Understanding and Preparation of Financial Statements: Kathmandu University School of Management (KUSOM)

Understanding and Preparation
of Financial Statements
MBA
Kathmandu University
School of Management (KUSOM)
harigopal@kusom.edu.np
Primary Objective of
Financial Reporting
Provide information for decision making
Extend credit $$?? Loan $$??

Borrow $$?? Sell stocks or bonds??
Invest?? Start new business??
Secondary Objectives of
Financial Reporting
Reflect the
companys
equity Reflect prospective
and claims to its cash receipts to
resources investors and creditors
Reflect prospective
cash flows to
the company
Assets = Liabilities + OE
Qualitative Characteristics
Understandability
To those willing to take
the time to understand it
Relevance Has capacity to

make a difference
Reliability Represents what

it purports
Comparability
between companies
Consistency
From one period to the next
Materiality
Will it make a difference
To the decision maker?
Conservatism
All else equal, choose
Least optimistic estimate
Basis of Recording Transactions
External and Internal Events
External events: interaction between entity
and outside environment
Internal events:
Interaction within
entity
Source Documents
Purchase Sales
Invoice Evidence needed Invoice
in an accounting
Cash system to record
Checks
Register transactions
Tape
Payroll Shipping Receiving

Records Document Document
Analyzing the Effects of
Transactions
on the Accounting
Equation
Issue Capital Stock for Cash
1/12 Transactions for Glengarry Health Club
Assets = Liabilities + Stockholders Equity

Cash Capital Stock
+ $ 100,000 = + $ 100,000
The accounting equation must always

remain in balance
Purchase of Property in
Exchange for Notes Payable
Land Notes Payable
+ $50,000 = + $200,000
Building
+ $150,000
Increase on left has
corresponding increase on right
Purchase of Equipment
on Account
Equip. Accts. Pay.
+ $20,000 = + $20,000
At least two accounts affected

by every transaction
Effect of Revenue and Expenses
on Retained Earnings
Statement of
Income Statement
Retained Earnings
Revenue Beg. R/E

Expenses + Net Income
= Net Income (Loss) (or Net Loss)
Dividends
= End. R/E
Sell Monthly Memberships
on Account
Accts. Rec. Retained Earnings
+ $15,000 = + $15,000
Revenues increase retained earnings
Sell Court Time for Cash

Cash Retained Earnings
+ $5,000 = + $5,000
Revenues increase retained earnings
Payment of Wages
and Salaries
$10,000 = $10,000
Expenses decrease retained earnings
Payment of Utilities
$3,000 = $3,000
Expenses also decrease assets

or increase liabilities
Collection of
Accounts Receivable
Cash
+ $4,000 = (no change in Liab. or S/E)
Accts. Rec.
$4,000
Assets were traded:

accounts receivable for cash
Payment of Dividends
$2,000 = $2,000
Dividends directly reduce retained earnings
Cumulative Effect of Transactions for
Glengarry Health Club
Assets = Liabilities + S/E
Sold stock + $100,000 = + $100,000
Bought prop.
with note + 200,000 = + $200,000
Bought equip.
on acct. + 20,000 = + 20,000
Sold
memberships + 15,000 = + 15,000
Sold court time + 5,000 = + 5,000
Paid wages 10,000 = 10,000
Paid utilities 3,000 = 3,000
Collected A/R + 4,000 = (no change in Liabilities + SE)
4,000
Paid dividends 2,000 = 2,000
+ $325,000 = + $220,000 + $105,000
Balance Sheet
January 31, 2012
Assets Liabilities and Stockholders Equity
Cash $ 94,000 Accounts payable $ 20,000
Accts. Rec. 11,000 Notes payable 200,000
Equipment 20,000 Capital stock 100,000
Building 150,000 Retained earnings 5,000
Land 50,000 Total liabilities
Total assets $325,000 and stockholders equity $325,000
Income Statement
For the Month Ended January 31, 2012
Revenues:
Memberships $15,000
Court fees 5,000 $20,000
Expenses:
Wages and Salaries
Net in $10,000
Utilities retain creas3,000
e 13,000
ed ea to
Net income rning $ 7,000
s
The T Account
Account Name
Debits are Credits are

entered on left entered on right
Representation of one account in the general ledger

The T Account
Account Name
400 dr. 900 cr.
Debits and credits

are netted to obtain 500 cr.
balance in account
Debits/Credits and
the Accounting Equation
STOCKHOLDERS
ASSETS = LIABILITIES + EQUITY
Dr. Cr. Dr. Cr. Dr. Cr.
+ + +
Opposite sides of the accounting equation are

increased/decreased in an opposite way
Link Between Revenues and
Retained Earnings
RETAINED
EARNINGS Both accounts
are increased

Dr. +
Cr. with credits
REVENUES
Revenues increase
retained earnings

Dr. Cr.
+ (part of stockholders equity)
Link Between Expenses and
Dividends and Retained Earnings
RETAINED
EARNINGS
Retained earnings is
decreased with debits DR. CR.
+
Expenses and dividends
decrease retained earnings EXPENSES AND
DIVIDENDS
Use debits to record (increase) DR. CR.
expenses and dividends
harigopal@kusom.edu.np +
Normal Account Balances
Debit Credit
Assets Liabilities
Expenses Stockholders Equity
Dividends Revenues
all increased all increased
with debits with credits
Transactions and T Accounts
Cash Capital Stock
(1) 100,000 100,000 (1)
(1) Issue capital stock for cash
Land
(2) 50,000
Notes Payable
Building 200, 000 (2)
(2) 150,000
(2) Purchase property in exchange

for a promissory note.
Equipment Accounts Payable
(3) 20,000 20,000 (3)
(3) Purchase equipment on account
Accounts Receivable Membership Revenue
) 15,000 15,000 (4)
(4) Sell monthly memberships on account
Cash Court Fee Revenue
) 100,000 5,000 (5)
) 5,000
T Accounts reflect
current and previous
postings to the account
for each period
(5) Sell court time for cash

Wage & Salary Expense Cash
6) 10,000 (1) 100,000 10,000 (6)
(5) 5,000 3,000 (7)
Utilities Expense
7) 3,000
(6) Pay employees wages for the month

(7) Pay utilities for the month
Cash Accounts Receivable
(1) 100,000 10,000 (6) (4) 15,000 4,000 (8)
(5) 5,000 3,000 (7)
(8) 4,000
(8) Collection of accounts receivable
Cash Dividends
(1) 100,000 10,000 (6) (9) 2,000
(5) 5,000 3,000 (7)
(8) 4,000 2,000 (9)
(9) Pay dividends

Determine the Balance
of the T Accounts
Cash Accounts Receivable
(1) 100,000 10,000 (6) (4) 15,000 4,000 (8)
(5) 5,000 3,000 (7)
(8) 4,000 2,000 (9) 11,000
94,000
The Journal
A chronological record of transactions
The book of original entry
Each entry has a debit and a credit
that equals
Transactions normally recorded in
general journal
Posting from Journal
Transactions are
entered in: And then posted to:
Journal
Journal
(via
(viajournal
journalentries):
entries): Ledger
LedgerAccounts
Accounts
Cash
Cash
Dr.
Dr. Cr.
Cr. Capital
Cash 100,000 CapitalStock
Stock
Cash 100,000
Capital
CapitalStock
Stock 100,000
100,000
To
Torecord
recordthe
theissuance
issuanceof
of10,000
10,000shares
shares
Journal Entries
Dr. Cr.
Building 150,000
Land 50,000
Notes Payable 200,000
To record acquisition of property in exchange for note
Equipment 20,000
Accounts Payable 20,000
To record the acquisition of equipment on open account
Accounts Receivable 15,000

Membership Revenue 15,000
To record sale of monthly memberships on account
Journal Entries
Dr. Cr.
Cash 5,000
Court Fee Revenue 5,000
To record sale of court time
for cash.
Wage and Salary Expense 10,000

Cash 10,000
To record payment of wages
and salaries.
Utilities Expense 3,000

Cash 3,000
To record payment of utilities.
Journal Entries
Dr. Cr.
Cash 4,000
To record collection of accounts
receivable.
Dividends 2,000
Cash 2,000
To record payment of dividends.
Trial Balance
January 31, 2012 Debits Credits
Cash $ 94,000
Equipment 20,000
Building 150,000
Land 50,000
Accounts Payable $ 20,000
Capital Stock 100,000
Membership Revenue 15,000
Court Fee Revenue 5,000
Wage and Salary Expense 10,000
Utility Expense 3,000
Dividends 2,000
Totals
$340,000 $340,000
Basic Structure of a
Classified Balance Sheet
Current assets
+ Noncurrent (long-term) assets
Total assets
Current liabilities
+ Noncurrent (long-term) liabilities
+ Stockholders equity
Total liabilities and stockholders equity
Dixon Sporting
Rea
lize
Goods A = L + SE
on e d , so
Balance Sheetyea ld, o
r or
op
r co
ns era um
ting ed A
Assets cyc in
le
Current assets
Cash $ 5,000
Marketable securities 11,000
Accounts receivable 23,000
Merchandise inventory 73,500
Prepaid insurance 4,800
Supplies 700
Total current assets $118,000
Non Current Assets
Investments
Land held for future office site 150,000
Property, plant, and equipment
Land $100,000
Buildings $150,000
Less: Accumulated depreciation (60,000) 90,000
Store furniture and fixtures $ 42,000
Less: Accumulated depreciation (12,600) 29,400
Total property, plant and equipment 219,400
Intangible assets
Franchise agreement 55,000
Total assets $542,400
Dixon SportingSa Goods
ye tisfi
Balance Sheetar
or ed w
o i
A = L + SE
pe tEquity
rati hin o
Liabilities and Stockholders
ng ne
=L cy
Current liabilities
cle
Accounts payable $ 15,700
Salaries and wages payable 9,500
Income taxes payable 7,200
Interest payable 2,500
Bank loan payable 25,000
Total current liabilities $ 59,900
Long-term debt
Notes payable $ 120,000
Total liabilities $179,900
+ SE
Contributed capital
Capital stock, $10 par, 5,000 shares
issued and outstanding $ 50,000
Paid-in capital in excess of par value 25,000
Total contributed capital $ 75,000
Retained earnings 287,500
Total stockholders' equity $ 362,500
Total liabilities and stockholders equity $542,400

Analysis of Liquidity
Ability of
Of particular interest
company to
to bankers and other pay debts
creditors as they
become due
Working
Capital
Dixon Sporting Goods Liquidity
Current assets What's the $2,000

Current liabilities 1,600
trend??
Working = Current Assets

Capital (Current Liabilities) $58,100
Current = Current Assets

Ratio Current Liabilities 1.97:1
Single-Step
Income Statement
Revenues $$
Less: expenses ($$)
Net income $$
Multiple-Step
Income Statement
Sales
Cost of Goods Sold
= Gross Profit
Operating expenses:
General and
Four
administrative expenses
Selling expenses important
= Income from operations subtotals
+/ Other revenues and expenses
= Income before taxes
Income tax expense
= Net income
Dixon Sporting Goods
Multiple Step Income Statement
For the Year Ended December 31, 2012
Sales $357,500
Cost of Goods Sold 218,300
Gross Profit $139,200
Operating expenses:
Selling expenses
Depreciation on store furniture and fixtures $ 4,200
Advertising 13,750
Salaries and wages 22,000
Total selling expenses $ 39,950
General and administrative expenses
Depreciation of buildings and amortization
of trademark $ 6,000
Salaries and wages 15,000
Insurance 3,600
Supplies 1,050
Total general and administrative expenses 25,650
Total operating expenses 65,600
Income from operations $ 73,600
Other revenues and expenses:
Interest revenue $ 1,500
Interest expense 16,900
Excess of other revenues over other expenses 15,400
Income before taxes $ 58,200
Income tax expense 17,200
Net income $ 41,000
Analysis of Profitability
Of
particular
interest
Profit
to current and
Margin %
potential
investors
Dixon Sporting Goods
Profit Margin
Profit Margin % = Net Income
Operating Revenues
Profit Margin % = $41,000 = 11%
$357,500
(The amount of every sales dollar that
results in income)
Basic Format for the
Statement of Cash Flows
Cash flows from operating activities:
Involves the purchase and sale $$
of products or services
Cash flows from investing activities:
Involves the acquisition and sale $$
of long-term or noncurrent assets
Cash flows from financing activities:
Involves the issuance and repayment $$
of long-term liabilities and stock
Net increase in cash $$
Cash at beginning of year $$
Cash at end of year $$
Financial Statements
for a Real Company:
General Mills
General Millss Liquidity
(in millions) 2010 2009
Current assets $ 3,480.0 $ 3,534.9
Current liabilities 3,769.1 3,606.0
Working capital $ ( 289.1) $( 71.1)

Current = Current Assets
Current
Ratio ratio = Liabilities0.92:1
Current 0.98:1
(How many $ of current assets for

every $ of current liabilities)
General Millss Profitability
(in millions) 2010 2009 2008
Net sales $14,796.5 $14,691.3 $13,652.1
Net income $ 1,530.5 $ 1,304.4 $ 1,294.7
Profit margin % = 10.3% 8.9% 9.5%

Profit Margin % = Net Income
Sales
(How many cents on every dollar of sales are left
over after covering all expenses)
Elements of an Annual Report
Letter to stockholders
Description of companys products and markets
Financial statements
Notes to financial statements
Report of independent accountants
Management discussion and analysis
Summary of significant accounting policies
Recognition and Measurement
Recognition: formally I know I
recording an item in the need to
financial statements of record
an entity this...
...but at
current value Measurement:
or historical quantification of the
cost? economic effects of
the item on the entity
Cash vs. Accrual Basis
Cash basis: revenues and expenses are
recorded only when cash is received or paid
Accrual basis: revenues are recognized when

earned; expenses are recognized when incurred
Cash basis Accrual basis
statement statement
Statement of Income
Cash Flows Statement
Cash flows from Net income:

operating activities: $ 7,000
$(4,000)
What accounts for
the difference?
Revenue Recognition Principle
Revenue is recognized when realized and
earnedusually at time of sale
Exceptions:
Long-term contracts
Franchises
Commodities
Installment sales
Rent and interest
Matching Principle
Match expenses with associated revenues
Indirectly over Simultaneously

Directly
period they upon their
provide benefits acquisition
e.g., Inventory e.g., Buildings e.g., Utilities

Expense Recognition
Balance Sheet Income Statement
ASSETS: EXPENSES:
Inventory when sold Cost of goods sold
Supplies expense
Supplies
as used Insurance expense
Prepaid assets Rent expense
PP&E Depreciation expense

Intangibles over period they
l Amortization expense
provide benefits
Other expenses
(as incurred)
Types of Adjusting Entries
Deferred Accrued
expense RECOGNIZE liability
REVENUE OR
EXPENSES
BEFORE OR AFTER
CASH IS
EXCHANGED
Accrued Deferred
asset revenue
Deferred Expense
Cash paid before expense is incurred
Examples:
Prepaid rent
Prepaid insurance
Office supplies
Property and equipment
Costs are initially recorded as assets and

allocated to expenses in future periods
Deferred Expense Example #1
Prepay insurance for one year on September 1
Initial journal entry:
9/1 Prepaid Insurance 2,400
Cash 2,400
Monthly adjusting journal entry:
9/30 Insurance Expense 200
Prepaid Insurance 200
($2,400 annual 1/12 = $200 per month for 12 months)
Deferred Expense Example #2
Purchase new store fixtures on January 1 for $5,000.
Estimated useful life is 5 years (60 months); estimated
salvage value is $500
1/1 Store fixtures 5,000
Cash 5,000
1/31 Depreciation Expense 75
Accumulated Depreciation 75
($5,000 $500) 1/60 = $75 per month for 60 months)
Deferred Revenue
Cash received before revenue is earned
Examples:
Insurance collected in advance
Subscriptions collected in advance
Gift certificates
Receipts are initially recorded as liabilities (unearned
or refundable receipts) and recorded as revenues in
future periods when earned
Deferred Revenue Example
Received $2,400 for an insurance policy in advance on September
1

9/1 Cash 2,400
Insurance Collected in Advance 2,400
9/30 Insurance Collected in Advance 200
Insurance Revenue 200
($2,400 annual 1/12 = $200 per month for 12 months)
Accrued Liability
Expense incurred before cash is paid
Examples:
Payroll
Taxes
Interest
Record expense (and corresponding liability) in
period incurred; pay for it in a future period
No cash flow on recording, only when paid
Accrued Liability Example #1
Pay biweekly wages of $280,000
At end of month, between pay periods:

Wages Expense 40,000
Wages Payable 40,000
Next payday:
Wages Payable 40,000
Wages Expense 240,000
Cash 280,000
On March 1, assume a 9%, 90-day, $20,000
loan is taken out with a bank

3/1 Cash 20,000
3/31 Interest Expense 150
Interest Payable 150
($20,000 principal 9% 3/12 = $450 for 3 months
or $450/3 = $150 per month)
(continued)
To record payment of a 9%, 90-day, $20,000 loan with
interest due on May 30
5/30 Interest Payable 300

Interest Expense 150
Cash 20,450
Accrued Asset
Revenue earned before cash is received
Examples:
Rent
Interest
Record revenue (and corresponding receivable) in
period earned; receive payment in a future period
Accrued Asset Example
Rent payment of $2,500 due within first 10
days of month
First day of the month:

Rent Receivable 2,500
Rent Revenue 2,500
Upon receipt of cash:
Cash 2,500
Rent Receivable 2,500
Adjusting Entry Summary
Examples:
Deferred Expense
cash paid before expense is incurred
Deferred Revenue
cash received before revenue is earned
Accrued Liability
expense incurred before cash is paid
Accrued Asset
revenue is earned before cash is received
Steps in the Accounting Cycle
1. Collect and
7. Close the analyze info
2. Journalize
accounts transactions
6. Record and
post adjusting 3. Post
entries transactions to
general ledger
5. Prepare
financial 4. Prepare
statements work sheet
The Closing Process
Purpose:
To return the balance of revenue,
expense, and dividend accounts to
zero to begin the next period
to transfer the net income of the
period to Retained Earnings
Nominal Accounts
Revenues Expenses
Close to Normal Normal Close to
Income balance balance Income
Summary Summary
$ XX $ XX $ XX $ XX
Dividends Zero out

Normal Close to
nominal accounts
balance Retained
Earnings
to start accumulation
of next periods
$ XX $ XX results
Closing Entries
Income Summary
$XX $XX
from expense from revenue
accounts accounts
(Net loss) or net income

closed to Retained Earnings
Appendix
Accounting Tools:
Work Sheets
Unadjusted Trial Balance Columns
Begin by filling in the

trial balance
accounts and amounts

The Adjusting Entries Columns
Make adjustments;
formal journal
entries
are prepared later
Ad
ad d o
ac jus r s
co tm ub
un e tr
t b nts act
al fo
an r
c e ad
s jus
te
d
Adjusted Trial Balance Columns
The Income Statement Columns
Extend revenue and expense

account balances to the
income statement
The Balance Sheet Columns
Extend asset, liability, and

equity accounts to the
balance sheet
Contingent Liabilities
Obligation involving existing condition
Outcome not known with certainty
Dependent upon some future event
Actual amount is estimated
Contingent Liabilities
Accrue estimated amount if:
Liability is probable
Amount can be reasonably estimated
In year criteria are met:

Expense (loss) XXX
Liability XXX
harigopal@kusom.edu.np 90
Typical Contingent
Liabilities
Product warranties and guarantees
Premium or coupon offers
Lawsuits
harigopal@kusom.edu.np 91
Recording Contingent
Liabilities
Example:
Quickly Computer sells a computer product for $5,000

with a one-year warranty. In 2012, 100 computers were
sold for a total sales revenue of $500,000.
Analyzing past records, Quickly estimates that repairs
will average 2% of total sales.
Recording Contingent
Liabilities
Probable liability has been incurred?
YES
Amount reasonably estimable?
YES
Record in 2012:
Warranty Expense 10,000

Estimated Liability 10,000
(2% X $500,000 sales)
Disclosing Contingent
Liabilities
IF
not probable
but
Disclose in
reasonably Financial
Statement
possible notes
OR
amount not
estimable
Contingent Assets
Contingent gains and assets are not

recorded but may be disclosed in
financial statement notes
Conservatism principle applies
IFRS and Contingencies
International standards use the term provision for those
items that must be reported on the balance sheet
International standards have a lower threshold for those
items that must be reported so thus more items will be
recorded on the balance sheet.
International standards require the amount of the
recorded liability be discounted (recorded at present
value).
The term contingent liability is only used for those
items that are footnoted but not for those liabilities
reported on the balance sheet.
Thank You!

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Understanding and Preparation

Extend credit $$?? Loan $$??

Relevance Has capacity to

Reliability Represents what

Payroll Shipping Receiving

Assets = Liabilities + Stockholders Equity

The accounting equation must always

At least two accounts affected

Revenue Beg. R/E

Revenues increase retained earnings

Assets = Liabilities + Stockholders Equity

Revenues increase retained earnings

Expenses decrease retained earnings

Expenses also decrease assets

Assets were traded:

Dividends directly reduce retained earnings

Debits are Credits are

Representation of one account in the general ledger

400 dr. 900 cr.

Debits and credits

Dr. Cr. Dr. Cr. Dr. Cr.

Opposite sides of the accounting equation are

(1) Issue capital stock for cash

(2) Purchase property in exchange

(3) Purchase equipment on account

(4) Sell monthly memberships on account

(5) Sell court time for cash

(6) Pay employees wages for the month

(8) Collection of accounts receivable

(9) Pay dividends

Accounts Receivable 15,000

Wage and Salary Expense 10,000

Utilities Expense 3,000

Total liabilities and stockholders equity $542,400

Current assets What's the $2,000

Working = Current Assets

Current = Current Assets

Profit Margin % = $41,000 = 11%

Working capital $ ( 289.1) $( 71.1)

(How many $ of current assets for

Net income $ 1,530.5 $ 1,304.4 $ 1,294.7

Profit margin % = 10.3% 8.9% 9.5%

Accrual basis: revenues are recognized when

Cash flows from Net income:

Indirectly over Simultaneously

e.g., Inventory e.g., Buildings e.g., Utilities

PP&E Depreciation expense

Costs are initially recorded as assets and

Initial journal entry:

At end of month, between pay periods:

Initial journal entry:

5/30 Interest Payable 300

First day of the month:

Dividends Zero out

(Net loss) or net income

Begin by filling in the

accounts and amounts

Extend revenue and expense

Extend asset, liability, and

In year criteria are met:

Premium or coupon offers

Quickly Computer sells a computer product for $5,000

Warranty Expense 10,000