1Midterm Review 15.501/516 Accounting Spring 2004 Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology Mar 8, 2004Exam Structure z Ques 1: Tabular analysis of the effects of various transactions on the balance sheet equation z Ques 2: Revenue recognition and accounts receivables z Ques 3 Inventories z Ques 4 Cash flow from operations z Expect to be tested on anything discussed in class 2Balance Sheet Equation: Assets = Liabilities + Owner’s Equity z Assets =probable future economic benefits owned by the firm z Liabilities = probable future economic sacrifices z Owners’ Equity = Assets – Liabilities owners’ claim = “own” – “owe” z (Owners’ Equity is sometimes also called shareholders’ equity, net book value, or the “residual claim”) z Assets = Liabilities + Owners equity 3Changes in Shareholders’ Equity Beginning of year: S. E.Paid in Capital Retained Earnings -Beginning Beginning Ending Retained Earnings + Net Income+ new paid in capital Dividends Ending Paid in Capital End of year: S. E. 4Balance Sheet Equation z Assets = Liabilities + Owner’s Equity z Key: Every economic event that leads to an accounting entry has two sides z Given an event and an accounting entry, you should be able to identify the two sides 5Contra-Asset Accounts z Contra asset accounts act like liability accounts – increases are recorded as credits z Their existence is tied to specific asset accounts z For example z Allowance for Doubtful Accounts (existence tied to Accounts Receivables, a current asset) z Accumulated Depreciation (existence tied to depreciable long-term assets like PP&E) z On the balance sheet, Accounts Receivables is reported net of ADA and PP&E is reported net of Accumulated Depreciation z Thus, contra-asset balances are not reported on the liabilities side, but as negative numbers on the asset side z Assets – Contra-Assets (if any) = Liabilities + Stockholders’ Equity 6Debits and Credits z Assets = Liabilities + Owner’s Equity z Increases in assets are debits z Increases in liabilities are credits z Increases in Owner’s Equity (Capital Stock, RE) are credits z Revenues increase Retained Earnings – Credits z Expenses reduce Retained Earnings - Debits 7Accounting Entries z Every accounting entry has two sides – a debit and a credit. This is the same point as two slides before 8Accounting Entries z Two kinds: z Transactions based z Adjusting entries z Transactions-based entries record the effects of specific transactions z Adjusting entries are entries that arise out of the basic principles of accrual accounting z Depreciation expense z Salaries expense even when employees have not actually been paid z Bad debt expense 9Basic Principles of Accrual Accounting z Determine what net income has been earned during a period, not just what cash has been generated during the period from operations z Why? To capture the economic events that have occurred during the period z Determine revenues applying the revenue-recognition principles z Report as expenses those costs that have been or will be incurred to generate those revenues 10Accruals and Cash flows: Four Cases 1) Cash precedes expense Time Pay Cash Recognize Expense (a) (b) Balance Sheet Date Examples: Rent paid in advance, Prepaid Insurance, PP&E, Inventory Associated entries: (A) = (SE) Cash Prepaid RentPrepaid RentRet. Earn. (a) –$ +$ (b) –$ –$ (rent expense) 11Example: Prepaid Rent z Assume on Jan 1, you pay rent for the next year for @ $1,000 per month Dr Prepaid Rent (CA) 12,000 Cr Cash (CA) 12,000 z Say you make adjusting entries at the end of every month. At the end of the first month, on Jan 30th, you would record the following expense: Dr Rent Expense (RE) 1,000 Cr Prepaid Rent (CA) 1,000 z The first entry increase a current asset (Prepaid Rent) and decreased Cash z The second entry decreased Retained Earnings and also decreased a current asset (Prepaid Rent) 12Accruals and Cash flows: Four Cases 2) Cash follows expense Time Recognize Expense (a) (b) Pay Cash Balance Sheet Date Examples: Taxes paid after yearend, Salaries paid on the 15th of the month, bad debt expense, warranty expenses Associated entries: (A) = (L) (SE) Cash Salaries Payable* Ret. Earn. (a) +$ –$ (salary expense) (b) –$ –$ * sometimes also called “accrued salaries”13Accruals and Cash flows: Four Cases 3) Cash precedes revenue Time Receive Cash Recognize Revenue (a) (b) Balance Sheet Date Examples: Airplane tickets sold in advance Newspaper subscriptions sold in advance Associated entries: (L) (SE) Cash Unearned Revenue*Unearned Revenue*Ret. Earn. (a) +$ +$ (b) –$ $ (revenue) *sometimes also called “deferred revenue” 14Accruals and Cash flows: Four Cases 4) Cash follows revenue Time Recognize Revenue Receive Cash (a) (b) Balance Sheet Date Examples: Accounts Receivable Goods shipped but cash not yet received Services provided but cash not yet received Associated entries: (A) (A) (SE) Cash Accounts Receivable Ret. Earn. (a) +$ +$ (revenue) (b) $ –$ 15Revenue Recognition z Revenue recognition principles: Service has been provided by the company, customer has been billed and there is reasonable certainty of cash collection z Issues in revenue recognition z Credit sales z Warranties and returns z Bill & hold sales, SAB 101 16Accounts Receivable z Not all accounts receivables will be collected in cash z The balance in Allowance for Doubtful Accounts at the end of the year reflects estimated defaults. z Bad debt expense is recorded at the end of every period to adjust the balance in ADA to the desired amount 17Income Statement and Balance Sheet Relations Accounts Receivable (A) Beg Balance Amount of Credit Sales Cash collected Write-offs Ending balance Allowance for doubtful accounts (XA) Beg Balance Amount of Bad Debt Expense Write-offs Ending balance 18AR and ADA Account Balances Accounts Receivable (A) – Allowance For Doubtful Accounts (XA) Beginning Balance Beginning Balance + Credit Sales+ Amounts Recorded as – Cash Collected Bad Debt Expense – Net Amounts Written – Net Amounts Written Off Off = Ending Balance = Ending Balance 19Inventories - The Key Equation Inventory Beg. Inventory Purchases/ Production Cost of goods sold End. Inventory Beg. inventory + purchases/production - COGS = End. inventory 20Accounting for Inventory A Comparison of LIFO and FIFO