FINANCIAL ACCOUNTING

Accounting is the language of business. Its the way business people set goals, measure results and evaluate performance, and its difficult to participate if you dont speak the language. What is accounting ? It is simply the means by which you measure and describe the results of economic activities. Purpose of Accounting To provide decision makers with information useful in making economic decisions. Primary goals of this course develop your understanding of accounting information, develop your ability to use it effectively. TYPES OF ACCOUNTING INFORMATION Financial Accounting Refers to information describing the financial resources, obligations, and activities of an economic entity. Financial position: describes an entitys financial resources and obligations at one point in time. Results of operations: describes its financial activities during an accounting period.

Managerial Accounting Involves the development and interpretation of accounting information intended specifically to aid management in running the business (budgeting cost accounting, etc). Tax Accounting Specialized field.

Financial Reporting for management but, primarily for people outside the organization external users

all publicly-owned corporations are required by law to make much of their financial information public. External users of financial accounting information owners, potential investors, creditors, suppliers, customers, employees, labor unions, trade associations, government agencies, tax authorities, SEC, general public, etc. Objectives of external financial reporting If you had invested in a company, or had loaned money to a company, what would you be interested in? Two things:

will the company return the money to me at a certain point in time ? return of investment, will the company pay me something for the money I invested or loaned ? return on investment (interest or dividends). So, the four basic objectives of external financial reporting are to provide information: useful in making investment and credit decisions,
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about economic resources, claims to resources, and changes in these resources and claims, useful in assessing amount and timing of future profits, useful in assessing amount and timing of future cash flows.

FORMS OF BUSINESS ORGANIZATIONS Business entities are organized to earn a profit. Legally, a profit-oriented company is one of three types: sole proprietorships, partnerships and corporations. Sole Proprietorships This form of organization is characterized by a single owner. Many small businesses are organized as sole proprietorships. Very often, the business is owned and operated by the same person.. The owner maintains title to the assets and is personally responsible, generally without limitation, for the liabilities incurred. The proprietor is entitled to the profits of the business but must also absorb any losses. Partnerships The primary difference between a partnership and a sole proprietorship is that the partnership has more than one owner. A partnership is an association of two or more persons coming together as co-owners for the purpose of operating a business for profit. The assets belong to all the partners who are personally and jointly responsible for all debts of the partnership. A partnership is often referred to as a firm. Partnerships are the least common form of business organization, probably because they often wind up with too many bosses. However, they are widely used for professional practices such as medicine, law, and public accounting. Partnerships are also used for many small businesses, especially those that are family-owned. Partnerships fall into two types : general partnerships and limited partnerships. a) General Partnerships

In a general partnership, each partner has rights and responsibilities similar to those of a sole proprietor. For example, each general partner can withdraw cash and other assets from the business at will. Also, each partner has the full authority of an owner to negotiate contracts binding upon the business. Every partner also

has unlimited personal liability for the debts of the firm. This makes a general partnership a potentially dangerous form of business organization. In summary, general partnerships involve the same unlimited personal liability as sole proprietorships. This risk is intensified, however, because you may be held responsible for your partners actions, as well as for your own. b) Limited Partnerships

The purpose of these modified forms of partnerships is to place limits upon the potential liability of individual partners. A limited partnership has one or more general partners and also one or more limited partners. The general partners are partners in the traditional sense, with unlimited personal liability for the debts of the business, and also the right to make managerial decisions. The limited partners are basically passive investors. They share in the profits of the business, but do not participate actively in management and are not personally liable for debts of the business. Their maximum exposure is limited to the loss of the amounts they have invested in the partnership. A limited liability partnership is a relatively new form of business organization. In this type of partnership, each partner has unlimited personal liability for his or her own professional activities, but not for the actions of other partners. Unlike a limited partnership, all of the partners of a limited liability partnership may participate in management of the firm.

Corporations Nearly all large businesses and many small ones are organized as corporations. What is a corporation ? A corporation is a legal entity, having an existence separate and distinct from that of its owners. The owners of a corporation are called stockholders (or shareholders), and their ownership is evidenced by transferable shares of capital stock. A corporation is more difficult and costly to form than other types of organizations. The corporation must obtain a charter from the state in which it is formed, and also must receive authorization from that state to issue shares of capital stock.

As a separate legal entity, a corporation may own property in its own name. The assets of a corporation belong to the corporation itself, not to the shareholders. A corporation has legal status in court it may sue and be sued as if it were a person. A corporation may enter into contracts, is responsible for its own debts, and pay income taxes on its earnings. On a daily basis, corporations are run by salaried professional managers, not by the stockholders. The stockholders are primarily investors, rather than active participants in the business. The top level of a corporations management is the board of directors. These directors are elected by the stockholders, and are responsible for hiring the other professional managers. In addition, the directors make major policy decisions, including the extent to which profits of the corporation are distributed to stockholders. The transferability of corporate ownership, together with professional management, gives corporations a greater continuity of existence than other forms of organizations. Individual stockholders may sell, give or bequeath their shares to someone without disrupting business operations. Thus, a corporation may continue its business operations indefinitely, without regard to changes in ownership. Stockholders in a corporation have no personal liability for the debts of the business. If a corporation fails, stockholders potential losses are limited to the amount of their equity in the business. To investors in large companies and to the owners of many small businesses limited personal liability is the greatest advantage of the corporate form of business organization. Creditors have claims against only the assets of a corporation, not the personal assets of the corporations owners.

INVESTMENTS AND WITHDRAWALS BY THE OWNER IN A SOLE PROPRIETORSHIP The owner of an unincorporated business may at any time invest assets in or withdraw assets from the business. These investment transactions cause changes in the amount of the owners equity, but they are not considered revenue or expenses of the business.

Investments of assets by the owner are recorded by debiting the asset accounts and crediting the owners capital account. This transaction is not viewed as revenue, because the business has not sold any merchandise or rendered any service in exchange for the assets received. The income statement of a sole proprietorship does not include any salary expense representing the managerial services rendered by the owner. One reason for not including a salary to the owner-manager is that individuals in such positions are able to set their salaries at any amount they choose. The use of an unrealistic salary to the proprietor would tend to destroy the usefulness of the income statement for measuring the profitability of the business. Thus, accountants regard the owner-manager as working to earn the entire net income of the business, rather than as working for a salary. Even though the owner does not technically receive a salary, he or she usually makes withdrawals of cash from time to time for personal use. These withdrawals reduce the assets and owners equity of the business, but they are not expenses. Expenses are incurred for the purpose of generating revenue, and withdrawals by the owner do not have this purpose.. Withdrawals could be recorded by debiting the owners capital account. However, a clearer record is created if a separate drawing account is debited. Debits to the owners drawing account result from such transactions as : 1. 2. 3. withdrawals of cash, withdrawals of other assets, payment of the owners personal bills out of company funds.

As investments and withdrawals by the owner are not classified as revenue and expenses, they are not included in the income statement.

INVESTMENTS AND WITHDRAWALS BY PARTNERS IN A PARTNERSHIP In most respects, partnership accounting is similar to that in a sole proprietorship except that there are more partners. As a result, a separate capital account and drawing account is maintained for each partner. Partnerships, like sole proprietorships, recognize no salaries expense for services provided to the organization by the partners. Amounts paid to partners are recorded by debiting the partners drawing account. The statement of owners equity is replaced by a statement of partners equity, which shows separately the changes in each partners capital account.
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INVESTMENTS IN AND WITHDRAWALS FROM A CORPORATION In the balance sheet of a corporation, the term stockholders equity is used instead of owners equity. The stockholders equity section of a corporate balance sheet must clearly indicate the source of the owners equity. The two basic sources of owners equity are (1) investment by the stockholders (paid-in capital), and (2) earnings from profitable operation of the business (retained earnings). When stockholders invest cash or other assets in the business, the corporation issues to them in exchange shares of capital stock as evidence of their ownership. In the simplest case, capital invested by the stockholders is recorded in the corporations records by a credit to an account entitled Capital Stock. The capital paid in by stockholders is regarded as permanent capital, not subject to withdrawal. Stockholders are not allowed to withdraw cash or any other asset from the corporation. If a corporation has sufficient cash, a distribution of profits may be made to stockholders. Distributions of this nature are called dividends and decrease both total assets and total stockholders equity. Because dividends are regarded as distribution of earnings, the decrease in stockholders equity is reflected in the Retained Earnings account. Thus, the amount of retained earnings at any balance sheet date represents the accumulated earnings of the company since the date of incorporation, minus any losses, and minus all dividends. Some people mistakenly believe that retained earnings represents a fund of cash available to a corporation. Retained earnings is not an asset; it is an element of the stockholders equity. Although the amount of retained earnings indicates the portion of total assets which are financed by earning and retaining net income, it does not indicate the form in which these resources are currently held. The resources generated by retaining profits may have been invested in land, buildings, equipment, or any other kind of asset. The total amount of cash owned by a corporation is shown by the balance of the Cash account, which appears in the asset section of the balance sheet Cash dividends The term dividends, when used by itself, is generally understood to mean a distribution of cash by a corporation to its stockholders. Dividends are stated as a specific amount per share of capital stock, e.g; a dividend of $ 1 per share. The

amount received by each stockholder is in proportion to the number of shares owned. Thus, a shareholder who owns 100 shares will receive a check for $ 100. Dividends are paid only through action by the Board of Directors. The Board has full discretion to declare a dividend or to refrain from doing so. Once the declaration of a dividend has been announced, the obligation to pay the dividend is a current liability of the corporation and cannot be rescinded.

Stock dividends Stock dividend is a term used to describe a distribution of additional shares of stock to a companys stockholders in proportion to their present holdings. The dividend is payable in additional shares of stock rather than in cash. Three primary financial statements

Balance sheet Gives the financial position of a company at a given point in time (usually at yearend) a snap-shot showing the assets (what the company owns), the liabilities (what the company owes), and the amount of the owners equity. Income Statement Indicates the profitability of a company over a certain period of time a movie or film showing the revenues, expenses and profits (or losses) of the company. Statement of Cash Flows Summarizes the cash receipts and cash disbursements of the business over the same period of time as the income statement.
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Basic purpose of these financial statements To assist users in evaluating the financial position, the profitability, and the future prospects of a company. These financial statements must be comparable, accurate and reliable. Therefore, financial statements must be prepared in conformity with certain rules which are referred to as GAAPs (Generally Accepted Accounting Principles). They must also be prepared by professionals within the company using internal control systems, and audited by external professionals (CPAs, ExpertsComptables, Chartered Accountants, etc).

Generally Accepted Accounting Principles (GAAPs)

Accounting information that is communicated externally to investors and creditors must be prepared in accordance with standards that are understood by both the preparers and users of that information. These standards are called Generally accepted accounting principles, or GAAPs. These principles provide the general framework for determining what information is included in financial statements and how this information is to be prepared and presented. GAAPs include broad principles of measurement and presentation, as well as detailed rules that are used by professional accountants in preparing accounting information and financial reports. Accounting principles vary somewhat from country to country. The phrase generally accepted accounting principles refers to the accounting concepts in use in the United States. However, the principles in use in Canada, Great- Britain, and a number of other countries are quite similar. Also, foreign companies that raise capital from U.S. investors usually issue financial statements in conformity with GAAPs. Several international organizations currently are attempting to establish greater uniformity among the accounting principles in use around the world in order to

facilitate business activity that increasingly is carried out in more than one country. In the U.S., two organizations are particularly important in establishing generally accepted accounting principles : the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). Not all of what are called generally accepted accounting principles can be found in the official pronouncements of the standard-setting organizations. The business community is too complex and changes too quickly for every possible type of transaction to be covered by an official pronouncement. Thus, practicing accountants often must account for situations that have never been addressed by the FASB. There is, however, a consensus among accountants and informed users of financial statements as to what these principles are. We shall now discuss briefly the major principles that govern the accounting process. The accounting entity concept One of the basic principles of accounting is that information is compiled for a clearly defined accounting entity. An accounting entity is any economic unit which controls resources and engages in economic activities. An individual is an accounting entity. So is a business enterprise, whether organized as a proprietorship, partnership or corporation. An accounting entity may also be defined as an identifiable economic unit within a larger accounting entity. For example, the Minute-Maid Division of The Coca-Cola Company may be viewed as an accounting entity separate from Cokes other activities. Although there is considerable flexibility in defining an accounting entity, one must be careful to use the same definition in the measurement of assets, liabilities, stockholders equity, revenue and expenses. An income statement would not make sense, for example, if it included all the revenue of The Coca-Cola Company but listed only the expenses of the Minute-Maid Division. This principle is extremely important in the case of allocation of revenue or expenses among different profit centers or business segments sharing joint corporate facilities, for example. The going-concern assumption An underlying assumption in accounting is that an accounting entity will continue in operation for a period of time sufficient to carry out its existing commitments. In general, the going-concern assumption justifies ignoring the liquidating values in presenting assets and liabilities in the balance sheet.
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For example, suppose that a company has just purchased a three-year insurance policy for $ 6,000. If we assume that the business will continue for three years or more, we will consider the $ 6,000 cost of the insurance as an asset (prepaid expense) which provides services to the business over a three-year period. On the other hand, if we assume that the insurance is to terminate in the near future (because we do not assume the going-concern process), the insurance policy should be recorded at its cancellation value (the amount of cash that can be recovered from the insurance company as a refund), say $ 5,500. Of course, although the going-concern assumption is justified in most normal situations, it should not be applied when it is not in accord with the facts. In case of real liquidation of a company, accountants should use the current liquidating values of the assets and the liabilities at the amounts required to settle the debts immediately, and not apply the going-concern assumption. The time-period principle The users of financial statements need information that is reasonably current and that is comparable to the information relating to prior accounting periods. Therefore, for financial reporting purposes, the life of a business must be divided into a series of relatively short accounting periods of equal length (at least, annually; for publicly-owned companies, at least quarterly; for most well-run companies, monthly). This concept is called the time-period principle. The stable-dollar assumption The stable-dollar assumption means that money is used as the basic measuring unit for financial reporting. The dollar, or any other currency unit, is a measure of value. This means that it indicates the relative price (or value) of different goods and services. When accountants add or subtract dollar values originating in different years, they imply that the dollar is a stable unit of measure, just as the meter, the liter, or the kilogram are stable units of measure. Unfortunately, the dollar (as well as the other currencies) is not a stable measure of value. (Inflation). To compensate for the shortcomings of the stable-dollar assumption, the FASB asks large corporations voluntarily to prepare supplementary information disclosing the effects of inflation upon their financial statements. In periods of low inflation, this assumption does not cause serious problems. During periods of severe inflation, however, the assumption of a stable dollar may cause serious distortions in accounting information.
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We will see later what the new IFRS (International Financial Reporting Standards) say about this problem. The objectivity principle The term objective refers to measurements that are unbiased and subject to verification by independent experts. Accountants rely on various kinds of evidence to support their financial measurements, but they seek always the most evidence available. Invoices, contracts, paid checks, and physical counts of inventory are examples of objective evidence. Despite the goal of objectivity, it is not possible to insulate accounting information from opinion and personal judgment. For example, the cost of a depreciable asset can be determined objectively but not the periodic depreciation expense. Depreciation expense is simply an estimate based upon estimates of the useful life and the residual value of the asset, and a judgement as to which depreciation method is most appropriate. Such estimates and judgements can produce significant variations in the measurement of net income. Objectivity in accounting has its roots in the quest for reliability. Accountants want to make their economic measurements reliable and, at the same time, as relevant to decision-makers as possible. There is a constant necessity to make a compromise between reliability and relevance of financial information. Asset valuation : the cost principle Both the balance sheet and the income statement are affected by the cost principle. Assets are initially recorded at cost, and no adjustment is made to this valuation in later periods, except to allocate a portion of the original cost to expense as the assets expire. At the time an asset is originally acquired, its cost represents the fair market value of the goods or services exchanged. With the passage of time, however, the fair market value of such assets as land or buildings may change greatly from their original, or historical, cost. These later changes in fair market value generally have been ignored in the accounts, and the assets have continued to be valued in the balance sheet at historical cost (less the accumulated depreciation). The newly issued International Financial Accounting Standards, however, are taking these changes in fair market value into consideration as we will see later on. Measuring revenue : the realization principle
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When should revenue be recognized ? When it is earned. However, the earning of revenue usually is an extended economic process and does not actually take place at a single point in time. Some revenue, such as interest revenue, is directly related to time periods. It is, then, easy to determine how much revenue has been earned by computing how much of the earning process is complete. However, the earning process for sales revenue relates to economic activity rather than a specific period of time. In a manufacturing business, for example, the earning process involves (1) acquisition of raw materials, (2) production of finished goods, (3) sales of the finished goods, and (4) collection of cash from credit customers. In this example, there is little objective evidence to indicate how much revenue has been earned during the first two stages of the earning process. Therefore, accountants usually do not recognize revenue until the revenue has been realized. Revenue is realized when both of the following conditions are met : (1) the earning process is essentially complete, and (2) objective evidence exists as to the amount of the revenue earned. I most cases, the realization principle indicates that revenue should be recognized at the time goods are sold or services are rendered. At this point , the business has essentially completed the earning process and the sales value of the goods or services can be measured objectively. After the sale, the only step that remains is to collect from the customer. Measuring expenses : the matching principle Revenue, the gross increase in net assets resulting from the production and sale of goods or services is offset by expenses incurred in bringing the firms output to the point of sale. The measurement of expenses occurs in two stages : (1) measuring the cost of goods and services that will be consumed or expire in generating revenue and (2) determining when the goods and services acquired have contributed to revenue and their cost thus becomes an expense. The second aspect of the measurement process is often referred to as matching costs and revenue and is fundamental to the accrual basis of accounting. Costs are matched with revenue in two major ways : 1. 2. in relation to the product sold or service rendered, in relation to the time period during which revenue is earned.

The consistency principle The principle of consistency implies that a particular accounting method, once adopted, will not be changed from period to period. This assumption is important
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because it assists users of financial statements in interpreting changes in financial position and changes in net income. (ex : depreciation methods). The principle of consistency does not mean that a company should never make a change in its accounting methods. In fact, a company should make a change if a proposed new accounting method will provide more useful information than does the method presently in use. But when a significant change in accounting methods does occur, the fact that a change has been made and the dollar effects of the change should be fully disclosed. The disclosure principle Adequate disclosure means that all material and relevant facts concerning financial position and the results of operations are communicated to users. This can be accomplished either in the financial statements or in the notes accompanying the statements. Adequate disclosure does not require that information be presented in great detail; it does require, however, that no important facts be withheld. Even significant events which occur after the end of the accounting period but before the financial statements are issued may need to be disclosed. The key point to bear in mind is that the supplementary information should be relevant to the interpretation of the financial statements. Materiality The term materiality refers to the relative importance of an item or an event. Accountants are primarily concerned with significant information and are not overly concerned with those items which have little effect on financial statements. (Pencil sharpener, wastepaper basket, stapler : asset with corresponding depreciation, or expense ?) Materiality of an item is a relative matter. What is material for one business unit may not be material for another. Materiality of a, item may depend not only on its amount but also on its nature. In summary : An item is material if there is a reasonable expectation that knowledge of it would influence the decisions of prudent users of financial statements.

Conservatism as a guide in resolving uncertainties

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Although the concept of conservatism may not qualify as an accounting principle, it has long been a powerful influence upon asset valuation and income determination. Conservatism is most useful when matters of judgment( or estimates are involved. When some doubt exists about the valuation of an asset or the realization of a gain, accountants traditionally select the accounting option which produces a lower net income for the current period and a less favourable financial position.

COMPANY XYZ BALANCE SHEET AS AT DECEMBER 31, 2009

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ASSETS Current Assets Cash Marketable Securities Notes Receivable Accounts Receivable Inventory Prepaid Expenses Total Current Assets Fixed Assets Land Buildings Equipment Cars & Trucks Total Fixed Assets Other Assets Goodwill Patents, etc. TOTAL ASSETS

LIABILITIES + EQUITY Current Liabilities Notes Payable Accounts Payable Other Payables S-T portion of L-T N/P Unearned Revenue Total Current Liabilities Long-Term Liabilities Notes Payable Bonds Payable Total Long-Term Liabilities Total Liabilities Equity Capital Retained Earnings Total equity TOTAL LIABILITIES + EQUITY

BASIC ACCOUNTING EQUATION

TOTAL ASSETS = TOTAL LIABILITIES + EQUITY Therefore: TOTAL ASSETS TOTAL LIBILITIES = EQUITY

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ASSETS = WHAT THE COMPANY OWNS LIABILITIES AND EQUITY = WHAT THE COMPANY OWES LIABILITIES = WHAT THE COMPANY OWES TO OUTSIDE PEOPLE EQUITY = WHAT THE COMPANY OWES TO ITS OWNERS

DEBITS AND CREDITS Accounting entries: Balances: amount recorded on the left side: debit (Dr) amount recorded on the right side: credit (Cr)

if Dr total higher than Cr total debit balance if Dr total lower than Cr total credit balance

Debit balances in Assets accounts: all assets accounts normally have debit balances assets are located on the left side of the B/S therefore, any increase in assets is recorded on the left (debit) side of the Asset Account Increases (Debits) Decreases (Credits)

a/c.

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Credit balances in Liabilities and Equity accounts: liabilities and equity accounts normally have credit balances liabilities and equity are located on the right side of the B/S therefore, any increase in liabilities and equity is recorded on the right (credit) side of the a/c. Liability or Equity Account Decreases (Debits) Increases (Credits) DEBIT & CREDIT RULES Assets Increases (Dr) Decreases (Cr) Dr balance Liabilities & Equity Increases (Cr) Decreases (Dr) Cr balance

DOUBLE ENTRY ACCOUNTING EQUALITY OF DEBITS AND CREDITS Every transaction is recorded by equal amounts of debits and credits. Assets = Liabilities + Equity Debit balances = Credit balances To maintain the equation in balance, any change on left side of equation (assets) must be accompanied by an equal change on right side (liabilities or equity) 10 = 6 + 4 12 = 8 + 4 10 = 6 + 4 8=4+4

If there is a change on the left side without any change on the right side, this change is balanced by an equal change (of the opposite sign) on the left side. 10 = 6 + 4 12 2 = 6 + 4

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The same applies for changes on the right side with no change on the left side. 10 = 6 + 4 10 = 8 2 + 4 1. Michael Mc Bryan sets up his company and deposits $ 50,000 in a bank account. 2. He buys some office equipment for $ 5,000 cash. 3. He buys a machine on credit for $ 15,000. 4. He pays half of his debt to his supplier. 5. He returns some office equipment, worth $ 1,000, which proved defective, amount receivable within 30 days. 6. He collects the $ 1,000. Journal Entries Each transaction is recorded/entered in a Journal. Sept. 1 Sept. 3 Sept. 5 Sept. 15 Cash Capital Office equipment Cash Machinery & Equipment Accounts payable Accounts payable Cash Accounts receivable Office equipment Cash Accounts Receivable Ledger accounts or T- accounts 5,000 5,000 15,000 15,000 7,500 7,500 1,000 1,000 1,000 1,000 50,000 50,000

Sept. 17 Oct. 17

INCOME STATEMENT

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Statement of Income Profit & Loss Statement (P&L) Statement of Earnings Revenues: increases in Cs assets results in positive cash flows Expenses: decreases in Cs assets results in negative cash-flows Net Result: difference between the 2. If Revenues are higher than Expenses: Net Income If Expenses are higher than Revenues: Net Loss. Name of business entity Name of statement : Income Statement For period ending (rather than point in time).

COMPANY XYZ INCOME STATEMENT FOR THE YEAR ENDING DECEMBER 31, 2009 REVENUES/NET SALES COST OF GOODS SOLD GROSS PROFIT OPERATING EXPENSES - Selling Expenses - General and Administrative expenses (G&A) - Total Operating Expenses

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OPERATING INCOME NON-OPERATING ITEMS INCOME BEFORE INCOME TAXES INCOME TAXES NET INCOME NET SALES = sales price of goods sold or services rendered COST OF GOODS SOLD = cost price of goods sold or of services rendered, including all costs to bring the goods into the company. GROSS PROFIT = Net Sales COGS OPERATING EXPENSES

SELLING: all costs and expenses related to the marketing, selling of the products or services, including all costs to bring the goods to the customer. G&A: all other costs and expenses (general management, secretarial, accounting, rent, insurance, utilities, depreciation, etc). OPERATING INCOME = GP Operating Expenses NON-OPERATING ITEMS = primarily Interest income and Interest expense INCOME BEFORE INCOME TAXES = Operating Income +/- Non-operating items INCOME TAXES = Taxes on above amount NET INCOME = IBT (EBT) Income Taxes So: Net Sales COGS = GP GP Operating Expenses = Operating Income

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Operating Income Non-operating items = EBT EBT Income taxes = Net income Debit and Credit rules for Income Statement As Revenues increase Assets, they are credited. The counterpart is a debit to Cash (for cash sales) or to Accounts Receivable (for sales on account). As Expenses (incl. COGS) reduce Assets, they are debited. The counterpart is a credit to cash (for expenses paid cash) or to Accounts Payable or Accrued Liabilities (for all expenses on account). Sept. 1 - The company buys inventory on account worth $ 150,000. Sept. 2 - The company sells on account finished products for $ 100,000, costing $ 75,000. Sept. 3 Rent for the month of September, amounting to $ 2,000, is paid cash. Sept. 5 Office Equipment, worth $ 10,000 is purchased on account. Sept. 10 The company receives the insurance bill for September in the amount of $ 1,500, payable within 30 days. Sept. 30 Salaries for the month, amounting to $ 12,500, will be paid on October 3 .

Sept. 1 Sept. 2 Sept. 2 Sept. 3

Inventory Accounts Payable Accounts Receivable Sales Cost of Goods sold Inventory Rental Expense Cash

150,000 150,000 100,000 100,000 75,000 75,000 2,000 2,000

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Sept. 5 Sept. 10 Sept. 30

Office Equipment 10,000 Accounts Payable Insurance Expense Insurance Payable Salaries Expense Salaries payable 12,500 1,500

10,000 1,500 12,500

What is the pre-tax profit for the month of September ? Lets now go back to our Balance Sheet. Gives the financial position of a business entity at a specific date. Assets Assets Cash Marketable securities N/R A/R Inventories Prepaid Expenses Land Buildings Equipment Cars, trucks, etc. Other Assets Liabilities N/P A/P Short-term & Long-term Name of business entity Name of financial statement (Balance Sheet) B/S date Liabilities + Owners equity

Liquid assets (easily convertible into cash or used in business ops)

More permanent assets

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Owners equity Capital Retained Earnings Assets economic resources owned by a business, expected to benefit future operations, physical: cash land- buildings, etc, not physical: claims on rights A/R, investments, etc. valuation of assets at cost (cost principle) Liabilities : debts to creditors purchases of supplies and services on account (A/P) borrowings of money (N/P).

Creditors claims have priority over those of owners. Owners equity amount of money invested by the owners (capital), plus increases (profits) or decreases (losses), owners claims to assets of the business once liabilities have been settled.

FINANCIAL ASSETS Not just Cash, but also assets easily and directly convertible into cash. Cash Marketable securities Receivables. Cash money on deposit in banks or held in company (notes, coins, checks, money orders, travelers checks, credit card slips, petty cash funds) first on B/S : most liquid asset valued at face value Marketable Securities

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investments in high quality stocks or bonds of publicly owned companies (traded daily). readily marketable at quoted market prices. generate dividends or interest. almost as liquid as cash. valued at current market price (mark to market). Receivables Notes Receivable Accounts Receivable

Notes Receivable: unconditional promise in writing to pay on demand or at a future date a definite sum of money, generally with interest. Valued at face amount of the note. Accounts Receivable: largest financial asset of many merchandising companies. Arise whenever a sale is made on credit. Relatively liquid assets, usually converting into cash within a period of 30 to 60 days. Valued at net realizable value. Uncollectible accounts No business wants to sell merchandise on account to customers who will be unable to pay. Many companies maintain their own credit departments that investigate the creditworthiness of each prospective customer. Nonetheless, if a company makes credit sales to hundreds, maybe thousands of customers, some accounts inevitably will turn out to be uncollectible. An account receivable which has been determined to be uncollectible is no longer an asset. The loss of this asset represents an expense, termed Uncollectible Accounts Expense. The counterpart is an Allowance for Doubtful accounts which will appear on the balance sheet as a deduction from the accounts receivable. The net balance is the net realizable value. Evaluating the quality of accounts receivable Collecting accounts receivable on time is important. A past-due account is a candidate for write-off as a credit loss. To help judge how good a job a company is doing in collecting its receivables, we use the A/R turnover rate how many times the companys average investment in A/R was converted into cash during the year :

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A/R turnover rate = Annual net sales Average A/R Avg. number of days it takes to collect A/R : Nr of days = 365 days A/R T/O rate INVENTORIES One of the largest current assets of a retail store or of a wholesale business. Their sale is the major source of revenue. Inventory consists of all goods owned and held for sale to customers. Inventory is converted into cash within the operating cycle: inventory A/R Cash. Current asset, right after A/R. In a manufacturing operation, 3 types of inventory: Finished Products (ready to sell) Work-in-process (WIP in process of being manufactured) Raw materials (plus components). Inventory is shown on B/S at its cost. As items are sold from inventory, their costs are removed from the B/S and transferred to the Income Statement (COGS). There are several different methods of pricing inventory and measuring COGS. Purchases of merchandise are recorded in the same manner under all the inventory valuation methods. The difference in these methods lies in determining which costs should be removed from Inventory when the merchandise is sold. Indeed, a company often has in its inventory units of a given product which were acquired at different costs (different dates, different suppliers, different purchase prices). Basically, four different valuation methods: specific identification,

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average cost, FIFO (first-in, first-out), LIFO (last-in, first-out). Evaluating the liquidity of inventory

How many times does the inventory turn over in a year ? Inventory T/O rate = Cost of goods sold Avg. Inventory Nr of days = 365 days Inventory T/O

Operating cycle : How long it takes to convert inventory sold into cash. Inventory days + A/R days PREPAID EXPENSES Payments in advance are often made for such items as insurance, rent, office supplies, and advertising supplies. If the advance payment (or prepayment) will benefit more than just the current accounting period, the cost represents an asset rather than an expense. The cost of this asset will be allocated to expense in the accounting periods in which the services or the supplies are used. Prepaid expenses are assets: they become expenses only as the goods or services are used up.

FIXED ASSETS Plant assets/Property, Plant & Equipment.

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Describes long-lived assets acquired for use in business operations rather than for resale to customers. Largest category of assets in most balance sheets. Fixed assets are similar to long-term prepaid expenses : land, buildings, plant and office equipment, cars & trucks, etc. They represent an advance purchase for many years of service. Cost of plant assets includes all expenditures that are reasonable and necessary for getting these assets to the desired location and ready for use (sales taxes, transportation costs, installation costs, etc. As these services are utilized by the business, the cost of these plant assets is gradually transferred to expenses through depreciation. Land is not depreciated it is considered to be there forever. All other fixed assets are depreciated over the expected life of the asset. These assets are expected to be of use to a company for only a limited period of years. Depreciation is the allocation of the cost of these assets to expense in the period in which services are rendered to the company from these assets. The basic purpose of depreciation is to achieve the matching principle, i.e. offset revenues of the accounting period with costs of goods and services being consumed in the effort of generating those revenues. Causes of depreciation: physical deterioration which results primarily from the use of those assets, obsolescence: means the process of becoming out of date or obsolete (computers, cars, Coke vending machines, etc.) Methods of computing depreciation - basically two methods:

Straight-line method : allocates an equal portion of depreciation expense to each period of the assets useful life.

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For an asset that has an estimated useful life of 5 years, the depreciation will be 1 divided by 5 = 20 %.

Accelerated depreciation : means that larger amounts of depreciation are recognized in the early years of the assets life and smaller amounts in later years.

Over the entire life of the asset, however, both straight-line method and accelerated method recognize the same total amount of depreciation. There is only one straight-line method, but there are several different accelerated depreciation methods (most commonly used are the double-declining method 200 % - or the 150 % declining method). For instance, if the life of the asset is 5 years, the straight-line method calls for a yearly depreciation of 20 %. By using the double-declining method, the company would use 40 % (20 % x 2), and in the 150 %, the depreciation rate would be 30 % (20 % x 1.5). Depreciation methods in use should be disclosed in the notes accompanying the financial statements. The straight-line method is generally used in financial statements. The accelerated method is generally used for income tax returns (higher charges to expenses, lower reported net income lower taxes). Different depreciation methods can be used for financial statements and for income tax returns. The depreciation of fixed assets is recorded by a debit to Depreciation Expenses and a credit to an account called Accumulated depreciation which appears on the B/S as a reduction of the fixed asset account. The B/S will then show the Net book value of the asset. OTHER ASSETS No physical substance - intangible. Goodwill, patents, trademarks, franchises, copyrights.

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Are amortized over the life of the asset the same way fixed assets are depreciated. Lets now go over to the right side of the balance sheet : how the companys assets have been financed, what the company owes. There are two ways of financing the assets:

liabilities : what the company owes to outside people banks, suppliers, creditors, employees, government, etc. equity : what the company owes to its owner(s) or to its stockholders. LIABILITIES Debts or obligations arising from past transactions or events, requiring settlement at a future date. What a company owes to banks, suppliers, employees, state, etc. Most liabilities are for a definite amount (N/P, A/P, Interest payable, Salaries payable, etc). Sometimes, they have to be estimated (e.g. warranty obligations on cars). Current Liabilities Obligations that must be repaid within one year. If not, are classified as Long-Term Liabilities. Four major classifications:

1. 2. 3.

Accounts payable : short-term obligations to suppliers for purchase of merchandise.

Other payables : short-term obligations to suppliers of goods or services other than merchandise. Accrued liabilities (accruals) : arise from recognition of expenses for

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which payment will be made at some future date (matching principle), e.g. : Interest payable : cost of borrowing Income taxes payable : income taxes accrue as profits are earned. Amount is estimated at end of period. Payroll liabilities : vacation pay, social security, 13th month or year-end bonus, unemployment taxes, etc. Unearned Revenue : arises when customers pay in advance for services that will be rendered at a later date (airline companies pre-selling flight tickets).

4.

Current portion of Long-Term Debt :

L-T debts are often payable in quarterly or annual installments. The principal amount due within one year is regarded as current liabilities and the balance is classified as long-term. Long-term liabilities Primarily, Notes Payable and Bonds Payable. Notes Payable Are issued whenever bank loans are obtained. Usually require borrower to pay interest charge. Interest is stated separately from principal amount of loan. Generally arise from major expenditures (acquisition of plant assets, purchase of another company). Company should disclose in its financial statements (accompanying notes) the interest rates and the maturity dates of all L-T Notes payable. Bonds Payable When a corporation needs to raise large amounts of money to finance big projects, it generally sells additional shares of capital stock or issues bonds payable. The issuance of bonds payable is a technique of splitting a very large loan into a great many units, called bonds.

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Each bond represents a long-term, interest-bearing note payable, usually in face amount of $ 1,000. Bonds are sold to the investing public, enabling many different bondholders to participate in the loan. Bonds are usually very long-term notes, maturing in 20 to 40 years. Bonds are transferable : bondholders may sell their bonds to other investors at any time. Bonds generally call for semi-annual interest payments to bondholders with interest computed at a specified contractual rate. Bonds are quoted daily as a percentage of their face/maturity value on the bond markets. A bond quoted at 98 means that the quoted price is $ 985. What are the primary factors that determine the market value of a bond ? relationship of the bonds contractual interest rate to the market interest rate for similar investments bond prices vary inversely with market interest rates, length of time until the bond matures, investors confidence that the issuing company has the financial strength to make all future interest and principal payments promptly. Advantage of bond financing The main advantage resides in the fact that the bond interest paid to bondholders is tax-deductible whereas dividends are not. EQUITY Sole proprietorships : Michael Bryan, Capital Partnerships : Tom Brown, Capital Jo White, Capital Bill Green, Capital 40,000 60,000 50,000 150,000 Corporations and Stockholders Equity 50,000

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Corporation: owners, Legal entity with rights and responsibilities separate from those of its Owners of a corporation are called stockholders (shareholders). Assets belong to the corporation itself, not to the stockholders, Responsible for its own debts, Has status in court may enter into contracts, Must pay income taxes on its earnings.

Why do businesses incorporate ? Two main reasons: limited stockholder liability: stockholders have no personal liability for the debts of a corporation, transferability of ownership: transferability of shares of capital stock which can be bought and sold on stock markets. Stockholders Each stockholders ownership is determined by the number of shares owned. (Coca-Cola) Basic rights: vote for Directors and on certain key issues (one share = one vote), participate in dividends declared by the Board, share in the distribution of assets in case of liquidation of the corporation. Shareholders meetings usually, once a year, usually, 1 to 2 % of shareholders proxies are sent by those shareholders not being able to attend. Stockholders Equity Two basic sources: Investments by stockholders = paid-in capital Increase in stockholders equity arising from profitable operations via Retained Earnings.

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Capital invested by the stockholders is recorded in the companys accounts by a credit to an account called Capital Stock. Increase in stockholders equity arising from profitable operations is called Retained Earnings. Stockholders Equity Capital Stock Retained Earnings Total stockholders equity Issuance of capital stock The Articles of Incorporation specify the number of shares a corporation is authorized to issue by the State of incorporation. If the shares are sold to the public, they must be approved by the SEC. The number of shares which have been issued (in the hands of the stockholders) are called outstanding shares; Par value : represents the legal capital per share, i.e. the amount below which the stockholders equity cannot be reduced except by losses from the business. This means that the Directors cannot declare a dividend that would cause the total stockholders equity to fall below the par value of the outstanding shares. The par value is generally insignificant ($ 1 Ford Motor C - $ 0.01 for Compaq - $ 0.001 for Microsoft). The par value of a share is not an indication of its market value. Issuance of stock At par : Above par: Cash Cash Capital stock $ 100,000 Capital stock Additional paid-in capital $ 20,000 $ 20,000 $ 20,000 $ 80,000 $ 1,000,000 600,000 ---------------$ 1,600,000

Additional paid-in capital is not a profit to the corporation. It is part of the invested capital and added to the corporations stock to show the total paid-in capital.

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Common stock and Preferred stock Many corporations issue different types (classes) of stock with different rights and opportunities. The basic type is called Common Stock : traditional rights of ownership (voting, participation in dividends, residual claim to assets in case of liquidation). Every corporation has Common stock. Some corporations also have one or more types of Preferred Stock.

Characteristics of preferred stock

1.

Stocks preferred as to dividends : entitled to receive each year a dividend of a specified amount before any dividend is paid on common stock, preferred stocks generally have a par value much higher than common stocks ($ 100) and the dividend is usually stated as a $ amount, or as a % of par value, so a 9 %, $ 100 preferred stock means that the preferred dividend will amount to 9 % of $ 100 = $ 9, preferred stocks generally offer more assurance that investors will receive dividends.

2.

Cumulative preferred stock : the dividend preference is generally cumulative if all, or any part of the dividend on preferred stock is omitted in a given year, the amount omitted is said to be in arrears and must be paid in a subsequent year before any dividend can be paid on common stock.

3. 4.

Stock preferred as to assets : preference as to distribution of assets in case of liquidation of the company. Callable preferred stock : most preferred stocks include a call provision which grants the issuing corporation the right to repurchase the stocks from shareholders at a stipulated call price (slightly higher than par value). 5. Convertible preferred stock :

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to add attractiveness to preferred stocks, corporations sometimes offer a conversion privilege which entitles the preferred stockholders to exchange their preferred stock for common stock in a stipulated ratio.

BOOK VALUE PER SHARE OF COMMON STOCK The book value per share of common stock corresponds to the net assets represented by one share of common stock. Book value (per share of common stock) = Total stockholders equity # of shares of CS outstanding Capital stock (4,000 shares) Addit. Paid-in capital Retained earnings Total stockholders equity Book value = $ 120,000 = $ 30 4,000 === Book value when a C has common stock and preferred stock : deduct the call price of the entire preferred stock and all dividends in arrears, divide the remaining balance of stockholders equity by the number of common shares outstanding. MARKET VALUE Prices at which shares change hands represent the current market price of the stock. This market price can differ substantially from par value and from book value. After the shares are issued, they belong to the stockholders, not to the issuing company. Thus, changes in the market price affect the financial position of the stockholders, not of the issuing company. Financial Analysis and Stock Price
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4,000 40,000 76,000 120,000

Assume that a company has rapidly been increasing net sales and earnings, and also earns high returns on assets and stockholders equity. Is its stock a good buy at the present ? Stock prices, like p/e ratios, are a measure of investors expectations. A company may be highly profitable and growing fast. But if investors had expected even better performance, the market price of its stock may decline. Similarly, if a troubled companys losses are smaller than expected, the price of the stock may rise. In financial circles, evaluating stock price by looking at the underlying profitability of the company is termed fundamental analysis. This approach to investing works better in the long run than in the short run. In the short run, stock prices can be significantly affected by many factors, including short-term interest rates, current events, political events, fads, and rumors. But, in the long run, good companies increase in value. Successful investing requires more than an understanding of accounting concepts. It requires experience, judgment, patience, and the ability to absorb some losses. But a knowledge of accounting concepts is invaluable to the long-term investor and it reduces the risk of getting burned. (Financial Accounting The Basis for Business Decisions Williams, Haka, Bettner Mc Graw BOOK VALUE and MARKET PRICE Book value is used in evaluating the reasonableness of the market price of a stock. If the market price is way above the book value, investors believe that management has created a business worth substantially more than the historical cost, which is the sign of a successful company. If the market price is below the book value, investors believe that the business is worth less than the historical cost. Thus, the relationship between book value and market price is one measure of investors confidence in a companys management. EARNINGS PER SHARE

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Another very important, and one of the most widely used accounting statistics, is earnings per share of common stock EPS. Investors who buy or sell stock in a corporation need to know the annual earnings per share. Stock-market prices are quoted on a per-share basis. If you are considering investing in a companys stock at a price of $ 100 per share, you need to know the earnings per share and the annual dividend per share to decide whether this price is reasonable. To compute earnings par share, the common stockholders share of the companys net income is divided by the average number of common shares outstanding. Only common stock preferred stockholders have no claim to earnings beyond the stipulated preferred stock dividends. When the company has only common stock and there have been no changes in the number of common shares outstanding throughout the year : EPS = Net income # of common shares outstanding

If more shares are issued during the year, the computation of EPS is based upon the weighted average number of shares outstanding. When the company has preferred stock outstanding, the amount of the current year preferred stock dividends must be deducted from net income. All publicly-owned corporations are required to present EPS data in their Income Statement. If the income statement includes sub-totals for Income from Continuing Operations and/or Income before Extraordinary Items, the per-share amounts are shown for these amounts as well as for Net Income. EPS from Continuing Operations represents the results of continuing and ordinary business activity. It is the most useful one for predicting future operating results. Net EPS shows the overall operating results of the current year, including any discontinued operations and/or extraordinary items. Primary (or basic) and fully diluted EPS Assume that a company has an outstanding issue of preferred stock that is convertible into shares of common stock. Conversion of this preferred stock would
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increase the number of common shares outstanding and might dilute (reduce) the EPS. Any stockholder will want to know what effect this conversion of preferred stock would have upon EPS. Remember that the decision to convert the preferred shares into common stock is made by the stockholders, not the corporation. Two figures are presented for EPS :

primary (or basic) EPS : based upon the weighted average of common shares actually outstanding during the year, fully diluted EPS : shows the impact that the conversion of preferred stock would have on the primary EPS is computed on the assumption that all the preferred stock had been converted into common stock at the beginning of the year hypothetical case, because EPS is computed even though the preferred stock actually was not converted it is just to warn the stockholders what would happen. In the financial newspapers and magazines, it is always the primary EPS that is shown. Another accounting statistic is the Price/Earnings ratio (p/e ratio) which expresses the relationship between EPS and stock price p/e ratio = Current market price EPS Stock prices reflect investors expectations of future earnings, whereas the p/e ratio is based upon the earnings over the past year. So, if investors expect earnings to increase substantially from current levels, the p/e ratio will be high, perhaps 20, 30 or more. But, if investors expect earnings to decline from current levels, the p/e ratio will be low, maybe 8 or less. A mature company with very stable earnings usually sells for 10 to 12 times earnings. Thus, the p/e ratio reflects investors expectations of the companys future prospects. P/e ratios are of such interest to investors that they are published daily in the financial pages of major newspapers. DIVIDENDS

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Basically, two types of dividends : Cash dividends Stock dividends.

Cash dividends Investors buy stock in a corporation in the hope of getting their original investment back as well as a reasonable return on that investment. The return of a stock investment is a combination of two forms : (1) the increase in value of the stock (stock appreciation) and (2) cash dividends. So, the prospect of receiving dividends is a main reason for investing in the stock of a corporation. An increase or a decrease in the established rate of dividends will usually cause an immediate increase or drop in the market price of the companys stock. Many profitable corporations, in an early stage of development and having to conserve cash for the purchase of plant and equipment or for other needs of the company, do not pay dividends. Often, only after a significant number of profitable operations does the board of directors decide that paying a cash dividend is appropriate. Stockholders are in favor of generous dividend payments, while boards are primarily concerned with long-term growth and financial strength. The preceding discussion suggests three requirements for the payment of cash dividends :

1.

Retained earnings : since dividends represent a distribution of earnings to stockholders, the theoretical maximum for dividends is the total undistributed net income of the company, represented by the credit balance of the Retained earnings account. However, many corporations limit dividends to amounts significantly less than annual net income, in the belief that a major portion of the net income must be retained in the business if the company is to grow.

2.

Adequate cash position : large earnings does not mean large amounts of cash on hand. This cash may be needed for the purchase of fixed assets, paying off debts, acquiring larger inventory. Cash dividends can only be paid out of cash !

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3.

Action by the Board of Directors : even if the companys retained earnings are substantial and its cash position is satisfactory, dividends are not paid automatically. A formal action by the Board is necessary to declare a dividend. Dividend dates 1. 2. 3. 4. Date of declaration Ex-dividend date Date of record Date of payment

As soon as a dividend is declared by the Board, it becomes a liability : Dividends payable. Stock dividends Is a distribution to stockholders of additional shares of the corporations own stock in proportion to their present holdings (in lieu of cash). When cash dividends reduce both assets (cash) and stockholders equity (retained earnings) by the same amount, stock dividends cause no change in assets nor in the total amount of stockholders equity. The only effect is to transfer a portion of Retained Earnings into the Common Stock account. Reasons for distributing stock dividends 1. 2. 3. to conserve cash no distribution of assets to reduce the price per share of stock to a more convenient trading range to avoid income taxes on stockholders. STOCK SPLITS If the market price of a stock reaches for instance $ 150 per share, by splitting the stock 5 to 1, reducing the price per share from $ 150 to $ 30, the number of shareholders may be increased. Most companies have done so and have, therefore, increased the number of stockholders. A stock split consists in increasing the number of outstanding shares and reducing the par value per share in that proportion.

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There is no change in the balance of any ledger account. It is only done by Memorandum. STATEMENT OF RETAINED EARNINGS The amount of Retained Earnings appearing in the Stockholders Equity section of the balance sheet represents the accumulated earnings of a corporation since the date of incorporation, minus any losses, and minus all dividends. 1st year (2007) Retained earnings = Net income for the year 2nd year (2008) Retained earnings end of 2007 + net income for 2008 = Retained earnings end of 2008 3rd year (2009) Retained earnings end of 2008 + net income for 2009 - dividends for 2009 = Retained earnings end of 2009.

REPORTING RESULTS OF OPERATIONS The most important aspect of corporate financial reporting is the determination of periodic income. Both the market price of common stock and the amount of cash dividends per share depend on current and future earnings. The income statement gives us a view of the performance of a company over the past year (revenue earned, expenses incurred, gross profit and net income generated). What about the future ? By analyzing the trend of earnings over time, we can often develop a reasonable estimate of future earnings. If the transactions summarized in the income statement for the year just completed are of a normal recurring nature, we can reasonably assume that the operating results were typical and that somewhat similar results can be expected for the following year.

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However, in any business, unusual and non-recurring events may occur which cause the current years income to be quite different from the income we should expect the company to earn in the future. Results of unusual and non-recurring transactions should be shown in a separate section of the income statement after the income/loss from normal business activities has been determined. Income from normal and recurring activities should be a more useful figure for predicting future earnings. The three categories of events that require special treatment in the income statement are as follows : a) b) c) results of discontinued operations, extraordinary items, cumulative effects of changes in accounting principles.

Continuing operations The first section of the income statement shows the results from continuing operations. The income from continuing operations measures the profitability of the ongoing operations and is helpful in making predictions for future earnings. a) Discontinued operations

If management sells or discontinues a segment of the business, results of that segment are shown separately in the income statement. Two items are included in the discontinued operations section : 1. the income/loss from operating the segment prior to its disposal, 2. the gain/loss on the disposal itself. The discontinued operation must be a segment of the business (entire segment : separate line of business or operation that serves a distinct category of customers). Discontinued operations are not really unusual due to the restructuring of many large corporations. b) Extraordinary items

Gain or loss that is : material in amount, unusual in nature,

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not expected to recur in the foreseeable future.

Extremely rare, seldom appear in financial statements. If it occurs, it appears after the section on discontinued operations, after the subtotal Income before Extraordinary Items. Other unusual gains and losses (e.g. losses because of strikes, or gains/losses resulting from sale of plant assets) are not considered to be extraordinary items. It is necessary to distinguish between unusual and extraordinary items. Is the event likely to happen again ? Restructuring charges : losses on write-downs or sales of plant assets, severance pay, relocation of operations. If the restructuring involves discontinued operations, it is considered discontinued operations. If not, it is considered normal operating expenses. c) Cumulative effect of changes in accounting principles

The accounting principle of consistency means that a business should continue to use the same accounting principles from one period to the next. However, this does not mean that a business can never make a change in its accounting methods. Changes may be made if the need for change can be justified and the effects of the change are properly disclosed in the financial statements. The cumulative change upon income of prior years is then shown in the income statement of the year in which the change is made. To compute this one-time catch-up adjustment, we re-compute the income of prior years as if the new accounting method had always been in use. The difference between this recomputed net income and the net income actually reported in those periods is the Cumulative effect of changes in accounting principles. If the income statement includes sub-totals for Income from Continuing Operations and/or Income before Extraordinary Items, and/or cumulative effect of changes in accounting principles, the earnings per-share amounts are shown for these amounts as well as for Net Income.

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EPS from Continuing Operations represents the results of continuing and ordinary business activity. It is the most useful one for predicting future operating results. Net EPS shows the overall operating results of the current year, including any discontinued operations and/or extraordinary items and/or Cumulative effect of changes in accounting principles.

PRIOR PERIOD ADJUSTMENTS Assume that a company discovers that a material error was made in the measurement of the net income of a prior year. How should this be corrected ? Since the net income of the prior year has been closed into Retained Earnings, the error is corrected by adjusting the balance of the Retained Earnings account. Such adjustments are called Prior Period adjustments. A prior period adjustment has no effect on the net income of the current period and does not appear in the income statement. It is shown in the Statement of Retained Earnings as an adjustment to the balance of Retained Earnings at the beginning of the current year. STATEMENT OF CASH FLOWS Two key financial objectives of every business organization : operating profitably, staying solvent. Operating profitably : providing the owners with a satisfactory return on their investment (Income statement) Staying solvent : being able to pay debts and obligations when due (Balance sheet). A third major financial statement : Statement of Cash Flows. Purpose: to provide information about the cash receipts and cash disbursements of a business entity during an accounting period. It is also intended to provide information about all investing and financing activities during the period. Three major categories : operating activities
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investing activities financing activities

A. Cash flows from operating activities Shows the cash effects of revenues and expense transactions. 2 methods : direct

indirect Direct method Net cash flows from operations = cash receipts from customers + investment income received (interest and dividends) cash payments for purchases of merchandise and expenses. We must, therefore, convert the companys accrual basis measurements of revenue and expenses to the cash basis. Cash receipts collections from cash sales collections of A/R (from credit sales) interest and dividends received other receipts from operations Cash payments payments to suppliers and employees payments of interest payments of income taxes other payments relating to operations Note : receipts and payments of interest are operating activities (not financing). Cash received from customers = Cash collected from cash sales + Net sales + decrease in A/R or - increase in A/R Interest and dividends received = Interest revenue + decr. in interest rec. or incr. In interest rec.

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Cash paid for purchase of merchandise : The relationship between cash payments for merchandise and cost of goods sold depends upon changes during the period in inventory and accounts payable. Cash payments for merchandise = COGS + increases in inventory or decreases in inventory and + decreases in A/P or - increases in A/P Cash paid for expenses : Depreciation expense requires no cash payment, but it increases the total expenses measured on the accrual basis. Therefore, in converting accrual- basis expenses to cash basis, we must deduct depreciation expense and any other noncash item. A second area of differences arises from short-term timing differences between recognition of expenses and the actual cash payments. Expenses are recorded in the accounting records when the related goods or services are used. However, cash payments for these expenses might occur: in an earlier period (prepaid expenses) in the same period in a later period (accrued expenses payable).

Cash payments for expenses = Expenses depreciation & other non-cash items and + increases in related prepayments or - decreases in prepayments and + decreases in accrued expense liab. or - increases in accrued exp. liabilities. Cash paid to suppliers and employees =
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Cash payments for merchandise + cash paid for expenses. Cash payments for interest and taxes = Same as for expenses. Increases and decreases are determined by comparing Y/E balances at beginning and end of year. Net cash flows from operating activities = Cash received from customers + Interest and dividends received Cash paid to suppliers and employees Interest and taxes paid.

B. Cash flows from investing activities Receipts : cash proceeds from selling investments and/or plant assets cash proceeds from collecting principal amounts on loans Disbursements : payments to acquire investments or plant assets amounts advanced to borrowers C. Cash flows from financing activities : Receipts : proceeds from S-T/L-T borrowing cash received from owners (issuance of stock) Disbursements : repayments of amounts borrowed (loans) payments to owners (cash dividends). Critical importance of cash flows from operating activities In the long run, a company must generate a positive net cash flow from its operating activities if a business is to survive.

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Creditors and stockholders are reluctant to invest in a company that does not generate enough cash from operating activities. Indirect method The FASB recommends use of the direct method in presenting net cash flows from operating activities. The majority of companies, however, elect to use the indirect method. Companies using the direct method are required to provide a supplementary schedule illustrating the computation of net cash flows from operating activities by the indirect method Net Income Add : Depreciation Decrease in A/R Decrease in Interest receivable Decrease in Inventories Decrease in Prepaid expenses Increase in A/P Increase in Accrued expenses payable Increase in Interest payable Increase in deferred income taxes payable Non-operating losses deducted in computing net income Less: Increase in A/R Increase in Interest receivable Increase in Inventories Increase in Prepaid expenses Decrease in A/P Decrease in Accrued expenses payable Decrease in Interest payable Decrease in deferred income taxes payable Non-operating gains added in computing net income = Net cash provided by (used in) operating activities

FINANCIAL STATEMENT ANALYSIS

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Financial statements are the instrument panel of a business enterprise. The information contained in financial statements of corporations have been prepared by accountants in accordance with GAAPs, have been audited by CPA firms, and for publicly-owned corporations, reviewed in detail by governmental agencies (SEC - IRS). These financial statements include a lot of financial information that is useful to and used by investors, creditors, and other external users. Financial statements are designed for analysis. They are : classified : certain characteristics are placed together in certain classes; classifications are standardized in most countries. comparative : they appear side by side so it is possible to evaluate changes and trends. Comparative financial statements Few figures appearing on a financial statement have much significance standing by themselves. It is the relationship of one figure to another and the amount and direction of change over time that are important in financial statement analysis. Three analytical techniques are widely used : 1. Dollar and percentage changes on statements + trend percentages (horizontal analysis) 2. Common-size statements/component percentages (vertical analysis) 3. Ratios Dollar and percentage changes 2009 2008 Net sales COGS Gross profit Expenses Net income $ 600 $ 370 300 230 200 194 36 40 500 $ 400 235 165 160 115 50 2007

2009/2008 2008/2007 Amt % Amt % Net sales COGS Gross profit Expenses Net income 70 30 $ 100 20 23 15 34 21 (4) (10) $ 100 25 65 27 35 21 45 39 (10) (20)
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If a company is experiencing growth in its economic activities, sales and earnings should increase at more than the rate of inflation. In measuring the dollar or percentage change in quarterly sales or earnings, one should compare the results of the current quarter with those of the same quarter in the preceding year. Percentages become misleading when the base is small, e.g. 2007 net income = $ 100,000 2008 net income = $ 10,000 i.e. a decrease of 90 % 2009 net income = $ 100,000 i.e. an increase of 900 % !! Trend percentages 2009 Sales Net income Sales Net income 450 23 360 14 2008 2007 2006 2005 2004 330 21 321 19 312 16 300 15

150% 120% 110% 107% 104% 100% 153 93 140 126 106 100

A base year is selected and each item in the financial statements for the base year is given a weight of 100 %. Each item in the financial statements for the following years is then expressed as a percentage of its base year amount. Common-size statements/component percentages Component percentages indicate the relative size of each item included in a total. Common-size Balance Sheet : each item is expressed as a percentage of total assets. This shows quickly the relative importance of each type of asset as well as the relative amount of financing obtained from current creditors, long-term creditors, and stockholders. Common-size Income Statement : all items are expressed as a percentage of net sales.

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Ratios A simple mathematical expression of the relationship of one item to another. Ratios are particularly important in understanding financial statements because they allow us to compare information from one financial statement with information from another financial statement. For example, we might compare net income with total assets to see how effectively management is using available resources to earn a profit. For a ratio to be useful, there must be a significant (logical) relationship between the two figures. A . Measures of liquidity Credit risk a. The short-term creditor Short-term creditors, such as suppliers, want to be repaid on time. Therefore, they focus on the companys cash flows and on its working capital since these are the companys principal sources of cash in the short run. Liquidity refers to a companys ability to meet its continuing obligations as they arise. Current assets: relatively liquid resources (Cash Marketable Securities Accounts Receivable Inventories Prepaid expenses), capable of being converted into cash or used up within a relatively short period of time (maximum one year). Current liabilities: existing debts that are expected to be satisfied by using the companys current assets. (Notes payable due within 1 year, Accounts payable, Unearned Revenue, Accrued Expenses). The relationship between current assets and current liabilities is important. Current liabilities will be paid in the near future, and cash to pay these liabilities will come from current assets. 1. Working Capital

Is the excess of current assets over current liabilities. The amount of working capital available to a firm is of considerable interest to short-term creditors since it represents assets financed from long-term capital sources that do not require rearterm repayment. Working capital = Current assets Current liabilities
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It measures a companys potential excess of sources of cash over its upcoming uses of cash. Current assets = $ 180,000 Current liabilities = $ 100,000 Working capital = $ 180,000 - $ 100,000 = $ 80,000. 2. Current ratio

Most widely used measure of short-term debt paying ability. Current ratio = Current assets Current liabilities Current ratio = $ 180,000 = 1.8 to 1 $ 100,000 A current ratio of 1.8 to 1 means that the companys current assets are 1.8 times as large as its current liabilities. The higher the current ratio, the more liquid the company appears to be. Historically, bankers and short-term creditors have believed that a company should have a current ratio of 2 to 1, or higher, to qualify as a good credit risk.

3.

Quick ratio (acid test)

Inventory and Prepaid expenses are the least liquid current assets. So, we deduct them from current assets and we compare only the most liquid (quick) assets with the current liabilities cash, marketable securities, and receivables (N/R + A/R) Quick ratio = Quick assets Current liabilities A quick ratio of 1 to 1, or higher, is considered to be good. 4. Accounts Receivable Turnover Rate and Accounts Receivable Days Net sales Avg. A/R

A/R T/O rate =

A/R days = 5.

365 days A/R T/O rate Inventory Turnover rate and Inventory days

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Inventory T/O rate =

COGS Avg. Inventory

Inventory days =

365 days Inventory T/O rate

b. The long-term creditor Long-term creditors are concerned with both the near-term and the long-term ability of a company to meet its commitments. They are concerned with the near term since the interest they are entitled to is normally paid on a current basis. They are concerned with the long term since they want to be fully repaid on schedule. 1. Debt ratio

Long-term creditors are interested in the percentage of total assets financed by debt, as distinguished from the percentage financed by stockholders. This measured by the debt ratio. Debt ratio = Total liabilities Total assets

The lower the debt ratio, the safer the position of creditors. Indeed, a low debt ratio means that stockholders have contributed a higher percentage of the business. A debt ratio of less than 50 % is generally considered to be good. 2. Interest coverage ratio

Bondholders feel that their investments are relatively safe if the issuing company earns enough income to cover its annual interest obligations by a comfortable margin. A common measure of creditors safety is the ratio of operating income available for the payment of interest to the annual interest expense, called the interest coverage ratio or times interest earned. Interest coverage ratio = Operating Income Annual interest expense

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Ratios vary between 2 (average) and 6 (strong companies). 2 . Measures of profitability Are of interest primarily to the equity investors (stockholders) and management and are drawn from the income statement. 1. Multiple-step income statement

Four major sections: Net Sales - COGS = Gross Profit Gross Profit Operating Expenses = Operating Income Operating Income +/- non-operating items = Net Income a. Revenue = Net sales

Important: trend - % change from year to year rate of inflation industry average b. Cost of Goods Sold

Important that % change from prior year is lower than % change in sales. Gross Profit Is expressed as a percentage of net sales. If COGS % change is lower than Net sales % change, then GP % change will be higher than sales % change. Gross profit rate = Gross Profit in $ Net sales c. Operating Expenses

Are incurred for the purpose of producing the revenue (selling and G/A). Operating Income Operating Income shows the relationship between revenue earned and expenses incurred in producing this revenue.

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If operating expenses grow at a lower rate than Gross Profit, the Operating Income will grow at a higher rate than Gross Profit. Operating Income shows the profitability of a companys basic or core business. Operating Income % = Oper. Income Net Sales d. Non-operating items Not directly related to the companys primary business. Two significant non-operating items: o interest expense: manner in which assets are financed o income tax expenses: do not help to produce revenue. Net Income Most important figure in the Income Statement. Represents the overall increase or decrease in the owners equity from all profit-directed activities during the period. Net Income % = Net Income in $ Net Sales

2.

EPS

EPS = Net Income Avg. # of shares of common stock outstanding The trend in EPS and expected earnings in future periods are the major factors affecting the market value of a companys shares. 3. P/E ratio

P/E ratio = Current market price of share EPS

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The p/e ratio reflects investors expectations concerning the companys future performance. Average: 12 to 15. 4. ROI - Return on Investment The most common method of evaluating the efficiency with which the financial resources are employed is to compute the rate of return earned on these resources. Two main ratios: ROA (Return on Assets) = Operating Income Avg. total assets Has management earned a reasonable return with assets under its control regardless of whether they are financed with debt or with equity ? The company should be able to earn a ROA higher than the companys cost of borrowing. ROE (Return on Equity) = Net Income Avg. total Stockholders equity Looks only at the return earned by management on the stockholders investment. Standards for comparison In using dollar and percentage changes, trend percentages, component percentages, and ratios, financial analysts constantly search for some standards of comparison against which to judge whether the relationships they have found are favorable or unfavorable. Two criteria are generally used in evaluating the reasonableness of a financial ratio: trend in the ratio over a period of years (is the companys performance or financial position improving or deteriorating ?) comparison of financial ratios with those of similar companies and with industry wide averages (how is the company doing compared to its competitors and to the business environment ?) Usefulness and limitations of financial ratios A financial ratio expresses the relationship of one amount to another. Most users of financial statements find that certain ratios assist them in quickly evaluating the financial position, profitability, and future prospects of a business. A comparison of

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key ratios for several successive years indicates whether the business is becoming stronger or weaker. Ratios also provide a way to compare quickly the financial strength and profitability of different companies. Users of financial statements should recognize, however, that ratios have several limitations. For example, management may enter into year-end transactions that temporarily improve key ratios a process called window-dressing. For example, cash purchases of assets may be delayed until the beginning of the next accounting period so that large amounts of cash will be included in the Balance Sheet and the Statement of Cash Flows. Another example: Lets assume current assets of $ 180,000 and current liabilities of $ 100,000. The current ratio is equal to 1.8 to 1. Now, lets assume that management wants to improve this current ratio. What should they do ? If they pay $ 20,000 worth of accounts payable (which are due at the end of January of the following year) just before year-end, current assets fall down to $ 160,000 and current liabilities to $ 80,000, with a new, more impressive current ratio of 2 to 1 ! No ratio ever tells the whole story Each financial ratio focuses on only one aspect of the companys total financial picture. There are numerous factors of greater importance to a companys future performance than just financial ratios. Financial ratios give no indication of a companys progress in achieving nonfinancial goals, such as improving customer satisfaction, gaining market share, developing and launching new products, improving workers productivity. In summary, financial ratios are useful tools, but they can be interpreted only by individuals who understand the characteristics of the company and its environment.

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