Financial Reporting

Standards
Financial Reporting
Standards
A Decision-Making Perspective
for Non-Accountants
David T. Doran
Financial Reporting Standards A Decision-Making Perspective
for Non-Accountants
Copyright Business Expert Press, 2012.
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted in any form or by any
meanselectronic, mechanical, photocopy, recording, or any other
except for brief quotations, not to exceed 400 words, without the prior
permission of the publisher.
First published in 2012 by
Business Expert Press, LLC
222 East 46th Street, New York, NY 10017
www.businessexpertpress.com
ISBN-13: 978-1-6064-9387-8 (paperback)
ISBN-13: 978-1-60649-388-5 (e-book)
DOI 10.4128/9781606493885
A publication in the Business Expert Press Financial Accounting and
Auditing collection
Collection ISSN: 2151-2795 (print)
Collection ISSN: 2151-2817 (electronic)
Cover design by Jonathan Pennell
Interior design by Exeter Premedia Services Private Ltd.,
Chennai, India
First edition: 2012
10 9 8 7 6 5 4 3 2 1
Printed in the United States of America.
To my lovely, patient and understanding wife Mary Anne,
and our three children Patrick, Caley, and Matthew.
Abstract
Accounting is the score keeping system in the game of businessyou
cant do well in any game if you dont understand how the score is kept.
Tis book is intended to beneft practicing managers, MBA students, and
nonaccounting business majors. United States fnancial reporting stand-
ards are compared and contrasted with international fnancial reporting
standards where appropriate. Te book emphasizes how managements
choice of accounting methods and their required estimates in reporting
transactions and events impact fnancial statements, both immediately
and in the future. Unlike typical accounting books, journal entries are not
used to illustrate topical coverage.
Tis unique book exclusively provides a users decision-making per-
spective by using the accounting equation format to directly illustrate
fnancial statement efects of transactions and events. Most of the topics
addressed in this book are typically studied by accounting majors in the
two course intermediate accounting sequence, but the text also includes
discussion of consolidationsa topic generally covered in the advanced
accounting course. Intermediate accounting textbooks alone typically
exceed well over 1,500 pages. By exclusively applying a users perspective,
and limiting topical content to areas relevant for decision making, this
book allows nonaccountants to acquire the requisite underlying knowl-
edge in a concise, easy to understand text.
Keywords
Financial Statements, GAAP, Cash Flow vs. Earnings, Accounting
Equation Format, Accounting Method Choice, Accounting Estimates,
Of-Balance-Sheet Financing, Economic Consequences of Accounting,
Earnings Management, Substance Over Form, IFRS.
Contents
Chapter 1 Overview of Financial Accounting ...................................1
Chapter 2 Cash, Receivables, and Revenue Recognition .................27
Chapter 3 Inventory and Cost of Goods Sold .................................57
Chapter 4 Operational Assets .........................................................89
Chapter 5 Liabilities: Current, Contingent,
and Long-Term Debt ..................................................125
Chapter 6 Leases ..........................................................................163
Chapter 7 Financial Instruments: Investment
Securities and Derivatives ............................................179
Chapter 8 Accounting for Postretirement
Benefts and Income Taxes ...........................................223
Chapter 9 Stockholders Equity and Earnings Per Share ...............261
Chapter 10 Statement of Cash Flows ..............................................297
Index .................................................................................................319
CHAPTER 1
Overview of Financial
Accounting
Introduction
Te objective of accounting is to provide information useful for users
decision making. Two primary areas of accounting are fnancial accounting
and managerial accounting.
1
Financial accounting is intended to provide
information to external users in meeting their decision making needs
and is the exclusive topic of this text. Unlike managers, external users
are not involved in the day-to-day decision making within the frm, but
need information in making decisions. Te two key external user groups
with the greatest fnancial interest targeted to beneft from fnancial
accounting information are current and potential creditors and investors.
Since this text assumes the corporate form of business throughout, inves-
tors are stockholders. Creditors need to decide whether or not to lend
money to the corporation and if so what interest rate should be charged
to compensate for the level of risk. Stockholders need information to
accommodate buy, hold, or sell decisions. Management has a vested inter-
est in understanding fnancial accounting information because it impacts
the corporations stock price, and the corporations ability to obtain loans
and the related borrowing rates.
1
Managerial accounting is intended to help internal users (management) in mak-
ing decisions. Since management is in the best position to determine what specifc
information optimally suits their particular decision making needs, there are no rules
or guidelines regarding what information is provided for managerial accounting pur-
poses. As such, the study of managerial accounting involves examination of common
conventions and practices, for example, cost-volume-proft analysis, budgeting and
variance analysis, diferential analysis, etc.
2 FINANCIAL REPORTING STANDARDS
Both creditors and stockholders provide resources to the corpo-
ration in order to receive future cash fows; creditors in the form of
principal and interest payments and stockholders in the form of divi-
dends and proceeds from sale of the stock. Since the corporation has
numerous creditors and stockholders, it cannot conceivably provide
information to each on an individual user basis. Terefore, fnancial
accounting information is intended to be useful in assessing the future
cash fows of the frm. Tree things are important regarding the frms
future cash fows for valuation purposes, their amounts, timing, and
uncertainty. Considering each individually, the greater the amounts,
the sooner they occur, and the lesser their uncertainty, the more valu-
able is the debt or stock investment. By meeting the information needs
of investors and creditors, fnancial accounting information is useful in
meeting the decision making needs of other external user groups. For
example, customers look to fnancial accounting information in order
to assess a frms ability to continue providing goods and services in the
future; and employees are interested in fnancial accounting informa-
tion as it relates to the frms ability to pay them salaries and wages in
the future.
Te fnancial statements (including disclosure notes) are the primary
product of fnancial accounting and the information provided therein is
the exclusive topic of this book. Te three primary fnancial statements
include a balance sheet, an income statement, and a statement of cash
fows. Most frms also provide a statement of stockholders equity. Te
fnancial statements of Behrend Corp. are illustrated in Exhibits 1.21.5.
Tese fnancial statements are intended to be useful to external users
in assessing the amounts, timing, and uncertainty of Behrends future
cash fows. Tese users compare Behrend Corp. with other corporations
and over time in making their decisions. Tis is why the information
provided in the fnancial statements needs to comply with certain rules
and guidelinesso that it is comparable across frms and within the frm
over time. Te rules and guidelines that the fnancial statement informa-
tion must comply with are referred to as generally accepted account-
ing principles (GAAP). GAAP information must be both relevant
OVERVIEW OF FINANCIAL ACCOUNTING 3
(make a diference) and provide faithful representation
2
(actually
represent what is supposed to be represented) in order to be useful for
decision making. An important part of the fnancial reporting process
is the audit opinion, where independent Certifed Public Accountants
attest to the fairness of the information provided in the fnancial state-
ments in conformity with GAAP.
Te organization with legal authority to establish GAAP for publicly
traded frms in the United States is the Securities and Exchange Com-
mission (SEC). Te SEC has primarily delegated the responsibility for
setting U.S. GAAP to nongovernmental organizations. Te current
private sector organization with the responsibility to determine U.S.
GAAP is the Financial Accounting Standards Board (FASB).
3
Although
U.S. frms comply with FASB GAAP, most non-U.S. corporations
report fnancial statements based upon a similar but not identical set
of GAAP that is formulated by the International Accounting Standards
Board (IASB). Tis IASB set of GAAP is commonly referred to as Inter-
national Financial Reporting Standards (IFRS).
4
At the time of writing
this text, the SEC has indicated it may in the future require U.S. frms
to comply with IFRS. Financial accounting topics are addressed in
2
Previously, the two primary qualities considered necessary for information to be
useful for decision making were relevance and reliability. In a September 2010
revision, the FASB changed the primary quality of reliability to faithful represen-
tation. In doing so, the FASB pronouncement regarding the two primary qualities
information must have to be useful for decision making is now consistent with those
identifed by the IASB relevance and faithful representation. Both of these organiza-
tions are discussed below.
3
Te FASB replaced the Accounting Principles Board that presided from 1959 to
1973. Te original private sector organization that formulated U.S. GAAP was the
Committee on Accounting Procedure that was formed in 1939. Pronouncements of
these predecessor bodies that have not been superseded by the FASB remain part
of U.S. GAAP. U.S. GAAP is contained in the Accounting Standards Codifcation
ASC. Te FASBs website is at www.fasb.org.
4
Te IASB was formed in 2000 and was preceded by the International Accounting
Standards Committee IASC. Pronouncements of the IASC that have not been
superseded by the IASB remain as part of IFRS.
4 FINANCIAL REPORTING STANDARDS
this text primarily from a U.S. GAAP perspective, but highlight signif-
cant diferences between GAAP and IFRS when appropriate.
Financial Statements
Te balance sheet depicts a corporations fnancial position at a point in
time. All the other fnancial statements are for a period of time and explain
changes that occur in certain balance sheet items during the period. It is
important to note that these change statements are for the same period
of time, beginning and ending at the comparative balance sheet dates. For
Behrend Corp. the change statements are consistently for the year ended
12/31/12. Te ending balance sheet of the previous period is the current
periods beginning balance sheet. Comparing Behrends year-end 12/31/12
balance sheet (Exhibit 1.5) with its beginning balance sheet at 12/31/11
(Exhibit 1.1) indicates that cash has decreased by $80,000 during the year.
Tis change in cash is illustrated in detail in the statement of cash fows for
the period 2012 (see Exhibit 1.4). Likewise, changes in retained earnings
and other components of stockholders equity that occurred during 2012
are depicted in the income statement and the statement of stockholders
equity (see Exhibits 1.2 and 1.3). Te FASB has defned the basic elements
contained in the fnancial statements. Tese elements are next discussed as
they relate to the particular fnancial statement.
Balance Sheet
Te balance sheet presents a corporations fnancial position at a point
in time by reporting its assets (things of worth) versus its liabilities plus
stockholders equity (claims to the assets). Te balance sheet account-
ing equation is expressed as: ASSETS = LIABILITIES + OWNERS
EQUITY (A = L + OE). Te fnancial statements result from the accumu-
lation, classifcation, and summarization of numerous individual transac-
tions and events. Each transaction or event that impacts the fnancial
statements is termed to be recognized. Te accounting equation is
always in balance. As discussed later, each transaction or event recognizes
its dual (at a minimum) efects, which in turn maintains the equality of
the accounting equation. Tis is referred to as double entry accounting.
OVERVIEW OF FINANCIAL ACCOUNTING 5
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6 FINANCIAL REPORTING STANDARDS
Exhibit 1.2. Behrend Corp. Income Statement for the Year Ended
12/31/2012
Net Sales Revenue $1,900,000
Cost of Goods Sold 1,000,000
Gross Prot $900,000
Operating Expenses:
Selling & General Administrative Expenses:
Salary and Wage Expense $610,000
Research and Development Expense 55,000
Depreciation Expense 40,000 705,000
Operating Income: $195,000
Other Revenue, Expense, Gain and Loss:
Interest Expense 45,000
Income From Continuing Operations
Before Tax
$150,000
Income Tax Expense 30,000
Income From Continuing Operations $120,000
Extraordinary Loss $50,000
Less Tax Benet 10,000 40,000
Net Income $80,000
Earnings Per Share assume 100,000 shares of
stock outstanding:
Income From Continuing Operations $1.20
Extraordinary Loss $.40
Net Income $.80
Exhibit 1.3. Behrend Corp. Statement of Stockholders Equity
for the Year Ended 12/31/2012
Paid-in
capital
Retained
earnings
Total
stockholders
equity
Beginning of Year 12/31/2011 $100,000 $165,000 $265,000
Issued Stock 50,000 50,000
Net Income 2012 80,000 80,000
Dividends <25,000> <25,000>
End of Year 12/31/2012 $150,000 $220,000 $370,000
OVERVIEW OF FINANCIAL ACCOUNTING 7
Assets are defned as probable future economic benefts as a result of
past transactions or events. Liabilities are the opposite of assets and are
defned as probable future economic sacrifces as a result of past transac-
tions or events. Tese are the most important defnitions of fnancial
statement elements because all other elements are defned in terms of
assets and liabilities. For example, the remaining balance sheet element is
equity, which is defned as the residual interest in the assets that remains
after deducting its liabilities. A classifed balance sheet separates cur-
rent from long-term assets and liabilities. A current asset is one that
will be realized in cash or used up within the next year or the operating
cyclewhichever is longer. A current liability is one that will be satisfed
by using current assets. Te operating cycle is the period that begins with
the corporations acquisition of goods held out for sale or the providing of
services and ends with the collection of cash from customers in the nor-
mal course of business. Although there are exceptions, current liabilities
are generally those that will be satisfed within one year or the operating
Exhibit 1.4. Behrend Corp. Statement of Cash Flows
for the Year Ended 12/31/2012
Cash Flow from Operating Activities:
Collected from Customers $1,890,000
Paid to Suppliers for Inventory $1,120,000
Paid to Employees for Salary
and Wage 600,000
Paid for Research and Development 55,000
Interest Paid 50,000
Income Tax Paid 20,000 <1,845,000> $45,000
Cash Flow from Investing Activities:
Cash Paid for Truck <50,000>
Cash Flow from Financing Activities:
Stock Issuance $50,000
Payment of Principal on Debt $100,000
Payment of Dividends 25,000 <125,000> <75,000>
Change in Cash During 2012 $<80,000>
Cash at 1/01/2012 150,000
Cash at 12/31/2012 $70,000
8 FINANCIAL REPORTING STANDARDS
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OVERVIEW OF FINANCIAL ACCOUNTING 9
cyclewhichever is longer. Since most businesses have an operating
cycle of less than one year, unless indicated otherwise, this book assumes
classifcation of assets and liabilities as current or long-term based upon
the one-year period.
Te balance sheet is used to gauge a frms debt paying ability. Te
term liquidity is used in two ways. Te liquidity of individual assets is
determined by their nearness to cashtherefore, cash is deemed to be
the most liquid of all assets. Investments in marketable debt and equity
securities can be easily and quickly converted to cash and are considered
highly liquid. Comparing inventory with accounts receivable, inventory
is deemed less liquid because, relative to accounts receivable, it is one
step removed from cash receiptthe sale has not yet occurred. Liquid-
ity is also used to describe a frms short-term debt paying ability. Cur-
rent assets (CA) must be considered relative to current liabilities (CL) in
making this liquidity assessment. Frequently used liquidity measures are
working capital, the current ratio, and the quick ratio. Working capital is
calculated as: CA CL. Although working capital provides an important
numeric measure of a frms short-term debt paying ability, it is dif cult
to compare the amount of working capital across frms of diferent size.
Ratios provide relative measures that accommodate comparison across
frms. Both the current ratio and the quick ratio use CL as the denomi-
nator but their numerators are diferent. Te current ratio is computed
as CA/CL, whereas the quick ratios numerator includes only the most
liquid of current assets, called quick assets. Quick assets (QA) are CA
excluding inventory and prepaid expenses and typically include cash,
short-term investments, and accounts receivable. Te quick ratio is com-
puted as QA/CL.
A common measure of a frms capital structure is the debt-to-equity
ratio. Te debt-to-equity ratio includes all debt (D) or total liabilities in
the numerator and total stockholders equity (E) in the denominator.
Te debt-to-equity ratio is calculated as D/E. Te D/E ratio generally
infuences a frms long-term debt paying ability (solvency). Although
a numeric measure of a frms solvency can be considered its net assets,
or stockholders equity A L = OE, the debt-to-equity ratio provides a
more comparable measure across frms. Te D/E ratio can be used to
10 FINANCIAL REPORTING STANDARDS
gauge a frms leverage or degree to which assets are fnanced through
debt versus equity. Te degree of leverage can also be used to assess the
frms fnancial fexibility. Financial fexibility is the frms ability to
respond to unexpected needs and opportunities. Generally, the higher
the D/E ratio, the more dif cult it is for the frm to make interest and
principal payments on its debt, particularly during bad times, or to
quickly borrow funds in order to take advantage of business opportuni-
ties when they arise.
Income Statement
Comprehensive income is defned as all changes in net assets (equity)
during the period except those resulting from contributions by owners
and distributions to owners. Comprehensive income has two compo-
nents, net income and other comprehensive income. Te income
statement
5
of Behrend Corp. for the year ended 12/31/2012 is illustrated
in Exhibit 1.2. Net income or loss is the diference between the sum totals
of revenues plus gains versus expenses plus losses. Revenues are defned
as increases in net assets from providing goods or services that consti-
tute the frms ongoing central operations. Expenses are decreases in net
assets from providing goods or services that constitute the frms ongoing
central operations. Like revenues and expenses, gains and losses also
respectively provide increases and decreases in equity, but they result from
nonowner peripheral or incidental transactions rather than ongoing
central operations.
Net income and net cash fows over the entire life of the frm are
equal after excluding cash fows that result from contributions by and
distributions to owners, but on a period by period basis, may difer
in terms of timing. Revenue and gain may be included in the income
statement (recognized) concurrent with, before, or after the related net
cash infow occurs. Tis timing issue is likewise the case for income
statement recognition of expenses and losses relative to the related
5
Technically the correct title should be the Statement of Net Income however,
because it is commonly used in practice, the text also refers to such as the Income
Statement.
OVERVIEW OF FINANCIAL ACCOUNTING 11
net cash outfow. Tis timing diference is caused by GAAPs require-
ment to apply the accrual basis of accounting. Te accrual basis of
accounting is based upon two underlying principlesthe revenue
(recognition) principle, and the expense recognition principle. Te
revenue principle requires that revenue be included in the income
statement (recognized) in the period earned whether or not the cash
is received in that period. Normally, revenue is deemed to be earned
in the period the goods or services are provided to the customer. Te
expense recognition principle attempts to assure that expenses follow
revenues in order to provide a meaningful measure of income. Income
is sometimes termed the change in well-ofness that occurs during
the period. Te expense recognition principle requires that expenses be
recognized with revenue of particular periods, whether or not the cash
is paid in that period.
When a frm incurs costs that provide probable future economic
beneft, they are presented as assets in the balance sheet. When these
economic benefts are realized, the asset must be recognized as expense
in the income statement. Te expense recognition principle considers
four diferent classifcations of costs for purposes of determining
the period(s) in which the related expense should be recognized. Tese
cost classifcations are:
1) directly related to revenue with a cause and efect relationship
examples include cost of goods sold and sales commissions;
2) directly related to particular income statement time periods
examples include rent, interest, and sales salaries;
3) systematically and rationally allocated to income statement peri-
ods estimated to be beneftedexamples include depreciation and
amortization; and
4) immediately recognized as expense due to a high degree of uncer-
tainty that future beneft will resultexamples include research and
development or R&D.
Te FASB contends that the accrual basis of accounting provides users
with information more useful in assessing the frms future cash fows than
a cash basis income statement would provide. It is ironic that income
12 FINANCIAL REPORTING STANDARDS
reported under GAAP is based upon past transactions and events, but is
primarily benefcial to creditors and stockholders only to the extent that
it is useful in predicting future income (and cash fows). Te degree to
which a frms reported income is useful in predicting its future income
and cash fow performance is termed the Quality of Earnings. Te
FASBs requirement to use the accrual basis is predicated upon their con-
tention that reporting income under the accrual basis results in higher
quality of earnings than would result if the cash basis of accounting was
applied. Higher quality earnings should occur with full disclosure and
transparency in the fnancial reporting process where managements req-
uisite accounting method choices and estimates regarding future events
are made with neutralitywith freedom from bias. Of all the fnancial
statements, many users place primary emphasis on the income statement
in making decisions. Terefore, the concept of Quality of Earnings is of
utmost importance and will be revisited in future chapters.
Although the accrual basis is usually considered an income concept,
there are directly related implications for assets and liabilities in the bal-
ance sheet. As discussed previously, the accrual basis requires revenue to
be recognized in the period earnedwhether or not the cash is received
in that period, and expenses follow revenues and are recognized in par-
ticular periodswhether or not the cash is paid in that period. When the
income statement recognition of revenue or expense precedes the cash
fow, it is termed an accrual. When the cash fow precedes the revenue
or expense recognition in the income statement, it is termed a deferral.
Accruals include revenue recognition with related asset recognition, for
example, interest revenue and interest receivable, and expense recogni-
tion with related liability recognition, for example, interest expense and
interest payable. Deferrals include increases and decreases in cash with the
related recognition respectively of liabilities, for example, unearned rent
revenue, or recognition of an asset, for example, prepaid rent.
Tose income statement items that are considered more recurring or
permanent in nature are more important to the user than those items
that are nonrecurring or temporary in nature. Te income statement
for Behrend Corp. in Exhibit 1.2 is in multiple-step form. Te items
that are given prominence by appearing frst are generally deemed to be
more important because they are more permanent in nature. Te frst
OVERVIEW OF FINANCIAL ACCOUNTING 13
step in the income statement deducts cost of goods sold from sales rev-
enue to present gross proft of $900,000. Te normal recurring oper-
ating costs for selling and general administrative expense are deducted
to yield $195,000 for operating income. Next, the more peripheral or
incidental other revenues, expenses, gains, and losses category is added
or deducted to determine income from continuing operations before
tax. Tis example assumes only interest expense of $45,000 is reported
in this other category. A tax rate of 20% is assumed which reduces
income from continuing operations to $120,000 after income tax. Tis
is commonly referred to as the line for purposes of presenting two
potential below the line items under U.S. GAAP. Te frst is discon-
tinued operations followed by extraordinary items. Each is presented
separately net of tax efect because there is little if any implication con-
cerning future cash fows.
Discontinued operations involve component operations of a business
that will not be continued in the future. Tere are two elements of this frst
below the line item: 1) revenues versus expenses from the components
operation during the period, and 2) gain or loss on disposal. Although
Behrend has no discontinued operations to report during 2012, it does
report an extraordinary loss. Te gross amount of the loss is $50,000, but
with a 20% tax rate, results in a tax savings of $10,000, that reduces the
reported loss net of tax to $40,000. For an item to be considered extraor-
dinary, it must be: 1) infrequent in occurrence, and 2) unusual in nature.
According to U.S. GAAP, very few items should meet both criteria and
be presented as extraordinary. Presentation of extraordinary items difers
under U.S. GAAP and IFRS. Diferences between U.S. GAAP and IFRS
will be indicated throughout the text by highlighting. Although IFRS in
accounting for discontinued operations is similar to U.S. GAAP, IFRS
does not permit separate reporting of extraordinary items in the income
statement. Behrend reports net income of $80,000 for 2012.
Earnings per share is a standardized measure of earnings performance
that can be compared over time. Te Behrend Corp. example assumes
100,000 shares of stock outstanding during the period. Te amounts of
income from continuing operations, extraordinary loss, and net income
are each divided by the 100,000 shares resulting in the earnings per share
amounts reported in Exhibit 1.2.
14 FINANCIAL REPORTING STANDARDS
Comprehensive Income
As mentioned previously, comprehensive income has two components. In
addition to net income discussed above, it also includes other compre-
hensive income (OCI). Te FASB has identifed four areas where changes
in equity from nonowner exchanges elude inclusion in the income state-
ment and are instead included in OCI net of tax efects. Each exception
involves the application of fair value accounting with resulting recog-
nition of unrealized gain or loss. Tese four areas are: 1) translation
of foreign subsidiaries fnancial statements into U.S. dollars, 2) certain
hedging activities using derivative securities, 3) funded status of pension
and other postretirement plans, and 4) accounting for certain investments
in marketable securities. Although OCI items are discussed later in the
text, it is worth noting here that a signifcant diference between below
the line and OCI items is that OCI items do not afect reported earnings
per share.
Presentation of comprehensive income is consistent across U.S. GAAP
and IFRS. Comprehensive income must be presented in one of two ways:
1) two separate statements (NI and OCI), or 2) one single combined
statement of comprehensive income.
6
In our illustrations, Behrend does
not report OCI in its fnancial statements because we assume none of the
four OCI items occurred during 2012.
Statement of Stockholders Equity
Te statement of stockholders equity is a detailed reconciliation of begin-
ning to ending balances in the individual components of stockholders
equity in the balance sheet. Behrends statement of stockholders equity
for the year ended 12/31/2012 is illustrated in Exhibit 1.3. Each income
6
Prior to 2012, U.S. GAAP allowed a third presentation formatincluding OCI
in the statement of stockholders equity. Tis was the primary choice by frms prior
to 2012. Accounting Trends & Techniques-2010 New York: AICPA p. 425, indicates
492 of 500 surveyed frms reported comprehensive income in their fnancial state-
ments with 408 of them doing so within the statement of stockholders equity. IFRS
never allowed the U.S. GAAP alternative of presenting OCI within the statement of
stockholders equity.
OVERVIEW OF FINANCIAL ACCOUNTING 15
statement account is closed to the permanent balance sheet account
retained earnings at the end of the period. Net income of the period
increases retained earnings whereas a net loss would decrease retained
earnings. Te closing process accomplishes two things: 1) the income
statement accounts are brought to a zero balance to accommodate the
next period, and 2) retained earnings is adjusted to the correct end of
period balance. Although distributions to owners (dividends) do not
afect income in any way, dividends of the period do reduce the amount
of retained earnings. Unlike net income that is closed to retained earnings,
OCI is closed to accumulated other comprehensive income (AOCI),
which is another permanent component of equity. Te 12/31/11 balance
sheet (Exhibit 1.1) does not include AOCI, which indicates Behrend has
no unrealized gain or loss from the four items included in OCI under
GAAP at the beginning of the year. Since Behrend has no OCI during
2012, net income and comprehensive income are one and the same, and
no AOCI is reported at 12/31/12. Consistent with dividends, contribu-
tions by owners do not afect income. Contributions by owners increase
paid in capital. Te statement of stockholders equity is generally con-
sidered to be of least importance to users.
Statement of Cash Flows
Like the income statement and the statement of stockholders equity, the
statement of cash fows is for a period of timethe year ended 12/31/2012.
Te statement of cash fows shows the change in cash that occurred during
the period in three categories: 1) operating, 2) investing, and 3) fnancing.
Users place primary emphasis on the net cash fow from operating activity
because a frms long-term viability is dependent upon its ability to gener-
ate suf cient positive net cash fow from its ongoing central operations.
Ironically, GAAP does not provide an all-inclusive list of cash fows that are
classifed as operating activities. Instead, GAAP specifcally identifes cash
fows that constitute investing or fnancing activities, and any remaining
cash fows not specifcally identifed as investing or fnancing are to be
classifed as operating activities. Tere are two formats used in present-
ing operating cash fowthe direct method, and the indirect method.
Behrend Corp. is using the direct presentation format in Exhibit 1.4.
16 FINANCIAL REPORTING STANDARDS
Investing activities include cash fow from purchase or sale of PP&E
and securities of other entities, making loans to other entities, and the
collection of principal on those loans. Financing activities include issu-
ance and reacquisition of stock, issuance of debt, repayment of debt
principal, and payment of dividends. Although an all-inclusive list is not
provided for operating activities, its main cash fow components generally
include: collections from customers, payments to suppliers, payments to
employees and others for expenses, payments of interest, and receipts of
interest or dividends from investment securities. Teoretically, dividends
and interest received on investment securities are considered investing
activities, while interest paid on debt is considered a fnancing activity.
However, since GAAP does not specifcally identify them as such, they
are classifed as operating activities.
Review of the Accounting Process
Te accounting process is the underlying system that accumulates the
requisite information presented in the fnancial statements. Using
Behrend Corp. as our example we will review the accounting process
under the accounting equation framework. We start with Behrends
beginning balance sheet (Exhibit 1.1). Note that total assets ($940,000)
are equal to the sum of liabilities ($675,000) and stockholders equity
($265,000). Tis 12/31/2011 balance sheet information is transferred to
Exhibit 1.6 where we next illustrate the impact that various transactions
and events have on the accounting equation.
Summary Entries
Each transaction or event is individually entered into the accounting
system. Summary entries are used here to illustrate the impact that
numerous similar individual transactions have on the accounting equa-
tion as a whole. For example, transaction b. involves sales to customers on
account. Tis likely involves thousands of sales transactions throughout
2012, each of which needs to be recorded. All of the sales for the entire
year are summarized, and the efects on the accounts analyzed as if there
was only one transaction recorded.
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20 FINANCIAL REPORTING STANDARDS
Transaction a.Purchase inventory on account from suppliers for
$1,100,000. Te efects on the accounting equation are that the asset
(inventory) and the liability (accounts payable) are both increased by
$1,100,000.
Transaction b.Goods (inventory) is provided to customers on
account for an aggregate selling price of $1,900,000. Also, assume that
Behrends cost of the inventory transferred to customers is $1,000,000.
Because the goods are transferred to the customers in 2012, revenue
should be recognized in the 2012 income statement whether or not the
cash is received in 2012. In terms of the accounting equation, the asset
accounts receivable is increased $1,900,000 as will be retained earnings
when the income statement account sales revenue is closed. Te expense
recognition principle requires that $1,000,000 cost of goods sold be rec-
ognized in 2012 because the expense is directly related to the $1,900,000
in sales revenue recognized. Te asset inventory is reduced by $1,000,000,
as will be retained earnings when the income statement account cost of
goods sold is closed.
Transaction c.Cash of $1,890,000 is collected from customers on
account. Tere is no efect on the right side of the accounting equation.
Te asset cash is increased while the asset accounts receivable is decreased,
each for $1,890,000. Tis cash infow is classifed as operating in the
statement of cash fows.
Transaction d.Cash of $1,120,000 is paid to suppliers on accounts
payable. Both the asset cash and the liability accounts payable are reduced
by $1,120,000. Tis cash outfow is classifed as operating in the state-
ment of cash fows.
Transaction e.Employees are paid monthly in the month fol-
lowing the month of service. Tere is a one-month time lag between
employees providing services and Behrend paying them for those ser-
vices. For example, employees are paid for work performed in Decem-
ber 2011 in January 2012, work performed in January 2012 is paid in
February 2012, and work performed in December 2012 will not
be paid by Behrend until January 2013. Under the expense recogni-
tion principle, this is an example of an expense that is directly related
to periods of time. Te expense must be recognized in the period
the employee provides the service, whether or not the cash is paid
OVERVIEW OF FINANCIAL ACCOUNTING 21
in that period. Behrend pays salaries and wages during 2012 in the
amount of $600,000. A portion of this payment ($50,000) relates to
employee services that were provided in December 2011 (see salaries
and wages payable in the 12/31/11 balance sheet Exhibit 1.1), and the
remainder ($550,000) is recognized as a 2012 expense because it relates
to services provided by employees from January through November
2012. Note that an adjusting entry will be needed to recognize sala-
ries and wages expense for December 2012 that will not be paid until
January 2013 (see adjustment p. below). Te efects on the accounting
equation are: a reduction in the asset cash for $600,000, the liability
salaries and wages payable is decreased by $50,000, and retained earn-
ings will be decreased by $550,000 when the income statement account
salaries and wages expense is closed. Tis cash outfow is classifed as
operating in the statement of cash fows.
Transaction f.Paid $20,000 in income taxes based upon estimated
2012 taxable income of $100,000 and tax rate of 20%. Estimated tax
payments are due periodically during the year. Actual taxable income is
equal to the $100,000 estimated, and the actual income tax due for the
year was $20,000.
7
Note from the income statement (Exhibit 1.2) that
income tax expense on the income statement is $30,000. Tis is based
upon the 20% rate applied to income from continuing operations before
tax ($150,000). Behrend experienced an extraordinary loss (event l.)
below) of $50,000 before considering its tax beneft of $10,000 ($50,000
loss deduction @ 20% = $10,000 tax savings). Tese two net out to the
correct total tax provision, $20,000. Te efects on the accounting equa-
tion are a decrease in cash of $20,000 and an eventual decrease in retained
earnings when the income statement accounts are closed. Tis cash out-
fow is classifed as operating in the statement of cash fows.
Specic Transactions and Events
Transaction g.Purchased a new delivery truck for $50,000 cash on
1/26/12. Te efects on the accounting equation are strictly within
7
Later in the text we discuss diferences between GAAP-based income before tax and
taxable income per the return, but until then will assume there are no diferences.
22 FINANCIAL REPORTING STANDARDS
assets with cash decreased and property plant and equipment (PP&E)
increased by $50,000. Tis cash outfow is classifed as investing in the
statement of cash fows.
Transaction h.On 3/12/12 Behrend received the results of a mar-
keting research project and immediately paid the research frm for its
service, $55,000. Under the expense recognition principle, this is con-
sidered R&D and must be immediately recognized as an expense because
there is a high degree of uncertainty regarding whether or not a future
beneft will result. Te accounting equation is afected by a reduction in
the asset cash, and decrease in retained earnings when the income state-
ment accounts are closed. Tis cash outfow is classifed as operating in
the statement of cash fows.
Transaction i.Interest on outstanding debt is payable annually on
6/30 at a 10% rate. Interest is calculated as: PRINCIPAL INTER-
EST RATE PORTION OF YEAR. Interest for the one year period
ending 6/30/12 is $50,000 ($500,000 10% 12/12), half of which
is for the period 7/1/1112/31/11, and the other half is for the period
1/1/126/30/12. Tis is the interest payable liability from the 12/31/11
balance sheet (Exhibit 1.1). Consistent with transaction e. above, this is
an expense directly associated with specifc income statement time peri-
ods and must be recognized in the period incurred regardless of when the
cash is paid. Te efects on the accounting equation are cash is decreased
$50,000, interest payable is decreased $25,000, and retained earnings is
decreased by $25,000 after closing the interest expense account. Note
that an adjustment will be needed at 12/31/12 to accrue interest expense
for the period 7/01/1212/31/12. Tis cash outfow is classifed as oper-
ating in the statement of cash fows.
Transaction j. Record the $100,000 debt principal payment made
on 6/30/12. Tis payment reduces cash and eliminates the $100,000 of
debt currently due liability that appeared on the 12/31/11 balance sheet.
Note that the amount of debt principal is reduced to $400,000. Tis cash
outfow is classifed as fnancing in the statement of cash fows.
Transaction k.On 9/30/12 Behrend declared and paid a cash divi-
dend to shareholders at the rate of $.25/share 100,000 shares = $25,000.
Te efects on the accounting equation are cash and retained earnings are
OVERVIEW OF FINANCIAL ACCOUNTING 23
each decreased by $25,000. Tere is no income statement efect. Tis
cash outfow is classifed as fnancing in the statement of cash fows.
Event l.On 10/19/12 a meteor fell from outer space and unfortu-
nately destroyed an empty storage building with a book value of $50,000.
Te loss was uninsured. Tis hopefully meets the criteria for classifcation
as an extraordinary itemboth infrequent in occurrence and unusual in
nature. Te efects on the accounting equation are a decrease of $50,000
in PP&E and an equal reduction in retained earnings to recognize the
gross loss. Although the gross loss was $50,000, the associated tax deduc-
tion with a 20% tax rate, results in a $10,000 tax beneft that reduces
the extraordinary loss reported in the income statement to $40,000
(net of the $10,000 tax beneft). Recall that transaction f. discussed the
2012 $20,000 overall tax burdens presentation in the income statement.
Te amount of tax burden that would have been incurred if there were
no below the line items is reported as tax expense ($150,000 @ 20% =
$30,000), above the line; and the tax beneft resulting from the tax
deductibility of the meteor damage reduces the reported extraordinary
loss, below the line.
Transaction m.Behrend issues an additional 50,000 shares of stock
for $1/share on 12/30/12. Te efects of this transaction on the account-
ing equation are an increase in cash of $50,000 and an increase in paid in
capital for an equal amount. Tere is no income statement efect. Tis
cash infow is classifed as fnancing in the statement of cash fows.
Adjusting Entries
Adjusting entries are necessary for the fnancial statements to be pre-
sented under the accrual basis of accounting, which is required under
GAAP. Adjusting entries are generally needed in the case of accruals and
deferrals discussed previously, and therefore should afect at least one
income statement account and at least one balance sheet account.
Adjustment n.Recognize depreciation expense. Te expense
recognition principle requires that when costs are incurred that
beneft multiple periods they be systematically and rationally recog-
nized as expense over the estimated periods benefted. Depreciation is
24 FINANCIAL REPORTING STANDARDS
an example of such a cost under the accrual basis of accounting. You
may be familiar with the straight line depreciation method. Under
the straight line method periodic depreciation is computed as: (ASSET
COST-ESTIMATED RESIDUAL VALUE)/ESTIMATED SERVICE
LIFE. For purposes of this example assume PP&E has an aggregate cost
of $600,000, zero estimated residual value, and an average estimated
service life of 15 years. Assuming Behrend uses the straight line method,
annual depreciation is computed as: ($600,000 $0)/15 years = $40,000
per year. Te efects of this adjustment on the accounting equation are
PP&E (net) is reduced by $40,000 and retained earnings is reduced
by $40,000 when the income statement account depreciation expense
is closed. Note that PP&E (net) represents the book value of the
assets. Book value is equal to cost minus accumulated depreciation. At
12/31/11 Behrend had PP&E with a cost of $600,000 and a book value
of $400,000, which indicates that accumulated depreciation at the
beginning of the year was $200,000.
Adjustment o.Recognize interest expense incurred but not paid on
outstanding debt. Recall from transaction j. that interest cost incurred for
the period 7/1/1212/31/12 must be recognized as expense on the 2012
income statement even though it will not be paid until 6/30/13. Inter-
est expense for this period is computed as: $400,000 10% 6/12 =
$20,000. Te efects of the adjustment on the accounting equation are to
increase the liability account interest payable by $20,000 and to reduce
retained earnings by $20,000 when the income statement account inter-
est expense is closed. Note that the income statement now includes inter-
est expense for the full calendar year 2012 of $45,000, $25,000 for the
frst six months, plus $20,000 for the last six months. Te $20,000 inter-
est expense that will be paid on 6/30/13 is presented in the 12/31/12
balance sheet as a current liability.
Adjustment p.Recognize salaries and wages expense for employee
services provided in December 2012 that will be paid in January 2013.
As discussed in transaction e. under the accrual basis salaries and wages
must be recognized as expense in the period the employee provides
the services, whether or not paid in that period. In order to recognize
expense for the full calendar year, an adjustment is necessary to rec-
ognize the expense for December employee services. Assume that the
OVERVIEW OF FINANCIAL ACCOUNTING 25
December payroll is $60,000. Te necessary adjustment increases the
liability salaries and wages payable by $60,000 and also reduces retained
earnings by $60,000 when the income statement account salaries and
wages expense is closed to retained earnings. Note that this adjust-
ment combined with transaction e. provides that the income statement
include salaries and wages expense for the full year 2012 of $610,000,
$550,000 of which was paid in 2012 and the $60,000 accrual that will
be paid in 2013. Note also that the 12/31/12 balance sheet refects the
current liability salaries and wages payable for $60,000.
In summary, we started the accounting process using the beginning of
the period balance sheet at 12/31/11. Pertinent transactions and adjust-
ments recorded during the year using the accounting equation format
were used to develop the change statements for the year ended 12/31/12
(income statement, statement of stockholders equity, and statement of
cash fows). After closing, the efects of all changes are refected in the
year-end balance sheet at 12/31/12. We will continue to use the account-
ing equation format to illustrate the efects of particular transactions and
events upon the fnancial statements in all future chapters.