Getting the most information out of a set of financial statement is much harder than preparing those financial statements. The basic task is to take the financial statements and gain an understanding of the transactions that gave rise to them. We are now at an important point where we start to turn our attention to working backwards from the financial statements.
The only way to learn how to do this is to just start trying - you have to take an active learning approach. In the Coldwater Creek case, you are given the beginning and ending balances sheets, the income statement and some information from the notes to the financial statements and asked to find a set of transactions that is consistent with all of the financial statements. While at first this assignment may seem quite daunting, with systematic thinking and a strong foundational understanding of accounting, this assignment can be quite rewarding.
Getting started is the hardest part, so let’s take an example that we have already done - Ralphy’s Business. First, we have the beginning and ending balance sheets:
The beginning balance sheet is nothing but zeros because the business was just starting. Here is our problem: What transactions caused Ralphy’s Business to go from the beginning balance sheet to the ending?
Some of these are not so tough. For example, Common Stock went from zero to 100. Ralphy’s Business must have issued Common Stock. Bonds Payable went from zero to $20. Ralphy’s Business must have issued some bonds.
An important caveat is needed here. The beginning and ending balance sheets only tell us the pictures at two points in time: April 1 and December 31, 20x4. Ralphy’s Business could have engaged in a lot of “round trip” transactions and we won’t be able to see them from just the beginning and ending balances. For example, Ralphy’s Business could have issued $500 of Common Stock, bought back $400, issued another $100 all between April 1 and December 31. Common Stock will still be $0 at April 1 and $200 at December 31. So what we are deducing is just the net activity in the accounts, not the total flows.
We can mitigate this problem if we have information about what the total flows were. Wait — the Income Statement tells us about total inflows (revenues) and outflows (expenses) related to operations. Let’s start there and see how far we can get.
Here is the Income Statement for Ralphy’s Business for the 9 months at issue:
Look at the Sales line. That tells us that $40 of resources flowed into the firm over these 9 months. These resources could have been cash or the rights to collect cash in the future (accounts receivable). That is, we can deduce this:
Suppose we assume all the sales were on credit. We would have this entry:
But what about cash sales? If we analyze Accounts Receivable correctly, cash sales will wash out. Think of it this way - a cash sale could be viewed as a sale on credit where the customer pays off what is due immediately. Let’s look at the T-account and see what happens. Here is what we know from the balance sheets:
If we make the entire debit to Accounts Receivable when we record the sales, we get:
Now look at the Income Statement again. Anything else there related to Accounts Receivable? How about the Bad Debts Expense:
Let’s post that entry to get:
Anything else that we can see would have affected Accounts Receivable? Not that I can see. We can see that we need a credit of $30.05 to balance:
We need an entry like this:
What type of account and what exact account do we need to debit? Go through a process of elimination, first with the type of account. Does it seem like we would debit a liability? Accounts Receivable have nothing to do with Ralphy’s Business’ liabilities. A permanent equity like Common Stock? Not likely. Retained Earnings or any temporary account that would get closed to Retained Earnings? We don’t make entries directly to Retained Earnings and we have already gone through the Income Statement and taken care of all the temporary accounts we could find.
This leaves us with an Asset. The most obvious candidate is Cash. If we see Accounts Receivable decreased and we have accounted for bad debts, the most natural assumption is that these accounts were paid. So let’s try this:
Getting to this T-account requires this Journal Entry:
Think about these entries. They are fully consistent with what we have seen for Accounts Receivable on the beginning and ending balance sheets, and with Sales and Bad Debts Expense on the Income Statement. What about Cash? It is too early in our analysis to tell because a lot of other transactions probably affected Cash, so we will just keep going and see if at the end of our work we get the right Cash ending balance.
The next item on the Income Statement is Cost of Goods Sold. What permanent accounts is it related to? Inventory? Accounts Payable? The next step would be to write down those two T-accounts and start hammering away.
That is the method. You keep going until you have a set of transactions that matches with the financial statements. It is a lot of work and requires knowing a whole lot about how accounting works. It also requires knowing a lot about how organizations transact with others in the society. But if you know those things and you practice, you can unlock a lot more information from a set of financial statements than just what they directly disclose.