INTRODUCTION TO ACCOUNTING

Definition of Accounting Accounting is a system of dealing with financial information that provides information for decision-making

Accounting vs. Bookkeeping The process of recording, analyzing, and interpreting the economic activities of a business BOOKKEEPING A method of recording all transactions for a business in a specific format

Why is Accounting Important Accountability People who handle cash in the company are responsible for it Budgeting This allows businesses to estimate its future sales and expenses Taxation Records must be kept in order to pay taxes

Why is Accounting Important Financial Statements These are reports that summarize the financial performance of a business These reports indicate the business’s economic health Annual Reports Financial statements are presented to shareholders and potential investors in the form of annual reports

An Information System What financial questions might you have about your business? Is the business earning profit? Are selling prices to high/low? How much does ABC company owe me? What is the value of my inventory? How much did John Smith earn last year? Do we have enough money to pay our bills?

An Information System Who else may want financial information about the business? Government Bankers Lenders Potential Investor A Lawyer

OWNING A BUSINESS If you decide to operate your own business you will find yourself facing such accounting tasks as: Banking Payroll Keeping track of amounts owed by and owed to customers Keeping track of amounts owed to the government Producing an income statement for income tax purposes

Categories of Accounting Work Routine Daily Activities Processing Bills Preparing Cheques Daily Banking Recording Transactions Preparing Business Papers Periodic Accounting Activities (these activities occur at regular intervals) Paycheques(bi-weekly) Bank accounts (balanced monthly) Financial reports (monthly, quarterly, yearly) Income tax returns (yearly)

Categories of Accounting Work Miscellaneous Activities Employee resignation An advertisement is prepared New capital equipment is purchased A new loan A new employee is hired

The Fundamental Accounting Equation The fundamental accounting equation states that: ASSETS – LIABILITIES = OWNER’S EQUITY OR ASSETS = LIABILITIES + OWNER’S EQUITY

ASSETS An asset is anything that the business owns that has value What are some examples of personal assets? House Car Cash RRSP’s

LIABILITIES A liability is anything that the business owes; any debts of the business What are some examples of personal liabilities? Credit Line Mortgage Owed to Parents Credit cards

OWNER’S EQUITY Owner’s Equity is also referred to as capital or net worth It is the difference between the total assets and total liabilities of a business

PERSONAL NET WORTH Here is a list of my assets: House Car Furniture Cash in Bank Savings RRSP’s Teachers Pension

PERSONAL NET WORTH Here is a list of my liabilities: Mortgage Credit card ( paid of every month, but still a potential liability) Line of credit

PERSONAL NET WORTH What do I need to do to calculate my net worth? Take my total assets and subtract them from my total liabilities

PERSONAL NET WORTH We can see how this looks by examining a Balance Sheet containing my personal assets, liabilities, and net worth Mrs. Drummond Balance Sheet May 20, 2012   Assets Liabilities Cash in Bank $ 2,000.00 Credit Card $ 1,500.00 Savings Car Loan $ 25,000.00 RRSP's $ 5,000.00 Credit Line $ 10,000.00 Teachers Pension Mortgage $ 170,000.00 Household Items $ 20,000.00 Car $ 30,000.00 Total Liabilities $ 206,000.00 House $ 400,000.00 Net Worth Mrs. Drummond’s Equity $ 258,000.00 Total Assets $ 464,000.00 Total Liabilities and Equity

YOUR NET WORTH Make a list of all of your assets and all of your liabilities Calculate your total assets and your total liabilities Now calculate your net worth (remember the fundamental accounting equation) Make a new net worth statement for yourself for 10 years from now!

The Balance Sheet

BALANCE SHEET = a statement of financial position Liabilities (debts you owe) + Owners Equity (the owner’s share of the assets) Assets (Things owned) =

THE ACCOUNTING EQUATION ASSETS = LIABILITIES + OWNERS EQUITY A=L+OE

BALANCE SHEET A “freeze frame” or snapshot of what the business owns, owes and the owners invested interest. A financial picture of the business at a point in time. The balance sheet does not indicate whether a business has made a profit, only whether it is financially strong.

Features of the Balance Sheet The Balance Sheet looks like the Fundamental Accounting Equation A = L + OE Assets are on the left side and the liabilities and owner’s equity are on the right side

Features of the Balance Sheet A Three Line Heading is Used WHO? – The name of the individual, business or other organization WHAT? – The name of the financial statement (in this case the balance sheet) WHEN? – The date on which the financial position is determined

WHO? – The name of the individual, business or other organization What? WHO? – The name of the individual, business or other organization When?

CASH AND LIQUIDITY Liquidity – how easily an Cash is arguably the MOST valuable asset of a business. WHY?? It can easily be exchanged for other assets Liquidity – how easily an asset can be exchanged for any other asset or converted to cash.

ASSETS Ownership (title- legal right to use) is separate from financing (source of funds used to purchase asset). With ASSETS, an owner can: Use Sell Give away Leave to heirs Whether bought for cash or on credit, the owner still has “title” to his/her property

CATEGORIZING ASSETS Current Assets – things a business owns that disappear quickly, usually in less than one year.  Long-term Assets (Capital Assets or Fixed Assets) – assets that a business keeps for a long time.  

ASSETS In order of liquidity, assets include: cash, bank balances, accounts receivable (listed in alphabetical order), inventory and supplies, and furniture, equipment, fixtures, vehicles, property and buildings (listed in the order in which they will be used up).

ACCOUNTS RECEIVABLE Customers of the business will often buy goods or services with the understanding that they will be paid for in the future These debts owed represent a dollar value to the business, so the business has a right to include them among the assets on the balance sheet Each of these customers that owes money to the business is one of its debtors

CURRENT ASSETS Current Assets Cash $ 50,000 Accounts Receivable $ 30,000 Inventory $120,000 Supplies $ 15,000 Total Current Assets $215,000 ORDER Of LIQUIDITY CLOSEST TO CASH FARTHEST FROM CASH

FIXED ASSETS Fixed Assets Land $ 200,000 Building $ 1,100,000 IN ORDER OF REVERSE DEPRECIATION Fixed Assets Land $ 200,000 Building $ 1,100,000 Equipment $ 950,000 Furniture $ 225,000 Vehicles $ 215,000 Total Fixed Assets $ 2,690,000 ONE THAT WILL BE AROUND THE LONGEST ONE THAT WILL BE AROUND THE LEAST AMOUNT OF TIME

LIABILITIES Liabilities are the debts of a business. Businesses acquire debt in two main ways: 1) Accounts Payable – purchasing inventory and supplies on credit. 2) Loans Payable (Notes Payable) – acquired by borrowing money from investors, banks, etc.

CATEGORIZING LIABILITIES Liabilities are listed in order of priority, or how quickly they need to be paid off. Current Liabilities – debts such as invoices for merchandise inventory, that are paid off quickly. Long-term Liabilities – debts such as a mortgage loan, that may not be repaid for decades.

ACCOUNTS PAYABLE A business often purchases goods and services from its suppliers with the understanding that payment will be made later These debts to suppliers represent a dollar obligation of the business, the business must include them among its liabilities Each of the suppliers owed money by the business is one of its creditors

CURRENT LIABILITIES Current Liabilities Wages Payable $ 10,000 ORDER Of MATURITY* Current Liabilities Wages Payable $ 10,000 Accounts Payable $ 80,000 Other Liabilities $ 50,000 Current Portion - Mortgage $ 15,000 Total Current Liabilities $ 155,000 * Maturity – When a debt is “mature” it’s payment is due FIRST TO BE PAID LAST TO BE PAID

LONG TERM LIABILITIES Long Term Liabilities Vehicle Loans $ 150,000 Equipment Loan $ 900,000 Mortgage $ 850,000 Total Long Term Liabilities $1,900,000 ORDER OF MATURITY* SHORTEST TERM LONGEST TERM

OWNER’S EQUITY Owner’s Equity Owner’s Capital $ 750,000 ORDER SHOWN Owner’s Equity Owner’s Capital $ 750,000 Plus: Net Income $ 150,000 $ 900,000 Less: Drawings ($ 50,000) Total Owner’s Equity $ 850,000 CAPITAL +/(-) INCOME/ (LOSS) THEN SUBTOTAL SUBTRACT DRAWINGS AND THEN TOTAL

MEASURING SUCCESS WITH A BALANCE SHEET Working Capital = Current Assets – Current Liabilities Working capital indicates a business’s ability to pay its short-term debts. Working Capital has to be positive Current Ratio = Total Current Assets / Total Current Liabilities Current Ratio shows how many dollars of liquid assets (cash or near cash) a business has for every dollar of short-term debt. Current ratio has to be over 1.2

MEASURING SUCCESS WITH A BALANCE SHEET Total Debt to Total Asset Ratio = Short Term Debt + Long Term Debt/Total Assets A metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. Calculated by adding short-term and long-term debt and then dividing by the company's total assets.

Current Assets – Current Liabilities = (1150+2000+1400)-(1350)= 3200 Working Capital Current Ratio Current Assets/Current Liabilities = (1150+2000+1400)/(1350)= 3.37

The Income Statement

WHAT IS AN INCOME STATEMENT? Remember: a Balance Sheet is a snapshot of a business on one day in time An Income Statement shows what happens over a period of time in a business, it could be one month, six months, or a year An Income Statement shows how much money a business made or lost over a period of time

THE INCOME STATEMENT As a business operates it makes money from daily activities Through these daily activities the business also accumulates expenses What are some of the expenses of day to day operations for a business?

THE INCOME STATEMENT RECALL: What is the difference between a cost and an expense? Cost  Expense 

Order of Entries on an Income Statement Just like the Balance Sheet, the Income Statement has a three line heading: Who? (the name of the business/individual) What? (in this case, an Income Statement) When? (period of time ending on a certain date)

The Income Statement The sources of Revenue are listed next These are listed in alphabetical order Revenue (Sales or Income) is the money, or the promise of money, received from the sale of goods or services

The Income Statement Then Cost of Goods Sold is listed or calculated (if applicable) Cost of Goods Sold is the cost of inventory that was sold to generate business revenue for a specific period of time Cost of Goods Sold is calculated using information from the balance sheet, from invoices that detail the year’s purchases, & from the physical inventory count at the end of the fiscal year  Purchases show the total amount of the goods bought by the business in a year.

COST OF GOODS SOLD COST OF GOOD SOLD (COGS) = BEGINNING INVENTORY + PURCHASES – ENDING INVENTORY Example: Inventory, May 1st, 2012 - $50,000 Inventory, May 31st, 2012 - $20,000 Purchases - $30,000 COGS = $50,000 + $30,000 – $20,000

The Income Statement Then Gross Profit is calculated (if applicable) Gross Profit = Total Revenue – COGS Gross Profit shows how much money covers the cost of the product and how much is left over to cover the business expenses.

The Income Statement Expenses are listed next, in alphabetical order Operating expenses or overhead are the costs of operating the business during the period the sales took place. Expenses include things like salaries, advertising, maintenance, and utilities, and are used to help generate the revenue of a business.

The Income Statement Matching Principle – all the costs of doing business in a particular time period are matched with the revenue generated during the same period. Example: If you run a hot dog stand, you would report the cost of the buns & sausages in the same period that you sell the hot dog

The Income Statement Lastly, a net income, or net loss is calculated This is calculated by subtracting the expenses from the revenue Net Income/Net Loss = Gross Profit – Expenses A net income occurs when the revenue is larger than the expenses, and a net loss occurs when expenses are greater than revenue

For the Year Ending December 31, 2011 Donahue's Shoe Store Income Statement For the Year Ending December 31, 2011 Revenue Shoe Sales $250,000 Total Revenue Cost of Goods Sold Beginning Inventory, Jan 1, 2011 $50,000 Inventory Purchased $75,000 Cost of goods available for sale $125,000 Ending Inventory, Dec. 31, 2011 $40,000 Total Cost of Goods Sold (COGS) $85,000 Gross Profit $165,000 Expenses Advertising $1,200 Rent $12,000 Salaries $60,000 Supplies $350 Utilities $15,000 Total Expenses $88,550 Net Income $76,450

Measuring Success Management looks at income statements to measure profitability. Rate of Return on Net Sales = (Net Profit / Total Revenue) x 100% Rate of Return on net sales indicates, as a percentage, the portion of a business’ sales that are kept as profit.

Measuring Success Gross Profit Percentage = (Gross Profit / Total Revenue) x 100% The gross profit percentage indicates how much of the revenue is left after costs (COGS) have been covered. Management can see how much of its potential profit pays for product (cost of goods sold) and how much is left to pay for expenses (overhead).

Gross Profit Percentage If a business has a high gross profit percentage, it means the business is earning a high margin on its sales. Margin is the difference between the cost of the product and the selling price of the product.

Measuring Success Profit Margin= (Net Income/ Total Revenue) x 100% A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20\% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales. Also known as Net Profit Margin.