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More free books @ www.BingEbook.com Chapter 5: The Effects and Reporting of Profit a. Prepare the annual income statement of the business in single-step form. The income statement in single-step form is: Sales Revenue $15,700,000 Cost of Goods Sold Expense $9,800,000 Selling and General Expenses 4,860,000 Interest Expense 225,000 Net Income $14,885,000 $815,000 b. Prepare a summary journal entry for the sales and for each expense of the business for the year. The summary entries are as follows: Sales Revenue: Cash Accounts Receivable Sales Revenue $13,900,000 $1,800,000 $15,700,000 Cost of Goods Sold Expense: Cost of Goods Sold Expense Inventory Cash Accounts Payable $9,800,000 $500,000 $10,050,000 $250,000 Selling and General Expenses: Selling and General Expenses Prepaid Expenses Cash $4,860,000 $125,000 $4,465,000 Accounts Payable $150,000 Accrued Expenses Payable $225,000 Accumulated Depreciation $145,000 Interest Expense: Interest Expense Cash Accrued Expenses Payable $225,000 $200,000 $25,000 c. Prepare a comprehensive entry showing the changes in assets and liabilities from profit for the year. The comprehensive entry summarizing the changes in assets and liabilities caused by sales and expenses during the year is as follows: 117 More free books @ www.BingEbook.com 118 Part II: Preparing Financial Statements Cash Accounts Receivable $815,000 $1,800,000 Inventory $500,000 Prepaid Expenses $125,000 Accounts Payable $400,000 Accrued Expenses Payable $250,000 Accumulated Depreciation $145,000 Owners’ Equity — Retained Earnings $815,000 You may notice that cash decreases in this scenario. In other words, the sales and expenses of the business result in an $815,000 cash decrease even though the business earned $815,000. The fact that the cash decrease and profit are the same amounts is purely coincidental. n The comprehensive entry for this business summarizing the changes in assets and liabilities from its sales and expenses for the year is as follows: Cash $280,000 Accounts Receivable $825,000 Inventory $375,000 Prepaid Expenses $25,000 Accounts Payable $955,000 Accrued Expenses Payable $475,000 Accumulated Depreciation $390,000 Owners’ Equity — Retained Earnings $875,000 Prepare a schedule of changes in assets and liabilities for its board of directors that summarizes the effects on the business’s financial condition from its profit for the year. Summary of Asset and Liability Changes From Making Profit Cash ($280,000) Accounts Receivable $825,000 Inventory $375,000 Prepaid Expenses Fixed Assets (Depreciation) $25,000 ($390,000) Net Increase of Assets $555,000 Accounts Payable $955,000 Accrued Expenses Payable $475,000 Increase of Liabilities Net Worth Decrease From Loss $1,430,000 $875,000 In this scenario, net worth decreased $875,000 because liabilities increased $1,430,000 and assets increased only $555,000. This unfavorable difference is the essence of a loss. Notice that even though the business suffered a loss for the year, its cash balance decreased far less than the amount of loss. The cash decrease is relatively low because the business avoided cash payments due to the relatively large increases in its accounts payable and accrued expenses payable. More free books @ www.BingEbook.com Chapter 6 Reporting Financial Condition in the Balance Sheet In This Chapter 䊳 Breaking down the balance sheet 䊳 Building and filling out a balance sheet 䊳 Valuing assets in balance sheets Y our rich aunt just left you a small fortune, and you’ve always wanted to own and manage a business. Well, wouldn’t you know? The owners of a reputable business in your hometown want to sell out. It’s a privately owned corporation, and the shareowners offer to sell all their stock shares to you. You ask to see the business’s latest annual financial report, but before the present owners hand over this information, they ask you to sign a confidentiality agreement. This contract requires that if you decide not to buy the business, you must keep confidential all the information in the financial report. You may not divulge anything you learn from the financial report. You agree and sign the agreement. The annual financial report of a business includes four essential elements: ⻬ Income statement for the year just ended ⻬ Balance sheet at the close of business on the last day of the year ⻬ Statement of cash flows for the year just ended ⻬ Footnotes that supplement and are an integral part of the financial statements The financial statements of a private business may or may not be audited by an independent CPA. An audit opinion adds credibility to the financial statements but doesn’t come cheap. So you study the annual income statement of the business you’re interested in purchasing. All the examples and questions in this chapter are based on the following information for this business: The company reports $12,000,000 sales revenue and $11,400,000 total expenses for the year, which equal 95 percent of sales revenue. So net income is $600,000 for the year, or 5 percent of sales revenue. In your opinion, its profit performance is satisfactory for a company in this line of business. You now turn your attention to its balance sheet, which is a summary of the business’s assets and liabilities and, as such, provides a comprehensive picture of the business’s financial condition. Getting Started on the Balance Sheet Satisfactory profit performance doesn’t guarantee that the financial condition of the business is satisfactory. In fact, the business could have serious financial problems even though it’s earning profit. It may have too little cash and assets that can be converted into cash soon More free books @ www.BingEbook.com 120 Part II: Preparing Financial Statements enough to pay its short-term liabilities. It could be operating at the mercy of its creditors. Conversely, the business may be sitting on a hoard of cash. You have to look in the balance sheet to find out what’s really going on financially. The balance sheet is also called the statement of financial condition, which better indicates its nature and purposes. This financial statement presents a summary of the assets and the liabilities of a business. Liabilities are claims against the assets of the business; they arise from unpaid purchases and expenses and from borrowing money. The readers of a balance sheet compare the liabilities of the business against its assets and judge whether the business will be able to pay its liabilities on time. The total assets of a business should be more than its total liabilities, of course. The excess of assets over liabilities equals the owners’ equity of the business. Liabilities have definite due dates for payment, but owners have no such claims on the business. Owners’ equity is in the business for the long haul. By majority vote, the owners can decide to dissolve the business, liquidate all its assets, pay off all liabilities, and return what’s left to the owners. But individual owners can’t call up the business and ask for some of their equity to be paid out to them. In short, owners’ equity is the permanent capital base of the business. A business corporation reports two sources of owners’ equity: ⻬ The total amount of capital its owners invested in the business ⻬ The accumulated amount of profit earned and retained by the business In contrast, business partnerships, limited liability companies, and sole proprietorships typically report just one total amount for owners’ equity. Assets, liabilities, and owners’ equity accounts aren’t intermingled in the balance sheet. Assets are presented in one grouping, liabilities in another, and owners’ equity in a third. Balance sheets typically report five to ten assets, five to ten liabilities, and two, three, or four owners’ equity accounts. (These are rough averages, I should mention.) The balance sheet of the business you’re thinking of buying reports these three basic groups: total assets equal $8,000,000, total liabilities equal $4,800,000, and total owners’ equity equals $3,200,000 at the end of its most recent year. Using printing option terminology that appears in almost all programs, the most common format, or layout, of the balance sheet is landscape (horizontal). The following is the company’s balance sheet presented in the landscape layout: $4,800,000 Liabilities $8,000,000 Assets = + $3,200,000 Owners’ Equity Many businesses use the portrait (vertical) format instead of the landscape (horizontal) format. One advantage of the portrait format is that it allows a business to keep its balance sheet on one page in its financial report, whereas the landscape format may require a business to put its balance sheet on two facing pages in its annual financial report. The following is the company’s balance sheet presented in the portrait format: $8,000,000 Assets = $4,800,000 Liabilities + $3,200,000 Owners’ Equity More free books @ www.BingEbook.com Chapter 6: Reporting Financial Condition in the Balance Sheet Q. The large majority of businesses use either the horizontal or vertical formats for reporting their balance sheets. However, now and then, you see a third format in which total liabilities are subtracted from total assets to determine owners’ equity. The following shows this alternative format for the business example: A. Personally, I like this third format because it makes clear that liabilities have a first, or senior, claim on the assets of the business and that owners get what’s left over. After paying liabilities, the owners of a business could end up holding an empty bag. 2. A business has $4,800,000 total liabilities and $6,500,000 total owners’ equity. Present three balance sheet formats for the business. $8,000,000 Assets – $4,800,000 Liabilities = $3,200,000 Owners’ Equity What is the rationale for this third balance sheet format? 1. A business has $2,500,000 total assets and $1,000,000 total liabilities. Present three balance sheet formats for the business. Solve It Solve It 121 More free books @ www.BingEbook.com 122 Part II: Preparing Financial Statements 3. A business has $3,600,000 total assets and $4,600,000 total liabilities. Present three balance sheet formats for the business. 4. Solve It A business has $725,000 total assets and $425,000 total owners’ equity. Present three balance sheet formats for the business. Solve It Building a Balance Sheet A brand-spanking-new business starts with a blank balance sheet. It builds up its balance sheet over time with three basic types of transactions: ⻬ Financing activities: Includes the investment of capital in the business by its owners, the return of some capital to owners (which may happen from time to time), and distributions from profit (if the business decides to make such distributions) ⻬ Investing activities: Includes the purchase and construction of long-lived assets used in the operations of the business, the purchase of intangible assets used in manufacturing and making sales, and the disposal of operating assets when they’re no longer needed or are replaced ⻬ Operating activities: Includes the profit-making activities of the business, including sales, expenses, and other income and losses In Chapter 5, I explain how sales and expenses change the financial condition of the business. In fact, a good part of its balance sheet is driven by the profit-making transactions of the business. Before a business begins its profit-making activities, it needs to raise capital and invest capital in long-term operating assets. These financing and investing activities are the place to start in building a balance sheet. More free books @ www.BingEbook.com Chapter 6: Reporting Financial Condition in the Balance Sheet Q. Q. Several investors come together to start a new business. They raise $1,000,000 and invest this sum in the business. The business issues 10,000 shares of capital stock to them. The business borrows $1,500,000 from a bank on the basis of a long-term interest-bearing note payable. The business purchases various long-term operating assets (fixed assets) for a total cost of $2,000,000. It’s now ready to begin hiring employees, manufacturing products, and making sales. Prepare the company’s balance sheet after these initial financing and investing activities. Use the landscape (horizontal) format for the balance sheet. After its initial financing and investing activities, the business manufactures its first batch of products. The total cost of this production run is $800,000. No sales have been made yet, but the business is poised to send out its sales force to call on customers. Its balance sheet after the first production run is as follows: Assets Liabilities & Owners’ Equity Cash $440,000 Accounts Payable $225,000 Inventory $800,000 Short-term Notes Payable $500,000 Long-term Notes Payable $1,500,000 Property, Plant, & $2,000,000 Equipment Accumulated Depreciation ($15,000) Cost less Depreciation $1,985,000 Total Assets $3,225,000 Owners Equity: Capital Stock (10,000 shares) $1,000,000 Total Liabilities & Owners’ Equity $3,225,000 Explain the changes in the company’s balance sheet, starting with its balance sheet immediately after its initial financing and investing transactions (see the preceding example question). A. The changes in its balance sheet caused by manufacturing the first batch of products are summarized in the following journal entry: A. The company’s balance sheet after its initial financing and investing activities is as follows: Assets Liabilities & Owners’ Equity $500,000 Cash Property, Plant, & $1,500,000 Long-term Notes Payable Owners Equity: Equipment $2,000,000 Total Assets $2,500,000 Capital Stock (10,000 shares) $1,000,000 Total Liabilities & Owners’ Equity $2,500,000 The business hasn’t yet started manufacturing products, making sales, and incurring expenses. Therefore, its balance sheet doesn’t yet include certain other assets and liabilities that are generated by the profit-making process. Balance Sheet Changes Caused By Manufacturing First Batch of Products Cash Inventory $60,000 $800,000 Accounts Payable $225,000 Short-term Note Payable $500,000 Accumulated Depreciation $15,000 Read this entry as follows. The $800,000 cost of manufacturing the first batch of products was provided by borrowing $500,000, by purchasing $225,000 raw materials on credit, by $15,000 depreciation, and by spending down cash $60,000. The business realized that it didn’t have enough cash to pay for its first production run, so it borrowed an additional $500,000 from its bank on the basis of a short-term note payable. Because it made purchases on credit for the raw materials needed for manufacturing products, accounts payable has a balance of $225,000. The cash balance is $60,000 lower compared with its balance immediately after the initial financing and investing transactions ($500,000 balance before – $440,000 balance after = $60,000 decrease). To have products available for sale, the business had to first manufacture the products. The cost of manufacturing its first batch of products was $800,000, which is in the inventory asset account. The business recorded depreciation on its fixed assets (property, plant, and equipment) because these resources were used in the manufacturing process. The business recorded $15,000 depreciation, which is included in the cost of products manufactured. 123 More free books @ www.BingEbook.com 124 Part II: Preparing Financial Statements 5. Instead of the initial financing and investing transactions presented in the preceding example questions, assume the business issued 100,000 capital stock shares for $1,500,000, borrowed $2,000,000 on a longterm note payable, and invested $2,800,000 in fixed assets. Using the landscape (horizontal) format, prepare its balance sheet after these initial financing and investing transactions. 6. Solve It Following its initial financing and investing transactions in Question 5, the business manufactured its first batch of products. The cost of products manufactured was $650,000, depreciation was $20,000, and accounts payable increased $185,000. To provide additional cash, the business borrowed $250,000 and signed a short-term note payable. Using the landscape (horizontal) format, prepare its balance sheet after its first production run. Start with the balance sheet after the initial financing and investing transactions in your answer to Question 5. Solve It 7. A new business has just been organized. A group of investors put $5,000,000 in the business and the business issued 5,000,000 shares of capital stock to them. The business borrowed $2,500,000 from a local bank on the basis of a long-term note payable. (Several of the investors had to guarantee this note, or the bank would not have loaned the money to the business.) The business negotiated the purchase of land and buildings that cost $1,250,000. It also paid $5,250,000 for machinery, production equipment, delivery vehicles, and office equipment and furniture. Using the landscape (horizontal) format, prepare the balance sheet of the business immediately after these initial financing and investing activities. Solve It 8. The business introduced in Question 7 manufactured its first batch of products. It has not yet sold any of these products. The balance sheet changes caused by the first production run are summarized in the following journal entry: Cash Inventory $665,000 $2,000,000 Accounts Payable $550,000 Short-term Note Payable $750,000 Accumulated Depreciation $35,000 Using the portrait format, prepare its balance sheet after giving effect to the first production run. Start with your balance sheet answer to Question 7. Solve It More free books @ www.BingEbook.com Chapter 6: Reporting Financial Condition in the Balance Sheet Fleshing Out the Balance Sheet The most recent balance sheet of the business you’re considering buying is presented in Figure 6-1. The first few transactions of the business that I explain earlier in the chapter (see the example question in the section “Building a Balance Sheet”) took place some years ago. Since then, the business has grown and prospered. Assets Liabilities & Owners’ Equity Cash $1,500,000 Accounts Payable $700,000 Accounts Receivable $1,000,000 Accrued Expenses Payable $600,000 Inventory $1,800,000 Short-term Notes Payable $1,500,000 Total Current Liabilities $2,800,000 Long-term Notes Payable $2,000,000 Prepaid Expenses Total Current Assets Property, Plant, & Equipment Figure 6-1: Accumulated Depreciation The most Cost Less Depreciation recent balance sheet of the business in question. Total Assets $300,000 $4,600,000 $4,800,000 ($1,400,000) $3,400,000 $8,000,000 Owners Equity: Capital Stock (10,000 shares) $1,000,000 Retained Earnings $2,200,000 Total Owners’ Equity $3,200,000 Total Liabilities & Owners’ Equity $8,000,000 What does the balance sheet in Figure 6-1 tell you about the business? In fact, it tells you a lot. You know that the business sells on credit because it reports the accounts receivable asset, and you know that it sells products, the cost of which is reported in the inventory asset. Because it reports prepaid expenses, you know that the business pays some of its expenses in advance, and the report of accrued expenses payable liability indicates that it delays paying some expenses. Also, you can tell that the business buys on credit because it reports the accounts payable liability. The balance sheet reveals that the business borrows money, which is evident in its short-term and long-term notes payable liabilities. It has invested $4,800,000 in longterm operating assets, and over the years, it has depreciated $1,400,000 of the cost of these assets. According to the balance sheet, the owners invested $1,000,000 in the business for which they received 10,000 shares of capital stock. And the business has retained $2,200,000 of its cumulative net income over the years. Did you get all that from reading the balance sheet? If not, read it again! 125 More free books @ www.BingEbook.com 126 Part II: Preparing Financial Statements Q. Does the balance sheet shown in Figure 6-1 report the current replacement costs of the business’s fixed assets (which are labeled “Property, Plant & Equipment” in the balance sheet)? Also, does the balance sheet indicate which depreciation methods the business uses to depreciate its fixed assets? A. The short answer to the first question is no, balance sheets don’t report current replacement cost values of fixed assets. Indeed, the business probably hasn’t taken the time and troubles to estimate these replacement costs because it isn’t planning to replace its fixed assets. The answer to the second question is a little more involved. This business, like most businesses, doesn’t disclose its depreciation methods in the balance sheet itself, but it discloses depreciation methods in the footnotes to the financial statements. (You have to take my word for it because this example doesn’t present the footnotes to the business’s financial statements.) The following questions are based on the balance sheet details outlined earlier in this section. 9. Suppose the business didn’t make credit sales and made only cash sales. Which account(s) would you not expect to see in its balance sheet? Solve It 10. Suppose the business didn’t own any of its fixed assets (long-term operating assets). Instead, it entered into long-term leases for all these assets (buildings, machinery, equipment, trucks, and so on). Which account(s) would you not expect to see in its balance sheet? Solve It