FINANCIAL ACCOUNTING

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FINANCIAL ACCOUNTING

• Revision of double-entry

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Today we want to

• Revise double-entry
• Understand the cash flow statement
• Practice with examples

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Example Marvin Company

• Marvin Company balance sheet at the 1st of
  January was as follows

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Transaction 1a

• Goods were sold for 12,000. The client pays
  cash.
• Analysis
• The asset Cash increases
• The revenue Sales Revenue increases
• Journal entry
• Cash.12,000
• Sales revenue..12,000
• Posting

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Transaction 1b

• The inventory value of the goods sold is 7,000.
  Analysis
• The asset Inventory decreases
• The expense Cost of Sales increases
• Journal entry
• Cost of sales.7,000
• Inventory....7,000
• Posting

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Transaction 2

• Marvin places an order to Star Company
  merchandise for 7,000 and receives the goods.
• Analysis
• The asset Inventory increases
• The liability Trade payables increases
• Journal entry
• Inventory.7,000
• Trade payables..7,000
• Posting

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Transaction 3a

• Goods sold for 2,500 and paid in cash
• Analysis
• The asset Cash increases
• The revenue Sales revenue increases
• Journal entry
• Cash.2,500
• Sales revenue..2,500
• Posting

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Transaction 3b

• The inventory value of the goods sold is 1,500.
  Analysis
• The expense Cost of Sales increases
• The asset Inventory decreases
• Journal entry
• Cost of sales.1,500
• Inventory....1,500
• Posting

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Transaction 4a

• Goods sold for 3,400 on credit
• Analysis
• The asset Trade receivables increases
• The revenue Sales revenue increases
• Journal entry
• Trade receivables.3,400
• Sales revenue..3,400
• Posting

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Transaction 4b

• The inventory value of the goods sold is 2,000.
  Analysis
• The expense Cost of Sales increases
• The asset Inventory decreases
• Journal entry
• Cost of sales.2,000
• Inventory....2,000
• Posting

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Transaction 5

• Marvin pays the employees for January 4,200 in
  cash
• Analysis
• The expense Wages increases
• The asset Cash decreases
• Journal entry
• Wages.4,200
• Cash....4,200
• Posting

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Transaction 6

• Marvin purchases land for 20,000 and pays in
  cash
• Analysis
• The asset PPE increases
• The asset Cash decreases
• Journal entry
• PPE(Land).20,000
• Cash....20,000
• Posting

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Transaction 7

• Marvin purchases a two year insurance policy for
  2,800 and pays in cash
• Analysis
• The asset Prepaid expenses increases
• The expense Insurance increases
• The asset Cash decreases
• Journal entry
• Prepaid expenses.2,683
• Insurance117
• Cash....2,800
• Posting

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General journal for Marvin
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Trial balance for Marvin at the 9 of January
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Trial balance, income statement and balance sheet
Balance sheet for Marvin co. asat the 9 of
January -
Income statement for Marvin co. for the period
ending 9 of January -
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Statement of Cash Flows

• The Statement of Cash Flow can help answer the
  following questions
• How did cash increase when there was a net loss
  for the period?
• Is cash flow greater or less than net income?
• How was the expansion in the plant and equipment
  financed?
• How was the the debt retired?
• How much money was borrowed during the year?
• What amount was paid in dividends?

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Sources of Information for theStatement of Cash
Flows

• The cash flow statement is a created statement
  that relies on information from the income
  statement and balance sheet. Therefore, to
  prepare the cash flow statement, you need
• Current income statement (only current year)
• Comparative balance sheet (2 years)
• Additional information

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Format of the Statement of Cash Flows

• Cash Flow Statement has four sections
• operating
• investing
• financing
• significant non-cash investing and financing
  activities

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Operating Activities

• Income Statement Information Needed
• Net income
• Depreciation and amortization (noncash
  expenditures)
• Gain(loss) on sale of assets or investments
• Balance Sheet Information Needed
• Change in Current Assets
• Change in Current Liabilities

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Investing Activities

• Income Statement Information Needed
• Gain(Loss) on Assets
• Balance Sheet Information Needed
• Change in Long-Term Assets
• Property Plant and Equipment
• Long-Term Investments

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Financing Activities

• Income Statement Information Needed
• None
• Balance Sheet Information Needed
• Change in Long-Term Liabilities
• Change in Stockholders Equity
• Retained Earnings Stmt Information
• Dividends Paid

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Significant Non-Cash Activities

• Transactions that do not affect cash are NOT
  reported in the body of the statement of cash
  flows. However, these items are reported
• In a separate schedule at the bottom of the
  statement of cash flows or
• In a separate note or supplementary schedule to
  the financial statements.

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Examples of Significant Non-Cash Activities

• Issuance of common stock to purchase assets.
• Conversion of bonds into common stock.
• Issuance of debt to purchase assets.
• Exchanges of plant assets.

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Converting Net Income to Cash Flow From Operations
Accrual Method
Cash Method
Revenue earned
Non cash expenses (e.g. depreciation)

- Expense incurred
Decreases in current assets Increases in current
liabilities

NET INCOME
Increases in current assets Decreases in current
liabilities
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CASH FLOW FROM OPERATIONS
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Steps in Preparing Cash Flow Statement

• Determine the net Increase (decrease) in cash.
  Note This will serve as the check figure.
• Determine the cash provided (used) by operations.
• Determine the cash provided (used) by investing.
• Determine the cash provided (used) by financing.
• Determine any significant noncash transactions
  that should be disclosed.

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Cash Flow statement (1)
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Cash Flow statement (2)
Indirect method
Direct method
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• Using The Accounting Framework
• America Online Inc.

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Accounting Tools That Will Be Used

• The accounting equation
• Relationships (Articulation) among the financial
  statements
• Information disclosed in footnotes to the
  financial statements
• Debits, credits and T-accounts

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Total Assets 1996 959 million Total Assets
1997 847 million Change in Total Assets (112
million) WHY?
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The accounting equation
Equity
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Total Liabilities 1996 446 million Total
Liabilities 1997 719 million Change in
Liabilities 273 million
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Total Equity 1996 513 million Total Equity
1997 128 million Change in Equity (385
million) HERE IS THE KEY!
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Explanation for Changes In Shareholders Equity

• Retained earnings decreased by 499 million
• Common stock and additional-paid-in capital
  increased by 98 million
• AOL issued additional shares of stock

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The role of the income statement
Equity
Income Statement
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Analysis of the expenses

• Cost of revenues 1,041 million
• Marketing 409 million
• General administrative 194 million
• Write-off of deferred
• subscriber acquisition cost 385 million
• What is the last entry?

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Subscriber Acquisition Costs - Footnote 2

• Costs attributable to marketing programs that
  result in subscriber registrations
• These expenditures are recorded as an asset
• What?
• Amortized (as opposed to depreciated) monthly
  over a period less than 24 months

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Subscriber Acquisition Costs - Footnote 3

• Due to change in business model, AOL changed to a
  flat-rate pricing and reduced reliance on online
  subscriber revenues.
• This change in the future stream of revenue
  created uncertainty as to whether these
  expenditures created an asset (i.e., produced a
  future benefit)
• After 10/1/96 these costs were expensed as
  incurred - no longer recorded as assets. Thus,
  the asset must be written off.

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How Does A Company Write Off An Asset ?

• AOL must remove the asset from its books and
  debit the expense, deferred subscriber
  acquisition expense and credit the asset,
  deferred subscriber acquisition cost. Footnote 3
  indicates that AOL wrote off 385 million for the
  year.
• Deferred subscriber acquisition expense
  385,221,000
• Deferred subscriber acquisition cost
  385,221,000

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How Does A Company Write Off An Asset ?

• Remove (credit) the asset from the books
• Add (Debit) the corresponding expense
• Footnote 3 indicates that AOL wrote off 385
  million for the year.
• Journal entry
• Deferred subscriber acquisition expense
  385,221,000
• Deferred subscriber acquisition cost
  385,221,000

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T-accounts (1)
Accumulated Deficit (Retained Earnings)
7,767
Balance 6/30/96 From balance sheet
1997 loss from income statement
499,347
Balance 6/30/97 From balance sheet
507,114
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T-accounts (2)
Deferred Subscriber Acquisition Costs (Asset
account)
Balance 6/30/96
314,181
130,229
The Statement of Cash Flows indicates that an
additional 130,229 cash was spent on these costs
between 7/1/96 and 9/30/96.
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T-accounts (3)
Deferred Subscriber Acquisition Costs (Asset
account)
56,189
314,181 130,229
The Statement of Cash Flows indicates that
amortization of these costs between 7/1/96 and
9/30/96 was 56,189. AOL estimated that 56,189
of the asset expired over this time period.
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Writing-off the asset (1)
Deferred Subscriber Acquisition Costs (Asset
account)
314,181 130,229 385,221
56,189
Balance 9/30/96
Write-off on 10/1/96
385,221
It was this 385,221 that was written off as an
expense on 10/1/96
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Writing-off the asset (2)
Deferred Subscriber Acquisition Costs (Expense
account)
385,221
This expense will enter the income statement and
will affect The Balance sheet through the profit
and/or loss for the year
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Income statement and cash flow
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Information from the Cash Flow Statement

• AOLs cash flow statement shows that
• Cash flow from operations was a positive 123
  million.
• Cash flow from financing activities provided cash
  of 79 million. Note this is consistent with our
  earlier analysis of stockholders equity.
• Investing activities used cash of 197 million.
  This is to be expected from a growing company.
• Overall increase in cash, 6 million.
• How could AOLs income statement show such a
  large loss, yet have a positive cash flow?

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Information from the Cash Flow Statement

• Operating cash flows, positive 123 million
• Investing activities used cash of 197 million -
  this is to be expected from a growing company
• Financing activities provided cash of 79 million
  - from issuance of new stock
• Overall increase in cash, 6 million.
• How could a large loss have caused no cash
• flow problem?

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Explanation of Increase in Cash Flow

• The write-off (expense) of the 385 million in
  deferred subscriber acquisition costs, current
  subscriber acquisition costs of 59 million, 22
  noncash restructuring charges, and 64 million of
  depreciation and amortization are all non- cash
  expenses that are added back to net income. It is
  a noncash expense. Therefore, the income
  statement reported 530 million dollars in
  expenses that did not require the outlay of cash!

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Summing up

• Accounting is far from being an exact picture of
  the situation of the company
• Crucial importance of the balance sheet equation
• The relationship between the income statement at
  the balance sheet equation