1. 1 EUP 222 ENGINEERS IN SOCIETY FINANCIAL ACCOUNTING Dr Nastaein Qamaruz Zaman

2. 2 Part A INTRODUCTION

3. Objective 3 Be able to understand the basic accounting equation Be able to differentiate between income statement, statement of retained earnings, and balance sheet Be able to prepare income statement, statement of retained earnings, and balance sheet from transactions Be able to appreciate the importance of ethics and integrity when doing accounting

4. Basic Accounting 4 Price $ 120 Cost $ 70 Plan…sell at parking lot during university games PROFIT??

5. Estimate profit if sell 50 pieces per game 5 Sales ($120 x 50) $6000 Less expenses: Cost of shirts ($70x 50)$ 3500 University fee (for stall) 100 Total expenses 3400 Net income $2600 A sound profit, go ahead with sale

6. After first game, asses success (or failure). Based on actual sale (only 40 pieces sold): 6 Sales ($120 x 40) $4800 Less expenses: Cost of shirts ($70x 40)$ 2800 University fee (for stall) 100 Total expenses 2700 Net income $2100 Business was profitable but not as planned

7. Two ways accounting is useful 7 (i) To plan the business Use accounting to project the expected profit (ii) To determine, if in fact profit has been made after business operation ACCOUNTING IS USED DURING ALL PHASES OF PLANNING AND OPERATING A BUSINESS

8. Organizational chart of a typical corporation 8

9. Accounting: Definition 9 Systematic process of measuring economic activity of a business to provide useful information to those who make economic decisions E.g. bankers for loan approvals Financial advisers for investment recommendations Government regulators use accounting info to decide if firms are complying with various laws and regulations

10. Types of accounting 10 Accounting Specialty Decision makerExamples of decisions Financial AccountingShareholders Creditors Buy shares Hold shares Sell shares Lend money Determine interest rates Managerial accountingManagersSet product prices Buy or lease equipment Tax accountingManagersComply with tax laws Minimize tax payments Assess the tax effects of future transactions

11. Managerial accounting 11 Managers make numerous decisions. These include: whether to build a new plant how much to spend for advertising research and development whether to lease or buy equipment and facilities whether to manufacture or buy component parts for inventory production, or whether to sell a certain product.

12. Managerial accounting 12 Managerial accounting provides information for these decisions Information is more detailed and specific to decision making than financial accounting information Information is not disclosed to parties outside the firm

13. Tax accounting 13 Includes two related functions tax compliance and tax planning

14. Tax accounting 14 Tax compliance: Calculation of the firm’s tax liability. Sometimes a lengthy process and complex tax forms. Done usually after a year’s transactions have been completed. Tax planning: Takes place before the fact. E.g. a car purchased by loan, leased from a dealer. Structure of the transaction determines the tax consequences and requires specialized tax knowledge when doing accounts.

15. Financial accounting 15 Provide information to decision makers who are external to the business E.g. IBM over 600,000 shareholders, as owners of the corporation. Delegate most of their decision making power to the corporation’s board of directors and officers Shareholders use acct info to evaluate (i) performance of the business, and (ii) the advisability of retaining their investment in the business

16. Focus – financial accounting 16 How does one determine the status of ones business – profitable or loss? Use financial statements – prepare income statement, statement of retained earnings, balance sheet Determine profitability, solvency, etc. Ethics in doing accounting

17. Financial Statements 17 Balance Sheet lists the balances in all Asset, Liability and Owners' Equity accounts. Income Statement lists the balances in all Revenue and Expense accounts. The Balance Sheet shows account balances at a particular date. The Income Statement shows the accumulation in the Revenue and Expense accounts, for a given period of time, generally one year. The Income Statement can be prepared for any span of time, and companies often prepare them monthly or quarterly.

18. Financial statements 18 It is common for companies to prepare a Statement of Retained Earnings. This statement provide a link between the Income Statement and the Balance Sheet. They also reconcile the Owners' Equity or Retained Earnings account from the start to the end of the year.

19. 19 Part B ACCOUNTING EQUATION

20. Accounting Equation 20 Assets = Liabilities + Owners’ Equity

21. Assets 21 Assets are economic resources owned by a company. Includes current assets and non-current assets Current Assets o Current assets are listed in the order in which they are expected to be consumed or converted to cash. For example: o cash and cash equivalents, o accounts receivable, o inventories, and o prepaid expenses.

22. Assets – current 22 Cash and cash equivalents include currency, bank deposits, and various marketable securities that can be turned into cash on short notice merely by contacting a bank or broker. These amounts are presently available to meet the firm’s cash payment requirements. Note that only securities that are purchased within 90 days of their maturity dates, or are scheduled to be converted to cash within the next 90 days, may be classified as cash equivalents. Accounts receivable represent credit sales that have not been collected yet. The relevant amount is the estimated cash to be generated from collections of the accounts. They are converted into cash as soon as the customers or clients pay their bills (their accounts).

23. Assets – current 23 Inventory represents items that have been purchased or manufactured for sale to customers. That is, inventory can either be created through the manufacturing and assembly efforts of the organization or be acquired from others and held for resale. Today, inventory is often “high tech,”such as silicon wafers, memory chips, or disk drives. Should the company discover that some of its inventory is unsalable, or marketable only at a greatly reduced price, the reported value of the inventory should be reduced accordingly.

24. Assets – current 24 Prepaid expenses, represents unexpired assets such as insurance premiums. Insurance policies, for example, are frequently paid ahead on an annual basis. The unexpired portion, the portion of the policy paid for but not yet used, is shown as part of prepaid expenses, which are interpreted as current assets. Prepaids are usually minor elements of the balance sheet, and, in the usual course of events, prepaids will not be converted or turned into cash. Instead, the rights to future benefits will be used up in future periods.

25. Assets – non-current 25 Noncurrent assets are long-term assets that are used in the conduct of the business. Whereas current assets are liquid and turn over in relatively short time periods, noncurrent assets usually turn over very slowly, on the order of once in several years. Property, Plant, and Equipment. For most firms, noncurrent assets consist mainly of property, plant, and equipment. These assets are widely referred to as fixed assets. Property usually represents the land on which the firm’s offices, factories, and other facilities are located. In most cases, property is a relatively minor portion of the total noncurrent assets, yet in some cases, such as firms engaged in mining, logging, or oil and gas exploration, property constitutes a major operating asset.

26. Assets – non-current 26 Buildings and equipment may be office, retail, or factory buildings; warehouses or supply depots; or hospitals or health clinics. Equipment includes office desks and chairs, tools, drill presses, robots, computers, x-ray and other scanners, podiums, and so on. In other words, buildings and equipment are the primary productive assets of many organizations.

27. Liabilities 27 Liabilities are the company’s debt or obligations They can be current (short term): due & payable within 1 year and/or long-term: due & payable in over 1 year

28. Liabilities – current liabilities 28 The current liabilities consist of accounts payable, notes payable, warranty obligations, accrued expenses, and taxes payable. These liabilities represent various claims against the firm’s economic resources Accounts Payable: for routine expenses and inventory purchased on credit. Accounts payable also includes amounts that the firm owes for other services used in its operations, such as rentals, insurance, utilities, and so on. Notes Payable: short- or long-term loans from banks or other lenders. Notes payable are more formal current liabilities than the accounts payable. A note may be signed on the borrowing of cash from a local bank. The note represents a legal document that a court can force the firm to satisfy.

29. Liabilities – current liabilities 29 Accrued Expenses: represent liabilities for services already consumed but not yet paid for or included elsewhere in liabilities. These can include accounts such as interest payable, taxes payable, wages payable, and other similar accruals at the end of the year. Warranty obligations represent the firm’s estimated future costs to fulfill its obligations for repair or refund guarantees. Unlike accounts and notes payable, the exact amount of the firm’s obligations for warranties cannot be determined by referring to purchase documents, formal contracts, or similar evidence. Instead, the amount reported for the warranty obligation is based on management’s judgment about future claims for repairs and refunds that may arise from past sales.

30. Liabilities – current liabilities 30 Taxes payable represents unpaid taxes that are owed to the government and will be paid within a year. Taxes payable may include employee withholding taxes, unemployment taxes, employer income taxes, or any number of other taxes that are incurred in the normal course of operations.

31. Liabilities – non-current 31 Most noncurrent liabilities represent contracts to repay debts at specified future dates Two types of noncurrent liabilities: bonds payable and mortgage payable

32. Liabilities – non-current 32 Bonds payable are a major source of funds for larger business firms. They represent liabilities that the firm incurs by selling a contract called a bond. A bond contains the firm’s promise to pay interest periodically (usually every six months) and to repay the money originally borrowed (principal) when the bond matures. The amount of money that the firm receives from investors for its bonds depends on investors’ views about the riskiness of the firm and the prevailing rate of interest. Investors rely on the ability of the firm to generate sufficient cash flows from its operations to meet the payments as they become due.

33. Liabilities – non-current 33 Mortgage payable is similar to bonds payable because firms must also make principal and interest payments as they are due. Unlike most bonds, a mortgage represents a pledge of certain assets that will revert to the lender if the debt is not paid. The simplest example of a mortgage is that of a bank holding title to your house until your loan is fully paid. If the loan is not paid, the bank can sell the house and use the proceeds to pay off the debt.

34. Equity 34 Equity is the owners' claim on assets. Equity, as noted above, is also the difference between assets and liabilities. Equity may include multiple financial elements. The most common equity elements are capital (common stock), current year earnings, and retained earnings. Capital (common stock for corporations) represents the amounts contributed by owners to the business. Depending on the legal form of a business, capital can be named differently. Current year earnings are the net income or loss of the business for the current year. This amount is the difference between all revenues and all expenses on the income statement. Current year earnings are presented on the balance sheet only until they are transferred to retained earnings.

35. Equity 35 Retained earnings are net income (loss) retained (accumulated) by your company. For a company with relatively simple operations, retaining earnings are cumulative net incomes (losses) less dividends paid out since the company's origination. Note that when dividends are paid out, they reduce retaining earnings. Also note that retained earnings may be a negative amount in situations when the company is not profitable (i.e. more losses than net incomes).

36. 36 Part C BUSINESS TRANSACTIONS

37. Transactions = interactions 37 Involve the exchange of goods or services for cash or promise to pay cash at future date

38. Procedure 38 Insert scan pp 30

39. Step 1: Transaction Analysis 39 Info in documents such as cash receipts, checks, invoices, and contracts ACCOUNTING EQN Remember A = L + OE ACCOUNTING EQN LEFT SIDE = RIGHT SIDE Transactions analyzed to see effect on the accounting equation: Assets, liabilities and equity

40. Step 1: Transaction Analysis 40 Scenario 1: A clothing store purchases merchandise such as jeans for resale. The jeans are purchased from a manufacturer on credit (a promise to pay at some later date) Asset? + (increase in the inventory of merchandise, an asset, that the firm has available to sell) Liability? + (debt increase to be paid in future)

41. Step 1: Transaction Analysis 41 Scenario 2: Eventually the firm issues a check to the manufacturer as payment for the merchandises. In the payment transaction Asset? - (cash decrease by the amount of the check) Liability? - (debt has been paid)

42. Step 1: Transaction Analysis 42 Scenario 3: Purchase of a truck to be used for making deliveries to customers Asset ? + (acquisition of trucks) Asset ? - (cash out for paying trucks) No change to total assets, therefore no change in owners’ equity and/or liability Equality of the accounting equation

43. Example1 43

44. Example 2 44

45. Example 3 45

46. Example 4 46

47. Example 5 47

48. Example 6 48 Example 6 describes several different transactions and the dollar effect of each transactions on the accounting equation. Examine each of the transactions, noting the effects on each equation component (assets, liabilities, owners’ equity) and subcomponents (cash, equipments, accounts payable, etc.). Note that the equality of the accounting equation is maintained in each transactions.

49. 49

50. Step 2: Recording data from transaction analysis 50 After transactions have been analyzed for their effects on the accounting equation, the information is entered into formal records of the business Keeping of accounts facilitates the accumulating and recording of transaction data A separate account is maintained for each major subcomponent of the asset, liability, and owner’s equity components of the accounting equation

51. Step 2: Recording data from transaction analysis 51 For example, there will be separate asset accounts for cash, accounts receivable, inventory, land, equipment, buildings etc. T-account o Recording transaction o Ensures dollar amounts in each accounts are increased and decreased uniformly o 3 elements: (i) title of account, (ii) the left or debit side, (iii) the right or credit side

52. Step 2: Recording data from transaction analysis 52 Question 1: Which to use, debit or credit Debit always left, credit always right Question 2: Which side, debit or credit, increases or decreases an account? Answer depends upon what type of account is being debited or credited

53. Step 2: Recording data from transaction analysis 53 Asset accounts : increased by debits, decreased by credits Opposite for liability and owners’ equity

54. Step 2: Recording data from transaction analysis 54 Example 6 showed examples of seven transactions and their effects on the components of the accounting equation Example 7 presents the same seven transactions in T-account form along with the debit and credit effects of each transaction on the appropriate account

55. Example 6 55

56. Example 7 56

57. Step 3: Journalization 57 Actual recording of transactional data in the accounting records of a company is done in a journal A journal, contains a chronological history in debit/credit format of all transactions that affect the accounts of the company. The transactional data is recorded in the journal by means of a journal entry.

58. Step 3: Journalization 58 A journal entry includes the following: The date of the transaction The names of all accounts to be debited and credited as a result of the transaction The dollar amounts of the debit or credit for each account affected A brief explanation of the transaction Format is: list all debits first, then list all credits, finally brief description of transaction

59. Example 8 follows from Example 6 & 7 59

60. Step 3: Journalization – summarizing data 60 After a transaction is journalized, each debit and each credit amount in the journal entry must be transferred to the individual ledger accounts affected This transfer is done so that the cumulative effect of all transactions on a given account during a specific period of time can be determined. As stated earlier, all accounts used by a business appear in its general ledger

61. Step 3: Journalization – summarizing data 61 This process is called posting (Example 9) After the posting of all debit and credit to the accounts is completed, a balance is calculated for each account

62. Example 9 62

63. Step 4: Reporting accounting information 63 Once the equality (debit = credit) verified, information in the accounts can be used to prepare financial statements Trial balance Balance sheet

64. Trial balance 64 In list form, it illustrate the rule that asset accounts usually have debit balances and that liability and owners’ equity usually have credit balances Note that total debits are equal to total credits (error has been made in the accounting process or preparing trial balance if not agree) Not a required financial statement, primarily a worksheet to help prepare financial statement

65. Balance sheet 65 Is a formal presentation of the basic accounting equation, thus left side lists assets while the right side lists liabilities and owners’ equity and two sides must be equal

66. SUMMARY PROCEDURE 66 Essentially the recording of transactions in debit and credit format into several accounts

67. Debits and Credits 67 Journals and Ledgers can be viewed as pages of a book. Each page has lines and columns. A journal page has columns for the date, account name, and two columns for dollar amounts, referred to as the Debit and Credit columns.

68. When do we use Debit or Credit? 68 When to use debit or credit to record a journal entry is one of the biggest problems for beginners. It doesn’t have to be difficult, if your remember a few simple rules First, you will always use both a debit and credit. That’s the idea of a double-entry system. You have two columns, so every journal entry will have an equal dollar amount in each column. Remember the Accounting Equation?

69. When do we use Debit or Credit? 69 Assets=Liabilities + Owners’ Equity Left sideRight side Debit sideCredit side Debit = IncreaseCredit = Increase Credit = DecreaseDebit = Decrease Accounts on the Left side will INCREASE with a Debit (Left column) entry. Accounts on the Right side will INCREASE with a Credit (Right column) entry. They will each DECREASE with the OPPOSITE entry Refer to the Chart of Accounts to determine whether an account falls one the Left or Right side of the Accounting Equation.

70. Chart of accounts 70

71. Example 10 71 Let’s try use the summarized concept in this example: March 20, the company made a cash sale for $100 The date always starts a journal entry. Enter the month once on a page, and put the day in front of each journal entry on the page, even if they are all on the same date. The day indicates the beginning of a new journal entry. 1) Is Cash used in this transaction? YES 2) Was Cash received or paid? RECEIVED [Increase = Debit column) --- enter the Cash portion of the journal entry DateAccountDebitCredit Mar - 20 CashMar - 20Cash$100

72. Example 10 72 3) Enter the balancing dollar amount in the opposite column from Cash Almost done ….. DateAccountDebitCredit Mar - 20Cash$ 100 DateAccountDebitCredit Mar - 20Cash$ 100

73. Example 10 73 4) Refer to the information given, check the Chart of Accounts and select the correct account for the second part. This is a sale, so we will use Sales Revenue for the Credit side of the journal entryChart of Accounts The journal entry is in balance, and is complete 5)Posting into the respective accounts DateAccountDebitCredit Mar - 20Cash$ 100 DateAccountDebitCredit Mar - 20Cash$ 100 Sales Revenue$ 100 Cash DebitCredit $ 100 Sales Revenue DebitCredit $ 100

74. Example 11 74 April 1, the company paid rent $500 Note: it is customary to enter the debit part first, and the credit entry second. 1) Is Cash used in this transaction? YES 2) Was Cash received or paid? PAID (Decrease = Credit column) 3) Enter the balancing amount in the opposite column as Cash DateAccountDebitCredit Apr - 1 Cash$ 500 Apr - 1$ 500 Cash$ 500

75. Example 11 75 4) Refer to the information given, check the Chart of Accounts and select the correct account for the second part. This is an example of paying an expense, in this case Rent ExpenseChart of Accounts 5) Posting into the respective accounts DateAccountDebitCredit Apr - 1$ 500 Cash$ 500 Apr - 1Rent expense$ 500 Cash$ 500 Cash DebitCredit $ 500 Rent expense DebitCredit $ 500

76. Example 12 76 April 20, purchased computer on credit for $1000

77. 77 Part D The Financial Statement

78. 78  Income statement—A summary of the revenue and expenses for a specific period of time.  Statement of retained earnings – a summary of the changes in the retained earnings that have occurred during a specific period of time.  Balance sheet—A list of the assets, liabilities, and owner’s equity as of a specific date. Review

79. Income Statement 79 The first statement prepared is the Income Statement. The Income Statement reports a business’ performance for the period. A simple format for an income statement is: Revenues – Expenses = Net Income

80. Income Statement 80 Revenues are earned for the sale of goods or services. Note that revenues occur when the sale is made. The payment may or may not have been received. Examples of revenues include sales, service revenue and interest revenue.

81. Income Statement 81 Expenses are incurred when a business receives goods and services. Like revenues, payment may or may not have been made. Examples of expenses include salaries expense, utility expense and interest expense.

82. Income Statement 82 Most businesses require more information from their businesses than a simple income statement can provide. Therefore, they use a multi-step income statement format. A format for a multi-step income statement is:

83. Income Statement 83 Sales revenue - Cost of goods sold Gross profit - Operating expenses Income from operations +/- Non-operating items Income before taxes - Income taxes Net income

84. Income Statement 84 Cost of goods sold represents the expense a business incurred to buy or make a product for resale. Example - a book store buys a book for $25 and then sells it for $32. The cost of goods sold is $25.

85. Income Statement 85 Operating expenses are the usual expenses incurred in operating a business. Accounts such as salaries expense, utility expense, and depreciation expenses are all shown in this section.

86. Income Statement 86 Non-operating items are revenue, expenses, gains and losses that do not relate to the company’s primary operations. Accounts include interest expense and gains and losses of the sale of equipment and investments.

87. Income Statement 87 Income taxes are computed by multiplying Income before taxes by the income tax rate. Example – Income before taxes is $50,000. The income tax rate is 30%. Income taxes = $50,000 * 30% = $15,000.

88. Statement of Retained Earnings 88 The Statement of Retained Earnings reports how net income and dividends affected a company’s financial position during the period. The format of the statement is: Beg. balance, retained earnings + Net income - Dividends End. balance, retained earnings

89. Statement of Retained Earnings 89 Note that the Income Statement must be prepared before the Statement of Retained Earnings. This is because you have to know the amount of net income in order to compute the ending balance of retained earnings.

90. Balance Sheet 90 The purpose of the balance sheet is to report the financial position of an accounting entity at a particular point in time. The basic format for the balance sheet is: Assets = Liabilities + Equity

91. Classifications on the balance sheet 91 AssetsLiabilities Current AssetsCurrent liabilities InvestmentsNon-current liabilities Fixed Assets Intangible AssetsEquity Other Non-current AssetsCommon Stock Retained Earnings horizontal Assets Current Assets Investments Fixed Assets Intangible Assets Other Non-current Assets Liabilities Current liabilities Non-current liabilities Equity Common Stock Retained Earnings vertical

92. Balance Sheet 92 Assets are economic resources owned by a company. Examples include cash, accounts receivable, supplies, buildings and equipment.

93. Balance Sheet 93 There are two different types of assets shown on a balance sheet. These are current assets and non-current assets. Current assets + Non-current assets Total assets

94. Balance Sheet 94 Current assets are assets that will be used or turned into cash within one year. Examples include cash, accounts receivable, inventory, short-term investments, supplies and prepaids.

95. Balance Sheet 95 Non-current assets comprise the remainder of the assets. These include accounts such as: long-term investments, land, building, equipment and patents.

96. Balance Sheet 96 Liabilities are the company’s debt or obligations. Examples are accounts payable, unearned revenues and bonds payable.

97. Balance Sheet 97 There are two different types of liabilities shown on a balance sheet – current liabilities and long-term liabilities. Current liabilities + Long-term liabilities Total liabilities

98. Balance Sheet 98 Current liabilities are obligations that will be paid in cash (or other services) or satisfied by providing service within the coming year. Examples include accounts payable, short-term notes payable, and taxes payable.

99. Balance Sheet 99 Long-term liabilities are obligations that will not be paid or satisfied within the year. Examples include mortgage payable and bonds payable.

100. Balance Sheet 100 Equity is the residual balance. Assets – liabilities = equity. Equity is commonly called stockholders’ equity if the business is a corporation as it represents the financing provided by the stockholders along with the earnings from the business not paid out as dividends. Stockholders’ Equity is divided into two categories: contributed capital and retained earnings. Contributed capital + Retained earnings Total stockholders’ equity

101. Balance Sheet 101 Contributed capital is the amount of cash (or other assets) provided by the shareholders. Common Stock and Additional Paid in Capital are accounts in this section.

102. Balance Sheet 102 Retained earnings is the total earnings that have not been distributed to owners as dividends.

103. The Balance Sheet 103 Current assets + Non-current assets Total assets Current liabilities + Long-term liabilities + Stockholders’ equity Total liabilities and stockholders’ equity

104. Balance Sheet 104 The Balance Sheet must be prepared after the Statement of Retained Earnings in order to have calculated the ending balance of Retained Earnings.

105. Income Statement Net income Income Statement Net income Statement of Retained Earnings Beginning Retained Earnings +Net income –Dividends Ending retained earnings Statement of Retained Earnings Beginning Retained Earnings +Net income –Dividends Ending retained earnings Balance Sheet Ending Balance Retained Earnings Balance Sheet Ending Balance Retained Earnings Order of Preparation 105

106. Example 13 Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 106

107. Step 1 107 Classify the accounts as assets, liabilities, equity, revenue or expenses.

108. Assets Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 108

109. Assets, Liabilities, Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 109

110. Assets, Liabilities, Equity Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 110

111. Assets, Liabilities, Equity, Revenues Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 111

112. Assets, Liabilities, Equity, Revenues, Expenses Cash5,000Sales100,000 Utility Expense8,000Buildings65,000 Common Stock45,000Accounts Payable12,000 Supplies4,000Cost of Goods Sold58,000 Interest Expense5,000Additional Paid in Capital 20,000 Bonds Payable40,000Supplies Expense3,000 Salaries Expense16,000Accounts Receivable10,000 Inventories45,000Retained Earnings5,000 (beg. bal.) Income Tax Rate30% 112

113. Step 2 113 Prepare the Income Statement. Sales revenue - Cost of goods sold Gross profit - Operating expenses Income from operations +/- Non-operating items Income before taxes - Income taxes Net income

114. Income Statement Sales100,000 - Cost of Goods Sold-58,000 Gross Margin42,000 - Operating Expenses-27,000 Income from Operations 15,000 - Non-operating Items-5,000 Income before Taxes10,000 - Income Taxes-3,000 Net Income7,000 114

115. Income Statement Sales100,000 - Cost of Goods Sold-58,000 Gross Margin42,000 - Operating Expenses-27,000 Income from Operations 15,000 - Non-operating Items-5,000 Income before Taxes10,000 - Income Taxes-3,000 Net Income7,000 115 Operating expenses include: Utility expense 8,000 Salaries expense 16,000 Supplies expense 3,000

116. Income Statement Sales 100,000 - Cost of Goods Sold-58,000 Gross Margin42,000 - Operating Expenses-27,000 Income from Operations 15,000 - Non-operating Items-5,000 Income before Taxes10,000 - Income Taxes-3,000 Net Income7,000 116 Non-operating items include: Interest expense 5,000

117. Income Statement Sales 100,000 - Cost of Goods Sold-58,000 Gross Margin42,000 - Operating Expenses-27,000 Income from Operations 15,000 - Non-operating Items-5,000 Income before Taxes10,000 - Income Taxes-3,000 Net Income7,000 117 Income taxes = Income before taxes * Income tax rate 10,000 * 30% = 3,000

118. Step 3 118 Prepare the Statement of Retained Earnings. Beg. balance, retained earnings + Net income - Dividends End. balance, retained earnings

119. Statement of Retained Earnings Beginning Balance, Retained Earnings 5,000 + Net Income+7,000 - Dividends-0 Ending Balance, Retained Earnings 12,000 119 Net Income is brought forward from the Income Statement.

120. Step 4 120 Prepare the Balance Sheet. Current assets + Non-current assets Total assets Current liabilities + Long-term liabilities + Stockholders’ equity Total liabilities and stockholders’ equity

121. Balance Sheet Current Assets:Current Liabilities: Cash5,000Accounts Payable12,000 Accounts Receivable10,000Long-term liabilities: Inventories45,000Bonds Payable40,000 Supplies4,000Stockholders’ Equity: Non-Current Assets: Common Stock45,000 Buildings65,000Additional Paid in Capital 20,000 Retained Earnings12,000 Total Assets129,000Total Liabilities and Equity 129,000 121

122. Balance Sheet Current Assets:Current Liabilities: Cash5,000Accounts Payable12,000 Accounts Receivable10,000Long-term liabilities: Inventories45,000Bonds Payable40,000 Supplies4,000Stockholders’ Equity: Non-Current Assets: Common Stock45,000 Buildings65,000Additional Paid in Capital 20,000 Retained Earnings12,000 Total Assets129,000Total Liabilities and Equity 129,000 122 End. Bal. is brought forward from the Statement of Retained Earnings

123. Example 14 123 Prepare the financial statements based on the following information ParticularsRM Sales1,500,000 Cost of goods sold430,000 Salary240,000 SOCSO2,000 Maintenance cost10,000 Utility24,000 Telecommunication12,000 Management fee2,000 Office expenses1,500 Travelling expenses3,000 Insurance4,000 Security6,000 Stationary1,200

124. Example 14 124 Mark as (R) Revenue or (E) Expenses ParticularsRMClassification Sales1,500,000R Cost of goods sold430,000E Salary240,000E SOCSO2,000E Maintenance cost10,000E Utility24,000E Telecommunication12,000E Management fee2,000E Office expenses1,500E Travelling expenses3,000E Insurance4,000E Security6,000E Stationary1,200E

125. Example 14 125 Income statement: Revenue – Expenses = Net Income ParticularsRM Sales1,500,000 (-) Cost of goods sold430,000 Gross profit1,070,000 Less expenses: (-) Salary240,000 (-) SOCSO2,000 (-) Maintenance cost10,000 (-) Utility24,000 (-) Telecommunication12,000 (-) Management fee2,000 (-) Office expenses1,500 (-) Travelling expenses3,000 (-) Insurance4,000 (-) Security6,000 (-) Stationary1,200 Total expenses332,100 Net profit737,900

126. Example 15 126 Prepare a balance sheet with the provided information ParticularsRM Cash$45,000 Buildings330,000 Current liabilities95,000 Long-term liabilities300,000 Accounts receivable115,000 Invested capital100,000 Inventories100,000 Retained earnings95,000

127. Example 15 127 Remember balance sheet: Assets = Liability + Owners Equity Classify each item as Assets (A), Liability (L) or Owner’s Equity (OE) ParticularsRMClassification Cash$45,000 A Buildings330,000 A Current liabilities95,000L Long-term liabilities300,000L Accounts receivable115,000A Invested capital100,000E Inventories100,000A Retained earnings95,000E

128. Example 15 128 Prepare balance sheet Balance Sheet for year 2010 Asset Cash$ 45000 Buildings330000 Accounts receivable115000 Inventories100000 Total Assets$ 590000 Liability Current liability$ 95000 Long-term liability300000 Owners' equity Capital100000 Retained earnings95000 Total Liability and Owner's Equity$ 590000

129. 129 PART E ANALYSING FINANCIAL STATEMENTS

130. 130

131. Financial ratio analysis 131 The financial health of a company is determined by analyzing the financial statements. The vital signs are tested mostly by various financial ratios that are calculated from the financial statements. These vital signs can be classified into three main categories: 1. Short-term liquidity: o working capital, current ratio, quick ratio 2. Long-term solvency. o times interest earned, debt to equity ratio, debt to asset ratio 3. Profitability. o Gross margin, gross margin percentage, profit margin on sales, return on investment

132. Short-term liquidity 132 Can this company survive? Business survival means being able to pay the bills, meet the payroll, and come up with the rent. In other words, is there enough liquidity to provide the cash needed to pay current financial commitments? “Yes” means survival. “No” means bankruptcy.

133. Short-term liquidity 133 Most businesses cannot operate without positive working capital, the question of whether current assets exceed current liabilities is crucial. When current assets are greater than current liabilities, there is sufficient liquidity to enable the enterprise to survive. Net current assets (current assets - current liabilities) is known as working capital.

134. Short-term liquidity 134 Current Assets Current assets are those that will be available to conduct business and pay bills in the near future, within the coming year. Long term assets are those that will benefit the company beyond the current year. Current assets consist of: o Cash o Accounts Receivable o Notes Receivable o Short Term Investments o Inventory o Prepaid Expenses

135. Short-term liquidity 135 However, when current liabilities exceed current assets the enterprise may well be in imminent danger of bankruptcy. It is expressed as “2.5 to 1” or “2.5_1” or just “2.5.” Keeping the current ratio from dropping below 1 is the bare minimum to indicate survival, but it lacks any margin of safety. The financial ratio used to measure this risk is current assets divided by current liabilities, and is known as the current ratio.

136. Short-term liquidity 136 A company must maintain a reasonable margin of safety, or cushion, because the current ratio, like all financial ratios, is only a rough approximation. For this reason, in most cases a current ratio of 2 or more just begins to provide credible evidence of liquidity.

137. Short-term liquidity 137 Quick ratio is often called the acid test. “Quick” means close to cash. The quick ratio indicates the resources that may be available quickly, in short term, for repaying the current liabilities. Quick Assets are used to calculate the Quick Ratio. Cash, Accounts and Notes Receivable, and Short Term Investments are quick assets.

138. Short-term liquidity 138 For this reason, Inventory and prepaid expenses are left out Values for quick ratio are often less than 1.0 but not lesser than 0.3. Declining trends should cause the most concern To calculate this quick ratio, cash and receivable are added and then divided by all current liabilities.

139. Short-term liquidity 139 Current Liabilities Current liabilities are those that will come due within the next year. They are matched to current assets, because the money generated from current assets will pay the current liabilities. Current liabilities consist of: o Current portion of Notes Payable o Accounts Payable o Accrued Expenses Payable (taxes, interest, payroll) o Unearned Revenue