Real Estate CE Course - Real Estate Accounting

Real Estate Accounting

by Lei Bao

The Four Financial Statements

Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different financial statements, which form the backbone of financial accounting:

• To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement.

• To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement.

• To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet.

• To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows.

To introduce you to these statements, we have prepared the financial statements for your outdoor guide service, Sierra Corporation, after your first month of operations. To summarize, you officially started your business in Truckee, California, on October 1, 2017. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe outdoor day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, at this point the company has limited outdoor equipment for customer use. Instead, your customers either bring their own equipment or rent equipment through local outfitters. The financial statements for Sierra’s first month of business are provided in the following pages.

Income Statement

The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time. To indicate that its income statement reports the results of operations for a specific period of time, Sierra dates the income statement “For the Month Ended October 31, 2017.” The income statement lists the company’s revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra Corporation’s income statement is shown in Illustration 1-4. Congratulations, you are already showing a profit!

Why are financial statement users interested in net income? Investors are interested in a company’s past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company’s future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock. Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn’t think it would be repaid, it wouldn’t loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan. Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing.

Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1-7), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1-5)

Retained Earnings Statement

If Sierra is profitable, at the end of each period it must decide what portion of profits to pay to shareholders in dividends. In theory, it could pay all of its current-period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation. The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1-5 presents Sierra Corporation’s retained earnings statement.

By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices. Some investors seek companies, such as Dow Chemical, that have a history of paying high dividends. Other investors seek companies, such as Amazon.com, that reinvest earnings to increase the company’s growth instead of paying dividends. Lenders monitor their corporate customers’ dividend payments because any money paid in dividends reduces a company’s ability to repay its debts.

Balance Sheet

The balance sheet reports assets and claims to assets at a specific point in time. Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners’ claim to assets is called stockholders’ equity. Illustration 1-6 shows the relationship among the categories on the balance sheet in equation form. This equation is referred to as the basic accounting equation.

• Assets = Liabilities + Stockholders’s Equity (Illustration 1-6)

This relationship is where the name “balance sheet” comes from. Assets must balance with the claims to assets.

As you can see from looking at Sierra’s balance sheet in Illustration 1-7, the balance sheet presents the company’s financial position as of a specific date – in this case, October 31, 2017. It lists assets first, followed by liabilities and stockholders’ equity. Stockholders’ equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company sells new shares of stock; retained earnings is the net income retained in the corporation. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders’ equity of $12,360.

Creditors analyze a company’s balance sheet to determine the likelihood that they will be repaid. They carefully evaluate the nature of the company’s assets and liabilities. In operating the Sierra Corporation guide service, the balance sheet will be used to determine whether cash on hand is sufficient for immediate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock financing.

Statement of Cash Flows

The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. To help investors, creditors, and others in their analysis of a company’s cash position, the statement of cash flows reports the cash effects of a company’s operating, investing, and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period.

Users are interested in the statement of cash flows because they want to know what is happening to a company’s most important resource. The statement of cash flows provides answers to these simple but important questions:

• Where did cash come from during the period?

• How was cash used during the period?

• What was the change in the cash balance during the period?

The statement of cash flows for Sierra, in Illustration 1-8, shows that cash increased $15,200 during the month. This increase resulted because operating activities (services to clients) increased cash $5,700, and financing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.

Interrelationships of Statements

Illustration 1-9 (page 16) shows the financial statements of Sierra Corporation. Because the results on some financial statements become inputs to other statements, the statements are interrelated. These interrelationships can be seen in Sierra’s financial statements, as follows.

1. The retained earnings statement uses the results of the income statement. Sierra reported net income of $2,860 for the period. Net income is added to the beginning amount of retained earnings to determine ending retained earnings.

2. The balance sheet and retained earnings statement are also interrelated. Sierra reports the ending amount of $2,360 on the retained earnings statement as the retained earnings amount on the balance sheet.

3. Finally, the statement of cash flows relates to information on the balance sheet. The statement of cash flows shows how the Cash account changed during the period. It shows the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $15,200 of cash at the end of the period. The ending amount of cash shown on the statement of cash flows must agree with the amount of cash on the balance sheet.

Study these interrelationships carefully. To prepare financial statements, you must understand the sequence in which these amounts are determined and how each statement impacts the next.

Business Transaction (Account, Debit, and Credit)

Account

An account is an individual accounting record of increases and decreases in a specific asset, liability, stockholders’ equity, revenue, or expense item. For example, Sierra Corporation has separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so on. (Note that whenever we are referring to a specific account, we capitalize the name.)

In its simplest form, an account consists of three parts:

1. the title of the account,

2. a left or debit side, and

3. a right or credit side.

Debits and Credits

The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account.

When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

Debit and Credit Procedures

Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system.

Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more efficient than the plus/minus procedure used earlier.

Summary of Debit/Credit Rules

Illustration 3-16 summarizes the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. No matter what the transaction, total debits must equal total credits in order to keep the accounting equation in balance.