Accounting Accounting is an information system for the complete processing of financial information. Financial Serves external users, relates to activities of firm as a whole Managerial Accounting Serves internal users, helps in planning, forward looking rather than historical

Balance Sheet Balance sheet: looks at what an organization owns and owes at a particular point in time Total assets = total liability + owners equity Assets: what a company owns Liability: what a company Owes

Balance Sheet – Assets Side Current Assets: assets that you expect can be turned into cash within a period of 1 year. Listed in declining liquidity (aka the rate of which they can be turned into cash: quickest first) MUST KNOW THIS ORDER! Cash Marketable Securities: short term assets of the company Accounts receivable: money owed to the company for products/services that you have not yet been paid for (someone purchased on credit for example). Notes receivable: Money owed to company from other business/individuals Inventories: Goods on hand that have yet to be sold. Prepaid Expenses: Expenses we paid for that are recorded as assets before they are consumed or used (such as insurance or office supplies).

Balance Sheet – Assets Side Fixed Assets: tangible Assets purchased to be used over a long period of time. Land Buildings The values written down on the balance sheet are the “book value” of that particular item (land, building….) “book value” = how much the land cost when you purchased it. It doesn’t matter if the value of the land has gone up because we don’t know what it will sell at until it actually sells, so we keep the book value on the balance sheet only. Depreciation: value that the asset decreases over time How do we calculate this? : in this class assume straight line depreciation. Basically it depreciates the same amount every year. In an exam we will know how long the useful life of a building is. Then we divide it’s cost over that many years, and that will be the depreciation (multiplied by the number of years passed). Equipment and building both depreciate. The sum of Land, Building after depreciation, and equipment after depreciation.

Balance Sheet – Assets Side Other Assets: investments put on the balance sheet on the date we acquired the assets Not placed with current assets because we intend to hold on to these for more than one year (stocks, bonds…) Goodwill (“a big one”): When we acquire a company and pay more than the book value for that company, we say the difference between what we paid and the book value is called Goodwill. If book value of the company is 1 mil, and you buy for 1.1 mil, then 100 000 is goodwill. Question to get answered: why is goodwill on the Assets side if we paid this extra 100,000 to another company? Does this not mean that the people who previously owned the company now have this 100,000, and not us?

Balance Sheet – Liabilities Current Liabilities: Order DOES NOT matter for this section Accounts payable Notes payable: Money that we owe to other people or companies Taxes payable: Taxes that need to be paid TODAY (snapshot time) Interest payable: Interest owed TODAY Wages Payable: Wages owed to the employees TODAY (not the entire year).

Balance Sheet – Liabilities Long Term Liabilities: Must be due sometime after the current year. Notes payable: Loaned money to be returned within the next year. Bonds Payable: Long term investments people make in the organization.

Balance Sheet – Liabilities Shareholder’s Equity Common Stock Retained earnings: Dividends that are invested into the company instead of paid out.

Balance Sheet Problems On an exam, there will be a list of assets and liabilities (not in any order) that need to be placed in their correct positions on a balance sheet and added up. Difference between this and an exam setting is on the exam there will be EXTRA DATA provided that must be filtered out.

Balance Sheet Example MUST HAVE A TITLE WITH THE DATE! Assets: Current Assets: (IN ORDER!!) Cash: 20,000 Accounts Receivable: 35,000 Inventory: 60,000 Office Supplies: 2,000 Total: 117,000 Fixed Assets: Land: 10,000 Buildings: 80,000 Equipment: 35,000 Total: 125,000 Other Assets: Goodwill: 8,000 Total: 8,000 Total Assets: 250,000 Liabilities: Current Liabilities: Accounts Payable: 40,000 Notes Payable: 25,000 Wages Payable: 1,500 Interest Payable: 500 Total: 67,000 Long Term Liabilities: Notes Payable: 55,000 Total: 55,000 Shareholder’s Equity Common Stock: 100,000 Retained Earnings: 28,000 Total: 128,000 Total Liabilities: 250,000

Income Statement Income statement looks at our performance as an org. over a period of time. (this is one of TWO Financial Annual reports): Looks at “How” we made money… Items include: Gross Sales (overall sales) Less Returns (for retail... Negative number) Net Sales (Gross sales Less the returns) Less: Cost of Goods Sold: (direct costs incurred from items) Beginning Inventory Add Purchases Total goods on hand at the start is the sum of these two items above Less ending inventory TOTAL Costs Of Goods Sold (COGS)= total goods on hand – ending inventory Gross Profit: Gross Sales - COGS

Income Statement Operating Expenses (general and administrative, and Selling). General and Administrative: Office Salaries Rent Insurance Selling: Advertising Commissions Deliveries Total Operating Expenses calculated by added “G&A” to “Selling” Net Income BEFORE taxes: Gross Profit – Operating Expenses Income Tax (% of tax to subtract from net income). Net Income is value before tax LESS the tax.

Income Statement Problem Given the Following: Gross Sales: 60,000 Selling Expenses: 8,000 Inventory (Jan 1, 1992): 10,000 Sales Returns: 1,500 Income Tax Rate: 50% Purchases: 35,000 Inventory (Dec 31, 1992): 9,000 G&A Expenses: 6,000 Gross Sales: 60,000 Sales Returns: 1,500 Net Sales = 60,000 – 1,500 = 58,500 Inventory (Jan 1, 1992): 10,000 Purchases: 35,000 Total Goods On Hand: 45,000 Inventory (Dec 31, 1992): 9,000 COGS: 36,000 Gross Profit: Net Sales – COGS = 22,500 Operational Expenses: G&A Expenses: 6,000 Selling Expenses: 8,000 Total: 14,000 Net Income (before Tax): COGS – OE = 8,500 Tax (50%): 4,250 Net Income: 4,250

Double-entry Accounting Concept of writing every business transaction in two places – this is why the balance sheet “balances” Example: Borrow $30K from Bank Current assets (cash) increase by 30K, but Long-term Liabilities (notes pay.) also increase by 30K

Double-entry Accounting Example: Company buys $50K of inventory on credit 50k inventory increases 50k accounts payable increases Example: Company raises 10K from shareholders (ie: issues 10K in new shares). Cash increases 10k Common Stock increases 10k

Ratio Analysis A logical relationship exists between certain pairs of items on financial statements. Can the company pay its bills? Is too much money tied up in inventory?

What do we do with ratios? Industry Standards Look at industry as a whole Several companies in the same industry Historical Standards Historical trends over the past years Looking at MY company Company Ratios Look at other companies

Commonly Used Ratios Liquidity Ratios – ability to pay current debts Indebtedness Ratios – relate to how much debt an organization is using (debt acquired) Operating Ratios (Activity Ratios) – deal with the stability of the firm (day to day stability) Profitability Ratios – measures the profit level of a business

Liquidity Ratios Two ratios to know: Current, and Quick Current Ratio: Current Assets/ Current Liabilities Usually want this to be 2:1 Measures ability of firm to cover current obligations Quick Ratio: (Current Assets – (Inventory + Prepaid Expenses))/ Current Liabilities More strict measure of liquidity Ideally want this to be 1:1 Working Capital = Current assets – Cur. Liab.

Indebtedness Ratios Debt to Total Assets = Total Liabilities/ Total Assets For Every dollar of assets how much is financed with debt and owner’s equity If less than one, company financed more with Owner’s Equity If high, means the company is “leveraged” (lots of debt) Is this bad?..... Not always. May need to be leveraged to derive profits in the future. This is only a problem when not used properly.

Operating Ratios Avg. Collection Period: Accts. Receivable / Avg. Daily Sales How long does it take for us to collect our money (IN DAYS!!!!) Avg. daily sales = Net sales / 365 This number should be 31 or less. Inventory Turnover: C.O.G.S./ ((Beginning Inventory + Ending Inventory) / 2) Average number of times inventory is sold and restocked each year IF low, then too much inventory If high, then not enough inventory!

Profitability Ratios Profit Margin = Net Income/ Sales The percentage of income that is profit to company. The higher the profit margin, the better the cost controls the company. Want this to be high (good cost controls) Return on Equity = N.I./ Total Owner Eqty How much profit a company generates with shareholder’s money. Want this to be a high percentage (20% is good, 1% is bad).

Ratio Question from old Exam Accounting Ratios: Given the following data, prepare the ratios as required as of Dec 31, 2005. Please show the formula for each ratio as part of your answer: Taxes Payable: 700,000 Accounts Payable: 500,000 Accounts receivable: 2,000,000 Marketable Securities: 700,000 Sales: 25,000,000 Common Stock: 9,000,000 Retained Earnings: 1,500,000 Net Income: 2,500,000 Notes Payable: 3,000,000 Inventory (Dec 31, 2005): 4,000,000 Inventory (Jan 1, 2005): 2,000,000 Purchases: 10,000,000 Sales Expense: 350,000 Cash: 1,000,000 Prepaid Expenses: 340,000 Quick Ratio Inventory Turnover Return on Equity Average Collection Period

Ratio Question from old Exam Answer: First thing to do is indicate where each of the items goes NEXT: perform the ratios using the required numbers for each of the formulas…. (next slide) (CL)Taxes Payable: 700,000 (CA)Marketable Securities: 700,000 (CA)Accounts receivable: 2,000,000 (SE)Common Stock: 9,000,000 (IS)Sales: 25,000,000 (IS)Net Income: 2,500,000 (SE)Retained Earnings: 1,500,000 (COGS,CS)Inventory (Dec 31, 2005): 4,000,000 (CL)Notes Payable: 3,000,000 (COGS)Inventory (Jan 1, 2005): 2,000,000 (COGS)Purchases: 10,000,000 (IS)Sales Expense: 350,000 (CA, CS)Cash: 1,000,000 (CA)Prepaid Expenses: 340,000 (CL)Accounts Payable: 500,000

Ratio Question from old Exam ALWAYS STOP AFTER 2 DECIMAL PLACES!!!!! Quick Ratio = (Current Assets – (Inventory + Prepaid Expenses))/ Current Liabilities Current Assets = 2,000,000 + 700,000 + 1,000,000 + 4,000,000 + 340,000 Inventory = 4,000,000 (because date is on Dec. 31) Prepaid Expenses = 340,000 Current Liabilities = 700,000 + 3,000,000 + 500,000 Quick Ratio = ((2,000,000 + 700,000 + 1,000,000 + 4,000,000 + 340,000) – (4,000,000 + 340,000)) / (700,000 + 3,000,000 + 500,000) = 0.88 A quicker way to calculate this is to completely exclude Inventory and Prepaid expenses. This gives: Quick Ratio = ((2,000,000 + 700,000 + 1,000,000) / (700,000 + 3,000,000 + 500,000) = 0.88 Inventory Turnover = C.O.G.S./ ((Beginning Inventory + Ending Inventory) / 2) COGS = Beginning Inventory + Purchases – Ending Inventory = 2,000,000 + 10,000,000 – 4,000,000 = 8,000,000 AVG Inventory = (2,000,000 + 4,000,000) / 2 Inventory Turnover = 8,000,000 / 3,000,000 = 2.67 Return on Equity = N.I./ Total Owner Equity Net Income = 2,500,000 Owner’s Equity: Common Stock + retained earning = 9,000,000 + 1,500,000 = 10,500,000 Return on Equity = 2,500,000 / 10,500,000 = 0.24 (or 24%) which is GOOD! Average Collection Period = Accts. Receivable / Avg. Daily Sales Accounts Receivable: 2,000,000 Average Daily Sales: Net Sales / 365 = 25,000,000 / 365 = 68,493.15 Average Collection Period = 2,000,000 / 68,493.15 = 29.20 (GOOD since less than 31 days).