INVESTING AND FINANCING DECISIONS AND THE ACCOUNTING

SYSTEM
FINANCIAL STATEMENTS AND BUSINESS DECISIONS

 The 4 basic FINANCIAL STATEMENTS:

 Balance sheet: reports the “financial position” of a company AT a certain point in time
 Income statement: reports the revenues and expenses incurred DURING the accounting
period
 Statement of Cash Flow: reports the inflows and outflows of cash from Operating,
Investing and Financing activities
 Statement of stockholders’ equity: reports the changes in each of the stockholders’
equity accounts

 GAAP [Generally Accepted Accounting Principles]

After the events of 1929 (“black Tuesday”), the US Congress decided to create an entity
whose job was to WORK OUT THE DETAILED RULES FOR MEASURING FINANCIAL
STATEMENTS (i.e. GAAP).
This body was the SEC (“Securities and Exchange Commission”), but today this task is
handled by the FASB (“Financial Accounting Standards Board”).

At an international level, we have the IFRS (“International Financial Reporting System”),

handled by the IASB.

 WHAT IS THE PURPOSE OF “FINANCIAL REPORTING”?

Providing information about the financials of a company can be useful to existing and
potential investors, creditors, lenders, in making decisions, in order for them to lend
resources (money) to the company.
 Pervasive Cost-Benefit Constraint: Benefits of providing information should
outweigh its costs

But what information CAN and SHOULD BE SHARED?? [competitors can also see]
Only useful information. Their “qualitative characteristics” of useful information are:
 Relevance
 Faithful representation
There are also additional attributes that ENHANCE these 2 characteristics:
 Comparability
 Verifiability
 Timeliness
 Understandability

What are the ELEMENTS that need to be MEASURED and REPORTED?

 Assets, Liabilities, Stockholders’ Equity, Investments by Owners, and
Distributions to Owners
 Revenues, Expenses, Gains, and Losses
  Comprehensive Income

Recognition, Measurement, and Disclosure Concepts:

Assumptions: Time Period (in Ch. 3)
Principles: Revenue Recognition and Expense Recognition (in Ch. 3)

 ASSETS
 Cash
 Short/long-term investments
 Accounts receivable (money that people own the company for their goods/services)
 Notes receivable (pseudo-loan that the company has given out)
 Inventory
 Land
 Buildings
 Intangibles
 Accumulated depreciation (it’s a “counter-asset” [XA], i.e. -A)
 Pre-paid expenses (expenses that have been paid already, but not yet incurred)
 ETC…

 LIABILITIES
 Accounts payable
 Notes Payable
 Accrued expenses (expenses which have been incurred, but yet to be paid)
 Taxes payable
 Unearned revenue (amounts paid TO the company in the PAST for goods/services
which people expect in the FUTURE)
 Bonds payable
 Dividends payable
 Wages payable

 STOCKHOLDER’S EQUITY
 Common stock (total value of the issued stocks, based on the PAR VALUE)
 Additional paid-in capital (or “Share premium”) [(market value of the share – par
value) x number of issued stocks]
 Retained earnings

CHIPOTLE CASE

ASSETS LIABILITIES STOCKHOLDERS’

EQUITY
A Cash +300 Common stock +1
Additional paid-in cap.
+299
B Cash +2 Notes payable +2
C Land +8 Notes payable +1
 Buildings +34
Equipment +10
Intangibles +3
Cash -54
D Cash -1 Notes payable -1
E Short-term inv. +9
Long-term inv. +35
Cash -44
F Div. payable +2 Retained earnings -2

 HOW DO COMPANIES KEEP TRACK OF ACCOUNT BALANCES

(TRANSACTIONS)??
1. General Journal = they contain “journal entries”
They record WHEN the transaction happened and its VALUE (chronological list of
transactions)

2. General Ledger (or “t-accounts”)

They keep track of balances (transactions) and what they affect [its bottom line
“makes up” the balance sheet at the end of the accounting year]

+ CASH (A) -
1/01/2018 186 54 - NOTES PAYABLE (L) +
300 1 0 1/01/2018
2 44 0 1
0
389

 Trial balance: it’s essentially a list with all the ending balances of all accounts
(be they debit or credit), made to check whether debits and credits are EQUAL
 We might also have to consider LANDS/EQUIPMENT (not only cash) when
calculating the equivalent value (stockholders’ equity) that investors bring in
 Any PERSONAL purchase made with PERSONAL money (NO company
money) IS NOT RECORDED
 Even if investors sell their shares to others, that DOES NOT COUNT in our
journal/ledger

 OPERATING DECISIONS AND THE ACCOUNTING SYSTEM

Elements of the “Income Statement”:

 Revenues = increases in assets / settlement of liabilities coming from CENTRAL
ONGOING OPERATIONS
 Expenses = decreases in assets / increases of liabilities coming from ongoing
operations INCURRED TO GENERATE REVENUES
- COGS [Cost Of Goods Sold]
 - Operating Expenses
- Non-operating expenses
- Financing expenses
- TAXES are recorded BUT generally SETTLED NEXT YEAR (arrears)
 Gains = Increases in assets or settlements of liabilities from PERIPHERAL
TRANSACTIONS
 Losses = Decreases in assets or increases in liabilities from PERIPHERAL
TRANSACTIONS

First, consider your OPERATING activities:

1. Revenues
2. Operating expenses
3. General and administrative expenses

Then, calculate your PERIPHERAL activities (interest revenue/expense)

Then, SUBTRACT taxes
And you have your NET INCOME

CASH BASIS ACCOUNTING

Def: Record revenues WHEN cash is RECEIVED and expenses when cash is PAID
(everything non-cash is ignored)
 NOT ALLOWED by GAAP, as it could lead to wrong future interpretations
 Usually used by small companies

ACCRUAL BASIS ACCOUNTING

Def: Revenues and expenses are recognized WHEN the TRANSACTION that
causes them OCCURS (not necessarily when cash is received/paid)

- “Revenue Recognition Principle”: a company can recognize smtg. as “revenue”

ONCE the goods/services HAVE BEEN DELIVERED

1. If cash is received before the company delivers the goods/services, the liability
UNEARNED REVENUE is recorded
2. If cash is received after the company delivers goods or services, an asset
ACCOUNTS RECEIVABLE is recorded.
- “Expense Recognition Principle” (Matching Principle): if expenses are incurred,
they must be “matched” with the revenues
TO RECAP:
 ADJUSTING ENTRIES

Before closing the account at the end of every year, some ADJUSTMENTS need to be
made [revenues/expenses can be RECORDED BEFORE/AFTER the actual payments].
(Companies wait until the end of the accounting period to adjust their accounts because
doing so daily or weekly would be very costly and time-consuming)

 Deferred revenues = revenues are recorded AFTER the cash is received

(Unearned revenue, cash first, revenues second)
 Accrued revenues = revenues are recorded BEFORE the cash is received

 Deferred expenses = expenses are recorded AFTER the payments is made

Many assets are used over time to generate revenues, such as:
• Supplies • Buildings and equipment • Prepaid expenses
These assets are deferred expenses (that is, recording the expenses for using these
assets is deferred to the future). At the end of every period, an adjustment must be
made to record the amount of the asset that was used during the period.

 Accrued expenses = expenses are recorded BEFORE the payment is made

Closing entries:
1. Transfer net income (or loss) to
Retained Earnings
2. Establish a zero balance in each
of the temporary accounts to start
the accumulation in the next
accounting period
(Temporary = revenue, expense,
gain and loss accounts)

THE FINAL ADJ. ENTRY OF THE

YEAR IS TO RECORD INCOME TAXES