Accounting 2 plant assets (2)
Intro duc tion
I. T HE F INA NC IA L S T A T E ME NT A NA L Y S IS F R A ME W O R K
A . F inanc ial R eporting and F inanc ial S tateme nt A naly s is
A c c ounting, from the viewpoint of the C F A examination, is an input (a tool)
us ed in the inves tment proc es s , rather than an end in its elf. T he emphas is is
on the us e of financ ial s tate ments by an ana lys t who is making an inves tment
dec is ion, rather than on their preparation by an
ac c ountant. It is s till
nec es s ary, however, for ana lys ts to unders tand the proc edures tha t
ac c ountants us e and the latitude tha t the y are pe rmitted when c ons truc ting
financ ial s tatements , both domes tic ally a nd g loba lly, to judg e the us efulnes s of
the information c onta ined in them to the inves tment dec is ion-making proc es s .
T he financ ial analys t mus t go beyond the knowledg e of ac c ounting mec ha nic s
and learn how to us e the data provide d in financ ial s tatements , in c onjunc tion
with other information to make inves tment dec is ions .
II.MA J O R F INA NC IA L S T A T E ME NT S A ND O T HE R INF OR MA T IO N S O UR C E S
T he financ ial reports prepa red by bus ines s es for external us e us ually c ontain the
following key financ ial s tatements :
A . B ala nc e S heet
T he balanc e s heet (als o referred to as the s tatement of financ ial pos ition)
reports major c las s es and amounts of as s ets , liabilities , and equity c apital at a
s pec ific point in time (i.e., the balanc e s hee t date). A s s ets repres ent probable
future ec onomic benefits tha t are either purc has ed by the firm or gene rated
through its ope rations . L iabilities repres ent probable future s ac rific es of
ec onomic benefits and are the c reditors ' c laims on the as s ets of the entity.
E quity c apital (s hareholders ' equity for a c orporation) repres ents the owne rs '
c apital c ontributions and othe r internally generated s ourc es of c apital (e.g ., the
c umulative undis tributed earning s of the entity).
It is important to unders tand tha t the as s et and liability values reported on the
balanc e s hee t do not nec es s arily reflec t the fair market value of thes e items
for various reas ons that will be dis c us s ed throughout the text.
B ec aus e the as s ets and liabilities of a c ompa ny are mea s ured in a variety of
ways , mos t of whic h do not even purport to reflec t their true market value, the ways , mos t of whic h do not even purport to reflec t their true market value, the
the (market) value of a c ompa ny.
B . Inc o me S tatement
T he inc ome s tate ment, als o known as the s tatement of ope rations or the profit
and los s (P &L ) s tatement, reports on the performanc e of the firm (i.e., the
res ults of its ope rating ac tivities ) for a s pec ific period of time. T he inc ome
s tatement is prepared us ing ac c rua l methods and relies on the matc hing
princ iple. A s a res ult, it is interrelated with the balanc e s heet and explains
s ome, but not all, of the c hanges in the as s ets , liabilities , and equity c apital of
a firm between two c ons ec utive balanc e s hee t dates . T he two ba s ic elements
reported on the inc ome s tatement are revenues , whic h repres ent inflows of
res ourc es from the entity's "c ore" operations , and expens es , whic h repres ent
outflows of res ourc es from the s ame operations .
U.S . GAAP does not s pec ify the exac t format of the inc ome s tatement
although s pec ific dis c los ures are required. T he de finitions for s ome of the
terms found in the inc ome s tate ment a re:
R evenues (Net s ales ) are the proc eeds from the s ale of goods and
s ervic es produc ed regularly by the c ompa ny, les s returns and allowanc es .
O pe rating expens es inc lude the c os t of g oods s old, whic h is the amount
the firm pa id for the produc ts s old during the ac c ounting pe riod, and
s elling , general and adminis trative (S G &A ) expens es . D eprec iation and
amortization expe ns es are ofte n not broken out s eparately, but c an be
found on the s tatement of c as h flows or in the notes to the financ ial
s tatements .
O the r revenues (and expe ns es ) are nonoperating items s uc h as inc ome
from inves tments and inc ome from c redit exte nded to c us tomers (i.e .,
interes t inc ome) .
Unus ual and/or infreque nt items are nonoperating items that are
dis c us s ed in more de tail in the next s tudy s es s ion.
P reta x earning s from c ontinuing ope rations is s ometimes referred to as
ope rating inc ome. W he n inte res t e xpens e is added bac k, this is referred to
as ea rnings before inte res t a nd taxes (E B IT ).
Inc ome from c ontinuing ope rations is a key dividing point in the inc ome
s tatement with all items appe aring above referred to as "above the line"
items and all items appe aring below referred to as "below the line" items .
T he s pec ific ac c ounting and dis c los ure requirements for below the line
items a re c overed in the next s tudy s es s ion.
Net inc ome is the "bottom line" of the inc ome s tate ment. It is the amount
tha t is trans ferred to retained earnings from whic h dividends c an be paid.
Note
R eported inc ome does not us ually meas ure the s us ta ina ble inc ome from
whic h future inc ome c an be projec te d bec aus e:
* R evenue and c os t data are reported with a lag and are ba s ed upon
his toric al c os ts , rathe r than c urrent pric es and unit c os ts .
* S ome c os t data , s uc h as es timated bad debts and deprec iation expens es ,
are rea lly alloc ations that may not bear any relations hip to the ac tua l way in
whic h c os ts are inc urred.
* S ome revenues and expe ns es are reported in periods that are different
from thos e in whic h c as h was ac tually rec eived or s pent.
* S ome revenues , expe ns es , and inc ome ( los s es ) are not expec ted to recur.
F or all of thes e reas ons , the financ ial da ta pres ented in an inc ome s tatement
are only an approximation of ec onomic reality. T hus , the financ ial data are
only partially us eful to an analys t who is attempting to dete rmine the long -term
ability of a c ompa ny to gene rate funds that are available to mee t its obligations
to c reditors and whic h c an be dis tributed to its owners .
C . S tatement of C as h F low s
T he s tate ment of c as h flows reports a firm's c as h rec eipts and c as h payments
for the
ac c ounting pe riod c las s ified as operating, inves ting, or financ ing
ac tivities . O perating ac tivities reflec t the day-to-day operations of a c ompany,
inves ting ac tivities inc lude the c ompa ny's purc has es and s ales of long-term
as s ets , and financ ing
ac tivities relate to the c ompa ny's debt and equity
trans ac tions . T he s tate ment of c as h flows provide s information that c an be
us ed to as s es s a c ompa ny's liquidity, s olvenc y and financ ial flexibility.
D . S tatement of (C hang es in) S toc k holders ' E q uity
T his s tatement reports the beginning-of-period and end-of-period balanc e
s hee t amounts and c hanges in equity c apital ac c ounts from trans ac tions with
the owners and as a res ult of c omprehe ns ive inc ome. T he individua l
c omponents of the s tatement inc lude:
1. P referred s hares (total amount c ontribute d)
2. C ommon s hares (at par)
3. A dditional paid-in c apital
4. R etained earnings (or de ficit)
5. E mployee s toc k owners hip plan (E S O P ) adjus tments
6. A c c umulated other c omprehens ive inc ome ("direc t-to-equity" adjus tments )
7. T reas ury s hares (reduc tion)
In prac tic e, many firms report the
c omponents of the s tatement of
s toc kholde rs ' equity on the fac e of the balanc e s heet, inc ome s tatement
(c hang e in reta ined earnings only), and in the notes to the financ ial
s tatements .
III. F INA NC IA L S T A T E ME NT F O O T NO T E S A ND O T HE R S O UR C E S O F INF O R MA T IO N F O R MA T IO N
F inanc ial s tate ments inc lude s upplementary information in addition to the financ ial
data. T his information is found in footnotes , s upplementary s c hedules ,
Manag ement's
D is c us s ion and
A na lys is (MD &A ) dis c los ures , and proxy
s tatements .
A . F ootnotes
T he footnotes (note s ) to the financ ial s tate ments are an integral part of the
s tatements thems elves and are required for a c omplete pres entation in
c onformity with Internationa l F inanc ial R eporting S tandards (IF R S ) and U.S .
g enerally ac c epted ac c ounting princ iples (U.S . G A A P ), T he footnotes provide
detailed dis c los ures , mos t of whic h are s pec ifically manda ted by IF R S , U.S .
GAAP, or other regulatory authorities s uc h as the U.S . S ec urities and
E xc ha nge C ommis s ion (S E C ). E xamples of the types of information dis c los ed
in the footnotes inc lude:
• A s ummary of the s ignificant ac c ounting polic ies inc luding the ac c ounting
methods , as s umptions , a nd e s timates us ed by mana gement to prepare the
financ ial s ta tements
• D is c los ures for mos t as s et c ateg ories inc luding marketable s ec urities ,
rec eivables , inventories , fixed as s ets , intangibles , and long -term
inves tments
• D is c los ures for debt ins truments , leas es , and off-balanc e s he et financ ing
• Inc ome taxes
• Hedg ing and other ris k mana gement ac tivities
• B us ines s s egment da ta
• P ens ion and othe r pos tretirement be nefit plan dis c los ures
• P ending or threate ned litigation and othe r c ontingenc ies
F ootnote dis c los ures are pa rtic ularly important when the analys t is c ompa ring
the financ ial s tate ments of different c ompanies . B oth IF R S and U.S . G A A P
allow the us e of alternate
ac c ounting methods to reflec t the
ec onomic
differenc es between c ompa nies . F or example, IF R S and U.S . G A A P allow
c ompa nies to c hoos e between s everal inventory c os ting methods whe n
ac c ounting for inventory. If two c ompa nies us e different inventory methods , it
is diffic ult to c ompare the c ompa nies ' financ ial performanc e without making
adjus tments for the differenc es . T he financ ial s tate ment footnotes provide the
information nec es s ary to make s uc h adjus tments .
A dditionally, footnote
dis c los ures make it pos s ible to identify and adjus t for differenc es between
IF R S and U.S . G A A P whe n c ompa ring U.S . c ompanies to their inte rnationa l
c ounterparts .
B . S upplementary S c hedules
S upplementary s c hedules , s ome of whic h are required by the S E C or other
regulatory agenc ies , provide an additiona l s ourc e of us eful information. T hes e
s c hedules may inc lude s uc h information as the five-year performanc e rec ord
of a c ompa ny, a breakdown of unit s ales by produc t line, quarterly s ales and
inc ome, a lis ting of oil and gas res erves , and s o forth. T hes e s c hedules are
typic ally unaudited.
C . Manag ement D is c us s io n and A naly s is (MD &A )
P ublic ly traded c ompa nies are ofte n required to provide, as part of their annual
reports to s hareholders , a dis c us s ion and analys is of the ir operations and
pros pe c ts tha t is "both us eful and unde rs ta ndable." T he s pec ific topic s to be
addres s ed in the MD &A inc lude:
• A review of the c ompany's c ons olidated operating performanc e and its
financ ial c ondition.
• A n as s es s ment of the s ignific ant effec ts of known trends , events , and
unc ertainties on the c ompa ny's liquidity, c apital res ourc es , and operating
res ults .
• T he c apital res ources available to the firm and its liquidity.
• E xtraordina ry or unus ual events (inc luding dis c ontinue d operations ) that
have a material effec t on the c ompa ny.
• A review of the performanc e of ope rating s eg ments that have a s ignificant
impac t on the bus ines s or its fina nc es .
D . P rox y S tatements
P roxy s ta tements are is s ue d by public ly held c ompanies in c onne c tion with
s hareholder meetings and c ontain us eful information about board membe rs
and mana gement, exec utive
c ompens ation, s toc k options , and major
s hareholders .
E . Interim R eports
P ublic
c ompanies are generally required to provide inte rim financ ial
information, either quarterly or s emiannually. Interim financ ial reports , whic h
inc lude the key financ ial s tatements and footnotes , are not audited. T hey
provide upda tes to a c ompa ny's audited annual financ ial information s o that
inves tors , ana lys ts , and othe r interes ted parties c an as s es s a c ompany's
inc remental financ ial performanc e.
F. O ther S ourc e s of Information
W hen performing fina nc ial s tate ment analys is , othe r s ourc es of information
inc lude c orporate pres s releas es , information on c orporate webs ites , and
exte rnal indus try, pe er, and gene ral ec onomic information.
G . R ole of the A uditor and the A uditor's R eports
1. F inanc ia l S tateme nt A udit
Manag ement is primarily res pons ible for the prepa ration of the financ ial
s tatements of an ente rpris e. T his res pons ibility inc ludes c hoos ing whic h of
the alternatively ac c eptable ac c ounting princ iples are us ed in c ons truc ting
the m. T o as s ure the us ers of fina nc ial s tatements that the information
c ontained in the financ ial s tatements is ac c urate and reliable, regulatory
agenc ies require tha t publicly
he ld firms inc lude audited financ ial
s tatements in the ir annual reports to s ha reholders and in c ertain other
filings . A udits c an als o be required by law or by contrac tua l agreement.
A udits mus t be done in ac c ordanc e with applicable auditing s tandards . In
the United S tates , auditing s tandards for public c ompanies are is s ued by
the P ublic C ompany A c c ounting O vers ight B oa rd (P C A OB ) . Inte rnationa l
auditing s tandards , whic h ha ve bee n adopted in many c ountries , have
bee n is s ued by the Internationa l A uditing and A s s uranc e S tandards B oa rd
of the International F ederation of A c c ountants . O ther c ountries have the ir
own auditing s tandards .
A lthough they a re paid by mana gement, the inde pendent auditor (gene rally
a firm) is c hos en by a vote of s ha reholders or by the audit c ommitte e, a a firm) is c hos en by a vote of s ha reholders or by the audit c ommitte e, a
mana gement's financ ial s tate ments and renders an opinion as to whether
the y are in c onformity with applicable ac c ounting s tandards (U.S . G A A P ,
IF R S , or equivalent) .
B oth U.S . and international auditing s tandards require a three paragraph
s tandard ( unqua lified) inde pendent auditor's report, inc luding the following :
• Introduc tory P arag raph - S tates the
financ ial s tatements audited,
mana gement's res pons ibility for (preparing) the financ ial s tate ments ,
and the auditor's res pons ibility for expres s ing an opinion thereon.
• S c ope P arag raph - S tates the auditing s tandards us ed in c onduc ting the
audit, the nature of the audit proc es s , and that the auditor has a
reas onable ba s is for the audit opinion given.
• Opinion P arag raph - S tates the auditor's opinion that the financ ial
s tatements give a "true and fair view" (international) or are "fairly
pres ented" (U.S . and international) in
ac c ordanc e with applicable
ac c ounting s tandards .
An unqualified or "c lean" audit opinion provides reas ona ble, but not
abs olute , as s uranc e that the audited financ ial s tatements are free of
mate rial mis s ta tement res ulting from errors , fraud, or illeg al ac ts tha t have
a direc t and material effec t on the fina nc ial s tatements . O the r audit
opinions are a ls o pos s ible:
• Qualified ( E x c ept F or) O pinion - Is s ued when there is a material ins tanc e of
nonc omplianc e with applic able
ac c ounting s ta ndards or there is a
limitation on the auditor's ability to c omplete the audit as required by
auditing s tandards . A qualified opinion will inc lude an explanatory
paragraph des c ribing the problem that prevents the auditor from is s uing
an unqualified opinion.
• A dv ers e O pinion - Is s ued when there are ins tanc es of nonc omplianc e with
applicable ac c ounting s tandards that are s o material that the financ ial
s tatement are not fairly pres ented.
• D is c laimer of Opinion - Is s ued when the auditor doe s not ha ve the ability to
is s ue an opinion for s ome reas on.
2. R eporting on Internal C ontro ls
In the United S tates , the S arbane s -O xley Act of 2002 inc reas ed
mana gement's res pons ibility for mainta ining effec tive inte rnal c ontrols and
expa nde d the auditor's required reporting on inte rnal c ontrols . S a rbanes -
O xley requires c ompa nies to:
• A c c ept res pons ibility for the effe c tivenes s of inte rnal c ontrols .
• E valuate the effec tivene s s of internal c ontrols by g athering s uffic ient,
c ompetent evidenc e.
• P repa re a report on internal c ontrols tha t:
o S ta tes mana g ement's res pons ibility for es tablis hing and mainta ining
internal c ontrols .
o O utline s mana g ement's framework for evaluating the effec tivene s s
of inte rnal c ontrols .
o S ta tes mana g ement's as s es s ment of the effec tivene s s of the
c ompany's internal c ontrol over fina nc ial reporting as of the end of
the mos t rec ent yea r.
o Inc lude s a s tatement that the c ompany's auditors have is s ued an
attes tation report on manag ement's as s es s ment.
F inanc ial R eporting Mec hanic s
I. A C C O UNT S A ND F INA NC IA L S T A T E ME NT S
F INA NC IA L S T A T E ME NT E L E ME NT S A ND T HE A C C O UNT ING E Q UA T IO N
F inanc ial s tate ments
c an be broken down into five bas ic elements : as s ets ,
liabilities , e quity, revenues , and expens es . T he ac counting equation de s c ribes the
relations hip be tween thes e elements . A dditiona lly, thes e elements c an be further
broken down into c ompa ny-s pec ific s ubc ategories
c alled
ac c ounts .
A lthough
c ompa nies us e different ac c ounts , it is important for the analys t to have a gene ral
unders tanding of the ac c ounts that are mos t c ommonly us ed. T he next s tudy
s es s ion outlines the mos t c ommon ac c ounts (line items ) s een in the financ ial
s tatements .
A . A c c ounting E quation
T he bas ic ba lanc e s he et equation reflec ts the fac t that the as s ets of a firm are
financ ed by eithe r the liabilities or equity c apital of the firm. T he bas ic equation
is :
A s s e ts = L iab ilities + E quity C apital
B y s ta ting the equa tion as follows , the definition of equity c apital as the
owne rs ' res idual c laim on the net as s ets afte r all c reditors ' c laims ha ve bee n
s atis fied, is c learly demons trated:
A s s ets – L iabilities = E quity C apital (Net A s s ets )
E quity c apital c an be c las s ified by origin: c apital c ontributions from owners and
earnings retained in the bus ines s . E quity c apital can therefore be written as :
E quity C apital (Net A s s e ts ) = C ontributed C ap ital + R etained E a rning s *
* A s dis c us s ed in the next s tudy s es s ion, a firm's internally-g enerated c apital inc ludes
retained earning s , whic h reflec ts the ac c umulated undis tributed profits that have
flowed throug h the inc ome s tatement, and ac c umulated other c omprehens ive
inc ome, whic h inc ludes other "direc t-to-equity" adjus tments .
A s a res ult, the ba s ic a c c ounting equation c an be rewritte n as :
A s s ets = L iabilities + C ontributed C apital + R eta ined E arnings
T he balanc e s heet reflec ts a c ompany's financ ial pos ition at a point in time,
while the inc ome s tatement reports a c ompany's financ ial ac tivity over a period
of time. T he s e two financ ial s tatements are linked by the reta ined earnings
c omponent of equity c apital. R etained earning s c an be broken down into an
underlying e quation:
R etained E arnings E nding = R etained E arnings B eginning + Net Inc ome – D ividends
T he bas ic inc ome s tatement equa tion s tates :
Net Inc o me = R ev enues – E x pens es
B y s ubs tituting this equation into the ending retained ea rning s formula above,
an expa nded reta ined earning s formula tha t c learly inte g rates the inc ome
s tatement c an be de velope d:
R etained R etained
+ R evenues – E xpens es – D ivide nds
E arnings E nding
E arnings
B eginning
T his formulation of reta ined earnings
c an then be inc lude d in the bas ic
ac c ounting equa tion, res ulting in an expanded equation that is a c ombined
repres enta tion of the balanc e s he et and the inc ome s ta tement:
C ontribute d R etained
A s s ets = L iabilities +
+ R evenues – E xpens es – D ivide nds
C apital
E arnings B eginning
II. T HE A C C O UNT ING P R O C E S S
A . R ec o rding B us ines s T rans ac tions
T he ac c ounting proc es s be gins with a bus ines s trans ac tion. E ac h bus ine s s
trans ac tion mus t be rec orded in the ac c ounting s ys tem and ultimately reported
in the financ ial s tatements . T he ac c ounting equa tion illus trate d above is the
bas is for ente ring trans ac tions into an
ac c ounting s ys tem. To kee p the
ac c ounting equa tion in balanc e, ea c h trans ac tion mus t affec t at leas t two
financ ial s tatement ac c ounts whe n it is rec orded. T his is des c ribe d as double-
entry a c c ounting.
T o rec ord a trans ac tion, the following s te ps mus t be us ed:
• Ide ntify the amount of the trans ac tion and whic h two (or more)
financ ial s ta tement ac c ounts a re inc reas ed or de c reas ed.
• D etermine how the trans ac tion affec ts the ac c ounting equa tion by
identifying the financ ial s ta tement elements related to eac h ac c ount.
• E nter the trans ac tion into the ac c ounting s ys tem.
• V erify tha t the a c c ounting equation is in ba lanc e.
F inanc ial s tate ments
c an then be develope d at any time bas ed on the
information ente red into the ac c ounting s ys tem.
1. Illus tration - R ec ording a B us ines s T rans a c tion
T o illus trate thes e s teps , as s ume tha t a s mall pe s t c ontrol bus ines s , B ug
B us ters , is es ta blis hed on D ec ember 31, 20X 7 by two individuals who
c apitaliz e the c ompa ny by c ontributing $25,000 eac h. T his trans ac tion
res ults in an inc reas e in c as h (as s et) of $50,000 and an inc rea s e in
c ontributed c apital (equity) of $50,000.
T he c ompa ny will us e the following
ac c ounts to rec ord its bus ines s
trans ac tions :
• A s s ets -
C as h, R ent
D epos it, Inventory,
A c c ounts R ec eivable,
E quipment and A c c umulated D eprec iation (a c ontra-as s et ac c ount)
• L iabilities - Unea rned S ervic e R evenue, A c c ounts P ayable, A c c rued
P ayroll, Interes t P ayable, Notes P ayable
• E quity - C ontributed C apital, R eta ined E arnings
• R ev enue - S ervice R evenue
• E x pens e -
C os t of S ervic es P rovided, R ent
E xpens e,
A dvertis ing
E xpe ns e, P ayroll E xpens e, Interes t E xpens e, D eprec iation E xpens e
D uring J anuary 20X 8, B ug B us te rs ha s the following bus ines s trans ac tions .
F or eac h trans ac tion, the ac c ounts inc reas ed or dec rea s ed are identified
(s tep 1). T he financ ial s tatement element (as s et, liability, equity, revenue,
expe ns e) that c orres ponds to eac h ac c ount is als o identified ( s tep 2).
a. J anuary 2 - P aid $2,000 for offic e s pa c e. T he $2,000 inc ludes a $500
refundable de pos it a nd $1,500 for J anuary rent. T his trans ac tion res ults
in a dec reas e in c as h (as s et) of $2,000, an inc reas e in rent expens e
(expens e) of $1, 500 and an inc reas e in rent depos it (as s et) of $500.
b. J anuary 3 -
B orrowed $15,000 from a loc al bank. P rinc ipal and interes t at
8% are due on J anuary 1, 20X 9. T his trans ac tion res ults in an inc reas e
in c as h (as s et) of $15,000 and an inc rea s e in notes pa yable (liability) of
c. J anuary
5 - P urc has ed offic e equipment for $2,000, pes t c ontrol
equipment for $14,000, and a truc k for $20, 000. T he equipment and equipment for $14,000, and a truc k for $20, 000. T he equipment and
trans ac tion res ults in a dec reas e in c as h (as s et) of $36,000 and an
inc reas e in e quipment (as s et) of $36,000.
d. J anuary
8 - P aid $1,000 to advertis e the bus ine s s in s everal loc al
news pape rs during J anuary. T his trans ac tion res ults in a de c reas e in
c as h (as s et) of $1, 000 and an inc reas e in advertis ing expens e
(expens e) of $1, 000.
e. J anuary 10 - P urc has e pes t c ontrol c hemic als for $12,000 on a c c ount. T he
c hemic als will be us ed evenly over 20X 8. T his trans ac tion res ults in an
inc reas e in inventory (as s et) of $12,000 and an inc reas e in ac c ounts
payable (liability) of $12,000.
f. J anuary 15 - R ec eived $30, 000 c as h from fifty ne w res ide ntial c us tomers
as pa yment for 12 months of pes t c ontrol s ervic e. T his trans ac tion
res ults in an inc reas e in c as h (as s et) of $30,000 and an inc rea s e in
une arned s ervice revenue (liability) of $30,000. T his trans ac tion res ults
in unearned revenue rather than ac tua l revenue bec aus e the c ompa ny
has not yet earned the revenue by performing pe s t c ontrol s ervic es .
g. J anuary
20-31 - P rovide d pes t c ontrol s ervices to te n loc al bus ines s
c us tomers . E ac h c us tomer will be billed $250 per month when s ervic es
are pe rformed. T his trans ac tion res ults in an inc reas e in ac c ounts
rec eivable (as s et) of $2, 500 and an inc reas e in s ervice revenue
(revenue) of $2,500.
T he proc es s of entering the s e trans ac tions into the ac c ounting s ys tem
(s tep 3) is illus trated in the following s preads heet:
ASSETS = L iabilities
E quity C apital
B eg . 1/1/x8
$ -- $ -- $ -- balanc e
1/2/x8 P ay rent ( 2,000)
depos it
Note
1/3/x8 B orrow 15,000
payable
B uy fixed 1/5/x8
E quip.
as s ets
1/10/x8 A dvertis e (1,000) ( 1,000)
B uy
A c c ounts
Unea rned
s ales
revenue s
S ale on
A c c ounts
1/30/x8
2,500 ac count
F rom this s preads hee t, we c an verify that the ac c ounting equation (A s s ets
= L iabilities +
C ontributed
C apital +
B e ginning R eta ined
E arning s +
R evenues - E xpens es - D ividends ) is in ba lanc e (s tep 4):
T ota l A s s ets = $56,000 c as h + $51,000 other as s ets = $107,000
and
T ota l L iabilities + E quity = $57,000 liabilities + $50,000 c ontributed
c apital + $0 beginning reta ined earnings + $2,500 revenue – $2, 500
expe ns e – $0 dividends = $107,000
B . F inanc ial S tatement A c c ruals and A djus tments
B oth IF R S and U.S . GAAP require public
c ompa nies to us e
ac c rual
ac c ounting , whic h requires that revenues be rec orded when earned and that
expe ns es be rec orded when inc urred. A c ompa ny mus t review its operations
at the end of ea c h reporting pe riod to dete rmine if any ac c ruals or adjus tments
nee d to be made to the financ ial s tate ments . T he acc ruals and adjus tments
mus t be rec orded s o tha t revenues and expe ns es are reported in the prope r
ac c ounting period. A c c rual ac c ounting c an be illus trate d us ing the B ug B us ters
example a bove.
1. Illus tration- R ec ording A c c ruals and A djus tments
O n J anua ry 31, 20X 8, B ug B us ter will rec ord the following ac c ruals and
adjus tments to prope rly reflec t its J anuary revenues and expens es :
th J anuary 31 - O n J anuary 25 , B ug B us ters hired a part-time bookkeeper
through an agenc y. T he agenc y will pa y the employee and ha ndle all
payroll taxes . T he c ompany mus t pa y the agenc y $20 per hour. T he
employee works 20 hours in J anuary, but will not be paid until F ebruary.
O n J anuary 31s t, the c ompany mus t rec ord the wag es of $400 owed for
J anuary by inc reas ing ac c rued payroll (liability) by $400 and inc reas ing
payroll expens e (expe ns e) by $400.
J anuary 31 - P rovided pes t c ontrol s ervic es to the fifty res idential
c us tomers from J anuary 20 - 31. A t the time the s e s ervices were
provide d, B ug B us ters earned pes t c ontrol s ervic e revenue equal to
1/12 of the $30,000 payment made by the res idential c us tomers on
J anuary15th. T his will res ult in an inc reas e in s ervice revenue (revenue )
of $2,500 and a dec reas e in unearne d s ervic e revenue (liability) of
J anuary 31 - W hen B ug B us ters provide d pes t c ontrol s ervices to its loc al
bus ines s c us tomer and its ten res idential c us tomers , the c ompa ny us ed
1/12 of the pes t c ontrol c hemic als (1/12 x $12, 000 = $1,000) purc ha s ed
on J anuary 10th. T he us age of the c hemic als is rec orded by inc reas ing
c os t of s ervic es provided (expe ns e) by $1,000 and dec reas ing
inventory (as s et) by $1,000.
J anuary 31 - T he interes t on the $15,000 note pa yable is not due until the
note is repaid on J anua ry 1, 20X 9. However, eac h month 1/12 of the
total annual interes t ($15,000 x 8% x 1/12 = $100) mus t be rec orded as total annual interes t ($15,000 x 8% x 1/12 = $100) mus t be rec orded as
(expens e) by $100 and inc reas ing inte res t payable (liability) by $100.
J anuary 31 - O ne month (1/60) of the total $36,000 c os t of the equipment
is alloc ate d to J anua ry's
c os t of doing bus ines s by inc rea s ing
deprec iation expe ns e (expe ns e) by $600 and inc reas ing ac c umulate d
deprec iation (contra- as s et) by $600. A c ontra-as s et ac c ount is an
ac c ount that offs ets the value of an as s et. A c c umulated deprec iation
offs ets the equipment ac c ount to s how the net book value of the
equipment afte r de prec iation.
T he proc es s of entering the s e adjus tments and
ac c ruals into the
ac c ounting s ys tem (s tep 3) is illus trated in the following s preads heet:
ASSETS = L IA B IL IT IE S +
B us ines s
T rans ac tio ns :
1/1/X 8 B eg. balanc e
1/2/X 8 P ay rent
R ent depos it
1/3/X 8 B orrow
Note payable
1/5/X 8 B uy fixed
E quip.
1/8/X 8 A dvertis e
1/10/X 8 B uy inventory
A c c ounts payable
1/15/X 8 C as h s ales
/30/X 8 S ale on ac c ount
A c c ounts
rec .
A djus tme nts :
1/31/X 8 J anuary payroll
A c c rued payroll
1/31/X 8 R es idential
1/31/X 8 C os t of
s ervic es
1/31/X 8 Interes t
Interes t
ac c rual
payable
1/31/X 8 D eprec ation
F rom this s preads hee t, we c an verify that after rec ording the bus ines s
trans ac tions and the adjus tments and ac c ruals , the ac c ounting equa tion
(A s s ets = L iabilities + C ontributed C apital + B e ginning R etained E arnings +
R evenues - E xpens es - D ividends ) is s till in balanc e (s tep 4):
T ota l A s s ets = $56,000 c as h + $49,400 other as s ets = $105, 400
and
T ota l L iabilities + E quity = $55,000 liabilities + $50,000 c ontributed
c apital + $0 beginning reta ined earnings + $5,000 revenues - $4,600
expe ns es - $0 dividends = $105,400
C . F inanc ial S tatements
T he s preads heet above c an be us ed to prepare
B ug
B us ters ' inc ome
s tatement, balanc e s he et, s tate ment of c hanges in owners ' equity, and
s tatement of c as h flows for J anuary 20X 8. T he inc ome s ta tement c an be
prepa red from the revenue and expe ns e c olumns . Net inc ome from the
inc ome s tatement bec omes pa rt of B ug B us ters ' ending reta ined earnings ,
whic h is equal to
be ginning retained earnings plus net inc ome minus
dividends . T he balanc e s hee t c an be prepared from the as s et, liability, and
equity c olumns . T he s tatement of c hanges in owners ' equity is prepa red from
the equity c olumns and the data from the c as h c olumn form the bas is for the
s tatement of c as h flows .
B ug B us ters
INC OME
S T ATE ME NT
F or the Month E nded J anuary 31, 20X 8
S ervice revenue
$5, 000
C os t of s ervic es provided
1,000
O pe rating expens es
3,500
Interes t e xpe ns e
100
T ota l expens es
4,600
Net inc ome
$ 400
B ug B us ters
BALANCE SHEET
A s of J anuary 31, 20X 8
12/31/X 7 1/31/X 8
A s s e ts
C as h $50,000 $ 56,000
A c c ounts rec eivable -- 2,500
Inventory --
O ffic e e quipment --
R ental depos it -- 500
T ota l as s ets $50,000 $105,400
L iab ilities
A c c ounts pa yable -- $ 12,000
A c c rued payroll -- 400
Interes t payable -- 100
Unea rned revenue --
Notes payable -- 15,000
T ota l liabilities
E quity
C ontributed c apital $50,000
R etained earnings -- 400
T ota l equity 0,000 50,400
T ota l liabilities & equity $50,000 $105,400
B ug B us te rs
STATEMENT OF OWNERS' EQUITY
A s of J anuary 31, 20X 8
B alanc e at 1/1/X 8
$ -- $50,000
C ontributed c apital
D ividends
. --
B alanc e at 1/31/X 8 $50,000 $400 $50,400
Introduc tion:
T he inc ome s tatement pres ents information on the financ ial res ults of a
c ompany's bus ines s
ac tivities over a period of time. T he s tatement
c ommunic ates how muc h revenue the c ompany generated during a period and
what c os ts it inc urred in c onnec tion with g enerating that revenue. T he bas ic
equation underlying the inc ome s tatement, ig noring gains and los s es , is
R evenue minus E xpens e equal Net Inc ome. T he inc ome s tatement is als o
s ometimes referred to as the "s tatement of operations ", "s tatement of
earning s ", or "profit and los s (P &L ) s tatement". Under International F inanc ial
R eporting S tandards ( IF R S ) , the inc ome s tatement may be pres ented as a
s eparate s tatement followed by a s tatement of c omprehens ive inc ome that
beg ins with the profit or los s from the inc ome s tatement or as a s ec tion of a
s ingle s tatement of c omprehens ive inc ome. Under U.S . g enerally ac c epted
ac c ounting princ iples (U.S . G A A P ) , the inc ome s tatement may be pres ented
as a s eparate s tatement or as a s ec tion of a s ing le s tatement, but als o
dis c us s es c omprehens ive inc ome ( profit or los s from the inc ome s tatement
plus other c omprehens ive inc ome).
I. C OMP O NE NT S A ND F O R MA T O F T HE INC O ME S T A T E ME NT
T he inc ome s tatement (s tate ment of ope rations , s tatement of earnings , or "P &L ")
meas ures a c ompany's financ ial performanc e over a s pec ific period. Net inc ome
(net earning s , profit, or "the bottom line") meas ures the c ompa ny's revenues les s
ope rating and othe r expens es . C ompa nies c an pres ent their res ults us ing eithe r
the multi-s tep format or the s ing le-s tep format. T he multi-s tep format inc ludes a
gros s profit s ubtota l (when applic able) and s epa rate s operating revenues and
expe ns es from nonoperating revenue s and expe ns es a nd other gains and los s es .
In a s ingle-s tep format, all expens es (and los s es ) are pres ented together and
s ubtrac te d in total from all revenues (and gains ). T he following example us es the
multi-s tep format.
Widget Company and Subsidiaries
CONS OLIDATE
D INCOME S TATE ME NT
For the Years Ended December 31
20X 7
20X 6 20X 5
Net s ales
C os t of g oods s old
G ros s profit 525.2
S elling , g eneral, and adminis trative (S G &A ) expens es 90.0 83.7 84.1
O ther operating expens es 15.2 30.6 19.4
O perating inc ome 420.0
Interes t expens e
O ther ( inc ome) expens e (21.4) 19.7 ( 16.3)
Inc ome from c ontinuing operations b efore tax &
minority interes t 256.8
P rovis ion for inc ome taxes
Inc ome from c ontinuing operations before minority
interes ts 154.1
Minority interes t in inc ome from c ontinuing operations
Inc ome from c ontinuing operations 139.8
Inc ome ( los s ) from dis c ontinued operations ( net of tax) ( 23.2) (7.2) --
Net inc ome $116.6
T he above pres entation c ompares c urrent year res ults (in the firs t c olumn) to the
res ults for two prior years , as is typic ally done for U.S . c ompanies . A lternatively,
the inc ome s tatement c an pres ent the mos t rec ent year in the las t c olumn. W hile
the pres entation above reports res ults for the years ended D ec ember 31, 20X 7,
20X 6 and 20X 5, s ome c ompa nies report on a "fis c al yea r" rathe r than on a
c alendar year. F or example, retail firms typic ally us e fis c al years ending nea r the
end of J anua ry.
T he "top line" for an inc ome s tatement is net s ales or net revenues , whic h ha ve
virtua lly the s ame meaning. T he multi-s te p format then s ubtrac ts the c os t of
goods s old from ne t s ales to derive g ros s profit.
S elling , g ene ral and adminis trative ("S G &A ") expens es , as well as othe r operating
expe ns es , are s ubtrac ted from gros s profit to arrive at the ope rating inc ome
(operating profit). E ac h ope rating expens e line item (e.g ., c os t of goods s old,
S G &A expe ns es , othe r operating expens es ) generally reflec ts a c harge for
deprec iation of relate d prope rty, plant & equipment. A lternatively, the inc ome
s tatement may inc lude deprec iation expens e as a s epa rate line item. A s a res ult, s tatement may inc lude deprec iation expens e as a s epa rate line item. A s a res ult,
determine the deprec iation and amortiz ation expens e for the period.
O the r nonope rating inc ome and expens e items follow ope rating inc ome on the
inc ome s tatement. T his s ec tion inc lude s interes t expens e and interes t inc ome,
whic h may be reported in total as ne t inte res t expens e. T he multi-s te p format als o
reports revenue and expe ns e items that are inc luded in c ontinuing ope rations
before taxes and any s ubs equent ("below the line ") items , inc luding the res ults of
dis c ontinued operations , net of taxes . T his pres entation is c overed in more de tail
under ana lys is of nonoperating and nonrec urring items
be low. T he fina nc ial
res ults reported for W idget
C ompany als o inc lude a minority inte res t
(nonc ontrolling interes t) in inc ome from c ontinuing operations . T his repres ents the
portion of inc ome (los s ) tha t belongs to the minority (nonc ontrolling) s hareholders
of les s than wholly owne d (i.e., les s tha n 100 percent owned) c ons olidate d
s ubs idiaries , rather tha n to the parent c ompany.
II. INC OME ME A S UR E ME NT IS S UE S
A s dis c us s ed in the previous s tudy s es s ion, inc ome s tatements prepa red under
both IF R S and U.S . G A A P are ba s ed on the
ac c rual c onc ept , whic h rec ogniz es
revenues and expe ns es when an ec onomic exc hange takes plac e, rathe r tha n at
the time c as h is exc hanged.
ac c ounting matc hes
expe ns es with as s oc iated revenues rather than the c as h rec eived from the
trans ac tion, ac c ounting profit (earnings or net income) will not equa l c as h flow. In
addition,
ac c rual- bas is
ac c ounting requires management to make many
s ubjec tive judg ments regarding revenue and expe ns e alloc ation among
ac c ounting pe riods .
A . R ev enue R ec o g nition
1. G enera l P rinc iples of R ev enue R ec o g nition
In the IF R S
F ramework, inc ome, whic h inc lude s both revenues from
ope rating ac tivities and gains from s ec ondary (nonoperating ) ac tivities , is
defined as :
Inc reas es in ec onomic be nefits during the ac c ounting period in the
form of inflows or enhanc ements of as s ets or dec rea s es of liabilities
tha t res ult in inc reas es in equity, other tha n thos e relating to
c ontributions from equity pa rtic ipants .
Unde r IF R S , revenue is rec og niz ed for a s ale of goods when all of the
following revenue rec ognition c riteria are met:
1. T he entity ha s trans ferred to the buyer the s ignific ant ris ks and rewards
of owners hip of the goods ,
2. T he entity does not mainta in managerial involvement to the deg ree
as s oc iated with owners hip or effec tive c ontrol of the goods s old,
3. R evenue a nd related c os ts c an be reliably meas ured, and
4. It is proba ble that the ec onomic benefits as s oc iated with the trans ac tion
will flow to the entity.
Unde r IF R S , revenue from s ervices are rec og niz ed over the term of the
s ervic e c ontrac t, rather than at the end of the s ervic e c ontrac t, us ing the
perc entage of c ompletion method whe n the following c riteria are met:
1. R evenue a nd related c os ts c an be reliably meas ured,
2. It is proba ble that the ec onomic benefits as s oc iated with the trans ac tion
will flow to the entity, and
3. T he s tage of c ompletion of the trans ac tion at the balanc e s hee t date
c an be reliably meas ured.
2. Is s ues in R ev enue R ec og nition
a. R ev enue R ec o g nition for L ong -term C ontrac ts
B oth IF R S and U.S . G A A P provide two methods of rec og niz ing profit on
long - term c ontrac ts s uc h as c ons truc tion c ontrac ts . However, if a los s
is expe c ted, the entire es timated los s is rec og nized in the ac c ounting
period in whic h the los s bec omes appa rent under both IF R S and U.S .
GAAP.
A djus tments to inc ome to reflec t revis ed los s es are made
pros pe c tively, and ne ver retroac tively.
1. P erc e ntag es -C ompletion Method
W hen reliable es timates of a projec t's total revenues and c os ts (i.e.,
ability to c alc ulate gros s profit) and deg ree of c ompletion are
available, perc entage-of-c ompletion is the preferred method under
both IF R S a nd U.S . G A A P .
Unde r this method, a c ompa ny es timates the perc entage of projec t
c ompletion eac h ac c ounting pe riod and rec ogniz es tha t perc enta ge
of total projec t revenues . P rojec t c os ts are expens ed as inc urred s o
tha t gros s profit is reported eac h pe riod.
T he formula to rec ogniz e revenues eac h year under the perc enta ge-
of- c ompletion method is :
C urrent
T otal
P rior
C os t inc urred to D ate
P eriod
E xpe c ted
– P eiod
R evenue
T otal E xpec ted C os ts
R evenue R evenues
Note that the s ame formula c an be us ed to s olve for the gros s profit
to be rec og niz ed in the c urrent period by s ubs tituting "total expe c ted
gros s profit" and "prior pe riod(s ) gros s profit."
E x a mple
In 20X 1, a c ompany unde rtakes a 3-year projec t at a c ontrac ted
pric e of $750,000 and an es timated c os t of $600,000. If the c os ts
inc urred eac h year are $120,000, $300, 000, and $180,000,
res pec tively, the tota l revenue ($000) rec ogniz ed ea c h yea r under
the perc enta ge-of-c ompletion method is c alc ulate d as :
T ota l revenue rec og niz ed ($000) = $150 + $375 + $225 = $750
If the profit es timates are revis ed as the projec t prog res s es , reported
inc ome adjus tments are made pros pe c tively (never retroac tively). If
a los s is es timated, the entire los s is rec orded as s oon as its
mag nitude c an be es timate d (los s es are not s pread over future
applicable a c c ounting periods ).
2. C os t R ec o v ery Method (IF R S )
W hen reliable es timates of a projec t's total revenues and c os ts (i.e.,
ability to c alc ulate gros s profit) or
de gree of c ompletion are
una vailable, IF R S requires the us e of the c os t rec overy method to
rec ogniz e revenue on a long -term c ontrac t. Unde r the c os t rec overy
method, revenue is rec og niz ed only to the extent of the c os ts method, revenue is rec og niz ed only to the extent of the c os ts
c ompleted.
E x a mple
In 20X 1, a c ompany unde rtakes a 3-year projec t at a c ontrac ted
pric e of $750,000 and an es timated c os t of $600,000. If the c os ts
inc urred eac h year are $120,000, $300, 000, and $180,000,
res pec tively, the tota l revenue ($000) rec ogniz ed in 20X 1 and 20X 2
under the c os t rec overy method is equal to the c os ts inc urred eac h
period. T he revenue rec og niz ed in 20X 3 is equa l to the c os ts
inc urred in 20X 3 plus the $150, 000 profit on the projec t:
T ota l revenue rec og niz ed ($000) = $120 + $300 + $330 = $750
3. C omple ted C ontrac t Method ( U.S . G A A P )
W hen reliable es timates of a projec t's total revenues and c os ts (i.e.,
ability to c alc ulate gros s profit) or
de gree of c ompletion are
una vailable, U.S . GAAP requires that
c ompanies rec ord no
revenues , c os ts , or profit until the entire projec t is c ompleted. A ll
c os ts
ac c umulate as inventory {c ons truc tion-in-prog res s ) and all
amounts billed to c us tomers ac c umulate as a liability (advanc e
billing s ) on the balanc e s heet. F or financ ial reporting purpos es ,
c ons truc tion-in-prog res s and advanc e billing s appe ar as a net
c urrent as s et or liability.
E x a mple
In 20X 1, a c ompany unde rtakes a 3-year projec t at a c ontrac ted
pric e of $750,000 and an es timated c os t of $600,000. Unde r the
c ompleted c ontrac t method, no revenue is rec og niz ed in 20X 1 and
20X 2 a nd the e ntire $750,000 in revenue is rec ogniz ed in 20X 3.
4. F inanc ia l A naly s is Imp lic ations of L ong -term C ontrac t Methods
T he perc enta ge-of-c ompletion method is a les s
c ons ervative
revenue rec og nition approac h tha n the c omplete d c ontrac t method
or the
c os t rec overy method
be c aus e the former requires
mana gement es timates and is therefore les s objec tive. However,
the perc entage-of-c ompletion method res ults in better revenue and the perc entage-of-c ompletion method res ults in better revenue and
event, c ompanies are required to dis c los e the methods us ed
(us ually in the s ummary of s ignific ant polic ies footnote) and analys ts
s hould c ons ider the impac ts when c ompa ring financ ial res ults and
ratios of s ubjec t c ompanies .
b. Ins tallme nt S ales
R evenue and the c orres ponding profit are generally rec og niz ed when
goods are de livered or s ervices are rendered irres pec tive of the c as h