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Chapter 3 – Balance Sheet,

Income Statement and Statement
of Cash Flow

FINANCIAL ACCOUNTING
Myrisha de Lima
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Learning Objectives

1. Learn to prepare a balance sheet and an

Income Statement.
2. Understand the accrual basis of accounting.
3. Understand when firms recognize revenues and
expenses.
4. Build skills in recording transactions.
5. Understand end-of-period adjustments.
6. Develop skills to analyze the income statement.
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Exercise

Given the following information, please prepare

an accrual based income statement (5 minutes):
1.Cost of Goods Sold ANG 52,300
2.Depreciation expense ANG 2,500

3.Income Tax expense ANG 10,700

4.Interest expense ANG 1,150

5.Prepaid rent paid ANG 3,500
6.Rent expense ANG 4,000
7.Sales ANG 118,600
8.Wage expense ANG 31,900
9.Wage payable ANG 3,000
3-4
Exercise
Given the following year-end balances,
prepare a balance sheet (5 minutes):
1.Accounts payableANG 19,800
2.Accounts receivable ANG 13,550
3.Accumulated depreciation ANG 6,250

4.Retained earnings ANG 16,450

5.Cash ANG 12,500
6.Cost of Goods Sold ANG 52,300
7.Fixed assets ANG 129,000
8.Inventory ANG 16,250
9.Long-term note payable ANG 111,500
10.Paid-in capital ANG 14,450

11.Prepaid rent ANG 10,350

12.Wages payable ANG 13,000
3-5 Exercise
Given the following year-end balances, prepare an income
statement (5 minutes):
1.Sales ANG 3,750,000
2.Advertising expense ANG 750,000
3.Depreciation on office furniture and equipment ANG 85,500
4.Cost of Goods Sold ANG 1,750,000
5.Administrative salaries ANG 75,000
6.Sales salaries ANG 318,000
7.Sales returns ANG 175,000
8.Inventory ANG 5,750
9.Interest Expense ANG 43,500
10.Interest Income ANG 5,750
11.Other selling expenses ANG 95,000
12.Cost of display sales ANG 155,250
13.Other administrative expenses ANG 78,500
14.Dividends declared on preferred stock ANG 24,000
15.Tax rate 25%
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1. The Accounting Period
 Income generating activity occurs almost
continuously in modern firms.
 Financial reports are prepared at the end of
time periods of uniform length, for example,
months or quarters or years.
 Uniform time periods facilitate comparisons
and analyses.
 Many companies use the end of the calendar
year as the end of their accounting period.
3-7 2. Accounting Methods for Measuring
Performance

(a) Cash basis of accounting.

 Revenues are recognized when cash is

received and expenses are recognized when

cash is paid.
(b) Accrual basis of accounting.
 Revenues and expenses are recognized on an

economic basis without regard for the actual

flow of cash.
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2.a. Cash Basis of Accounting
 Intuitiveand easy.
 Provides reliable information about cash flows.

 Provides information on the liquidity of a firm.

 Liquidity is the ability of a firm to meet its short

term cash obligations.

 Subject to manipulation, for example, the firm

can delay having to recognize an expense by

postponing cash payment.
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2.b. Accrual Basis of Accounting
 More difficult conceptually.
 Economically, changes in wealth may occur
without involving cash, for example, a barter
trade or a customer purchasing goods on
account.
 Revenues and expenses are recognized
independent of the timing of the cash flow.
 Provides information on long-term profitability.
 Subject to manipulation by the choice of
recognition rules.
3-10 3. Measurement Principles of Accrual
Accounting

Measurement involves both the amount and the

timing of the recognition for both revenues and
expenses.
(a) Timing of revenue recognition.
(b) Measurement of amount of revenue.
(c) Timing of expense recognition.
(d) Measurement of amount of expenses.
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3.a. Revenues -- Timing
 When does the accountant recognize revenue?
 When both of the following are met:

1. The firm has performed all or most of the

services or it has delivered the goods, that is,
it has earned the revenue.
2. The firm has received a good, service or
right in exchange and can reasonably
measure the value of the good, service or
right. A promise to pay (such as a
receivable) is a right.
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3.b. Revenues -- Amount
 Revenues are measured by the cash or
equivalent that it expects to receive.
 Uncollectible Accounts have no value by
definition and are not included in revenue.
 Sales Discounts and Allowances are reductions
in price and not included in revenue.
 Sales Returns are a reversal of the sale and are
not included in revenue.
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3.c. Expenses -- Timing
 Assets provide future benefits to the firm and
are consumed in the process of generating
revenues.
 As assets are consumed, the value of the

remaining asset is reduced and an expense in

incurred, thus, assets flow out of the firm as
expenses.
Balance Sheet Income Statement
Assets Expenses (Expired Costs,
(Unexpired Costs) which reduce shareholders’
equity on the balance sheet.)
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3.d. Criteria for Expense Recognition

Accountants recognize expenses as follows:

1. If an asset expiration associates directly with a
revenue, that expiration becomes an expense in
the period when the revenue is recognized, that
is, expenses are matched to revenues.
2. If an asset expiration does not clearly associate
with revenues, that expiration becomes an
expense of the period in which the firms
consumes the benefits of that asset.
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Example of an Expired Cost:

A company spends $10,000 to acquire product catalogs,

which it records as a prepaid expense in January. It hands
out the catalogs during a trade show in March, at which
point it charges $10,000 cost to marketing expense. The
$10,000 becomes an expired cost in March.

A company pays $100 for office supplies in June. Though

the supplies may not be used for several months, it is not
worth the time of the accounting staff to recognize such a
small cost over several reporting periods. Instead, the $100
is charged to expense as incurred, which means it is an
expired cost in June.
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Examples of Expense Recognition

 Product Costs -- the cost of making a product

is not an expense until the product is sold, then
it becomes a cost of goods sold expense. Prior
to this time, the cost is the unexpired asset,
inventory.
 Marketing Costs -- may or may not give rise to
revenue. Most accountants prefer to expense
marketing costs in the period when occurred.
 Administrative Costs -- cannot easily be
matched with revenue, so are considered a
period cost.
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4. Overview of Accounting Procedures

(a) Relation between balance sheet and income

statement.
(b) Purpose and use of individual revenue and
expense accounts.
(c) Debit and credit procedures for revenues,
expenses and dividends.
(d) Adjusting journal entries.
3-18 4.a. Relation between Balance
Sheet and Income Statement.

 The balance sheet reports assets and financing

of those assets at a point in time.
 The income statement reports revenues and

expenses over a period of time.

 Dividends are a return to the shareholders and

are not an expense.

 Two consecutive balance sheets are connected

by the income statement.

3-19 The Basic Accounting Equation with
Revenues, Expenses and Dividends
Liab- Shareholders’
Assets = ilities + Equity

Contri-
Liab- Retained
Assets = ilities + buted
Capital
+ Earning

Contri- Retained
Liab- Net Income
Assets = ilities + buted +
Earning
Beginning + for period - Dividends
for period
Capital of Period

Contri- Retained
Liab-
Assets = ilities + buted +
Earning
Beginning +
Revenues
for period - for period -
Expenses Dividends
for period
Capital of Period
3-20 4.b. Purpose and Use of Individual Revenue
and Expense Accounts
 Revenue and expenses could be recorded
directly to the Retained Earnings account.
 It is more informative to collect revenues and

expenses separately during the accounting

period.
 At the end of the accounting period, revenues

and expenses are cleared (reset to zero) for the

new accounting period. Their balances flow
into Retained Earnings. This is called closing
the accounts.
3-21 4.c. Debit and Credit Procedures for
Revenues, Expenses and Dividends

 Revenues, expenses and dividends are closed to

Retained Earnings.
 Recall that Retained Earnings normally carries

a credit balance since it represents a source of

financing; thus, credits increase R.E. while
debits decrease R.E.
Shareholders’ Equity (or R.E.)
decreases increases
(debit) (credit)
Expenses Revenues
Dividends Issues of Stock
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4.d. Adjusting Entries
 Some journal entries are made at the end of the
accounting period just to separate the effect of an
event into its proper periods.
 Examples include:

1. Recognition of accrued revenues and

receivables,
2. Interest calculations,
3. Recognition of accrued expenses and payables,
4. Allocation of prepaid operating costs, and
5. Recognition of depreciation.
3-23 4.d.1. Recognition of Accrued Revenues
and Receivables
 A firm earns revenue as it renders services. If
part of the service has been rendered in one
accounting period and the remainder in others,
accrual accounting calls for apportioning the
revenue among the appropriate periods.
 For example, a firm earns rental revenue as the
tenant occupies the property. If the rental
period spans two accounting periods, accrual
accounting calls for splitting the rent revenue
between the two in proportion to the rental time.
3-24 4.d.1. Recognition of Accrued Revenues and
Receivables (Cont.)

 Noticein contrast, that cash basis accounting

would recognize revenue as the cash rent
payments were received.
 Other examples include notes receivable
which accrue interest revenue as time passes
without regard for the timing of cash
payments.
 The accrued revenue (a credit) is offset by an
accrued receivable (a debit) until the cash is
paid.
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4.d.2. Interest Calculations

 Interest revenue is earned and interest expense

is incurred as time passes. Both of these are
accrued in proportion to time.
 If the interest period spans two or more

accounting periods, accrual accounting calls for

recognizing the interest at the end of each
accounting period in proportion to the amount
of time the interest was in effect.
 The offsetting journal entry is to a receivable (if

a revenue) or a payable (if an expense).

3-26 4.d.3. Recognition of Accrued Expenses and
Payables

 As a firm receives services, it incurs an

obligation to pay for them.
 If the services are received over a time period

spanning two or more accounting periods,

accrual accounting calls for recognizing the
proportion of service received as an expense.
 The offsetting journal entry is to a liability

account, generally a payable.

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4.d.4. Allocation of Prepaid Operating Costs

 Sometimes, the firm prepays for a service.

Since a prepaid service has future benefit, it is
an asset until the time for the service expires.
 If the time period of service spans two or
more accounting periods, accrual accounting
calls for recognizing the asset when the service
begins and adjusting the asset down at the end
of accounting periods in proportion to the
amount of service used.
 The asset is reduced (credited) and an expense
is recognized (debited).
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4.d.5. Recognition of Depreciation
 Depreciation is a long-term form of a prepaid
service. An asset may last many years. As the
asset is used, it is expensed.
 One simple form of depreciation is straight-
line. The original cost of the asset is expensed
over the useful life in equal amounts over
time.
 Because assets may be purchased at any time
during the accounting period, some special
rule must apply to the first year of
depreciation -- some firms just take one half
of a year’s depreciation for the first year.
3-29 5. Interpreting and Analyzing
the Income Statement
 The income statement provides information about the
profitability of the firm over the long term.
 Three tools are useful in analysis:
1. Common size statements -- revenues are set to 100% and each
expense item is shown as a percentage of revenue.
2. Time series analysis -- changes from year to year are
calculated in both revenue and expense items. It is hoped
that revenues will grow but that expenses will remain stable
or even reduce in proportion to revenue.
3. Cross-section analysis -- revenues and expenses are compared
to competitors. Some differences are strategic and some may
be driven by different production technologies, but some
differences may be due to inefficiency.
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Introduction Statement of Cash Flows

 Reports details of the where cash came from

and where it went to.

 Cash flows are classified into:

 Operating,
 Investing, or
 Financing.
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Chapter Summary
 The income statement which measures net
income is presented.
 Revenues and expenses are defined and how
they relate to retained earnings is presented.
 Adjusting entries are defined as journal entries
that are made at the end of an accounting
period to recognize revenues or expenses but
they are not initiated by an economic event.
 Further chapters discuss the use and analysis
of the income statement.