Shareholders' Equity
Shareholderst equity, sometimes called net assets, is the owners'claims to the assets of the company. There are two ways owners can create equity in a company. The first way is by making capital contributions-contributed capital. Usually, the capital is cash, but it could be equipment or other items of value. When Tom started his T-shitt business, he in- vested $5,000 of his own money. Sometimes this is called the owner's investment in the company. The term investment may be confused with investments that the company itself makes with its extra cash. For example, General Motors may invest some of its extra cash in the stock of Google, which General Motors would call an investment. To avoid that con- fusion, we will refer to owners' investments in the firm as capital contributions.
The second way to create equity in a business is to make a profit. (That is the preferred way.) When Tom's Wear sells a shirt, the profit from that shirt increases Tom's equity in the company. Revenues increase shareholders'equity; expenses reduce shareholders'equity;
and dividends, when declared, reduce shareholders' equity.
In corporations, the two types of equity are separated on the balance sheet. The first is contributed capital, also known as paid-in capital; the second is retained earnings. In a sole proprietorship or partnership, both types of equity are together called capital. Separat- ing these amounts for corporations provides information for potential investors about how much the owners have actually invested in the corporation.
Measurement and Recognition in Financial Statements
We will now take a closer look at some of the features of the balance sheet and income state- ment. Recall, the balance sheet is simply the accounting equation: Assets = Liabilities
* Shareholders' equity. The three elements are major categories, each divided into subcategories.
Measuring Assets. We will starl with assets. The most well-known asset is cash. It is listed frst on the balance sheet. As you will notice on Home Depot's balance sheet, all other
Liabilities are obligations the company has incurred to obtain the assets it has a c o u i r e d .
Current liabilities are l i a b i l i t i e s t h e c o m p a n y w i l l settle-pay off-in the next fiscal year.
Noncurrent liabilities, or long- term liabilities, are liabilities t h a t w i l l t a k e l o n g e r th a n a year to settle.
A classified balance sheet shows a subtotal for many items, including current assets and current liabilities.
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Shareholders' equity is the n a m e fo r o w n e r s ' c l a i m s t o the assets of the firm. lt includes both contributed capital and retained earnings.
Contributed capital, sometimes called paid-in capital, is the amount the owners have put into the business.
Retained earnings is capital the company has earned and has not been distributed as dividends.
Capital is the combined contributed caoital and earned caoital-retained earnings-of a sole
proprietorship or partnership.
62 C H A P T E R I o QUALITIES O F A C C O U N T I N G I N F O R M A T I O N
assets are listed in order of their liquidity-how easily they can be converted to cash. A monetary value is computed for each asset. Cash, for example, is the total amount of money in checking and savings accounts. The next asset could be short-term investments, ones the company can easily sell for cash at any time. The next asset on the balance sheet is usually accounts receivable-the total amount that customers owe the company for credit sales. In- ventory is another asset, measured at its cost. We saw that Tom's Wear's balance sheet in- cluded the cost of the T-shirts still in the inventory on the balance sheet date.
Earlier you learned two characteristics of the way things are measured for the financial statements. First, they are measured in monetary units. For us, that means dollars. For ex- ample, the actual number of T-shirts in the inventory is not shown on the balance sheet; only the cost of the inventory is shown. Second, the items on the financial statements are recorded at historical cost-what the company paid for them. They are not recorded at the amount the company hopes to sell them for. Some assets continue to be shown at cost on the balance sheet, and others are revalued to a more current amount for each balance sheet.
You will learn the details of which assets are revalued and which assets are not revalued in the chapters to come.
Recognizing Revenue and Expenses. When should revenue be included on an income statement? GAAP says when it is earned, that is when revenue is recognized-meaning that is when revenue is included on the income statement. When Tom delivers a shirt to a customer, Tom's Wear has earned the revenue. This is called the revenue-recognition prin- ciple. When one of Tom's friends says he is going to buy a T-shirt next week, no revenue is recognized. When an exchange actually takes place, or when the earnings process is com- plete or "virtually complete," that is the time for revenue recognition. When Tom's Wear and a customer exchange the cash and the T-shirt, there is no doubt the transaction is com- plete. However, even when Tom's Wear only delivers the T-shirt and the customer agrees to pay for it later (the sale is on credit), the company will consider the earnings process virtu- ally complete. Tom's Wear has done its part, so the sale is included on the income statement.
What about expenses? When an expense is recognized depends on when the revenue that results from that expense is recognized. Expenses are recognized-included on the in- come statement-when the revenue they were incurred to generate is recognized. This is called the matching principle, and it is the basis of the income statement. Expenses are matched with the revenue they helped to generate. An example is the cost of goods sold.
Only the cost of the T-shirts sold is recognized-included as an expense on the income statement. The expense is matched with the revenue from the sale of those shirts. The cost of the unsold T-shirts is not an expense-and will not be an expense-until those shirts are sold. An expense is a cost that has been used to generate revenue. If a cost has been incurred but it has not been used up, it is classified as an asset until it is used. Prepaid insurance is an example of a cost that is classified as an asset until it is used; and when it is used, it be- comes lnsurance expense.
Must the customer actually pay the company in cash before a sale can be counted as revenue? No. Notice that the sales of all the shirts are included in the sales total, even though 15 of the shirts have not been paid for yet. When a customer purchases an item on credit, the earnings process is considered virtually complete, even though the cash has not been collected. Similarly, a cost incurred in the generation ofrevenue need not be paid to be in- cluded on the income statement. In calculating the revenue and exoenses for an income Recognized revenue is
revenue that has been recorded so that it will show up on the income statement.
The revenue-recognition principle says that revenue should be recognized when it is earned and collection is reasonably assured.
The matching principle says that expenses should be recognized-shown on the income statement-i n the same period as the revenue they helped generate.
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A c c o u n t i n g i n f o r m a t i o n r e a l l y m a t t e r s ! M i l l s C o r p o r a t i o n , a s h o p p i n g - m a l l r e a l - e s t a t e investment trust, disclosed that the SEC was investigating its accounting practices, in- cluding the way the firm recognizes revenue. An analyst for Banc of Americas Securi- t i e s d o w n g r a d e d M i l l s s h a r e s t o " s e l l " s t a t u s b e c a u s e t h e a n n o u n c e m e n t s u g g e s t e d t h e firm overbooked revenue and may have understated expenses. What happened? The firm's share price dropped by 12%.
C H A P T E R 2 o E L E M E N T S O F T H E statement, accountants do not follow the cash. Instead, they use the time when the "eco- nomic substance" of the transaction is complete.
Accountants use the expressions virtually complete and economic substance to de- scribe the same idea-that a transaction does not need to be technically complete to recog- rize the resulting revenue. If the transaction is substantially complete, the revenue is recognized. When Tom's Wear sells the T-shirts, delivering them and receiving the cus- tomers' promise to pay is considered the economic substance of that transaction. Cash may come before the transaction is complete or it may come afterward. This way of accounting for revenues and expenses-using the economic substance of the transaction to determine when to include it on the income statement instead of using the exchange of cash-is called accrual accounting.
When to recognize revenue is easy for some businesses and extremely diffrcult for oth- ers. There is a lot of disagreement among accountants about the timing of revenue recogni- tion. They agree that revenue should be recognized when the revenue has actually been earned and it is reasonable to assume the customer will pay. That is, the transaction is vir- tually complete. But they often cannot agree on exactly when that has happened. This is an important topic that is regularly debated in the financial community. Unfortunately, im- proper revenue recognition has caused serious problems for many companies. Many of the accounting scandals with the earnings reported by major corporations in the last few years are related to revenue recognition.
Exhibit 2.10 summarizes the assumptions, principles, and constraints of accounting information.
F I N A N C I A L S T A T E M E N T S 6 3
Accrual accounting refers to the way we recognize revenues ano expenses, Accountants do not rely on the exchange of cash to determine the timing of revenue recognition. Firms recognize revenue when it is earned and expenses when they are incurred-no matter when the cash is received or disbursed.
Accrual accounting follows the matching principle.
E X F I I B I T 2 . 1 0
Assumptions, Principles, and Constraints of Financial Reporting Assumptions:
Principles:
Time-period assumption The life of a business can be divided into artiflcial time periods for financial reporting.
Separate-entity assumptron
Financial statements of a flrm contain financial information about only that firm.
Monetary-unit assumption Only items that can be measured in monetary units are included in the flnancial statements.
Going-concern assumption
A company wiII remain in business for the foreseeable future.
Historical-cost principle Assets are recorded at cost.
Revenue-recognition principle
Revenue is recognized when it is earned and collection is reasonably assured.
Matching principle Expenses are recognized in the same period as the revenue they helped generate.
F\rll-disclosure principle
A company should provide information about any circumstances and events that would make a difference to the users of the financial statements
Materiality
Materiality refers to the size or significance of an item or transaction on the company's financial statements.
Conservatism
When there is any question about how to account for a transaction, the accountant should select the treatment that will be least likely to overstate income or overstate assets.
Constraints:
6 4 C H A P T E R 2 . QUALITIES O F A C C O U N T I N G I N F O R M A T I O N
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When to recognize revenue-record it so that it appears on the period'S in- c o m e s t a t e m e n t - i s o n e o f t h e m o s t d i f f i c u l t ju d g m e n t s a c o m p a n y m u s t m a k e . A 2 0 0 5 s t u d y o f 4 0 0 b u s i n e s s l e a d e r s b y R e v e n u e R e c o g n i t i o n . c o m a n d I n t e r n a t i o n a l D a t a C o r p o r a t i o n f o u n d t h a t m o r e th a n h a l f o f a t l p u b l i c c o m p a n i e s h a v e c h a n g e d t h e i r r e v e n u e re c o g n i t i o n p o l i c i e s a s a r e s u l t o f S a r b a n e s - O x l e y . B u t i t i s c h a n g i n g b u s i n e s s m o d e l s th a t a c c o u n t fo r m o r e c h a n g e s i n r e v e n u e re c o g n i t i o n p o l i c i e s t h a n a n y o t h e r s i n g l e fa c t o r . N e w b u s i n e s s m o d e l s c a n b e q u i t e c o m p l e x , i n v o l v i n g b u n d l e d p r o d u c t s a n d s e r - v i c e s d e l i v e r e d o v e r l o n g p e r i o d s o f t i m e . W h e n t o r e c o g n i z e r e v e n u e c a n b e d i f f ic u l t to d e t e r m i n e .
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D e f i n e a c c r u a l a c c o u n t i n g , e x p l a i n h o w i t d i f f e r s fr o m c a s h b a s i s a c c o u n t i n g , a n d i d e n t i f y e x a m p l e s o f a c c r u a l a c c o u n t i n g o n a c t u a l f i n a n c i a l s t a t e m e n t s . An accrual transaction is one in which the revenue is earned or the exoense is incurred before the exchanqe of cash.
A deferral transaction is one in which the exchange of cash takes place before the revenue is earned or the expense incurred.
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Accrual accounting involves both accruals and deferrals.
Give an example of the matching principle from the income statement for Tom's Wear for February.
Accruals and Deferrals
Accrual Basis Accounting
The term accrual basis accountlng includes two kinds of transactions in which the exchange of cash does not coincide with the economic substance of the transaction. The revenues and expenses are recognized at a time other than the time when the cash is collected or paid.
One kind of accrual basis transaction is an accrual and the other is a deferral. The meaning of each kind of accrual basis transaction is shown in Exhibit 2.1 1.
When the action comes before the cash ,itis an accrual. When Tom's Wear made a credit sale, it was an accrual transaction. To accrue means to "build up" or "accumulate." In ac- counting, we are building up our sales or our expenses even though the cash has not been ex- changed. The sale is completed first-merchandise is delivered to the customer-and the cash payment will come later. Instead of receiving the asset cash from the purchaser, the company records an asset called accounts receivable-meaning cash due from the pur- chaser. Accounts receivable is the amount owed to the company by customers. Because GAAP is based on accrual accounting, the necessary part ofthe transaction for recording the revenue is the actual sale of goods or services, not the cash receipt from the customers.
When the dollars come before the action, it is called a defenal. When Tom's Wear paid for the insurance, it was an advance purchase-as we all pay insurance premiums up front, not after the expiration date of the policy. But the amount paid for the insurance was not considered an expense until it was actually used. To defer something, in common language, means to put it off-to delay or postpone it. In the language of accounting, a deferral means that the company will postpone recognizing the expense until the insurance is actually used.
When Tom's Wear paid the cash in advance of the period covered by the insurance, the com- pany recorded the cash disbursement. In other words, Tom's Wear recorded it in the busi- ness records as cash that had been spent. However, the expense was not recognized when the cash was paid. It will be recognized-and remember, that means included on the income statement-when the cost is actually used.
I Accrual Accounting :
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Later
Cash Basis Versus Accrual Basis Accounting
There is another type of accounting called cash basis accounting-revenue is recognized only when the cash is collected, and expenses are recorded only when the cash is paid. This is not a generally accepted method of accounting according to the FASB and the SEC. Us- ing the exchange of cash as the signal for recognizing revenue and expense does not com- municate the performance of the business in a way that allows us to evaluate its achievements. The cash flows are important, but alone they do not provide enough infor- mation for decision makers. This does not stop some businesses from using it as the basis of their own accounting records. Remember, some businesses are not required to follow GAAP. For example, doctors who are sole proprietors may use cash basis accounting in their businesses. This means they recognize only the cash they receive as revenue. If they provide services to someone who has not yet paid for those services at the time an income statement is prepared, they would not include the fee not yet received as revenue for that in- come statement. That is not GAAP. If the doctors were following GAAP, they would count it as revenue and as a receivable (accounts receivable).
Accounting Periods and Cutoff lssues
Why does it matter-for accounting purposes-if there is a difference between the time when the goods or services are exchanged-the economic substance of the transaction- and the time when the cash related to that transaction is received or disbursed? If a com- pany makes a sale on credit and the cash is collected later, why does it matter when the sale is recognized-included as revenue on the income statement? Studying Tom's Wear will help you see the answers to these questions.
When Tom began his business in 2006, he chose the calendar year as his company's fiscal year. Each of his annual income statements will cover the period from January 1 to December 31 of a specific year. It is important that what appears on the income statement for a specific year is only the revenue earned during those 12 months and only the expenses incurred to generate that revenue. What is included as a sale during the period? Accountants have decided to use the exchange of goods and services, not the cash exchange, to define when a sale has taken place. Expenses are matched with revenues, also without regard to when the cash is exchanged. This makes the financial statements of all companies that fol- low GAAP consistent and comparable.
Exhibit 2.12 shows the relationship between the balance sheet and the income state- ment and the time periods involved. Recall, the balance sheet is a snapshot view of the as- sets, liabilities, and shareholders' equity on a specific date. For a company with a fiscal year-end on December 3 1, that is the date of the balance sheet. Remember, the end-of-the- year balance sheet for one year becomes the beginning-of-the-year balance sheet for the next year. When you are out celebrating New Year's Eve, nothing is happening to the bal- ance sheet. When Tom goes to sleep on December 31,2006, the cash on the December 31, 2006, balance sheet of Tom's Wear is exactly the amount of cash that the company will have on January l, 2007 . So the final balance sheet for one year simply rolls forward to the next year.
Then, transactions start happening-exchanges take place. The revenues and expenses for the period of time are shown on the income statement. The income statement covers a
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C H A P T E R 2 . A C C R U A L S A N D D E F E R R A L S 6 5
Cash basis accounting is a system based on the exchange of cash. In this system, revenue is recognized only when cash is collected. and an expense is recognized only when cash is disbursed. This is not an acceotable method of accounting under GAAP.
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12t31/09 Balance
lncome Statement for the Year Ended 12131/09
: E X F I I B I T 2 . ' I 2 T h e B a l a n c e S h e e t a n d I n c o m e S t a t e m e n t
Every balance sheet presents the assets, liabilities. and
shareholders'equity of a business firm at a moment in time. The income statement describes what happened between two balance sheet dates.
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56 C H A P T E R 2 . QUALITIES O F A C C O U N T I N G I N F O R M A T I O N
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F i n a n c i a l s t a t e m e n t s provide information about the risk related to i n v e s t i n g i n a c o m p a n y . W i l l y o u g e t a g o o d r e t u r n on your investment? How l o n g w i l l i t t a k e ?
period of time. A company may construct weekly, monthly, quarterly, or annual hnancial statements. Many companies prepare monthly and quarterly financial statements; all com- panies prepare annual financial statements. The income statement for a speciltc year gives the revenues and expenses for that year. It gives information about how the balance sheet has changed between the beginning of the year and the end of the year. The revenues in- crease owners'claims; expenses reduce owners'claims. If the difference between revenues and expenses is positive-if revenues are greater than expenses-the company has a net in- come. Ifthe expenses are greater than revenues, the company has a net loss. The net income or net loss is sometimes called the bottom line.
What is the difference between cash basis and accrual basis accounting?
How lnvestors-Owners and Creditors- Use Accrual Accounting Information
Owners and creditors are both considered investors in a business. Both invest their money to make money, and they both take a risk in investing their money in the business. In this context, you can think of risk as the uncertainty associated with the amount of future re- turns and the timing of future returns. Some investments are riskier than others are. For ex- ample, when a bank makes a loan to a company, the banker evaluates the ability of the company to repay the loan amount-the principal-plus interest-the cost of borrowing the money. If the bank makes a loan to a company that does not do well enough to repay the debt, the company may need to sell noncash assets to raise cash to pay off the loan plus interest due. When lending money, the bank must compare the risk with the expected return.
Most often, the risk and return of an investment change value in the same direction- we say they are positively correlated. Positively correlatedmeans they move in the same di- rection-higher risk means higher expected return for taking the higher risk; lower risk means lower expected returns. For higher investment risk, the potential for a higher return is needed to attract investors.
Investing in a company as an owner is riskier than investing as a creditor. A creditor's claim to the assets of a company has priority over an owner's claim. (Creditors have first claim to the assets.) If a company has just enough money either to pay its creditors or to make a distribution to its owner or owners, the creditors must be paid, and they always must be paidbefore anything-if there is anything left-is distributed to the owners. That trans- Iates into less risk for a creditor. The owner's risk is that the company will go out of business.
However, the owner, who takes more risk, has the right to share the profit. So the risk for the owner is accompanied by the potential for a higher return. A creditor, on the other hand, will never receive more than the amount of the loan, plus the amount of interest that is agreed on when the loan is made.
Financial information is useful for someone deciding whether or not to invest in a com- pany. Suppose Tom's Wear wanted to borrow money to expand. A bank would want to ex- amine Tom's Wear's income statement, balance sheet, and the statement of cash flows. The reason is to evaluate potential risk-the company's ability to make the required principal and interest payments.
The balance sheet shows a company's assets and who has claim to them. A bank loan officer would use the information on the balance sheet to evaluate Tom's Wear's ability to repay the loan. He would want to be sure that the company did not have too many debts.
The more debt a company has, the more cash it must generate to make the loan payments.
The information on the balance sheet would not be enough to assure the bank loan of- ficer that Tom's Wear would be able to repay the loan. Because a loan is repaid over several months or years, information about the future earning potential of the business is important.
Studying the past performance of a business helps predict its future performance. That makes the profit the company earned during the past year relevant to the banker. Details about the sales revenue and expenses incured to generate that revenue would help the bank evaluate the company's potential to generate enough cash to repay a loan.