HBSP Product Number TCG 328

THE CRIMSON PRESS CURRICULUM CENTER

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THE CRIMSON GROUP, INC.

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Note on Understanding Financial Statements



Financial accounting is concerned principally with financial information prepared for distribution outside an
organization. This Note contains an introduction to financial accounting and the statements used to present fi-

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nancial accounting information. It also provides some guidance for undertaking a preliminary analysis of a set
of financial statements. The learning objectives for this Note are contained in Exhibit 1.
____________________________________________________________________________________________________________
Exhibit 1. LEARNING OBJECTIVES
Upon completing this Note, you should know about:
1.
The balance sheet and what it measures, including:
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assets
•
liabilities

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•
owners' equity
2.
Some specific assets and liabilities, including:
•
cash
•
accounts receivable
•
inventory
•
equipment
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accounts payable
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loans payable
•
interest payable
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•
goodwill
3.
The income statement and what it measures, including:
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revenue
•
expenses
•
net income
4.
The creation of owners' equity, and the basis for changes in it
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5.
Five of the nine fundamental accounting concepts.*

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the entity concept
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the dual aspect concept
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the money measurement concept
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the cost concept
•
the realization concept
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The four remaining concepts are going concern, conservatism, materiality, and matching
6.
Some basic accounting and finance concepts, including:
•
the distinction between levels and flows
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•
the nature of an account

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the accounting period
•
the current vs. non-current distinction
•
working capital and the current ratio
•
leverage
•
unmeasured value
•
the accounting cycle
•
depreciation
•
interest expense

____________________________________________________________________________________________________________
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This note was prepared by Professor David W. Young.

Copyright © 2014 by David W. Young and The Crimson Group, Inc. To order copies or request permission to reproduce this docu-
ment, contact The Crimson Press Curriculum Center at 617-497-9600 (Voice) or 617-576-7693 (Fax), or go to
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 TCG328 • Note on Understanding Financial Statements
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ROLE OF FINANCIAL ACCOUNTING

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Financial accounting information plays an important role in an economy. It is used by managers, investors,
financial analysts, creditors, regulators, and even employees and customers on occasion. All of these people
need to understand both the current financial status of an organization, as well as the events that caused a
change in that status from some prior point in time.
A Brief History

Accounting’s roots can be traced to the Italian Renaissance and its then-emerging city states. At that time, as

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commerce among the city states was becoming increasingly significant, merchants began to recognize the need
for improved record keeping, both to avoid mistakes in keeping track of financial data, and to provide them with
better information on the performance of their businesses.


The breakthrough came when a Franciscan monk, Fra. Luca Pacioli, devised the system of double-entry
bookkeeping that remains the cornerstone of accounting today. Fra. Pacioli, a mathematician, reasoned that if
instead of making a single entry to the accounts each time a transaction took place, a bookkeeper made two en-
tries in two different accounts, there could be a system of checks and balances. His insight gave rise to the dual
aspect concept of accounting, which we will examine later in this chapter.

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The Fundamental Financial Accounting Statements

The purpose of an accounting system is to collect, summarize, and report information concerning the impact
of various business events on an organization's financial status and financial performance. Organizations peri-
odically report their financial status as of a certain date, and their financial performance for some period of time
preceding that date, called the accounting period. They do this on four separate financial statements: the balance
sheet, the income statement, the statement of retained earnings, and the statement of cash flows.

The balance sheet is a financial status report prepared as of the last day of the accounting period. The in-
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come statement is a financial performance report for the accounting period. The statement of retained earnings
explains the changes that took place in owners’ (as opposed to lenders’) claims on the organization. The state-
ment of cash flows, or SCF, explains in an organized way the reasons for any change in the organization’s cash
during the accounting period.
STANDARDS AND STANDARD SETTERS

For financial accounting information to be useful to readers of financial statements, it must be collected and
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presented in a reasonably similar fashion by all organizations. As a result, the accounting profession uses a set
of standards, called Generally Accepted Accounting Principles, or GAAP. The goal of these principles is to try to
assure financial statement users that a particular item means essentially the same thing on the financial state-
ments of any organization doing business in any industry. As we will see, this is a tricky proposition, and de-
spite the presence of GAAP, most organizations have considerable latitude in the way they interpret information
and present it on their financial statements. Indeed, as the financial scandals in the first few years of the 21st
century demonstrated, sometimes the latitude extends beyond a legitimate choice in the application of GAAP to
a serious misrepresentation or downright fraud.
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The U.S. Financial Accounting Standards Board

In the United States, the development of the standards needed to implement accounting principles is the re-
sponsibility of the Financial Accounting Standards Board, or the FASB. The FASB is a private sector body with
seven full-time board members and a large staff. It has an annual budget of about $24 million, which is contrib-
uted by a variety of organizations, including public accounting firms.1

In setting accounting standards, the FASB works closely with the accounting profession, especially the
American Institute of Certified Public Accountants, or AICPA. Prior to issuing a new standard, the FASB issues
discussion papers, solicits testimony from interested parties, and, in general, follows an open process. Neverthe-
less, many of its pronouncements concerning accounting standards are highly controversial.
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The International Accounting Standards Board

Outside the U.S., international accounting standards (IAS) are developed by the International Accounting
Standards Board (IASB). The IASB is an independent board, overseen by a “geographically and professionally
diverse body of trustees.” It has been in existence for about 15 years, and is supported by an external advisory

1
For additional details, go to www.fasb.org

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 TCG328 • Note on Understanding Financial Statements
3 of 39
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council, an Accounting Standards Advisory Forum of national standard-setters, and an IFRS (International Fi-

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nancial Reporting Standards) Interpretations Committee. The committee offers guidance where there is a diver-
gence in practice.2

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The Role of Auditors

In the United States, any company wishing to have its stock traded publicly, i.e., on a stock market, must
have its financial statements audited by a certified public accountant (CPA), often called a “chartered public ac-
countant” outside the U.S.. Many CPAs work independently or in small- to medium-sized public accounting

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firms. Others work for one of the four large international public accounting firms.3

Although an audit could be conducted by a single CPA, most audits are conducted by audit teams. An audit
team usually consists of one of the firm’s partners, who is in charge of the audit, and several other members of
the firm who, while CPAs, have not yet achieved partnership status.

The auditors’ role is to determine if an organization—their client—followed GAAP in the preparation of its
financial statements. At the conclusion of its audit, the auditors issue an opinion letter, usually signed by the
firm itself, not by the individuals who conducted the audit. The opinion letter states that the auditors conducted
all reasonable tests to ascertain whether the company’s accountants followed GAAP in preparing the financial
statements.4

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If the auditors believe that the company followed GAAP, and that there were no material errors or omis-
sions, they give the company a clean opinion. If, in the auditors’ judgment, the company did not follow GAAP,
or if the auditors believe there were material errors or omissions, they give the company a qualified opinion. In
giving a qualified opinion, the auditors indicate that the accuracy of the financial statements is subject to ques-
tion in certain areas, which they specify in their opinion letter.
Public Company Accounting Oversight Board

In the U.S., following the accounting scandals of the early 2000s,the U.S. Congress passed the Sarbanes-
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Oxley bill, which was signed into law in 2004. The Sarbanes-Oxley law mandates several actions in an attempt
to create a more arms-length relationship between a company and its auditors. Among other steps, it restricted
the provision of non-audit services by an organization’s auditing firm, mandated the rotation of the lead auditor
from the firm conducting the audits, and instituted a one-year “cooling off” period between the time a partner
resigned from his or her firm and when he or she could be employed by the client. In addition, the law created
the Public Company Accounting Oversight Board (called “the Board”), which was charged with monitoring the
provisions of the act.5
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According to the act, the Board is to have five full-time “financially literate” members, appointed for five-
year terms. The members are to be appointed by the Securities and Exchange Commission (SEC). The head of
the SEC is to “consult” with the Chairman of the Federal Reserve Board and the Secretary of the Treasury prior
to making the appointment. The SEC may remove any of these members at any time “for good cause.”

In an attempt to assure the board’s independence as well as a focus that is broader than just accounting, per
se, the Act requires that two of the members must be or have been certified public accountants, but that the re-
maining three members must not be and cannot have been certified public accountants (CPAs). The Chair may
be held by one of the CPA members, provided that he or she has not been engaged as a practicing CPA for five
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years. In addition, during their service on the Board, the members may not share in any of the profits of, or re-
ceive payments from, a public accounting firm (other than fixed continuing payments, such as retirement pay-
ments).

2
For additional details, go to www.ifrs.org

3
The four firms are Deloitte Touche Tohmatsu, PricewaterhouseCoopers, Ernst & Young, and KPMG. The first two have annual
revenues of about $33 billion; the second two have annual revenues of about $24 billion. The four firms have between 155,000 and
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210,000 employees. The fifth largest firm, BDO International, has revenues of about $6.5 billion and about 55,000 employees.
Some consolidation has taken place over the past few years to create these four. Further consolidation is, of course, a possibility.
4
Note that the financial statements are prepared by the company’s (client’s) accountants. The underlying information and accounting
practices that went into the statements are the subject of the audit. This is the case in most medium-sized and large organizations.
In small organizations, the statements actually may be prepared by the auditors, who also audit the underlying information and re-
cords they used to prepare the statements.
5
A more complete summary of the Sarbanes-Oxley Act of 2004 can be found at

www.aicpa.org/info/sarbanes_oxley_summary.htm The full text of the Act itself may be found at

http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf. To learn about the Board, go to www.pcaob.org.

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 TCG328 • Note on Understanding Financial Statements
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The Internal Revenue Service

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In many instances, the Internal Revenue Service (IRS) has accounting standards that differ from the FASB’s.

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For this reason, an organization usually must prepare two sets of financial statements: one according to the
FASB standards, and one for tax purposes. There is nothing illegal or unethical about this; rather, there are two
sets of standards and guidelines that are not always consistent with each other. In general, we will not be con-
cerned with tax accounting in this book, although in later chapters we will see how the guidelines for tax ac-
counting affect the financial statements prepared according to GAAP.
Nonprofit and Governmental Organizations

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Nonprofit and governmental organizations march to the beat of yet a different drummer. Many nonprofit or-
ganizations use something called fund accounting, and the financial statements of most governmental organiza-
tions differ considerably from financial statements prepared according to GAAP. Moreover, the standard setting
organization for state and local government organizations is not the FASB, but the GASB (for Government Ac-
counting Standards Board).6 The GASB is similar to the FASB (and is located in the same building), but it has a
smaller staff and budget, and has not been in operation as long as the FASB.
LEVELS AND FLOWS

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Much of what we do financially is built around the idea of levels and flows. If, for example, we wish to de-
termine whether someone is wealthy, we might look at how much he or she owns as of a certain date, such as
cash in a bank account, an automobile, a house, or other property, less what he or she owes, such as a mortgage
on a house. Alternatively, we might look at how much the person accumulates during a given period of time,
such as his or her salary for a year, less any personal expenses for that year. If we look at what a person owns as
of a point in time, we are concerned with the level of resources. If we look at earnings and expenses, we are
concerned with resource flows.

In accounting, levels are called assets, liabilities, and equity, and flows are called revenues and expenses.
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All of these will be discussed in this Note. Beginning with flows, revenues arise from the sale of a company’s
goods or services to its customers, and expenses are incurred by the company in the course of earning its reve-
nues. Example of expenses are the rent a company pays for its offices and the salaries of its employees.

The difference between revenues and expenses is called income. Income can have many modifiers, such as
operating income, income before tax, and net income. Also, in practice, we occasionally encounter some con-
fusing terminology. For example, some people use the term income to mean what accountants call revenue.
Moreover, the measurement of revenues and expenses poses some conceptual problems, since revenue is not
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necessarily cash received, and an expense is not necessarily cash paid out. This is one of the more counter-
intuitive aspect of accounting, and will be discussed in some detail in this Note.
Relationship Between Levels and Flows

Levels and flows are related. For example, if your salary during a given period of time exceeds your per-
sonal expenses, you add to the level of your wealth. To illustrate, assume that as of December 31, 2011, you had
the following personal asset:
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Cash in checking account
$6,000

The $6,000 is the beginning level of your personal asset. During 2012 you earned $40,000 and had personal
expenses of $38,000. These are your flows. You deposit the $40,000 in your checking account, and you write
checks for $38,000. Therefore, as of December 31, 2012, you had the following personal asset:


Cash in checking account
$8,000

The level of your asset increased by $2,000 as a result of the net inflow of resources, i.e., your net income.
Since you had a beginning level of $6,000 and net income of $2,000, you had an ending level of $8,000.
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The Nature of an Account

The above activities describe the nature of an account. All of financial accounting uses this basic building
block. Everything that appears on a set of financial statements is derived from an organization's accounts, and
each account behaves in exactly the same way. Specifically:

6
For a brief treatment of financial accounting in nonprofit and governmental organizations, see David W. Young, Note on Financial
Accounting in Nonprofit Organizations, or David W. Young, Note on GAAP in Nonprofit and Governmental Organizations. Both
are available from the Crimson Press Curriculum Center (www.TheCrimsonGroup.org)..

This document is authorized for educator review use only by Syed Shah, National University of Modern Languages until December 2015. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860
 TCG328 • Note on Understanding Financial Statements
5 of 39
___________________________________________________________________________________________________________
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It has a beginning level, called the beginning balance.

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It is increased with inflows and decreased with outflows.
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It has an ending level, called the ending balance.

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To illustrate, the behavior of your checking account was as follows:

Beginning Balance
$6,000

Inflows
40,000

Outflows
(38,000)

Ending Balance
$8,000

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Organizations have many different accounts in their accounting systems. Regardless of the number of ac-
counts, however, each always behaves in exactly the same way: beginning balance + inflows - outflows = end-
ing balance. The task of the accountant is to determine the accuracy of both the balances and the inflows and
outflows. As we will see, while rather simple sounding, this task sometimes becomes quite complicated in prac-
tice.
THE BALANCE SHEET

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The financial statement that is used to show an organization's levels (or status) as of a particular date is
called the balance sheet. Whenever you see a balance sheet, you will see the relevant ending date, i.e., the date
when the ending balances were calculated.

It is important to understand that a balance sheet is prepared as of a particular date. This does not necessarily
mean that it was prepared on that date. Thus, a balance sheet for December 31, 2011 probably was prepared in
early 2012.

To illustrate how a balance sheet works, assume that you have decided to form a company that will purchase
toys from manufacturers and distribute them to retailers. You have decided to call your company Toys FR' Kids.
To begin your company, you will need to engage in a variety of activities. Many of these will affect your ability
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to be profitable, but will not appear directly on your financial statements. Others will show up in some form on
your financial statements. Among these latter activities are the following:
•
You plan to purchase some special equipment for storing, packing, and shipping the toys
•

You plan to purchase some toys from manufacturers in preparation for sales to retailers
•

You plan to pay salaries, rent, utilities, and other expenses
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Assume that the amounts associated with the above items are as follows:
•
Purchase of special equipment
$25,000
•
Purchase of toys
20,000
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Annual salaries
30,000
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Annual rent, utilities, and other expenses
18,000

You will need to purchase the special equipment and toys immediately. The salaries and other expenses, by
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contrast, will occur fairly evenly throughout the first year of your operations. Let’s assume that, being cautious,
you decide that you would like to have enough cash on hand after buying the equipment and toys, to pay for two
months of salaries and other expenses. Therefore, to begin your business, you will need to have the following
amount of cash:
•
To purchase special equipment
$25,000
•
To purchase toys
20,000
•
To pay two months of salaries
5,000
(30,000÷12 = $2,500 per month; $2,500 per month x 2



months = $5,000)
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To pay two months of other expenses
3,000
(18,000÷12 = $1,500 per month; $1,500 per month x 2

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months = $3,000)

Total
$53,000

This means that before you can even begin operations, you must have a total of $53,000 in cash. Where do
you get it?

There are only two sources for this cash: investors and lenders. Investorsprovide you with resources (gener-
ally cash) in return for some ownership in your company. Lenders, will provide resources (usually cash) without
expecting ownership; instead, they will expect you to repay their loans with interest.

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 TCG328 • Note on Understanding Financial Statements
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The Entity Concept

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You may decide to be an investor in your own company. This happens all the time. When it does, account-

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ants must distinguish between two entities: you as an individual and your company. Your company may be a
sole proprietorship, a partnership, or a corporation. As a sole proprietorship, there is only one owner (and inves-
tor)—you. A partnership, by contrast, has two or more owners (who generally, although not necessarily always,
also are investors). A corporation also has two or more owners, generally many. Unlike a partnership, however,
it is an entity that is legally distinct from its owners. In a sole proprietorship or partnership, for example, the
owner(s) can be sued individually for the entity’s activities, but in a corporation the owners may not be sued for

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the corporation's activities; only the corporate entity itself may be sued.

Regardless, of the form chosen, the entity concept holds that, for accounting purposes, the company is a
separate entity from its owners. As such, if you decide to form a corporation (by far, the most common business
form), you as an individual can invest in or lend money to your corporation. If you do this, the accountants treat
you and your corporation as separate entities, and keep separate accounting records for each. Let's see how the
entity concept works for Toys FR’ Kids.

To get the business off the ground, you decide to invest some of your own funds in it. You remove some
cash from your savings account, sell your collection of baseball cards, and borrow some money from your fam-
ily. When you are all finished, you have amassed $20,000, which you invest in your newly-formed corporation.

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You expect that, over time, this investment will grow in value as the corporation earns profits.

How do you account for what is yours and what is the corporation's? To help resolve this question, we need
to distinguish between the two different entities: you and your corporation. The fact that you have borrowed
from your family to obtain some of the cash that you invested in the corporation, for example, is of no conse-
quence to the entity called Toys FR‘ Kids, i.e. the corporation. The loan is related to the entity “You.” This is the
entity concept.

The discussion in the remainder of this Note, will focus on the entity Toys FR’ Kids, or TFK. The goal will
be to help you understand how a variety of economic events affects the financial status of TFK. Let’s begin with
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some of the steps you would take to create your new entity. First, since you have raised only $20,000 of the
$53,000 that is required to get started, you must find some additional cash.

Let's assume that you convince a friend to invest $20,000, and a bank to lend you the remaining $13,000 on
a one-year note (or loan) at an interest rate of 10 percent (per year). On January 2, 2012, having completed the
necessary legal work to form the corporation, you put the $53,000 into a bank account in the name of the corpo-
ration, Toys FR' Kids.

So far, TFK has purchased no toys for resale, has sold nothing, and has no employees. But it does have
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$53,000 in cash in a bank account. This $53,000 was received from both investors (totaling $40,000) and lend-
ers ($13,000). For financial accounting purposes, the entity must be able to reflect its status as of January 2,
2012. This is the purpose of the balance sheet.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Problem: How would you set up the balance sheet for Toys FR’ Kids?

Prepare your own analysis in the space provided before looking at the answer that follows. Do so using your
intuition of how you might set up the information so someone else could make sense out of it.
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•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
This self-testing feature is a key aspect of the learning process. Please do not try to shortcut
it by looking at the answer first. Rather, prepare the answer to the best of your ability, and
then look at the one given.
Toys FR' Kids
Balance Sheet
As of January 2, 2012
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Do

•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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 TCG328 • Note on Understanding Financial Statements
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Answer. In accounting, all events must be represented by at least two separate items. For example, take the invest-

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ment of $40,000 ($20,000 of which is yours and $20,000 of which is your friend's). The two aspects of this invest-
ment were (a) the creation of $40,000 in cash in a bank account and (b) the creation of equity (ownership) of

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$40,000, called contributed capital. Similarly, the $13,000 loan led to an additional $13,000 in cash, and the creation
of a liability of $13,000, called a note payable. The result is a balance sheet (so named because its two sides must
balance) that looks as follows:

Toys FR' Kids

Balance Sheet
As of January 2, 2012

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Cash

$53,000
Note payable
$13,000



Contributed capital
40,000
Total

$53,000
Total
$53,000

Note that we have not distinguished between the portion of cash in the bank account that came from lenders
and the portion that came from investors. We don't need to. The distinction is shown on the other half of the bal-
ance sheet. We also don't identify on the balance sheet the number of owners or the amount each owns, although
this information would be kept somewhere in the company’s records. Indeed, a corporation must keep this in-

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formation so that it can communicate with its owners and pay them dividends on their investments.
The Dual Aspect Concept

In financial accounting, the left side of the balance sheet is called assets, and the right side is liabilities and
equity. Assets are those things an entity owns or has claim to, liabilities represent obligations of the entity to
outsiders, and equity represents obligations of the entity to its owners.

In accounting, assets always must equal liabilities and equity. This is not an empirical proposition; it is true
by definition. Whatever happens in financial accounting—whatever entries the accountant makes to the system,
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whatever purchases, sales, etc. that take place by the company—cannot change this fundamental equality. As a
result, the basic accounting equation is
ASSETS = LIABILITIES + EQUITY

This equality is known as the dual aspect concept of accounting. In effect, every accounting-related event
that takes place in an organization can be analyzed in terms of its effect on this equation. If an asset increases,
the amount of its increase must be matched by (a) a decrease of an equal amount in one or more other asset ac-
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counts, (b) an increase of an equal amount in one or more liability accounts, (c) an increase of an equal amount
in one or more equity accounts, or (d) some combination of the above. At the end of the process, the two sides
of the equation must remain equal (their overall totals may change, however).

Let's now look at the pieces that comprise the dual aspect concept in TFK.

Assets. At the moment, TFK has only one asset: cash. Later we will change the composition of its assets,
and discuss the definition of assets more fully.


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Liabilities. Recall that liabilities result from resources that are provided to the entity by individuals and
groups other than its investors. If a manufacturer sells us some toys and lets us wait for, say, 30 days before we
must pay cash, that manufacturer has provided us with a resource— the toys—for which we have not had to pay
any cash; instead, we have a 30-day loan, called an account payable. This is a liability—we owe the money to
the manufacturer.

The bank that lent us $13,000 also has provided us with a resource—cash—in exchange for the liability of a
one-year loan (the note payable). We have a liability because we owe the money to the bank. In general, the in-
dividuals or entities other than owners that provide funds to us are called our creditors. That is, they have ex-
tended credit to us.
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Equity. Equity (sometimes called “Owners' Equity” or “Shareholders’ Equity”) consists of two parts. (1) the
portion provided by investors, and (2) the portion earned by the entity during the course of doing business. As
indicated above, contributed capital consists of contributions that have been made to the entity by investors in
exchange for a share of ownership, or “a piece of the business” as it sometimes is called.

The second portion of equity is termed retained earnings. It consists of the aggregate sum of the company's
inflows revenues and expenses over its entire lifetime, less the total of all dividend payments that have been
made to the investors. A positive difference between revenues and expenses is called net income or profit; a
negative difference is called a loss. Since TFK is a brand new organization on January 2, 2012, it has no re-
tained earnings; it has only contributed capital.

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 TCG328 • Note on Understanding Financial Statements
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The two sources of equity are shown schematically in Exhibit 2. You should spend a few minutes studying

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Exhibit 2, and relating the following discussion to it.

As the exhibit indicates, an organization earns revenues from the sale of its goods or services. Expenses are

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those resources that it consumes in the course of carrying out its activities and earning revenue. Some of the de-
tails concerning the measurement of revenues and expenses—which can be quite tricky at times—are discussed
briefly later in this Note. The various complications, including the reporting of dividends, are beyond the scope
of this Note.

The difference between revenues and expenses is the organization’s net income (or loss). This amount, less
any dividends paid to its shareholders, accumulates over time. That is, the net income or loss shown on the in-

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come statement for any given accounting period, less dividends, results in a change in the retained earnings ac-
count on the balance sheet. These retained earnings are combined with contributed capital. The total of these
two is owners’ equity.
____________________________________________________________________________________________________________
Exhibit 2. SOURCES OF EQUITY

Revenues Expenses are

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are earned incurred in
SHAREHOLDERS from the sale providing
of goods the goods
and services and services

Resulting in a

Contribute funds,
Net Income
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resulting in
or (Loss)

Dividends Retained
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These retained
These are paid portions of net
to the income
shareholders as (and losses)
a return on accumulate over
their the life of
investment the organization,
resulting in
No

Contributed These two are

combined, Retained
Capital Earnings
resulting in

OWNERS' EQUITY

____________________________________________________________________________________________________________
Do

Structure of the Balance Sheet

The balance sheet for an organization reflects the basic accounting equation. Usually, the left side (some-
times the top) of the balance sheet contains a listing of the organization's asset accounts and their amounts, and
the right side (sometimes the bottom) lists the liability and equity accounts and their amounts. All accounting-
related activities in an organization could be depicted solely through the use of the balance sheet. That is, an
accounting-related activity will always affect some combination of asset, liability, and equity accounts. The
practice case at the end of this Note will help you to understand this idea.

Let’s now recast the intuitive balance sheet shown above into a more formal format.

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 TCG328 • Note on Understanding Financial Statements
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Toys FR' Kids

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Balance Sheet
As of January 2, 2012

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Assets

Liabilities & Equity
Cash

$53,000
Note payable
$13,000
Total current assets
$53,000
Total current liabilities
$13,000
Non-current assets
0
Non-current liabilities
0

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Total liabilities
$13,000







Owners' equity:




Contributed capital
$40,000



Retained earnings
0
Total
assets
$53,000
Total liabilities & equity
$53,000

There are 3 items worth highlighting on this balance sheet: (1) the nature of assets, liabilities, and equity, (2)
the relationship between specific asset accounts and specific liability or equity accounts, and (3) the concept of

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current and non-current accounts.

Nature of Assets, Liabilities, and Equity. Assets are resources that are owned by an entity, liabilities and
equity can be viewed most easily as the ways the entity has financed its assets. Rarely is there a one-to-one cor-
respondence between a given asset account and a given liability or equity account, however. Rather, the liability
and equity accounts allow us to see how much of the total assets have been financed with debt (liabilities) and
how much with the organization's own funds (equity). This is important because, as mentioned above, debt gen-
erally must be repaid whereas equity need not be.
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Although equity need not be repaid, shareholders expect a return on their investment. This can come in one
of two forms: (1) dividends or (2) appreciation in the market value of the stock. The contributed capital line on
the balance sheet shows only the initial amount paid by shareholders for the stock; it does not show the stock’s
market value (which could be either higher or lower depending on how the stock market views the entity’s
value). Sale of a company’s stock on the stock market has no direct impact on the amount of equity shown on
the company’s balance sheet. Ordinarily, however, if a company is performing well, the stock market price of its
stock will greatly exceed the amount shown on the balance sheet. Investors then can get a return by selling the
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stock for more than they paid for it.

Relationship Between Accounts on the Two Sides of the Balance Sheet. Note that we can see a rather
clear relationship between the amount in the cash account and the portion of that amount that came from each
provider group (i.e., the bank and the owners). Over time, as the balance sheet becomes increasingly complex,
we will lose our ability to establish a one-to-one relationship between a given asset and a given liability. All we
will know is that total assets are equal to the sum of total liabilities and equity. You will see later why this is so.

Current vs. Non-Current. The distinctions shown above between current and non-current assets, and be-
No

tween current and non-current liabilities are important ones in accounting. A current asset is either cash or near
cash (such as a money market fund), or is an asset that we would expect to use up or convert into cash within a
year. Similarly, a current liability is a liability that we need to pay off in cash within a year. Since the bank loan
is a one-year loan, it is considered to be a current liability. Non-current items do not have this one-year-
convertibility characteristic.

The current/non-current distinction is an important one when analyzing an organization's financial state-
ments. Consider the following question:
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Question: If an organization had current liabilities that exceeded its current assets by $100,000, would you be con-
Do

cerned about its financial health? If so, why?

Please think about this for a few minutes before looking at the answer.
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Answer. The relationship between current assets and current liabilities is important because of the one-year-
convertibility characteristic. If current assets theoretically are convertible into cash within one year and current li-
abilities are payable in cash within a year, then we would hope that, unless some very special circumstances existed
(and they do for some companies), our current assets would be greater than (or at least equal to) our current liabili-
ties. Otherwise we might not have the cash on hand to pay off the liabilities when they come due.

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iming differences during the year can affect the relationship between current assets and current liabilities. That

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is, some current assets will be collected fairly early in the year, and others will be created and collected during the
year, while some current liabilities may not be due until near the end of the year. Nevertheless, if current liabilities

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exceeded current assets, we at least would have some cause for concern.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Analyzing the Relationship Between Current Assets and Current Liabilities

There are two relatively easy ways to analyze the relationship between current assets and current liabilities:

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the current ratio and working capital. The current ratio is computed by dividing current assets by current liabili-
ties. Working capital is computed by subtracting current liabilities from current assets.
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Problem: What is the current ratio for Toys FR’ Kids? How much working capital does the organization have?
Make your calculations in in the space provided before reading further.

Current Ratio
Working Capital

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Answer. The current ratio is current assets ÷ current liabilities, or $53,000 ÷ $13,000 = 4.1. This generally is re-
garded as a quite healthy current ratio. Although there are exceptions, a current ratio of 2.0 or better generally is
considered to be reasonable.

Working capital is current assets - current liabilities, or $53,000 - $13,000 = $40,000. This means that Toys FR’
Kids could pay off all of its current liabilities and still have $40,000 in cash left over.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
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Mini-Test #1. Now, test yourself to make sure you understand the concepts discussed so far.

For each of the four situations described below, write out the answer on the balance sheet contained
on the next page. Assume that all of these events took place on January 3, so that your next balance sheet
will be as of the close of business on January 3, 2012. The answers are contained in the Appendix at the
end of the Note.
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Situation #1. Additional Loan. TFK decides that it needs more cash. Its bank agrees to lend it an
additional $17,000 at an interest rate of 10 percent. The interest payment is due on the last day of the
month, but the full amount of the loan itself (the principal) is not due for two years. No interim principal
payments are required.

How would this event change the balance sheet? Write your answer on the balance sheet. Change the
account balances where necessary, and add new accounts as needed. Then go on to Situation #2. Do not
look at the answer yet.

Situation #2. Purchase Merchandise Inventory. TFK purchases $6,000 of toys for resale and pays
No

its vendors in cash. These toys will be classified as Merchandise Inventory, which is a current asset on
the balance sheet.

How would this event change the balance sheet? Write out your answer as before, and go on to
Situation #3. Do not look at the answer yet.

Situation #3. Accounts Payable. TFK purchases an additional $14,000 of toys for resale. This time,
the vendors of these toys tell TFK that it can wait for 30 days before paying. Therefore, there is an ac-
count payable that needs to be put onto the balance sheet.

How would this event change the balance sheet? Write out your answer as before, and go on to
Situation #4. Do not look at the answer yet.
Do

Situation #4. Purchase Equipment. TFK purchases $25,000 of equipment for cash. The equipment
will appear as a noncurrent asset on the balance sheet.

How would this event change the balance sheet? Write out your answer as before.

Now look at the answers in the Appendix. Compare your solution with the one given. If there are
differences, make sure you know why they exist. An explanation for each item follows the completed
balance sheet.

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
Toys FR' Kids

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Balance Sheet
As of January 3, 2012

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Assets

Liabilities & Equity

Cash

$53,000
Note payable
$13,000

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Total current assets

Total current liabilities

Non-current assets


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Total liabilities








Owners' equity:

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Contributed capital
$40,000

Retained earnings

No

Total assets

Total liabilities & equity

Do

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
IMPORTANT CONCEPTS

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There are several important concepts that underlie the analysis of Mini-Test #1.

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Asset Exchanges

When we use cash to purchase an asset, such as inventory, we do not affect either liabilities or owners' eq-
uity. We simply exchange one asset for another. In the case of Situation #2, we exchanged some cash (one type
of asset) for some inventory (another type of asset). Nothing else changed. The same is true for the purchase of

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equipment in situation #4.
Leverage

When we borrow from the bank or from our vendors (or other creditors), we give ourselves the ability to
purchase more assets than we could if we had only cash from contributed capital. For example, if we had not
borrowed from the bank, our beginning balance sheet would have shown only $40,000 in cash and $40,000 in
contributed capital. There would have been no bank loan.

If we did not borrow from the bank or have our vendors extend credit to us, we could not have purchased

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both $20,000 of inventory and $25,000 of equipment, since the sum of these two items ($45,000) exceeds the
$40,000 in cash. By borrowing from the bank and from our vendors, we gave ourselves the ability to purchase
not only the $20,000 of inventory and the $25,000 of equipment, but to have $39,000 left in our cash account
after these purchases had been made.

The idea of using liabilities to finance asset acquisition is known as leverage. In effect, we use our liabilities
as a “lever” to increase the amount of assets above what would have been possible with only equity. Leverage
can be very helpful but it also has some drawbacks. The most significant drawback is that liabilities ordinarily
have a defined repayment schedule. The vendors want to be paid in 30 days for example, and the bank wants its
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$13,000 loan to be paid in one year and its $17,000 loan to be paid in two years. We will need cash to make
these repayments.
Money Measurement Concept

Financial accounting always measures items for the balance sheet (and other financial statements) in terms
of money. This is called the money measurement concept.
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To illustrate this concept, assume that TFK’s inventory consisted only of Nintendo electronic games at a cost
of $20 each, and a competitor's inventory consisted only of Barbie Dolls at a cost of $10 each. The two invento-
ries might look as follows:

Item
Toys FR’ Kids
Competitor

Number of Nintendo electronic games
1,000
0
Number of Barbie Dolls
0
2,000
No

While it might be helpful for you to know this about your competitor (and for your competitor to know it
about you), you will not be able to see this distinction on your balance sheets.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Problem: How would the merchandise inventory account look on the two balance sheets?

Write out your answer in the space provided before reading further.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Name of Asset Account
Toys FR’ Kids
Competitor
Do

•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Answer. The two merchandise inventories would be identical on the balance sheets of the two companies, as fol-
lows:

Assets
Toys FR’ Kids
Competitor

Merchandise inventory
$20,000

Merchandise inventory

$20,000
••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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 TCG328 • Note on Understanding Financial Statements
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The Double Entry Approach

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The double-entry approach is the mechanism for putting the above relationships into practice. That is, every

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accounting-related event that takes place must result in at least two entries to the accounting system. Only in
this way will it be possible to have the basic equation of Assets = Liabilities + Equity remain intact. A single
entry would destroy the equality of the relationship. Note that each of the four situations in the Mini-Test re-
quired two changes to the balance sheet. Sometimes, three or more changes can take place, but in all cases, the
result must be one in which assets remain equal to liabilities plus equity.
Unmeasured Value

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There are many items of value to TFK that do not appear as assets on its balance sheet. For example, if you,
the chief executive officer of TFK, have a great deal of experience in the toy business, you are of considerable
value to the company. You know what kinds of toys children enjoy, which retail stores have the highest volume
sales, which manufacturers have the best quality and lowest prices, and so forth. But this value does not appear
anywhere on the balance sheet. There are many things of value to a company that financial accounting does not
measure.
The Role of Cash

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Cash is critical to the financial viability of an organization. Nevertheless, as we saw with Situation #3, for
financial accounting purposes, some activities recorded on an organization's financial statements do not involve
cash. As a result, the change in cash between two balance sheets frequently says very little about the profitabil-
ity of an entity. As indicated earlier, the statement of cash flows explains the reasons for a change in cash be-
tween two balance sheets. Nevertheless, one of the most difficult aspects of financial accounting for beginning
students is the fact that revenues do not necessarily correspond to cash received, and expenses do not necessar-
ily correspond to cash paid out. Moreover, cash received does not necessarily mean that revenue was earned,
and cash paid out does not necessarily mean that an expense was incurred. Students typically require some prac-
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tice with problems and cases before they fully understand this idea.
Basis for Equity Changes

Note that, although there was a fair amount of activity that took place between the balance sheets of January
2, 2012 and January 3, 2012, none of that activity affected owners' equity. As discussed above, owners' equity
can be affected in one of only two ways: changes to contributed capital and changes to retained earnings.

Contributed capital increases if investors (either existing or new ones) make additional contributions, and
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decreases if the company repurchases any of its outstanding stock. The retained earnings account changes if the
company earns revenue, incurs expenses, or pays dividends to its investors (usually called “shareholders”).
Since TFK has not begun to sell anything yet, it has had no opportunity to either earn revenue or incur expenses.
It therefore has no retained earnings.

In this regard, it is important to emphasize that the purchase of inventory is not an expense of TFK. It simply
is an exchange of assets. TFK will incur the expense when it sells the merchandise, not before (unless there is
an unusual event such as a fire that destroys the inventory). For the moment, then, we leave Toys FR’ Kids
poised for action.
No

PUTTING THE CONCEPTS INTO PRACTICE

To put these concepts into practice, you should now work through Practice Case #1, Homeworks, Inc. (A),
at the end of the Note. A solution is contained in the Appendix. However, you should work your way through
the case completely before looking at the solution.

You should prepare the Homeworks, Inc. (A) case before reading further.

The Homeworks (A) case allows us to see the above concepts operationalized, as follows:
Do

1. Dual Aspect Concept

Throughout the example, the Assets side of the Balance Sheet remained equal to the Liabilities + Equity
side. The totals changed, but the two sides always remain equal.
2. The Balance Sheet

The balance sheet is the financial statement used to depict all the activity of the organization. Note that it has
the asset accounts on the left and the liability and equity accounts on the right.

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___________________________________________________________________________________________________________

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3. Nature of Asset, Liability and Equity Accounts

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At the end of the activities in the case, we see that the organization has cash and supply inventory. These as-
sets total $13,200. We also see that it has financed these assets with $10,000 of contributed capital, $200 of re-
tained earnings, and $3,000 of debt (or liabilities). This debt is owed to the organization's suppliers.
4. Double Entry

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Notice that each accounting-related event resulted in at least two entries to the accounts. For example the
initial contribution of capital resulted in an increase in the asset account Cash and an equal increase in the own-
ers' equity account Contributed Capital. Similarly, the purchase of supply inventory on January 12 resulted in an
increase of $3,000 in the asset account Supply Inventory and an increase of $3,000 in the liability Accounts
Payable. By contrast, the purchase of inventory on January 20 resulted in an increase of $1,000 in the asset ac-
count Supply Inventory but a decrease in the asset account Cash.
5. Non-Cash Activities

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Note that when the organization bought $3,000 of supplies on January 12, none of the $3,000 was paid in
cash; the entire amount was on credit. This is an example of an activity that did not involve the use of cash and
yet is relevant for financial accounting purposes.
6. Equity Creation

Equity was created in two ways, corresponding to the two sources shown in Exhibit 2. First, there is $10,000
of contributed capital from the shareholders; they now hold shares of stock in Homeworks. Second, there is
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$200 of retained earnings. This is because the organization earned $200 during the accounting period. This
came about as a result of the receipt of $4,125 ($1,875+$2,250) in revenue (from customer payments), less
payments of $3,925 ($875+$1,000+$1,050+$1,000) in expenses (service staff wages and the president’s salary).

As a result of these two sources, the Owners' Equity account increased from 0 to $10,200; the ending bal-
ance is shown on the balance sheet. Note that the contributed capital portion is shown separately from the re-
tained earnings portion.

With Homeworks, the measurement of revenue and expenses was quite easy, since all items were in cash.
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What may be less clear at this point is why the supply inventory purchases were considered to increase assets
rather than be classified as expenses. To understand why, note that when the supplies were purchased, there was
no impact on equity. That is, when we purchased the supplies on January 12, we increased supply inventory (an
asset) by $3,000 and increased accounts payable (a liability) by $3,000. On January 20, we increased supply
inventory by $1,000 and decreased cash by $1,000. In neither instance did the organization's equity change.

An expense arises through the using up of a resource, and it is this that reduces equity. Thus, as the supply
inventory is consumed in the course of doing business, Homeworks incurs expenses. For reasons of simplicity,
we do not see that happening here. What we do see, however, is labor being consumed, which is an expense.
No

DEFINITION OF AN ASSET

Accounting for the supply inventory in the Homeworks case gives rise to some questions about what an as-
set actually is, and how it is treated for purposes of financial accounting. Assets were discussed briefly above;
we will now look at them in greater detail.

To be considered as an asset, an item must satisfy three requirements:
1.
It is owned by the organization.
2.
It has current or future value to the organization.
3.
It has been acquired at a cost that can be easily measured.
Do

Some Examples

Let us look at the question of what constitutes an asset by means of some examples:
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Problem: Dr. Ellen Terra, working in her garage, has developed a new type of tape cassette that is completely free
from noise distortion, which she thinks will be competitive with CDROM players. She has received a patent for the
device. She estimates that the device's worth (in terms of future profits for the company that produces it) is $300
million over the next 17 years (the life of the patent).

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 TCG328 • Note on Understanding Financial Statements
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Dr. Terra decides to form a company—called Audiotronics—to sell the device. Although she has no cash to invest,

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she finds some investors to put up the cash in her company. The investors agree to give Dr. Terra shares of stock
worth $2 million in exchange for the rights to the patent.

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Should the patent be reported on the balance sheet of Audiotronics? If not, why not? If so, why and at what
amount?

Write your answer in in the space provided before reading further.

••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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Answer. The patent would be reported on the balance sheet at $2 million. It meets all three of the above require-
ments. Note that, by virtue of the arm's-length transaction between Dr. Terra and her investors, a measurable cost has
been determined. Note also that the entity concept allows us to distinguish between Dr. Terra and Audiotronics as
separate entities.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
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Problem: Toys FR’ Kids has signed a one-year rental agreement with its landlord for the warehouse it will use to
store its toys. The rental agreement gives TFK the right to use the warehouse in exchange for a monthly payment of
$3,000, or a total of $36,000 for the year the agreement is in effect.

Should the warehouse be reported on the balance sheet of TFK? If not, why not? If so, why and at what amount?

Write your answer in in the space provided before reading further.

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Answer. The warehouse would not be reported on the balance sheet . It fails to meet requirement #1 above. TFK
does not own it.
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Problem: Toys FR’ Kids has been operating for three years, and has developed a reputation for selling only high
quality toys. It has a no-questions-asked return policy that distinguishes it in the industry from all of its competitors.
tC

The management of TFK estimates that this reputation adds approximately $1 million each year to the profits of the
company.

Should TFK's reputation be reported on its balance sheet? If not, why not? If so, why and at what amount?

Write your answer in in the space provided before reading further.
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No

Answer. The reputation would not be reported on the balance sheet. It fails to meet requirement #3 above. TFK did
not acquire its reputation at a measurable cost.
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Problem: Toys FR’ Kids has been operating for three years, and has developed a reputation for selling only high
quality toys. It has a no-questions-asked return policy that distinguishes it in the industry from all of its competitors.
TFK is purchased by Goodies FR’ Grabbers (GFG), another toy company. Because of TFK's excellent reputation,
GFG agrees to pay $1 million more for it than the difference between TFK's assets and its liabilities as shown on its
balance sheet. That is, if the difference between TFK's assets and liabilities was, say, $700,000, GFG agreed to pay
$1,700,000 for TFK.
Do

Should the extra $1 million be reported on the balance sheet of GFG? If not, why not? If so, why and at what
amount?

Write your answer in in the space provided before reading further.

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 TCG328 • Note on Understanding Financial Statements
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Answer. The amount would be reported on GFG's balance sheet . It meets all three requirements. The asset would be

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called Goodwill. It arises only when one company is acquired by another, and reflects the difference between the
equity (assets minus liabilities) of the purchased company and the purchase price. Goodwill goes on the financial

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statements of the purchasing company as a non-current asset.
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Problem: There was severe water damage to several of the toys in the warehouse of Toys FR’ Kids. As a result,
$10,000 of toys in the inventory cannot be sold, even at a discount. They must be discarded.

Should these toys be reported as part of the inventory on the balance sheet of TFK? If not, why not? If so, why
and at what amount?

rP
Write your answer in in the space provided before reading further.
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Answer. The $10,000 of toys would not be reported on the balance sheet. They fail to meet requirement #2. They
have no value to the company.

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Problem: Toys FR’ Kids has sold $100,000 of toys to one of its best customers (a store), but has not yet been paid.
The customer always pays within 30 days.

Should the amount the customer owes TFK be reported on TFK's balance sheet? If not, why not? If so, why and at
what amount?

Write your answer in in the space provided before reading further.

•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
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Answer. The amount would be reported on the balance sheet. It meets all three requirements. TFK owns the right to
the money that the customer owes, the amount is of value to TFK, and the cost is measurable (it is the amount for
which the toys were sold).
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tC

Accounts Receivable

The asset in the last problem is known as an account receivable. Accounts receivable consist of amounts
owed to a company by its customers. In general, no specific document is signed when the customer purchases
some goods, other than a purchase order or the bill of lading signifying the receipt of the goods by the customer.
Rather, the company has a general agreement with each customer (sometimes signed by both parties) that the
customer will pay its bills within some predetermined time period, usually a month.

Accounts receivable typically do not have an interest charge. Indeed, sometimes a company will offer its
customers a reduction in the amount due in exchange for timely payment. For example, a bill sent by Toys FR’
No

Kids to one of its customers might say something like “2% 10, net 30,” meaning that if the bill is paid within 10
days, the customer may deduct 2 percent from the amount due. Otherwise, the entire amount is due in 30 days.
THE ACCOUNTING CYCLE

You now have sufficient knowledge to take Toys FR’ Kids through what is called an accounting cycle. An
accounting cycle is the sequence of events that takes an organization from one balance sheet to the next. At this
stage of the game, we will go through a somewhat oversimplified cycle. The cycle is somewhat more compli-
cated than what you will see here, but its essential character remains unchanged.

During its accounting cycle, a company can engage in one or more of several accounting-related activities. It
can (a) purchase or sell assets, (b) incur or pay off liabilities, or (c) increase or decrease equity. The latter it can
Do

do either by (a) selling more stock or repurchasing some outstanding stock, or (b) adding to or decreasing its
retained earnings.

During the accounting cycle, these various activities are measured so that they can be reported on the com-
pany's financial statements. In the earlier discussion, and in Mini-Test #1, TFK engaged in a variety of activities
that added to the assets and the liabilities on its balance sheet. In so doing, it technically moved through an ac-
counting cycle. However, it did not actually sell toys to its customers, as it would do under normal circum-
stances. Rather it built up some inventory and purchased some equipment.

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 TCG328 • Note on Understanding Financial Statements
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The events associated with the additions to TFK’s assets and liabilities that were discussed above and in

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Mini-Test #1 resulted in a balance sheet as of January 3, 2012. The accounting for those events was shown in
the solution to Mini-Test #1. The result is the following balance sheet:

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Toys FR' Kids
Balance Sheet
As of January 3, 2012

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Assets
Liabilities & Equity
Cash
$39,000

Note payable
$13,000
Inventory
20,000

Accounts payable
14,000
Total current assets
$59,000

Total current liabilities
$27,000



Non-current liabilities



Note payable
$17,000



Total liabilities
$44,000









Owners' equity:

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Non-current assets


Contributed capital
$40,000

Equipment
$25,000

Retained earnings
0





Total equity
40,000
Total assets
$84,000

Total liabilities & equity
$84,000
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Mini-Test #2. Now test your knowledge of what you have learned so far by taking Toys FR’ Kids
through several steps in its accounting cycle.
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Assume that during the month of January, 2012, the following events take place:
1.
TFK sells toys to its customers for $30,000. Of this amount $20,000 is paid in cash. The remaining $10,000 of sales are
made to customers who buy on credit, and agree to pay TFK within one month.

2.
The toys that were sold were purchased for $15,000. That is, they were recorded in TFK’s inventory at a cost of $15,000.
tC

3.
TFK paid the bank $250 in interest on the two loans. The interest payment was calculated as follows: Total loans out-
standing are $30,000 ($13,000+$17,000). The interest rate on each loan is 10 percent. Therefore, the annual interest is
$3,000 ($30,000 x .10). The monthly interest is 1/12 of the annual amount, or $250 ($3,000 ÷ 12).
What would the balance sheet for Toys FR’ Kids look like as of the close of business on January 31, 2012.

To prepare your answer, use the balance sheet that follows. For each of the above three events, cross out the appropriate
asset, liability, and/or equity amounts and write in the new amounts. Remember the dual aspect concept, i.e., you need to
maintain the Assets=Liabilities+Equity relationship. Check your work by calculating revised totals for all accounts, includ-
ing total assets and total liabilities + equity. Make sure that total assets equals the total of liabilities + equity.
No

Toys FR' Kids

Balance Sheet
As of January 31, 2012
Assets
Liabilities & Equity
Cash
$39,000

Note payable

$13,000




Accounts payable

14,000




Total current liabilities

$27,000




Non-current liabilities




Note payable

$17,000
Do

Inventory
$20,000

Total liabilities

$44,000

Owners' equity:





Contributed capital

$40,000
Total current assets
$59,000

Retained earnings

0
Non-current assets




Equipment
25,000





Total assets
$84,000

Total liabilities & equity

$84,000

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 TCG328 • Note on Understanding Financial Statements
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Now look at the answers in the Appendix. Compare your solution with the one given. If there are differences,

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make sure you know why they exist. An explanation for each item follows the completed balance sheet.

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Important Points

There are several important points concerning the transactions in Mini-Test #2.



Increases in Retained Earnings. The cash received from sales was not the same as the increase in retained
earnings. This is because some of the revenue was in the form of accounts receivable rather than cash. This is
often the case; that is, retained earnings is increased by the amount that is earned from the sale of a company's

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products or services, which frequently is accompanied by an increase in accounts receivable rather than cash.
Thus, with few exceptions, revenue is earned when the sale is made, regardless of whether it is for cash or on
credit, i.e., for an account receivable.

Decreases in Retained Earnings. The decrease in retained earnings that accompanied sales is based on the
cost of the inventory that was sold. In general, all assets, including inventory, are maintained on the balance
sheet at their acquisition cost; this is known as the cost concept. Thus, when the products are sold, the retained
earnings account is decreased by the cost of those items. As discussed above, this decrease (and every other de-
crease in retained earnings that is associated with operations) is called an expense.

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Interest versus Principal. The interest expense did not change the amount of the loan that is due. The
amount of the loan that is due is called the principal. Interest is the expense TFK incurs in exchange for the right
to use the bank's money.

The Dual Aspect Concept. The dual aspect concept was maintained throughout. That is, the increase in as-
sets (cash and accounts receivable) associated with sales was accompanied by an increase in equity (transaction
#1), the decrease in assets (inventory) associated with the sale was accompanied by a decrease in equity (trans-
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action #2), and the decrease in assets (cash) associated with the interest was accompanied by a decrease in eq-
uity (transaction #3).
Spend a few minutes now to verify the dual aspect concept.
Review each transaction and make sure that you understand
how it abides by the dual aspect concept.
tC

Changes in Cash Without a Change in Retained Earnings

As the dual aspect concept indicates, changes in cash can take place without there being a change in retained
earnings. For example, an increase in cash without a change in retained earnings took place when TFK bor-
rowed $13,000 from the bank. Cash increased by $13,000, but so did the current liability called “Note payable.”
Similarly, retained earnings can increase without an increase in cash. This happened with the $10,000 sale that
led to an account receivable.
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No

Problem: Assume that, in addition to the three transactions in Mini-Test #2, the following took place at TFK during
the month of January:

4. The company purchased an additional $25,000 of inventory for cash

5. The company paid off $1,000 of its bank loan (current)

How would these items affect the balance sheet for Toys FR’ Kids as of close of business on January 31, 2012?

To prepare your answer, cross out the appropriate asset, liability, and equity amounts in the balance sheet shown in
the Solution to Mini-Test #2 in the Appendix, and write in the new amounts. Then calculate revised totals for all
Do

accounts, including total assets and total liabilities + equity.

Prepare your own analysis in the Appendix before looking at the answer that follows. Remember the dual
aspect concept.
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Answer. As of the close of business on January 31, 2012, the balance sheet would look as shown on the next page..
The changes are numbered to correspond to the items above, and are shown in bold faced type.

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 TCG328 • Note on Understanding Financial Statements
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Toys FR' Kids

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Balance Sheet
As of January 31, 2012

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Assets
Liabilities & Equity
Cash


Note payable




Beginning balance
$39,000


Beginning balance
$13,000



From sales (1)
+20,000


For payment (5)
-1,000


For interest (3)
-250


Ending balance

$12,000


For inventory (4)
-25,000

Accounts payable

14,000

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For bank loan (5)
-1,000

Total current liabilities

$26,000


Ending balance

$32,750






Non-current liabilities

Accounts receivable


Note payable

17,000


Beginning balance
0

Total liabilities

$43,000


From sales (1)
10,000


Collections
0

Owners' equity:


Ending balance

10,000
Contributed capital

$40,000

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Inventory


Retained earnings

Beginning balance
$20,000


Beginning balance
0


Purchases (4)
+25,000


From sales (1)
+30,000


Sold (2)
-15,000


For inventory (2)
-15,000

Ending balance

30,000

For interest (3)
-250
Total current assets

$72,750

Ending balance

14,750

Non-current assets




Equipment

25,000



op
Total assets

$97,750
Total liabilities & equity

$97,750

Note that in both instances, there were decreases in cash without a change in retained earnings.
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DEPRECIATION



Thus far, we have not done anything with the non-current asset called “Equipment” other than record it as an
asset at the time we purchased it. Recall that this equipment is for the storage, packing, and delivery of toys to
tC

our customers. It is highly specialized equipment, suggesting that, if we tried to sell it, its market value would
probably be below its cost. Nevertheless, because of the cost concept, it remains on the balance sheet at its cost.

As we operate our business, the equipment gradually will deteriorate and lose its value to us. The estimated
amount of value lost each year is known as depreciation. Depreciation is the expense to TFK of using its
equipment. Eventually, after several years of depreciating the equipment, it will become “fully depreciated,”
and will be removed from the balance sheet. In the meantime, it remains on the balance sheet at its cost less the
amount of depreciation that has accumulated; this depreciated amount it known as its book value, or sometime
net book value.
No

Economic Life and Residual Value

Unlike inventory, where we could physically count what was used up to derive the associated expense, the
amount of equipment that was used up during an accounting period cannot be determined with much precision.
Instead, the depreciation expense relies on two estimates: economic life and residual value. Let's look at how
the calculation process works.

As indicated above, the equipment does not become fully depreciated on a single day. Rather, it depreciates
over a number of years. This time period is known as its economic life, or service life.


An asset's economic life is not always the same as its physical life. As technology changes, the asset may
become obsolete, and will need to be replaced if the firm is to remain competitive. When this happens, the firm
Do

may be able to find a buyer for the obsolete equipment. If this is the case, the old equipment has what is called a
residual value. Residual value is an estimate of what the asset’s sale price at the end of its economic life.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Problem: Assume that TFK's equipment asset has an economic life of 10 years and no expected residual value. By
how much does it depreciate each year of its economic life?

Write your answer in the space provided before looking at the answer.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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Answer. The cost of the equipment was $25,000. Its residual value is zero. Its economic life is 10 years. Therefore,
we can make the calculation as follows:

Cost

$25,000

Less: residual value
0

Equals amount to be depreciated
$25,000

Divide by economic life
10 years

Equals annual depreciation expense
$2,500

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As a result of this depreciation expense, TFK's accountants will decrease the amount of the equipment asset shown
on the balance sheet by $2,500 each year, and decrease retained earnings by the same amount.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
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Problem: How would the above depreciation expense affect the balance sheet for Toys FR’ Kids as of close of busi-
ness on December 31, 2012?

To prepare your answer, cross out the appropriate asset, liability, and equity amounts in the last balance sheet
shown above, and write in the new amounts. Then calculate revised totals for all accounts, including total assets and
op
total liabilities + equity. In doing this analysis, you may assume that TFK took a full year’s worth of depreciation.

Write your answer on the above balance sheet. Remember the dual aspect concept.
•••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Answer. As of the close of business on December 31, 2012, the balance sheet would look as shown below. The changes asso-
ciated with depreciation are numbered (6), and are shown in bold faced type.
tC

Toys FR' Kids

Balance Sheet
As of December 31, 2012
Assets
Liabilities & Equity
Cash
$32,750

Note payable

$12,000
Ac-
counts receivable
10,000

Accounts payable

14,000

Inventory
30,000


Total current assets
$72,750

Total current liabilities

$26,000
No

Non-current liabilities

Non-current assets


Note payable

17,000

Equipment


Total liabilities

$43,000


Beginning balance
$25,000


For depreciation (6)
-2,500

Owners' equity:


Ending balance
22,500

Contributed capital

$40,000


`


Retained earnings





Beginning balance
0





From sales (1)
+30,000






For inventory (2)
-15,000
Do

For interest (3)
-250

For depreciation (6)
-2,500





Ending balance

12,250
Total assets
$95,250

Total liabilities & equity

$95,250

Note that the depreciation expense reduced the asset, Equipment, with a corresponding reduction in Retained Earnings, but it
had no effect on cash. This is an example of a decrease in retained earnings with no reduction in cash. In this regard, it is im-
portant to remember that depreciation is always a non-cash expense.
••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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 TCG328 • Note on Understanding Financial Statements
21 of 39
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Some Caveats

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There are several caveats that should be borne in mind with regard to depreciation:

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(1)
The depreciation expense is only an estimate, and depends on projections of the economic life and
the residual value, both of which might be quite inaccurate.
(2)
The depreciation expense is an average, yet the equipment might lose a great deal more of its value
in the first year or two of its life, and less in later years. Consider, for example, the case of an auto-
mobile, which loses about 25 percent of its value the moment it leaves the dealer's showroom.7

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(3)
Some assets (generally buildings) actually appreciate while they are being depreciated.
(4)
Because of the first three points above, the book value of an asset generally bears little if any rela-
tionship to the asset’s “market value,” i.e. what it can be sold for.
****************************************************************************
Accounting Vignette

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Chambers Development Company

According to an article in Business Week, Chambers Development Company improved its net income considera-
bly by depreciating its landfills for much longer than their usual life. “Nobody is certain… how long a landfill
takes to fill up with trash. That gives accountants plenty of wiggle room in deciding how long to allow a com-
pany to depreciate landfills. The longer the period, the smaller the hit to annual earnings.” When Chambers re-
computed its annual earnings based on changes to its estimated economic life for landfills, plus some other
changes to what the article called “aggressive interpretations of accounting rules,” its 1991 earnings dropped
from 83¢ per share to only 3¢ per share. The company’s stock price fell by more than half in a single day.8
op
****************************************************************************
PUTTING THE CONCEPTS INTO PRACTICE

To put these concepts into practice, you should now work through Practice Case #2, Homeworks, Inc. (B). A
solution is contained in the Appendix at the end of the Note. However, you should work your way through the
case completely before looking at the solution.
tC

You should prepare the Homeworks, Inc. (B) case before reading further.
Try to do so without looking at your solution to the Homeworks, Inc. (A) case.
Review of Concepts

The Homeworks (B) case allowed you to practice with both depreciation and some of the other concepts
discussed above, as follows:

Depreciation Expense. Homeworks’ balance sheet shows $6,000 in equipment (carpentry tools, snow shov-
No

els, etc.) that were purchased on January 5. We know that this equipment will not last forever, and that eventu-
ally we will need to replace it. As we saw above, the financial accounting system attempts to measure how
much of this equipment is “used up” during each accounting period by means of the technique of depreciation.
In this instance, we computed depreciation as $100 per month.

While Homework’s equipment is a rather small amount, there are situations, such as in many manufacturing
organizations, where equipment is quite large and where the depreciation expense therefore is a more significant
number. Additionally, the accounting system records depreciation for buildings, such that when an organization
owns a building the accounting system will contain a rather large depreciation expense for it as well.

Interest Expense. Note that interest was computed in the same way as before. Unless you are told specifi-
Do

cally otherwise, an interest rate is always expressed in annual terms. Thus, Homeworks loan for 12 percent is
for 12 percent a year. The monthly amount is 1/12 of that, or 1 percent.

7
The use of accelerated depreciation helps to recognize this fact. However, accelerated depreciation is more of a tax-saving incen-
tive than an attempt to match the depreciation expense to the actual loss of an asset’s value. A discussion of accelerated deprecia-
tion is beyond the scope of this Note.
8 “Burying Trash in Big Holes—on the Balance Sheet,” Business Week, May 11, 1992.

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22 of 39
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Supply Expense. The supply expense was computed by determining how much in supplies was used up

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during the month. Remember, the acquisition of the supply inventory was not an expense; it simply was an ex-
change of cash for an asset or the creation of an asset by borrowing on accounts payable. The expense comes

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when the asset is used up.


THE INCOME STATEMENT

Thus far, we have been discussing all revenues and expenses in terms of their impact on the retained earn-
ings account on the balance sheet. This is appropriate since revenues increase the retained earnings account and
expenses decrease it. The problem with this approach is that unless we have the underlying detail on an organi-

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zation's accounts (which external readers of financial statements do not have), we would not know the reasons
for an increase or decrease in retained earnings. All we would see is the ending balances of the account on two
separate balance sheets.

For example, in the Homeworks (B) case, we saw that retained earnings decreased by $450 during the ac-
counting period. Why? If we were looking only at two balance sheets, all that we would know is that expenses
exceeded revenue by $450 during the accounting period. There are many combinations of revenue and expenses
that might have produced a change of this magnitude, however. How much revenue was earned? How much
were the expenses? We cannot determine this by looking only at the balance sheet. Instead, we need some detail

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on the underlying figures.

To provide the details that underlie a change in the retained earnings account, we divide the account into a
number of separate accounts. Some of these are for resources that the organization has earned during the year,
i.e. revenue, and some are for the resources that it has used up during the year, i.e. expenses. The income state-
ment summarizes and presents this underlying detail. Most income statements use similar terminology, which is
discussed below.
Revenue
op

The term revenue is used to describe the amount of money earned by to the company from the sale of its
products and services. A key concept in financial accounting is the realization concept. According to this con-
cept, a company earns revenue when its goods or services have been delivered and there is reasonable certainty
that the recipient will pay for them, i.e. that the revenue will be realized. It is the presence of these two condi-
tions—delivery of the good or service plus reasonable certainty of payment—and not the receipt of cash, per se,
that gives rise to the recognition of revenue on an entity's income statement.
tC

This concept leaves much room for interpretation. At the extremes, the decisions are simple. An order for
some goods is not considered to be revenue, for example. A cash sale at a hot dog stand clearly constitutes reve-
nue for the vendor. Between these extremes, however, accountants frequently must exercise considerable judg-
ment.
****************************************************************************
Accounting Vignette
Ogden Projects, Inc.
No

According to an article in Business Week, Ogden Projects, Inc., increased its stockholders’ equity by 24.9 percent
in 1991 by recognizing revenues in advance of when they were realized. The revenue was due in 1992 and 1993,
but, as of the end of 1991, had not been earned; indeed, the company had not even billed its customers, several
municipalities. According to the article, the company’s controller conceded that the practice was unusual, but
argued that “there’s no question we’ll get paid unless the cities go bankrupt.”9

****************************************************************************
Cost of Goods Sold

The term cost of goods sold (sometimes called cost of sales) is an expense item that shows the cost to the
Do

company of the items that it sold. All companies that sell products of some sort will have a cost of goods sold
(COGS) account. These companies include manufacturers, distributors, retail merchants, and even some service
organizations, such as restaurants. Other service organizations, such as a law office, ordinarily will not have a
cost of goods sold. Some service organizations that sell a few products in conjunction with their services (such
as a hair salon) will have a small cost of goods sold account. Homeworks does not sell its supplies, and hence
will not have a cost of goods sold account.

9 “Burying Trash in Big Holes—on the Balance Sheet,” Business Week, May 11, 1992.

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___________________________________________________________________________________________________________
Gross Margin

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The term gross margin is the difference between revenue and cost of goods sold. Sometimes a gross margin

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percentage, i.e. gross margin as a percent of sales revenue, is calculated. The gross margin percentage tends to
vary across industries. By knowing the gross margin percentage norm for its industry, a company can assess
whether its pricing and cost control policies are comparable to those of its competitors.
Operating Expenses

The section called operating expenses contains all the organization's other expenses except interest (which is

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a financing item). It contains salaries, depreciation, rent, and other expenses. As we saw in the Homeworks (B)
case, expenses need not be paid in cash. For accounting purposes, the only factor of importance is that the ex-
pense was incurred during the accounting period.
Operating Income

Operating income is the difference between gross margin and operating expenses. It is the income the entity
generated from its ordinary operations, not including its interest expense.

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Interest Expense

Interest expense is almost always listed separately. As indicated above, it is considered to be a financing item
and therefore not part of operating expenses, per se.
Income Before Taxes

Income before taxes is the difference between all revenues and all expenses prior to the assessment of in-
come taxes.
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Provision for Income Tax

On the surface, understanding the income tax item on the income statement is relatively easy. It is listed
immediately after the Income before taxes line, and ordinarily is called provision for income taxes. As such, it
functions as any other expense, serving to reduce retained earnings. However, calculating the amount of income
tax is somewhat complicated. This is because some of the accounting principles used for determining taxable
income differ from GAAP. A discussion of tax accounting principles is beyond the scope of this Note.
tC

Provision for income tax is the amount of tax the entity must pay, based upon its taxable income. The federal
tax rates vary from year to year depending upon changes in the tax law. State income taxes also will vary, de-
pending on each state's tax laws. Because the guidelines for computing income tax differ in some instances from
GAAP, a company will prepare a separate income statement for purposes of computing its income tax. What-
ever amount it computes on this separate statement will be shown on the “provision for income tax” line of the
income statement prepared according to GAAP.


Income from Continuing Operations
No

Income after taxes is sometimes called income from continuing operations. This is because an income
statement occasionally will contain some sources of income (or losses) that fall outside the scope of ordinary
operating activities. These are called extraordinary items; they typically include sales of non-current assets, ma-
jor damage to non-current assets, and other items that are not normally within the scope of the entity’s normal
operations. They are presented net of their tax effects. A discussion of extraordinary items is beyond the scope
of this Note.
Net Income

Net income is the income earned after all expenses, including income tax, have been deducted from revenue.
Do

PUTTING THE CONCEPTS INTO PRACTICE

To put these concepts into practice, you should now work through Practice Case #3, The Opera Workshop A
solution is contained in the Appendix at the end of the Note. However, you should work your way through the
case completely before looking at the solution.

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 TCG328 • Note on Understanding Financial Statements
24 of 39
___________________________________________________________________________________________________________
You should prepare The Opera Workshop case now.

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Note: there are a couple of “curve balls” in this case that will require you to figure out some
ways of recording information that have not been discussed.

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Use your knowledge of accounting, and your intuition, and see how far you can get.
IMPORTANT CONCEPTS

There are several important concepts in the Opera Workshop:

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Interest Expense

Because the Opera Workshop has some debt, there is a need to calculate an interest expense. Remember that
the 12 percent figure given in the case is for the entire year. Therefore the interest for the year is $1,200
($10,000 x .12). ( If for some reason we wished to calculate a monthly interest amount, we would divide this
amount by 12, but we do not need to make this calculation.)
Accrued Interest

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As with the Homeworks, Inc. (B) case, there is some accrued interest. This arises because the interest ex-
pense has been incurred (i.e., the year has ended and the bank has earned its interest of $1,200). In all cases, the
relevant issue for financial accounting purposes is that the bank has earned its interest, which means that the
Opera Workshop has incurred the expense. Even though the Workshop has not paid the interest in cash, we still
must include the expense in the computation of retained earnings. The result is an adjusting entry (so called be-
cause it is an adjustment that the accountants must make to the financial statements without any specific instruc-
tions or paperwork telling them to do so). In this instance, the adjusting entry results in an account called inter-
est payable (sometimes called accrued interest).
op
Accounts Receivable

The Opera Workshop needs an accounts receivable account. This is because revenue has been earned but not
all the cash associated with that revenue has been received. Remember, for financial accounting purposes, reve-
nue is deemed to have been earned when the product or service has been delivered, and when there is reason-
able certainty that the relevant cash will be collected. It is not necessary to have the cash in hand, however.
tC

Wages Payable

Wages payable is a new concept. It is a liability that is similar to the accounts receivable asset. In the case of
an account receivable, the revenue has been earned, but the cash has not yet been collected. In the case of wages
payable, salaries have been earned but the cash has not yet been paid out. Since the wage expense has been in-
curred, but has not been paid in cash, an adjusting entry is necessary, resulting in the wages payable (or, some-
times, accrued wages ) account.
Paying off Accounts Payable
No

The Opera Workshop has made a payment on its accounts payable account. Here, a cash payment has been
made but no expense has been incurred.
PREPARING THE INCOME STATEMENT

The amount of detail we see on the income statement will depend entirely on how many separate accounts
we decide to use to explain the changes in retained earnings. For example,with the Opera Workshop case, we
can see the possibility for several accounts that might be included on the income statement:
Do

1.
The $1,200 interest on the loan would be placed in an account called interest expense.
2.
The $2,700 ($3,000 - $300) in supplies and materials that were used for the sets would be included
in an account with a name like set supply expenses or supply expenses. We would not call this ac-
count cost of goods sold, since the workshop does not sell its sets, but instead uses them in its oper-
atic productions. Note that this account would not include the $300 in supplies and materials that
remain in inventory, since, although acquired, these resources have not yet been consumed.

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___________________________________________________________________________________________________________

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3.
The $18,000 in ticket sales would be included in an account called sales revenue. Remember, it is
not important whether the $18,000 has been received in cash or on account. In either case, when a

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sale has been made, revenue has been earned (assuming that the operatic performance has taken
place).
4.
Payments to staff of $12,000 for the year would be included in an account with a name like salary
and wage expense. It is not important for the income statement that $500 of this amount was still
owed to the Executive Director as of the end of 2011. Even if the payment has not been made in

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cash, the expense has been incurred since the Executive Director has earned her salary.
5.
The $900 of depreciation of the audio equipment is included in an account called depreciation ex-
pense.

Note that all these accounts are related to transactions that affected the retained earnings account in the solu-
tion to the case. Again, paying off the accounts payable does not constitute an expense; it simply represents a
reduction in a liability. The expense is associated with the using up of the materials, and can exist regardless of
whether the materials were purchased on account or for cash.

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RELATIONSHIP BETWEEN THE BALANCE SHEET AND INCOME STATEMENT

The relationship between the balance sheet and the income statement can be seen most easily by asking the
question “How much net income is enough?” For example, is Organization A that earns $1 million in net in-
come more profitable than Organization B that earns $100,000?

While the answer to the latter question might seem obvious, it is not. Suppose, for example, you were told
that Organization A had assets on its balance sheet that totaled $20 million, and Organization B had assets total-
op
ing $400,000. Would that change your conclusions?
Think about this question for a few minutes before reading further.

To answer the question, we must calculate some rates of return. Specifically, Organization A earned a return
on its assets of 5 percent ($1 million on revenue of $20 million), whereas Organization B earned a return of 25
percent ($100,000 on revenue of $400,000). Would you rather invest in a company that earns 5 percent on its
tC

assets or one that earns 25 percent? Most people would prefer the company with a 25 percent return, since the
rate of return on assets provides a more useful indicator of performance than the absolute amount of net income.

The return on assets (ROA) ratio is an important one in accounting, and it is used frequently to compare or-
ganizations of different sizes and in different industries. In effect, it allows us to link the income statement and
the balance sheet by determining how much income an organization has earned compared to the assets that were
used to earn it. Another comparable ratio is return on equity (ROE), which allows shareholders to compare the
performance on their investment to that of other companies. 10
THE STATEMENT OF CASH FLOWS
No

In addition to the balance sheet and income statement, financial reports include a third statement called the
statement of cash flows (SCF). The SCF is prepared by rearranging information taken from the balance sheet
and income statement. It does not involve the actual collection of material in the accounts as is the case with the
other two statements.

The SCF reports on the sources of cash that flowed into the entity during the period and the uses to which
this cash was put. These sources and uses of cash are separated into three categories: operating activities, invest-
ing activities, and financing activities. A SCF can be prepared according to either the direct method or the indi-
rect method. A SCF for The Opera Workshop for the 2011, using the direct method, is shown below.

The $5,500 paid to vendors includes $1,000 for new supplies and $4,500 to pay off the accounts payable.
Do

Thus, while the income statement shows the supply expense associated with consuming $2,700 of inventory, the
SCF shows the cash paid to acquire the inventory, regardless of how much was consumed. Also, the SCF shows
only the cash paid to employees, not the accrued wages. The SCF excludes depreciation (a non-cash item),
showing instead amounts spent to acquire equipment (there were none during this accounting period). Finally, it
includes the cash received from the bank, but excludes the interest (since it has been accrued but not paid).

10 For a discussion of ratio analysis, see David W. Young, Note on Ratio Analysis, HBSP Product TCT308, 2013.

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___________________________________________________________________________________________________________

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The Opera Workshop
Statement of Cash Flows for December

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Direct Method
Cash generated from (used by) operations

Cash received from clients
$17,000

Cash paid to vendors

(5,500)

Cash paid to employees
(11,500)

Cash provided (used) by operations

$0

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Cash generated from (used by) investing activities

Purchase of equipment

0
Cash generated from (used by) financing activities

Loan from bank


10,000
Net change in cash



$10,000
Plus: Beginning cash balance

500
Equals: Ending cash balance

$10,500
The Indirect Method

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The SCF also can be prepared by beginning with the net income and making the necessary adjustments to
reconcile it to the change in cash. This approach is called the indirect method. An SCF using the indirect
method is shown on the next page.
Note that both approaches show the same totals for each category. Many
people feel that the direct method has the advantage of being intuitive understandable, whereas the indirect
method can be confusing. Others like the indirect method because it reconciles the net income with the change
in cash. Many sets of financial statements include both approaches. Details concerning the actual preparation of
a statement of cash flows are beyond the scope of this Note.
op
The Opera Workshop
Statement of Cash Flows for December
Indirect Method
Cash generated from (used by) operations
Net income
$1,200
Add depreciation (a non-cash expense)
900
Add increase in wages payable (a non cash expense)
500
tC

Add increase in interest payable (a non-cash expense)
1,200

Add decrease in supply inventory (a non-cash expense)
1,700
Deduct increase in accounts receivable (a non-cash revenue item)
(1,000)
Deduct decrease in accounts payable (a non-expense cash item)
(4,500)

Cash provided (used) by operations

$0
Cash generated from (used by) investing activities

Purchase of equipment

0
Cash generated from (used by) financing activities

Loan from bank


10,000
No

Net change in cash



$10,000

Plus: Beginning cash balance


500
Equals: Ending cash balance


$10,500
SUMMARY

The role of financial accounting is to prepare financial information principally for distribution outside an or-
ganization. The three basic financial statements are the balance sheet, the income statement, and the statement
of cash flows. This Note discussed those statements as well as some concepts that are important to understand-
ing a set of financial statements, such as the nature of asset, liability and equity accounts, the notion of asset ex-
Do

changes, the nature of revenues and expenses, and the distinction between changes in equity and changes in
cash. In particular, the Note emphasized five fundamental accounting concepts:
•
The Entity Concept. In financial accounting, records are kept and financial statements prepared for the
organizational entity, as distinct from its owners. The owners may choose to have financial statements
prepared for themselves, but when they do so, they are functioning as a different entity from the organi-
zation itself.
•
The Dual-Aspect Concept. Assets = Liabilities + Equity.

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27 of 39
___________________________________________________________________________________________________________

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•
The Money-Measurement Concept. Items that appear on financial statements (as well as the account-
ing records that underlie them) are expressed exclusively in terms of monetary terms. Items that can be

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counted must be expressed in monetary terms, and anything that cannot be measured in monetary terms
is excluded from the financial statements.
•
The Cost Concept. In financial accounting, with some minor exceptions, items are shown on the bal-
ance sheet at their cost, not at their market value.

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•
The Realization Concept. In financial accounting, revenue is realized and recorded on the income
statement when the good or services are delivered, not when an order is received, nor necessarily when
the associated cash is received.

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op
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No
Do

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 TCG328 • Note on Understanding Financial Statements
28 of 39
___________________________________________________________________________________________________________
PRACTICE CASE #1. HOMEWORKS, INC. (A)

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Homeworks, Inc. was a small corporation that provided home repair services in the Town of Ellington. Its

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services included chores, minor repairs, painting, snow-shoveling, and gardening. It charged $15 per hour to its
clients, and paid its service staff $7 per hour.

Homeworks began operations in January 2012. During the month of January, the following events occurred:
January 2
Homeworks' investors contributed a total of $10,000 in cash.

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January 12
$3,000 of supplies (e.g. paint) were purchased from a local hardware store. Payment was
not due until February 10.
January 14
Clients paid for 125 hours of work that were completed during the first two weeks of the
month.
January 15
Service staff was paid for the 125 hours of work that was completed.

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January 16
The president was paid $1,000 for two weeks of work.
January 20
$1,000 of additional supplies were purchased. Payment was made in cash. No supplies
were used during January.
January 28
Clients paid for 150 hours of work that were completed during the second two weeks of
the month.
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January 29
Service staff was paid for the 150 hours of work that was completed.
January 31
The president was paid $1,000 for two weeks of work.
Assignment
1.
Prepare a balance sheet for Homeworks as of January 31, 2012. To do so, draw up a basic balance sheet
tC

format, and make entries to the appropriate accounts for each event described above. Leave sufficient
space below each asset, liability, and equity account to make several entries.
2.
Prepare a formal balance sheet as of January 31, 2012.
3.
By how much did Homeworks' equity increase during January 2012? Why?
4.
How has Homeworks financed its assets?
No
Do

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 TCG328 • Note on Understanding Financial Statements
29 of 39
___________________________________________________________________________________________________________
PRACTICE CASE #2. HOMEWORKS, INC. (B)

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Homeworks, Inc. was a small corporation that provided home repair services in the Town of Ellington. Its

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services included chores, minor repairs, painting, snow-shoveling, and gardening. It charged $15 per hour to its
clients, and paid its service staff $7 per hour.

Homeworks began operations in January 2012. During the month of January, the following events occurred
(changes from the (A) case are shown in bold face type):

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January 2
Homeworks' investors contributed a total of $10,000 in cash.
January 3
Homeworks' took out a $5,000 loan from a local bank to help finance its activities. The loan
was not due to be repaid this year. The interest rate was 12 percent, and would be for the
full month.
January 5
$6,000 of equipment (e.g. carpentry tools, snow shovels, etc.) was purchased for cash. Depre-
ciation began as of the first of the month. The equipment had a five year economic life
with no residual value.

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January 12
$3,000 of supplies (e.g. paint) were purchased from a local hardware store. Payment was not
due until February 10.
January 14
Clients paid for 125 hours of work that were completed during the first two weeks of the
month.
January 15
Service staff was paid for the 125 hours of work that was completed.
op
January 16
The president was paid $1,000 for two weeks of work.
January 20
$1,000 of additional supplies were purchased. Payment was made in cash.
January 28
Clients paid for 150 hours of work that were completed during the second two weeks of the
month.
tC

January 29
Service staff was paid for the 150 hours of work that was completed.
January 31(a)
The president was paid $1,000 for two weeks of work.
January 31(b)
The interest payment was not made to the bank.
January 31(c)
A count of the supply inventory showed that $3,500 was left. Therefore, $500 worth of
supplies had been used during the month.
No

January 31(d)
Depreciation was recorded.

Assignment
1.
Prepare a balance sheet for Homeworks as of January 31, 2012. To do so, draw up a basic balance sheet
format, and make entries to the appropriate accounts for each event . Leave sufficient space below each as-
set, liability, and equity account to make several entries.
2.
Prepare a formal balance sheet as of January 31, 2012. By how much did Homeworks' equity increase dur-
Do

ing January 2012? Why?

4.
How has Homeworks financed its assets?

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
PRACTICE CASE #3. THE OPERA WORKSHOP

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The Opera Workshop was a small organization dedicated to advancing the public's knowledge of operatic

os
works as well as providing support and training for aspiring artists. The Workshop had been in existence for two
years. Its balance sheet as of the end of 2010 is shown in Exhibit 1. During 2011, the following events occurred
(in summarized form):
1.
On January 1, 2011, the Workshop took out a $10,000 loan from a local bank to finance its activities.
The entire amount of the loan was due on January 5, 2012, including interest at a rate of 12% for all of

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2011. No interest would be due for the first 5 days of 2012.
2.
It purchased $1,000 worth of supplies and materials for constructing its sets, paying the entire amount in
cash.
3.
It sold $18,000 worth of tickets for its four productions. $17,000 of this was received in cash. The re-
maining $1,000 were for tickets that had been sold to a local opera club; the amount was due on January
3, 2012. The Workshop expected that the entire amount would be paid on time.

yo
4.
Its staff earned a total of $12,000 for the year. Of this amount, $500 was still owed to the Executive Di-
rector as of the end of 2011. The Workshop expected to pay her this amount in early January, 2012.
5. It paid off the accounts payable shown on its balance sheet (Exhibit 1). No accounts payable were due as
of the end of 2011.
6.
As of the end of 2011, an inventory showed that $300 of the supplies and materials still remained on
hand. The sets had been thrown out after the final performance of each opera.
op
7.
The equipment shown on the balance sheet consisted of audio equipment used for performances. It had
been purchased in January 1997 for $10,000 in cash, and had an estimated useful life of 10 years, after
which it could be sold for approximately $1,000.
8.
It incurred interest on the loan for all of 2011. No cash payments had been made.
tC

Assignment
1.
Set up the balance sheet in Exhibit 1 in a worksheet format, and place the beginning balance in the ap-
propriate place in each account.
2.
Record all events onto the balance sheet.
3.
Prepare an income statement for 2011, and a balance sheet as of December 31, 2011.
No

4.
What is your assessment of the financial status of the Opera Workshop?

Do

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
THE OPERA WORKSHOP (B)

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Exhibit 1. Balance Sheet as of December 31, 2010

os
ASSETS
LIABILITIES + EQUITY

Cash
$ 500
Accounts payable
$ 4,500

Supply and material inventory
2,000

______

Total current assets
$ 2,500
Total current liabilities
$ 4,500

rP

Equipment (net)1
8,200
Contributed capital
2,000



Retained earnings
4,200

Total Assets
$10,700
Total Liabilities and Equity
$10,700

Note:

yo
1. Equipment (net) is calculated as follows:

Purchase price
$10,000

Less: salvage value
(1,000)

Amount to be depreciated
$9,000

Economic life
10 years
op

Annual depreciation
$ 900
($9,000 ÷10)

Depreciation for first two years

(i.e. 1994 and 1995)
$1,800
( $900 x 2)

Book value or equipment (net)
$8,200
($10,000 - $1,800)
tC
No
Do

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 TCG328 • Note on Understanding Financial Statements
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t
os
APPENDIX

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SOLUTIONS
TO THE MINI TESTS
AND PRACTICE CASES
Practice Cases:

Mini-Test #1
yo
This Appendix contains solutions to the following Mini-Tests and
op
Mini-Test #2
Practice Case #1. Homeworks, Inc. (A)
Practice Case #2. Homeworks, Inc. (B)
Practice Case #3. The Opera Workshop
tC

You should attempt to analyze the Mini-Tests and the practice cases to
the best of your ability before
looking at the solutions in this Appendix.
No

Each solution should then be compared to your own solution. You

should identify any discrepancies, and attempt to determine why they
exist.

This approach is a crucial aspect of

Do

the learning process.

Please do not take shortcuts.

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
MINI TEST #1

t
SOLUTION

os

A balance sheet with the correct entries is shown below. The entries are numbered to correspond to the four
situations that were given you. A brief description of each answer follows the balance sheet:
Toys FR' Kids
Balance Sheet
As of January 3, 2012

rP
Assets
Liabilities & Equity
Cash


Note Payable


Beginning balance
$53,000


Beginning balance
$13,000

(1) From new bank loan
+ 17,000


Changes
0

(2) To purchase inventory
-6,000


Ending balance

$13,000

(4) To purchase equip.
-25,000

Ending balance

$39,000
Accounts payable

yo
Merchandise inventory



Beginning balance
$0

Beginning balance
$ 0


(3) For inv'tory purchase
14,000



(2) Purchase for cash
+6,000


Ending balance

14,000

(3)Purchase on credit
+14,000





Ending balance

20,000
Total current assets

$59,000
Total current liabilities

$27,000
Non-current assets


Non-current liabilities
Equipment


Note payable

op

Beginning balance
$ 0


Beginning balance
0

(4) Purchase
25,000


(1) New loan amount
+17,000

Ending balance

$25,000

Ending balance

17,000






Total liabilities

$44,000









Owners' equity:





Contributed capital
$40,000
tC

Retained earnings
0




Total owners’ equity

40,000

Total assets

$84,000
Total liabilities & equity

$84,000
Situation #1. Additional Loan

The bank loan increases cash by $17,000. Since it is not due for two years, it is a non- current liability. Note
that the amount of interest due is not recorded. We will deal with the interest expense in Part II, when we pre-
pare our next balance sheet.
No

Situation #2. Purchase Merchandise Inventory

Since TFK pays its vendors in cash, it uses up $6,000 of cash in this transaction. In effect, we have ex-
changed one asset for another: cash for inventory.
Situation #3. Accounts Payable

Inventory increases by $14,000. Note that it does not matter whether the inventory was purchased for cash
or on account. In both instances it increases by the amount of the purchase. This time, however, since the ven-
dors of the toys tell TFK that it can wait for 30 days before paying for them, an account payable is created as a
liability on the balance sheet, i.e. $14,000 is owed to the vendors.
Do

Situation #4. Purchase equipment

TFK purchases $25,000 of equipment. The equipment will appear as a non-current asset on the balance
sheet. As with the inventory purchase in Situation #2, this is simply an exchange of assets: cash for equipment.

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 TCG328 • Note on Understanding Financial Statements
34 of 39
___________________________________________________________________________________________________________
PRACTICE CASE #1. HOMEWORKS, INC. (A)

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SOLUTION
Question 1

os

The accounts for the balance sheet and the appropriate entries are as follows. The numbers in parentheses
indicates the dates of the transactions.

ASSETS

LIABILITIES + EQUITY
Cash
Supplies Inventory
Accounts Payable
Contrib.Cap.

rP
(2)

+10,000
(12)
+ 3,000
(12) +3,000
(2) +10,000
(14)

+ 1,875
(20)
+ 1,000

3,000

10,000
(15)

- 875

4,000
(16)

- 1,000




Ret. Earngs
(20)

- 1,000




(14)
+ 1,875
(28)

+ 2,250




(15)
- 875
(29)

- 1,050




(16)
- 1,000
(31)

- 1,000




(28)
+ 2,250


9,200




(29)
- 1,050

yo







(31)
- 1,000








200
Total Assets = $13,200


Total Liabilities+Equity =
$13,200

Notes:
1. 14 January increase in Ret. Earngs calculated as follows: 125 hours @ $15/hour = $1,875.
2. 15 January decrease in Ret. Earngs calculated as follows: 125 hours @ $7/hour = $875.
op
3. 28 January increase in Ret. Earngs calculated as follows: 150 hours @ $15/hour = $2,250.
4. 29 January decrease in Ret. Earngs calculated as follows: 150 hours @ $7/hour = $1,050.
Question 2

The formal balance sheet looks as follows:
Homeworks
tC

Balance Sheet
As of January 31, 2012
Assets

Liabilities & Equity
Cash

$9,200
Accounts payable
$3,000
Supplies inventory
4,000
Total current liabilities
$3,000

Total current assets
$13,200




Non-current liabilities:



Total liabilities
$3,000
No

Owners' equity:




Contributed capital
$10,000



Retained earnings
200
Total
assets
$13,200
Total liabilities & equity
$13,200
Question 3

Homeworks' equity increased by $10,200. $10,000 of this was from contributed capital, and the remainder
from retained earnings. In the retained earnings category, it received a total of $4,125 ($1,875 + $2,250) from
Do

selling its services, which increased its retained earnings. It paid $1,925 ($875 + $1,050) to its service staff and
$2,000 ($1,000 + $1,000) to its executive director; these payments decreased retained earnings by a total of
$3,925.

Note that the increase in cash is $9,200, which is smaller than the increase in equity. Although cash was in-
creased by $10,200 as a result of the increase in equity, it also was decreased by the purchase of supplies, which
did not entail an expense. As you will see later, cash does not always change by the same amount as the change
in equity. In fact, it rarely does.

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
Question 4

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Assets of $13,200 have been financed by a combination of $3,000 in liabilities and $10,200 in equity. The

os
liabilities consist of $3,000 in accounts payable to a hardware store.
MINI-TEST #2
SOLUTION

As of the close of business on January 31, 2012, the balance sheet would look as shown below. The

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changes are numbered to correspond to the items given in the test, and are shown in bold faced type.
Toys FR' Kids
Balance Sheet
As of January 31, 2012

Assets
Liabilities & Equity
Cash


Note payable

$13,000

yo

Beginning balance
$39,000

Accounts payable

14,000

From sales (1)
+20,000

Total current liabilities

$27,000

For interest (3)
-250

Ending balance

$58,750
Non-current liabilities




Note payable

$17,000
Accounts receivable

Beginning balance
0

Total liabilities

$44,000

From sales (1)
+10,000
op

Collections
0

Owners' equity:


Ending balance

$10,000
Contributed capital

$40,000




Retained earnings
Inventory



Beginning balance
0

Beginning balance
$20,000


From sales (1)
+30,000

Sold (2)
-15,000


For inventory (2)
-15,000

Ending balance

5,000

For interest (3)
-250
tC

Total current assets

$73,750

Ending balance

14,750

Non-current assets




Equipment

25,000





Total assets

$98,750
Total liabilities & equity

$98,750
No
Do

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
PRACTICE CASE #2. HOMEWORKS, INC. (B)

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SOLUTION
Question 1

os

ASSETS

LIABILITIES + EQUITY
Cash
Equipment
Loan Payable
Contrib. Cap.
(2)
+10,000

(5)
+ 6,000
(3)
+5,000
(2) +10,000
(3)

+ 5,000
(31d)
- 100


5,000
10,000

rP
(5)

- 6,000

5,900

(14)

+ 1,875


Interest Payable
Ret. Earngs
(15)

- 875


(31b)
+ 50
(14)
+ 1,875
(16)

- 1,000





(15)
- 875
(20)

- 1,000
Supplies Inventory
Accounts Payable
(16)
- 1,000
(28)

+ 2,250
(12)
+ 3,000
(12)
+ 3,000
(28)
+ 2,250
(29)

- 1,050
(20)
+ 1,000


3,000

(29)

- 1,050
(31)

- 1,000


4,000



(31a)

- 1,000


8,200
(31c)

- 500





200

yo





3,500



(31b)
- 50









(31c)
- 500









(31d)
-100











(450)

Depreciation Computation: The $6,000 of equipment purchased on January 5 has a 5 year economic life
and no residual value. Depreciation calculations are as follows:
op
Purchase price
$ 6,000
Less residual value
0
Equals amount to be depreciated
$ 6,000
Divided by economic life
5 years
Equals annual depreciation expense
$ $1,200
tC

Divide by 12 months in year
12

Equals monthly depreciation expense
$ 100

Interest Computation: The $5,000 loan has an interest rate of 12 percent a year. Therefore, the annual in-
terest amount would be $600 ($5,000 x .12). The monthly interest amount is 1/12 of this, or $50 ($600 ÷ 12).

Other Items. There are several items that are important to identify:
•
Supply inventory is now $3,500, as was determined by the inventory count.
No

•
The net book value of the equipment is now $5,900, reflecting the reduction of $100 that came about
with the depreciation expense for the month of January.
•
An interest payable account has been created since the expense was incurred (with the use of the
bank’s money for one month) but no cash was paid.
•
Even though these three “adjusting” transactions caused retained earnings to fall by $650, there was no
change in cash; it remains at $8,200. This will be true of all adjusting entries — they are always non-
cash expenses, i.e. they reduce (sometimes increase) retained earnings but they do not affect cash.
Do

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
Question 2

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The formal balance sheet looks as follows:

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Homeworks
Balance Sheet
As of January 31, 2012

Assets

Liabilities & Equity

rP
Cash

$8,200
Accounts payable
$3,000
Supplies inventory
3,500
Interest payable
50
Total current assets
$11,700
Total current liabilities
$3,050





Non-current liabilities:



Note payable
5,000



Total liabilities
$8,050
Non-current assets:




Equipment (net)
5,900
Owners' equity:

yo



Contributed capital
$10,000



Retained earnings
(450)


-----------

-----------
Total
assets
$17,600
Total liabilities & equity
$17,600


Question 3
op

Homeworks' equity increased by $9,550. $10,000 of this was from contributed capital, and the remainder
from the negative retained earnings. In the retained earnings category, it received a total of $4,125 ($1,875 +
$2,250) from selling its services, which increased its retained earnings. It paid $1,925 ($875 + $1,050) to its
service staff, $2,000 ($1,000 + $1,000) to its executive director. It also incurred expenses of $400 for supplies,
$100 for depreciation, and $50 for interest.

Note that the increase in cash was $8,200, which again is different from the increase in equity.
tC

Question 4

Assets of $17,600 have been financed by a combination of $8,050 in liabilities and $9,550 in equity. The
liabilities consist of a $5,000 loan from a bank, $3,000 in accounts payable to a hardware store, and $50 in in-
terest to the bank.
No
Do

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
PRACTICE CASE #3. THE OPERA WORKSHOP

t
SOLUTION*
Question 1.

os

The initial balance sheet looks as follows (note that balances in asset accounts are contained on the left,
and balances in liability and equity accounts are contained on the right.

ASSETS

LIABILITIES
EQUITY

rP

Cash

A

ccounts Payable

Contributed Capital

500




4
,500


2,000










Supply & Material Inven.





Retained Earnings

2,000








4,200










Equipment (net)

8,200

yo
Total assets = $10,700



Total liabilities + equity = $10,700
Question 2. The events can be recorded as follows:11

ASSETS

LIABILITIES
EQUITY

Cash

Accounts Payable

Contributed Capital
BB
500
-1,000 (2)
(5) - 4,500 4,500 BB
2,000 BB
op

(1) + 10,000
- 11,500 (4)


(3) + 17,000
-4,500 (5)




-----------------------------------
-----------------------------
----------------------------

EB
10,500


0
EB


2,000 EB
Accounts Receivable

Salaries & Wages Payable
Retained Earnings
(3) + 1,000


+ 500 (4)

4,200 BB





(4) -12,000
+18,000 (3)
tC

(6) - 2,700





(7) - 900





(8) - 1,200
------------------------------
----------------------------------
-----------------------------

EB 1,000


500
EB


5,400 EB




Supply & Material Inven.


Interest Payable

BB 2,000
No

(2) + 1,000
- 2,700 (6)
+1,200
(8)

---------------------------------
------------------------



EB 300


1,200
EB

Equipment (net)

Loan Payable
BB
8,200
- 900 (7)

+ 10,000
(1)
---------------------------------
-------------------------


EB 7,300




10,000 EB


Do

11
Note that: (1) “BB” = beginning balance in the account, and “EB” = ending balance in the account. (2) Additions to an asset ac-
count are shown on the left side whereas additions to liabilities and equity accounts are shown on the right side. (3) Reductions are
shown on the right side for assets, and on the left side for liabilities and equity.

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 TCG328 • Note on Understanding Financial Statements
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___________________________________________________________________________________________________________
Question 3

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The balance sheet as of 31 December 2011 is as follows:

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ASSETS




LIABILITIES + EQUITY

Cash
$ 10,500
Salaries and wages payable
$ 500

Accounts receivable
1,000
Interest payable
1,200

Supply and material inventory
300
Loan payable
10,000

rP

Total current assets
$ 11,800
Total current liabilities
$ 11,700

Equipment (net)1
7,300

Contributed capital
2,000



Retained earnings
5,400

Total Assets
$19,100
Total liabilities and equity
$19,100

An income statement for the Opera Workshop would look as follows:

yo
The Opera Workshop
Income Statement for 2011
Revenues: Ticket sales

$18,000
Less: operating expenses:

Salaries and wages
$12,000
op

Supplies and materials
2,700

Depreciation
900

Total operating expenses

15,600
Operating income

$2,400
Less: interest expense

1,200
Income before taxes

$1,200
tC

Question 4

At first glance, the Opera Workshop seems to be a viable entity. Its net income was $1,200 during 2011. It
had a ROA of 6.3% ($1,200 on assets of $19,100), and a ROE of 16.2% ($1,200 on equity of $7,400). Also, its
cash increased by $10,000 (from $500 to $10,500). However, there are several areas of concern, some of which
are not apparent from the financial statements:
•
In the two prior years, retained earnings had increased by $4,200 (they began at zero), which is an av-
No

erage of $2,100 a year. Thus, this year was only about half as profitable as the two prior ones.
•
Although cash has increased by $10,000, the entire loan is due on January 5, 2012, i.e. in 5 days, after
which cash will be only $500 again.
•
Also on January 5, the Workshop will owe $1,200 in interest, but it will have only $500 in cash. Un-
less the $1,000 owed to it by the local opera club is received before January 5, the Workshop will not
be able to make the interest payment.
•
Assuming the $1,000 is received and the interest payment is made, the Workshop will have only $300
in cash ($500+$1,000 - $1,200). Unless some additional cash is found, it will not be able to pay the
Do

Executive Director the $500 it owes her in early January.

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