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Chapter 6 The Statement of Cash Flows: The Foundational Theory and A Case Study Tutorial

2011-06-26T10:15:00.000-07:00

Introduction

In Chapter Two you were introduced to the Monetary Unit Assumption that limits financial accounting to transactions that can be measured in money. As you further studied in Chapter Two, this limitation means that other (non-monetary) information that is important to financial markets needs to be provided from sources outside the financial accounting paradigm. Since the financial accounting portion of the financial market information pie is limited, and some would say shrinking, the FASB wanted to make the information that it did provide as useful as possible. So in 1987, FAS 95 required the Cash Flow Statement in GAAP financial reports.

The authoritative foundation of the Statement of Cash Flows is in Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises.

49. Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, including cash dividends and other distributions of enterprise resources to owners, and about other factors that may affect an enterprise’s liquidity or solvency. For example, although reports of an enterprise’s cash receipts and cash outlays during a period are generally less useful than earnings information for measuring enterprise performance during a period and for assessing an enterprise’s ability to generate favorable cash ﬂows (paragraphs 42–46), information about cash ﬂows or other funds ﬂows may be useful in understanding the operations of an enterprise, evaluating its ﬁnancing activities, assessing its liquidity or solvency, or interpreting earnings information provided. Information about earnings and economic resources, obligations, and owners’ equity may also be useful in assessing an enterprise’s liquidity or solvency[1].

The Statement of Cash Flows is a reconciliation of the Cash account (recall the account analysis tool you studied in Chapter Five) that organizes all of the transactions recorded in the period into three categories: Operating, Investing and Financing. In this Chapter you will study the Indirect Method, which is not as precise as the Direct Method, but it is still GAAP, is much simpler to produce and according to Accounting Trends and Techniques (a reference book produced by the AICPA), is the de-facto standard.

Cash: Not Just Another Asset! The Theory Behind the Statement of Cash Flows

Cash is the lifeblood of any organization. Without it or the ability to quickly acquire it in the financial marketplace[2], a company will fail regardless of its cool technology, potential for growth and assembled intellectual capital. Nobody ever accused the money market of being omnipotent and wise. When trying to sell its I O U in the money market, any organization from any industry will face the same question, namely, what are they going to do with the money they seek? Does the organization need to subsidize its operations? Is the money needed for investment in assets that will help generate future operating income? Will the money be used to refinance the company, paying off current creditors or shareholders? Each of these reasons may be valid depending on the economic situation of the company and the financial market. The Statement of Cash Flows will help investors and lenders evaluate how the company has procured and used cash in the past which will help them predict its future cash transactions.

Intercompany Analysis of Statements of Cash Flows Table 6.1

In Table 6.1 above, you can see the condensed Statements of Cash Flows for five companies in various industries. Since Google is kind enough to host this textbook, lets begin by looking at their data. Google’s Cash increased from $10,198 on January 1, 2010 to $13,630 on December 31, 2010, a net increase of $3,432. By organizing all of the accounting transactions for 2010 into Operating, Investing or Financing[3], Google’s Statement of Cash Flows provides the readers of its financial report with useful information about how Google acquired and spent its cash. Notice that Google produced a net increase to Cash of $11,081 from its operations. Recall that in Chapter Five we isolated Income From Operations on the multi-step Income Statement. While the definition of “Operations” remains the same on the Statement of Cash Flows, the transactions included in this section are a little broader than those included in the Income From Operations section in the Income Statement[4]. Basically this section is informing the reader about the organization’s acquisition and use of cash in its day-to-day operations by presenting a cash-basis Income Statement with some selected transactions removed.

Most business textbooks attempt to bring relevance to this academic material by informing students about the “typical” life cycle of a for-profit enterprise, that an organization uses cash in its operations during startup, but as it matures it produces cash that can be used for investing and repaying debts. This rule of thumb is a logical theory, but in the real world it is worthless because enterprises do not follow a standard rule. As a student you should always be skeptical of simple explanations to complex subjects. In the case of Google in 2010, the organization procured more Cash than it is expended on period costs. If the reverse were true, it would need to subsidize its operations with cash from other sources. Next, notice that Google used $10,680 in Cash on investing activities that its management decided would produce acceptable returns for the organization and finally, notice that Google procured $3,050 from the money market during the year. Like any financial statement, try to avoid jumping to conclusions based on information provided in a financial report. Remember that this type of data is for broad comparison purposes and should serve as a starting point for a more detailed analysis.

Take a few moments and reflect on the data contained in Table 6.1. Why do organizations go to the money market for financing? Should investors care what organizations plan on doing with the cash it borrows? What happens to a company that cannot access financial markets (nobody will accept its I O U’s)? Placing yourself in the shoes of an investor will help you understand the purpose of this financial statement and will make it easier to learn how to prepare a proper GAAP Statement of Cash Flows.

Cash Provided From (Used In) Operations

An organization’s operations are defined as its mission or purpose. For example, consider a supermarket that sells groceries to the public. Purchasing product for resell, paying its employees and paying the monthly rent on its building would all be examples of operational uses of Cash while collecting money from its customers would produce Cash. Since the Balance Sheet (which includes the effect of all transactions recorded in the period) is on an accrual basis (Chapter Four), this section of the Statement of Cash Flows must adjust Net Income to remove the changes in accruals during the period, creating a cash basis Net Income. Since Net Income includes transactions that are not included in Operating Income, some transactions will be identified and removed from the section. Not ALL non-operating transactions are removed. For example, interest income and expense are not adjusted out of this section.

Cash Provided From (Used In) Investing

An organization invests its Cash in something (property, patent, copyright, etc) because it seeks a return on its investment. This section isolates an organization’s sources and uses of Cash related to investing. When an organization purchases an asset, it is using Cash, when it sells an investment (regardless of whether or not there is a gain or loss) it is producing Cash. Using our Supermarket example, a purchase of a cash register represents an investment that will enable the grocer to check people out faster, hence producing more operating income. If the grocer would sell his cash register to generate cash, this would be an example of producing cash from an investment.

Cash Provided From (Used In) Financing

This section details the organization’s interaction with the financial market. Borrowing money or selling shares would be examples of taking Cash out of the market while paying Dividends or paying down principal would be examples of putting Cash into the market.

Building The Statement Of Cash Flows: A Case Study / Tutorial Tables 6.2, 6.3 and 6.4

The spreadsheets used in this chapter are available on Google Docs at Google Docs Ch 6 The companion YouTube lecture is available below.

Please replicate this work, using paper and pencil, on columnar paper[5]. The remainder of this Chapter will be dedicated to constructing the Statement of Cash Flows. The Balance Sheet, since it reflects ALL of the transactions of the period, is the basis for creating the Statement of Cash Flows. By analyzing the changes in the beginning and ending balances of all accounts, transactions can be properly classified into one of the three categories.

The statement is a reconciliation of the Cash account, which reflects a $250 increase from the beginning of the year to the end of the year. Since the Balance Sheets reflect the Accounting Equation (Assets = Liabilities + Owners’ Equity), the net change in Cash must be equal to the net change in the rest of the accounts. For example, a company that increases its assets from $100 to $200 during the year will have a corresponding increase in liabilities and owners’ equity of $100. Therefore, is we isolate the change in one account in the Balance Sheet, Cash, the change in the balance will be offset by the change in all of the other accounts combined. The challenge is to analyze the change that occurred in the account balances during the year and properly classify the transactions that created the changes into operating, investing and financing categories.

Operating Section: Tables 6.5, 6.6 and 6.7

This section converts Net Income on the Income Statement from the accrual basis of accounting to cash basis. Furthermore, certain non-operating transactions are removed from the net balance.

MEMORIZATION: Net Income plus C (changes in current assets and liabilities) L (losses and gains) A (amortization and depreciation) D (deferred taxes).

The first line item in this worksheet, Net Income, comes from our analysis of the Retained earnings balance sheet account (Table 6.6).

Net Income of $300 increased the Retained earnings account (increase in Cash) while the Dividends of $850 decreased the balance. Dividends will be accounted for in the Financing section of this worksheet. This analysis confirms that we have captured all of the transactions related to the change in the Retained earnings account and properly categorized the transactions in the Statement of Cash Flows.

Changes in current assets and liabilities reflect the changes in accruals from the beginning of the year to the end of the year. Showing the changes in these accounts in the operating section converts the accrual basis Net Income to cash basis accounting. These accounts do not require a detailed analysis; just drop the net change into the Operating section. Accounts receivable increased by $300. Recall from Chapter Four (Table 4.7) the type accrual journal entry that gave rise to this transaction.

Sales are included in Net Income, but the cash has not yet been received. Therefore, the Cash needs to be deducted from the Operating section. If Accounts receivable had DECREASED, this would reflect receiving more cash than recorded sales in the period. Inventory and Accounts payable are the other accounts in this tutorial that are analyzed in this manner. When analyzing accounts, always go back to the journal entry that was used to record the transaction that changed the account balance. For example, when Inventory was purchased, Cash went down. When Accounts payable increased, an asset (Cash) increased.

Losses and gains result from selling property or settling liabilities for an amount different than their carrying amount. Since this type of transaction is non-operating, it must be adjusted out of Net Income. Since gains increase Net Income, they must be subtracted from Net Income. On the other hand, losses decrease Net Income and must therefore be added back. In this example, there was one disposal of Equipment during the year that was discovered by analyzing the account (Table 6.7).

Equipment with a net book value of $500 was disposed of during the year (thrown away) resulting in a $500 loss. If it had been sold, the proceeds would be included in the Investing section as an increase in Cash.

While depreciation is an operating expense, it results from accrual accounting of a purchase of a long-term asset. Since we capture new Property plant and equipment purchases in the Investing section in the period in which they occur, depreciation needs to be added back to the Operating section to adjust Net Income to cash basis. Amortization related to a premium or discount on Bonds, a subject we will cover in a subsequent Chapter. The theory is the same as depreciation. As you can see in Table 6.7 above, depreciation of $300 is added back to Net Income in the Operating section.

Finally, the changes in Deferred taxes must be added back or subtracted from Net Income as appropriate. In the Lizzie Incorporated example in Chapter Five, I demonstrated a simple example of an accrual of income taxes at period end. If the liability increases, then it is added to the Operating section (a decrease in the liability would reflect a payment of Cash). Technically, if it is a current liability (short-term timing item) then it could be treated like any other current liability. However, accounting for income taxes is generally much more complicated. You will study this in much more detail during Intermediate Accounting.

Investing Section: Table 6.8

From our analysis of Equipment (Table 6.7 above), we learned that XYZ purchased $1,300 of new equipment during the year. This is the only Investing transaction in this tutorial. As discussed above, if XYZ had received any proceeds from the disposal equipment, it would have been included here as an increase in Cash.

As discussed earlier in the Chapter, organizations invest in order to seek a return. What does it tell you about an organization that is producing a great deal of Cash from its investing section? Is it selling off productive assets that are needed for operations in order to generate Cash? What does this mean for its future? Is there any good business reason to sell assets (hint... think change in business focus)?

Financing Section: Tables 6.9, 6.10 and 6.11

XYZ had three transactions during the year with the financial market. From our analysis of Retained earnings in Table 6.6 above, we discovered that a dividend of $850 was paid, a use of Cash. In Table 6.9 below, the analysis of Bonds payable is presented.

The repayment of principal on the Bond represents a use of Cash during the period. If there had been new borrowings, they would have been presented in the financing section as a source of Cash. By analyzing the Common stock account below (Table 6.10) we discovered that the sale of stock provided $300 in Cash during the period.

These transactions are presented in the financing section as follows:

Completing the Statement of Cash Flows Table 6.12

We have now accounted for the change in all of XYZ’s balance sheet accounts and have categorized all of the transactions during the period as operating, investing or financing.

While the example presented in this tutorial is basic, the approach is the same one that you will use to prepare a Statement of Cash Flows for an organization with millions of transactions, some of them quite complex. Please practice with the tutorial in Google Docs and revisit the Statements of Cash Flows and supporting worksheets presented in Chapters Four and Five (Lizzie Incorporated).

Kuhn Paradigm Science… The Importance of PRACTICE

Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm. The framework is the foundation upon which the community is built, providing its rules for communication and social interaction. Without the framework the community does not exist. Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product. Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.

If, for example, the student of Newtonian dynamics ever discovers the meaning of terms like force, mass, space, and time, he does so less from the incomplete though sometimes helpful definitions in this text then by observing and participating in the application of these concepts to problem-solving (p. 46-47).

What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm.

[1]Link to FASB Pronouncement

[2] The absolute worst time to seek financing is when the cash is gone and the organization is desperate.

[3] Exchange rate changes are changes in Cash that are part of comprehensive income (i.e. not on the Income Statement). You will cover this topic in Advanced Accounting.

[4] One of my favorite managers, Amos Galon of Haifa, used to say: “I’d rather be roughly correct than precisely wrong.” FASB adopted the same approach here.

[5] http://www.printablepaper.net/category/columnar

Chapter 5 Refining Financial Statements: Classified Balance Sheet and Multi-Step Income Statement

2011-06-17T21:48:00.000-07:00

Introduction

In this Chapter, you will incrementally refine your financial accounting knowledge base by studying the Classified Balance Sheet and Multi-Step Income Statement. If you are not proficient in the base financial accounting rules, mechanics and terminology, then the material presented in this Chapter will be quite confusing. On the other hand, if you have mastered the foundational accounting language and are confident in your ability to analyze basic economic transactions and to complete a full accounting cycle as outlined in Chapters One through Four, you will find this Chapter to be very simple. Since I am writing this book for the best students who want to be challenged, refining a couple of financial statements isn’t enough meat for a full Chapter so I am going to supplement it with the most important (and most interesting and challenging) topic that an accounting student can study. I do not expect you to find easy answers, I want you to embark on an academic journey that begins by asking the question: Is There a Crisis in the Financial Accounting Paradigm?

Is There a Crisis in the Financial Accounting Paradigm?

In order to understand what this question means, please read Kuhn (1996) The Structure Of Scientific Revolutions[1] Chapter 8, The Response to Crisis and Chapter 9, The Nature and Necessity of Scientific Revolutions.

Let us assume that crises are a necessary precondition for the emergence of novel theories and ask next how scientists respond to their existence. Part of the answer, as obvious as it is important, can be discovered by noting first what scientists never do when confronted by even severe and prolonged anomalies. Though they may begin to lose faith and then to consider alternatives, they do not renounce the paradigm that has led them into crisis (p. 77).

If Kuhn’s theory is correct, it is unlikely that your accounting professor will question the validity of financial accounting. It is even less likely that the AICPA will begin to lobby the U.S. Government to radically change the nature of financial reporting requirements for public companies. After all, this act would reek of “the carpenter who blames his tools” (p. 79).

The Collapse of the Financial System

On a Friday afternoon in September 2008, the world financial markets collapsed. Over that weekend, the U.S. government decided to inject trillions of dollars into the system in order to reopen the banks on the following Monday. On top of direct cash infusions from the U.S. Treasury to private, for-profit financial service companies through the Troubled Asset Relief Program (“TARP”), nationalization of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Association (“Fannie Mae”), and security purchases by the Federal Reserve Open Market Committee (“FOMC”), the government assumed legal responsibility as counterparty on trillions of dollars of financial bets that were unsupported by sufficient capital. With the signature of President Bush, trillions of dollars of financial contracts that were valueless promises of failed; for-profit financial firms became obligations of the U.S Treasury. In 2011, we still do not know the full cost of the bailout, or even if it worked or was merely a ploy to buy time, delaying the inevitable collapse. (The true cost of the bank bailout | Need to Know) Some have suggested that poor individual financial literacy skills amongst American citizens led to the collapse of financial markets. Understanding how a system that was revered with dogmatic faith failed so completely and spectacularly will inform the question that seeks to discover the culpability of the financial accounting paradigm.

America at the start of the 21^st century embraced a culture of conspicuous consumption financed by debt and a casino mentality that rewarded financial transactions, regardless of their economic merit. The repeal of depression-era bank regulations known as Glass-Steagall created a culture of lending without responsibility. Lenders profited by originating a loan, regardless of whether or not the borrower paid the money back. After all, the lender never put its own money at risk; it was someone else’s property, perhaps the assets of a government employee pension fund and after the loan was made, the banker had no remaining financial interest in the loan. American citizens were flooded with messages from all parts of society to get aboard the ownership society while they were able, prices were only going up and if they waited they could miss their opportunity at the American dream. Buy a house… or houses, any fool can make money in real estate. Just like the “stupid people” who tried to settle the Great American Desert resulting in the Dust Bowl[2], a generation of Americans destroyed their personal wealth by borrowing heavily to purchase homes and college educations at highly inflated prices. After the repeal of depression era banking regulations, America’s financial institutions became highly leveraged organizations seeking ever-higher investment returns while seemingly disregarding risk and the financial accounting profession seemingly did little to avert catastrophe. After all, bankers and financial accountants deluded themselves into believing that risk was non-existent because they mistakenly calculated that American real estate only increases in value. Individual loans that met certain standards (i.e. not subprime mortgages) were purchased by Government Sponsored Enterprises (“GSE’s”) Fannie Mae and Freddie Mac, guaranteed by the government, then turned over to the financial services industry to be marketed to private investors (including state and local government employee pension funds). In order to make the mortgage pools more lucrative, the financial services industry created side bets known as derivatives on the GSE backed mortgage pools. Some of these derivatives offered returns of several hundred percent, and best of all; the risk could be insured with an unregulated instrument called a Credit Default Swap. A single $100,000 home mortgage could be used to generate millions of dollars in financial products, many of which were granted impeccable grades from the rating agencies.

At the core of this scheme, an individual American was signing a note to purchase a house at an artificially inflated price. When the market crashed, the U.S. government covered the losses of the for-profit financial service firms who created the failed system but individual mortgage holders learned that the ownership society meant they were on their own. In addition, trillions of dollars in private savings, including public pension funds that were invested in the system were gone, funneled into the pockets of bankers and as a result, a generation of Americans will have virtually no retirement savings to supplement Social Security. At the same time, the resulting increase in government debt is threatening to significantly curtail future Social Security and healthcare benefits as well as pensions for government employees.

A Small Piece of the Picture Table 5.1

The first evidence of a systemic anomaly in the financial accounting paradigm, at least of the new millennium, was the Enron scandal. Look at the dollar value of the Enron scandal and consider the resulting national “crisis response” that included the destruction of Arthur Andersen, Congressional hearings (http://www.youtube.com/watch?v=hPqH3DrWEEU), and the enacting of Sarbanes-Oxley[3] that was designed to prevent future accounting scandals.

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, which he characterized as "the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt." The Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the "Public Company Accounting Oversight Board," also known as the PCAOB, to oversee the activities of the auditing profession (http://www.sec.gov/about/laws.shtml#sox2002).

“SOX” was a complete and utter failure, which is not a surprise because it changed NOTHING within the financial accounting paradigm. The SOX approach was to “double-down” on the FASB, making market participants loudly swear their allegiance to the omnipotent group. While it generated a great deal of billable hours for CPA’s in the short-term, in the end it has had the net effect of damaging the profession and quite possibly hastening the collapse of financial markets.

Since the collapse of the financial market in 2008, what has been the governmental response? Kuhn observed that political revolutions (cultural reorganizations) aim to change political institutions in ways that those institutions themselves prohibit. Their success therefore necessitates the partial relinquishment of one set of institutions in favor of another, and in the interim, society is not fully governed by institutions at all. Is Kuhn’s observation relevant when evaluating the SEC’s and FASB’s ability to change the financial accounting paradigm? Recall from Chapters One and Two the purpose of financial accounting and consider the words of George Santayana “Fanaticism consists in redoubling your effort when you have forgotten your aim.[4]” I am challenging you dear student, to NOT forget the aim of financial accounting. You can be a part of the replacement of the current paradigm with a new improved paradigm that will improve the symmetry of information in financial markets and help the world achieve more efficient and democratic financial markets and a society with greater welfare for all.

Refining Financial Statements: The Classified Balance Sheet and Multi-Step Income Statement

The spreadsheets used in this chapter are available on Google Docs at Google Doc Worksheet. The companion YouTube lecture is available above. Please replicate this work, using paper and pencil, on columnar paper[5]. The remainder of this Chapter will be dedicated to identifying and recording certain transactions in the accounting records that facilitate the preparation of a Classified Balance Sheet and a Multi-Step Income Statement, both of which are the required by GAAP. The worksheet used in the Chapter is an extension of the Lizzie Incorporated case study that you have been using since Chapter Two. If you have mastered the material in the first four chapters, this section should only take a couple of hours (at most) to completely master.

The material presented in the Chapter is merely an incremental refinement of material that you already covered in Chapters One and Two. The FASB, drawing on Statement of Financial Accounting Concepts No. 8[6], has created standard rules that make these two financial statements more relevant to users by providing information that helps users make decisions and enhancing the predictive value.

· QC5. The fundamental qualitative characteristics are relevance and faithful representation.

o QC6. Relevant financial information is capable of making a difference in the decisions made by users.

o QC7. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both.

Since financial statement rules MUST be applicable to all organizations in all industries, the refinements studied here are very minor.

Classified Balance Sheet Table 5.2

In Chapter One you memorized the accounting equation which is presented in the financial report as the Balance Sheet: Assets = Liabilities + Owners’ Equity. You also memorized that some asset and liability accounts were classified as current or long-term, but I didn’t tell you why at the time. In Chapter Four, you studied Periodicity and the Operating Cycle, a concept that is important to understand when learning how to classify an asset or liability as current.

· General Rule: If an asset or liability will expire in less than 1 year, it is classified as current. For example, if a Note receivable has a due date of 370 days from period end, it is non-current (synonymous with long-term). A debt that has a payment due date 360 days from period end would be classified as current.

o Exception: If the operating cycle of the entity is greater than 1 year, then the longer of the two would be the measurement used to classify current assets and liabilities. For example, Getya Drunk Whisky (from Chapter Four) had a 10-year operating cycle. Therefore, Its inventory would always be classified as current.[7]

Multi-Step Income Statement Table 5.3

In Chapter One, you memorized that the Income Statement presented: Revenue – Expenses = Net Income. Now you are going to study how to organize the revenue and expenses in the correct format.

1. Define NET sales as gross sales, less returns and allowances and sales discounts.

2. Making a distinction between product costs and operating costs. Subtract product costs (Cost of goods sold) from Net Sales to present Gross Profit.

3. Clearly identify non-operating revenue and expenses and income taxes.

Analyzing the Classified Balance Sheet and Multi-Step Income Statement Tables 5.4 and 5.5

Refining the financial statements can improve the predictive value of the financial statements as you can see in this intracompany analysis of Google Inc. and intercompany analysis of Wal-Mart Stores, Inc. and Target Corporation.

This is a horizontal analysis (comparing two periods) using vertical analysis tools to “common size” the financial statements. This analysis may lead a financial statement user to predict that in 2011, Google’s Gross Profit will be close to 64%.

This analysis could enable a user of financial reports to compare two retailers to each other and to facilitate comparison of each company’s financial reports to companies outside of the retailing industry. Recall from Chapters One and Two that financial reporting is designed to facilitate symmetry of information so investors can choose the best I O U to buy.

MEMORIZATION ADDITIONS

SIX ACCOUNT TYPES (plus a song)– Table 5.6

In order to produce the Balance Sheet and Income Statement in accordance with GAAP, you will need to slightly refine your memorization from Chapter One. Recall the mnemonic D A E L O R (Dave And Ed Live On Red), two hard working college students Dave and Ed study non-stop into the wee hours of the night. To stay up and alert, they drink large quantities of Red Bull. We are going to add E I O to the end (think of the song Old McDonald had a farm.. e i e i o…)

Account Type	Definition	Natural Balance	Financial Statement
Dividend	Assets distributed to stockholders	Debit	Retained Earnings
Asset	Assets are probable future economic beneﬁts obtained or controlled by a particular entity	Debit	Balance Sheet
Expense	Expenses are outﬂows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations	Debit	Income Statement
Liability	Liabilities are probable future sacriﬁces of economic beneﬁts arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future	Credit	Balance Sheet
Owners’ Equity	The owners’ claim on assets (assets-liabilities)	Credit	Beginning Retained Earnings on Retained Earnings Statement, rest on Balance Sheet
Revenue	Revenues are inﬂows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations	Credit	Income Statement
Expenses or Losses - Other Income or Gains - Other	Gains are increases (Losses decreases) in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owner	Gains and Other Income – Credit; Losses and Other Expense - Debit	Income Statement

Recall the words of Newt Becker, the pioneering financial accounting educator who founded the Becker CPA Review Course, coined the phrase “an ounce of memorization is worth a pound of logic.”

Common Account Names – Table 5.7

Account Type	Account Name
Dividend	Cash dividend
Asset	Current: Cash, Accounts receivable, Interest receivable, Inventory, Supplies, Prepaid rent, Prepaid insurance, Prepaid expense Long-term: Land (used in business), Property Plant and Equipment, Accumulated depreciation (contra-asset), Patent, Long-term investment
Expense	Cost of goods sold, Income tax expense, Salaries expense, Maintenance expense, Rent expense, Selling expense, Shipping expense, Insurance expense, Rent expense, Unearned revenue, Utilities expense
Liability	Current: Accounts payable, Note payable (depending on term of note), Income taxes payable, Interest payable Long-term: Mortgage payable
Owners’ Equity	Common stock, Retained Earnings
Revenue	Sales revenue, Sales returns and allowances (contra-revenue), Sales discounts (contra-revenue)
Expenses or Losses - Other Income or Gains - Other	Expenses or Losses – Other: Interest expense, Loss on disposal of equipment Income or Gains – Other: Interest income, Gain on sale of equipment

Identifying, Analyzing and Recording Transactions

Selling a Fixed Asset at a Loss Table 5.8

Lizzie Incorporated purchased a piece of equipment on December 30, then returned it the next day. The mean old equipment dealer only returned $625, so Lizzie Inc. suffered a loss. Since Lizzie Inc. is not in the business of selling equipment (it sells toy mice), it is important to capture this transaction in an account that can be clearly identified as non-operating.

Customer Returns Merchandise 5.9

On November 30, Lizzie Inc. sold merchandise to a customer on account (je #7). On December 31, the customer returned $500 of merchandise. Rather than reduce the Sales account, Lizzie Inc. records returns to a contra-revenue account so it can track the level of sales returns. Since Lizzie Inc. uses a periodic inventory system; the change to inventory will be picked up during the physical inventory at yearend.

Since the customer owes Lizzie Inc. $500 less, the Accounts receivable is reduced with a credit entry.

Recording Interest Income and Interest Expense Table 5.10

When reconciling the bank account (bankrec), Lizzie Inc. discovered that it had earned $6 of interest on its checking account (je #13). The accrual of interest expense (je #14) was covered in Chapter Four and the calculation is on the “Accrual Calculations” tab in the Google worksheet.

Since companies have different options for financing (issuing stock, paying dividends, mortgages, etc), both interest income and expense are included in “Other” on the Income Statement. This enables readers of financial reports to isolate and compare the operating performance of an individual organization.

Recording Income Tax Expense Table 5.11

Usually one of the last journal entries of a period for any company is the accrual of the income tax liability that arose during the period. You will study this topic more in detail when you take Intermediate Accounting… I promise it isn’t that hard.

Just like any other accrual of a liability, an expense is the offsetting entry.

Now, post the journal entries to the ledger, total the ledger and complete the accounting cycle. Do this a minimum of three times without error.

Kuhn Paradigm Science… The Importance of PRACTICE

What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm.

[1] I really want you to get the book, but a Professor at Emory has done a great job summarizing the work http://www.des.emory.edu/mfp/Kuhn.html.

[2] Those who cannot remember the past are condemned to repeat it… http://www.npr.org/templates/story/story.php?storyId=5128581

[3] http://www.sec.gov/about/laws.shtml#sox2002

[4] Life of Reason (1905) vol. 1, Introduction

[5] http://www.printablepaper.net/category/columnar

[6] http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175821997186&blobheader=application%2Fpdf

[7] I like to brag that I have done everything there is to do in accounting… but I have never had the opportunity account for an entity with an operating cycle longer than one year.

Chapter 4 Accrual Accounting

2011-06-11T12:06:00.001-07:00

The Periodicity Assumption

Recall that in Chapter Two you were introduced to the Generally Accepted Accounting Principle Periodicity Assumption that financial reports are prepared at yearend, regardless of an economic entity’s operating cycle[1]. An organization’s operating cycle describes how quickly it turns its cash (used to buy or manufacture Inventory) into cash it receives from its customers (including any time to collect Accounts receivable). To illustrate this concept, consider two companies described in Table 4.1.

Table 4 1

Getya drunk is a distiller of rotgut whiskey based in Fayette, MO. It is a small company with a hardcore following of dedicated customers. Sooper Dooper is a retailer based in nearby Columbia, MO. It is one of the largest companies in the world with retail stores located throughout the world. When Getya purchases supplies from its suppliers, it accepts the same terms that they offer all of their customers, namely thirty days. At the end of this credit period, Getya pays cash, starting its operating cycle. Getya’s product is concocted with an old family recipe that calls for it to be aged in a smelly boot for a decade. When the product is ready, Getya ships it to liquor stores (the kind with dirt floors and cinder block walls) who are extended thirty-day credit terms. The operating cycle ends when Getya receives cash from its customers. Sooper on the other hand is very powerful in vendor negotiations. It dictates favorable terms that include 180 day credit terms which begin when Sooper receives its merchandise. Inventory doesn’t sit very long at Sooper, on average only seven days and its customers pay cash when they leave the store. While the operations of these two organizations are very different (Getya has a ten year operating cycle while Sooper’s is a negative 173 days), they are both required by GAAP to produce an annual financial report enabling investors to compare the financial reports of the two companies.

Getya’s fiscal year corresponds with the calendar year while Sooper Dooper adopted a January 31 yearend. A fiscal yearend is selected based on industry standards. Retailers generally choose a January 31 yearend because a December 31 yearend would not allow them to capture the entire Christmas selling/return season. Even though financial reports can have different yearends, this does not materially damage comparability between different industries. What facilitates the comparability is the application of GAAP, including the Periodicity Assumption. Rules related to timing issues, or what period transactions are properly recorded in, are related to the Accrual Basis Assumption, the subject of this Chapter.

The Revenue Recognition and Matching Principles

Recall that in Chapter One (Table 1.2) we defined Revenues as inﬂows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations while Expenses were defined as outﬂows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. All of the adjusting and accrual transactions introduced in Chapter Four will relate to either the Revenue Recognition or Matching Principles.

Recording Adjusting and Accrual Transactions

The spreadsheet workbook used in this Chapter is available on Google Docs at https://spreadsheets.google.com/spreadsheet/ccc?key=0AgmH5rG6dzTmdGhwSE1HMjdEbzRXamc2UFZvbjlISVE&hl=en_US. The companion YouTube lecture is available at http://www.youtube.com/watch?v=YdDKBZFEv0g. Please replicate the work demonstrated in this Chapter using paper and pencil, on columnar paper[2]. Use the proper form you learned in Chapter Three! Record transactions in the General Journal then post them to the General Ledger. This Chapter will cover the identification, analysis and recording of transactions in their proper period according to the Revenue Recognition Principle and Matching Principle.

Adjusting Balances and the Roll Forward: Accountant’s Toolbox Tables 4.2 and 4.3

This YouTube video details a handy tool for calculating the adjusting journal entry balance that is required to state balance sheet accounts at their correct balance http://www.youtube.com/watch?v=c24kcO3L8Sc . This approach is based on the assumption that the beginning balance is correct and all of the transactions related to the account in question have been recorded properly during the period. If these assumptions are correct, and the calculation of the ending balance is correct then the adjusting entry will record the related revenue or expense in the proper period. In the real world, this approach, called the “Balance Sheet approach” doesn’t always work because the data is not always complete. However, in your academic work the Balance Sheet approach works great. It is especially handy when you have a question that requires you to work backwards (you are given an ending balance and need to calculate the adjusting entry). This tool comes in handy when you are provided with the unadjusted ending balance.

Table 4 2

A variation of this tool is the accounting roll forward, presented in the following YouTube video http://www.youtube.com/watch?v=MBtyiJE_PTU. You have already used this same “tool” when you learned the Statement of Retained Earnings in Chapter Two. Learning to use standard tools is an important step in learning the language of a paradigm, in this case, the language of financial accounting. Throughout this textbook I will refer to these standardized tools and demonstrate how to use them on a variety of subject areas. For an example of how this tool is used in financial markets, Google “Net Subscriber Additions” to see how closely analysts track this “KPI” (Key Performance Indicator) in the telecom industry.

Table 4 3

Expiring Assets

In Chapter Three you learned in journal entries #1 through #5 how to record the acquisition of assets that will benefit Lizzie Inc. in future periods. If any portions of these assets expire in the current period, then the asset balance must be reduced with a credit and a corresponding debit to an expense account. Examples of expiring assets include: Inventory that has been sold, Supplies that have been used, Prepaid insurance premiums that have expired and Equipment that was used in the period. All of these expired assets helped generate Revenue in the period and therefore must be MATCHED against the Revenue on the Income Statement. Lizzie Incorporated had three different assets that expired in the period.

Please prepare a roll forward worksheet for Lizzie Inc.’s Inventory. Since this was the company’s first year of operations, the beginning balance was $0. During the year (June 30) it purchased $18,839, its only purchase of the year. Therefore, the Cost of Goods Available for Sale during 2010 was $18,839, which is also the General Ledger balance before adjustment. At yearend, Lizzie Inc. determined that no inventory remained. Using the roll forward we can see that the Cost of Goods Sold was $18,839.

Table 4 4

Lizzie's equipment that she purchased on July 1 was used for 6 months helping her generate revenue. Therefore, a portion of this asset expired in the period. The term to describe the expiration of fixed assets is depreciation. Unlike other assets, the fixed asset account balance is not directly adjusted. It will remain at its historical cost until the asset is disposed of. To reduce the net[3] book value of the asset to its proper balance, a contra-asset account, Accumulated depreciation, is used. We will study different GAAP depreciation methodologies later in this text. For now, I will provide you with the Depreciation expense for the period of $580.

Table 4 5

Recall that on July 1 (je #5) Lizzie Inc. purchased a one-year insurance policy. The company properly recorded this as an asset because when purchased, the policy was going to benefit future periods. Prepare a roll forward for this insurance policy. The beginning balance (Jan 1) was $0, the one-year policy was purchased on July 1 (addition) and the proper balance in the Prepaid insurance account at yearend should be $375, ($750 * 6/12).

Table 4 6

Failure to record this type of adjusting entry will result in Assets and Owners’ Equity being overstated at yearend.

Expiring Liabilities

Liabilities that expire in the period require the account balance to be reduced by debiting the account with a corresponding credit to a revenue account. Lizzie Inc. did not have any liabilities expire in the example, so I am creating a scenario that is NOT in the Google Docs worksheet[4]. For illustration sake, lets assume that on November 1, 2010, Lizzie Incorporated received a $500 deposit from its customer for the future delivery of product. According the terms of the sales contract, Lizzie Inc. must return the Cash if it does not deliver the goods. This transaction would have resulted in an increase in Cash (debit) and an increase in Unearned revenue, a current liability (credit). The balance in Unearned revenue at December 31 would be $500 before adjustment. When it closed its books, the company determined that it had in fact shipped the product required under the sales contract and therefore, the proper balance in Unearned revenue should be $0. The appropriate entry in this case would be to decrease the current liability by debiting it and a corresponding entry to Sales (credit).

Failure to record this type of adjustment will result in overstated Liabilities and understated Owners’ Equity.

Accruing Assets

Accruing is a legal term used in financial accounting to describe the arising of a legal claim. In this case, Lizzie Inc. recognizes a new claim on an asset that arose in the period. When closing the books at yearend, the accountant of Lizzie Inc. realized that the company had shipped some product to a customer, but she had not yet prepared the invoice. Even though the invoice has not yet been sent to the customer, Lizzie Inc. has a legal claim for money that it is owed… an Account receivable. In some cases a company may wish to set up a separate Unbilled accounts receivable account, in this case we will use the regular old Accounts receivable.

Table 4 7

Failure to record this type of accrual will result in both Assets and Owners’ Equity being understated.

Accruing Liabilities

Recall that on July 1 (je #4), Lizzie Inc. sold its Note payable with a face value of $20,000 and a term of two years. Even though the first interest payment is not due for another six months, Lizzie Inc. has a legal obligation that has arisen over the last six months of 2010 that it needs to record. Using your business math skills you calculate the liability to be $1,000 at December 31(P*R*T $20,000*10%*(6/12)=$1,000).

Table 4 8

Failure to record this type of accrual will result in understated Liabilities and overstated Owners’ Equity.

Accounting in the Real World: Accrual and Adjusting Entry Closing Checklist

In order to ensure that all possible types of adjusting and accrual entries are recorded, it is a good idea to work from a checklist so that no material entries are overlooked. This is not an exhaustive checklist, but it will give you a good idea of the types of adjusting and accrual entries that we will cover in Financial Accounting 1.

1. Expiring Assets

a. Prepaid expenses (including insurance, rent, etc)

b. Inventory

c. Supplies

d. Equipment (depreciation)

e. Accounts receivable (allowance for doubtful accounts)

f. Bonds or Notes receivable (premium of discount)

2. Expiring Liabilities

a. Unearned revenue

b. Bonds or Notes payable (premium or discount)

3. Accruing Assets

a. Accounts receivable (services or goods provided but not yet billed)

b. Interest receivable

4. Accruing Liabilities

a. Interest payable

b. Goods and services received but not yet invoiced (utility bills, etc)

c. Legal claims from civil suits, whether a lawsuit has been filed or not

d. Wages earned by employees but not yet paid or recorded in Wages payable (earnings since last payroll before period end)

This checklist is part of an accounting system that helps people work in a consistent manner every period. This consistency promotes comparability between periods and is one of the enhancing qualities of useful information described in Chapter Two.

Kuhn Paradigm Science… The Importance of PRACTICE

This section is a repeat from Chapter Three, but it is important for you to understand what is required of you to learn this material. Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm. The framework is the foundation upon which the community is built, providing its rules for communication and social interaction. Without the framework the community does not exist. Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product. Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.

What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm. Practice the work in Chapter Four at least three full times using the same numbers. Work through an entire accounting cycle, from the General Journal through to financial statement presentation. Compare the financial statements for Lizzie Incorporated that you prepared in Chapter Three to the statements you prepare in Chapter Four. Ponder how the revenue recognition and matching principles changed what these financial statements are communicating.

Next, experiment with different types of adjusting and accrual entries. Try to do entries that are listed in the checklist. Compare financial statements (with your changes) to understand the impact of various decisions. This chapter is instrumental in learning accounting, if you practice hard, the remainder of this course will be easy!

[1] The SEC requires quarterly financial reports and organizations customarily close their books at the end of each month.

[2] http://www.printablepaper.net/category/columnar

[3] “Net” in Financial Accounting means combining or offsetting different accounts. For example, Net Income combines revenues and expenses.

[4] I am too lazy to update the video… I will get to it later and add the Unearned revenue transaction.

Chapter 3 Analyzing and Recording Transactions

2011-06-05T13:12:00.000-07:00

Chapter 3

Measuring Wealth

In Chapters One and Two you studied why financial accounting is an important component of our financial market. Without standardized financial reporting in accordance with rules issued by an authoritative body (FASB), investors would have a difficult time comparing competing financial instruments (IOU’s), and markets would be less efficient. In the next two chapters you begin to investigate what information financial accounting is designed to record and report in a standardized format. At the dawn of the Industrial Revolution, Adam Smith observed and painstakingly documented a phenomenon with empirical evidence gathered though observation and quantitative data analysis. His findings were the basis for a new scientific paradigm devoted to studying England’s new economic culture. Wherever you live, Smith’s words from 1776 are still relevant to you today. Please read: Volume One Introduction and Plan of the Work and Book I, Chapter I Of the Division of Labor http://www.econlib.org/library/Smith/smWN.html. This reading should take no more than 30 minutes, that is if you are able to stop…

In Chapter One, you studied the “invisible hand” that moves the economy. Adam Smith described the economy’s change in focus from King and country to the motivation of each individual citizen. Whereas Socrates described the economic benefit of teaching men to work for the greater good, Smith asserted that expecting a benevolent economic architect to create a greater good was an impossible and unrealistic dream. Smith observed that a rational man acting in his own self-interest produced the greatest amount of wealth. Through specialization and division of labor, each man becomes more productive by deciding for himself how best to spend his time. In short, the paradigm can be described as thinking small, concentrating on the individual desires and motivation of men, in order to accomplish something grand, creating the greatest amount of wealth.

Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. (Smith, 1776, Book 1, Chapter II, Paragraph 2)

The idea to provide ALL men with the knowledge and freedom to act in their own best interest was revolutionary and represented the destruction of the previous “top-down” economic paradigm and is the philosophical basis of our free market economy.

In order to protect and promote a free market economy, Smith proclaimed that the role of government should be limited to only three types of activities each of which supports the individual; defense from foreign threats, domestic police and civil court systems and providing services to individuals that the market cannot provide due to market failure (Smith, 1776). This does not mean he was for limited government, to the contrary, he strongly advocated for competent government where it was needed to support the individual, enabling him to act rationally in his best interest to facilitate a free market. If government does not provide services to the citizenry that they cannot provide for themselves because of market failure, then a free market economy cannot be achieved. Smith proclaimed public education to be an example of an indispensible government service.

The institutions for instruction are of two kinds: those for the education of youth, and those for the instruction of people of all ages (Smith, 1776, Book V, Chapter I, Paragraph 70).

Loudly demeaning necessary public services like education or Social Security as “socialism,” a dirty word in 21^st century American politics, is the tool of a demagogue who in fact seeks to diminish the ability of America to achieve a free market.

In Chapter Two you studied how investors and borrowers have competing interests with regards to the money market. Each person desires to increase his wealth by trading in markets, including the money market. This tension is part of the invisible hand that creates more wealth in the economy. As evidence, Smith observed that an 18^th century English laborer had a higher standard of living than an African King who commanded 10,000 people in a non-industrialized economy[1]. I would like for you to discuss the following points with your classmates.

1. Is the theory of each man working in his own best interest the same theory competition for limited resources?

2. Does stealing (or ripping people off) lead to greater wealth in society?

3. Is it possible for mankind to work for the common good in a free market economy?

Defining Wealth

Since the self-interest of each person is to increase his or her wealth, it is worthwhile to define what wealth is, since that is what financial accounting is designed to record and report. The concept of wealth has been extensively chronicled throughout recorded history, yet it is not a universally descriptive term. To narrow the focus of this literature review I will begin by eliminating positive personal attributes that can be confused with wealth. What isn’t wealth is explained well by Socrates’ student Xenophon[2] in Oeconomicus, “Does this horse have wealth?” Socrates asks of a revered “noble animal”. The resounding answer from his fellow Athenians was NO (Xenophon, 362 BCE). Health, strength, intelligence, confidence, happiness, ability and the adoration of others are not wealth, though in the opinion of the author, they do not hinder a man who is attempting to acquire it.

This is very significant to financial accounting, because wealth is money and stuff that can be objectively measured by money, in financial accounting language, an asset. Money provides man a means of exchange that enables him to trade for things he needs as well as an ability to store wealth for future consumption. It is a man-made creation, the value of which is dependent on its acceptance by people and it represents a common language spoken throughout the world; and throughout recorded history, it is a good thing to have. Philosophers have proclaimed that wealth can encompass a far greater scope than merely money and the ability to consume, including happiness, a pleasant community, making a contribution to society, health and opportunities for children. However, the current economic paradigm defines it simply as assets minus liabilities (debts quantified in money), things “owned” minus things “owed.” Does this sound familiar? It should, it is the Accounting Equation, which describes the nature of the Balance Sheet, one of the four primary financial statements required by GAAP.

Money Aint Everything…

Attributes that are important to savers and investors, but are not easy to subjectively measure by financial accountants are ignored in financial reporting. Recall that in Table 2.1 you observed that investors valued things other than net assets. The importance of financial reporting to savers is also limited by the fact that it describes economic events that occurred in the past. Investors want to know what is going to happen in the future, and while past performance can help predict future performance, it is far from a perfect indicator.

Knowledge = Wealth

French economist Jean Baptiste Say[3] observed the notable phenomenon that wealth is a function of knowledge, early in the 19^th century.

Objects, however, cannot be created by human means; nor is the mass of matter, of which this globe consists, capable of increase or diminution. All that man can do is, to re-produce existing materials under another form, which may give them an utility they did not before possess, or merely enlarge one they may have before presented. So that, in fact, there is a creation, not of matter, but of utility; and this I call production of wealth (Book I, Chapter I, Paragraph 7).

Therefore, mankind only increases societal wealth by improving scientific knowledge of himself and his environment. Since financial accounting is designed to objectively measure an organization’s wealth, it would be beneficial to come up with a methodology that allowed savers and investors to evaluate an organizations knowledge and compare it to other organizations that may be operating in completely different industries. You see how complicated this is. Consider the pin company that Adam Smith described in Book I Chapter 1. By improving its knowledge of material science, manufacturing, machinery and people (the organization had to know that people needed more pins), the pin company increased individual productivity from 10 lousy pins a day to almost 5,000 inexpensive pins that were of high quality. How could I compare this very impressive bit of information to an iron foundry to determine which organization has a more favorable wealth (knowledge) position?

This brings us to the standardized financial statements that are part of GAAP financial reporting. These reports allow readers to compare an organizations wealth position over time as well as providing a basis to compare dissimilar organizations with a common albeit imperfect measuring tool.

Recording Transactions

The spreadsheets used in this chapter are available on Google Docs at https://spreadsheets.google.com/spreadsheet/ccc?key=0AgmH5rG6dzTmdHhEWVdZVDBtVEVwV1RKQ2JDQlZiVmc&hl=en_US#gid=0 . The companion YouTube lecture is available at http://www.youtube.com/watch?v=Ooibihp3QPo . Please replicate this work, using paper and pencil, on columnar paper[4]. The remainder of this Chapter will be dedicated to identifying and recording certain transactions in the accounting records. As you have already learned, not every event can be objectively measured with money, so in most cases this type of economic event will be ignored. Examples of extremely important events that are not recorded in the accounting records are:

1. Hiring a new employee may be one of the most important things a company does, however, until the employee actually works and earns wages, it is ignored in the accounting records. Is there any other place this transaction is recorded (think Human Resource records).

2. The company discovers a new scientific breakthrough. The research costs are recorded, but until the great idea translates into revenue, it is ignored.

3. Another company discovers a scientific breakthrough that renders the product of your company obsolete.

Step 1 Table 3.1 Chart of Accounts

Before beginning the accounting cycle for an organization, the accountant must define the organization’s Chart of Accounts. Recall that in Chapter One you memorized some typical accounts. Accounts will be used to classify transactions into buckets of information that can be accumulated and used create financial statements.

Notice that the Chart of Accounts does not have any numbers on it or a date. This is because it is the first accounting task that is completed, before any numbers can be recorded, and it is never complete. As an organization grows in complexity its information requirements change, necessitating new accounts. In computerized systems account numbers are used but in this textbook we will only use account names. These are the only places we can store accounting information so all journal entries must choose from accounts on the Chart of Accounts.

Step 2 Tables 3.2 and 3.3 General Journal and General Ledger

All transactions are entered into the General Journal (3.2) as journal entries, and then each journal entry is posted to the General Ledger (3.3).

Notice that neither the General Journal nor the General Ledger is dated. Both of these will be used as long as the organization requires accounting. The General Journal is the place where transactions are recorded and these are tracked by date and sequentially. The General Ledger has a T (Debits are the left side of the T and Credits the right side) account for each account listed in the Chart of Accounts. As journal entries are recorded, they are immediately posted to the General Ledger and referenced by date and by sequential General Journal number. Notice journal entry #1 from the General Journal is posted to the Dr. column for Cash ($100) while the Cr. column is posted to the Common Stock General Ledger account. This work must be done very precisely or your records will be corrupt. The good news is that computer software now does all of this for you. However, it is still important to understand how the software works so you can learn to analyze how different transactions will effect the financial statements.

Step 3 Identifying, Analyzing and Recording Transactions

Acquiring Assets with Common Stock Journal Entry # 1

Lizzie Incorporated received its approval from Secretary of State to create a corporation dedicated to selling toy mice[5]. Lizzie Incorporate is a separate entity from Lizzie the person, it must file a tax return, it can sue or be sued in a court of law, it can be indicted for a crime… about the only thing Lizzie Incorporated cannot do is vote in elections. The first activity of Lizzie Incorporated is to acquire some assets, so it creates a financial instrument (100 shares of common stock) and sell it in the marketplace. The only person who sees the potential of Lizzie Incorporated, is Lizzie the person, so she purchases all of the common stock for $100. Lizzie Incorporated’s Cash increases by $100 and its Common stock increases by $100. See Table 3.2 above for the for of this journal entry and Table 3.3 to see it posted to the Cash and Common Stock General Ledger T accounts. All journal entries will have their Debits = Credits. If we were to total up the General Ledger at this point, Lizzie’s Accounting Equation would be Assets (Cash $100) = Liabilities ($0) + Owner’s Equity (Common stock $100).

Acquiring Assets with Trade Debt Table 3.4

After six months of intensive research, Lizzie Incorporated devised a plan of what it wanted to sell and how it wanted to sell it. It located a vendor who would manufacture and sell it product with credit terms of net 60 days. Accounts payable is a form of trade debt and represents the most important type of financing for many small businesses. Lizzie places an order on June 30 for $18,839 and receives the merchandise on the same day. Lizzie’s Inventory increases by this amount and her Accounts payable increases by the same amount.

Post both sides of this journal entry to the General Ledger. After this transaction, Lizzie Incorporated’s Assets (Cash $100; Inventory $18,839) = Liabilities (Accounts payable $18,839) + Owner’s Equity (Common stock $100).

Borrowing Money (Selling an IOU) Table 3.5

Lizzie Incorporated needs to acquire some working capital to fund its operations, selling toy mice. It creates an IOU and finds a saver who is willing to purchase it for $20,000 on July 1. The terms of Lizzie Incorporated’s IOU are face amount, $20,000, term of 2 years, interest of 10% payable annually. This transaction increases Cash and Long-term Notes payable by $20,000.

How does this transaction effect Lizzie’s Accounting Equation? If the saver would have been willing to purchase 95% of the common stock (1,900 shares) for $20,000, what should the stockholder of Lizzie Incorporated have done? There is not a right or wrong answer here. Consider the upside of the company and the risk that debt brings to the organization. Post the transaction to the General Ledger.

Purchasing a Long-Term Asset with Cash Table 3.6

Lizzie Inc. is trading its most precious asset… cash, for equipment that will help it sell its product. The business plan calls for a handcart that will enable an employee to push it to a desirable location, and attractively display product. The handcart will be used for many years, and without it, Lizzie Inc. cannot sell its product.

How did this transaction affect the wealth of Lizzie Inc.? The Accounting Equation did not change in total; one asset went up while another went down. Cash is the most important asset because it is the lifeblood of a business, running out of it is fatal. On the other hand, Lizzie Inc. cannot transact business without sacrificing its cash.

Purchasing a Short-Term Asset with Cash Table 3.7

Lizzie Inc. purchases a one-year liability insurance policy with cash. Since the policy will benefit future periods, it is recorded as an asset rather than directly expensed as a period cost. If Lizzie Inc. had elected to pay the insurance premium monthly, the debit would have been to Insurance expense. Please take a look at this short video lecture on insurance http://www.youtube.com/watch?v=SvwINGDx-Z4 .

Notice how similar this transaction is to journal entry #4 (Table 3.6) above. Cash is sacrificed for an asset that will benefit future periods. As the asset expires, it is reduced

by crediting the account and debiting an expense account.

Settling a Portion of Accounts Payable with Cash Table 3.8

Recall that in transaction #2, Lizzie Inc. purchased inventory with trade credit. This vendor relationship is very important to Lizzie Inc. because if they become dissatisfied, they will not sell her any more products on credit. While Lizzie Inc. is the customer; it cannot treat its vendors like crap or it could threaten its business[6]. In this case, Lizzie Inc. is only paying a portion of the Accounts payable balance, but the vendor agreed to this arrangement since Lizzie Inc. is just starting out.

Cash goes down (credit) and Accounts payable goes down (debit). I put the credit entry first to show you that it does not matter what order you do your journal entries. Textbooks that make a big deal about the order of the lines in the journal entry are archaic and missing the point of the purpose of accounting. How does this transaction affect the Accounting equation? Does the transaction have any effect on Lizzie Inc.’s wealth?

Recording a Sale on Credit Table 3.9

Lizzie Incorporated made its first sale. Hooray, this is why it exists, to buy low and sell high! This is your first entry to an account that is used on the Income Statement.

How does this transaction affect the wealth of Lizzie Incorporated? You do not know the cost of the merchandise sold (yet) because Lizzie Incorporated uses a periodic inventory system, i.e. it adjusts inventory and records Cost of goods sold only one time at the end of the period. If she used a perpetual inventory system, it would record the Cost of goods sold (and reduce Inventory) every time it recorded a sale. What does the accounting system fail to capture in this transaction? What if Lizzie Inc. just established an important and profitable business relationship that will benefit the organization for years to come? Is this captured in the accounting records[7]?

Receipt of Cash to Settle Accounts Receivable Table 3.10

In this transaction, Lizzie Inc. trades one asset (Accounts receivable) for another very important asset… Cash.

The Accounting Equation is unchanged; one asset goes up while another goes down. Did Lizzie Inc. make a good trade in this transaction?

Adjusting the Periodic Inventory Table 3.11 and 3.12

At December 31, 2010, Lizzie Inc. performs a physical inventory and discovers that no product remains. In accounting language, there are no more assets (inventory) that will benefit a future period, therefore, the Inventory balance must be adjusted to zero with a corresponding entry to Cost of goods sold.

This “rollforward” should look familiar to you, go back to Chapter Two and see which financial statement uses the same approach. While you are at it, total up each General Ledger Account, then use the account totals to create a Trial Balance and then, Income Statement, Statement of Retained Earnings and Balance Sheet. Make sure to clearly differentiate your current and long-term assets and liabilities so the reader of the Balance Sheet can quickly wee the respective totals.

Total Each General Ledger Account Balance 3.13

Net the debits and credits and enter the balance on the correct side.

Kuhn Paradigm Science… The Importance of PRACTICE

What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm. Practice the work in Chapter Three at least three full times using the same numbers. Then experiment with changed to the entries and see how the financial statements are affected. Compare financial statements (with your changes) to understand the impact of various decisions. What if Lizzie Inc. only sold stock instead of borrowing money? How would the financials change if Lizzie paid Cash for everything? This chapter is instrumental in learning accounting, if you practice hard, the remainder of this course will be easy!

[1] Smith actually referred to “savages,” which sounds kind of stupid, but in Book I Chapter 2 Paragraph 4 you get a better indication of his belief in the equality of all men.

[2] Xenophon’s writings inspired The Warriors, http://www.youtube.com/watch?v=SXmPH2nTcac, perhaps the greatest American film ever produced. There really are NO new stories to tell.

[3] A treatise on Political Economy: Or, The Production, Distribution and Consumption of Wealth can be investigated here: http://www.econlib.org/library/Say/sayT.html

[4] http://www.printablepaper.net/category/columnar

[5] Lizzie is a cat

[6] In my experience, customers who are the biggest pains in the ass are not worth the trouble. They bitch about price, return broken product, pay late and eventually, they will go bankrupt. Send them to you competitor.

[7] W. Edwards Deming is an important contemporary philosopher who urged business leaders to think in terms of systems, not to be constrained by the accounting paradigm. Many successful businesses concentrate on only a few customer and vendor relationships.

Chapter 2 Financial Reporting

2011-05-30T17:33:00.000-07:00

Chapter 2

Money Market

Lets begin with the kindergartner’s explanation. A market is a place where buyers and sellers meet to trade. When a person needs food, he goes to the supermarket to purchase groceries (trading money for products); hence he is a “consumer” or “buyer.” A farmer produces food and sells it to the supermarket; hence he is a “producer” or “seller.” Your friendly grocer is an intermediary (middleman) who provides a valuable service for which he is compensated. Without the supermarket it would be a terrible hassle to visit a ranch to buy beef, a baker to buy bread, etc. A common name for our money market (there is only 1 market for the world) is “Wall Street”, and it serves the same basic function as your local grocery store.

A person who has too much money, more than he or she can spend immediately, needs to save it for future use. He is called a “saver,” “lender” or “investor.” This individual is motivated by self-interest to get the best deal possible. This means selecting the financial instrument (from all that are available) with the least risk and highest returns on investment. A person who needs money (a “borrower”) must create an IOU (financial instrument) with terms that may include interest and promises to keep the money as safe as possible. The borrower must fashion his IOU to be more attractive to investors than his competition, the IOU’s of other borrower. However, the self-interest of the borrower is to provide the least security along with the lowest returns, exactly the opposite of the interest of the lender. Savers and borrowers can use an intermediary, like a bank, or they can deal directly with one another. In any case, the philosophy of a money market is simple… people trade money for financial instruments (IOU’s). Since an IOU is not tangible, the money market requires faith in order to operate. If savers lose confidence in markets, they will refuse to purchase IOU’s and the economy will grind to a screeching halt.

The competing self-interests of savers and borrowers creates two basic problems:

1. How can savers compare competing IOU’s on a basis that enables them to select the best one (i.e. apples to apples)?

2. How can borrowers be prevented from lying?

The answer to both of these questions is that an imperfect quilt of public laws and regulatory bodies coupled with private organizations and “market forces” attempt to create a level playing field for the money market. This course deals with one significant portion of the patchwork; the rules surrounding the preparation and presentation of financial statements. The Financial Accounting Standards Board (FASB”) describes itself as follows:

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities. Those standards are officially recognized as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are important to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, and understandable financial information.[1]

In short, the Securities and Exchange Commission[2] (“SEC”), the U.S. government’s financial market regulatory body, and the American Institute of Certified Public Accountants[3] (“AICPA”), the professional association of U.S. Certified Public Accountants, both follow FASB pronouncements as authoritative, i.e. accounting law. This textbook is primarily dedicated to teaching you the language and mechanics of GAAP.

If a borrower wishes to sell an IOU to the general public, the SEC will likely have regulatory authority (there are some exemptions) and may require a financial statement audit by a licensed CPA to attest that the statements are materially correct under Generally Accepted Accounting Rules (“GAAP”) as proclaimed by the FASB. Even if a borrower wishes to enter into a private transaction that is not governed by SEC rules, it is likely that the investor will demand audited financial statements in accordance with GAAP. This is a pretty sweet deal for the CPA profession. If a borrower wants access to money markets for anything other than routine personal business (home mortgage, credit card or student loan), they will probably need to hire a CPA. Please consider and discuss these issues with your classmates:

1. Who benefits from the work of the FASB?

2. What are the benefits of the FASB being a private organization? Would the FASB produce different work if it were part of our democratic government?

3. Should FASB expand its role by setting standards on information other than financial accounting?

There are no right and wrong answers to these questions. Please consider both sides of every argument as well as possible unintended consequences of any changes to the current financial accounting paradigm.

The Limited Importance of GAAP Financial Statements: Table 2.1

While financial reports (which include financial statements) are important, they are certainly not the only source of relevant information for investors comparing competing financial instruments issued by different companies. In some cases, one may conclude that other than the price of admission to access public financial markets, they are relatively insignificant when compared to the universe of other available information. In the following table you can see a comparable financial instrument (common stock), across various companies, compared to their net assets (assets-liabilities) and tangible net assets (assets-intangible assets-liabilities) in accordance with GAAP.

If GAAP financial statements were the only relevant variable that investors considered, then all companies would receive the same relative price for their common stock (e.g. price/earnings ration or market cap/net assets ratio). As you can see in this table, the financial market values accounting assets quite differently. The market values every $1 of net tangible assets of Exxon Mobile at $2.77 while $1 of Apple, Inc’s net tangible assets is valued at $6.64. Both Apple and Exxon are required to account for their assets using the same rules.

Apparently the market considers factors other than GAAP financial statements when valuing common stock. In some cases factors such as exponential forecasted growth or decline, major technological changes (Kondratieff Waves) or environmental factors can turn financial reports into useless “noise.” However, these incidents would be exceptions to normal day-to-day business operations. In the normal course of business, Generally Accepted Accounting Principles creates a common language that facilitates an efficient money market. Consider the analysis presented in Table 2.1. All of the numbers in this table were pulled from financial reports prepared in accordance with GAAP. Furthermore, the financial reports were audited by a Certified Public Accountant and received unqualified opinions (clean audit opinions). This enables us to make an apples to apples comparison between companies from any industry.

Both tangible and intangible assets were presented in Table 2.1 for the reader to consider. Tangible assets are items that an organization generally purchases for money that have physical matter (desk, chair, computer, etc.) while an intangible asset generally is something without physical matter that is purchased by a company for money (patent, non-compete agreement, customer list, etc.). An intangible that a company develops on its own, for example the trademark Coca Cola, has no value on The Coca Cola Company’s books. But, if Coca Cola Company purchased the trademark for Mountain Dew, it would record the intangible asset at its purchase price (Historical Cost Principle). The largest intangible asset on General Motors’ balance sheet is Goodwill, an intangible asset that is created in when one company purchases another and pays more than the price of the tangible and identifiable intangible assets. We will not study the specifics of goodwill in this text; it is a subject for an advanced accounting text. I highlight it to make a point about how FASB creates rules. While the members of the FASB are just like you and I, fallible human beings, they are guided by declared Assumptions, Principles and Constraints[1]. All rules must comply with these guiding declarations… unless of course a declaration gets in the way of something the FASB or its constituents (SEC and AICPA) want to do. This is what happened with the rules surrounding accounting for Goodwill. Goodwill, unlike almost every other asset is not accounted for using the Historic Cost Principle, instead the FASB adopted a new approach, the Fair Value Principle.
In this textbook I will take a different approach to teaching the FASB Concepts Statements and FASB’s Assumptions, Principles and Constraints. Rather than teaching them as a separate subject area, I will present them as they relate to a subject area that I am teaching, a markedly different approach from most textbooks.

Kuhn: Normal Science

Paradigms create boundaries that restrict the thoughts of its members. In effect, people are forced to think within the framework in order to function in their community. For example, a chemist must communicate with his colleagues using the language of the imperfect Periodic Table of Elements. Kuhn (1996) concedes that this is a limitation imposed by paradigms, but he argues the benefits outweigh the limitations.

Ought we conclude from the frequency with which such instrumental commitments prove misleading that science should abandon standard tests and standards instruments? That would result in an inconceivable method of research. Paradigm procedures and applications are as necessary to science as paradigm laws and theories, and they have the same effects. Inevitably they restrict the phenomenological field accessible for scientific investigation in a given time (p. 60).

The words “in a given time” are profound for if a given paradigm is not replaced by an improved paradigm, it is a sign that scientific advancement has stopped. But abandoning a paradigm because it has problems in the hope that a better one will eventually come along is nonsensical because it is the knowledge gained in the current paradigm that leads to scientific revolution and paradigm replacement.

Once the paradigm is established, advancement within the paradigm occurs through experimentation and refinement that Kuhn calls “Normal Science.” In science, the paradigm creates a language and boundaries that enable its practitioners to apply its principles to different real world scenarios and communicate findings. For example, in the early 1950’s, Watson and Crick, both of whom were accomplished molecular biologists, discovered the double helix structure of DNA while performing Normal Science in the field of molecular biology. Within 50 years, using the language created by Watson and Crick to describe their new scientific paradigm (A:T C:G), genetic scientists were able to map the human genome, a scientific breakthrough that could change the future of mankind. Please read Chapter Three of The Structure of Scientific Revolutions to investigate how Kuhn describes Normal Science. The purpose of this textbook is to help you learn the language and rules of the financial accounting paradigm so you can become an accounting scientist, or at a minimum, understand what financial accountants are telling you.

Financial Statements: Communicating With Standardized Language

Recall the U.S. Census Department sponsored survey regarding worklife earnings http://preview.tinyurl.com/3hlvzue presented in Chapter One. A major weaknesses that you may have identified in this report is that its dependent variable[5], Synthetic Worklife Earnings, is a future estimate based on historic information. Furthermore, the categorization of the independent variables may cause the reader to make an incorrect decision based on the report (“If I earn a Juris Doctor degree from Podunk U., I am going to be rich”). Even though this report was subjected to peer review, its research design and final report were not based on a standard set of rules issued by an authoritative[6] body. If a reader wished to compare this report to any other report correlating educational achievement to future earning power, he or she would need to study the methodology and definitions used in both reports, then decide the best way to reconcile the reported findings. As more reports were read, the complexity of this task would grow exponentially. The FASB (or International Accounting Standards Board[7] “IASB”) attempt to solve this incompatible information problem so savers can easily make apples to apples comparisons on certain tightly defined variables.

FASB declared the following:

OB2. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit[8]

Therefore, the financial reporting is designed with the ultimate user of the information in mind, the saver or investor. With standardized financial reporting the readers of the financial statements can easily compare companies from different industries. While Arch Coal and Google are very different organizations, they both produce comparable financial reports that are subject to the same rules. As a result, investors can more easily decide whose IOU they want to take a chance on. Imagine how complicated this task would be for savers if each borrower invented its own reporting terminology and methodology.

You should have already memorized a good deal of the financial accounting language that we will use throughout the rest of this textbook. If not, you should now be convinced why this is so important, so if you are not yet proficient, please redouble your efforts. Before you begin to apply this new language, you must adopt the financial accounting mindset. For the remainder of this class, please restrict yourself to the language of the paradigm when discussing (or thinking about) financial accounting. Specifically, use the memorized terms properly, i.e. do not say “cost” when you mean “expense”, and do not use colloquial language like “making money” which has no meaning in financial accounting. Language is important and it is how you identify yourself as a serious member of a scientific community. Refrain from making absolute statements. For example, instead of saying “it is” and use “it appears,” and when possible quantify your observations; stating that Net sales increased by 25% from 2010 to 2011 is much more precise than declaring that Company X’s sales are “growing like crazy.”

Preparing Financial Statements

In this section you will learn how to create the Income Statement, Statement of Retained Earning and the Balance Sheet. These three statements are required components of GAAP financial reporting. A financial report will include the Statement of Cash Flows, which you will learn later in this text, along with other required disclosures (full disclosure principle) that are referred to as Notes to Financial Statements, which we will only discuss lightly in this text[9]. A financial report must include all of the required components or it is invalid. It is not acceptable to merely present one or two items, for example, an Income Statement and Balance Sheet. An incomplete financial report could mislead a reader; therefore, they are prohibited by GAAP.

All of the spreadsheets used in this Chapter are available in Google Docs (https://docs.google.com/templates?view=public&authorId=16126875423278426092). You will need to register for a free account to use the spreadsheets. The following is a YouTube companion lecture to this textbook http://www.youtube.com/watch?v=LsOGkKbZvlg. The steps we will follow for preparing financial statements are as follows:

1. Prepare a Trial Balance as of the last day of the period.

2. Prepare the Income Statement (Revenues and Expenses) for the entire period.

3. Prepare the Statement of Retained Earnings for the entire period (Beginning Retained Earnings and Dividends).

4. Prepare the Balance Sheet as of the last day of the period (Assets, Liabilities and Paid in Capital accounts).

Step 1: The List of Accounts

Time to begin putting your memorization skills to the test. Please copy the following list of accounts onto green bar paper, exactly the way you see it here. Please make sure to carefully copy the numbers and agree your total to the total in the book. Next, fill in the “Account Type” column based on you memorization of terminology in Chapter 1. You are doing an after the fact Chart of Accounts, generally you would have set up the accounts and account types before any transactions were entered into your accounting system, but we are doing this because we are jumping to the financial statements before we learn to analyze transactions.

Table 2.2 List of Accounts

If you need to refer back to Chapter One to determine the proper account type, then this is an indication that your memorization needs work. The next step is to categorize the balance in each account as either a Debit or Credit. The accounts included here are for the legal entity of Lizzie Incorporated and are not comingled with any other entity (the owner). It is further assumed that we are using the monetary unit of U.S. Dollars as the unit of measurement; things that cannot be measured in Dollars are not in the financial statements. Furthermore, it is assumed unless otherwise stated, that Lizzie Incorporated is a going concern and is not expected to go out of business before it can realize its assets in the normal course of business.

Table 2.3 Trial Balance

Copy the format of the Trial Balance onto a fresh sheet of green bar columnar paper. Categorize the accounts based on your previous memorization work. We always start with a trial balance because if our debits and credits do not equal, then there is a problem with our accounting records and we should not even attempt to create financial statements.

After you match the balance in Table 2.3, you are ready to create your first three financial statements. Make sure you have three sheets of columnar paper available, accountants hat it when you put two financial statements on the same sheet of paper! As you use an account on the Trial Balance, put a check mark next to it. Each account will be used only one time on the financial statements and all accounts will be used.

Table 2.4 Income Statement

Pay special attention to the heading of each financial statement. This tells the reader exactly what they are looking at and frees you from the responsibility of explaining your methodology and the definitions of your variables. Copy the format of this table onto your columnar paper and attempt to bring over the necessary accounts on your own. When you are done, compare your work to the table before going to the next statement.

Notice the date on this statement. It tells the reader of the statement that it covers a period of one year, from January 1 through December 31, 2010. If you merely wrote, “As of 12/31/2010”, the reader of the statement would have no way to know what period it covered.

Table 2.5 statement of Retained Earnings

This statement (as well as the Statement of Cash Flows) must cover the same period as the Income Statement. Beginning Retained Earnings and Dividends come from the Trial Balance (zero balance) while Net Income is from the Income Statement. How would the financial statements have been effected if dividends had been declared and paid during 2010?

Table 2.6 Balance Sheet

Finally, prepare the Balance Sheet using the above guide. Notice the date is as of the last day of the period. This is because the Balance Sheet represents only a snapshot in time, not all activity over the period (i.e. the Cash is the balance at Midnight on 12/31/2010). Notice that we made it easy for the reader to identify both current and long-term assets and liabilities.

Please practice this problem over and over until you can complete it in less than 15 minutes. It is very simple, but this is the foundation of your knowledge base and you must be able to complete this work without thinking about it too much

Qualities of Useful Information

The following is a direct quote from FASB’s Statement of Financial Accounting Concepts No. 2.

Relevance and reliability are the two primary qualities that make accounting information useful for decision making. Subject to constraints imposed by cost and materiality, increased relevance and increased reliability are the characteristics that make information a more desirable commodity—that is, one useful in making decisions. If either of those qualities is completely missing, the information will not be useful. Though, ideally, the choice of an accounting alternative should produce information that is both more reliable and more relevant, it may be necessary to sacriﬁce some of one quality for a gain in another.

To be relevant, information must be timely and it must have predictive value or feedback value or both. To be reliable, information must have representational faithfulness and it must be veriﬁable and neutral. Comparability, which includes consistency, is a secondary quality that interacts with relevance and reliability to contribute to the usefulness of information. Two constraints are included in the hierarchy, both primarily quantitative in character. Information can be useful and yet be too costly to justify providing it. To be useful and worth providing, the beneﬁts of information should exceed its cost. All of the qualities of information shown are subject to a materiality threshold, and that is also shown as a constraint.[10]

GLOSSARY OF TERMS (Statement of Financial Accounting Concepts No. 2

Qualitative Characteristics of Accounting Information)

Bias

Bias in measurement is the tendency of a measure to fall more often on one side than the other of what is represents instead of being equally likely to fall on either side. Bias in accounting measures means a tendency to be consistently too high or too low.

Comparability

The quality of information that enables users to identify similarities in and differences between two sets of economic phenomena.

Completeness

The inclusion in reported information of everything material that is necessary for faithful representation of the relevant phenomena.

Conservatism

A prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered.

Consistency

Conformity from period to period with unchanging policies and procedures.

Feedback Value

The quality of information that enables users to conﬁrm or correct prior expectations.

Materiality

The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or inﬂuenced by the omission or misstatement.

Neutrality

Absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior.

Predictive Value

The quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events.

Relevance

The capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to conﬁrm or correct prior expectations.

Reliability

The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent.

Representational Faithfulness

Correspondence or agreement between a measure or description and the phenomenon that it purports to represent (sometimes called validity).

Timeliness

Having information available to a decision maker before it loses its capacity to inﬂuence decisions.

Understandability

The quality of information that enables users to perceive its significance.

Veriﬁability

The ability through consensus among measurers to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias.

[1] Retrieved from http://www.fasb.org/facts/index.shtml#structure on May 28, 2011.

[2] http://www.sec.gov/about/whatwedo.shtml

[3] http://www.aicpa.org/About/Pages/About.aspx

[4] See http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156317989

[5] This is a great definition of variables in scientific study from the U.S. Department of Education’s website http://nces.ed.gov/nceskids/help/user_guide/graph/variables.asp

[6]1. Able to be trusted as being accurate or true; reliable: "clear, authoritative information".

2. (of a text) Considered to be the best of its kind and unlikely to be improved upon

[7] http://www.ifrs.org/Home.htm

[8] Statement of Financial Accounting Concepts No. 8

[9] The Statement of Comprehensive Income will be covered in Intermediate Accounting.

[10] http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820900526&blobheader=application%2Fpdf

Chapter 1 Introduction to Financial Accounting

2011-05-26T17:31:00.000-07:00

Chapter 1

Welcome to Accounting 1

Before we dive into the mechanics of accounting, the debits and credits, journal entries and financial statements that will dominate your life this semester, we are going to investigate how financial accounting fits into our culture. I am taking this approach to counter what I consider to be a fundamental flaw with many college level accounting and finance textbooks that focus almost exclusively on financial accounting mechanics and are supplemented with a plethora of glossy photos and irrelevant “feature stories” that provide students little guidance in understanding the context of their academic work. The drawback to this method of teaching accounting is that students learn which buttons to push on their calculator and in what order… without knowing why. Another motivation was to battle with what I consider to be outrageous pricing of textbooks used in American higher education. There is little competition in the accounting textbook market and unsurprisingly, all of the books I reviewed retail for roughly the same price… what a coincidence.

Culture: The Role of Education

Culture is an integrated pattern of human knowledge, belief, and behavior that depends upon the capacity for symbolic thought and social learning. You have been a student of our culture since your birth and your learning will continue until you die. Without culture, man is a pointing/grunting Cro-Magnon hunter-gatherer. We have a few examples of children who have been abandoned and raised by animals in the wild (feral children) and while Hollywood portrays the “unspoiled human” (Tarzan, Mowgli, Simba… ok Simba was a lion) as a romanticized super-human, unfortunately, real feral children (it really does happen) are tragic consequences of social failure. If you are reading this, you are not a feral child, but if you are ignorant of a key aspect of our culture sometimes you may feel like one. This book is designed to introduce you to the culture of commerce and economy, an important component of our shared culture.

Some aspects of your culture are unique, for example, some of you attend church on Sunday while others of you are avid fans of Dance of the Cossacks (http://preview.tinyurl.com/2dokt86). This textbook describes components of a common culture shared by all people; you cannot opt out of it unless you want to live alone in a shack in the woods. Every mechanical accounting topic covered in this textbook will be discussed in context of our culture, which makes it unique. If you want to know why you are being asked to learn this academic material, then hopefully this book will help you discover the role of accounting in our society.

Epistemology

“Whoever is searching for the human being first must find the lantern” Nietzsche

Human knowledge is constructed by an individual’s perception and social experience. The theory of human knowledge, known as epistemology, encompasses the following five questions:

1. What is knowledge?

2. How is knowledge acquired?

3. What do people know?

4. How do we know what we know?

5. Why do we know what we know?

These questions outline a framework that enables the study of human knowledge. A paradigm is a framework, or set of rules and boundaries for knowledge. Without a framework, man is ineffective and must question everything, hence, he knows nothing. Paradigms can be viewed as the structure of society… the culture and accepted norms that enable man to stand on the shoulders of those who came before him. Absent a paradigm, man is alone, lacking rules for interacting with others and having to learn and understand everything on his own resulting in an absence of societal structure. Therefore, even paradigms that are greatly flawed have value to mankind. Understanding how paradigms are established and how they are destroyed and replaced by new ones will help you understand why you are studying accounting.

Paradigm Science

This textbook is presented through the lens of Thomas S. Kuhn’s The Structure of Scientific Revolutions. This link has a couple of its chapters online http://www.marxists.org/reference/subject/philosophy/works/us/kuhn.htm, but I am requiring you to purchase the book (used copies on Amazon are $2). I will be assigning sections for study and analysis and I will adopt Kuhn’s terminology when describing the different paradigms that are investigated in this course including the financial market paradigm, banking paradigm, accounting paradigm, and others. Do a little investigating of your own on Kuhn. I consider him to be the most important philosopher since the Age of Enlightenment, but you are going to have to discover him for yourself.

Kuhn recognized the role of paradigms in epistemology by observing that social scientists many times couldn’t agree on “the” question, let alone the method of scientifically finding an answer to “the” question, while natural scientists did not have this problem. Yet he knew that based on history and his knowledge of the natural sciences, the answers from the natural scientists were no more absolute and permanent than were the answers of the social scientists. New physical science discoveries can invalidate previously accepted “facts.” For example, if man discovered that the interior of the moon contained an advanced civilization of lizard people, much of what he thought that he knew, including the paradigms governing many of our natural sciences would be proven wrong. However, even if lizard people are not discovered, it is certain that many if not all natural science paradigms are imperfect and will be replaced as knowledge improves. Through examination of historic natural science paradigm changes, Kuhn attempts to prove the importance of paradigms, even ones that are incomplete, in advancing man’s knowledge of the world around him. For example, the periodic table of elements provides scientists a paradigm that facilitates study of the nature of chemicals. However, scientists are aware of flaws and limitations in the paradigm and someday, it will be replaced with an improved paradigm, relegating the ubiquitous colorful poster that adorns science classrooms around the world to the trash bin of history. In the meantime it is an invaluable tool that facilitates the dissemination of knowledge throughout the world. While Kuhn primarily addresses natural science paradigms, he points out that a paradigm’s relationship to epistemology is the same for all human knowledge, natural (hard) science and social (soft) science. In fact, Kuhn demonstrates that the concept of hard and soft science is a fallacy because human knowledge is not absolute in any scientific discipline and mankind must endeavor to continually improve his knowledge.

This textbook is designed to help you learn the structure of the financial accounting paradigm and its place in our culture. The paradigm is flawed, some would say greatly. However, it is the best one we have and it you want to be have a voice in discovering and creating a better paradigm; you must be an expert in the existing paradigm. Your goal should be to learn its structure, including its rules and language, as well as its limitations and flaws.

Why This Course Matters

The vast majority of students who enroll in this course do so to improve their future earning power. If this describes why you are taking the course… good on you, mate! When I took this course at the University of Missouri, if you asked me why I was taking a class in accounting I probably would have answered: “because it is required.” There is no need to feel ashamed for looking out for your own best interest, after all, that is the “invisible hand” that drives the economy. Before going further, please visit http://www.econlib.org/library/Smith/smWN.html and read Book I, Chapter 2, Paragraph 2 from Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations. Does Smith’s observation that “an invisible hand” drives the economy mean selfish behavior by all people improves overall national wealth? If an individual steals from his neighbors, isn’t he acting in his own best interest? Does public policy have any place in a free market? Is there any example of a culture with no government structure that prospered?

Throughout this textbook I will be assigning short readings from the works of philosophical masters who envisioned, described and helped create our social and economic frameworks. Accounting is a component of these frameworks, another brick in the wall if you will (http://www.youtube.com/watch?v=M_bvT-DGcWw). If you do not understand our cultural framework, at best you will only learn mechanics and terminology with no context. This approach is akin to learning which buttons to push on a machine, when and in what order. While this can help you get a job, it works against you if the machine changes or another person learns the mechanical work and is willing to do it for one-fifth of what you are being paid.

I wrote this textbook in order to inspire you to adopt a different approach to higher education, and I am going to appeal to your economic self-interest to convince you. The biggest problem with using your college experience as a credentialing service is… it will not work because your professors do not have a clue exactly what you need to know to maintain gainful employment for an entire worklife. How could they? You are responsible for your education not your professor, Pink Floyd was spot-on.

Whenever possible I will assign readings from authoritative sources and original master works and while I will provide some guidance on points that I would like for you to consider, I am not going to provide a rote analysis for you to memorize and regurgitate back at exam time. Instead, I want for you to think for yourself and relate these readings to your life and environment. Hopefully this class will spark the fires of your intellectual curiosity that will burn brightly for a lifetime.

Using numbers to tell a story

You are probably familiar with the U.S. Census Department sponsored survey regarding worklife earnings http://preview.tinyurl.com/3hlvzue. Consider what the authors of this study are trying to communicate to their readers and how they are constructing their arguments. As you read the pamphlet, think about the following:

1. Terminology… worklife, synthetic worklife earnings, mean, median, education… how are these words defined? Are these accepted definitions for all people or do some people define these words differently?

2. Is the categorization of educational attainment appropriate? Are all Bachelors degrees the same regardless of school or field of study?

3. What is the purpose of the other variables identified in the study?

4. In the Answers to Issues section the authors state “There is an education-earnings relationship.” Is the same thing as saying “If you get more education you will earn more money?”

5. What kind of public policy do you think this study would support?

6. Is it possible that rich people can afford a better education so their children have higher levels of educational attainment?

Is this study an example of accounting? Does this report contain any bias? Are there any laws or rules that govern this report?

The Financial Accounting Paradigm

In Chapter V of The Structure of Scientific Revolutions Kuhn observed that a scientific community is a social system organized around a paradigm that provides its rules for communication and social interaction and enables “normal science” to take place. Without the framework, the community does not exist. The purpose of this textbook is to teach you the rules, language and theories of the Financial Accounting paradigm. Like any paradigm, financial accounting is a flawed invention of man that can seem illogical at times. However, as we learned from Kuhn, even a flawed paradigm is better than none at all. To successfully complete this class, whether or not you plan on becoming an accountant, you must understand what is expected of you. Upon completion of this course, you will have memorized the fundamental language and the mechanics of the scientists who practice financial accounting. In order to do this, you are going to have to trust me when I tell you that you must memorize something. If you do not master the material in Chapters 1 and 2, it will be nearly impossible for you to learn the rest of the material. This is not a class that you can cram into your brain for the final examination. On the other hand, this is not that difficult of a subject and if you devote the necessary time for the first several weeks of class, it will get easier.

As you become more comfortable with the foundational material, I will challenge you to investigate the flaws and limitations of the paradigm and how it interacts with other paradigms. Within the relatively narrow field of accounting there are many different professional paradigms. For example; tax accounting, auditing, cost accounting, payroll and human resources are all professional communities that interact with the financial accounting paradigm professionals. In some cases these communities use the same language and in some cases they do not. The better you understand the importance of language and culture in paradigms, the more prepared you will be to work in a diverse organization that is comprised of multiple professional communities, some of which are not accounting related in any way, for example, legal, engineering, marketing and sales. Furthermore, as you progress in your career, you will work with representatives from even more diverse paradigms outside of your organization. Although financial accountants are probably the most fascinating people on the planet, if you are only equipped to work with other financial accountants, you are not well prepared for a career.

The language of financial accounting

This section contains the foundational language of financial accountants that we will be using throughout this textbook. I will provide you some tips and mnemonics to help you be successful, but in the end you are going to have to practice over and over until you have committed this section to memory. The first tip is to wipe your brain clean of any other meanings that you have assigned to these terms. Treat this as if you are learning a new language. Sometimes the financial accounting definitions will match what you already know, and sometimes they will not. If you violate this first rule, you will be as we say in Nuevo Mexico “muy embarazada” or very embarrassed (for those of you who do not speak Spanish as fluently as I do).

This section must be mastered before proceeding to Chapter 2. Until you can complete the Chapter 1 test, please do not go any further. If you commit yourself to this material, you should be able to complete this task in about a week. No TV, internet, reading the newspaper, etc. for one week until this task is completed. Prepare note cards and keep them with you at all times, turn 20 minutes of unproductive time into a study opportunity. If you cannot commit the time and effort to master this foundational material, it will be impossible to learn the material in this textbook in a meaningful way. This is not the time for critical thinking or learning how or why. This task requires brute force.

MEMORIZATION

FOUR FINANCIAL STATEMENTS – Table 1.1

Statement name	Heading: Period Ended or Date Certain	Account types from Trial Balance used on statement	Bottom Line
Income Statement (link)	For the period ended	Revenue and Expenses	Net Income
Retained Earnings Statement (link)	For the period ended (same heading as Income Statement)	Beginning Retained Earnings and Dividends	Ending Retained Earnings
Balance Sheet (link)	As of XX/XX/XXXX (Date Certain) snapshot in time… last day of Income Statement Period	Assets = Liabilities + Owners’ Equity (except Beginning Retained Earnings)	Proof that the accounting equation works…
Cash Flows Statement (link)	For the period ended (same heading as Income Statement)	None…	Change in cash in the period… transactions detailed into Operating, Investing and Financing categories

The four financial statements are required by G.A.A.P (Generally Accepted Accounting Principles) to be presented together along with related footnote disclosures. Omitting one of the financial statements or a footnote disclosure could result in a reader being misled. Use the mnemonic I R B C (Icky Rats Bite Cats) to remind you that these statements must be done in this order. The Net Income is needed to calculate the Ending Retained Earnings which in turn is needed to complete the Balance Sheet. The Cash Flows Statement uses information from all three statements.

SIX ACCOUNT TYPES – Table 1.2

We only have six types of accounts to memorize, easy peasy! The mnemonic D A E L O R (Dave And Ed Live On Red), two hard working college students Dave and Ed study non-stop into the wee hours of the night. To stay up and alert, they drink large quantities of Red Bull.

Account Type	Definition	Natural Balance	Financial Statement
Dividend	Assets distributed to stockholders	Debit	Retained Earnings
Asset	The cost of something purchased for the organization	Debit	Balance Sheet
Expense	A cost that expires (used) in a period	Debit	Income Statement
Liability	A debt that can be quantified	Credit	Balance Sheet
Owners’ Equity	The owners’ claim on assets (assets-liabilities)	Credit	Beginning Retained Earnings on Retained Earnings Statement, rest on Balance Sheet
Revenue	Value received for goods sold or services provided in the period	Credit	Income statement

Newt Becker, the pioneering financial accounting educator who founded the Becker CPA Review Course, coined the phrase “an ounce of memorization is worth a pound of logic.” Think of your big beautiful brain as a semi-conductor… you need to build some hard wiring instead of relying on thousands of lines of software code.

Keep in mind these definitions are pretty basic and we will beef them up as we go forward.

Common Account Names – Table 1.3

The very first task when setting up an accounting system is to devise a chart of accounts. I used to like to think of accounts as information buckets… places to store information. Depending on the complexity of the organization and its information needs, the chart of accounts can include millions of accounts and sub-accounts. For example, a company may have an account number 3000-101-12-78-01 that is used for Revenue (3000), Americas (101), Machinery division (12), Dozers (78), Yellow (01). In this course we will not use account numbers, only names, and there will not be very many of them. So… I want you to memorize them. When a new topic requires some new General Ledger accounts, they will be added in a table like this:

Account Type	Account Name
Dividend	Cash dividend
Asset	Current: Cash, Accounts receivable, Interest receivable, Inventory, Supplies, Prepaid rent, Prepaid insurance, Prepaid expense Long-term: Land (used in business), Property Plant and Equipment, Accumulated depreciation (contra-asset), Patent, Long-term investment
Expense	Cost of goods sold, Income tax expense, Salaries expense, Maintenance expense, Rent expense, Selling expense, Shipping expense, Insurance expense, Rent expense, Unearned revenue, Utilities expense
Liability	Current: Accounts payable, Note payable (depending on term of note), Income taxes payable, Interest payable Long-term: Mortgage payable
Owners’ Equity	Common stock, Retained Earnings
Revenue	Sales revenue

Two conventions that I integrated into this table are classifying Assets and Liabilities as current or non-current and using red letters for contra-accounts. You will learn more about both as you progress.

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