Week 2Creating Financial Statements From Transactions

A Little Review The Accounting Equation

Assets = Liabilities plus Owners’ Equity

The Balance Sheet Assets

Resources with future value Liabilities

Obligations to non-owners A source of the resources

Owners’ Equity The difference between assets and liabilities Another source of the resources Two forms

Contributed Capital (Common Stock) Earned Capital (Retained Earnings)

The Income Statement A measure of entity performance for a period

of time. Based on accrual accounting Ties to the Balance Sheet through retained

earnings Major components

Revenues and gains Expenses and losses

Two Methods To Record Transactions Traditional (Hard!) way used by

accountants/bookkeepers Debits Credits T-accounts

Our methods Spreadsheet based on accounting equations

Increases and decreases

Journal Entries

Transaction Analysis

Credit Sales Transaction

Expense Payment Transaction

Accrued Expense Transaction

Deferred Revenue Transaction

Asset Write-Down (Impairment) Transaction

Arcadia Company Review Problem1. Smith contributed $250,000 in cash2. The firm purchased a shop for $150,0003. The firm borrowed $120,000

1. Interest only of 6% paid semi-annually

4. $150,000 of inventory purchased with $120,000 cash and $30,000 credit

5. $80,000 (cost) of the inventory was sold for $160,000 in cash

6. The shop is depreciated over 20 years on a straight-line basis

7. Smith withdrew $20,000 of his capital contribution

Problem 2.2 Received $50,000 in cash from investors as an equity

investment. Borrowed $40,000 from a bank. Purchased two parcels of land, each costing $15,000, for a

total of $30,000 cash. Paid $10,000 cash to rent office equipment for the year. Provided real estate appraisal services valued at $25,000,

receiving $20,000 in cash and an account receivable for an additional $5,000.

Paid miscellaneous expenses totaling $11,000 in cash. Sold one parcel of land, costing $15,000, for $22,000 cash. Paid a $5,000 cash dividend to shareholders.

Some Useful Ratios Profitability

Why not just consider net income?

Return on Assets (ROA) Considers how will you did with what you

invested. Both income statement and balance sheet.

ROA Tells us what is available for all investors

(both debt and equity). Return of equity (ROE) similar for just

shareholders. Can be decomposed into two components in

order to shed more light on performance.

ROA ROA = Return on sales (ROS) x Asset Turnover (AT)

Return on Equity Only considers return to shareholders Therefore no need to add back interest

expense Also only divide by shareholders’ equity

rather than total assets

ROE Like ROA, ROE can also be decomposed Sometimes called the Dupont Model ROE = ROS x AT x Leverage

Evaluating Risk Debt to equity Interest coverage

What Number Do You Want? Accounting is a political process, not an exact

science.

There is a great deal of discretion available to managers.

Earnings Management Reasons to manage earnings

ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS

Earnings Management - Why Compensation contracts

Debt contracts

Political considerations

Question?Why might a company’s stockholders want its

managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary?

Debt Contracts

Firms that are near violation of their debt contracts have incentives to manage earnings upward.

Question?The following excerpt was taken from a recent

financial statement of Cummins Engine Company:

Loan agreements contain covenants which impose restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings.

Why would a creditor such as a bank impose such restrictions when making a loan?

Political Reasons

Firms may wish to portray a certain image to the public, government, or regulatory body.

Common Earnings Management

Smoothing earnings Managing earnings upward Taking a bath Off balance sheet financing

Problem 2.11 See handout