Please workexercise 2-6 thru 2-12, chapter 2 pages and work template attached.

CHAPTER 2 THE FINANCIAL STATEMENTS CHAPTER LEARNING OBJECTIVES Upon completion of this chapter, you should be able to: Understand the detailed composition of each of the four general-purpose financial statements. Analyze how financial statements interrelate with each other. Calculate earnings per share. Explain how the amount of cash held by a firm changes over a reporting period. Reconcile the beginning amount of contributed capital to the ending amount of contributed capital. Determine the ending amount of retained earnings by adjusting beginning retained earnings for periodic net income and dividends. Analyze how the purchase and depreciation of long-term assets affects financial statement disclosures. Recall from Chapter 1 that general-purpose financial reports consist of four specific financial statements. The first chapter of this workbook identified these four financial statements as the: 1. 2. 3. 4. Income Statement Statement of Shareholders' Equity Balance Sheet Statement of Cash Flows We used Redlands, Inc. to illustrate these four financial statements in the previous chapter. That example, however, was overly simplistic. Chapter 2 extends your understanding of the financial statements by presenting an in-depth examination of each of the four financial statements. This chapter also explores how the four financial statements tie together. It does so by reviewing the activities of a fictitious start-up business. The Financial Statements A group of recent college graduates decided to form their own business, rather than work for someone else. These aspiring entrepreneurs perceived a market niche for extreme sports equipment, especially those items not stocked by traditional sporting goods retailers. These budding businesspeople incorporated their business by purchasing shares of stock in the company using personal funds. The owners/managers did not want to open a storefront because they lacked capital, sought broader market penetration, and perceived a more efficient distribution channel. As a result, they formed Extreme Edge, Inc. as an Internet retailer on January 1, 2012. Financing and Investing Activities The company's initial financing resulted from the sale of stock to the owners and by borrowing cash from a bank. Thus, two claims existed against the company's cash on that first day of business. The owners (shareholders) investment in the company's resources constituted initial shareholders' equity. 1 The sole obligation to non-owners (debt), on the other hand, was the money borrowed from a bank. Extreme Edge then invested some of its cash to acquire resources needed to conduct business operations, such as inventory and computer equipment. After acquiring these assets, the firm was able to begin business operations. Operating Activities Like all profit-seeking businesses, the owners of Extreme Edge want to maximize their wealth. To that end, the company sells merchandise at historical cost plus a retail markup. The income statement reports the results of the company's wealth-seeking activities. The equation (revenues - expenses = net income) reports Extreme Edge's ability to produce wealth over a specified interval of time. Assuming Extreme Edge earns income; it can keep or \"retain\" the entire profit in the business, distribute it all to the owners in the form of dividends, or keep a portion and pay out the rest. 2 Retained earnings represent undistributed profits, whereas dividends equal payments to shareholders. Incomerelated decisions capture the most important aspect of the statement of shareholders' equity. This statement, in essence, reports beginning shareholders' equity + net income - dividends = ending shareholders' equity.3 Another way to view the primary portion of the statement of shareholders' equity is as a bridge connecting the income statement to the balance sheet. It links the two statements because the income statement measures wealth changes over time, and the balance sheets bracket that income statement disclosure with the beginning and ending amounts of income retained in the business. The ending balance in shareholders' equity also increases when the firm sells stock to shareholders. Inasmuch as Extreme Edge began operations in 2012, its shareholders' equity statement for that year reported changes in contributed capital, or the owners' investment in the firm. Companies can also reduce capital contributions. If, for example, Extreme Edge were to purchase some of its own stock in a secondary market, its number of outstanding shares (and related dollar amount) would decrease. 4 Extreme Edge reported all of the transactions related to financing, investing, and operating the business in its general journal during the year. Consequently, the firm prepared a balance sheet on December 31, 2012 to report its financial position at the end of the year. This statement of financial position, like all balance sheets, maintained the integrity of the balance sheet equation: assets = liabilities + shareholders' equity. Exercise 2-1 Required: Explain how the following transactions affected the balance sheet equation by completing the table below. Record an I for increase, D for decrease, or N/E for no effect. The table contains the solution for the first transaction. 1. Received cash from the sale of common stock to investors 2. Borrowed money from a bank 3. Purchased equipment (furniture, computers, and so forth) with cash 4. Purchased some inventory with cash 5. Purchased additional inventory on credit (i.e., the promise to pay cash at a future date) 6. Made a sale by selling some of the inventory to a customer on credit 7. Recorded the decrease in inventory associated with the sale made in number 6 above. 2 Trans. 1 2 3 4 5 6 7 Assets I Liabilities N/E Shareholders' Equity I Cash Flows All corporate stakeholders require information about the amount and timing of cash flows. We have already discussed that accrual-based accounting reports events having cash consequences, as opposed to focusing on just the cash flowing into and out of an organization. As noted in Chapter 1, revenues and expenses do not equal cash inflows and outflows. For example, assume Extreme Edge made some 2012 sales that went uncollected until the next year. Those 2012 sales created cash consequences, but their 2013 cash collections produced the actual cash. The fourth financial statement compensates for the limitation that accrual accounting tends to give short shrift to cash changes over time. The statement of cash flows reports the net change in cash during a reporting period. Three distinct activitiesoperating, investing, and financingcompose the statement of cash flows. Extreme Edge receives cash when it collects on sales, and uses cash when it pays cash for merchandise in the normal course of business. The statement of cash flows reports these events as cash flows from operating activities (CFOs). The company used cash provided by owners and creditors to acquire the equipment necessary to run the business. Such cash flows from investing activities (CFIs) constitute the second section of a cash flows statement. Extreme Edge generated cash flows from financing activities (CFFs), which is the third segment of the financial statement, when it sold stock and borrowed money from the bank to launch the business. Exercise 2-2 Required: Explain how each of the transactions in Exercise 2-1 affected the statement of cash flows by completing the following table. Use the I, D, and N/E symbols established in Exercise 2-1 to do so. Trans . 1 2 3 4 5 6 7 Operating Activities Investing Activities Financing Activities N/E N/E I 3 Sample Financial Statements Exhibit 2-1 presents the first three years financial statements for Extreme Edge. These financial statements will serve as the basis for many of this workbook's illustrations and exercises. (Note that the financial statement amounts are unrealistically low. We have chosen to use small dollar amounts to focus your attention on the accounting, rather than on making arithmetic computations.) Exhibit 2-1 Extreme Edge Financial Statements (in thousands of $) Income Statements (in thousands) For the Year Ended December 31 2114 2113 Sales revenues Cost of goods sold Gross profit Depreciation expense Other operating expenses Income from continuing operations Financial (interest) expense Pretax income (loss) Income tax expense (benefit) Net income (loss) Earnings (loss) per share $ 1,240 719 521 120 341 60 20 40 16 24 0.48 Statements of Shareholders' Equity (in thousands, except par value) Balance as of January 1, 2012 Common stock issued, $1 par value Net income Dividends declared and paid Balance as of December 31, 2012 Common Stock $ 42 $ 42 Balance as of January 1, 2013 Common stock issued, $1 par value Net income Dividends declared and paid Balance as of December 31, 2013 $ Balance as of January 1, 2014 Common stock issued, $1 par value Net income Dividends declared and paid Balance as of December 31, 2014 $ $ $ 4 $ 2112 1,200 660 540 120 365 55 20 35 14 21 0.42 $ 1,000 600 400 100 235 65 10 55 22 33 0.79 Additional PIC $ 378 $ 378 Retained Earnings $ 33 (8) $ 25 42 8 50 $ 50 50 $ $ $ 378 72 450 $ 450 450 $ $ $ 25 21 (2) 44 44 24 (2) 66 Balance Sheets at December 31 (in thousands, except par value) Assets Current Assets: Cash Accounts receivable, net of estimated bad debts Inventory Prepaid expenses Total current assets Property, Plant and Equipment: Equipment, net of depreciation Total Assets 2114 2113 $ 187 $ 45 175 280 13 655 Liabilities Current Liabilities: Accounts payable Accrued liabilities Total current liabilities Long-term Liabilities: Notes payable Total Liabilities Shareholders' Equity Common stock, $1 par Additional paid-in-capital on common stock Total contributed capital Retained earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity Statements of Cash Flows (in thousands) For the Year Ended December 31 Cash flows from operating activities: Net Income Depreciation expense, equipment Changes in current accounts: Accounts Receivable Inventory Prepaid Expenses Accounts Payable Accrued Liabilities 380 835 400 $ 780 50 21 71 $ 160 55 215 220 349 220 291 120 335 50 450 500 66 566 $ 915 50 450 500 44 544 835 42 378 420 25 445 $ 780 2113 2112 260 $ 915 $ $ $ 80 49 129 $ 24 120 (35) (15) (8) 30 28 5 30 120 220 10 280 $ Cash flows from investing activities: $ 140 265 5 455 2114 Net cash provided (used) by operating activities 2112 144 $ 21 120 (20) (45) 5 (110) (34) (63 ) $ 33 100 (120) (220) (10) 160 55 (2) Purchase of equipment Net cash provided (used) by investing activities Cash flows from financing activities: Issue (retire) notes payable Issue common stock - (100) (100) (500) (500) - 100 80 (2 ) 178 15 120 420 Pay cash dividend Net cash provided (used) by financing activities Net change in cash (2) (2) $ 142 $ Cash, beginning of the year Net change in cash Cash, end of the year $ $ 45 142 $ 187 $ 30 15 45 (8) 532 $ 30 $ $ 30 30 Our discussion of the financial statement disclosures in this chapter will be limited to 2012 and 2013, the first two years of operations. Data from the last year's financial statements, 2014, will serve as inputs for chapter exercises. Income Statement Income statements report corporate profitability (or loss, if expenses exceed revenues) over a time interval, such as one year. Some companies refer to the income statement as a statement of earnings, statement of operating performance, profit and loss statement, or P&L statement. Extreme Edge, for instance, earned $33,000 in its first business year (2012) and $21,000 in its second business year (2013). The income statement consists of four parts: revenues (and gains), expenses (and losses), income or loss, and earnings per share. As alluded to in the last chapter's discussion of the revenue realization principle, revenues increase assets or settle liabilities through selling goods and rendering services. Sales or services constitute an entity's central business activity. In our example, Extreme Edge earns revenues by selling sporting goods over the Internet. Gains are like revenues, except they arise from peripheral or incidental transactions.5 The Internet retailer did not have any gains in its first two years of operations. Expenses are the cost of doing business, or the resources consumed to make sales or provide services. They decrease assets or increase liabilities. Our hypothetical Internet retailer classified expenses into four categories: costs of goods sold, depreciation and other operating expenses, interest (or financial) expense, and income tax expense.6 Peripheral or incidental costs result in losses, rather than expenses. None occurred for Extreme Edge in either 2012 or 2013. Revenues and gains less expenses and losses equal net income or the change in wealth over a specified time interval, such as one year. Many income categories exist, as evidenced by Extreme Edge's income statements. Income statements report profit before or after operating expenses, and before or after income taxes. Managers often focus on earnings levels per share, instead of aggregate amounts of income. The most important of these income numbers is earnings per share. EPS reports the amount of net income earned by each share of stock during a reporting period. In this case, shareholders held 42,000 and 50,000 shares of Extreme Edge common stock in 2012 and 2013, respectively. Therefore, EPS amounted to $.79 for 2012 and $.42 for 2013. Extreme Edge computed these EPS amounts as follows: 7 6 2012: $33,000 / 42,000 shares = $.79 2013: $21,000 / 50,000 shares = $.42 Exercise 2-3 Required: Compute 2014 earnings per share. (Extreme Edge had 50,000 shares of stock outstanding in 2014). The various income categories mentioned above result from Extreme Edge's income statement presentation method. As noted, the Internet firm reported four expense categories, each of which resulted in a measure of profit (e.g., gross profit, income from continuing operations, pretax income, and net income). Managers refer to this type of disclosure as a multiple-step income statement. Conversely, a single-step income statement first reports all categories of revenues and gains, and then subtracts all expenses and losses from them to determine pretax income. While GAAP allows either method, managers find the multiple-step format more informative and often recast single-step income statements into multiple-step ones. Cost of goods sold (cost of sales) is the historical cost of inventory sold during a reporting period. Merchants and manufacturers deduct their cost of sales from sales revenues to determine gross profit (gross margin or gross profit margin). Extreme Edge's gross profits were $400,000 in 2012 and $540,000 in 2013. Apart from its cost of goods sold, Extreme Edge's other expenses consist of operating expenses (sometimes called selling, general and administrative, or SG&A, expenses). Deducting these recurring expenses from gross profit determines income from continuing operations (or operating income). This income number represents earnings from core business activities. 8 Our Internet merchant made income from continuing operations of $55,000 from selling merchandise in its second year of business (2013). Other revenues (and gains) and expenses (and losses) change income, but do not affect operating income. The most prominent item in this category is interest on borrowed funds. Extreme Edge incurred a $20,000 interest (financial) expense in 2013, which represented interest on borrowed funds (i.e., notes payable).9 Adjusting operating income for non-operating expenses (and revenues) produces income before taxes or (pretax income). Governments tax these earnings on a percentage basis, producing income tax expense (provision for income tax). Extreme Edge's tax rate was 40% for each year reported, as derived by dividing income tax expense by pretax earnings. In 2012, for example, we compute the income tax rate as follows: $22,000 / $55,000 = 40%. Exercise 2-4 Required: Determine the 2014 income tax rate for Extreme Edge. Statement of Shareholders' Equity There are two primary components of the statement of shareholders' equity: contributed capital and retained earnings. This statement reports their beginning and ending amounts, as well as changes in them. Let us examine both aspects of shareholders' equity in detail. As we discussed earlier in this chapter, contributed capital reports the owners' investment in a business. Equity investors transfer resources from their personal lives for shares of corporate ownership. 10 Two stock classes exist: Corporations issue common stock, and, in some instances, preferred stock. This latter ownership category is a more conservative form of investment than common stock. Preferred shareholders receive dividends before common shareholders do, but their return on investment (in the form of dividends) is usually lower than that for common stockholders. 11 7 The selling price of the stock (fair value or market value) differs from its par value (or legal capital).12 Firms identify the amount paid above par value, and report it as additional paid in capital (paid in capital in excess of par). The amount of stock at its par value plus the amount of additional paid in capital equals total contributed capital. Extreme Edge sold common stock worth $420,000 in 2012, and an additional $80,000 the next year. We compute an average selling price of $10 per share in 2012 because $420,000 of contributed capital divided by 42,000 shares equals $10 per share. 13 Similarly, common stock has a par value of $1 per share ($42,000 / 42,000 shares). Retained earnings are the cumulative amount of income kept within the business for all the years the business has operated. Managers need to remember that retained earnings are intangible: This account does not have physical substance! Inasmuch as revenues and expenses do not equal cash inflows and outflows, net income does not equal net cash. Consequently, retained earnings summarizes the conceptual total of income kept within the business, and does not equal cash reported on the balance sheet. Extreme Edge did not have any earnings when it started business on January 1, 2012. It earned $33,000 in income its first year but declared and paid dividends of $8,000. 14 Thus, the company retained earnings of $25,000 in 2012. That amount, in turn, became the 2013 beginning balance of retained earnings. Undistributed income of $19,000 in Extreme Edge's second business year increased retained earnings to $44,000 by December 31, 2013. Balance Sheet The balance sheet, or statement of financial position, reports resources and claims against those resources at the end of each reporting period. Assets, liabilities, and shareholders' equity are the more prevalent business terms used to describe the elements of the balance sheet than the more economically oriented phrases resources and claims against them. We now investigate how Extreme Edge discloses each of these three balance sheet elements. Assets are revenue-producing resources. More specifically, assets represent future economic benefits, which entities control as the result of past transactions. Most companies classify assets as either current or long-term resources, based on their convertibility into cash. Extreme Edge, like all companies, converts current assets into cash within one year or one operating cycle, whichever is longer. 15 Longterm assets produce cash indirectly. These means of production (plant and equipment) generate revenues, which, in turn, yield cash. Noncurrent assets exist for more than one reporting periodhence their longterm designation and distinction from current assets on the balance sheet. The three major categories of long-term assets are financial investments; property, plant, and equipment; and intangible assets. Liquidity, or a resource's nearness to cash, determines the sequence of current asset disclosures. Cash appears as the first current asset because it is readily available to pay the maturing obligations (liabilities) of the firm.16 A company next discloses its short-term investments. These debt and equity positions in other entities are liquid because management intends to sell them in the financial markets in the near term.17 Accounts receivable represent expected collections of unpaid customers' bills. Inventory reports the historical cost of unsold products at the end of the reporting period. 18 Prepaid expenses represent advanced payment made for future expenses such as insurance, rent, and advertising. Unlike other current assets, firms do not convert these accounts into cash; however, the reporting entity consumes them in the normal course of business, usually within one year. The amount of prepaid expenses is usually immaterial relative to total assets. 8 Extreme Edge reported $45,000 of cash at the end of its second year of business. The company had $140,000 of net accounts receivable at that time. Aggregate (or gross) receivables exceeded that amount, but an allowance was made for estimated customer defaults (i.e., not everyone pays their bills). The company owned $270,000 of merchandise at year-end (inventory) that it expected to sell at markedup prices. Extreme Edge also had $5,000 worth of prepaid expenses (such as rent paid in advance) at the end of 2013. Property, plant, and equipment represent a firm's productive, long-term tangible resources. A reporting entity charges the historical cost of these assets against revenues (as depreciation expense) over their productive (revenue-producing) lives. The accumulation of these cost allocations reduces the reported amount of an asset on the balance sheet to its book, carrying, or net value. Our hypothetical retailer discloses $400,000 and $380,000 of net equipment at the end of 2012 and 2013, respectively. You can examine financial statement interrelationships to deduce these ending balances. For instance, Extreme Edge purchased $500,000 of fixed assets in 2012, according to its cash flows statement. That statement also disclosed depreciation expense of $100,000. The 2012 book value of property plant, and equipment, therefore, is $400,000 ($500,000 cost - $100,000 of depreciation on the equipment). 19 Liabilities are future economic sacrifices arising from present obligations to transfer assets or provide services that arose from past transactions. Balance sheets categorize them as either current (shortterm) or noncurrent (long-term) liabilities, depending on payment date. Current liabilities, such as obligations to vendors, employees, property owners, advertisers, utility companies, and taxing authorities, require cash payment within the next year. Unlike current assets, which companies list in order of liquidity, current liabilities follow no strict disclosure patterns. Extreme Edge reported $71,000 worth of current liabilities at the end of its second year of business. Its accounts payable represents vendors' obligations for previously purchased inventory. 20 The firm's accrued liabilities are the sum of the unpaid bills for other (non-inventory related) operating costs. Existing obligations payable beyond the next reporting period define long-term (noncurrent) liabilities. Long-term obligations include bonds payable, notes payable, and mortgages payable. Companies pay some debts periodically over many years, such as mortgages on property; therefore, they partition the debt into current and long-term components. In our case, Extreme Edge owed money to its bank on two notes. The company borrowed $120,000 in 2012 and $100,000 in the following year, but it will not pay either obligation in 2013 or 2012; hence, they disclose both notes as long-term liabilities. Ownership claims to the assets of the firm equal shareholders' equity. Balance sheets disclose contributed capital and retained earnings, which firms initially define in their statements of shareholders' equity. Notice that common stock, additional paid in capital, and retained earnings on Extreme Edge's 2012 balance sheet equal those account balances on its statement of shareholders' equity at the end of that year. This relationship among equity disclosures is another example of how financial statements interrelate, or articulate. Statement of Cash Flows The statement of cash flows differs from the other three financial statements in that it reports cash information, rather than accrual-based disclosures. As noted earlier, this statement reports three types of cash flows: operating, investing, and financing activities. The latter two sections directly report the amount of cash that came into and went out of a business during a reporting period. Operating activities usually disclose cash activities indirectly by reconciling (accrual-based) net income to operating cash flows. 9 The most important portion of this statement is the cash flows from operating activities (CFOs) section. It reports net cash produced or consumed by the core activity of a business, or its central wealthbuilding endeavor. The statement reports operating cash flows on either a direct or an indirect basis. The direct method reports cash received from the sale of goods and services and cash paid to suppliers, employees, creditors (for interest), and taxing authorities. As noted above, the indirect method reconciles accrual-based net income to operating cash flows by reporting noncash items and changes in current balance sheet accounts. Direct cash flows provide more information to financial statement users, but most companies report on an indirect basis. Reporting on an indirect basis, Extreme Edge disclosed an operating cash decrease of $2,000 in 2012 and another cash decrease of $63,000 in 2013. They added depreciation of equipment to net income when determining operating cash flows because that expense did not require a cash payment. Extreme Edge also adjusted income for changes in its balance sheet current accounts (excluding cash) in order to reconcile to cash flows produced by operations. Note, for example, that the firm subtracted the $20,000 accounts receivable increase in 2013 ($120,000 to $140,000) from net income when computing its 2013 CFOs. It did so because those receivables reflected accrual-based sales revenues, which increased 2013 income, but did not produce cash in 2013. Conversely, the company added its $5,000 decrease in prepaid expenses ($10,000 to $5,000) to its 2013 operating cash flows. That adjustment represents the consumption of items purchased with cash during 2012, but expensed in 2013. Prepaid expense recognition in 2013 decreased net income, but not cash flows; consequently, Extreme Edge added the account's 2013 net decrease when computing its 2013 cash flows. The second section of the cash flows statement reports cash flows from investing activities (CFIs). These disclosures inform financial statement users about cash used for the acquisition of fixed assets, and cash generated from their disposal. As a business startup, Extreme Edge used cash to buy assets. Therefore, it had net cash outflows from investing activities during its first two years of business. The cost of equipment ($500,000) and additional purchase of equipment in 2013 ($100,000), reduced the company's ending cash balances in those years. The final portion of the cash flow statement reports cash flows from financing activities (CFFs). This section of the statement contains information about cash received from investors and creditors and cash returned to them. As such, it measures changes in long-term liabilities and shareholders' equity for a reporting period. The Internet retailer generated cash from financing activities during its first two years of business. These contributions reflect the normal pattern of financing cash flows for a new business as investors inject cash to get the company started. Stock issues accounted for $420,000 and $80,000 of cash in 2012 and 2013, respectively. Long-term bank financing (notes payable) produced cash inflows of $220,000 ($120,000 in 2012 and $100,000 in 2013). Dividend payments, however, reduced these cash infusions by $8,000 and $2,000 in 2012 and 2013, respectively. Exercise 2-5 Required: Examine the Extreme Edge 2014 statement of cash flows to determine the following amounts (if any): 1. Equipment purchased. 2. Common stock sold 3. Money borrowed on a long-term basis 4. Dividends paid Financial Statement Articulation 10 Financial statement articulation means that the four financial statements work together to provide meaningful information to their readers. Each of the above financial statements report a specific type of economic activity (such as the balance sheet reporting the organization's financial position and the income statement reporting the company's financial performance). The same underlying transactions, however, can affect all four financial statements. Each financial statement merely captures certain aspects of those transactions. Ultimately, the balance sheet reflects the effect of all economic transactions because the balance sheet reports an entity's financial position at the end of specific reporting period (e.g., December 31, 2014). Articulation Illustrated Financial statement readers must consider all four financial statements as an integrated set of information rather than as separate sources of financial data. Exhibit 2-2 graphically presents the interrelated nature of the financial statements. Exhibit 2-2 Articulated Financial Statements Statement of Shareholders' Equity Ownership interest Income Statement Financial Performance Statement of Cash Flows Balance Sheet Cash Effects Financial Position Articulation Examples 11 We now draw on the 2012 and 2013 Extreme Edge financial statements presented in Exhibit 2-1, and the financial statement discussion in the first part of this chapter, to illustrate financial statement articulation. (Recall that Extreme Edge began operating on January 1, 2012; therefore, beginning account balances for that year are zero.) Study the table calculations in Exhibit 2-3 in conjunction with the financial statements presented in Exhibit 2-1 to comprehend financial statement articulation. Reinforce your understanding by completing the exercises following each part of Exhibit 2-3 (see attached templates for exercises 2-6 thru 2-12). Exhibit 2-3 Extreme Edge, Inc. Financial Statement Articulation Cash Reconciliation: Accounts Beginning cash balanceJanuary 1 +/- net change in cash (per the statement of cash flows) Ending cash balance (per the December 31 balance sheet) 2013 $30 15 $45 2012 $0 30 $30 2013 $420 8 72 $500 2012 $0 42 378 $420 2013 $420 80 $500 2012 $0 420 $420 2013 2012 Exercise 2-6. Required: Reconcile cash for 2014. Contributed Capital Reconciliation (#1): Accounts Beginning contributed capitalJanuary 1 + Common stock issued (per the statement of shareholders' equity) + Additional paid in capital (per the statement of shareholders' equity) Ending contributed capital (per the December 31 balance sheet) Exercise 2-7. Required: Reconcile contributed capital for 2014. Contributed Capital Reconciliation (#2): Accounts Beginning contributed capitalJanuary 1 + Cash from the issue of common stock (per the statement of cash flows) Ending contributed capital (per the December 31 balance sheet) Exercise 2-8. Required: Reconcile contributed capital for 2014. Retained Earnings (#1): Accounts 12 Beginning retained earningsJanuary 1 + Net income (per the statement of shareholders' equity) - Dividends (per the statement of shareholders' equity) Ending retained earnings (per the December 31 balance sheet) $25 21 (2) $44 $0 33 (8) $25 2013 $25 21 (2) $44 2012 $0 33 (8) $25 2013 $100 400 500 (120) $380 2012 $500 0 500 (100) $400 Exercise 2-9. Required: Reconcile retained earnings for 2014. Retained Earnings (#2): Accounts Beginning retained earningsJanuary 1 + Net income (per the income statement) - Dividends (per the statement of cash flows) Ending retained earnings (per the December 31 balance sheet) Exercise 2-10. Required: Reconcile retained earnings for 2014. Equipment (#1): Accounts Purchase of equipment (per the statement of cash flows) Plus: net or book value of equipmentfrom previous December 31 Net or book value of equipmentJanuary 1 Less: Depreciation expense (per the income statement) Net or book value of equipment (per the December 31 balance sheet) Exercise 2-11. Required: Reconcile equipment for 2014. Equipment (#2): Accounts 2013 2012 Purchase of equipment (per the statement of cash flows) $100 $500 Plus: cost of previous years' equipment purchases 500 0 Total cost of equipmentJanuary 1 600 500 Less: Accumulated depreciation (per the income statements)* (220) (100) Net or book value of equipment (per the December 31 balance sheet) $380 $400 * accumulated depreciation for 2013 of $220 (2012 depreciation expense of $100 + 2013 depreciation expense of $120) Exercise 2-12. Required: Reconcile equipment for 2014. Summary 13 This chapter examined detailed accounting disclosures. The first section of Chapter 2 discussed the composition of each of the four financial statements. It defined critical accounts and presented how organizations disclose them. After establishing the financial statement composition, Chapter 2 illustrated the concept of financial statement articulation. Numerous examples based on the Extreme Edge set of financials illustrated how statement data interrelate. For example, the reader learned how the income statement, statement of shareholders' equity, and statement of cash flows all provide data that appears on the balance sheet. Key Terms Additional paid in capital (paid in capital in excess of par) Cash flow from operating activities Cash flows from financing activities Cash flows from investing activities Common stock, Contributed capital Cost of goods sold (cost of sales) Current assets Current liabilities Dividends Donations or contributions Earnings per share (EPS) Financial statement articulation Gains Gross profit (gross margin, gross profit margin) Income from continuing operations (or operating income) Income before taxes or (pretax income) Income tax expense (provision for income tax) Intangible assets Interest (financial) expense Liquidity Long-term (noncurrent) liabilities Losses Multiple-step income statement Noncurrent assets Not-for-profit (NFP) organizations Operating expenses (selling, general and administrative; SG&A expenses) Par value (or legal capital) Preferred stock Property, plant, and equipment Retained earnings Single-step income statement Statement of earnings (statement of financial performance, profit and loss statement, P&L statement) Comprehensive Problem Refer to the accompanying comprehensive problem spreadsheet. 14 Required: 1. Note that some of the cells for the 2015 financial statements are blank (i.e. no monetary amount presented). Determine the following account amounts: a. Cost of goods sold for 2015 b. Earnings per share for 2015 (Hint: EPS is a negative amount) c. Retained earnings on December 31 2015 d. Cash on December 31, 2015 e. Total liabilities and shareholders' equity on December 13, 2015 2. Reconcile the following amounts for 2015 a. Cash b. Contributed capital (two methods) c. Retained earnings (two methods) d. Equipment (two methods) 15 1 Synonyms for shareholders' equity include stockholders' equity, owners' equity, and share-owners' equity. 2 The distribution of profits assumes sufficient cash exists to make dividend payments. 3 People commonly refer to this subset of the statement of shareholders' equity as the statement of retained earnings. 4 Such an event is highly unlikely for a start-up company. We discuss these treasury stock transactions in the next chapters of the text. 5 For a more complete discussion of all of the financial statement elements refer to the FASB's Statement of Financial Accounting Concepts No. 6, \"Elements of Financial Statements,\" (Stamford CT: FASB, 1985). 6 The first two expenses are costs of operating Extreme Edge. Interest (financial) expense is Extreme Edge's annual cost of financing a portion of its assets through debt. 7 These calculations assume the company issued the stock at the beginning of each year. 8 Depreciation expense, salaries expense, utilities expense and rent expense exemplify operating expenses. Most companies collapse these different types of expenses into just a few line items for disclosure purposes. 9 We assume that the borrowing took place at the beginning of each year. Interest rates were 8.33% in 2012 and 10% in 2013. 10 Cash is the primary means of financing an entity, but investors can exchange other consideration (noncash assets) for stock. 11 Preferred stock features reflect some of the characteristics of long-term debt, rather than equity capital. 12 Par value equals the minimum legal selling price for stock in most states. 13 We could use the same approach for the 2013 stock issue, which generated $80,000 in cash. 14 Cash dividends are the most prevalent form of investor compensation, but not the only kind. Other types, such as stock and property (non-cash asset) distributions, exist. In addition, a company needs only to have retained earnings to declare a dividend, but it must have the cash (stock or property) to pay them. There is a time lag between the declaration date and payment date. 15 An operating cycle is the length of time it takes a company to convert inventory into cash in the ordinary course of business. For most industries, the operating cycle is shorter than one year; consequently, this text assumes current asset conversion within one year. 16 GAAP requires disclosure of restricted cash because it affects liquidity. Moreover, cash dedicated to a long-term use, such as the retirement of a noncurrent note payable, is reported as a long-term investment. Disclosures about cash or reclassifying it as another asset illustrate the reporting concept of substance over form. A company reports the economic substance of its accounts, rather than their legal basis. In this case, companies classify cash as such only if it is unencumbered. 17 Firms sometimes refer to short-term investments as marketable securities. Cash conversion is not an issue for short-term investments because available buyers exist at market-determined prices at all times. 18 Balance sheets technically report inventory at the lower of cost or current market value. 19 Some long-term assets are intangible in nature. That is they lack physical substance. We account for intangible assets in Chapter 5. 20 This book defines accounts payable as obligations to suppliers of finished goods or raw materialsproducts that will be sold to its customers. A broader definition considers all obligations to suppliers of goods and services, regardless of whether buyers purchase the goods for resale purposes, as accounts payable. This definition of accounts payable complicates analysis. Therefore, we classify all non-inventory related short-term obligations as accrued liabilities. Homework Templates (Exercise 2-6 thru Exercise 2-12) Exercise 2-6: Cash Reconciliation Accounts Beginning cash balanceJanuary 1 +/- net change in cash (per the statement of cash flows) Ending cash balance (per the December 31 balance sheet) 2014 Exercise 2-7: Contributed Capital Reconciliation (#1) Accounts 2014 Beginning contributed capitalJanuary 1 + Common stock issued (per the statement of shareholders' equity) + Additional paid in capital (per the statement of shareholders' equity) Ending contributed capital (per the December 31 balance sheet) Exercise 2-8: Contributed Capital Reconciliation (#2) Accounts 2014 Beginning contributed capitalJanuary 1 + Cash from the issue of common stock (per the statement of cash flows) Ending contributed capital (per the December 31 balance sheet) Exercise 2-9: Retained Earnings (#1) Accounts Beginning retained earningsJanuary 1 + Net income (per the statement of shareholders' equity) - Dividends (per the statement of shareholders' equity) Ending retained earnings (per the December 31 balance sheet) Exercise 2-10: Retained Earnings (#2) Accounts Beginning retained earningsJanuary 1 + Net income (per the income statement) - Dividends (per the statement of cash flows) Ending retained earnings (per the December 31 balance sheet) Exercise 2-11: Equipment (#1) Accounts Purchase of equipment (per the statement of cash flows) Plus: net or book value of equipmentfrom previous December 31 Net or book value of equipmentJanuary 1 Less: Depreciation expense (per the income statement) Net or book value of equipment (per the December 31 balance sheet) Exercise 2-12: Equipment (#2) Accounts Purchase of equipment (per the statement of cash flows) Plus: cost of previous years' equipment purchases Total cost of equipmentJanuary 1 Less: Accumulated depreciation (per the income statements) Net or book value of equipment (per the December 31 balance sheet) 2014 2014 2014 2014