fina cc mba course

8/3/2019 Fina Cc Mba Course

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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 andobligations at one point in time.- Results of operations: describes its financial activities during anaccounting period.

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Managerial Accounting

Involves the development and interpretation of accounting information intendedspecifically to aid management in running the business (budgeting costaccounting, 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 oftheir 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 wouldyou 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 provideinformation:

- useful in making investment and credit decisions,

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- about economic resources, claims to resources, and changes in theseresources 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 companyis 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 isowned and operated by the same person.. The owner maintains title to the assetsand is personally responsible, generally without limitation, for the liabilitiesincurred. The proprietor is entitled to the profits of the business but must alsoabsorb any losses.

Partnerships

The primary difference between a partnership and a sole proprietorship is that thepartnership has more than one owner. A partnership is an association of two ormore 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 andjointly responsible for all debts of the partnership.

A partnership is often referred to as a firm. Partnerships are the least commonform of business organization, probably because they often wind up with toomany bosses. However, they are widely used for professional practices such asmedicine, law, and public accounting.Partnerships are also used for many small businesses, especially those that arefamily-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 tothose of a sole proprietor. For example, each general partner can withdraw cashand other assets from the business at will. Also, each partner has the full authorityof an owner to negotiate contracts binding upon the business. Every partner also

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has unlimited personal liability for the debts of the firm. This makes a generalpartnership a potentially dangerous form of business organization.

In summary, general partnerships involve the same unlimited personal liability assole 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 thepotential liability of individual partners.

A limited partnership has one or more general partners and also one or morelimited partners. The general partners are partners in the traditional sense, withunlimited personal liability for the debts of the business, and also the right to makemanagerial decisions.

The limited partners are basically passive investors. They share in the profits ofthe business, but do not participate actively in management and are not personallyliable for debts of the business. Their maximum exposure is limited to the loss ofthe amounts they have invested in the partnership.

A limited liability partnership is a relatively new form of business organization. Inthis type of partnership, each partner has unlimited personal liability for his or herown professional activities, but not for the actions of other partners. Unlike alimited partnership, all of the partners of a limited liability partnership mayparticipate 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 thatof its owners. The owners of a corporation are called stockholders (or

shareholders), and their ownership is evidenced by transferable shares of capitalstock.

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 alsomust receive authorization from that state to issue shares of capital stock.

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As a separate legal entity, a corporation may own property in its own name. Theassets of a corporation belong to the corporation itself, not to the shareholders. Acorporation has legal status in court it may sue and be sued as if it were aperson. 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 bythe stockholders. The stockholders are primarily investors, rather than activeparticipants in the business.

The top level of a corporations management is the board of directors. Thesedirectors are elected by the stockholders, and are responsible for hiring the otherprofessional managers. In addition, the directors make major policy decisions,including the extent to which profits of the corporation are distributed tostockholders.

The transferability of corporate ownership, together with professionalmanagement, gives corporations a greater continuity of existence than otherforms of organizations. Individual stockholders may sell, give or bequeath theirshares to someone without disrupting business operations. Thus, a corporationmay continue its business operations indefinitely, without regard to changes inownership.

Stockholders in a corporation have no personal liability for the debts of thebusiness. If a corporation fails, stockholders potential losses are limited to theamount 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 ofbusiness organization.

Creditors have claims against only the assets of a corporation, not the personalassets 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 orwithdraw assets from the business. These investment transactions causechanges in the amount of the owners equity, but they are not considered revenueor expenses of the business.

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Investments of assets by the owner are recorded by debiting the asset accountsand crediting the owners capital account. This transaction is not viewed asrevenue, because the business has not sold any merchandise or rendered anyservice in exchange for the assets received.

The income statement of a sole proprietorship does not include any salary expenserepresenting the managerial services rendered by the owner. One reason for notincluding a salary to the owner-manager is that individuals in such positions areable to set their salaries at any amount they choose. The use of an unrealisticsalary to the proprietor would tend to destroy the usefulness of the incomestatement for measuring the profitability of the business. Thus, accountants regardthe 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 usuallymakes 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 bythe 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 theowners drawing account result from such transactions as :

1. withdrawals of cash,2. withdrawals of other assets,3. payment of the owners personal bills out of company funds.

As investments and withdrawals by the owner are not classified as revenue andexpenses, 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 servicesprovided to the organization by the partners. Amounts paid to partners arerecorded 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 insteadof owners equity.

The stockholders equity section of a corporate balance sheet must clearly indicatethe 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 profitableoperation of the business (retained earnings).

When stockholders invest cash or other assets in the business, the corporationissues 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 capitalpaid in by stockholders is regarded as permanent capital, not subject towithdrawal.

Stockholders are not allowed to withdraw cash or any other asset from thecorporation. If a corporation has sufficient cash, a distribution of profits may bemade to stockholders. Distributions of this nature are called dividends anddecrease both total assets and total stockholders equity. Because dividends areregarded as distribution of earnings, the decrease in stockholders equity isreflected in the Retained Earnings account. Thus, the amount of retained earningsat 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 cashavailable to a corporation. Retained earnings is not an asset; it is an element of thestockholders equity. Although the amount of retained earnings indicates theportion of total assets which are financed by earning and retaining net income, itdoes 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 ownedby 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 adistribution of cash by a corporation to its stockholders. Dividends are stated as aspecific amount per share of capital stock, e.g; a dividend of $ 1 per share. The

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amount received by each stockholder is in proportion to the number of sharesowned. 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 hasfull 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 isa current liability of the corporation and cannot be rescinded.

Stock dividends

Stock dividend is a term used to describe a distribution of additional shares ofstock to a companys stockholders in proportion to their present holdings. Thedividend is payable in additional shares of stock rather than in cash.

Three primary financial statements

Balance sheet

Gives the financial position of a companyat a given point in time (usually at year-end) a snap-shot showing the assets

(what the company owns), the liabilities(what the company owes), and theamount of the owners equity.

Income Statement

Indicates the profitability of a companyover a certain period of time a movie orfilm showing the revenues, expenses andprofits (or losses) of the company.

Statement of Cash Flows

Summarizes the cash receipts and cashdisbursements of the business over thesame period of time as the incomestatement.

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Basic purpose of these financial statements

To assist users in evaluating the financial position, the profitability, and the futureprospects of a company.

These financial statements must be comparable, accurate and reliable.

Therefore, financial statements must be prepared in conformity with certain ruleswhich are referred to as GAAPs (Generally Accepted Accounting Principles). Theymust also be prepared by professionals within the company using internal

control systems, and audited by external professionals (CPAs, Experts-Comptables, Chartered Accountants, etc).

Generally Accepted Accounting Principles (GAAPs)

Accounting information that is communicated externally to investors and creditorsmust be prepared in accordance with standards that are understood by both thepreparers and users of that information. These standards are called Generallyaccepted accounting principles, or GAAPs.

These principles provide the general framework for determining what informationis included in financial statements and how this information is to be prepared andpresented. GAAPs include broad principles of measurement and presentation, aswell as detailed rules that are used by professional accountants in preparingaccounting information and financial reports.

Accounting principles vary somewhat from country to country. The phrasegenerally accepted accounting principles refers to the accounting concepts inuse 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 thatraise capital from U.S. investors usually issue financial statements in conformitywith GAAPs.

Several international organizations currently are attempting to establish greateruniformity among the accounting principles in use around the world in order to

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facilitate business activity that increasingly is carried out in more than onecountry.

In the U.S., two organizations are particularly important in establishing generallyaccepted 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 inthe official pronouncements of the standard-setting organizations. The businesscommunity is too complex and changes too quickly for every possible type oftransaction to be covered by an official pronouncement. Thus, practicingaccountants often must account for situations that have never been addressed bythe FASB. There is, however, a consensus among accountants and informed usersof 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 aclearly defined accounting entity. An accounting entity is any economic unit whichcontrols resources and engages in economic activities. An individual is anaccounting entity. So is a business enterprise, whether organized as aproprietorship, partnership or corporation. An accounting entity may also bedefined as an identifiable economic unit within a larger accounting entity. For

example, the Minute-Maid Division of The Coca-Cola Company may be viewed asan accounting entity separate from Cokes other activities.

Although there is considerable flexibility in defining an accounting entity, one mustbe careful to use the same definition in the measurement of assets, liabilities,stockholders equity, revenue and expenses. An income statement would not makesense, for example, if it included all the revenue of The Coca-Cola Company butlisted only the expenses of the Minute-Maid Division.

This principle is extremely important in the case of allocation of revenue orexpenses 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 continuein operation for a period of time sufficient to carry out its existing commitments. Ingeneral, the going-concern assumption justifies ignoring the liquidating values inpresenting assets and liabilities in the balance sheet.

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For example, suppose that a company has just purchased a three-year insurancepolicy for $ 6,000. If we assume that the business will continue for three years ormore, we will consider the $ 6,000 cost of the insurance as an asset (prepaidexpense) 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 policyshould be recorded at its cancellation value (the amount of cash that can berecovered from the insurance company as a refund), say $ 5,500.

Of course, although the going-concern assumption is justified in most normalsituations, it should not be applied when it is not in accord with the facts. In case ofreal liquidation of a company, accountants should use the current liquidatingvalues of the assets and the liabilities at the amounts required to settle the debtsimmediately, and not apply the going-concern assumption.

The time-period principle

The users of financial statements need information that is reasonably current andthat is comparable to the information relating to prior accounting periods.Therefore, for financial reporting purposes, the life of a business must be dividedinto a series of relatively short accounting periods of equal length (at least,annually; for publicly-owned companies, at least quarterly; for most well-runcompanies, 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 measuringunit for financial reporting. The dollar, or any other currency unit, is a measure ofvalue. This means that it indicates the relative price (or value) of different goodsand services.

When accountants add or subtract dollar values originating in different years, theyimply that the dollar is a stable unit of measure, just as the meter, the liter, or thekilogram are stable units of measure. Unfortunately, the dollar (as well as the othercurrencies) is not a stable measure of value. (Inflation).

To compensate for the shortcomings of the stable-dollar assumption, the FASBasks large corporations voluntarily to prepare supplementary informationdisclosing 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 maycause 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 toverification by independent experts. Accountants rely on various kinds of evidenceto support their financial measurements, but they seek always the most evidenceavailable. Invoices, contracts, paid checks, and physical counts of inventory areexamples of objective evidence.

Despite the goal of objectivity, it is not possible to insulate accounting informationfrom opinion and personal judgment. For example, the cost of a depreciable assetcan be determined objectively but not the periodic depreciation expense.

Depreciation expense is simply an estimate based upon estimates of the useful lifeand the residual value of the asset, and a judgement as to which depreciationmethod is most appropriate. Such estimates and judgements can producesignificant variations in the measurement of net income.

Objectivity in accounting has its roots in the quest for reliability. Accountants wantto make their economic measurements reliable and, at the same time, as relevantto decision-makers as possible. There is a constant necessity to make acompromise between reliability and relevance of financial information.

Asset valuation : the cost principle

Both the balance sheet and the income statement are affected by the costprinciple. Assets are initially recorded at cost, and no adjustment is made to thisvaluation in later periods, except to allocate a portion of the original cost toexpense as the assets expire.

At the time an asset is originally acquired, its cost represents the fair marketvalue of the goods or services exchanged. With the passage of time, however, thefair market value of such assets as land or buildings may change greatly from theiroriginal, 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 thebalance sheet at historical cost (less the accumulated depreciation).

The newly issued International Financial Accounting Standards, however, aretaking 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 anddoes 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 howmuch of the earning process is complete. However, the earning process for salesrevenue relates to economic activity rather than a specific period of time. In amanufacturing business, for example, the earning process involves(1) acquisition of raw materials, (2) production of finished goods, (3) sales of thefinished goods, and (4) collection of cash from credit customers. In this example,there is little objective evidence to indicate how much revenue has been earnedduring the first two stages of the earning process. Therefore, accountants usuallydo not recognize revenue until the revenue has been realized. Revenue is realizedwhen both of the following conditions are met : (1) the earning process is

essentially complete, and (2) objective evidence exists as to the amount of therevenue earned.

I most cases, the realization principle indicates that revenue should be recognizedat the time goods are sold or services are rendered. At this point , the business hasessentially completed the earning process and the sales value of the goods orservices can be measured objectively. After the sale, the only step that remains isto collect from the customer.

Measuring expenses : the matching principle

Revenue, the gross increase in net assets resulting from the production and sale ofgoods or services is offset by expenses incurred in bringing the firms output to thepoint of sale. The measurement of expenses occurs in two stages : (1) measuringthe cost of goods and services that will be consumed or expire in generatingrevenue and (2) determining when the goods and services acquired havecontributed to revenue and their cost thus becomes an expense. The secondaspect of the measurement process is often referred to as matching costs andrevenue and is fundamental to the accrual basis of accounting.

Costs are matched with revenue in two major ways :

1. in relation to the product sold or service rendered,2. in relation to the time period during which revenue is earned.

The consistency principle

The principle of consistency implies that a particular accounting method, onceadopted, 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 financialposition and changes in net income. (ex : depreciation methods).

The principle of consistency does not mean that a company should never make achange in its accounting methods. In fact, a company should make a change if a

proposed new accounting method will provide more useful information than doesthe method presently in use. But when a significant change in accounting methodsdoes occur, the fact that a change has been made and the dollar effects of thechange should be fully disclosed.

The disclosure principle

Adequate disclosure means that all material and relevant facts concerningfinancial position and the results of operations are communicated to users. Thiscan 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 butbefore the financial statements are issued may need to be disclosed. The key pointto bear in mind is that the supplementary information should be relevant to theinterpretation 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 notoverly concerned with those items which have little effect on financial statements.(Pencil sharpener, wastepaper basket, stapler : asset with correspondingdepreciation, or expense ?)Materiality of an item is a relative matter. What is material for one business unitmay not be material for another. Materiality of a, item may depend not only on itsamount but also on its nature.

In summary : An item is material if there is a reasonable expectation thatknowledge of it would influence the decisions of prudent users of financialstatements.

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 incomedetermination. Conservatism is most useful when matters of judgment( orestimates are involved. When some doubt exists about the valuation of an asset or

the realization of a gain, accountants traditionally select the accounting optionwhich produces a lower net income for the current period and a less favourablefinancial position.

COMPANY XYZBALANCE SHEET

AS AT DECEMBER 31, 2009

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ASSETS LIABILITIES + EQUITY

Current Assets C urrent Liabilities

Cash Notes PayableMarketable Securities Accounts PayableNotes Receivable Other PayablesAccounts Receivable S-T portion of L-T N/PInventory Unearned RevenuePrepaid ExpensesTotal Current Assets Total Current Liabilities

Fixed Assets Long-Term Liabilities

Land Notes PayableBuildings Bonds PayableEquipment Total Long-Term LiabilitiesCars & TrucksTotal Fixed Assets Total Liabilities

Other Assets Equity

Goodwill CapitalPatents, etc. Retained Earnings

Total equity

TOTAL ASSETS 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:

- amount recorded on the left side: debit (Dr)- amount recorded on the right side: credit (Cr)

Balances:

- 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 thea/c.

Asset Account

Increases Decreases(Debits) (Credits)

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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 Increases(Debits) (Credits)

DEBIT & CREDIT RULES

Assets Liabilities & Equity

Increases (Dr) Increases (Cr)Decreases (Cr) Decreases (Dr)Dr balance 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 10 = 6 + 4

12 = 8 + 4 8 = 4 + 4

If there is a change on the left side without any change on the right side, thischange is balanced by an equal change (of the opposite sign) on the left side.

10 = 6 + 412 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 + 410 = 8 2 + 4

1. Michael Mc Bryan sets up his company and deposits $ 50,000 in a bankaccount.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 Cash 50,000Capital 50,000

Sept. 3 Office equipment 5,000Cash 5,000

Sept. 5 Machinery & Equipment 15,000

Accounts payable 15,000

Sept. 15 Accounts payable 7,500Cash 7,500

Sept. 17 Accounts receivable 1,000Office equipment 1,000

Oct. 17 Cash 1,000Accounts Receivable 1,000

Ledger accounts or T- accounts

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 XYZINCOME 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 theproducts 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-operatingitems

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 (forsales 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 Payableor 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 Inventory 150,000Accounts Payable 150,000

Sept. 2 Accounts Receivable 100,000Sales 100,000

Sept. 2 Cost of Goods sold 75,000Inventory 75,000

Sept. 3 Rental Expense 2,000Cash 2,000

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Sept. 5 Office Equipment 10,000Accounts Payable 10,000

Sept. 10 Insurance Expense 1,500

Insurance Payable 1,500

Sept. 30 Salaries Expense 12,500Salaries payable 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.

- Name of business entity- Name of financial statement (Balance Sheet)- B/S date

Assets Liabilities +Owners equity

AssetsCash

Marketable securities Liquid assetsN/R (easily convertibleA/R into cash or usedInventories in business ops)Prepaid Expenses

LandBuildings More permanentEquipment assetsCars, trucks, etc.

Other Assets

Liabilities

N/P Short-term &A/P Long-term

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Owners equity

CapitalRetained Earnings

Assets

- economic resources owned by a business, expected to benefit futureoperations,- physical: cash landbuildings, 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 beensettled.

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 afuture date a definite sum of money, generally with interest. Valued at faceamount 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 60days.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 investigatethe creditworthiness of each prospective customer. Nonetheless, if a companymakes credit sales to hundreds, maybe thousands of customers, some accountsinevitably will turn out to be uncollectible.

An account receivable which has been determined to be uncollectible is no longeran asset. The loss of this asset represents an expense, termed UncollectibleAccounts Expense. The counterpart is an Allowance for Doubtful accounts whichwill appear on the balance sheet as a deduction from the accounts receivable. Thenet balance is the net realizable value.

Evaluating the quality of accounts receivable

Collecting accounts receivable on time is important. A past-due account is acandidate for write-off as a credit loss. To help judge how good a job a company isdoing 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 theyear :

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A/R turnover rate = Annual net salesAverage 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 costsare 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 theinventory valuation methods.

The difference in these methods lies in determining which costs should beremoved from Inventory when the merchandise is sold.

Indeed, a company often has in its inventory units of a given product which wereacquired at different costs (different dates, different suppliers, different purchaseprices).

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 soldAvg. Inventory

Nr of days = 365 daysInventory 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, officesupplies, and advertising supplies.

If the advance payment (or prepayment) will benefit more than just the currentaccounting period, the cost represents an asset rather than an expense.

The cost of this asset will be allocated to expense in the accounting periods inwhich the services or the supplies are used.

Prepaid expenses are assets: they become expenses only as the goods or servicesare 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 forresale to customers.

Largest category of assets in most balance sheets.

Fixed assets are similar to long-term prepaid expenses : land, buildings, plant andoffice 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 necessaryfor 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 ofyears.

Depreciation is the allocation of the cost of these assets to expense in the period inwhich services are rendered to the company from these assets.

The basic purpose of depreciation is to achieve the matching principle, i.e. offsetrevenues of the accounting period with costs of goods and services beingconsumed in the effort of generating those revenues.

Causes of depreciation:

- physical deterioration which results primarily from the use of thoseassets,- 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 expenseto 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 1divided by 5 = 20 %.

- Accelerated depreciation : means that larger amounts of depreciation arerecognized 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 andaccelerated method recognize the same total amount of depreciation.

There is only one straight-line method, but there are several different accelerateddepreciation 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 ayearly depreciation of 20 %. By using the double-declining method, the companywould use40 % (20 % x 2), and in the 150 %, the depreciation rate would be 30 % (20 % x1.5).

Depreciation methods in use should be disclosed in the notes accompanying thefinancial statements.

The straight-line method is generally used in financial statements.

The accelerated method is generally used for income tax returns (higher chargesto expenses, lower reported net income lower taxes).

Different depreciation methods can be used for financial statements and forincome tax returns.

The depreciation of fixed assets is recorded by a debit to Depreciation Expensesand a credit to an account called Accumulated depreciation which appears onthe B/S as a reduction of the fixed asset account. The B/S will then show the Netbook 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 aredepreciated.

Lets now go over to the right side of the balance sheet : how the companysassets 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 settlementat 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, Salariespayable, etc). Sometimes, they have to be estimated (e.g. warranty obligations oncars).

Current Liabilities

Obligations that must be repaid within one year. If not, are classified as Long-TermLiabilities.

Four major classifications:

1. Accounts payable : short-termobligations to suppliers for purchase

of merchandise.

2. Other payables : short-term obligations to suppliers of goods orservices other than merchandise.

3. Accrued liabilities (accruals) : arisefrom recognition of expenses for

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which payment will be made at somefuture date (matching principle), e.g. :

Interest payable : cost of borrowing

Income taxes payable : income taxes accrue as profits are earned. Amount isestimated 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 willbe rendered at a later date (airline companies pre-selling flight tickets).

4. Current portion of Long-Term Debt :

L-T debts are often payable inquarterly or annual installments. Theprincipal amount due within one yearis regarded as current liabilities andthe 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 statedseparately 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 (accompanyingnotes) 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 agreat many units, called bonds.

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Each bond represents a long-term, interest-bearing note payable, usually in faceamount of $ 1,000.

Bonds are sold to the investing public, enabling many different bondholders toparticipate 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 anytime.

Bonds generally call for semi-annual interest payments to bondholders withinterest computed at a specified contractual rate.

Bonds are quoted daily as a percentage of their face/maturity value on the bondmarkets. 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 interestrate 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 strengthto 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 bondholdersis tax-deductible whereas dividends are not.

EQUITY

Sole proprietorships :

Michael Bryan, Capital 50,000

Partnerships :

Tom Brown, Capital 40,000Jo White, Capital 60,000Bill Green, Capital 50,000

150,000

Corporations and Stockholders Equity

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Corporation:

- Legal entity with rights and responsibilities separate from those of itsowners,- 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 thedebts of a corporation,

- transferability of ownership: transferability of shares of capital stockwhich 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 thecorporation.

Shareholders meetings

- usually, once a year,- usually, 1 to 2 % of shareholders proxies are sent by thoseshareholders not being able to attend.

Stockholders Equity

Two basic sources:

- Investments by stockholders = paid-in capital- Increase in stockholders equity arising from profitable operations viaRetained Earnings.

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Capital invested by the stockholders is recorded in the companys accounts by acredit to an account called Capital Stock.

Increase in stockholders equity arising from profitable operations is calledRetained Earnings.

Stockholders Equity

Capital Stock $ 1,000,000Retained Earnings 600,000

---------------- Total stockholders equity $ 1,600,000

Issuance of capital stock

The Articles of Incorporation specify the number of shares a corporation isauthorized to issue by the State of incorporation. If the shares are sold to thepublic, 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 whichthe 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 : Cash $ 20,000Capital stock $ 20,000

Above par: Cash $ 100,000Capital stock $ 20,000Additional paid-in capital $ 80,000

Additional paid-in capital is not a profit to the corporation. It is part of the investedcapital 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 andopportunities.

The basic type is called Common Stock: traditional rights of ownership (voting,participation in dividends, residual claim to assets in case of liquidation). Everycorporation has Common stock.

Some corporations also have one or more types ofPreferred Stock.

Characteristics of preferred stock

1. Stocks preferred as to dividends :- entitled to receive each year a dividend of a specified amount before anydividend is paid on common stock,- preferred stocks generally have a par value much higher than commonstocks ($ 100) and the dividend is usually stated as a $ amount, or as a % of parvalue, so a 9 %, $ 100 preferred stock means that the preferred dividend willamount to 9 % of $ 100 = $ 9,- preferred stocks generally offer more assurance that investors willreceive 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 inarrears and must be paid in a subsequent year before any dividend can be paid oncommon stock.

3. Stock preferred as to assets :preference as to distribution of assets in case of liquidation of the company.

4. Callable preferred stock :most preferred stocks include a call provision which grants the issuing corporationthe 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 aconversion privilege which entitles the preferred stockholders to exchange theirpreferred 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 assetsrepresented 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) 4,000Addit. Paid-in capital 40,000Retained earnings 76,000Total stockholders equity 120,000

Book value = $ 120,000 = $ 304,000 ===

Book value when a C has common stock and preferred stock :

- deduct the call price of the entire preferred stock and all dividends inarrears,- divide the remaining balance of stockholders equity by the number ofcommon shares outstanding.

MARKET VALUE

Prices at which shares change hands represent the current market price of thestock.

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 issuingcompany. Thus, changes in the market price affect the financial position of thestockholders, not of the issuing company.

Financial Analysis and Stock Price

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Assume that a company has rapidly been increasing net sales and earnings, andalso earns high returns on assets and stockholders equity. Is its stock a goodbuy at the present ?

Stock prices, like p/e ratios, are a measure of investors expectations. A companymay be highly profitable and growing fast. But if investors had expected evenbetter performance, the market price of its stock may decline. Similarly, if atroubled companys losses are smaller than expected, the price of the stock mayrise.

In financial circles, evaluating stock price by looking at the underlying profitabilityof the company is termed fundamental analysis.

This approach to investing works better in the long run than in the short run. In theshort run, stock prices can be significantly affected by many factors, including

short-term interest rates, current events, political events, fads, and rumors. But, inthe 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 thatmanagement has created a business worth substantially more than the historicalcost, which is the sign of a successful company.

If the market price is below the book value, investors believe that the business isworth less than the historical cost.

Thus, the relationship between book value and market price is one measure ofinvestors confidence in a companys management.

EARNINGS PER SHARE

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Another very important, and one of the most widely used accounting statistics, isearnings per share of common stock EPS.

Investors who buy or sell stock in a corporation need to know the annual earningsper 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 needto know the earnings per share and the annual dividend per share to decidewhether this price is reasonable.

To compute earnings par share, the common stockholders share of the companysnet 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 uponthe weighted average number of shares outstanding.

When the company has preferred stock outstanding, the amount of the currentyear preferred stock dividends must be deducted from net income.

All publicly-owned corporations are required to present EPS data in their IncomeStatement.

If the income statement includes sub-totals for Income from Continuing Operationsand/or Income before Extraordinary Items, the per-share amounts are shown forthese amounts as well as for Net Income.

EPS from Continuing Operations represents the results of continuing and ordinarybusiness activity. It is the most useful one for predicting future operating results.

Net EPS shows the overall operating results of the current year, including anydiscontinued operations and/or extraordinary items.

Primary (or basic) and fully diluted EPS

Assume that a company has an outstanding issue of preferred stock that isconvertible 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) theEPS.

Any stockholder will want to know what effect this conversion of preferred stockwould have upon EPS.

Remember that the decision to convert the preferred shares into common stock ismade by the stockholders, not the corporation.Two figures are presented for EPS :

- primary (or basic) EPS : based upon the weighted average of commonshares actually outstanding during the year,

- fully diluted EPS : shows the impact that the conversion of preferredstock 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 theyear hypothetical case, because EPS is computed even though the preferredstock actually was not converted it is just to warn the stockholders what wouldhappen.

In the financial newspapers and magazines, it is always the primary EPS that isshown.

Another accounting statistic is the Price/Earnings ratio (p/e ratio) which expressesthe relationship between EPS and stock price

p/e ratio = Current market priceEPS

Stock prices reflect investors expectations of future earnings, whereas the p/eratio is based upon the earnings over the past year.

So, if investors expect earnings to increase substantially from current levels, thep/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 below, maybe 8 or less. A mature company with very stable earnings usually sells for10 to 12 times earnings. Thus, the p/e ratio reflects investors expectations of thecompanys future prospects.

P/e ratios are of such interest to investors that they are published daily in thefinancial 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 investmentback as well as a reasonable return on that investment. The return of a stockinvestment 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 animmediate increase or drop in the market price of the companys stock.Many profitable corporations, in an early stage of development and having toconserve cash for the purchase of plant and equipment or for other needs of thecompany, do not pay dividends.

Often, only after a significant number of profitable operations does the board ofdirectors decide that paying a cash dividend is appropriate. Stockholders are infavor 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 cashdividends :

1. Retained earnings : since dividends represent a distribution of earnings tostockholders, the theoretical maximum for dividends is the total undistributed netincome of the company, represented by the credit balance of the Retainedearnings account. However, many corporations limit dividends to amountssignificantly 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 ofcash on hand. This cash may be needed for the purchase of fixed assets, paying offdebts, 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 earningsare substantial and its cash position is satisfactory, dividends are not paidautomatically. A formal action by the Board is necessary to declare a dividend.

Dividend dates

1. Date of declaration2. Ex-dividend date3. Date of record4. Date of payment

As soon as a dividend is declared by the Board, it becomes a liability : Dividendspayable.

Stock dividends

Is a distribution to stockholders of additional shares of the corporations own stockin proportion to their present holdings (in lieu of cash).

When cash dividends reduce both assets (cash) and stockholders equity (retainedearnings) by the same amount, stock dividends cause no change in assets nor inthe total amount of stockholders equity.

The only effect is to transfer a portion of Retained Earnings into the Common Stockaccount.

Reasons for distributing stock dividends

1. to conserve cash no distribution of assets2. to reduce the price per share of stock to a more convenient trading range3. 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 ofshareholders 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 reducingthe 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 byMemorandum.

STATEMENT OF RETAINED EARNINGS

The amount of Retained Earnings appearing in the Stockholders Equity section ofthe balance sheet represents the accumulated earnings of a corporation since thedate 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 ofperiodic income. Both the market price of common stock and the amount of cashdividends per share depend on current and future earnings.

The income statement gives us a view of the performance of a company over thepast year (revenue earned, expenses incurred, gross profit and net incomegenerated).

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 justcompleted are of a normal recurring nature, we can reasonably assume that theoperating results were typical and that somewhat similar results can be expectedfor the following year.

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However, in any business, unusual and non-recurring events may occur whichcause the current years income to be quite different from the income we shouldexpect 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 businessactivities has been determined.

Income from normal and recurring activities should be a more useful figure forpredicting future earnings.

The three categories of events that require special treatment in the incomestatement are as follows :

a) results of discontinued operations,b) extraordinary items,

c) cumulative effects of changes in accounting principles.

Continuing operations

The first section of the income statement shows the results from continuingoperations. The income from continuing operations measures the profitability ofthe 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 ofcustomers).

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 sub-

totalIncome before Extraordinary Items.

Other unusual gains and losses (e.g. losses because of strikes, or gains/lossesresulting from sale of plant assets) are not considered to be extraordinary items.

It is necessary to distinguish between unusual and extraordinary items. Is theevent likely to happen again ?

Restructuring charges : losses on write-downs or sales of plant assets, severancepay, relocation of operations.

If the restructuring involves discontinued operations, it is considered discontinuedoperations.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 touse the same accounting principles from one period to the next.

However, this does not mean that a business can never make a change in itsaccounting methods. Changes may be made if the need for change can be justifiedand 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 incomestatement of the year in which the change is made.

To compute this one-time catch-up adjustment, we re-compute the income ofprior years as if the new accounting method had always been in use.

The difference between this recomputed net income and the net income actuallyreported in those periods is the Cumulative effect of changes in accounting

principles.

If the income statement includes sub-totals for Income from Continuing Operationsand/or Income before Extraordinary Items, and/or cumulative effect of changes inaccounting principles, the earnings per-share amounts are shown for theseamounts as well as for Net Income.

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EPS from Continuing Operations represents the results of continuing and ordinarybusiness activity. It is the most useful one for predicting future operating results.

Net EPS shows the overall operating results of the current year, including anydiscontinued 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 themeasurement 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. Suchadjustments are called Prior Period adjustments.

A prior period adjustment has no effect on the net income of the current periodand does not appear in the income statement. It is shown in the Statement ofRetained Earnings as an adjustment to the balance of Retained Earnings at thebeginning 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 theirinvestment (Income statement)

Staying solvent : being able to pay debts and obligations when due (Balancesheet).

A third major financial statement : Statement of Cash Flows.

Purpose: to provide information about the cash receipts and cash disbursements ofa business entity during an accounting period. It is also intended to provideinformation 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 + investmentincome received (interest and dividends) cash payments for purchases ofmerchandise and expenses.

We must, therefore, convert the companys accrual basis measurements ofrevenue 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/Ror - 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 solddepends upon changes during the period in inventory and accounts payable.

Cash payments for merchandise =

COGS + increases in inventoryor - 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 totalexpenses measured on the accrual basis. Therefore, in converting accrual- basisexpenses to cash basis, we must deduct depreciation expense and any other non-cash item.

A second area of differences arises from short-term timing differences betweenrecognition of expenses and the actual cash payments. Expenses are recorded inthe 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 itemsand

+ increases in related prepaymentsor - 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 beginningand end of year.Net cash flows from operating activities =

Cash received from customers + Interest and dividends received Cash paid tosuppliers and employees Interest and taxes paid.

B. Cash flows from investing activities

Receipts :- cash proceeds from selling investments and/or plant assetscash 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 itsoperating activities if a business is to survive.

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Creditors and stockholders are reluctant to invest in a company that does notgenerate enough cash from operating activities.

Indirect method

The FASB recommends use of the direct method in presenting net cash flows fromoperating activities. The majority of companies, however, elect to use the indirectmethod.

Companies using the direct method are required to provide a supplementaryschedule illustrating the computation of net cash flows from operating activities bythe indirect method

Net Income

Add : Depreciation

Decrease in A/RDecrease in Interest receivable

Decrease in InventoriesDecrease in Prepaid expensesIncrease in A/PIncrease in Accrued expenses payableIncrease in Interest payable

Increase in deferred income taxespayableNon-operating losses deducted incomputing net income

Less: Increase in A/RIncrease in Interest receivable

Increase in InventoriesIncrease in Prepaid expensesDecrease in A/PDecrease in Accrued expenses payableDecrease in Interest payable

Decrease in deferred income taxespayableNon-operating gains added in

computing net income

= Net cash provided by (used in) operatingactivities

FINANCIAL STATEMENT ANALYSIS

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Financial statements are the instrument panel of a business enterprise. Theinformation contained in financial statements of corporations have been preparedby accountants in accordance with GAAPs, have been audited by CPA firms, andfor publicly-owned corporations, reviewed in detail by governmental agencies (SEC

- IRS).

These financial statements include a lot of financial information that is useful toand used by investors, creditors, and other external users.

Financial statements are designed for analysis. They are :- classified : certain characteristics are placed together in certainclasses; classifications are standardized in most countries.- comparative : they appear side by side so it is possible to evaluatechanges and trends.

Comparative financial statements

Few figures appearing on a financial statement have much significance standingby themselves. It is the relationship of one figure to another and the amount anddirection 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. RatiosDollar and percentage changes

2009 2008 2007

Net sales $ 600$ 500$ 400COGS 370 300 235Gross profit 230 200 165Expenses 194 160 115Net income 36 40 50

2009/2008 2008/2007Amt % Amt %

Net sales $ 10020 $ 10025COGS 70 23 6527Gross profit 30 15 3521Expenses 34 21 4539Net income (4) (10) (10) (20)

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- If a company is experiencing growth in its economic activities, sales andearnings should increase at more than the rate of inflation.- In measuring the dollar or percentage change in quarterly sales orearnings, 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 = $ 100,0002008 net income = $ 10,000

i.e. a decrease of 90 %

2009 net income = $ 100,000i.e. an increase of 900 % !!

Trend percentages

2009 2008 2007 2006 2005 2004

Sales 450 360 330 321 312 300Net income 23 14 21 19 16 15

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

A base year is selected and each item in the financial statements for the base yearis given a weight of 100 %. Each item in the financial statements for the followingyears 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 totalassets. This shows quickly the relative importance of each type of asset as well as

the relative amount of financing obtained from current creditors, long-termcreditors, and stockholders.

Common-size Income Statement : all items are expressed as a percentage of netsales.

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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 withinformation from another financial statement. For example, we might compare netincome with total assets to see how effectively management is using availableresources to earn a profit.

For a ratio to be useful, there must be a significant (logical) relationship betweenthe 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, theyfocus on the companys cash flows and on its working capital since these are thecompanys principal sources of cash in the short run.

Liquidity refers to a companys ability to meet its continuing obligations as theyarise.

Current assets: relatively liquid resources (Cash Marketable Securities AccountsReceivable 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 thecompanys current assets. (Notes payable due within 1 year, Accounts payable,Unearned Revenue, Accrued Expenses).

The relationship between current assets and current liabilities is important. Currentliabilities will be paid in the near future, and cash to pay these liabilities will comefrom current assets.

1. Working Capital

Is the excess of current assets over current liabilities. The amount of workingcapital available to a firm is of considerable interest to short-term creditors since itrepresents assets financed from long-term capital sources that do not require rear-term repayment.

Working capital =Current assets Current liabilities

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It measures a companys potential excess of sources of cash over its upcominguses of cash.

Current assets = $ 180,000

Current liabilities = $ 100,000Working capital = $ 180,000 - $ 100,000 = $ 80,000.

2. Current ratio

Most widely used measure of short-term debt paying ability.

Current ratio = Current assetsCurrent 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 timesas 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 shouldhave 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 deductthem from current assets and we compare only the most liquid (quick) assets withthe current liabilities cash, marketable securities, and receivables (N/R + A/R)

Quick ratio = Quick assetsCurrent liabilities

A quick ratio of 1 to 1, or higher, is considered to be good.

4. Accounts Receivable Turnover Rate and Accounts Receivable Days

A/R T/O rate = Net salesAvg. A/R

A/R days = 365 daysA/R T/O rate

5. Inventory Turnover rate and Inventory days

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Inventory T/O rate = COGSAvg. Inventory

Inventory days = 365 daysInventory T/O rate

b. The long-term creditor

Long-term creditors are concerned with both the near-term and the long-termability of a company to meet its commitments. They are concerned with the nearterm 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 onschedule.

1. Debt ratio

Long-term creditors are interested in the percentage of total assets financed bydebt, as distinguished from the percentage financed by stockholders. Thismeasured by the debt ratio.

Debt ratio = Total liabilitiesTotal assets

The lower the debt ratio, the safer the position of creditors. Indeed, a low debtratio means that stockholders have contributed a higher percentage of thebusiness.

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 companyearns enough income to cover its annual interest obligations by a comfortablemargin.

A common measure of creditors safety is the ratio of operating income availablefor the payment of interest to the annual interest expense, called the interestcoverage ratio or times interest earned.

Interest coverage ratio = Operating IncomeAnnual 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 fromyear 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 Netsales % 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 expensesincurred in producing this revenue.

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