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Session 1.3. Preparing Financial Statements Income Statement and Balance Sheet Part 2 Sync PDF
Session 1.3. Preparing Financial Statements Income Statement and Balance Sheet Part 2 Sync PDF
Session 1.3. Preparing Financial Statements Income Statement and Balance Sheet Part 2 Sync PDF
1.3.1
Learning objectives
1.3.2
Accounting – definition, types, and uses
• Balance sheet - Financial position (listing of resources and obligations) on a specific date
• Income statement - Results of operations over a period of time using accrual accounting
• Statement of cash flows - Sources and uses of cash over a period of time
2. Liabilities
Probable future economic sacrifice resulting from a current or past event
Amount is known or can be reasonably estimated
Transaction or event causing the obligation has occurred
3. Shareholders’ Equity
Contributed capital is the money provided in return for equity shares
Earned capital is the cumulative earnings (profits or loss) retained
Other components that we will learn later
Accounting equation A = L + SE is the basis of accounting system
1.3.5
Income statement - overview
Income statement capture the financial performance of a firm for a given period of time. It
is also called statement of operations or Profit & Loss a/c. Major components of income
statement comprises of –
Revenue -
A measure of economic benefits generated by the sale of products or providing of services
over a period of time
This is related to the main operations / business of the company
This leads in an increase in net assets (assets - liabilities)
Expenses -
A measure of economic sacrifices incurred to “earn” the revenues of a given period
This leads to a decrease in net assets (assets - liabilities)
1.3.6
Preparing financial statements – a simple example
HM Co. starts a business of selling printed T-shirts in June 2020. The company is started with an
initial capital contribution of $1,200 by the promoters. HM Co. also borrows $800 from the bank. The
following transactions took place during the month -
1. HM Co got 100 plain T-shirts for $5 a piece by making full cash payment to a supplier
2. For printing, HM Co buys a printer for $1,200. This printer can be used for 12 months.
3. Wages of $100 is paid to worker who operates the printer.
4. During the first week, the company sold 60 T-shirts for $10 a piece. But, of the 60 T-shirts picked
up, only 20 paid cash. For the other 40, HM agrees to accept payment next month.
5. Salary of $100 is paid to employee who provides admin and sales support.
At the end of the month, you were dismayed to find you had only $ 300 in cash remaining. Given that
you started with a cash of $2,000, does this suggest that you had lost $ 1,700 during the month?
REQUIRED
1. Show how your cash balance had dwindled to $ 300 at the end of Week 1
2. Prepare the income statement and balance sheet for the month
1.3.7
Keeping track of the cash
1 Payment to supplier
2 Payment for machine
3 Payment to worker
4 Collection from customers
5 Payment to sales staff
∆ Cash
Opening cash
Closing cash
Can we say that the business lost $1,700 during the month?
1.3.8
Accrual accounting -
This method focuses on the economic characteristics of transactions rather than their
cash flows. Application of this method leads to the creation of balance sheet and income
statement.
Even though cash is not received, revenue is Even though cash is received, no revenue is
recognized (ACCRUED) because the company recorded (DEFERRED) because no services have
has done its job and is sure of collections. been performed / n o goods have been delivered
An asset titled Accounts Receivables (AR) is A liability called Deferred Revenue (or
created. unearned revenue) is created because an
obligation exists to provide future services or
assets (such as inventory or a refund of cash)
When the cash is subsequently collected the Eventually, when the goods are delivered or
asset AR gets converted into cash services provided, revenue is recognized and
liability does not exist any more.
1.3.10
Cash in paid after expense is recognized Cash is paid before expense is recognized
Example – expense such as rent, wages, Example - Equipment, buildings, or vehicles etc that
salaries, interest, tax etc. has been incurred will be used over time; Prepayment of advertising,
(the benefit received) but no cash has been insurance, or rent becomes used up over time;
paid yet. Supplies are used over time, etc.
Even though cash is not paid, expense needs to An Asset is created because such cash paid in
be recognized based on matching principle. A advance will generate benefits in future and often
liability titled PAYABLE is created because more than one period
there is an obligation to pay in the future.
Subsequently, when the cash payment is done, Subsequently, when the asset is used or time elapses,
the liability does not exist any more the value of asset reduces.
1.3.11
HM Apparel Co
Income statement for the month ending June 30, 2020
Revenue
Net income
1.3.12
HM Apparel Co
Income statement for the month ending June 30, 2020 ( alternate way of presenting)
Revenue
Less:
Raw material consumed
Depreciation
Employee salaries
Net income
1.3.13
HM Apparel Co
Balance sheet as on June 30, 2020
Assets
Total assets
Liabilities & Shareholders’ equity
Liabilities
Total SE
Total liabilities & SE
1.3.14
Preparing financial statements – a more formal system
• For a made-up example (like what we have seen so far) we can keep track of
transactions and record them directly in the financial statements at the end of the
period.
• But in a real-world situation, even in a small company, there are a large number of
transactions.
• Hence, we need a more formal system to keep record each transaction and eventually
tracing its effect on the financial statements.
1.3.15
1.3.16
STEP 1 - Process of posting journal entries
• The accounting cycle begins by identifying the specific effects of economic events on the
accounting equation and posting journal entries.
• If an event does not affect the accounting equation, it is not recorded.
• We are not primarily concerned with cash movements – we do accrual accounting
• Journal entry is just like writing a “journal” - record transactions as and when they
happen while following the classic debits and credits that capture the transaction in the
language of bookkeeping .
• Formal books and records where journal entries are made are typically digital or part of a
larger Enterprise Resource Planning (ERP) system
• Debits and credits – what do they mean? Debits and credits do not mean positive or
negative, good or bad, or anything else. Do not search for more meaning here.
• They just mean LEFT and RIGHT of the accounting equation, A = L + SE
1.3.17
This basic accounting equation Assets = Liabilities + Shareholders’ Equity can be
expanded as follows -
• Assets = Cash assets + Noncash assets
• Shareholders’ equity = Contributed Capital + Retained earnings (or earned capital)
• Retained earnings = Beginning retained earnings + Net income – Dividends
• Net income = Revenue – Expenses
Increase Dr Dr Cr Cr Cr Cr Dr
Decrease Cr Cr Dr Dr Dr Dr Cr
1.3.18
Few more things to keep in mind while recording journal entries –
• Which specific asset, liability, stockholders' equity, revenue or expense accounts does
the transaction affect?
• Examples of assets - cash, marketable securities, financial investments, loan & advances
made, prepaid expenses, accounts receivables, inventory, property, plant & equipment
(PP&E), intangibles like patents, copyrights, goodwill
• Example of liabilities - accounts payable, accrued expenses, unearned revenue, borrowings,
bank loans, bonds, leases, pensions, tax payables
• Examples of expenses – raw material consumed, supplies consumed, wages and salaries,
selling, general, admin, advertising, technology, R&D, depreciation, interest, taxes
• By how much?
• Journal entry format - Always list Debits first and always indent Credits
Differences in terminology
US IFRS / India
Income statement / Statement of operations Profit and loss account
Sales Turnover
Net Income / Earnings Profit
Accounts receivables Sundry debtors
Accounts payable Sundry creditors
Inventory Stock
Property, Plant, and Equipment (PP&E) Tangible fixed assets
Long term debt Borrowings
Shareholders’ equity Capital and reserves
1.3.20
Financial Statement Effects Template (FSET)
1.3.21
Preparing financial statements – a more detailed example
1.3.23
Event (2). On Oct 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-
year, 12%, $5,000 note payable. Interest must be paid semi-annually.
1.3.24
Event (3). On October 2, Sierra purchased equipment by paying $5,000 cash to
Superior Equipment Sales Co.
1.3.25
Event (4). On October 3, Sierra received $1,200 in cash from a customer for
guide services to be performed in the future
1.3.26
Event (5). On October 3, Sierra received $10,000 in cash from Copa Company
for guide services performed.
1.3.27
Event (6). On October 3, Sierra Corporation paid its office rent for the month
of October in cash, $900.
1.3.28
Event (7). On October 3, Sierra paid $600 for a one-year insurance policy that
expires on September 30, 2020.
1.3.29
Event (8). On October 5, Sierra purchased three months of supplies on
account from Aero Supply for $2,500.
1.3.30
Event (9). On October 9, Sierra hired four employees to begin work on October
15. Salary is $500 / week / employee.
1.3.31
Event (10). On October 20, Sierra paid a $500 dividend.
1.3.32
Event (11). On October 28, Sierra paid the employees $4,000 in salaries for two
weeks worked up to and including Oct 28.
1.3.33
STEP 2 - Post adjustments (adjusting journal entries).
Companies make accounting adjustments so that financial statements are accurate and
complete
For example, employees might have earned wages during an accounting period but not
been paid before the end of the period. Failure to recognize the wages owed would
understate liabilities (because wages payable would be too low) and would overstate net
income for the period (because wages expense would be too low)
Both the balance sheet and the income statement would be inaccurate. SO, the company
makes an accounting adjustment
These are called “adjusting journal entries” if we are using the language of debits and
credits
1.3.34
Illustration 2.1 (continued) Accounting adjustments
Additional information –
At the end of October 2019, the following additional information needs to be considered before
preparing financial statements.
12. Physical count of inventory on October 31 reveals that $1,000 of supplies are still on hand.
13. What is the remaining value of prepaid rent?
14. The insurance policy of $600 that the company bought was for one year and now one month has
gone by. How do we adjust for that?
15. For Sierra Corporation, assume that depreciation on the office equipment is $40.
16. On October 3, Sierra received $1,200 in cash from a customer for guide services to be performed
in future. On October 31, the company determines that during the month it has performed some
services for the customer and can recognize $400 revenue.
17. On October 31, Sierra performed services worth $200 for which it will receive cash next month.
18. The interest on the 12% note payable ($5,000) from Bank is payable semi-annually, on April 1
and October 1 each year. How do we account for interest in the meanwhile?
19. Employees were paid for two weeks’ salaries ($4,000) on October 28. But we are preparing an
income statement for the month ending October 31. How do we account for the salary expense
for the remaining three work days in October?
1.3.35
Event (12). Physical count of inventory on October 31 reveals that $1,000 of
supplies are still on hand.
1.3.36
Event (13). Adjustment for the 1-month rent paid in advance
1.3.37
Event (14). The insurance policy of $600 that the company bought was for
one year, and now one month has gone by.
1.3.38
Event (15). For Sierra Corporation, assume that depreciation on the office
equipment is $40.
• When the equipment was purchased, we did not record that amount as expense
because the equipment can be used in future for a long time. Hence the expense
recognition is deferred.
• As time goes by, the equipment is used in the business operations to generate revenue.
Hence, by applying matching principle, certain expense will then be recognized to
capture the decline in the value of asset due to its use.
• Depreciation is the process of allocating the cost of the asset to expense over its useful
life. Simplest way to calculate depreciation is called Straight line method (SLM),
where
Depreciation = (Cost of PP&E – salvage value) / Useful life of PP&E
• We also want to keep track of how long we have been using the machine. An account
titled “Accumulated depreciation” is created for that purpose.
1.3.39
Why is this additional account accumulated depreciation needed? Suppose there are two
machines X and Y.
X Y
Cost 1,000 3,000
Salvage value 0 0
Useful life 10 6
SLM depreciation (1,000 - 0)/10 (3,000-0)/6
100 500
After 5 years
Cost 1,000 3,000
Less: Accumulated Depreciation (500) (2500)
Book value 500 500
If we just look at the book value, it appears as if both X and Y are same. However, they are
different in terms of acquisition cost, how long they have been used, how soon they need
to be replaced. To preserve this information, we don’t directly reduce the value of PP&E
while accounting for depreciation. We accumulate depreciation and show it as a
“CONTRA ASSET” i.e.as a reduction against the asset account in the balance sheet.
1.3.40
Event (15). For Sierra Corporation, assume that depreciation on the office
equipment is $40.
(XA)
1.3.41
Event (16). On October 3, Sierra received $1,200 in cash from a customer for guide
services to be performed in future. On Oct 31st the company determines that during the
month it has performed some services for the customer and can recognize $400 revenue.
1.3.42
Event (17). On October 31st, Sierra performed services worth $200 for which
it will receive cash next month.
1.3.43
Event (18). The interest on the 12% note payable ($5,000) from Bank is payable semi-
annually, on April 1 and October 1 each year. How do we account for interest in the
meanwhile?
1.3.44
Event (19). Employees were paid for two weeks ($4,000) on October 28. But we are
preparing an income statement for the month ending October 31. How do we account
for the salary expense for the remaining three work days in Oct?
1.3.45
STEP 3: Prepare financial statements
All T-accounts are then summarized into a Trial Balance - a list of accounts and their
balances at a given time. A traditional Trial Balance shows the debits and the credits
separately and the two MUST balance.
Unadjusted trial balance: the balance of each account BEFORE any accounting
adjustments (trial balance with transactions only)
Adjusted trial balance: the balance of each account AFTER the accounting
adjustments have been made (trial balance with transactions and adjustments)
1.3.46
[ACCOUNT NAME]
Debit (Dr.) Credit (Cr.)
An Account can be
illustrated in a T-
Account form.
1.3.47
ASSETS EXPENSE
Normal Debit (Dr.) Credit (Cr.) Debit (Dr.) Credit (Cr.)
Balance
Debit
Normal Balance Normal Balance
1.3.48
GENERAL JOURNAL
Date Account Titles & Explanation Debit Credit Cash
2014
Oct. 1 Cash 10,000
Common Stock 10,000
(Issued Stock for Cash)
1 Cash 5,000
Notes Payable 5,000
(Issued 3-month, 12% note for cash)
2 Equipment 5,000
Cash Payable
Notes 5,000
(Purchased equipment for cash)
2 Cash 1,200
Unearned Service Revenue 1,200
(Recd. advance for future service)
3 Cash 10,000
Service Revenue 10,000
(Recd. cash for services delivered)
3 Rent Expense 900
Cash 900
(Cash paid for Oct. office rent)
4 Prepaid Insurance 600
Cash 600
(Paid for 1-yr policy, effective Oct. 1)
5 Supplies 2,500
Accounts Payable 2,500
(Purchased on account)
20 Dividends 500
Cash 500
(Declared & paid cash dividend)
26 Salaries & Wages 4,000
Cash 4,000
1.3.49 (Paid salaries to date)
CASH
Dr. Cr.
Event 1 10,000 5,000 Event 3
Total Debits Event 2 5,000 900 Event 5 Total Credits
= 26,200 Event 4 10,000 500 Event 7 = 11,000
Event 9 1,200 4,000 Event 8
600 Event 11
15,200
Following the same procedure, T-accounts for all other accounts can be prepared.
1.3.50
CASH
Dr. Cr.
Sierra Corporation
10,000 5,000
5,000 900 Trial Balance, Oct. 31
1,200 600 Dr. Cr.
10,000 500
Cash 15,200
4,000
Accounts Receivable 200
Balance 15,200
Supplies 1,000
SUPPLIES Prepaid Insurance 550
Dr. Cr.
Equipment 5,000
2,500 1,500
Acc. Depreciation 40
Balance 1,000 Notes Payable 5,000
Accounts Payable 2,500
COMMON STOCK
Interest Payable 50
Dr. Cr.
10,000 Unearned Revenue 800
Salaries Payable 1,200
10,000 Balance Common Stock 10,000
Dividend 500
SERVICE REVENUE
Dr. Cr. Service Revenue 10,600
10,000 Salaries Expense 5,200
400 Office Rent Expense 900
200
10,600 Balance Supplies Expense 1,500
Depreciation Expense 40
SALARIES EXPENSE Interest Expense 50
Dr. Cr.
Insurance Expense 50
4,000
1,200 Total 30,190 30,190
Balance 5,200
1.3.51
Sierra Corp. Sierra Corp.
Adjusted Trial Balance Income Statement
October31,
October 31,2019
2014 For
For the
the month ended October
October 31,
31,2019
2014
Account Debit Credit Revenues
Cash $15,200 Service Revenue $10,600
Accounts Receivable 200
Supplies 1,000 Expenses
Prepaid Insurance 550 Salaries Expense $5,200
Equipment 5,000 Supplies Expense 1,500
Acc. Depreciation $40 Rent Expense 900
Notes Payable 5,000 Insurance Expense 50
Accounts Payable 2,500 Interest Expense 50
Interest Payable 50 Depreciation Expense 40
Unearned Revenue 800 Total Expenses $7,740
Salaries Payable 1,200
Common Stock 10,000 Net Income $2,860
Retained Earnings -
Dividends 500 Sierra Corp.
Service Revenue 10,600 Retained Earnings Statement
Salaries Expense 5,200 Forthe
For themonth
monthended
ended October
October 31, 2019
2014
Supplies Expense 1,500 Retained earnings, October 1 -
Office Rent Expense 900 Add: Net Income 2,860
Insurance Expense 50 2,860
Interest Expense 50 Less: Dividends 500
1.3.52 Depreciation Expense 40 Retained earnings, October 31 2,360
$30,190 $30,190 To Balance Sheet
Sierra Corp. Sierra Corp.
Adjusted Trial Balance Balance Sheet
October 31,
October 31, 2019
2014 Ason
As onOctober
October31,
31,2019
2014
Account Debit Credit Assets
Cash $15,200 Cash $15,200
Accounts Receivable 200 Accounts Receivable 200
Supplies 1,000 Supplies 1,000
Prepaid Insurance 550 Prepaid Insurance 550
Equipment 5,000 Equipment $5,000
Acc. Depreciation $40 Less Acc. Depreciation
Accumulated Depreciation 40
(40) 4,960
Notes Payable 5,000 Total Assets $21,910
Accounts Payable 2,500
Interest Payable 50 Liabilities & Stockholders' Equity
Unearned Revenue 800 Liabilities
Salaries Payable 1,200 Notes Payable $5,000
Common Stock 10,000 Accounts Payable 2,500
Retained Earnings - Salaries Payable 1,200
Dividends 500 Unearned Revenue 800
Service Revenue 10,600 Interest Payable 50
Salaries Expense 5,200 Total Liabilities $9,550
Supplies Expense 1,500 Stockholders' Equity
Office Rent Expense 900 Common Stock $10,000
Insurance Expense 50 Retained Earnings 2,360
Interest Expense 50 Total Stockholders' Equity $12,360
Depreciation Expense 40 Total Liabilities & Stockholders' Equity $21,910
$30,190 $30,190
1.3.53 From Retained Earnings
statement
STEP 4: Closing the books
At the end of the accounting period, companies transfer the temporary account
balances to the permanent stockholders’ equity account—Retained Earnings.
• Temporary account balances are reset to zero at the end of each period so
that they begin the next period at zero because we want to know the
performance for a given period of time.
• Permanent accounts are not reset to zero because we want to know the
cumulative position of a firm as on a given point of time.
1.3.54
Salaries and
Wages Expense
4,000 (2) 5,200
Process of closing the books.
1,200
5,200 5,200
Supplies
2
Expense Income Service
1,500 (2) 1,500 Summary Revenue
(2) 7,740 (1) 10,600 1 (1) 10,600 10,000
(3) 2,860 400
10,600 10,600 200
Rent 10,600 10,600
Expense
3
900 (2) 900
Retained
Earnings
(4) 500 --0--
Insurance (3) 2,860
Expense Bal. 2,360
50 (2) 50
4
Interest Dividends
Expense 500 (4) 500
50 (2) 50
Depreciation
Expense
40 (2) 40
1.3.55
Closing process FSET
• Remember that the FSET is a pedagogical tools that represent transactions’ effects on
financial statements
• Each transaction and adjustment is automatically transferred to retained earnings – no
additional closing process required when we use the FSET
• We simply begin a new FSET for the next period. All balance sheet account balances at
the end of the period become the opening balances for the next period.
• All income statement account balances are set to zero.
• The FSET is highly stylized, but its simplicity is instructive
1.3.56
Coming up
1.3.57