ACCT 217

Final Exam Review

Prof. Luminita Enache

Haskayne School of Business
University of Calgary
REVIEW
 The Accounting System
We do accounting to help people make decisions

§ Decisions made by people outside of the firm

ü Should I buy stock in this company?
ü Should I lend to this company?
ü Should my company partner with this company?
ü Union – should we try to negotiate a wage increase?

§ Decisions made by people inside the firm

ü Do we need to change strategy?
ü Has operating efficiency declined?
ü How many units do we need to sell before we start earning a profit?
ü Are we setting aside enough to pay our pension obligations?
 The Conceptual Framework

Objective of Financial Reporting: To provide financial information about the

reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.

Fundamental Qualitative Characteristics of Useful Information

Relevance – capable of making a difference in a decision
•Predictive of future or
•Corrects or confirms prior expectations
Faithful Representation: complete, neutral, free from error

Attributes that Enhance Qualitative Characteristics

Comparability
Verifiability
Timeliness
Understandability
 The Conceptual Framework

Assumptions
Separate entity: Activities of the business are separate from activities of
owners.

Continuity/Going Concern : The entity will not go out of business in the near
future.

Unit-of-measure: Accounting measurements will be in the national monetary

unit (i.e., $ in the U.S.).

Principle
Historical cost: Cash equivalent cost given up is basis for the initial recording
of elements.
 The Accounting Equation

A = L + SE
(Assets) (Liabilities) (Stockholders’
Equity)

Sources of Financing for Economic

Economic Resources
Resources Liabilities: From Creditors
Stockholders’ Equity: From Stockholders
The accounting cycle
Start of new period

During the Period

(Chapters 2 and 3)
1 Analyze transactions
2 Record journal entries in the general journal
3 Post entries to the general ledger (or T-account)

At the End of the Period

(Chapter 4)
4 Prepare a trial balance (check if debits = credits)
5 Adjust revenues and expenses and related balance sheet
accounts (record in journal and post to ledger)
6 Prepare financial statements and disseminate them to
users
7 Close revenues, expenses, gains, and losses to Retained
Earnings (record in journal and post to ledger)
Nature of Business Transactions

External events: exchanges of assets

and liabilities between the business
and one or more other parties

Borrow cash

from the bank

Nature of Business Transactions

Internal events: not an exchange between

the business and other parties, but have
a direct effect on the accounting entity

Loss due to
fire damage.
More on Transaction Analysis
1. Understand the Transaction
2. Identify the Accounts in the transaction (at least two
accounts for each transaction)
3. For each account, identify the TYPE of account (ASSET,
LIABILITY, STOCKHOLDERS’s EQUITY, REVENUE,
EXPENSE)
4. For each account, determine if it is increasing or
decreasing
5. Is the Accounting Equation still in balance?
Expanded transaction analysis
Note: As expenses
increase (are debited),
net income, retained
earnings, and
stockholders’ equity
ASSETS
(many
= LIABILITIE
S
+ STOCKHOLDERS’ EQUITY
decrease.
accounts) (many Contributed Capital Earned Capital
accounts) (2 accounts) (1 account)
+ − – + Common Stock and Retained
Debit Credit Debit Credit Additional Paid-in Earnings
Capital
– + – +
Debit Credit Debit Credit
Investment Dividends Net = REVENUE
S
– EXPENSE
S
s declared income (many (many
by owners accounts) accounts)
+ +
Credit Debit
 The General Ledger (G/L)

• The G/L serves as a place to “total” amounts by

account titles
• After journal entries are recorded, they are posted to
the G/L
• We will use “T” accounts to represent G/L accounts
where needed A/R
BB 0
3000
1000

EB 2000
 Operating Cycle vs. Accounting Cycle
The operating cycle is almost never complete when the
accountants decide to end the period.
Deliver product
Purchase or or provide service Receive payment
manufacture to customers on from customers.
products. credit.

What if accounting period ends

here?
Can we report revenue from
the sale in this period?
 How Are Operating Activities
Recognized and Measured?

Record revenues when earned and expenses

when incurred, regardless of the timing of cash
receipts or payments

Required by GAAP
or IFRS
Accrual accounting focuses on underlying
activities, not cash flows
 Accrual Accounting Principles
§ Revenue recognition principle: recognize revenues (1)
when the company transfers promised goods or
services to customers (2) in the amount it expects to
receive
§ Expense recognition principle: record expenses when
incurred in earning revenue
• Matching principle
• Period costs
 The Matching Principle

Resources consumed
to earn revenues in
an accounting period
should be recorded in
that period,
regardless of when
cash is paid.
 Transaction analysis steps
Step 1: Ask → Was a revenue earned by delivering goods or services?
If so, credit the revenue account and debit the appropriate accounts
for what was received.
or Ask → Was an expense incurred to generate a revenue in the current
period?
If so, debit the expense account and credit the appropriate accounts for
what was given.
or Ask → If no revenue was earned or expense incurred, what was received
and given?
• Identify the accounts affected by title (e.g., Cash and Notes Payable).

Remember: Make sure that at least two accounts change.

• Classify them by type of account: asset (A), liability (L), stockholders’ equity
(SE), revenue/gain (R), or expense/loss (E).
• Determine the direction of the effect. Did the account increase (+) or
decrease (−)?

Step 2: Verify → Is the accounting equation in balance? (A = L + SE)

 Transaction Analysis Illustrated
After analyzing all transactions, the balance in our T-accounts might
appear as follows:
+ Short-Term
+ Cash (A) – + Land (A) –
Investments (A) –
1/1/15 419,500 1/1/15 338,600 1/1/15 11,100
(a) 3,700 53,400 (c) (e) 9,000 (c) 10,000
(b) 2,000 4,600 (d) 347,600 21,100
44,000 (e)
323,200

+ Intangible + Long-Term
+ Buildings (A) – + Equipment (A) – Assets (A) – Investments (A) –
1/1/151,267,100 1/1/15 442,500 1/1/15 64,700 1/1/15 496,100
(c) 8,200 (c) 33,800 (c) 3,700 (e) 35,000
1,275,300 476,300 68,400 531,100

Short-Term Long-Term Dividends

– Other Liabilities (L)
– Notes Payable (L) + – Notes Payable (L) + – Payable (L) +
+
0 1/1/15 0 1/1/15 0 1/1/15 288,200 1/1/15
(d) 2,300 2,300 (c) 2,000 (b) 3,000 (f) (d) 2,300
0 2,000 3,000 285,900

– Common Stock – Additional Paid-in – Retained

(SE) + Capital (SE) + Earnings (SE) +
400 1/1/15 290,200 1/1/15 1,721,800 1/1/15
100 (a) 3,600 (a) (f) 3,000
500 293,800 1,718,800
Trial Balance
CHIPOTLE MEXICAN GRILL–TRIAL
BALANCE
(based on investing and financing transactions only during
the first quarter ended March 31, 2015)

(in thousands) Debit Credit

Cash 323,200
• The trial balance is a listing of Short-term investments 347,600
Accounts receivable 34,800
the ending balances in each Supplies 15,300
account in the general ledger Prepaid expenses 70,300
Land 21,100
Buildings 1,275,300
• The purpose of the trial Equipment 476,300
balance is to make sure the Accumulated depreciation 613,700
Long-term investments 531,100
debits and credits are equal Intangible assets 68,400
before we prepare the balance Accounts payable 69,600
sheet Unearned revenue 16,800
Dividends payable 3,000
Wages payable 73,900
Utilities payable 85,400
Short-term notes payable 0
Long-term notes payable 2,000
Other liabilities 285,900
Common stock 500
Additional paid-in capital 293,800
Retained earnings 1,718,800

Total 3,163,400 3,163,400

 Types of Adjustments

There are four types of adjustments.

Revenues Expenses
1. Unearned 3. Prepaid
Revenues. Expenses.
2. Accrued 4. Accrued
Revenues. Expenses.
 Unearned Revenues

End of
accounting period.

Cash received Revenues earned

Example includes rent received in

advance (an unearned revenue).
 PREPAID EXPENSES

End of
accounting period.

Cash paid Expense incurred

Examples include prepaid rent,

advertising, and insurance.
 ACCRUED REVENUES

End of
accounting period.

Revenues earned Cash received

Example includes interest earned

during the period (accrued revenue).
 ACCRUED EXPENSES

End of
accounting period.

Expense incurred Expense paid

Examples include accrued rent,

accrued interest, and accrued wages.
 Recording Depreciation
§ Always Debit DEPRECIATION EXPENSE
§ CREDIT: Accumulated Depreciation (a contra asset –
nets against the cost of the asset)

§ Cost of asset LESS Accumulated Depreciation equals

BOOK VALUE of asset.

§ Amount of Accumulated Depreciation accumulates

over the useful life of the asset so that at the end of
the assets useful life the Book Value is equal to the
Salvage Value.
 Book Value over Assets Life

Assume that the Asset Cost is Still $100,000, Useful life is still 5 years, but
Salvage Value is now $25,000.

Year Depreciation Asset Cost Accumulated Book Value

Expense Depreciation
Year 1 $15,000 $100,000 $15,000 $85,000
Year 2 $15,000 $100,000 $30,000 $70,000
Year 3 $15,000 $100,000 $45,000 $55,000
Year 4 $15,000 $100,000 $60,000 $40,000
Year 5 $15,000 $100,000 $75,000 $25,000
 Closing the Books

Even though the Closing entries:

balance sheet
1. Transfer net income
account balances
(or loss) to Retained
carry forward from
Earnings.
period to period, the
income statement 2. Establish a zero
accounts do not. balance in each of the
temporary accounts
to start the next
accounting period.
 Closing the Books

Here is an example of the closing process using an

illustration with just a few accounts.
 Closing Entry
§ All income statement accounts with a credit balance
(Revenue Accounts) are DEBITED to get their balance to
zero.

§ All income statement accounts with a debit balance

(Expense Accounts) are CREDITED to get their balance to
zero.

§ Difference which makes Debits and Credits EQUAL is to

RETAINED EARNINGS (and is equal to net income).
 Closing the Books

Why is it desirable to close the revenue and expense accounts? In

other words, why is it desirable to start the accounts at beginning
balances of zero for the next period?

So that these accounts to reflect the activity that occurs in the current
period only.

“Nominal” or “Temporary” accounts

• Revenues, expenses, gains, losses
• They are designed to capture the activity that occurs in the current
period only

“Real” or “Permanent” accounts

• Assets, liabilities, and stockholders’ equity
• They reflect the end result of activity over the firm’s entire history
 How are Financial Statements
Prepared and Analyzed?
Income Revenues – Expenses = Net Income
Statement
Beginning Retained Earnings
Statement of
+ Net Income
Stockholders’
- Dividends Declared
Equity
Ending Retained Earnings

Balance Assets = Liabilities + Stockholders’ Equity

Sheet
Contributed Capital
Cash

Retained Earnings

Statement Change = Cash from Operating Activities

of Cash Flows in + Cash from Investing Activities
Cash + Cash from Financing Activities
 Focus on Cash Flows
ALL Transactions can be classified as one of the
following categories:
1. Cash Flows from Operating Activities
2. Cash Flows from Investing Activities
3. Cash Flows from Financing Activities
4. Non-Cash Operating Activity
5. Non-Cash Investing and Financing Activity
 Key Ratio Analysis

Current Current Assets

Ratio = Current Liabilities

Current ratio for Chipotle’s:

2012 = 2.925
2013 = 3.344
2014 = 3.575
The current ratio for Chipotle’s shows a high level
of liquidity, well above 2
 NET PROFIT MARGIN
(how efficient Is management IN generatING PROFIT ON EVERY
DOLLAR OF sales?)

Net Profit Net Income

=
Margin Sales (or Operating) Revenues

Chipotle’s Net Profit Margin for 2014 is (dollars in thousands):

$445,300
$4,108,300 = 10.84%
 Total Asset Turnover
(how efficiently does management use assets to generate sales?)

Total Asset Sales (or Operating) Revenues

=
Turnover Average Total Assets

(Beginning total assets + ending total assets) ÷ 2

Chipotle’s Total Asset Turnover Ratio for 2014 (dollars in thousands):

$4,108,269
($2,009,280 + $2,546,295) ÷ 2 = 1.804
Types of Non-current Assets
Assets being
Plant, Property constructed
and Equipment Construction in
Progress
(PPE)

Investment
Intangibles Properties

A class of properties (land and/or

buildings) held to earn rentals or for capital
appreciation or both
PPE and Intangibles: acquisition,
usage, and disposal
PPE & Intangibles Terminology
Asset Account Related Expense Account
(Balance Sheet) (Income Statement)
Property, Plant and Equipment
Freehold Land None
Leasehold land Depreciation
Buildings, Machinery & Equipment Depreciation
Furniture & Fixtures Depreciation
Land Improvements Depreciation
Natural Resources Depletion
Intangibles
Intangibles with finite useful lives Amortization
Intangibles with indefinite useful lives None
 Cost of PPE
§ Measuring the Cost of a Plant Asset
• Sum of all costs incurred to bring the asset to its
intended use
• If you cannot use an asset without a certain cost, you
have to include the cost in determining the cost of the
asset.
• E.g.) Equipment + transportation costs: if you expense
the transportation costs during the acquisition period, it
is against matching. So capitalize all the costs.

Purchas an equipment on Dec. 31 2009 Dec. 31 2010

Jan. 1st 2009
Price: 10K (UL: 2yrs; No RV)
Transportation cost:1K
Measuring the Cost of a Plant Asset
Asset Costs included
Land Purchase price, commissions, survey & legal
fees, and back property taxes paid;
grading and removing unwanted buildings

Land Improvements Fencing, paving, security systems & lighting

Building – Architectural fees, contractors’ charges,
Constructed materials, labor, and overhead; interest on
funds borrowed
Building – Purchase price, broker’s commission, taxes
Purchased paid and all costs to repair and renovate
building
Equipment Purchase price, transportation, insurance in
transit, sale tax, installation and testing

Why do we need to distinguish Land improvements from Land?

Example: initial costs
§ Trautschold Furniture Co. purchased land, paying $80,000
cash plus a $300,000 note payable.
§ In addition, Trautschold paid property tax of $2,000, title
insurance costing $3,000, and $5,000 to level the land and
remove an unwanted building.
§ The company then constructed an office building at a cost
of $500,000.
§ It also paid $50,000 for a fence around the property,
$10,000 for a sign near the entrance, and $6,000 for
special lighting of the grounds.

§ Determine the cost of the land, land improvements, and

building. Which of these assets will Trautschold depreciate?
Example: initial costs
Land Building
Purchase price $380,000 Cost $500,000
Property tax 2,000
Title insurance 3,000 Land improvements
Remove and level 5,000 Fence $50,000
$390,000
Sign 10,000
Lighting 6,000

$66,000

Which of these assets will Trautschold depreciate?

Only Building and Land Improvements should be depreciated.

Land (Freehold Land) is not subject to depreciation.
Subsequent Costs
EXPENSES
CAPITAL EXPENDITURES (REVENUE EXPENDITURES)
Increase capacity or extend Do not extend capacity or
useful life useful life
Example: Major engine Maintain or restore working
order
overhaul
Example: regular service (oil
Cost is added to an asset
change, lubrication, etc)
account (Capitalized) Cost is recorded as an
expense

Distinction between the two requires judgment

• Errors? How do they affect the financial statements?

• Worldcom case: Operating costs (line costs) US$3.8 billion were
capitalized instead of being expensed.
Capital vs. Revenue Expenditures
Does the expenditure increase capacity
or efficiency or extend useful life?

YES NO

Capital Expenditure Expense

Debit asset account Debit repairs and maintenance
expense

Income statement Effects Income statement Effects

Expense lower Expense higher
Net Income higher Net Income lower

Balance Sheet Effects BalanceAsset

Sheetvalues
Effects
Asset values higher higher
Asset values lower
Exercise
§ Classify each of the following expenditures as a capital
expenditure or an expense related to machinery
Expense or
Capitalize
1. Purchase price Capitalize
2. Ordinary recurring repairs to keep the machinery in good Expense
working order
3. Lubrication before machinery is placed in service Capitalize

4. Periodic lubrication after machinery is placed in service . Expense

5. Major overhaul to extend useful life by three years Capitalize

6. Sales tax paid on the purchase price Capitalize

7. Transportation and insurance while machinery is in transit Capitalize
from seller to buyer
8. Income tax paid on income earned from the sale of products Expense
manufactured by the machinery
 Depreciation
§ Cost allocation for the usage of PPE
§ Depreciation
• Systematic allocation of the depreciable amount of an
asset over its useful life (FRS 16:6)
• Charged to Income Statement (as an expense)
• Cumulative amount charged is called Accumulated
Depreciation (a contra-asset account)
§ Supports matching principle
• PPE is consumed / used by the business in generating
revenues.
• As the economic benefits of PPE is used, its cost is
transferred from asset account to expense account.
Depreciation
Dr Depreciation expense Expense in income statement

Cr Accumulated depreciation Contra-asset in B/S

Partial balance sheet:

Building $120,000
Less Accumulated Depreciation (80,000)
Book Value (Carrying Value) $40,000

Accumulated
depreciation increases

Book value decreases

Asset’s final book value = Residual value

Depreciation
§ The calculation of depreciation requires
three amounts for each asset :
• Cost (both initial cost and capitalized
subsequent costs).
• Estimated residual value (or Salvage value)
Depreciable cost = Cost – Residual Value
• Estimated useful life.

• Depreciation expense may vary from company to company,

even for an identical item of PPE, because the
assumptions/estimates made by management differ.
Depreciation Methods

Straight-line

Units-of-production

Double-declining-
balance
Straight-Line (SL)

Depreciable cost

Useful life, in years

Results in equal
amount of expense
each year
Units-of-Production (UOP)

Depreciable cost
Depreciation
per unit
Useful life in units

Depreciation Activity for period

per unit (units, miles)
Double-Declining-Balance Method
— Accelerated method – writes off a greater amount of the
cost of an asset in earlier years of asset’s useful life
— Amount of depreciation expense recognized declines
each year

1: Double-declining-balance rate: straight-line rate times 2

1
Useful life in years X2

2: Multiply beginning book value by rate

Depreciation Double-declining- Beginning period

expense = balance rate × book value

Ignores residual value

Residual Value: DDB
Ignored until final year

Final year Book value at the Residual

depreciation beginning final year value

First-year depreciation is based on asset’s full cost

Final year depreciation is a “plug” amount needed to reduce book value

to residual value
Choose a Depreciation Method

Straight-line Units-of-production Double-declining-

• Best for assets • Best for assets balance
that generate that wear out • Best for assets
revenue evenly because of use that generate
• Best meets revenue early in
matching principle useful life
Two minor issues
(1) Changing Useful Life
Remaining depreciable book value

(New) Estimated remaining useful life

How does the change in useful life affect the company’s earnings?

(2) Partial year depreciation

Months from date of
purchase to end of year
Annual
depreciation

12
 Disposal of PPE
§ Means of disposal: sell, exchange, or junked
• First, bring depreciation up to date
• Then, compare assets received with book value of asset
being disposed of to determine if there is a gain or loss
• Finally, record entry to remove asset from books

§ Fully depreciated assets: if still useful and a

company continues to use it
• Report net book value (i.e, the residual value) on
Balance Sheet
• Record no more depreciation expense on Income
Statement
Disposal of PPE
§ Bring depreciation up-to-date to:
• Measure asset’s final book value
• Record depreciation expense up to date of disposal

§ Remove asset and related accumulated

depreciation account from books
§ If asset is junked:
• Fully-depreciated and no residual value
à No gain or loss
• If not full-depreciated and/or has a residual value
à Loss equals ending book value
Disposal of PPE
The NBV (Net Book Value, or Carrying Amount) of an item of
PPE shall be de-recognised:
(a) on disposal or
(b) when no future economic benefits are expected from its
use/disposal (FRS 16:67)

If proceeds received on disposal is > NBV à gain (I/S)

If proceeds received on disposal is < NBV à loss (I/S)
If proceeds received on disposal is = NBV à no gain/ loss

Gain shall not be classified as revenue. (FRS 16:68)

Why is this important?

 Intangible Assets
§ No physical form
• Carry special rights
• Include patents, copyrights and franchises

§ Two categories
• Finite lives
• Amortization recorded
• Straight-line method
• Intangible asset reduced directly
• Indefinite lives
• Tested for loss in value (impairment)
• Impairment loss recorded
Examples of Intangibles

Trademarks
Patents Copyrights and trade
names

Franchises
Goodwill
& licenses
Intangible Assets with finite lives
§ Two alternative ways of recording of Amortization
Expense:

Alternative 1.
Dr) Amortization Expense $$$ Expense in I/S

Cr) Intangible Assets $$$ Direct write of

intangible assets
in B/S

Alternative 2.
Dr) Amortization Expense $$$ Expense in I/S

Cr) Accumulated Amortization $$$ Contra-asset in B/S

Goodwill
§ Defined as the excess of the purchase price of
the company over the market value of its net
assets (not book value !)
• Net Assets = Assets − Liabilities
§ Represents earning power of company purchased
• Spent a good amount of money on advertising and
marketing and improve its brand value.
§ Not amortized, but subjected strict impairment
tests
• Brand value lasts forever, but it can be impaired
Goodwill
§ Companies are not allowed to record internally generated
goodwill that they create for their own business
§ Recorded only during the acquisition of another company

Recognition criteria:
a) it is probable that the expected future economic benefits that are
attributable to the asset will flow to the entity; and
b) the cost of the asset can be measured reliably.
(FRS 38:21)

Intangible assets are either Which one do you think will

(i) purchased/acquired; or be more likely to satisfy the
(ii) internally generated. recognition criteria?
Example: goodwill
PepsiCo, Inc., has acquired several other companies. Assume
that PepsiCo purchased Kettle Chips Co. for $8 million cash.
The book value of Kettle Chips’ assets is $12 million (market
value, $15 million), and it has liabilities of $10 million.

1. Compute the cost of the goodwill purchased by PepsiCo.

2. Record the purchase of Kettle Chips by PepsiCo.

Example: goodwill
Purchase price $ 8,000,000
Market value of net assets:
Assets $ 15,000,000
Liabilities (10,000,000)
___________ 5,000,000
__________
Cost of goodwill purchased $ 3,000,000

GENERAL JOURNAL
DATE DESCRIPTION REF DEBIT CREDIT

(in millions)
Assets 15
Goodwill 3
Liabilities 10
Cash 8
Impairment of Intangible Asset
§ Decline in asset value
§ Write-down required if value of intangible decreases
below cost
§ IFRS accounting rules allow companies to write intangible
assets up to new higher carrying values when market value
exceeds cost (Not in US GAAP).
§ Applies to all intangibles – both those with finite lives and
indefinite lives
JOURNAL
Date Accounts and explanation Debit Credit
Impairment loss on intangible XXX
Intangible asset XXX
Research and Development Costs
§ Costs associated with creation of intangible assets
are classified into research phase and
development phase.
§ Research phase
• Always expensed (Reliability problem)

§ Development phase
• Capitalized if criteria are met (e.g. feasibility)

§ Depends on Judgment
Understanding the Business

The mixture of debt and equity used to

finance a company’s operations is called the
capital structure:

Debt - funds from Equity - funds

creditors from owners
Liabilities Defined and Classified

Definition: probable future sacrifice of economic

benefits that arise from past transactions

Maturity = 1 year or less Maturity > 1 year

Current Noncurrent
Liabilities Liabilities
 Liabilities Defined and Classified

Liabilities are recorded

at their current cash
equivalent, which is
the amount of cash it
would take to settle the
liability immediately
(even if the liability won’t
actually be settled for a
long time).
Current Liabilities
 Accounts Payable Turnover

Cost of Goods Sold ÷ Average Accounts Payable

Measures how quickly management is paying it suppliers

A high accounts payable ratio normally suggests that a

company is paying its suppliers in a timely manner

The ratio can be stated more intuitively by dividing it into the

number of days in a year:

Average Age of Payables = 365 Days ÷ Turnover Ratio

 Notes Payable

A note payable specifies the interest rate

associated with the borrowing.
ØTo the lender, interest is a revenue.
ØTo the borrower, interest is an expense.

Interest = Principal × Interest Rate × Time

When computing interest for one
year, “Time” equals 1. When the
computation period is less than one
year, then “Time” is a fraction.
 Contingent Liabilities

Contingent liabilities are potential liabilities that have

arisen as a result of a past event

The probabilities of occurrence are defined in the following manner:

1. Probable — the chance that the future event or events will occur is
high (> 70% under U.S. GAAP)
2. Reasonably possible — the chance that the future event or events
will occur is more than remote but less than likely
3. Remote — the chance that the future event or events will occur is
slight
 PRESENT VALUE OF A SINGLE AMOUNT
(SAY, $20,000 IN 4 YEARS AT 12%)

Two ways to get answer

1. Formula
FutureAmount where i = interest rate and n = number of
PV =
(1 + i) n periods

So present value = $20,000 / (1 + .12) 4 = $12,710

2. Tables
PV = Amount x Factor from Table A.1 (see appendix)
PV = $20,000 x .63552 = $12,710

1
Note: = .63552
(1 + .12) 4

9-75
 Annuities

An annuity is a series of payments

that are equally spaced and have
equal amounts.

Today
 Present value of an Annuity

Present Value

$100,000 100,000 100,000 100,000 100,000 100,000

......
0 1 2 3 4 19 20

Jaime Yuen wins the $2,000,000 state lottery. She can choose
from two payment plans, one that pays $100,000 at the end
of each year for the next 20 years, or one that pays a single
lump sum of only $1,000,000 today. Which plan should she
take? Assume an appropriate interest rate of 8%.
 Present Value of an Annuity

Number Table A.2

of Discount Rate
Periods 4% 6% 8% 10% 12%

1 0.96154 0.94340 0.92593 0.90900 0.89286

5 4.45183 4.21236 3.99271 3.79079 3.60478
10 8.11090 7.36009 6.71008 6.14457 5.65022
15 11.11839 9.71225 8.55948 7.60608 6.81086
20 13.59033 11.46992 9.81815 8.51356 7.46944

Payment Amount x Factor from A.2 = PV of Annuity

$100,000 x 9.81815 = $981,815

 Bonds
§ A form of debt
§ Used when the company needs to borrow a large sum
§ Too much to borrow from a single creditor
§ So borrow smaller amounts from many creditors

§ The creditors hand over money in exchange for certificates, usually with a face
value of $1000 each

§ Bond certificates are like stock certificates in that they can be traded
 Terminology

Two types of cash payment in the bond contract:

1. Principal
2. Cash interest payments
Bond Terms
1. Principal, par value and face
value
2. Contract, stated, or coupon
rate of interest
3. Market, yield, or effective-
interest rate
 At the Date of Issuance
§ Must FIRST determine Issuance Price

Present Value of the Principal (a single payment)

+ Present Value of the Interest Payments (an annuity)
= Issue Price of the Bond

o If bond interest is paid annually, the interest rate you use

for PVFs is the market rate and the number of periods is the
number of years to maturity.

o If the bond interest is paid semi-annually, divide the

interest rate by 2 (both Market Rate and Stated Rate) and
double the number of periods
 Three Scenarios for Bond Issuance
1. Bonds issued at PAR: Market Rate = Stated Rate

2. Bonds Issued at DISCOUNT: Market Rate > Stated Rate

3. Bonds Issued at PREMIUM: Market Rate < Stated Rate

REMEMBER: Stated Rate is only used to determine the legally

required amount of interest payments to be made, nothing else!
 EXAMPLE: BONDS ISSUED AT PAR

On January 1, 2018, Burlington Northern Santa Fe

(BNSF) issues $100,000 in bonds having a stated
rate of 10% annually. The bonds mature in 10 years
and interest is paid semi-annually. The market
rate is 10% annually.

This bond is issued at a par.

¡ Determine the Issuance Price

9-83
How do you record the issuance at
PAR (at date of Issuance)?

GENERAL JOURNAL
Date Description Debit Credit
Jan 1 Cash (+A) 100,000
Bonds Payable (+L) 100,000
Example: Bonds issued at premium

On January 1, 2018, BNSF issues $100,000 in

bonds having a stated rate of 10% annually.
The bonds mature in 10 years (Dec. 31,
2027) and interest is paid annually. The
market rate is 8% annually.

This bond is issued at a premium.

§ Determine the issuance price assuming interest is paid annually

§ Determine the issuance price assuming Interest is paid semi-annually
 Bonds Issued at Premium –
SEMI-ANNUAL interest payments
The issue price of a bond is
composed of the present value of First, compute the
two items: present value of the
•Principal (a single amount) principal
•Interest (an annuity)

Market rate of 8% ÷ 2 interest periods per year = 4%

Bond term of 10 years × 2 periods per year = 20 periods
Present Value
Single Amount = Principal × Factor (i=4.0% , n=20)
$ 45,640 = $ 100,000 × 0.4564
 Bonds Issued at Premium –
SEMI-ANNUAL interest payments
The issue price of a bond is Now, compute
composed of the present value of
two items:
the present
•Principal (a single amount) value of the
•Interest (an annuity) interest

Market rate of 8% ÷ 2 interest periods per year = 4%

Bond term of 10 years × 2 periods per year = 20 periods

Present Value
Annuity = Payment × Factor (i=4.0% , n=20)
$ 67,952 = $ 5,000 × 13.5903
 Bonds Issued at Premium
– SEMI-ANNUAL interest payments
The issue price of a bond is composed of
Finally, determine
the present value of two items:
•Principal (a single amount) the issue price of
•Interest (an annuity) the bond

$ 45,640 Present Value of the Principal

+ 67,952 Present Value of the Interest
= $ 113,592 Present Value of the Bonds

The $113,592 is greater than the face amount of $100,000,

so the bonds are issued at a premium of $13,592
 Bonds Issued at Premium
– SEMI-ANNUAL interest payments
GENERAL JOURNAL
Date Description Debit Credit
Jan 1 Cash (+A) 113,592
Premium on Bonds Payable (+L) 13,592
Bonds Payable (+L) 100,000

BNSF
Partial Balance Sheet
The premium
At January 1, 2018 will be
Long-Term Liabilities amortized
Bonds Payable, 10%
Due Dec. 31, 2027
$ 100,000
over the 10-
Add: Bond Premium
Total L-T Liabilities $
13,592
113,592
year life of
the bonds
 Example: Bonds issued at discount

On January 1, 2018, BNSF issues $100,000 in

bonds having a stated rate of 10% annually.
The bonds mature in 10 years (Dec. 31,
2027) and interest is paid annually. The
market rate is 12% annually.

This bond is issued at a discount.

§ Determine the issuance price if interest payments were made

annually
§ What would the issuance price be if interest payments were made
semi-annually?
 Bonds Issued at Discount
– SEMI-ANNUAL interest payments
The issue price of a bond is
composed of the present value of First, compute the
two items: present value of the
•Principal (a single amount) principal
•Interest (an annuity)

Market rate of 12% ÷ 2 interest periods per year = 6%

Bond term of 10 years × 2 periods per year = 20 periods
Present Value
Single Amount = Principal × Factor (i=6.0% , n=20)
$ 31,180 = $ 100,000 × 0.3118
 Bonds Issued at Discount
– SEMI-ANNUAL interest payments
The issue price of a bond is composed of Now, compute the
the present value of two items:
•Principal (a single amount) present value of the
•Interest (an annuity) interest

Market rate of 12% ÷ 2 interest periods per year = 6%

Bond term of 10 years × 2 periods per year = 20 periods

Present Value
Annuity = Payment × Factor (i=6.0% , n=20)
$ 57,350 = $ 5,000 × 11.4699
 Bonds Issued at Discount
– SEMI-ANNUAL interest payments

The issue price of a bond is composed Finally, determine

of the present value of two items:
•Principal (a single amount)
the issue price of
•Interest (an annuity) the bond

$ 31,180 Present Value of the Principal

+ 57,350 Present Value of the Interest
= $ 88,530 Present Value of the Bonds

The $88,530 is less than the face amount of $100,000, so

the bonds are issued at a discount of $11,470
 Bonds Issued at Discount
– SEMI-ANNUAL interest
payments
Here is the journal entry to record the
bond issued at a discount
GENERAL JOURNAL
Date Description Debit Credit
Jan 1 Cash (+A) 88,530
Discount on Bonds Payable (+XL, -L) 11,470
Bonds Payable (+L) 100,000

This is a contra-liability account and appears in

the liability section of the balance sheet
 Bonds Issued at Discount

BNSF
Partial Balance Sheet The discount
At January 1, 2018
will be
Long-Term Liabilities amortized
Bonds Payable, 10%
Due Dec. 31, 2027
$ 100,000
over the 10-
Less: Bond Discount (11,470) year life of
Total L-T Liabilities $ 88,530
the bonds

Two methods of amortization are commonly used:

Straight-line

Effective-interest
 Reporting Interest Expense:
Effective-interest Amortization
l The effective interest method is
the theoretically preferred
method
l Compute interest expense by
multiplying the current unpaid
balance times the market rate of
interest
l The discount/premium
amortization is the absolute value
of the difference between interest
expense and the cash paid for
interest
 Bonds Issued at a Discount:
Effective-interest Amortization
BNSF issued their bonds on Jan. 1, 2018. The stated interest
rate was 10% and the market interest rate was 12%. The
issue price was $88,530. The bonds have a 10-year maturity
and $5,000 interest is paid semiannually.

Compute the periodic discount amortization using the effective

interest method.
Unpaid Balance × Effective Interest Rate × n/12
$88,530 × 12% × 1/2 = $5,312
Discount Interest Cash Paid
Amortization = Expense - for Interest
$ 312 = $ 5,312 - $ 5,000
 Bonds Issued at a Discount:
Effective-interest Amortization
GENERAL JOURNAL
Date Description Debit Credit
Jun 30 Interest Expense (+E, -SE) 5,312
Discount on Bonds Payable (-XL, +L) 312
Cash (-A) 5,000

BNSF
Partial Balance Sheet
At June 30, 2018
As the discount
is amortized, the
Long-Term Liabilities
Bonds Payable, 10% $ 100,000 carrying amount
Due Dec. 31, 2027
Less: Bond Discount (11,158)
of the bonds
Total L-T Liabilities $ 88,842 increases
 Effective-Interest Amortization Table
Interest Interest Discount Unamortized Book
Date Payment Expense* Amortization* Discount* Value
1/1/2018 $ 11,470 $ 88,530
6/30/2018 $ 5,000 $ 5,312 $ 312 11,158 88,842
12/31/2018 5,000 5,331 331 10,828 89,172
6/30/2019 5,000 5,350 350 10,477 89,523
12/31/2019 5,000 5,371 371 10,106 89,894
6/30/2020 5,000 5,394 394 9,712 90,288
12/31/2020 5,000 5,417 417 9,295 90,705
.................................
.................................
6/30/2027 5,000 5,890 890 944 99,056
12/31/2027 5,000 5,943 943 0 100,000
$ 100,000 $ 111,470 $ 11,470
* Rounded.
 Bonds Issued at a Premium:
Effective-interest Amortization
BNSF issued their bonds on Jan. 1, 2018. The issue price was
$113,592. The stated interest rate was 10% and the market
interest rate was 8%. The bonds have a 10-year maturity
and $5,000 interest is paid semiannually.

Compute the periodic discount amortization using the

effective interest method.

Unpaid Balance × Effective Interest Rate × n/12

$113,592 × 8% × 1/2 = $4,544
Premium Cash Paid Interest
Amortization = for Interest - Expense
$ 456 = $ 5,000 - $ 4,544
 Bonds Issued at a Premium:
Effective-interest Amortization

Here is the journal entry to record the payment of

interest and the premium amortization for the
six months ending on June 30, 2018

GENERAL JOURNAL
Date Description Debit Credit
Jun 30 Interest Expense (+E, -SE) 4,544
Premium on Bonds Payable (-L) 456
Cash (-A) 5,000
 Effective-Interest Amortization Table
Interest Interest Premium Unamortized Book
Date Payment Expense* Amortization* Premium* Value
1/1/2018 $ 13,592 $ 113,592
6/30/2018 $ 5,000 $ 4,544 $ 456 13,136 113,136
12/31/2018 5,000 4,525 475 12,661 112,661
6/30/2019 5,000 4,506 494 12,168 112,168
12/31/2019 5,000 4,487 513 11,654 111,654
6/30/2020 5,000 4,466 534 11,120 111,120
12/31/2020 5,000 4,445 555 10,565 110,565
.................................
.................................
6/30/2027 5,000 4,076 924 * 965 100,965
12/31/2027 5,000 4,039 965 0 100,000
$ 100,000 $ 86,408 $ 13,592
* Rounded.
 Recording on the date of maturity
§ You will make last interest payment journal
entry which will get the book value equal to the
face value.

§ The journal entry at the date of maturity

(paying back the face value) is always the same!
 Journal entry at maturity

Account Debit Credit

Bonds Payable $100,000
Cash $100,000

This entry is the same whether bonds were

issued at par, at a discount, or at a premium!
 Debt-to-Equity

Total Liabilities
Debt-to-Equity =
Stockholders’ Equity

This ratio shows the relationship between

the amount of capital provided by owners
and the amount provided by creditors. In
general, a high ratio suggest that a company
relies heavily on funds provided by
creditors.
 Treasury Stock

§ Repurchased shares are referred to as treasury

shares or treasury stock

§ Treasury stock is a contra-equity account (reduces

shareholders’ equity)

§ Treasury shares do NOT retain the right to vote,

receive dividends, or receive assets upon
liquidation

§ State laws or debt covenants may restrict

purchases of treasury stock, often by requiring a
minimum level of retained earnings.
 Earnings per Share (EPS)
Net Income*
EPS =
Weighted Average Number of Common
Shares Outstanding

* Preferred dividends, if any, should be subtracted from net income

Earnings per share is probably the single most widely

watched financial ratio. Whole Foods’s income for 2014 was
$579 million, and the average number of shares
outstanding was 367.8 million.

$579,000,000
EPS = = $1.57 per share
367,800,000 shares
 Dividends on Common Stock

Declared by board of Not legally

directors required

Creates liability at Requires sufficient

declaration Retained Earnings and
Cash
Declaration date
• Board of directors declares the dividend
• Record a liability
Date Description Debit Credit
Retained earnings (-SE) XXX
Dividends payable (+L) XXX
How are the financial statements
related?

Income is made up of cash revenues and

expenses and non-cash revenues and
expenses (Income-accruals=Cash from
operations)
 Why Focus on a Cash Flow
Statement?
§ The balance sheet tells us what we own (assets) and how
we finance those assets (liabilities and equity)

§ Net income reported on the income statement provides an

important measure of current period performance.
• Remember, net income is made up of cash and non-cash items
(accruals) – Accrual basis of accounting
• Net income is (normally) a better predictor of future cash flows
§ However, in the absence of cash flow, income does not
pay the bills. Principal payments on debt, interest,
dividend, and capital expenditures cannot be made
without cash.
§ The statement of cash flows tells us whether the company
has enough cash to meet obligations (liquidity needs) and
what the sources of the cash inflows and outflows are.
Statement of Cash Flows: Three
Sections
§ The cash flow statement separates changes
in cash into three categories:
1. Operating cash flow
2. Investing cash flow
3. Financing cash flow

§ The statement sums to the actual change in

cash and cash equivalents.
Beg. Bal. of cash + operating CF + investing CF + financing CF=End. Bal.
of cash
 Cash Flow Classification
1. Operating activities:
• Inflows and outflows related to the fundamental operations of the basic line of business that
the company is in.
• Related to the provision of goods and services (income statement items).

• The operating activity section is the cash-flow engine of the company. When the engine is
working effectively, it provides cash flows to cover the cash needs of the operations
• Start-up companies might have negative cash flows
• Companies in cyclical industries may have negative operating cash flow in a down year

2. Investing activities:
• Purchases and sales of assets not generally held for resale (PPE).
• Investments in government and other corporations’ securities

3. Financing section:
• Cash flows related to the issuance and retirement of debt and equity
• Dividends paid
 Purpose of the
Statement of Cash Flows

• Explains how cash was generated and used over

a period

• Provides more insight into why the cash balance

changed during the period
Relationships to the Balance Sheet
and the Income Statement
Information needed to prepare
a statement of cash flows:
l Comparative Balance Sheets

l Income Statement

l Additional details concerning

selected accounts
Relationships to the Balance Sheet
and the Income Statement

∆ Cash = ∆ Liabilities + ∆ Stockholders’

Equity - ∆ Noncash Assets

Derives from . . .

Assets = Liabilities + Stockholders’ Equity

 Classifications of the
Statement of Cash Flows
Operating Cash inflows and outflows directly related to
earnings from normal operations
Activities

Cash inflows and outflows related to the

Investing acquisition or sale of productive facilities and
Activities investments in the securities of other
companies

Financing Cash inflows and outflows related to external

sources of financing (owners and creditors)
Activities for the enterprise
Statement of Cash Flows: Basic Layout

Direct Method
CF from operating activities: $ XXX
Indirect Method

CF from investing activities: $ XXX

CF from financing activities: $ XXX

Net increase (decrease) in cash $ XXX

Cash at beginning of period $ XXX

Cash at end of period $ XXX

 Operating Activities Section
Why is Cash Flow from Operating Activities different from NI?

Income Stmt Parallel Why different?

Cash Inflows
Collections from Sales revenue A/R or Unearned Rev
customers
Interest and dividends Interest and Interest and dividend
collected dividend revenue receivable
Other operating cash Rent receivable or
receipts Rent revenue unearned rent Current
Assets &
Current
Cash Outflows Liabilities
Payments to suppliers COGS Inventory and A/P
Payments to employees Salaries expense Salaries payable
Payments of interest Interest expense Interest payable
Payments of taxes Tax expense Taxes payable

Net Cash from Ops Net Income

 Operating Activities – Indirect Method

§ NET INCOME
+ Depreciation, Losses
Sometimes
there are
noncurrent
operating
assets and- Gains
+ Decreases in Current Assets and
liabilities
whose
changes must
be handled
like the Increases in Current Liabilities (not N/P)
- Increases in Current Assets and
changes in
current assets
and liabilities.
Decreases in Current Liabilities (not N/P)

= NET CASH FLOW FROM OPERATING

ACTIVITIES
Using the Income Statement

ABC Co. What numbers are

Income Statement needed for indirect
For the Year Ended December 31, 2016 method?
Sales revenue $1,160,000
Cost of goods sold (748,000)
Gross margin 412,000

Operating expenses
Depreciation expense $40,500
Other operating expenses 235,900
Total operating expenses (276,400)

Income from operations 135,600

Other revenues/expenses
Gain of sale of land 8,000
Gain on sale of short-term investment 4,000
Dividend revenue 2,400
Interest expense (51,750) (37,350)
Income before taxes 98,250
Income tax expense (39,400)
Net income $58,850
Using the Balance Sheet

ABC Co.
Comparative Balance Sheets
As of December 31, 2016 and 2015
2016 2015 Change
Current assets
Cash $15,000 $4,000 11,000
Accounts receivable 17,500 12,950 4,550
Short-term investments 20,000 30,000 (10,000)
Inventory 42,000 35,000 7,000
Prepaid rent 5,100 12,900 (7,800)
Office supplies 1,000 750 250

Noncurrent assets
Land 125,000 175,000 (50,000)
Property and equipment 925,000 800,000 125,000
Accumulated depreciation (240,000) (199,500) (40,500)

Total Assets $910,600 $871,100 39,500

 Using the Balance Sheet

Balance sheet continued 2016 2015 Change

Current liabilities
Accounts payable $27,000 $32,000 (5,000)
Taxes payable 5,000 4,000 1,000
Interest payable 20,303 25,853 (5,550)
Accrued liabilities 5,000 3,000 2,000
Short-term notes payable 10,000 10,000 0

Noncurrent liabilities and owners' equity

Long-term notes payable 460,000 470,000 (10,000)
Contributed capital 260,000 237,500 22,500
Retained earnings 123,297 88,747 34,550
Total liabilities and owners' equity
$910,600 $871,100 39,500
Operating Activities -- Indirect Method

Statement of Cash Flows

For the Year Ended December 31, 2016
Cash flows from operating activities (INDIRECT METHOD)

Net income $58,850

Adjustments
Depreciation expense 40,500
Gain on sale of land (8,000)
Gain on sale of short-term investment (4,000)
Increase in accounts receivable (4,550)
Increase in inventory (7,000)
Decrease in prepaid rent 7,800
Increase in office supplies (250)
Decrease in accounts payable (5,000)
Increase in taxes payable 1,000
Decrease in interest payable (5,550)
Increase in accrued liabilities 2,000

Net cash provided by operating activities $75,800

 Cash Flows from Investing Activities

Inflows
Cash received from:
l Sale or disposal of property, plant
and equipment +
l Sale or maturity of investments in Cash
securities
Flows
Outflows from
Cash paid for: _ Investing
l Purchase of property, plant and
equipment Activities
l Purchase of investments in
securities
 Cash Flows from Financing Activities

Inflows
Cash received from:
l Borrowings on notes, mortgages,
bonds, etc. from creditors
l Issuing stock to owners +

Cash
Outflows Flows
Cash paid for: from
l Repayment of principal to
creditors (excluding interest,
_ Financing
which is an operating activity) Activities
l Repurchasing stock from owners
l Dividends to owners
 COPYRIGHT

Copyright © 2023 Luminita Enache, PhD, CPA, RN.

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