from above
Cash 10,000
Note:Ask yourself: 1) "Have any adjusting entries been done?" 2) "Did the error affect the income statement?"
For the above example:
1)No adjusting entries were done, but they would have been if MACHINERY had been debited.
2)Yes, there is too much money in the expenses; therefore, NI is understated until we correct the error.
II.(continued)
3)If done correctly, the following would have occurred:
3/1Machinery 10,000Assume: 3-yr. life10,000
Cash 10,0001,000 salvage -1,000
9,000
9,000 x 1/3 = 3,000/yr.
1995
12/31 Dep. Exp. 2,500
Accum. Dep. 2,5003,000 x 10/12 = 2,500 (10 months' usage)
Machinery Exp Cash
Error10,000 10,000 OK
SITUATION A:
Correcting Entries (after the 1995 closing process occurred, BUT before the financial statements are released.) (This is NOT a prior-period adjustment.)
Correcting (for 1995):
in Machinery 10,000These entries should be back-
earlyRetained Earnings 10,000dated to 12/31/95.
1996
Dep. Exp.2,500This situation is NOT a Prior- Accum. Dep. 2,500 Period Adjustment
Closing (for 1995):
RE2,500_
Dep. Exp.2,500
SITUATION B:
Correcting entries (after the 1995 financial statements are released; in other words, during the next year). THIS IS A PRIOR-PERIOD ADJUSTMENT (PPA) that is placed on the statement of Retained Earnings in 1996.
in
midMachinery 10,000NOTE: Do not debit an expense this (1996)year if
1996Retained Earnings-PPA 10,000 the dep. expense relates to last year!
Date the entries with July, 1996 date.
Retained Earnings-PPA 2,500 The NI was understated due to overstated
Accum. Dep. (1995)2,500 EXPENSES.
RE is understated because Mach. Exp. was closed into RE.
1996Dep. Exp.1,500(Assuming you discover the error at the beginning of July 1996.)
Accum. Dep.1,500
(First half year of usage)
Chapter 3 -- Appendix
IA. To find ONLY cash revenue or ONLY cash expense
Accrual to Cash
Revenue Expense
If A , then - If A , then +
If A , then + If A , then -
If L , then + If L , then -
If L , then - If L , then +
EXAMPLE:
Given: Accrual Revenue is $1,400,000 for 1996
Required: What is the Cash Revenue for 1996?
a) What ASSET and/or LIABILITY accounts relate to revenue?
Accounts Receivable
b) What is the NET change in the Accounts Receivable account--from the beginning of the year to the end of the year?
Accounts Receivable (AR)
Beg. 410,000
______
End. 520,000
The NET change is an increase of $110,000.
c) Reasoning: Since AR is an asset and it increased, then subtract $110,000 from the accrual revenue of $1,400,000. Therefore, the CASH revenue is $1,290,000.
BEWARE:
Name of accounts can be misleading.
Asset accounts: Liability accounts:
a)Receivables a) Payables
b)Prepaids b) Unearned Revenues
c)Deferred Expenses c) Accrued Expenses
IB. To find ONLY accrual revenue or ONLY accrual expense
Cash to Accrual
RevenueExpense
If A , then +If A , then -
If A , then -If A , then +
If L , then -If L , then +
If L , then +If L , then -
EXAMPLE: (Ex 3-23 -- Cash expenses only)
Given: Cash expenses are $55,470 for 1995.
Required: What are the Accrual expenses for 1995?
a) What ASSET and/or LIABILITY accounts relate to the expenses?
Accrued Expenses (miscellaneous payables)
Prepaid Expenses (miscellaneous assets that are paid in advance of usage)
b) What is the NET change in each of the accounts?
Accrued Expenses DECREASED by $1,327 from beginning to end of year.
Prepaid Expenses DECREASED by $142 from beginning to end of year.
c) Reasoning:
Since Accrued Expenses is a liability and it decreased, then subtract $1,327 from Cash expenses.
Since Prepaid Expenses is an asset and it decreased, then add $142 to Cash expenses.
Therefore, $55,470 (cash expenses)
- 1,327 (net change in Accrued Liabilities)
+ 142 (net change in Prepaid Expenses)
= $ 54,285 (EXPENSES based upon ACCRUAL ACCOUNTING
IIA. To find cash NET INCOME
Accrual to Cash
Revenues and Expenses
If A , then -
If A , then +
If L , then +
If L , then -
EXAMPLE: Statement of Cash Flows (Indirect Method)
The CASH FLOWS FROM OPERATING ACTIVITIES must be prepared from the Accrual Income Statement. In other words, the accountant converts the Accrual Net Income to Cash Net Income (also known as Cash Flows from Operating Activities).
a) Start with Net Income per accrual accounting.
b) Determine whether related current assets and current liabilities have increased or decreased from the beginning to the end of the year (accounting period). Calculate the NET CHANGE for each related account.
c) Use chart above to determine whether to add or subtract the NET CHANGE to the Net Income per accrual accounting.
d) The ACCRUAL Net Income plus or minus the NET CHANGES equals the CASH Net Income (Cash flows from operating activities).
IIB. To find accrual NET INCOME
Do the opposite of IIA Chart.
Start with CASH Net Income and adjust to ACCRUAL Net Income.
From CASH BASIS to ACCRUAL BASIS
Example:
(Cash to Accrual Basis) Joan E. Robinson, M.D., maintains the accounting records of Robinson Clinic on a cash basis. During 1997, Dr. Robinson collected $142,600 from her patients and paid $55,470 in expenses. At January 1, 1997, and December 31, 1997, she had fees receivable, unearned fees, accrued expenses, and prepaid expenses as follows (all long-lived assets are rented):
January 1, 1997December 31, 1997
Fees receivable$9,250$16,100
Unearned fees 2,840 1,620
Accrued expenses 3,435 2,200
Prepaid expenses 2,000 1,775
Instructions
Prepare a schedule that converts Dr. Robinson "excess of cash collected over cash disbursed" for the year 1997 to net income on an accrual basis for the year 1997.
Solution to Example:
Dr. Robinson does CASH AccountingCash Rev$142,600
Cash Exp 55,470
Cash NI 87,130
IF she did ACCRUAL BASIS, her GL Accounts would be as follows:
Cash Rev Fees Rec. Unearned Fee Rev.
B 92502840 B
1 142,6002 x142,60013
4
E 161001620 E
Rev.
149,450 29250 + X - 142,600
= 16,100
3X = 16,100 + 142,600 - 9,520
X = 149,450- 9250
4
$150,670
Per Solutions Manual:
Cash Rev. AddSubtractAccrual Rev.
149,450 =142,60016,100 9250 150,670
2,840 1620
the net change affects Revenue
in the Accrual-Basis
INCOME STATEMENT ITEMS
Exercise 4 - 13
Thought Process: Income before tax IBT
- Income Tax Expense IBT x Tax Rate
= Net Income IBT x (1.00 - Tax Rate)
(3) 100% Inc. before tax(4) IBT x 100% = 50 mil(5) IBT 50,000,000
(2) 30% Inc. Tax Exp. IBT x 30% =_15 mil_
(1) 70% NI IBT x 70% = 35 mil
START HERELoss of 18,000,000
(before tax) is included in the IBT
(50 mil + 18 mil)
(6) IBT before E/O Item = $68 mil.
Partial Income Statement
(7) Inc. from cont. opns$68,000,000
(8) Inc. tax expense 20,400,000 (68 mil. x 30%)
(9) Inc. before E/O Loss 47,600,000
(10) E/O Loss
(net $5.4 mil. tax benefit) 12,600,000(18 mil. x 30% = $5.4 mil.)
(11) NI$35,000,000
(12) Preferred Dividends:Per Share Data:
$ 12,600,000 (14)Inc.Bef. E/O $4.72
$4,500,000 x 8% 10,000,000 sh.
= $360,000 div.(13)E/O Loss (1.26)
NI $3.46
EPS = NI - Pref. Div =$35 mil. - $360,000=$3.46
# COMMON Shares 10 mil. sh.
Outstanding
Company Name
Statement of Cash Flows
FYE 12/31/97
INDIRECT METHOD
Note:Do Not use +'s and -'s on the formal statement.
Use parentheses for CASH outflows.
Not the deprec exp.
Not the int. income and Not the dividend income
Obtain from Balance Sheet / Cash Flows from Operating Activities:
Net Income
± _'s in CA and CL, excluding S.T. Rec. and S.T. NP
+ Deprec. Exp., Amortiz. Exp., Depletion Exp.
+ Losses
- Gains
± Other non-cash flows related to operations
Net Cash Flows from Operating Activities$ A
Cash Flows from Investing Activities:
± Property, Plant, and Equip.
± Other Operating Assets, e.g., Intangibles
± Investments in Stocks, Bonds, Mutual Funds, etc.
Short-term AND
Long-term
± Notes Receivable, Loans Receivable, etc.
Net Cash Flows from Investing Activities$ B
Cash Flows from Financing Activities:
± Common Stock, Preferred Stock
(including Paid in Capital Accts.)
± Treasury Stock
Short term
± Bonds Payable, Notes Payable and
Long term
- Dividends, Drawings
Net Cash Flows from Financing Activities$ C
Net Increase (or Decrease) in Cash$ (A+B+C)
Cash Balance, Jan. 1$
Cash Balance, Dec. 31$ Place this on
the Balance Sheet
Statement of Cash Flows
DIRECT METHOD
Problem 24-6
(Revenue)(Expense)
Cash InCash Out
CA , -CA , +
CA , +CA , -
CL , +CL , -
CL , -CL , +
OPERATING ACTIVITIES:
ACCRUALCASH
Related
Inc. StmtCA / CLAm't (000)SCF
Sales1,007,500AR34 -34973,500
CGS 403,000Inven60 +
+35
AP25438,000
S & A Exp.222,000Dep. Exp.- 40-25
GW Exp.- 2
Prepaids 6 -6
Supplies 3 -3
Accrued Liab. 9.62 -9.62 136,380
*L.T. Invest. RevSee T-Account*
115,000(Not on exam)L.T. Invest 75-75 40,000
55,000
S.T. Invest Rev. 15,000No Related Acct. 15,000
Intrest Exp. 99,000Bond Discount 13.88 -13.8885,120
"Contra-liability"
Inc. Tax Exp. 154,000Tax Pay 11 -11143,000
Note 1:Gain on Sale of Equipment is NOT a cash flow; therefore, ignore it in the DIRECT METHOD.
Note 2:Dividends that our company gives are NOT an Operating activity.
Note 3:The "Cash IN" scheme is also used to prepare the Cash Flow from Operating Activities for the INDIRECT METHOD.
SCF - DIRECT METHOD (PROBLEM 24-6)
INVESTING ACTIVITIES:
Land Bldg Equip L.T. Investments *
500,0001,300,000550,000700,000
50,000 115,000
40,000
cash div
645,0001,300,000 500,000 775,000
S.T. Investment Accum. Dep.- Bldg Accum. Dep.- Equip
325,000360,000135,000
5,000 25,000
40,000
350,000 155,000
400,000
_____Goodwill______Dividends Payable__
65,000 80,000
63,000_0_
FINANCING ACTIVITIES:
LTNP BP P. Stk C Stk T Stk ____
50,000 1,000,000 500,000 600,000 40,000
45,000 1,000,000 600,000 600,00020,000
Discount on BP PIC - P. Stk PIC- C Stk RE
64,630 100,000 550,000 749,630 Dividends 274,500 NI
150,000
50,750 115,000 550,000 874,130
Time Value of Money
Chapter 6
INTEREST is the time value of money.
In accounting records, we do NOT record the interest earned or owed UNTIL TIME HAS PASSED from the time that we loaned the money or borrowed the money.
Examples:
a) Interest REVENUE cannot be recognized until the “lending service” that we have provided has occurred over at least one month’s time. At the end of each month, we can recognize some interest revenue.
b) Interest EXPENSE cannot be recognized until we receive some “benefit” from the cash that we borrowed...over at least one month’s time. At the end of each month, we can recognize some interest expense.
Interest CALCULATION: Interest = Principal x Rate x Time
To use the PRESENT VALUE TABLES, you must know two items:
1) time period (n): the number of time periods that the interest compounds (Beware: the n does not necessarily mean the number of years that the interest compounds).
2) interest rate (i): the interest involved within each time period of compounding
======
There are three kinds of PRESENT VALUE situations.
1. PRESENT VALUE OF $1: This is used when you know the LUMP SUM future amount and you are trying to determine the LUMP SUM present amount of money.
______
Present Value of Future Value of
Lump Sum Lump Sum
Formula: PV$ = future value x table factor = fv x tf
To obtain table factor:
1) determine the number of time periods of compounding of the interest
2) determine the interest rate earned for each period of compounding
Example of PV$: You want to know how much money you have to deposit in your local bank at the beginning of 1996 in order to have $10,000 in the account by the end of 1999. The bank gives 6% interest compounded annually.
Solution:
a) Draw a time line of the situation: ______
??? $10,000
1/1/96 12/31/99
b) Decide whether it is a PV$ situation: Yes, it is. The lump sum that we are trying to find
is at the beginning of the time period (in the present). Also, there is another lump sum nvolved at the end of the time period.
c) Determine n and i :
1) n = 4 because there are four years of compounding of annual interest
2) i = 6% because interest is compounded annually and 6% is the annual interest.
d)Find the table factor in the PV$ tables. Table 6-2 in the textbook. tf = .79209
e) Use the PV$ formula and calculate the answer:
PV$ = $10,000 x .79209 = $7,920.90
2. PRESENT VALUE OF ORDINARY ANNUITY: This is used when you have EQUAL amounts of money involved, over EQUAL intervals of time AND the amounts of money are at the END of the period AND you want to find the present value of those amounts.
______
Present Value Am’t Am’t Am’t Am’t